Comment: Increased volatility on global foreign exchange markets

Richard Foley, Senior Portfolio Manager, Investment Management, Butterfield Bank Guernsey, outlines the latest currency trends.

The first quarter of 2007 witnessed an increase in volatility on global foreign exchange markets. The initial catalyst behind this was the sharp fall in the Chinese stock market, but weaker US economic data, particularly relating to housing, also hurt market sentiment in respect of the US Dollar versus most major currencies.

During the first half of the last quarter the US Dollar was generally well supported.  However, the Dollar adopted a weaker tone on the back of comments attributed to former Fed Chairman, Alan Greenspan who remarked that the chances of a recession in the US Economy were widely misinterpreted.

More recently, downward pressure on the Dollar has intensified following the Fed's recent policy statement, which suggested a move towards a more neutral bias in terms of monetary policy.

The Market has, so far, chosen to ignore comments in the Fed's statement, reiterating that they remained concerned about inflationary pressures and has focused more on the wording around monetary policy. Therefore, the outlook in the short term suggests that the US Dollar will likely remain under pressure, with a move through USD1.35 against the Euro not out of the question.

The near term trend will likely be dictated by the actions of both the Fed and the European Central Bank (ECB). In terms of the US, the Market is currently factoring in at least two 25 basis point interest rate cuts and in Europe, the ECB are expected to raise rates by 25 basis points twice before the end of the year.

While over the long run interest rate differentials, either administered or long-term, have not been a particularly reliable indicator of currency trends, they clearly are an important influence in respect of short term direction.

In terms of our outlook, we believe that the Fed will only have room to cut rates once before the year end. Chairman Bernanke has stated that that he remains concerned about inflationary pressures, and the sharp rise in the Oil price in recent weeks will put further upward pressure on monthly and quarterly inflation data. In addition, the US Economy is not yet slowing to such an extent to be a major cause of concern.

We therefore believe that investors expecting the Fed to cut interest rates twice or more will likely be disappointed, and the positive interest rate differential over the Euro will remain Dollar supportive. As such, taking into account the magnitude of the fall that the Dollar has already suffered versus the Euro, there is scope for the US currency to recover during the course of this year from what appears an oversold level.

In the United Kingdom, January's 0.25% increase in base rates helped Sterling to initially appreciate against both the Euro and the Dollar, with Sterling almost pushing through the psychological USD2 level. In the weeks that followed the Bank of England's (BOE) move, the Market initially believed that another 0.25% increase would follow in relatively short order.

However, more recent economic data in the form of GDP and inflation has been relatively benign, suggesting that rates may not need to rise by more than 0.25%. This reassessment of UK monetary policy has seen Sterling weaken against both the Euro and, to a lesser extent, the Dollar.

The positive interest differentials in favour of the Pound have continued to make Sterling carry trades attractive and this in our view has artificially supported the currency. Looking longer term, as this positive interest rate differential is eroded, we believe that Sterling will come under pressure. We have already seen evidence of this trend against the Euro, with the pound falling by just under 4% since the middle of January.

The Bank of Japan (BOJ) raised interest rates by 0.25% to 0.50% in February, but this move in itself had a limited impact on foreign exchange markets. Of more significance were the sharp reversals in equity markets that occurred later in the same month.

These moves triggered a change in the Market's attitude to risk, which in turn led to an unwinding of large volumes of Yen carry trades that have been a key factor in the Yen's ongoing weakness. The sell-off in equity markets caused many of these trades to be unwound and the Yen appreciated sharply against the US Dollar.

Japan's underlying economy still remains heavily reliant on the export sector, so the BOJ will not want to see a material appreciation of the Yen against the US Dollar.

With Japanese interest rates expected to remain well below those of other major currencies for the foreseeable future, we expect to see volumes in Yen carry trades increase, as equity markets resume more normalised trading patterns.

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