FX and Interest Rate Monthly - November 2010

• ‘Currency wars’ add significant risks to FX markets
  
  After the coordinated international response to credit crisis and recession, FX markets in 2010 clearly reveal political fragmentation as countries pursue mutually contradictory policies to secure incompatible goals of growth and financial stability. High-profile examples, such as yen intervention, renminbi appreciation and further quantitative easing (QE2) in the US, are just the tip of the ice-berg - in just one week there was policy action, currency intervention or rumours of intervention from 25 central banks. FX intervention has a poor track record – witness the failures so far this year of the Bank of Japan and Swiss National Bank to halt appreciation – and can provide potential trading gains for investors. However, we would caution that depreciating a currency, the objective of current central bank interventions, is inherently easier than propping up a failing one. Governments have also been backing it up with administrative measures, taxes on foreign capital flows and warnings over trade restrictions. The potential for escalation into full-blown trade wars and unforeseen side-effects add considerable risk to currency markets..
  
• QE2 means that everything goes up, except the US dollar
  
  Recent statements from the US Federal Reserve suggest that QE2 will be pursued until the threat of deflation has receded. We see the resultant dollar weakness as a ‘carry trade’ – borrow cheaply in dollars and invest in higher-yielding markets elsewhere. The trend can persist, but is inherently unstable given its dependence on investor sentiment. This vulnerability is reinforced if trade flows are in the opposite direction. We expect the recent sharp widening in the US trade deficit to reverse given improvement in export competitiveness, and hence see a stabilisation in the dollar against other developed economy currencies next year. Potential triggers for appreciation are an improving economic outlook and/or signs of an end to QE2.
  
• Fundamentals point to emerging economies and commodity exporters as key winners, with the euro appearing most exposed
  
  Stronger economies make many emerging economies, and developed economies benefiting from this success through commodity exports, attractive to investors seeking better returns. These economies are also in position where they can not only cope with, but increasingly require higher interest rates, which boost returns from holding their currencies, to suppress inflationary pressures. The euro has also been supported by the highest interest rate of the G4 economies and recent moves to tighten liquidity, even as Japan embarks on and the US and UK move towards QE2. However, euro appreciation has only added to the pressure on weaker economies in the euro-zone, highlighting longer-term structural risks to the euro.

• Important Information & FSCS
• Security
• Privacy & Cookies Policy
• Accessibility
• Sitemap