Summary of main changes to exchange & interest rate forecasts
World economic recovery is underway, led by the emerging markets. When the data for Q4 2009 are in, they will show that all of the G20 economies - which together account for over 90% of world gdp - are expanding. This recovery has three main implications for financial markets in 2010. The first is that ultra loose monetary and fiscal policies put in place to kick-start recovery will start to be reversed. Second, this will likely lead to renewed volatility. Third, it is likely to change the dynamics of interest rate and FX markets in the months ahead.
US economic growth looks likely to have expanded by about 4% at an annualised pace in Q4 2009. This is likely to underpin the dollar in early 2010, especially as the implications of this economic revival become burned into expected interest rate differentials. Strong though this recovery is however, it is generally weaker than previous upturns following recession and could level off in the next quarter. If so, this may limit the upside for the US currency in the short term against other major currencies. However, it is also the case that there could be a much stronger appreciation of the US unit than currently expected.
After all, there are some signs that commodity currencies are rising based on assumptions about demand that seem hard to square with the weakness in the world economy as a whole compared with the level of gdp at the peak in early 2008. But growing signs of global recovery should continue to support commodity prices in 2010, underpinning the currencies of major exporters. However, we believe the potential for further strong gains may be limited by the exceptional performance in 2009.
We expect data later this month to confirm that the UK economy returned to growth in the final quarter of 2009, belatedly ending a record sequence of six successive quarterly declines and an overall gdp drop of around 6%. However, we forecast only a muted recovery in 2010, with economic growth of close to 1%, after a fall of 4.6% in 2009. This primarily underpins our view that Bank rate will remain at a record low of 0.5% throughout 2010, while the risk of a further expansion of the APF is larger than many currently envisage. The publication of the minutes of the January 6-7 MPC meeting should give a good steer about whether the BoE will remain pat at the February meeting. We believe the first half of 2010 could prove particularly volatile for the pound, with key uncertainties surrounding the upcoming General Election and outlook for economic growth and inflation. We forecast £/$ at 1.52 and £/€ at 1.12 at end June 2010.
The out-performance of the emerging markets is likely to remain a key feature in the year ahead as the global economy returns to positive growth. After comfortably avoiding contraction in 2009, albeit largely underpinned by the unexpectedly strong resilience of China and India to the headwinds sweeping the global economy, the prospect of a more generalised rebound looms large in 2010. However, there will still be winners and losers, with financial markets rewarding the best and punishing the worst performers.
With the risks posed by inflation greatest in the developing economies at this time, official interest rates are likely to be raised sooner and more aggressively in emerging markets. We expect the Asian economies, which are further down the road to recovery, to lead the way - with India possibly raising the cash reserve ratio later this month. China has raised its reserve requirement ratio by 50 basis points effective from January 18. The prospect of widening interest rate differentials should continue to underpin Asian currencies in the year ahead. We expect China to resume gradual renminbi appreciation against the US $ in the first quarter of 2010.
Lloyds TSB Bank
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