Forex Investment and Currency Trading

The US dollar (USD) traded in a volatile pattern over the past month, but with a generally upward bias, as financial market expectations on U.S. short-term interest rates took a sharp turn higher on inflation concerns. However, market expects the USD to retrace some of its most recent gains, given the softness in the economy despite nearterm inflation pressures.

Forecasts in Europe now incorporate a 25-basis-point tightening from the ECB in the near term. This should help the euro remain well supported, although the ECB move is factored into market expectations. Market continues to expect a softer euro against the USD into 2009, as the cyclical economic momentum swings away from the euro area.

The Japanese yen depreciated noticeably in June, as changing rate expectations in the United States and the euro area dominated markets. However, the yen will likely appreciate during the rest of 2008, given the fact that policy rate expectations are too aggressive. Meanwhile, with the Bank of Japan monitoring downside risks to growth stemming from surging oil prices, a rate hike in Japan is very unlikely. This status quo in Japan’s policy limits the upside potential for the yen. In 2009, a shift of Japanese households’ portfolios into foreign-currency-denominated assets will probably generate a modest depreciation in the yen.

The fundamentals for the British pound (GBP) remain negative, with slowing growth, rising unemployment, plunging housing, and a 16-year high in inflation with surging inflation expectations. Market no longer expects the MPC to cut rates this year. In fact, there is a risk that the MPC will hike in response to high headline inflation and elevated inflation expectations. However, higher rates would exacerbate downside risks to growth and increase the risk of recession. Under these conditions, sterling is likely to continue to underperform.

Asian currencies have softened, as rising oil prices hurt the external account positions of net oil importers, although the appreciation trend of Asian currencies should continue. Concerns about contagion from the fallout in Vietnam also caution the near-term outlook of Asian currencies, especially those with both high inflation risks and large current account deficits — such as the Indian rupee, Indonesian rupiah, Korean won, Philippine peso, and Thai baht. Asian central banks have turned more hawkish, in part because the near-term outlook of the U.S. economy has improved and in part because of the continuous climb in inflation. Inflation risks remain high, with India, Indonesia, Malaysia, and Taiwan all responding to higher oil prices by reducing domestic subsidies. China may follow suit in coming months.

Although the Australian economy is slowing and the Reserve Bank of Australia has signaled that monetary policy is on hold, the risk to this view remains to the upside, with inflation expected to remain well above target until late 2009. The Australian dollar (AUD) should also gain support from ongoing gains in key commodity prices (especially coal and iron ore), boosting the terms of trade again. In contrast, the Reserve Bank of New Zealand has signaled that it will be easing monetary policy before yearend, most likely starting in September. Market forecasts include at least 100 basis points of easing in late 2008 and early 2009, and a weaker New Zealand dollar (NZD) as a result.

The Canadian dollar (CAD) likely will continue to weaken against major currencies over the forecast horizon. Market anticipates that the policy rate spread between Canada and the United States probably will remain constant. However, faster Canadian CPI inflation and somewhat better prospects for the U.S. economy likely will accelerate CAD depreciation versus the USD. The direction of commodity prices poses upside and downside risks to the projection.

The ongoing financial crisis and resultant reduction in risk appetite are likely key reasons why the Norwegian krone (NOK) is not trading at a stronger level. Additional monetary tightening in response to inflationary risks should be supportive of the Swedish krona (SEK), but periods of financial instability normally do not favor the SEK.

Although a number of indicators of global risk appetite have deteriorated since mid-May, the CEEMEA currencies that would normally have the greatest sensitivity to these measures — the Turkish lira, the South African rand, the Romanian leu, the Hungarian forint — have remained surprisingly stable. Since considerable risks remain in the event of a persistent slowdown in cross-border capital flows, market is cautious about currency stability in the region.