FX Forecast - A Beauty and The Beast

I like Yen and fear about the sustainability of the EUR. So far, the US is doing the right things to combat deflation whereas European policy remain active – not cutting rates enough and not easing fiscal policy aggressively.

I think the Euro as a concept will come under tremendous pressure in 2009. Economic growth and productivity misalignment among members will becoming more visible and there are estimates that countries like Spain and Ireland may need 20-30% fall in wages relative to elsewhere in Europe, owing to an overvalued real exchange rate. There is considerable excess leverage differences among member countries and now will these countries be willing to deflate to restore competitiveness, hence an equilibrium in their external accounts with the potential of a severe recession. It is very likely that this will not be the preferred option and most likely they will choose to spend their way out of this.
On the other hand, Germany is likely to fare worse than the Eurozone in 2009 due to its higher exposure to cyclical industrial export demand compared to its peers. Support of German internal demand via fiscal stimulus is only possible solution in the medium term. Plunging business surveys paint a bleak picture going forward.

As a result, bond spreads will rise on the back of fiscal reflation, in turn could have a very large contraction in domestic demand and potentially to the sustainability of the common currency.

By default, the Yen looks to be the strongest currency. Consumers, corporates and banks have de-leveraged for nearly a decade and with its high gross saving of 27% of GDP, it makes Yen not that expensive relative to its norm.

In short, market will eventually realize that Europe cannot live with Euro strength and the divergence of strengths in favour of UK may force the Euro possibly to parity level, if not slightly above the parity in late 2009.