Strategy Report

Currencies, Oil, Gold: Global Macro Forecast

If 2008 seemed like the last gasp of life across financial markets, then 2009 was a collective sigh of relief. As central banks dropped interest rates to record lows and governments frantically doled out some $2 trillion dollars in stimulus, the sheer panic that seized investors after the collapse of investment banking giant Lehman Brothers began to recede: the sharp declines in leading economic indicators began to slow, credit markets showed cautious signs of life, and a glimmer of hope began take root across the world’s exchanges. The first quarter proved dismal, but by March a sense that Armageddon had been averted had started to become the consensus view.

What happened next can only be appreciated in light of the carnage of the previous year. Having stared down a near-collapse of the global financial system, overjoyed investors began piling into so-called “risky assets”, setting off sharp rallies in equities, commodities, and high-yielding currencies. Sure, the world economy was far from healthy, but anything that was better than the dark days of late 2008 was good enough. This also brought a sharp decline in the US Dollar, which had previously banked on the sophistication of US financial markets and its unparalleled liquidity and flourished amid the mayhem as a natural safe haven asset. The result was a bipolar marketplace torn between “risk” and “safety” where gains in the Dollar meant declines across nearly every major asset class, and vice versa.

Eight months hence, capital markets have advanced to lofty levels: the MSCI World Stock Index equity benchmark has returned to pre-Lehman levels and are trading at the highest levels relative to earnings since 2002; crude oil is pushing $80/barrel having bottomed near $41 in January; gold is setting record highs above $1100; and high-yielding currencies like the Australian and New Zealand Dollar have retraced close to 80% of the drop that began last year. With the worst now increasingly behind them, however, investors seem to be gaining a sense of sobriety after the intoxicating exhilaration of surviving the credit crunch. The sustainability of the recovery after stimulus is withdrawn and concerns about runaway inflation as a result of ultra-loose monetary policy crop up more and more often, with calls for a retracement of the risk rally starting to mount in earnest. Indeed, October may yet prove to have been a watershed month as the MSCI World Stock Index dropped the most in since February while the VIX index of US stock options volatility that is often seen as a proxy for investors’ risk aversion gained the most in a year. As 2009 comes to a close, we examine the macroeconomic trends that are likely to play out in the year ahead.

Guided by Risk – Euro, Swiss Franc and the ‘Commodity’ Dollars

As the currency of the world’s second-most liquid and developed financial market, the Euro is the natural antithesis to the US Dollar and so will tend to rise and fall on the greenback’s fortunes. It is no wonder then that the EURUSD exchange rate is tightly linked to global equity markets considering the US unit’s standby safe-haven asset status. To that effect, the continuity of the stocks rally is the critical question driving EURUSD trading, with any correction lower likely to carry the pair along for the ride. Further, the Euro’s exchange rate to the Dollar is consistently about 99% inversely correlated with that of the greenback’s value against the Swiss Franc, suggesting that whatever happens with EURUSD is likely to be mirrored in USDCHF.

The so-called “commodity dollars” are also an all-but-pure reflection of the risk versus safety dichotomy. This is particularly the case with the antipodeans, who boast the highest interest rates in the G10 and so are the most attractive buys for yield-seeking “carry” trades. Reasonably, FX carry trades flourish when investors value returns over safety, making the Australian and New Zealand Dollars over 90% correlated with global stock performance (as measured by the MSCI World Stock Index).

Where Interest Rates Still Matter – The British Pound

The Pound is one of the few major currencies amid the polarized world of risk versus safety trading that is being driven by the most traditional of currency market catalysts: interest rates. Indeed, GBPUSD shows an impressive 85% correlation with the spread between next year’s March and December 90-day UK interest rate futures, the difference between priced-in borrowing costs in the first and the fourth quarters that reflects the market’s expectations for Bank of England monetary policy for 2010. For the moment, traders seem to be betting that the Fed will lag behind the their counterparts at the BOE, but this may soon change considering UK policymakers decided to expand their “unconventional” monetary stimulus measures (known as quantitative easing) while in the US the bank has been slowly but deliberately moving to unwind similar programs, hinting that perhaps Ben Bernanke will beat Mervyn King to raising benchmark borrowing costs and send the greenback higher.

Marching to Its Own Drumbeat – The Japanese Yen

The trajectory of the Yen is shaped largely by the impact of cultural factors on economic life in the world’s second-largest economy. Japan’s savings rate is high relative to other developed countries, reflecting the high cost of living on an island with limited space and scarce home-grown resources. This translates into Japanese investors’ preference for safe, liquid assets that offer a stable income over a long period of time. Typically, this means US Treasury bonds. Understandably, this means USDJPY is closely correlated with the Treasury yields. The relationship may prove to guide USDJPY higher in the year ahead with the US budget deficit set to hit a record-high11% of GDP this year and remain dangerous 9% in 2010: the Treasury will need to issue an unprecedented amount of debt to finance the shortfall, driving prices lower and sending yields and consequently USDJPY soaring in the process.

Hedging Against ‘The Great Inflation’ – Gold

The decision to effectively “print” money to secure adequate credit access on the part of the world’s top central banks has produced a spectacular rally in the price of gold. Ever the standby store of value, the metal has proved attractive as a hedge against what investors fear will be a period of runaway inflation as record-low interest rates and churning printing presses flood the market with currency and send prices soaring. However, it seems plausible the “great inflation” may not come after all. Focusing specifically on the US (as gold is priced in Dollars), the money multiplier ratio that determines the total impact on the Fed’s liquidity injections on the money supply has fallen to the lowest level in over 25 years at about 0.8. Meanwhile, the velocity of money (the speed with which it changes hands) has fallen to the lowest level since 1987. Put simply, this means that any newly-created supply is being absorbed into the economy at the slowest pace in over two decades, and with only about 80 cents of each Dollar that the Fed prints actually coming through. If this proves to show that concerns about an imminent spike in inflation have been overstated, a downward gold correction will not be far behind.

Playing Catch-Up with Speculators – Oil

As many other commodities, crude oil began to rebound as risk appetite reversed course higher in March 2009. The speculative nature of the rally is not difficult to identify: data on net positioning in the light, sweet crude contract from the US’ Commodity Futures Trading Commission shows that commercial long positions have been consolidating near 6-year lows since September 2008, while speculative positioning surged to the highest level in at least 26 years in October. In the near-term, this makes oil prices as vulnerable to a downward correction in risk sentiment as stocks and related currencies (see above). Looking further out, however, the big question is whether global demand can catch up to underpin prices at relatively higher levels. Separate forecasts from the IMF, the IEA and OPEC concur that this year will see the first meaningful decline in energy demand, with a shallow rebound of about 0.4% expected in 2010 on the back of global stimulus efforts. However, even such a modest rebound may prove too optimistic if: governments and central remove stimulus too soon, mistaking a brief policy-induced reprieve with the beginnings of a true recovery; or, if speculatively-driven oil prices rise so high as to cripple the recovery and weigh on demand. The latter seems imminent, considering OPEC has recently noted that oil at $90-100/barrel would be a significant hurdle to global output even as crude traded within a hair of that range near the $80 level.