[DanRath]

Currency returns in 2009 were dominated by renewed USD weakness, with every major currency – and almost all emerging currencies – gaining against USD. For all of the more exotic explanations put forward for USD weakness – diminishing reserve status, by-product of the Fed’s QE, diminishing US creditworthiness, etc. – market analysts still see USD’s losses largely resulting from “normal” cyclical drivers.

Whichever way we look at the interest rate background - levels, rates of change, real or nominal - USD continues to look like a loser in the early part of 2010. Market rate strategists expect no Fed hikes until Q4 2010 and, even though markets will anticipate the first move well ahead of the event, this still leaves the Fed at the back of the queue in the line to tighten policy.

…but get ready to flip

Just as USD’s losses are primarily cyclical, however, so the maturing of the rate cycles in the early hikers and, ultimately, the turn in the US rate cycle will pave the way for a reversal in USD’s fortunes before 2010 is out. Rather than set an arbitrary time-frame, let's using one of the Fed’s own “exit strategy” criteria as the condition for reversing an initially USD-bearish position. Specifically, mirroring the Fed’s focus on resource utilisation or slack, proxied by the unemployment rate. Historically, the Fed has tended to raise rates when slack is clearly being absorbed. At present US labour market slack (unemployment rate relative to five year average) is measured at -4.5% and this measure of slack tends to bottom 8-12 months ahead of a turn in Fed funds. A 1% point fall in this measure of labour market slack, most likely to occur around mid-2010 as the unemployment rate dips to 9.5%, is the pivot for closing a USD short and flipping to long.

A further factor which will limit USD’s losses against the G10 currencies and supports a turning point during the course of 2010, is the expectation of increasing exchange rate flexibility in Asia, led by an appreciation of CNY that goes beyond the 3.0% currently discounted by NDFs. Not surprisingly, AUD and JPY are most likely to follow CNY higher. At the other end of the spectrum, CAD and CHF
have the lowest leverage to CNY.