[FXJourney]

Inverse correlation between risk sentiment and USD to fade

Reserve manager flows – the process of reserve accumulation and the subsequent flow diversification – have been crucial for the link between risk “on”
(e.g., capital flows to EM) and EUR-USD. Analysts expect this influence to wane as
investor appetite for EM assets finally becomes satiated in Q4 2009. Analysts also believe markets may begin to focus on relatively stronger growth in the US. Overlooked and unloved US assets may return to fashion in 2010, especially in the context of a very cheap USD.

Valuation arguments becoming USD supportive

Furthermore, many G10 central banks are already distinctively lukewarm on the
potential for further local currency appreciation. The extreme case of this is the
Swiss National Bank, but all the commodity currency countries have also noted how negative currency strength is for the macroeconomic outlooks. Markets are
currently probing for a reaction from the incoming DPJ administration on the suspicion that the DPJ may be willing to accept a greater or faster rate of JPY appreciation. Most importantly, the forecast of EUR-USD above $1.50 at some point in the coming quarter will engender significant discomfort from European policymakers. Recall the pleas for intervention last year as EUR went past 1.50 toward 1.60. French President Sarkozy already proclaimed in August that the euro cannot be alone in bearing the weight of FX adjustments.

US policy credibility to be maintained

Markets are uncomfortable with the doubling of the Fed’s balance sheet, which will likely be tripled by year-end when the MBS, ABS and TSY purchase programs are complete. But the Fed is also beginning to step away from some its emergency support measures. This suggests the US central bank has a clear view of the exit and will be cognisant of any USD negative upticks in inflation expectations. Econimists look for core inflation to keep falling through the end of 2010. Such low inflation should be USD-positive in this context, especially against market expectations of rising, USD-debasing, inflation.