Optimistic signs but economic situation will remain volatile

Jun 3 2009 by Andrew Miller, The Journal

OVER the last few weeks, signs that the world economy is turning the corner – or, at least, not deteriorating quite so quickly – have become easier to spot.

For example, retail sales are not dipping as fast as expected in many economies, and some companies are reporting rather better than expected results.

Such signs of improvement have major implications for exchange rates, some of them more obvious than others.

Economic revival and the resulting pick-up in investors’ appetite for risk has, for example, an obvious positive impact on the so-called ‘commodity’ currencies – for example the Australian and New Zealand dollars.

Stronger growth, it is assumed, will push up demand for commodities from these economies and thus their currencies.

But some of the implications for other currencies may be less clear, and perhaps unexpected. The US dollar, for example, has been hurt by increasing signs of global economic revival, falling markedly in recent days.

The US dollar’s strength in recent months had been due, in part, to investors’ faith in it as a ‘safe haven’ currency. In other words, during a time of extreme economic turbulence, the US dollar has looked a good place to be.

But, with the world’s economic prospects now apparently improving, this safe haven appeal has become a less important priority for investors, removing one source of support for the currency.

A further problem has been the upward pressure exerted by apparent economic recovery on longer-term interest rates.

This seems likely to push up US mortgage rates and therefore threatens to undermine attempts by the US government and Federal Reserve to kick-start the US housing market.

Worries about this have therefore hurt the US dollar too.

But while the US dollar has suffered from rising hopes of economic recovery, sterling has gained, despite growing worries about the UK’s debt position.

Sterling has not enjoyed safe haven status – so has not been damaged by a recovery in risk appetite.

And UK mortgage rates don’t have such a clear link to longer-term rates, so increases here aren’t seen as so much of a problem.

We think that sterling’s recent appreciation makes sense, and is likely to continue if we see further economic recovery.

Even if we can identify such key exchange rate drivers, exchange rates are likely to remain extremely volatile and difficult to predict in the short term.

So is it possible to identify some longer-term, more constant, exchange rate trends? Attempts to do this centre on estimating an exchange rate’s long-term ‘fair value’, the level to which it should gravitate towards over time. There are various ways of doing this. Our approach, which focuses on international trade and finance flows, suggests that a number of emerging market currencies are currently significantly undervalued. Looking forward, economic outperformance by the developing economies will help push up the value of their currencies, as will relatively high local interest rates.

An acceptance by China, and others, that growth will have to be domestically-driven, rather than export-dependent, may also make their policymakers rather more relaxed about currency appreciation. Look for a surge of foreign capital inflows into these economies in coming years – and for their exchange rates to rise too.

Andrew Miller is regional office head of Barclays Wealth