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This is an excerpt from an article written by Danske Bank. For the full text of the original please visit: http://www.danskebank.com/danskeresearch


The EUR/USD has risen again to a new all-time high of around 1.45. The greenback has thereby weakened close to 9% vis-à-vis EUR since the beginning of the year. But USD weakness is even more widespread, with the DXY index also falling to an all-time low. We argue here that even though the USD weakness is prevailing, it is not inexplicable or out of touch with the factors normally driving USD. In fact, these estimations suggest an even weaker USD and that a level of 1.50 is not far away. We advise, however, that these results should be treated cautiously, since investors might be reluctant to buy EUR against USD at current levels and some latent factors might come into play if USD keeps declining.

A falling USD should in fact be a mystery to nobody. It is consistent not only with relative interest rate trends but also with wider developments in both financial markets and the global economy. Among the key drivers behind recent dollar weakness we note the following:

* Led by emerging markets, the global economy continues to grow well above trend; in particular, Chinese output has been impressively high and thus carries on to be the world's growth locomotive. While USD is a good defensive currency, it performs quite badly in good times.
* US interest rates have fallen sharply relative to other markets during the year. Since the middle of June the 3M US-Euroland spread one-year forward has narrowed by 70bp.
* Oil prices have rallied more than 40% since June, which is directly negative for USD / positive for EUR. Combined with sky-rocketing freight rates this makes energy extremely expensive in the US causing growth to slow down further.
* The stock market has risen rather strongly since the middle of August while equity volatility has slumped. None of that favours USD.
* US house data has of late been frankly terrible. US housing starts are currently at a 14-year low, existing home sales are at the lowest level since the series began in 1999 and new home sales have dropped since late 2005.
* The Fed has performed 'damage control' by lowering rates to help home-owners in distress. Speculation on a new easing cycle from the Fed might have spurred some of the USD sell-off.
* The huge deficit on the current account is the big elephant in the room nobody talks about. There is currently not much attention on this topic and the somewhat weaker USD will to some extent reduce the problem. It can, however, pop up occasionally causing further stress on USD.
* USD tends to under-perform when risk aversion rises. The credit crunch pushed risk aversion to all-time highs and we remain at an elevated level of risk aversion.

As we have argued on a number of occasions during the past few months, US dollar weakness has been entirely consistent with relative economic and financial trends. This continues to be the case. The combination of strong global growth, rising oil prices and relative US weakness is a highly negative mix for the dollar. Hence, we still see no reason to argue that the dollar weakness is driven by structural rather than cyclical factors, nor does EUR/USD strength seem excessive.

The dollar can stay weak for some time. The factors mentioned above are likely to persist - to a greater or lesser extent - for some time. The global economy is still expanding, US yields do not seem to go higher than elsewhere, oil prices might adjust but are still elevated, the stock market is not heading towards a major correction, US housing data is still awful, the Fed has a 'neutral' bias (ie, no tightening bias) and it will probably take some time before risk aversion returns to those levels we saw as 'normal' before the credit crunch.

We run a simple model on EUR/USD based on 3M forward rates, five-year real rates, oil prices, VIX and S&P500 (R2 0.88). Based on these fundamentals, this generates an estimate of 1.48(!). In fact, we are only one standard deviation from the psychologically important level of 1.50. There is - in other words - plenty of room for USD to drop even further. When one adds seasonality effects (USD tends to under-perform at year-end) we would not be surprised if we take 1.50 out soon.

So are there not any risks to this? Of course there are. That is why we take profit at 1.4510 on our long EUR/USD position opened on 10 October. And no-one has ever been blamed for locking in profit. USD has gained 7% in two and a half months. That said, if we see more USD negative factors ahead, we might take another ride upwards. Some investors will be tempted to cash in before a correction, which can be based on a number of things:

* US growth is still strong. Preliminary numbers for Q3 surprised on the upside by rising 3.9% y/y. If Europe could post such growth rates, we would still be celebrating.
* Q3 earnings for US companies have been strong. Around two-thirds have reported better than expected earnings (which, however, is quite normal), ie, the situation for US companies has not been shaken that much by the recent market turmoil.
* US business confidence and consumer confidence are still at reasonable levels, although declining but not unambiguously pointing towards a forthcoming US recession.
* The prospects for growth in the euro zone might have been exaggerated. If that is the case, this will not favour EUR going forward.
* The USD is fundamentally undervalued relative to EUR. Our PPP analysis suggests that EUR/USD should correct towards 1.20 if purchasing power should equalise in the regions. This level is not far away - we were there in March 2006.
* If USD keeps drifting lower, a coordinated central bank rescue plan might be set up to stop the decline. The G7 meeting failed to deliver a common point of view for the delegates but this forum has earlier intervened to correct currency movements considered 'unhealthy'.

Our newly adjusted EUR/USD forecasts are now as follows: 1m at 1.43, 3m at 1.46, 6m at 1.50 and 12m at 1.38.

We will monitor the situation closely as USD obviously is of primary concern. We recommend to hedge USD positions as the uncertainty towards USD is linked with considerable risks at the moment.

Danske Bank
http://www.danskebank.com/danskeresearch

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