Investment Strategies

Monthly Commentary

Currency Market Review and Outlook

September 2009

Although US dollar weakness re-emerged as a key theme in September, the British pound ended the month as the worst performing currency as investor anxiety over Bank of England policy intensified. Since the Lehman Bros bankruptcy the dollar has correlated negatively with the equity market and other risk assets. This trend was exacerbated by renewed debate around the dominant role of the US currency in international reserves, and the perceived need for greater flexibility in the Chinese renminbi in the run up to the Pittsburg G20 meeting. Growing concern that diversification flows out of the dollar would accelerate amid a delay in exiting this year’s extraordinary loosening of fiscal and monetary policies encouraged a 2% fall in the currency on a trade-weighted basis. USD/JPY spiked below 90 late in the month as investors interpreted comments from the new DPJ Finance Minister as reflective of a new “strong yen” policy.

Sterling fell 3.3% on a trade-weighted basis and ended the month over 7% below its early July peaks. Since the Bank of England’s u-turn on policy in November last year it has persistently surprised on the dovish side and this, in conjunction with investor concern around the sustainability of the UK’s projected fiscal position, has placed sterling under considerable downward pressure. After the shock decision by the Bank to increase the QE Asset Purchase programme at the August MPC meeting, sterling had begun to stabilise in early September in response to more positive economic data and a more hawkish than expected tone from the September MPC meeting. However, sentiment took a decisively negative turn in the aftermath of comments from Governor King that were perceived to be both dovish on the economy and negative on the currency.

Although the outlook for the dollar remains a key issue, sterling’s predicament is now generating more interest and could be a more critical issue over the remainder of this year. The memory of sterling’s dramatic 18% decline against the EUR in December 2008 is still strong in investors’ minds, and price action over the summer has raised concerns that a similar dynamic could unfold in Q4 2009. At this stage, although we are alert to downside risks, we continue to feel that relative economic strength and eventually policy dynamics will start to lift sterling from its heavily undervalued position. Our proprietary leading economic indicator for the UK has continued to recover sharply and has outperformed the eurozone since the winter. Importantly, diminishing spare capacity and higher import price inflation associated with currency weakness have combined to produce a sequence of higher than expected UK core CPI inflation releases in 2009.

Despite denials from key Bank of England officials at a special meeting with economists on 29 September, there is still a widespread perception that the Bank is deliberately seeking to talk down the pound and use the exchange rate as a key policy tool. However, we continue to assume that Bank comments on the competitive benefits of sterling’s weakness are referring to the impact of past currency movements and are not symptomatic of a preference for even more currency weakness. Even against the backdrop of a moderate economic recovery, past and future weakness in sterling would place further upward pressure on inflation, and it will be difficult for the MPC not to recognise this in the November Quarterly Inflation Report. It should also be remembered - given the importance of the UK to the eurozone economy - that weakness in sterling places considerable upward pressure on the overall value of the EUR, and recent comments from eurozone policymakers suggests that sensitivity to EUR strength is beginning to increase.

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.

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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