International Financial Outlook March 2010

Summary of main changes to exchange & interest rate forecasts

As widely predicted, financial markets have been volatile as the end of the period of extraordinary monetary and fiscal loosening draws nearer. Economic growth is picking up and becoming more entrenched in most countries. As a result of this, some central banks, like Australia and Norway, have raised rates a number of times. China and India are getting closer to increasing key benchmark policy interest rates. Expectations that the US Fed will be the first of the major developed economies to raise interest rates, as their economy recovers fastest, has meant that the dollar is strengthening. We expect this to be a major theme of the year ahead.

With the US economy recovering slowly, we maintain our view that the Federal Reserve will sanction the first increase in its federal funds rate, to 0.75%, only at the end of 2010. In the meantime, the Fed continues to note that an uncertain US economic climate continues to warrant “exceptionally low levels of the federal funds rate for an extended period”. But the current environment of abundant liquidity means that the Fed is also aware of the need to start tightening some aspects of monetary policy to prevent a potentially sharp build-up in price pressures. Thus, the so-called monetary policy ‘exit strategy' remains a vital theme.

The Fed has already terminated special liquidity facilities such as the Primary Dealer Credit Facility and Term Securities Lending Facility, amongst others. And it recently raised the discount rate – at which it lends directly to commercial banks – by 25bp, to 0.75%. Other potential ‘exit' measures include reverse repo operations to drain liquidity or an increase in the interest rate paid on bank reserves. With the US economic recovery continuing and a bias towards higher official policy rates later this year, we remain positive on the US dollar. Versus the euro, we look for 1.27 at end-2010 - unrevised from our February forecast.

In the euro-zone, economic recovery is fragile with expansion of just 0.1% quarter-on-quarter in 2009Q4. And like the Fed, the ECB is weaning banks off a generous supply of liquidity whilst signalling to markets that its key policy rate is likely to remain on hold for some time. We don't envisage an ECB rate rise until 2011H1. Meanwhile, in Greece, the recent €5bn issue of 10-year government bonds, together with €4.8bn in further fiscal austerity measures, has calmed European government bond markets - at least for the time being.

The second estimate of UK Q4 GDP revealed an upward revision to +0.3% quarter-on-quarter, from +0.1% previously. And various forward-looking business surveys show a rebound in economic activity following weatherrelated disruption during January. But despite some signs of improvement, retail sales activity remains weak. The Bank of England's February Inflation Report was fairly downbeat on UK economic prospects, while Governor Mervyn King noted that it was ‘far too soon' to conclude that no further asset purchases would be required. We look for Bank Rate to remain at 0.5% throughout this year.

Broadly speaking, we continue to expect emerging market currencies to be moderately stable against the US dollar short term, losing some ground towards year-end as the US economy gains further momentum. But since our last Outlook, a number of East European currencies have outperformed their emerging Asian counterparts. This appears to mark a reversal compared with the trend observed in recent months. But it is not yet clear whether this relative price action can be sustained going forward. In the case of the Polish zloty, for example, recent gains versus the US dollar may have reflected remarks by government officials pressing for monetary policy tightening to be brought forward. Similarly against the US dollar, Latin American currencies have also outperformed those of emerging Asia. The Colombian peso, for instance, has risen sharply since early February. But again, shortterm factors seem to be at play. The peso has reacted positively to a recent court ruling which has reinforced the nation's democracy by blocking President Alvaro Uribe's bid to seek a third term in office.

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