Highlights

  • Central banks signal continuation of expansive monetary policy, no exit 

  • Equity markets are boosted by liquidity and recovery hopes 

  • Growing discrepancy between market sentiment and fundamental prospects


Dollar: safe-haven appeal is fading

After moving sideways for months, the dollar has now fallen below the lower boundary of the trading range. The US currency weakened against almost all major currencies, the ICE Dollar Index dropped by around 2%. EUR-USD rose to about 1.46; USD-JPY fell below 91 – the lowest level since February.

The dollar’s breakout below the usual trading range happened quite suddenly on Tuesday morning. There was no particular reason for the movement; it was brought about by shifts in the economic situation as a whole.

Equity markets have firmed and credit spreads narrowed. Both these factors indicate that market participants are gaining confidence in economic recovery. After the rout at the beginning of September, which had caused alarm across the globe, Chinese equity markets have also stabilised again, – mainly because the government and the central bank reiterated that there would be no policy change, particularly as far as bank lending was concerned. The positive market development is pushing the macroeconomic risks into the background, investors’ risk appetite is increasing.

The sharp appreciation of the dollar last autumn was due to the financial crisis: dollar-oriented investors retreated into safe-haven US investments. At the same time, it became extremely difficult for banks and other market participants across the globe to refinance their short-term dollar liabilities. They therefore obtained liquidity wherever it was available (e.g. from the ECB), and bought dollars on the forex market.
During this phase, the regional crisis turned into a global recession. Growth outside the US collapsed, and central banks in Europe and in other parts of the world cut interest rates. The interest rate advantage over the US vanished in the space of a few months. As hopes of recovery grow, the forex market is starting to return to normal.

For a while, the dollar was supported by the notion that the US could be the first country to overcome the crisis and tighten monetary policy (“first in, first out”). On the first signs of economic stabilisation, markets had even speculated on the Fed starting to raise interest rates in autumn 2009.

Markets have now become much more cautious again, however. Given high unemployment, households’ loss of assets and banks’ lending constraints, the Fed is sceptical as to whether private consumption can provide enough momentum for a dynamic upswing. Furthermore, the Fed is signalling very clearly that it has no intention of tightening monetary policy at the present time. Fed vice chairman Donald Kohn said on Thursday that, given low inflation and the weak global economy, a sharp rise in short-term interest rates was quite unlikely. According to the official statement of the Open Market Committee “economic conditions are likely to warrant exceptionally low levels of the Federal Funds rate for an extended period”.

The confidence reflected in equity markets and credit spreads is in remarkable contrast to the central banks’ sober assessment of the economic outlook – with which we basically agree. It looks as though the rebound in equity markets is mainly a result of the favourable combination of cheap liquidity and high public spending.

There is nothing wrong with this. Policymakers are hoping that, with improved market valuation of shares and other assets, favourable financing conditions and growing confidence, companies and private households will gradually become more willing to increase spending again.

At the moment, however, the economic situation is still very difficult, particularly with regard to the employment situation and corporate capacity utilization and the burdens on the banking system. Moreover, in many countries there is little additional scope for fiscal policy. Most economic stimulus programmes, which are now still helping to stabilise incomes, will run out in 2010 and 2011. Thus the recovery might not be as dynamic as markets are expecting.

In this situation, the forex market players will have to weigh up very carefully the momentum, boosted by monetary and fiscal policy, from the equity markets, and the fundamental risks. In the short term, we do not see much likelihood of possible setbacks. The forthcoming economic indicators – for the third quarter – are set to remain favourable for the most part.