European bail-out leaves the FX markets awash with euros. European policymakers finally got ‘ahead of the curve’ with a €750bn rescue package on 9th May, extending support to any euro-zone member facing difficulty financing its debt. However, the associated fiscal consolidation now planned increases deflationary risks for the region, while the new policy also transfers credit risk from peripheral to core euro-zone nations. After the initial sharp rally in the euro, the prospect of weak growth, low interest rates and an erosion of ECB independence look set to continue weighing on the euro.
The US dollar re-exerts its status as reserve currency. With even the Chinese buying US Treasuries again, the Greek crisis has clearly derailed hopes for the euro to replace the dollar as the dominant reserve currency. While the US shares the huge deficit and debt problems of most developed economies, its economy is enjoying a healthy recovery. The dollar is likely to be supported as a safe haven and by our forecast for US interest rates to be raised ahead of other major economies.
Sterling and the yen look less bad than the euro, although with few reasons to be positive. Sterling is set to recover some lost ground versus the euro, with the euro-zone having taken over from the UK as the focus of concerns over deficit and debt levels. However, the new UK government’s commitment to fiscal consolidation is likely to bring subdued economic growth and keep interest rates low. By contrast, Japan’s ability to repatriate substantial overseas assets gives the yen ‘safe haven’ attraction in times of uncertainty, but the government’s verbal intervention and calls for quantitative easing makes us negative.
Weak euro-zone demand will hit emerging and commodity currencies, but their government finances are strong. Fiscal consolidation across much of the developed world will be a further drag on the global recovery, weighing on the currencies of emerging economies and commodity exporters, which are geared to the strength of global growth. Notably, the Australian dollar has lost 7% against the US dollar so far in May. However, commodity and emerging-market currencies also have other fundamental attractions including strong government finances, positive trade balances and expectations of higher interest rates.
Interest rate increases postponed again. With the two-year German bonds yielding 0.6%, below official ECB rates, it is clear the prospect of a rate hike is more distant than before, whether or not the ECB actually cuts interest rates or moves beyond the current plan of ‘sterilised’ intervention, swapping European Union funds for troubled member states’ debt. Indeed, the euro-zone’s crisis has reduced global growth and inflation expectations, pushing out rate-hike forecasts for the rest of the developed world and even emerging economies.
