International Financial Outlook July, 2009

Summary of main changes to exchange & interest rate forecasts

Currency movements in the past month are suggesting doubt about whether the global economy is on a smooth glide path to recovery, the view that many participants had seemed to hold. Although currency volatility is still much less than at the start of the year, it has risen recently. The reason: monthly economic data are suggesting that the growth momentum has eased and could even reverse in some countries. This is our underlying view; economic conditions have improved appreciably but are still not yet consistent with anything like a broad-based or sustainable economic recovery.

We have not changed our fundamental based view of a strong rebound in the US dollar in the coming 3-18 months. However, near-term targets for US$ crosses have been raised to reflect prevailing market levels and the continuing uncertainty about global growth prospects. We now look for £/$ at 1.51 at end 2009, falling to 1.44 at end 2010, while €/$ is seen at 1.30 and 1.25, respectively. However, volatility remains elevated and represents the main risk to our forecasts.

With official interest rates in major economies already at record lows in this easing cycle, the scope for further cuts is limited. However, we have seen surprises recently from the Bank of Canada and Sweden's Riksbank, indicating that reductions cannot wholly be ruled out. Nevertheless, we expect explicit commitment to keeping rates low and targeted expansion of the money supply to increasingly help to communicate the policy stance of central banks. In the UK, we expect the Bank of England to extend its asset purchase programme at its next meeting in August. The FOMC may also require additional ammunition once the current $300bn treasury purchase programme is completed in autumn. The ECB is likely to be pressed for further initiatives to boost bank lending, unless monetary data there improve soon.

We expect to see continued downward pressure on benchmark government bond yields, reflecting weak economic growth and growing realisation of the limited threat posed by inflation in the mediumterm. However, failure by central banks to communicate and effect credible 'exit strategies' poses a significant upside risk to inflation and bond yields further out.

Emerging market currencies remain vulnerable to a change in wider market sentiment about global growth prospects. However, some regions are clearly more at risk than others, with those economies facing particularly onerous external financing requirements potentially facing default or devaluation as a final resort. We expect a growing appreciation of the individual merits of economies across this asset class to lead to clear winners and losers in the search for foreign capital. We remain particularly positive about the medium-term prospects for Brazil, with $/Brl forecast to ease to 1.75 by end-2010.

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