The major themes of risk and recovery have dominated FX and other markets over the past year. The scale of the market collapse in 2008 and recovery in 2009 were sufficient to overwhelm all other factors. A binary trading environment has prevailed, with the US dollar and the yen on one side and practically everything else on the other side. It mirrored the same division between the safe haven of government bonds on one hand and risk assets, especially equities and commodities, on the other. As some stability returns to both the global markets and global economy, there is scope for other, currency-specific factors to regain greater influence over currency moves.
The reversal of the ‘carry trade’ has supported the US dollar. The current sell-off in risk assets has again coincided with a period of US dollar strength. A direct connection is the ‘carry trade’ where dollars, whether borrowed or part of investment portfolios, are invested in foreign-currency-denominated risk assets. A correction in risk assets, prompting an unwinding of these positions, means that as investors return to the 'safe haven' of US Treasuries they will move back into dollars.
Greece’s debt crisis has produced independent euro weakness. While the break-up of the eurozone remains a distant possibility, the direct and indirect costs of bailing out the Greek government will continue to weigh on the euro. A bail-out would represent an additional injection of euros into the market, while the tighter fiscal policy required of the Greek and other national governments further postpones any potential tightening of monetary policy. We do not forecast an interest-rate hike by the European Central Bank within the next twelve months.
Government policy remains a key driver of currency markets. Policy decisions are likely to be the key driver of emerging currency markets. With a swift recovery, having avoided many of the worst affects of the financial crisis, many emerging countries now face the options of higher inflation, higher interest rates or higher exchange rates. We expect the eventual outcome will include a significant appreciation of emerging market currencies against developed country currencies. By contrast the policy of the Swiss and Japanese authorities has been directed to preventing currency appreciation, as investors seeking ‘safe havens’ threaten to bid up their currencies to levels that endanger export competitiveness and therefore economic recovery in these countries.
