FX and Interest Rate Monthly - May 2010

• Global recovery gathers momentum.
  Strong and improving purchasing managers index figures, from surveys of major companies on orders, activity and hiring intentions, are pointing to strong growth across the key advanced and emerging economies. Manufacturing confidence is at robust levels and service sector confidence is also improving.
• Modest increase in US rate expectations, though inflationary pressure remains weak.
  Market expectations for rate increases in the US have increased modestly on the back of the improving economic outlook. However inflation remains subdued at 2.3% and with core inflation, excluding volatile energy and food prices, at only 1.1% inflationary pressures appear limited. We therefore continue to forecast that monetary policy tightening will be led by emerging economies, where growth and inflation are moving back above trend levels. We expect the US to be the first of the major developed economies to raise rates.
• Dollar supported by growth and rate expectations, but emerging markets and commodity exporters are the real winners.
  Expectations that an improving US economy would lead to higher interest rates by year end are supporting the dollar. Based on growth prospects and current valuation the dollar is the most appealing major currency. However, the US is likely to be outstripped by emerging and commodity-exporting economies. Politics influence exchange rates in many countries, making timing of decisions unpredictable. But Singapore, following record first-quarter GDP, has lifted its exchange rate band and set out a policy of “modest and gradual appreciation.” For the commodity exporters we continue to favour the Canadian over the Australian dollar, based on valuation and fewer risks from financial imbalances for the former.
• European Union’s woes to drag on, leaving the euro under pressure.
  The availability of the EU and IMF funds for Greece clearly underwrites near term funding for existing debt, but does not address structural problems. Imposition of deficit reduction plans is obviously deflationary – this is theoretically good for the currency, as per Japan – but Greece provides a counter-example of political and solvency risks that are likely to overhang the prospects for the euro.
• UK election fears weigh on the currency, but valuation is favourable.
  Politics will dominate the trading in the pound ahead of the 6 May general election, and beyond, if no party holds a majority. This compounds the anxiety over one of the highest government deficits in the world as a proportion of GDP, making sterling the currency to sell by investors concerned by solvency issues. However, the UK is comparable to other developed countries in terms of the magnitude of its deficit, short-term funding needs and total debt outstanding, leaving sterling looking oversold.

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