Currencies – Fundamentals Are Back

Many people say that last year was an unusual year for currencies, but to me, it was fairly standard given that there was tremendous volatility and being driven by a combination of sharp interest rate changes, volatile capital flows and brief outright USD scarcity. In my opinion, it was a very straightforward year of risk aversion. The three strongest currencies were the JPY, CHF and the USD that benefited from the closing of carry-trade positions, especially in the second half of the year.

Into this year, with the convergence of global growth (recession) and low global interest rate levels, this implies a return to normalcy especially in the second half of this year. Fundamental forces are expected to regain control, hence it would not be surprising if those low yielding currencies to be under-performing further, particularly if plagued by large external financing needs.

While the USD and GBP have already given back a substantial percentage of its gains during the risk-reduction period of September-November, further setbacks appear likely in months ahead. Further increases in USD supply on the back of extension of quantitative easing and likelihood of the Fed to hold rate near zero into early 2010 will put downward pressure on the currency.

Monetary policies are converging, but fiscal policies will take on increasing fundamental importance during this period. Currencies of countries with fiscal flexibility are likely to perform well. China has announced fiscal stimulus plans amounting to about 11% of GDP and that will enable the RMB to regain its uptrend versus the USD, in contrast with the 12-month NDF that suggests a 2.6% depreciation. On the other hand, countries like South Korea, Malaysia, Thailand and Indonesia which appear to have low debt ratios would open to potential larger fiscal initiatives. In Asia, KRW was meaningfully underperforming regional currencies in recent weeks to months – losing some 26% versus the USD and possibly we may see opportunity in long-short potential trades.

I always like commodity currencies, especially ones with stable domestic fundamentals. Key point to note is that I am in favour for it during the final three quarters of the year as the collapse of commodity prices in the 2H08 and the onset of a globally coincident inventory correction has driven manufacturing activity to unsustainably low levels. My top pick remains the AUD.