Markets remain focused on the impact of the coronavirus, amid wide-ranging lockdowns of most western economies. Despite extraordinary policy measures to mitigate the economic pain, most analysts expect a global recession. Even the best case scenario – lockdowns to be gradually lifted during the second half of April and early May in the US and Europe – would lead to a short-lived recession. However, there is a risk that the global economy suffers a longer downturn. Yesterday, Goldman Sachs said it forecasts a decline of 34% in US GDP this quarter (on an annualized basis). As virus concerns eventually start to fade, the extent of the recession will be crucial for currency markets.
Sterling has found some stability so far this week, and is trading around $1.23 against the dollar and €1.13 against the euro. This represents a significant recovery from the lows of March ($1.14 and €1.05 respectively).This move has been largely dollar driven, due to an easing of demand for the US currency as central banks pumped billions of dollars of liquidity into markets. However, this is probably a temporary backstop and the demand for dollars is likely to continue at some point.
Most factors are working against sterling right now: Ratings agency Fitch cut the UK credit rating last week, saying the country’s debt would surge as the government ramped up spending to help the economy. Also, the Bank of England has cut interest rates to 0.1% and virtually erased sterling’s yield appeal over the euro. Another factor is the UK’s high current account deficit, which makes sterling vulnerable when capital flows dry up. Finally, the UK and EU focus on fighting the pandemic means less time to negotiate a trade deal before the end of the year. Some banks are forecasting that the pound will again drop below $1.20 and €1.10 at some point, although forecasts are almost impossible given the current uncertainty. Forward contracts are recommended, to hedge known requirements and provide some certainty in such volatile markets.
Using the 2008 financial crisis as a guide, suggests we may soon see another period of dollar strength. The dollar is the currency of choice in global commerce (used in 90% of all currency transactions) and investors tend to head for safe and liquid assets at times of uncertainty. In 2008, the dollar strengthened over 20% due to overseas demand and gained again in early 2009 as equities bottomed out. This time, demand and supply shocks caused by the virus could last indefinitely and companies and investors are likely to hoard dollars as cash in the meantime. Historically, looking at previous recessions, it is the US economy that normally leads an eventual rebound in global growth, further supporting the dollar.
Source: AFEX, 01 April 2020