FX & Interest Rate Monthly - January

• The new year is forecast to start as 2009 ended - with a weak US dollar...
  Zero-yielding US dollars continue to flood the US economy in order to support the recovery. As a consequence, the US currency remains under pressure as investors switch into higher-yielding or higher-risk currencies as part of the ‘carry trade’.
• ...but we expect the currency to stage a rally later in 2010.
  However, November's stronger-than-expected US employment figures provided a timely reminder to the market that an economic recovery - however lacklustre - is underway. With the budgetary issues of the UK, Japan and some smaller EU countries highlighting the problems across the developed world, the US dollar versus other developed currencies seems - at least in relative terms - to be increasingly oversold.
• Next year also presents the potential for a more fundamental change in exchange rates.
  In fact, the aftermath of the global crisis appears to have set the scene for a fundamental change in exchange rate regimes in 2010. This is in response to the long-term trend of emerging market development, but the catalyst may well prove to be the policy decisions now being made in response to the after-effects of the turmoil.
• In developed economies, currencies will remain under pressure to depreciate…
  The headwinds to growth in developed economies mean that these countries may have to keep interest rates low for longer. These economies would also welcome a weaker currency as a means to encourage external demand and aid capital inflows to help finance existing debts. The depth of the recession and the need to repair banking systems limits the inflationary risks, whether from loose monetary policy or imported goods. In addition, some investors have fundamental concerns about the valuation of these countries’ fiat currencies. As a result of these factors, we forecast that developed economy currencies in general will depreciate against emerging market currencies.
• …while emerging markets struggle over a policy dilemma…
  Cheap money from developed economies is being diverted to invest in the faster-growing emerging economies. But the pegged exchange rates mean that these countries are effectively importing loose monetary policy from their developed counterparts. As emerging economies only suffered a short, sharp recession, the return of growth suggests inflationary pressures are building. As a consequence, these countries face the options of higher inflation, higher interest rates or higher exchange rates.
• …but may ultimately opt for a significant currency appreciation.
  Policy decisions are key to unlocking the potential change in currency markets. We expect a range of answers from different countries, including temporary stop-gap solutions such as Brazil’s capital controls, but we believe the eventual outcome will include a significant appreciation of emerging market currencies against developed country currencies.
  
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