Swiss franc and yen will win if US slows

New York: A United States economic slump would likely see investors sell the United States dollar and the currencies of commodity exporters such as Australia and instead support lower-yielders such as the Swiss franc and the Japanese yen.

That's exactly what has happened since Thursday, when a closely watched index of regional manufacturing activity from the Philadelphia Federal Reserve saw the first negative reading in more than three years, intensifying worries that the United States economy is heading for trouble.

If history replays itself, this pattern is likely to hold into 2007, when many economists expect the United States to be well into an economic downturn, if not outright recession.

"The reaction we've seen since the Philly Fed is just a taste of things to come," says Naomi Fink, senior currency strategist for BNP Paribas in New York.

"We should see broader-based dollar weakness, we should see underperformance in the commodity currencies, and we should see the euro being the first beneficiary of the dollar's weakness."

History shows that a United States economic slowdown will also slow global growth, and weaken commodity prices.

That bodes ill for the currencies of "dollar-bloc" countries Australia, New Zealand and Canada, which need commodity exports to maintain economic growth.

The Australian dollar has fared worst, on average falling around 8.0 per cent on a trade-weighted basis, while the winners are usually the Swiss franc, the euro and the yen.

There are plenty of reasons to think this pattern may repeat itself.

First, analysts cite signs that Europe's economy is holding up fairly well in spite of a United States slowdown, implying that euro-zone and Swiss interest rates could rise higher, narrowing the dollar's rate advantage.

A recent report by global banking group HSBC shows that in the past two decades, the Australian, New Zealand and Canadian dollars have been the biggest losers in times of a downturn in the global economy.

The European Central Bank has raised rates four times since December, and most economists expect it to do so twice more before year-end, bringing its key rate to 3.5 per cent.

This could put the euro first in line to benefit from a weaker dollar. Many economists also expect Japan's economy to stay resilient in the face of a United States slowdown, giving the Bank of Japan reason to nudge rates up from 0.25 per cent.

"Given the prospects for growth in Japan and in Asia you would certainly expect the yen to gain against the dollar," said Richard Clarida, global strategy advisor in New York for the United States bond fund manager PIMCO, which oversees $617 billion.

Clarida said the yen could strengthen to as much as 105 to the dollar in the coming year, while the euro could revisit record highs of $1.3670 scaled in late 2004.

The dollar was trading at 116.50 yen on Friday and is down around one per cent this year to date. The euro is currently at 1.2785 and has gained eight per cent since the end of 2005.

Of course, not all market watchers agree that the United States economy is about to slow down sharply.

Some say more bad news on the economy, and evidence that the global economy is cooling, might be needed before writing off commodity currencies and those of emerging markets such as Mexico and Brazil, which are closely tied to the global economic cycle.

"It's tempting to get sucked into this, but while my heart says go with it, my head is not convinced," says Richard Franulovich, currency stratagist at Westpac in New York.

Soft data this week has encouraged a view that the Federal Reserve is likely to keep its key rate at 5.25 percent for the time being, after luring global investors to the dollar with 17 consecutive rate rises in a two-year period from June 2004.

In fact, some market watchers, including BNP Paribas, expect the United States central bank to begin cutting interest rates to shore up a wobbly economy from as early as Dec-ember.

Lower rates could make it harder for the United States to attract the $3 billion of foreign capital every working day that it needs to plug its gaping current-account deficit, and that would hurt the dollar.

After adjusting for differences in inflation, the yen has been battered to a more than two-decade low on a trade-weighted basis in recent months, as speculators sold the currency for higher-yielding Australian and New Zealand dollars.

If the commodity currencies stumble, as many analysts expect, investors will have to buy back yen to bail out of these trades, thus supporting the Japanese currency.

The benchmark Reuters Jeffries CRB index, which covers 19 commodity futures including crude oil and gold, touched a 14-month low last week and has fallen 16 per cent since the Fed halted its tightening cycle in early August.

"We think it's prudent at this point in time to be building a short dollar-bloc stance," says David Mozina, head of currency strategy for Lehman Brothers in New York.

Slower economic growth in the United States could deal a particular blow to Canada, which relies on the United States market for about 80 per cent of its exports, Mozina said.

"If the United States sneezes I don't think Canada catches a cold I think it might actually get pneumonia," he added.

A recent report by global banking group HSBC shows that in the past two decades, the Australian, New Zealand and Canadian dollars have been the biggest losers in times of a downturn in the global economy.