Investment Strategies

Monthly Commentary

Currency Market Review and Outlook

October 2009

Renewed weakness in the US dollar during the first half of October took the currency to within 3% of its 2008 lows on a trade-weighted basis. Despite a decent setback in the first two trading days, the S&P 500 had risen another 4% to 1,100 by mid-month in the run-up to key third-quarter US corporate earnings reports. Upward pressure on Asian currencies and the associated buildup of central bank foreign exchange reserves intensified expectations of renewed diversification flows into the euro and EURUSD traded temporarily above 1.50. Meanwhile, the Reserve Bank of Australia’s decision to start removing policy accommodation with its first rate hike on 6 October^, propelled AUDUSD nearly 6.0% to an intra-month high of 0.9340.

Intriguingly, however, these movements proved unsustainable and many dollar crosses ended the month virtually unchanged. Equities were unable to hold their gains despite a generally positive flow of corporate results and the S&P 500 had its first down month since February. Increased talk of central bank “exit strategies”, and growing concern among some investors that the powerful rally in riskier assets since the first quarter was showing signs of fatigue, proved to be key catalysts for risk reduction. Additionally, comments from some European officials on the scale of recent euro gains and the growing scale of misalignment in currency markets in general, suggested that FX was becoming more of a policy issue.

Sterling was arguably the most interesting and volatile currency through October. Despite being clearly at odds with other data, a shockingly weak industrial production report early in the month reinvigorated expectations of another increase in the Bank of England’s Gilt purchase programme. EURGBP rallied nearly 3.0% to a peak of 0.9412 as investors feared that the Bank of England would accept a further weakening of the pound as part of an overall loosening of monetary conditions. Remarkably, sterling managed to stabilise and strengthen significantly from mid-month despite consensus expectations shifting to a GBP 50 billion expansion of “QE”, and EURGBP ended the month 2.3% lower at 0.8950.

Turning to the outlook, the US dollar and its relationship with other key currencies appears to be entering a critical phase. With a significant constituency in the market fearing the start of a transition to a more hawkish stance from the FOMC at the 4 November meeting, the generally dovish outturn may have lessened the potential for a short-term recovery in the US currency, and we are certainly alert to this possibility. However, with the unwind of the financial crisis-oriented rebound in the dollar now virtually complete, concern among policy-makers about the implications of another major leg down in the US currency must be intensifying.

Reticence in Asia to allow faster currency appreciation is arguably burdening the euro and the commodity oriented currencies with a disproportionate share of the adjustment. Tolerance of these trends cannot be unlimited and it is interesting to note a clear change of tone from a range of central banks in recent weeks. The Bank of Canada has protested aggressively and successfully against recent gains in the CAD and even the RBA has highlighted the role of the AUD in tightening Australian monetary conditions. Comments from European officials, especially around the role played by the Chinese renminbi in the global adjustment process, have also hardened. It remains the case that more aggressive weakness in the dollar from current levels is in nobody’s economic interest, and pressure on the US authorities to harden their stance on the currency could intensify rapidly. Consequently, we do not expect dramatic US dollar weakness going forward and still see some scenarios in which the currency could stabilise and recover in 2010.

For professional investors only. This document is intended solely to report on various investment views held by J.P. Morgan Asset Management. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable but should not be assumed to be accurate or complete. These views and strategies described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations.

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