FX and Interest Rate Monthly - April 2010

• Currencies reflect renewed confidence in global economic recovery.
  Despite a bitter winter the global economic recovery has continued and relapses, such as Sweden’s dip back into recession in the latter part of last year, have not been sufficient to derail it. The dissipation of investor concerns has been reflected in a rally in currencies with a positive gearing to growth and risk appetite at the expense of those regarded as safe havens.
• Interest-rate increases are still on the agenda.
  Malaysia joined a still-exclusive group of countries that have raised their interest rates over the past year. That list is set to lengthen over the coming year, but will be led and dominated by emerging economies. By contrast we expect the ‘big four’ of the US Federal Reserve, Bank of England, European Central Bank and Bank of Japan will be slow to increase. The balance of risks is skewed toward undershooting our forecasts as fiscal tightening takes precedence.
• Markets are still giving governments the benefit of the doubt on their deficits...
  While Greece’s debt crisis continues, the risk of contagion appears to have receded. Investors are giving governments with huge, recession-hit deficits the benefit of the doubt, with one apparent exception - the UK. This may be because it combines a huge structural government deficit, excessive consumer debt and an outsized financial industry. But it is just as likely to be that the size of its FX market means that sterling is a large and liquid trade for investors concerned about the world’s debt woes. Sterling at least provides a pressure release valve – good for recovery, but bad for holders of the currency.
• …but protecting the currency and debt holders brings deflation risks.
  By contrast the options for members of the eurozone are constrained. Sharp spending cuts, which bring the risk of deflation, are the option embraced by member countries that are facing a debt crisis. However, it is not an option for larger members or ones with heavy private-sector debt burdens. In the short term it is supportive for the currency, as the example of Japan demonstrates. But it may just be deferring the risks if debt burdens continue rising because growth is lacking and prices are falling.
• Liquid commodity currencies provide a proxy for anticipated emerging currency appreciation.
  The growth outlook for emerging economies remains strong, with continued recovery by developed economies removing a potential risk to that growth. A lack of liquidity and the restrictions of managed exchange-rate systems make trading in these currencies expensive and subject to political uncertainty. This leaves ‘commodity’ currencies such as the Canadian and Australian dollar with clear links to emerging growth as a more liquid proxy for investors seeking participation in these trends.

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