October FX month in review

Extract from Saxo Bank FX Monthly - October 2010

The last month has been a dramatic one for all asset classes. Here are a few highlights of the goings-on in the currency market since our last publication:

• Competitive Devaluation Strikes. The Brazilian Finance Minister recently declared that the world is engaging in “currency wars” as nations fight to prevent their currencies from appreciating in order to remain competitive in the global marketplace and reap what they can of insufficient world demand. On the one side of this war, we have the rapidly weakening currencies from low-growth developed nations led by the US that are devaluing their currency through ZIRP and QE aimed at boosting growth and preventing deflation. Japan and the UK are the other two major developed countries current either actively intervening (Japan) or threatening renewed QE (the UK.). This is triggering massive capital flows to the higher yielding emerging markets, which can’t absorb the flows without tremendous currency strengthening effects (they also boost the economy and become a self-fulfilling yield enhancer as higher growth rates mean policy must be kept relatively tight as well). In response, highly export-dependent countries like Korea and Brazil have enacted various capital controls and other policies aimed at punishing inflows and stemming currency strength. Above all nations fighting currency strength stands China, which accumulated an astounding USD 100 billion in reserves in September alone. Currently, the easy money policies of the Fed are triggering wild speculation in all major risk assets, but we still wonder whether this is sustainable – see more below in Cognitive Dissonance an in our Outlook section.

• The Euro finally gets respect. So far, despite street protests in Greece and a new bank bailout in Ireland that will mean an astonishing 30% of GDP shortfall in that country’s budget deficit, the EuroZone has managed to keep a lid on the sovereign debt and default fear situation as the ECB has bought sovereign bond debt (and as large European banks have front-run this buying). At the same time, the sudden realization that ECB policy is extremely tight relative to the more aggressive “QE” troika of the Fed, BoE and BoJ in a world of competitive devaluation, drove the Euro sharply higher after it had clearly become oversold versus the broader market. Short rates in Europe have dramatically risen vs. the other G-4 currencies as the ECB’s sovereign bond buying operations are sterilized and as it remains clear that the ECB is not interested in changing its overnight rate, further aggravating the liquidity at the short end of the curve. Is there more to squeeze out of this trade? Versus the USD, we’re not so sure.

• AUDUSD nips at parity. Just after Bernanke’s October 15 speech in which he outlined some of the tools the fed could use to fulfil the Fed’s mandate in a “low inflation environment”, AUDUSD pipped parity before falling later in the day, and AUD vs. the rest of the G-10 has eked out new highs for the cycle as risk appetite marched ever higher globally on the anticipation of endless easy liquidity from the US Fed and as commodities prices also rose sharply as a corollary of the competitive devaluation theme. But is the AUD rally overdone once again?

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