Race for weakness to see euro, sterling gain in 2013

Fri Jan 4, 2013 10:39am EST

Related Topics

* Fed and BOJ asset buying to undermine dollar, yen

* Euro and pound to benefit despite dour growth outlook

* Yen "carry trades" may drive currency markets in 2013

By Anirban Nag

LONDON, Jan 4 (Reuters) - The yen and dollar face a tough 2013 as the Japanese and U.S. central banks print money furiously to stimulate their economies, making the euro and sterling unlikely relative winners despite Europe's gloomy prospects.

With a global economic recovery looking shaky, analysts say the major central banks will be happy to see their currencies weaken this year if it helps their exporters to become more internationally competitive.

This could trigger a round of competitive devaluations among the world's most heavily-traded currencies, with Japan a likely winner in this race for weakness as its new government tries to end decades of regular recessions and deflation.

Currency forecasting is notoriously difficult and movements often seem at first to lack logic. For instance the euro rose 1.8 percent against the dollar in 2012 despite the threat of a euro zone break-up, although the gains followed a European Central Bank promise to safeguard the currency union.

Undaunted, analysts expect the yen to be the worst performer, while the dollar may lag the euro and the pound even though the United States is likely to outperform the euro zone and British economies in 2013.

This is because the U.S. Federal Reserve plans to flood markets with a trillion dollars in stimulus this year by buying mortgage and government bonds, pushing down the value of the U.S. currency. Similarly, the Bank of Japan is preparing to pump trillions of yen into its stagnant economy.

Their actions should outstrip any similar move by the Bank of England, which has paused its printing presses, or the ECB. In the foreign exchange market, where a currency is always valued relative to another, a fall in the dollar or yen will push the euro and sterling higher.

"Major central banks printing more money and debasing the most liquid currencies is a major theme that will play out in the currency market this year," said Tom Levinson, FX strategist at ING, referring to the Fed and BOJ.

Some investors will not necessarily trade one major currency for another and instead opt for the likes of the Australian dollar. "What this liquidity injection will spark is a push towards less liquid and more risky currencies," Levinson added.

Flooding markets with dollars and yen will help to gloss over any weakness in the euro and the pound caused by the struggling economies of Europe.

"Central bank action, especially that of the Fed and the BOJ will help paint over cracks in the macroeconomic picture, both in the euro zone and UK," said Jane Foley, senior currency strategist at Rabobank.

"Currencies will not move in a straight line. But we expect the euro to rise against the dollar to $1.35 in the medium term. The dollar will generally have a poor year, as will the yen."

The euro is trading now around $1.3050, having gained rapidly after the ECB conditionally promised in the late summer to buy bonds of struggling euro zone countries, should their governments seek international aid.

Since then, no government has requested a bailout and Spain says it does not need help at the moment. However, should the ECB start buying bonds, its programme would differ significantly from those of the Fed or BOJ. Its objective would be to help governments continue borrowing commercially at affordable interest rates, rather than stimulating the euro zone economy.

With Germany wary of anything that might be inflationary, ECB policymakers have promised not to crank up the euro printing presses. Any money spent on bonds would be "sterilised", meaning the ECB would withdraw equivalent sums from the banking system.

Early signs of the trends forecast for this year are already apparent. The euro rose 15 percent against the yen in 2012, hitting a 1-1/2 year high this week.

The pound stands at multi-month highs against the dollar and yen, mainly because of the dollar and yen weakness and not because of a British economic turnaround, traders said.

CARRY TRADES

The Fed has already made heavy asset purchases which have expanded its balance sheet. Some Fed policymakers have expressed concern about the long-term risks of this, even though they look set to continue the open-ended stimulus programme for the moment.

John Normand, head of global FX strategy at JPMorgan, said the Fed and BOJ actions would boost the balance sheets of major central banks by about 10 percent this year, on a par with the pace seen in 2012 when both the yen and the dollar lagged the euro and sterling.

The large cash injections have prevented a sharp contraction in economic activity and restricted swings in foreign exchange markets, making it harder for investors to make money in the most traded currencies.

That has driven many to take bigger positions in the less liquid and riskier currencies and Normand said the flood of liquidity in 2013 will ensure investors keep using "carry trades" in the search for higher returns.

In carry trades, investors such as hedge funds borrow money in the more liquid and low interest-bearing dollar and yen to buy higher-yielding currencies like the Australian dollar .

Reflecting the expected slide in the yen, it will emerge as the favourite funding currency in 2013, analysts said.

"We would expect the yen's use as a funding currency to broaden in the coming year," Morgan Stanley said in a recent report, forecasting the dollar to rise to 90 yen in the coming months from around 88 yen on Friday.

DOLLAR WEAKNESS

While the yen and the dollar are likely to struggle, any glimmer of recovery in the euro zone and Britain - where investors have priced in expectations of a prolonged slowdown - could give both the euro and the British pound a fillip.

BNP Paribas strategists expect sterling to outperform the euro and the dollar. The bank expects the euro to drop to 80 pence in a few weeks, from around 81.20 now, and forecasts sterling at $1.68 in coming months, from $1.60, once global recovery gathers pace and UK exports pick up.

While the euro may lag the pound it could rise against the dollar, drawing support from the ECB's promise to do whatever it takes to preserve the euro and the fact that the Fed will be pumping in more dollars.

"What looks absolutely assured is that in the first half of 2013, the Fed's balance sheet will expand significantly more than the ECB assets," said Alan Ruskin, macro strategist at Deutsche Bank, adding this was likely to lead to a lower dollar.

Ruskin expects the ECB's balance sheet to shrink slightly by 100 billion euros until it starts any bond purchases.

"While uncertainties remain in the euro zone, as well as a weak growth outlook, we view the euro is likely to remain supported and reach $1.35 by end-Q1," BNP Paribas said.

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