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FX and Interest Rate Monthly - October 2010

• FX markets have seen participants take off risky positions – but a changing outlook suggests a return to the market.
  
  An August correction in the dollar was driven by the closing of June’s record net short speculative positions in the futures market in both the euro and sterling against the US currency. This move left the market broadly flat, with only relatively small positive bets on the ‘safe havens’ of the yen and Swiss franc. This clearly reflects investors’ uncertainty over the economic and market outlook, with low-risk and defensive strategies predominating. However we would not expect this stance to persist as we move towards 2011, as the data either confirms continued growth (our central scenario) or a double-dip return to recession (the key risk). We also anticipate a second round of quantitative easing, starting with the US, and these key turning points are likely to be reflected in renewed volatility in FX markets.
• First among equals – why we prefer the dollar to the other G4 currencies.
  
  We remain strategically negative on all the currencies of the major G4 developed economies dollar, yen, euro and sterling. The combination of an overhang of consumer and/or government debt and a damaged banking sector are likely to constrain the recovery and future trend rate of economic growth. In this environment there will be continuing pressure from these economies for currency devaluation to boost exports. Against this background we believe that the US dollar appears better placed compared with the other G4 currencies. The dollar has already seen significant weakness since June, while the latest Obama stimulus plan and proposal to extend most of the ‘Bush’ tax cuts signals that there will be little, if any, US fiscal consolidation over the coming year, removing a potential drag on growth.
• Some short-term caution over commodity and emerging market currencies after strong performance, but we remain strategically positive.
  
  We turned more positive on the Australian dollar after a May sell-off of commodity-related currencies in response to a lowered global growth expectations. Our positive stance was not based on global growth or commodity-price optimism, but rather on the view that Australia, along with other commodity exporters and emerging economies, was not labouring under the same constraints as developed economies, as exemplified by the ability to raise local interest rates. The subsequent 10% rebound in the Australian dollar is gratifying, but the return towards the 2010 peak has been alongside a sharp rally in commodity prices, specifically industrial metals and agricultural products. While the resilience of Chinese demand has supported industrial metals, agricultural commodities have largely been boosted by short term, weather-related factors. Any short-term fall back in commodity prices could therefore act as a drag on the Australia dollar, as with other commodity exporter and emerging country currencies, even if the longer-term view and structural attractions remain.

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