The euro is not expected to experience abrupt movements versus the dollar over a several-month period. The slightly higher inflation rate recorded in the euro zone, tied to rising oil prices, has sparked fears of an anticipated tightening of monetary policy by the European Central Bank (ECB). In contrast, we feel that inflation does not constitute any real risk for the euro zone and moreover that the ECB is not inclined to repeat the mistake made in July 2008 when it raised its discount rate at an unpropitious time. The debt crisis is far from being resolved, and bond market tensions are expected to remain strong enough to depreciate the euro. On the other hand, beyond the next six months, the downside risk appears to weigh more heavily on the greenback. Continuation of an extremely lax budgetary policy (running the public deficit to 10% of GDP in 2010 and 2011), coupled with a zero Fed funds rate, will eventually lower the dollar’s value.

The need to cover America’s current deficit is considerable (3% of GDP); our assessment is that investors may in time demand a higher return on American debt or else a lower exchange rate. When faced with such a dilemma, we believe that American financial authorities will opt for a weaker dollar, a move that would favor exports, over a hike in long-term interest rates, which would hinder the domestic economy. Our projection calls for a euro exchange rate at 1.30 USD 6 months from now (with a slight risk to the upside, depending on political progress in Europe). Over a 12-month horizon, we anticipate the euro forging ahead to the 1.40-1.45 USD range.

 The yen might see a decline in 2011.Deflation just may be contained this year in Japan, with price stabilization expected by the end of 2011. The growth differential between the United States and Japan should lie within a range of 1.5 to 2 points, which would be reflected, at least partially, in the two-year interest-rate spread, which serves to guide USD/JPY parity. In practical terms, this trend should lead to the yen’s gradual fall, with a more pronounced impact certain to play out during the second half of the year (85 JPY/USD in 6 months, 90 JPY/USD a year out).

 The pound on a course towards strengthening versus both the euro and dollar. Sterling’s undervaluation versus the euro and dollar, as explained by an actual short-term U.K. interest rate more negative than anywhere else in the industrialized world, has been weighing on the pound’s value. Nonetheless, the Bank of England will undoubtedly be forced to raise the central bank’s discount rate to rein in anticipated inflation. Such a tightening should not be expected over the very short term given the drastic budgetary cuts currently underway. The pound’s upward movement will thus be limited and gradual. We maintain our scenario of a stronger pound versus the euro over the next year (0.85 GBP/EUR in 6 months, 0.80 GBP/EUR 12 months out).

 Emerging currencies will continue their climb: Higher inflation rates will necessitate monetary tightening measures, which in most emerging countries will be introduced gradually. The inflation rate currently observed in the emerging world stems from two sources: increases in commodity prices, and robust domestic economic activity. The appreciation in foreign exchange rates serves as an effective hedge against imported inflation, even if it cannot be controlled as directly as injecting credit into the economy.
We consider that emerging currencies will proceed along their upward path. The time has come however to emphasize those currencies that have not yet reached their pre-crisis parity versus the dollar or that have adopted a strictly-controlled exchange policy with a partial peg to a third currency. Measures for restricting capital flows, implemented in a number of countries, should only exert a limited impact on incoming flows, which should from a structural standpoint remain high. We feel that the Chinese yuan (CNY), Korean won (KRW), Malaysian ringgit (MYR) and Thai baht (THB) are to be included as currencies offering the greatest appreciation potential versus the US dollar over the next 12 months.