FX and Interest Rate Monthly - Updated 20th January

• Lack of euro crisis solution puts pressure on ratings

  Standard & Poor’s lowered it credit rating on nine eurozone countries on 13th January, citing a credit crunch for both private and public sectors that is weakening the region’s economy as they simultaneously pay down debt. The problems are compounded by the open and prolonged dispute over how to address them and a misplaced focus on fiscal austerity. Actions announced and taken were deemed inadequate to tackle the financial crisis. This is in line with our long-held view of the structural weakness of the eurozone and risks to the currency. However, with the tradeweighted euro already at a seven-year low amid widespread negative sentiment, short-term weakness looks limited. While a break-up is no longer inconceivable, the euro could rally yet again ahead of the next summit of European leaders on 30 January, given pressure to produce a solution.

• Developed-market rates stay low, more QE expected

  Persistent low interest rates for the major developed economies remove one source of currency volatility. We see only limited scope for change, apart from potential rate cuts in the euro-zone, where recession appears to have begun and is likely to persist through the first half of the year. We expect the European Central Bank to rate cuts below the previous 1.0% floor and expand its quantitative easing (QE), though the form this takes is likely to be complicated by the complex legal structures and political sensitivities of the euro-zone. We do not believe that QE will be confined to the euro zone, and announcement of other programmes could well add to short-term volatility in exchange rates. However, major currency realignments are not expected as none of the major developed economies are strong enough to sustain significant appreciation against key trading partners. A key risk to our forecasts is a more substantial depreciation of the yen. The Japanese trade balance has deteriorated, though huge overseas investments still provides a positive income flow, which could trigger a more pro-active response from Japanese policy-makers.

• Preference for emerging currencies not battered by trade winds

  We are cautious in the short term on the currencies of Asian economies exposed to economically sensitive trade and financial flows. Even where underlying growth remains strong, as in Singapore, there may be better entry points. The renminbi has become the primary investment driver for Asian currencies as smaller economies in the region attempt to remain competitive with their large neighbour. We see further renminbi appreciation as part of a trend of 4-6% gains per annum in 3-5 year bursts against the US dollar. Conversely, we would avoid those Asian economies where the slowdown of the global economy in 2011 has exposed more significant structural problems, as in India and Indonesia. Most currencies of the euro-zone’s emerging neighbours are similarly at risk. We prefer the currencies of Latin American countries with more limited exposure to global trade and positive economic outlooks, like Brazil, while also seeing Mexico as a major beneficiary of the current US recovery. The currencies of developed economies with strong commodity exports to growing emerging economies – such as the Australian and Canadian dollars and Norwegian krone – are similarly attractive.

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