International Financial Outlook September, 2009

Summary of main changes to exchange & interest rate forecasts

Selling pressure on the dollar remained in August, as the US economic recovery lagged that of Germany and France, and even Japan. Sterling moved like the US dollar in the last month, with the pound sagging a little against the euro, but gaining versus the US currency. There are increasing signs that the US and UK economies will return to growth in Q3. At that point (the figures are due to be released in late October), the US dollar in particular could find support. But despite signs of economic recovery, short and long term interest rates remain low, below even where they were a few months ago. Our view is that interest rates will remain depressed until a sustained economic recovery leads to the implementation of exit strategies from central banks that have loosened policies to exceptional levels to kick-start economic recovery. Meanwhile, many emerging market economies, unencumbered by the same financial crisis that has hit developed countries, are recovering strongly, boosting their currencies and commodity prices.

Increased confidence that the global economy is emerging from recession has seen the 'safe haven' demand for dollar assets wane as the yield attraction of its global counterparts rises, leading the dollar index last month to fall to its lowest level for a year. Although this trend could persist for some time, in our opinion, other more fundamental drivers of currencies, such as productivity and growth prospects, favour the US dollar. For this reason, we expect a broad-based recovery in the dollar over the coming 6- 12 months. We forecast €/$ falling to 1.37 at end 2009 and 1.27 at end June 2010. £/$ is seen at 1.59 and 1.51 respectively.

Massive official financial support has seen the cost of borrowing money on interbank lending markets continue to drive lower, despite improved recovery prospects. While we expect to see low benchmark three month libor rates in the US, UK and EU-16 in the short-term, a sharp upward adjustment is forecast next year as speculation of higher official interest rates intensifies.

Rising confidence about global economic prospects and comments by G20 finance ministers to suggest accommodative policy measures will remain in place until recovery is more firmly established have buoyed investor appetite for higher yielding alternative investments in emerging markets - helping to underpin their currencies. While the risk of a near term sharp correction remains, primarily reflecting the extent and pace of appreciation and the continuing uncertainty around global economic prospects, the improved relative merits of some economies versus their developed counterparts suggest further gains over a more medium-term horizon.

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