FX and Interest Rate Monthly - August 2010

• European bank stress tests give euro a short-term boost.
  
  The euro has rallied in response to the announcement of the European bank stress tests. These tests are a demonstration of increased political and financial commitment to EU institutions by member states. Hence investor fears of an imminent break-up of the eurozone have been allayed. Our estimates of the potentially punitive costs of leaving the eurozone, with the loss of up to 10% of the departing country’s GDP and an additional 1% for the rest of the euro-zone, suggests that no government is going to opt for the exit while viable alternatives remain. However, our concerns over longer-term structural issues within the euro-zone remain, so we continue to have a negative view on the euro and would recommend using the recent rally to reduce exposure to the currency.
• Fiscal strength will be a key support for currencies, whether recovery continues or not.
  
  While the global economic recovery continues, the fiscally ‘good’ (Canada, Norway, Sweden and most of Asia and Latin American) will see interest rate hikes to return monetary policy to ‘normal’ levels. If growth disappoints, these countries have fiscal flexibility to offset the worst of the downturn. By contrast the fiscally ‘bad’ (US, euro-zone, UK and Japan) are in trouble whether economic recovery continues or not. If it continues, the need for fiscal consolidation means that interest rates need to be held low for longer. Additional quantitative easing will be required to address any slowdown. Consequently, we reiterate our preference for currencies supported by relatively healthy fiscal positions.
• For the main developed economies rates will not just be low for longer - additional measures will be necessary.
  
  We forecast that growth next year will disappoint current expectations. This leaves us not only expecting that interest rates will remain low for longer, but that central banks of all the major developed economic regions will take a second look at unconventional measures to increase the supply of credit in the economy. While the timing of unconventional monetary measures could influence short-term direction and add volatility to the major currency markets, we forecast that the major long-term trend in exchange rates will be the continued appreciation of the currencies of emerging economies. In terms of the major currencies we are most negative on the longer-term structural problems of Japan and the euro-zone. The US should outperform on the back of a better underlying growth trend and its status as a reserve currency. The UK also appears relatively better placed on the basis of a more coherent political and economic policy response to its problems.

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