A recovery in risk appetite has been negative for the US dollar. The US dollar has continued to decline towards its trade-weighted lows for the year. In the absence of obvious negative economic data this seems, at least in part, to be a resumption of the carry trade, as investors borrow dollars at increasingly attractive rates to invest in higher-yielding or riskier assets around the world. We believe this will continue to drive the US dollar lower in the short term.
The US seems unfairly targeted as its weaknesses are shared across the developed world. We do not share the very bearish US dollar consensus: we believe that other developed countries’ currencies share the same risks and issues. The recession has been successfully combated by massive deficit spending and unconventional monetary polices, such as quantitative easing (QE), but this has left question marks over government finances and the valuation of fiat currencies, as well as fears of inflation.
Commodity currencies will benefit from higher returns. Amongst the developed world, the commodity exporters have performed strongly. We see scope for this to continue, not just on the back of commodity price strength, but also because their domestic economies are in better shape. As a result, we expect early interest rate increases in commodity economies, with the Reserve Bank of Australia having already announced its tightening bias.
Asian and emerging currencies have old fashioned virtues. We favour emerging Asian currencies for the longer term as a result of positive trade balances, strong government finances and the scope to increase interest rates as recovery takes hold. However, we recognise that continuing concern over the sustainability of the recovery means that no government is likely to welcome currency appreciation in the short term (and the precedents for intervention are now clearly established).
Interest rates will stay low for longer. Rate hikes may come later than anticipated, with fiscal tightening taking priority. Use of QE has reduced in significance and initial signs are that its reversal will not be a significant event, though many countries are not in a position to contemplate such action currently. The need to address ballooning fiscal deficits means that fiscal tightening may take priority over monetary tightening, and forecast interest rate increases could therefore be postponed further to avoid strangling the recovery.
