International Financial Outlook July 2010
Summary of main changes to exchange & interest rate forecasts
Overarching themes driving global financial markets have not changed significantly in the last month but some of the intensity has faded. Renewed euro buying relative to the dollar does not mean that concerns about the risk of sovereign debt default in Europe has gone away or that worries about the fragility of European banks have disappeared. However, they are now being seen more in the perspective of proliferating signs of weaker growth in the US, amid concern that job creation will be particularly slow in this economic upturn compared with the historical experience. Of course, the historical experience in our view should take into account the shock not just to the economy but to banking sectors in this downturn. Indeed, we would argue that in this sense, the slowness of the economic recovery is not odd at all but in fact should be expected, based on the past experience of when both such shocks occur simultaneously.
That said, the problems besetting the global financial system are predominantly located in the advanced economies and, as such, the drag on growth is most likely to be severe in those countries. This is indeed turning out to be the case, and so our forecast suggests that the rise in developed economies interest rates is going to be slower than in the developing economies as a group, as the latter are less affected by the negative shock emanating from the de-levering of balance sheets in advanced economies. In consequence, our projection of exchange rates shows a generalised appreciation of developing countries currencies against those of the advanced economies. It would not be a surprise if the volumes of FX trades also follows this pattern.
The indications are that UK economic growth accelerated significantly in the second quarter, which along with a largely market friendly emergency Budget, has provided a fillip for the currency. However, considerable uncertainties and challenges to the economic outlook remain, not least from the unprecedented scale of public spending cuts expected in coming years. While we do not expect a double-dip recession, our economic growth estimates for 2010 (1%) and 2011 (2%) are below the current consensus. We have nudged up our £/$ target for end-2010 to 1.46, but it has been revised down to 1.43 for end-2011. The profile for Bank rate is unchanged compared to last month.
Although growth prospects remain relatively upbeat, the disinflationary trend in the US looks like it could continue for some time given the sheer extent of slack. Core inflation has remained at 0.9% in the past two months - the lowest level since 1966 - with a further decline possible in coming months. With recovery still in its early stages and renewed concerns about the housing market and jobs growth, not to mention the softer global backdrop, we believe the FOMC may choose to tread more cautiously on raising interest rates. We now look for the first hike in the Fed target rate by end Q1 2011 and predict it to end next year at 2.25%.
Since our last Outlook , the euro-zone sovereign debt crisis remains an important theme, although tensions in euro area financial markets appear to have eased slightly. But there is some nervousness surrounding the forthcoming EU bank stress tests, due on 23 July. The ECB has welcomed these tests on the grounds of much-needed transparency within the euro-zone banking system. But they include the German Landesbanken along with a number of Spanish cajas, so the risks of igniting market fears about capital adequacy could still outweigh the benefits of transparency. The euro has risen against the US dollar over the past month, but the tests have the potential to drag on the euro short term.
The key event over the past month was the announcement that the Chinese authorities were ending the renminbi's soft peg against the USD. While the timing of the change surprised markets, it has not significantly altered our USD/ CNY forecast. We are looking for a modest fall to 6.75 by end 2010 and target 6.50 at end -2011. Looking at the other emergers, we expect most currencies to firm against the USD in the remainder of 2010 as financial markets stabilise. However, with a growing number of emerging Asian and Latin American countries raising interest rates, we expect these currencies to outperform their European counterparts in 2010 and most of 2011.
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