What's Next for the U.S. dollar, British Pound and Japanese Yen?

The global financial crisis has brought a lot of changes in the FX market. What is behind unprecedented moves in U.S. dollar, British Pound and Japanese Yen and how much longer these currencies can sustain its current levels?
Anna Fedec, contact@tradingeconomics.com 3/16/2009 11:50:07 AM

The Strength of U.S. Dollar May Be Temporary

At the beginning of the last year we were arguing that the U.S. dollar could lose its position as the most popular reserve currency in favor of the Euro. But in the second quarter of 2008 the dollar suddenly started to rebound and began one of its biggest rallies in years, going from 1.6 to 1.2 dollars per euro in only three months.

Indeed, back in 2006 and 2007, several countries were considered to be in much better economic condition than the United States. For example, in that period the Euro Area economic growth surpassed that of U.S. and as a result, international investors were more willing to hedge dollar exposure with investments into the Euro Zone. Moreover, even though some economic slowdown was becoming visible in the United States, the majority of economists believed that the slump would be short and there would be no chance of spilling over to other countries. However, few months later the situation changed drastically, and the underestimated slowdown in the U.S. economy was soon transformed into a major global recession. More importantly, as everyone was being hit by recession fears, the U.S. dollar was once again seen as a safe haven currency, supported international demand for U.S. government securities.

Even so, at Trading Economics we think that current safe heaven position of the U.S. dollar could be temporary.  For some time, the U.S. economy has been running a current account deficit and the bill for biggest fiscal stimulus plan in the U.S history could bring the U.S. financial debt to the world very close to unsustainable levels. In fact, with the Japanese and Chinese economies also fighting with the global economic slowdown, one should not be is the yields on U.S. treasuries rises to unprecedented levels, making the fiscal stimulus more pricey than previously estimated.

The End of Yen Appreciation May Be Close

At the end of January, the Japanese yen reached a series of multi-year highs. Yet, during the last month the currency retreated by almost 11%.

Not a long time ago we were predicting that the currency would decline with the global economy recovery. But, sooner than we have expected, market conditions have changed. Although, the Japanese banking sector seems to have weathered the financial turmoil better than many other countries, the Japanese economy is deteriorating day by day. For example, the economy shrank by 12.7% annualized in Q4, industrial production fell by 31% yoy in January and retail sales and consumption were also weaker than expected. In addition, the demand for yen is declining as the exports slowdown eliminates over-hedged positions by exporters and the unwinding of yen carry trade positions seems to be over. In addition, there is also evidence that the Japanese are increasingly selling domestic equities and buying overseas bonds.

The Sterling May Not Recover Any Time Soon

Since July 2008, the British pound has slumped by more than 30% against the U.S. dollar and the Japanese yen.

The last few years of the debt boom with soaring house prices, falling savings and a surging trade deficit brought the country to a recession not seen since the World War II.  The Bank of England was forced to lower interest rates and a lower yield made the U.K less attractive place for international investors to invest. To make things even worst, recently, the current account deficit reached 5.7 per cent of gross domestic product, the highest among the Group of Seven industrialized countries, leading to an outflow of foreign currency and putting further downward pressure on sterling.

At Trading Economics we thing that the only chance for the pound to start recovering may be the restoration of confidence on British economy, but considering its current condition,  it may not happen any time soon.