>Q3 2010 FX OUTLOOK: IT’S NOT JUST ABOUT THE EURO ANY MORE

All markets were extremely focused on the EuroZone situation in Q2, even though FX had been looking at this problem since the Euro downtrend really took off in December of 2009. The difference towards the end of Q2 versus earlier was that the EuroZone sovereign debt issue was finally judged to be critical enough to affect risk appetite across all markets and around the
world, rather than in FX only. This was remarkably similar to the way in which the market obstinately tried to contain the subprime issue as a US-only problem until well into 2008, even as Bernanke cut rates for the
first time in September 2007.

As we ponder the landscape for FX in the quarter ahead and beyond, we suspect that the main theme currently occupying a significant portion of the market’s bandwidth of attention – the EuroZone situation and its effect on risk appetite generally – will remain important. But we also suspect that this theme is occupying far too much of the market’s attention relative to other macro themes that could come to the fore in the coming quarter. Below we have a look at three of these themes.

Commodity currency countries – not just about risk anymore

In economic boom and bust cycles, the market expects the commodity currencies to act as high beta plays on global risk appetite and global growth, with the assumption that they will see the highest growth rates and interest rates during good times and appreciate the quickest on capital flows and carry trading, but will likewise see the fastest decline rates on the downside of the growth cycle as capital flows reverse due to quickly contracting interest rate spreads and as key
commodity prices fall and see a contraction in key domestic export industries. Most of these elements were in play in the boom and subsequent 2008-09 bust in commodity currencies. As global growth was suddenly in doubt in 2008, AUDUSD (to take a popular example) tumbled from a 25-year high to a five year low in the space of a couple of months..

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