EM currencies – waving goodbye to Uncle Sam? (pg 3)
We are now moving into the post crisis period of market development. The risk reward trade off favours
EM over the G10. If growth is being spurred by China and commodity prices continue to rise, EM
countries will face a massive policy dilemma. Policy will be too loose and they will need to raise rates.
Higher rates will see greater inflows and greater appreciation pressures on the currency. In essence, the
inflation threat through commodity and asset price inflation will break the dollar dependency cycle. Other
big EM currencies will be incentivised to internationalise their currencies, whilst other small EM
currencies will gravitate towards these larger EM currencies and move away from the USD.
Is the FX market back to normal? (pg 9)
Compared with late 2008 and early 2009, it is clear that the FX market is now in a much more ‘normal’
state. Valuations are much less stretched, realised volatility is back with historical ranges, and bid/offer
spreads have come back down to some extent. However, FX volumes are below levels that might be
considered normal, and implied volatilities are still elevated. On a scale of 1 to 10 where ‘10’ indicates a
well functioning currency market, we currently give it a 6.
Bond flows crucial for sterling (pg 14)
For sterling, it may be that bond market performance will prove even more important than equity market
developments. This is because of the dominance of bond flows in the UK external position at the
moment. Traditionally, bond investors are much more likely to hedge the FX exposure of their positions
than equity investors, so the impact of bond flows can be rather limited. If, however, foreign bond
investors become more comfortable with the prospects for the UK economy, the lifting of FX hedges
would be a major positive factor for sterling.
FX review – August (pg 16)
We include a review of the month to catch up on developments within the FX market.
Dollar Bloc (pg 20)
Canada – CAD strength, and dollar weakness, continues – The CAD continues to trade at levels that
some Canadian monetary officials might describe as stubbornly strong. Many of the sources of CAD
strength have been well documented, including persistent USD weakness, higher commodity prices,
increased risk appetite, and the relative health of Canada’s financial system. Less clear is the potential
actions Canada’s monetary officials could take in response to the CAD’s strength.
Australia – From strength to strength – Despite the worse than expected labour market data, the data
overall has continued to show improvements to the economy. There are two channels by which strong
data can affect the AUD. Strong growth relative to the rest of the world will increase imports and thereby
widen the current account deficit causing a weakening of the AUD. However, strong growth will also
imply higher rates of return relative to the rest of the world and will attract increased portfolio and direct
investment inflows. The overall impact is dependent upon which mechanism is dominant. We believe that
due to the importance of rates of return, portfolio flows and direct investment should dominate - this
should see the AUD strengthen.
New Zealand – Focus on fundamentals – The NZD has shown significant strength recently, and was
the best performing G10 currency against the USD in August. One of the reasons for this is due to a focus
on the economic fundamentals, as data came out stronger than expected.