FX & Interest Rate Monthly - February 2010

• Cheap liquidity continues to flood global currency markets...
  Quantitative easing (QE) has pumped liquidity into the global economy to help drive a recovery from the recession. As the Federal Reserve has issued huge quantities of zeroyielding US dollars, investors have sought to switch the US currency into higheryielding or higher risk ‘carry trades’ - so ensuring that the US dollar sold off in 2009.
• …but the tide is now turning, to the detriment of last year's winners.
  Having achieved the aim of averting a global depression and with growth now recovering, central banks are looking to withdraw some stimulus by reversing QE and raising interest rates. The prospect of this withdrawal - which we do not expect to start until the second half of the year - is already causing nervousness among investors, who have moved swiftly to close net short positions on the US dollar. While this move may be premature, with the ‘carry trade’ potentially re-emerging in the short term, we anticipate that the US currency will end the year at significantly stronger levels against other major currencies.
• The overvaluation of the yen and the euro is likely to be increasingly exposed in 2010.
  Among the major developed economies, the US is likely to enjoy the most impressive recovery in the near term. By contrast, Japan and the eurozone, which maintained more conservative monetary and fiscal policies, should lag, with neither economies expected to raise interest rates this year. In fact, there is a risk that they may need to take further action to support growth: in the case of the eurozone, because of the emergence of a crisis in one of its member states; and in Japan, the new finance minister has already talked of a weaker yen as an accompaniment to the new budget stimulus and action from the Bank of Japan.
• The pressure to raise interest rates is already apparent in developing economies that have emerged largely unscathed from the downturn.
  Policy decisions are key to unlocking potential changes in emerging currency markets as these countries face the options of higher inflation, higher interest rates or higher exchange rates. There are likely to be a range of measures from different countries, including temporary stop-gap solutions such as Brazil’s capital controls, as they struggle with conflicting risks. However, we expect the eventual outcome will include a significant appreciation of emerging market currencies against developed country currencies.


 
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