The dollar is oversold and poised to rally on any better news. When sentiment is very negative, currencies can rally even if the news, on the face of it, is poor. We believe that the current weight of negative expectations is likely to constrain any further weakness of the US dollar. We remain cautious on the outlook for the US economy, which faces problems left over from the liquidity crisis. Yet we calculate that the US dollar is clearly undervalued and so will rally as the economic recovery is confirmed, however weak and hampered by US consumers' woes that recovery proves to be.
Global re-balancing means the reversal of some fundamental trends. Global rebalancing has finally arrived in the aftermath of the crisis. The US trade deficit has halved over the past year, falling to under $44 billion from a peak of $94 billion in July 2008. This has had a corresponding impact on its trade counterparties, cutting exports around the world. As a consequence, an increasing proportion of the huge federal deficit will be financed by domestic savings, relieving some of the downward pressures on the dollar.
Sterling appears overvalued. Sterling has rallied during the market recovery. A return of economic growth would reduce the stress on the fiscal deficit and remove any need for further quantitative easing (QE), while sterling assets appear cheap, with the pound still 20% below its ten-year average. However, the Bank of England has extended QE, and the government’s fiscal policy is unlikely to be clear until after the next general election. We therefore forecast that sterling will give up some of its gains, though overseas asset purchases will be supportive, especially if capital markets are strong.
The unwinding of QE has already started. Both the nature and the scale of the measures adopted to address the liquidity crisis were unprecedented. That has prompted concerns over their impact and the likely difficulty of unwinding these measures. Yet the process has already started as participation in certain schemes has fallen, with total credit extended to banks down to less than $600 billion from $1.5 trillion at the start of the year, as the cost and access to the market has become more attractive. The current strategy seems to be to focus on the withdrawal of QE before increasing interest rates – underpinning our forecasts that interest rates will remain at current ‘rock-bottom’ levels into next year and, in some cases, the year beyond.
