2010 Currency Outlook: USD

After strong rallies in 2008 and early 2009, USD peaked in March. In order to combat the worst recession since the World War II, the Fed reduced the policy rate to an unprecedentedly low level and implemented a series of quantitative easing policies. The 'twin deficits' problem (current account and fiscal deficits) has put USD's status as the reserve currency at risks and triggered investors to dump the currency. Worries about the dollar's future as well as increase in risk appetite as global economic outlook recovered later in 2009 brought the greenback to extremely low levels.

Undervaluation: According Fed's measure, the trade-weighted USD index plummeted -13% against major currencies after making 2.5-year high in March. On annual basis, the gauge dropped -8%, the biggest loss since 2003. Despite modest recovery in December 2009, the dollar index continued hovering at historic lows.

ICE's US dollar index also showed a similar pattern. The valuation is about 1.5 standard deviations below its long-term average. From the viewpoint of mean-reversion, the dollar is poised for a strong rebound.

On a PPP basis, the dollar also looked undervalued when compared with major currencies. The table below shows the PPP values of 8 currencies which were used by Fed in composing the USD Major Currencies Index. Using closing price as of December 2009, USD is undervalued when compared with all 'major currencies'.

However, being cheap is not sufficient to make USD higher. The US needs to show promising economic growth to attract buying.

Economic growth in the US: Massive monetary and fiscal policies have helped reboot the growth engine as US data have turned more positive. US growth is expected to outpace its counterparts in the advanced economy, Labor productivity grew +4% in 3Q09, compared with decline in Germany and the UK, suggested faster recovery in the employment market in the US. In fact, appreciation in the euro and the yen in 2009 was a barrier for economic growth in the Eurozone and Japan. Economic expansion in Japan remained slow and deflationary risk continued to linger despite the government's expansionary measures. As urged by the Prime Minister, the central bank called for an urgent meeting in mid-December but the BOJ Governor Masaaki Shirakawa and his colleagues refrained from announcing more policy actions but sticking to a rate of 0.1% and a 10 trillion yen ($111 billion) lending program adopted in the previous meeting. It's widely anticipated that the BOJ will implement more expansionary policies to boost growth. In the UK, further QE cannot be ruled out if growth remained subdued.

Current account deficit widened +10% mom to -$108B in 3Q09. As a share of GDP, the deficit increased to 3% from 2.8%. Despite this, we see the trend of shrinking deficit as a % of GDP since the peak in 4Q2005.

Fiscal deficit in the US remains high. The chart below shows that the 'twin deficits' as a % of GDP reached 12.3% in 3Q09. Although it recovered modestly from a record of 15.6% in 1Q09, the double-digit reading is still worrisome.

Nonetheless, we believe fiscal deficit in the US is near the trough while fiscal situations in Europe and Japan may worsen. In recent elections, Japanese and German governments promised to increase government spending and reduce taxes while the US will likely focus on narrowing deficits next year.

A critical issue to offsetting the deficits is capital flow which is yet to improve. It's too early to say it will rise in the near-term but as the balance sheet in the US starts to improve, investors will flee to US asset, particularly when USD is trading at historic lows.

Gradual Exit from QE (End of the Asset Purchase Program): The Fed funds futures factored in 50-60% chance that the Fed will increase the policy rate by at least +25 bps by June. However, analysts in the street are more conservative and the consensus is that the first rate hike will not take place earlier than 4Q10. Although the Fed may not raise interest rates in the near futures, the end of the asset purchase program can effectively withdraw liquidity from the market and indirectly tighten monetary policies.

According to the accompanying statement of December's FOMC meeting, most of the Fed's special liquidity facilities (including the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, and the Term Securities Lending Facility) will expire on February 1, 2010, consistent with the Fed's announcement of June 25, 2009. The amounts provided under the TAF will continue to be scaled back in early 2010. The anticipated expiration dates for the TALF remain set at June 30, 2010, for loans backed by new-issue commercial mortgage-backed securities and March 31, 2010, for loans backed by all other types of collateral.

To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Fed announced purchases of $1.25 trillion of agency MBS and about $175 billion of agency debt. While the program remains in progress, the Fed is gradually slowing the pace and these transactions will be executed by the end of the first quarter of 2010.

As the asset buying program ends by the first quarter, abundant Treasury supply will no longer be absorbed by the Fed and this will add upward pressures to long-term interest rates. Credit Suisse forecasts Treasury 10-year note yields will rise to about 4.25% this quarter. Many investors view the end of the program as an end of the Fed's pledge to keep long-term interest rate low. In this case, market will react as if the Fed is tightening.

To conclude, we expect the dollar to strengthen in 2010 as it was dumped to extremely low level in 2009. Moreover, recovery in economic condition and removal of excessive liquidity in the market should attract foreign investments. While it's not likely for a broad-based rally against all currencies, we believe long positions in USDYEN will yield good returns as the Fed's gradual exit from QE and the BOJ's re-entrance of QE should push the US-Japan yield in favor of the dollar.

2010 Forecast Table - USD