FX and Interest Rate Monthly - September 2010

• Interest rates are forecast to stay low for longer in the G4.
  
  A continuing but weak global economic recovery leads us to expect that interest rates will remain at low levels for an extended period in the G4 economies (the US, euro-zone, Japan and the UK). While we still predict that rates will rise next year (except, of course, in Japan), we see scope for longer-term rates to decline further, despite the yield on the benchmark ten-year German bund already at record lows below 2.5%.
• Unconventional monetary policy measures are expected, driving further volatility in G4 exchange rates.
  
  With growth in developed economies expected to be subdued and interest rates at rock bottom levels, central banks are poised to introduce further unconventional monetary policy measures, be they quantitative easing (QE) or other methods to stimulate the money supply and to keep short and long-term interest rates low. Such measures have generally had a negative impact on the local currency, producing sharp swings in FX markets. We believe that unconventional monetary policy measures in the G4 are more likely than not over the next year, with the US expected to lead the way. This will drive further FX volatility, but will not necessarily dictate the trend, as previous experience suggests that while early policy moves may see a currency hit, late movers suffer more.
• We continue to prefer the US dollar among the major currencies...
  
  The US economy has weakened the most obviously in recent months, and the Federal Reserve is leading the discussion over the use of further QE to tackle deflationary pressures. The market's retreat from June's high represents the pricing in of QE expectations and the postponement of interest rate rises. With these issues also set to affect the other major developed economies, we see the US dollar as relatively attractive. The yen seems most at risk, with policymakers bemoaning the impact of currency strength. Higher interest rates offer support to the euro, but only at the expense of increasing the pressure on the weak peripheral economies. That leaves sterling appearing in a relatively favourable light, although the Bank of England is also discussing QE.
• …but our focus is still on higher-yielding commodity and emerging market currencies.
  
  Our positive forecast for most emerging market and ‘commodity’ currencies is not based on an overly-optimistic view of global recovery and commodity prices. Rather it is because the problems of developed economies will continue to weigh on G4 currencies, with unconventional policy measures deployed to support growth exerting further pressure. Provided the recovery continues to provide a degree of stability to the global economy, we expect investors to continue to move capital into the healthier economies of the emerging world, as well as Australia and Canada.

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