FX Outlook for 2Q09

Data flows are still ugly and growth expectations are now in a suitably negative place. Policy makers have used up a lot of fiscal and monetary bullets and are still staring at deep and prolonged recession.

The biggest risk for USD is still monetization through official bond buying. It changes psychological of market and open to constant testing on whether it is in, how large the intervention and so on, and it also kills price discovery in a bellwether market, undermining many other signals the Fed values including inflation expectations.

The EUR discussion, on the other hand, centres on whether the real sector adjustment becomes so wrenching that the costs of the withdrawal from the EUR gets serious consideration. The fears that the EUR may tear itself up from the inside will live on through 2009, along with concern about the sustainability of national fiscal accounts. It constitutes a very limited payoff for stubborn ECB anti-inflation policies and relative fiscal constraint, and will put the region at a distinct disadvantage.

Until global trade returns to the fore, it strikes harder at the European core as economic activity is redrawn along national lines as consumer demand to be hammered on a more durable basis and protectionist pressures will steadily build. This is more obviously challenging for economies with greater trade opening, like Singapore, Hong Kong, Taiwan and to some extent of Malaysia, whose whole raison d’etre is trade.

Japan has very powerful reasons for preparing for FX intervention on a huge scale against the rising JPY. The MoF is ready to go, perhaps by early-mid Q2 and on the background, US may encouraging intervention to recycle Japanese surplus savings back to the US. However, any JPY sell-off is unlikely to last long. Repatriation by Japanese life insurers, which may be larger than usual as they suffer losses on equity investments and need to realize the profits, will also support JPY toward fiscal year-end. Also, Japan has a stimulus package of $720 billion – roughly 14% of GDP.

Commodity currencies, while at one hand is yet to feel the full-blast of the cold winds coming from the global downturn, I still think commodity economies are getting close to the end of the rate easing cycle.

My base case for structural appreciation of RMB remains for no change, and is could be a possibility that PBOC will target a stable currency in order to deter a further rise in capital outflows. The credit growth will remain strong as the government disburses funds related to the stimulus package at full speed, banks will likely to increase their matching loans to large infrastructure projects that have (implicit or explicit) government guarantee.