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Currency Considerations: A Current Global Overview

11 February 2009 Josef Portelli, Portfolio Manager, TriAlpha Group: London

Historically the carry trade - selling low-yielding currencies in favour of high-yielding ones - was a well-established trend. Aided by sustained levels of low volatility, traders were able to capture the difference between interest rates and maximise profits with minimal risk.

The trade would work as long as interest rates remained stable. When risk appetite began dropping in mid 2007 it became clear that the cash cow would eventually dry up. Currently we are now witnessing a profound change in attitudes to risk which is causing huge outflows as individual economies do all they can to claw back investment into their domestic economies. Such activity is causing governments to cut interest rates in an attempt to kick-start their economies by discouraging savers and enticing spenders. With nations around the globe in desperate need of capital the cuts are being made in unison and causing rates to converge to very low levels. As such, the carry trade which exploited interest rate differentials, can no longer function. With the loss of this tool traders have been forced to go back to basics and look at the deeper fundamentals behind a currency before investing. The traditional lenient approach has gone into reverse as investors reassess the risks of investing into countries with sizeable fiscal and current account deficits. The US Dollar will benefit from safe haven flows owing to its status as the world’s reserve currency. This however hides considerable flaws which will be revealed as deleveraging demand fades and through the continued use of quantitative easing into 2009. As the US economy is already heavily indebted it will have to increase the money supply or bear yet more debt to finance the purchase of assets. This is not a long term solution so it’s questionable how long such practices can be sustained. In an uncertain environment where recent events have proved that anything is possible it is difficult to predict when the tipping point will be.

After the Japanese economy experienced the longest expansion in over 60 years the Japanese Yen is now having a tough time. As an export dependent economy, it is suffering from the drop in demand from the traditionally high spending western regions and the government has had to face up to the fact that it did not do enough to quell the growing fiscal deficit in the good times, leaving little room to manoeuvre in the bad ones. Until exports recover, the likelihood of a recovery is minimal. It’s a chicken and egg situation as exports won't recover until global trade resumes which won’t be until the credit crisis has somehow been resolved.

Europe is suffering as Eurozone banks reveal huge exposures to the now sharply slowing Eastern European currencies. Countries already identified as being potentially vulnerable are Austria, Belgium and the Netherlands. Add to this the widely regarded opinion that the European Central Bank (ECB) was behind the curve in cutting rates, and disparities between the competiveness of the Euro members’ labour productivity and the area is a cause for concern.

For those European currencies outside of the Euro, namely the Swiss Franc and Sterling the situation is similar. Switzerland has a huge banking crisis on its hands, a consequence of over extending itself in terms of leverage. This is now undermining the currency’s performance. In the UK Sterling has also been pummelled as fears pervade over the ailing banking sector, despite drastic interest rate cuts. Globally Sterling is cheap against many currencies; however risk of a currency and government bond funding crisis remains.

The Australian Dollar and the Norwegian Krone fair better. Due to its geographical proximity, Australia supplies China with many of its commodities so when China spends internally it is generally good for the region. The fundamentals of the Krone are strong as it is commonly viewed that the weakness in oil prices are behind us. As oil price trends tend to impact the appreciation and depreciation of the Krone this is a good thing.

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