Investment Strategies

Monthly Commentary

Currency Market Review and Outlook

October 2008

A worsening of the financial crisis and a severe weakening of the global economic outlook combined through October to create unprecedented policy reactions and a “superspike” in FX market volatility. By the end of the month we had witnessed the strongest rate of recovery in the overall value of the USD since the end of the Bretton Woods era in the early 1970s, a 22% decline in AUDJPY and a cumulative 100bps cut in the US Federal funds rate to 1.0%. Importantly, risk aversion spread more widely through the emerging markets as investors became increasingly concerned by the deteriorating growth outlook, especially in China. The TRY and ZAR fell 18% and 15% respectively against the USD, and most Eastern European currencies came under severe pressure against the EUR.

Policy actions taken in September proved insufficient to stabilize investor sentiment, and a series of weaker than expected economic releases early in October intensified downward pressure on equities and other risk assets. It became clear through the month that economic activity across the OECD had hit an “airpocket” in September and early October. Indeed, our proprietary leading economic indicators started to suggest that the ensuing recession would be significantly worse than either the early 1990s or early 2000s episodes. Coordinated interest rate reductions from key central banks on October 8^th provided only temporary relief to markets, and European Union governments were forced to replicate the UK Treasury’s previously announced plans to inject tax payer funds into increasingly undercapitalized banks.

This policy was ultimately followed by the US Treasury with some of the funding sourced for TARP being diverted to key money centre banks. Several new programs were announced by the Federal Reserve through the month to address the shortage of short-term USD funding and these began to gain some traction late in the month. This, in conjunction with growing risks of direct FX market intervention to offset the alarming decrease in market liquidity and increase in volatility, started to lessen upward pressure on the JPY, CHF and USD in the final week of October. This was supported by a strong G7 statement on the JPY on the 26^th and evidence of actual intervention to support the AUD by the RBA, and new rate cuts from the FOMC on the 29^th and, more surprisingly, the Bank of Japan on the 31^st.

Looking ahead, our conviction is continuing to grow that we are entering a severe and coordinated global downturn that will leave significant increases in spare capacity and disinflation in its wake. Our proprietary policy indicators for the ECB, Bank of England and Federal Reserve suggest that pressure is building to ease monetary policy by significantly more than is currently discounted in financial markets. With US rates already close to the so-called “zero-bound”, there is an increasing risk that the Federal Reserve embarks on a form of “Quantitative Easing” that is reminiscent of Japanese policy actions between 2001 and 2004.

Although further liquidation pressure in emerging market currencies between now and year-end would likely support the USD in the short-term, expectations of more dramatic Federal Reserve policy action could severely undercut the currency’s recovery. Furthermore, the record declines in commodity prices witnessed since the second quarter and the clear shift of policy focus away from inflation in recent months, suggests that the rationale for the shift back toward a strong USD policy seen in June has been greatly eroded. Meanwhile, protracted weakness in global commodity prices and yield convergence toward Japanese and Swiss levels should ensure that trend weakness in the commodity bloc currencies and trend strength in the JPY and CHF persists.

For professional investors only. This document is intended solely to report on various investment views held by JPMorgan 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.

The value of investments and the income from them may fluctuate and your investment is not guaranteed. Past performance is no guarantee of future results. Please note current performance may be higher or lower than the performance data shown.

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