[BillPaay]

The US dollar (USD) has rebounded in recent weeks, especially versus emerging-market (EM) currencies. The likely triggers have been (1) Brazil’s decision to impose a 2% tax on hot-money inflows into local stock and fixed income markets, and sharp rhetoric against currency appreciation in economies such as South Korea, South Africa, and Canada; (2) the early arrival of the ‘yearend effect’ as leveraged funds in particular have reduced risk; and (3) stretched valuations in some asset markets, especially credit and equity markets, notably in Asia.

However, nothing has changed fundamentally. The global recovery remains firmly on track. The West is likely to report strong growth figures in Q4 and into Q1-201, supported by fiscal and monetary stimulus. The global industrial cycle is poised to expand further near-term, which suggests that Asian exports should continue to
recover strongly. A more challenging time may come in H2-2010, when inventory restocking and fiscal stimulus, especially in the West, have run their course.

A key factor is the extraordinary monetary policy measures taken by the global liquidity providers – including the US, the euro area, Japan, and large EM such as China. The extraordinary measures taken by the Federal Reserve, the European Central Bank (ECB), and the Bank of Japan (BoJ) may be phased out in the
coming three to nine months, and China’s monthly bank lending growth has already slowed substantially compared to H1. However, this has likely already been factored in by markets.

[BillPaay]

Near-term, the USD may rally further given declining risk appetite and positioning. However, going into year-end, we see further downside for the USD given seasonal factors and the greenback’s expanded role as the world’s new funding currency. Among EM currencies, the preferred picks are the Brazilian real (BRL), South African rand (ZAR), IDR, KRW, and Indian rupee (INR), where strong fundamentals should continue to attract capital inflows.

Market forecasts a rebound in the USD in H1-2010, especially versus ’crowded’ G10 currencies such as the AUD, NZD, and CAD. The key driver is likely to be disappointing growth performance, especially in the West, in the latter half of 2010. This should also trigger a rebound in the USD versus the BRL, ZAR, IDR, and KRW, where offshore positioning is heaviest. However, some expect EM to outperform G10 for two reasons: (1) the strong fundamentals are in EM, not in the West or Japan; (2) in times of USD weakness, EM currencies tend to follow G10 with a lag, and at a slower pace, due to the more interventionist approach to exchange rates in EM – especially in emerging Asia.