Schroders Currency market perspectives Paul Duncombe Global Head of Strategic Solutions March 2009
Key points: Our valuation models suggest that the US dollar/sterling exchange rate is now just inside fair value, indicating that the medium-term upside for sterling has been somewhat reduced. With both US and UK rates likely to stay at current low levels for at least another 12 months, our estimates for where the exchange rate is fairly valued are likely to remain stable around current levels. Sterling still appears to be undervalued against the euro, with the sharp fall in the euro at the start of the year being reversed when quantitative easing was introduced in the UK. The current valuation boundaries suggest that the euro needs to fall to about 0.80/eur to bring it back into fair value. While quantitative easing has undermined sterling recently, we expect that the ECB will be forced to cut rates over the next few months which will weaken the euro. Our valuation models indicate that the euro is fairly valued against the US dollar. The introduction of quantitative easing in the US far earlier than expected has caused us to neutralise our positive dollar view. However expected future reductions in European rates will likely result in a resumption of euro weakness towards the summer. With the euro close to its upper valuation boundary against the dollar, we expect any euro upside to be limited. The combination of the fair value boundaries drifting down and the dollar rising has brought the dollar/yen exchange rate just back into fair value territory. We believe that the current trend will continue as the Japanese authorities face collapsing export markets and have always historically resisted yen appreciation below Y90/USD. Volatility in foreign exchange markets back Since the last review in early December, volatility in the foreign exchange markets had abated somewhat with exchange rates reversing some of the large moves seen in the fourth quarter. There was a final flurry of volatility in December where the usual lack of liquidity at year end exaggerated some upward movements, particularly in the euro and Swiss franc, and then a period of relative calm in the first two months of 2009 as some stability returned to the market. However the recent moves by the Bank of England and the Federal Reserve to introduce quantitative easing have caused the pound and dollar to fall sharply. The move by the Fed took the market by surprise, as it has started much earlier than anticipated, and the dollar has weakened significantly. The Swiss authorities have also taken steps to prevent appreciation of the Swiss currency. The SNB announced that it would purchase foreign currencies as well as introduce quantitative easing measures. The currency duly weakened on the news. Even though risk assets have been recently testing new lows, the foreign exchange markets are not behaving in the same way as they did last year when risk assets were falling. The second half of 2008 saw the large scale unwinding of the carry trade, with the chief beneficiaries being the dollar and yen. The yen continued to appreciate into December as short-term investors took advantage of the trend in the currency to put on anti-carry trades, taking long positions in the Japanese currency. As we noted in the last review, the moves in the yen in 2008 had already driven it to levels which appeared unsustainable on a valuation basis and were likely, in our opinion, to result in a reversal at some stage in the first half of 2009. The appalling economic data (for example, industrial production -26% qtr/qtr in Q4) coming out of Japan in January and February have already triggered the start of that reversal. Sterling has weakened against other major currencies Summarising exchange rate movements over the last three months to the end of February, the pound has fallen by 7% against the dollar and euro, and by 5% against the yen. The US dollar was very slightly up against the Australian dollar, but was down by about 4% against the Swiss franc. The pound has been the weakest currency over the last three months, although the moves have been more muted than in the second half of 2008. The economic situation in the UK is poor and has similarities to the US, but the weakness partly reflects the state of the UK banking sector and the acknowledgement by the UK authorities that monetary policy alone will not be sufficient to stimulate lending and revive the economy. The announcement that the Monetary Policy Committee will introduce quantitative easing did weaken sterling, but ultimately it will turn out to be one of the essential steps in the road to recovery.
Eurozone under pressure While the sorry state of the UK banking sector has attracted headlines, Europe has its own set of different, but equally significant problems. Both the unique structure of the euro and the inability of the European Central Bank (ECB) to issue bonds have combined to put the whole common currency project under strain and intense scrutiny. Comments from the ECB since the turn of the year show that board members now realise the severity of the crisis in Europe. Interest rates were cut 50 basis points in January and again at the March meeting. The markets are also aware of the problems that individual countries face from a lack of control of interest rate and exchange policy, especially in the case of the newer eastern members. These factors had combined to undermine the euro in recent weeks and push it down. While it is currently experiencing resurgence against the other G-3 currencies, the medium term economic prognosis is just as bad. Given that the US and UK are further along the path of attempting to resolve their financial problems, the euro will still face further downward pressure as both the EU and ECB search for solutions which will very likely require large interest rate cuts as well as large and unpopular fiscal transfers from richer to poorer countries. Valuation trends Turning to our valuation models, we can see in our US dollar/sterling model that the fair value boundaries have continued to fall faster than the exchange rate over the last few months. The exchange rate is now just inside fair value, indicating the medium-term upside for sterling has been reduced, as at levels above $1.70 sterling would move into overvalued territory. With both US and UK rates likely to stay at current low levels for at least another 12 months, we are unlikely to see any change in the valuation boundaries from a change in interest rate policy in either country. Figure 1: US dollar/sterling valuation model 2.40 2.20 2.00 1.80 1.60 1.40 1.20 Mar-92 Mar-93 Mar-94 Mar-95 Mar-96 Mar-97 Mar-98Mar-99Mar-00Mar-01Mar-02Mar-03Mar-04Mar-05 Mar-06 Mar-07 Mar-08 Source: Schroders, as at 27 February 2009 Page 3
Sterling still looks undervalued against the euro Sterling still appears to be undervalued against the euro, with the sharp fall in the euro at the start of the year being reversed when quantitative easing was introduced in the UK. The fair value boundaries are still gently trending upwards, but this trend will be slowed if the ECB brings eurozone rates down to the same level as UK rates, which is quite likely. The current boundaries suggest that the euro needs to fall to about 0.80/eur to bring it back into fair value. In the short term, the euro may well resist this reversal, but we would not expect it to hold out beyond the early summer. The position for the euro against the US dollar is not dissimilar to its position against sterling. While the fair value model is indicating that the euro is fairly valued, the exchange rate is close to the top of the fair value range. This suggests that the euro will have a harder time rallying significantly than it will falling. The boundaries are also quite stable and appear unlikely to move much in either direction in the next few months. Figure 2: Sterling/euro valuation model 1.10 1.00 0.90 0.80 0.70 0.60 0.50 Mar-92 Mar-93 Mar-94 Mar-95 Mar-96 Mar-97 Mar-98Mar-99Mar-00Mar-01Mar-02Mar-03Mar-04 Mar-05 Mar-06 Mar-07Mar-08 Source: Schroders, as at 27th February 2009 Page 4
Figure 3: US dollar/euro valuation model 1.80 1.70 1.60 1.50 1.40 1.30 1.20 1.10 1.00 0.90 0.80 0.70 Mar-92 Mar-93 Mar-94 Mar-95 Mar-96 Mar-97 Mar-98Mar-99Mar-00Mar-01Mar-02Mar-03Mar-04Mar-05 Mar-06 Mar-07Mar-08 Source: Schroders, as at 27th February 2009 Downward trend for the yen set to continue Turning to the yen, a combination of the fair value boundaries drifting down and the dollar rising has brought the exchange rate just back into fair value territory. As noted earlier, this move was not unexpected, especially as the yen has been overvalued against all three of the other major currencies. We believe that the current trend will continue as the Japanese authorities have always historically resisted yen appreciation below Y90/USD. Any efforts to stimulate domestic demand will face an uphill battle with the shrinking and ageing population, and so the export sector remains critical for any recovery in the economy. Given the strong correlation between plunging exports and appreciation in the yen, the authorities will welcome any fall in their currency. (Chart on next page) Page 5
Figure 4: US dollar/japanese yen valuation model 180 160 140 120 100 80 60 Mar-92 Mar-93 Mar-94 Mar-95 Mar-96 Mar-97 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Source: Schroders, as at 27 February 2009 Important Information: The views and opinions contained herein are those of Paul Duncombe, Global Head of Strategic Solutions, and do not necessarily represent Schroder Investment Management Limited s house view.. This document is not suitable for retail clients. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA, which is authorised and regulated by the Financial Services Authority. For your security, communications may be taped or monitored. Page 6