International Financial Outlook

Summary of main changes to exchange & interest rate forecasts

Downwardly revised data showed the UK economy stagnated in Q2, leading to a sharp decline in the pound last month. However, we do not expect the Bank to reduce interest rates this year, given that CPI inflation is likely to rise above 5% near term, well above the BoE's 2% target. We have brought forward our sterling depreciation projection and now see £/$ at 1.70 by the year-end and 1.65 by mid-2009.

The eurozone economy contracted in Q2, weighing on the euro exchange rate. However, with CPI still uncomfortably high at 3.8% in August and not expected to fall back to the 2% until 2010, the ECB left interest rates on hold at 4.25% and reiterated its neutral bias for the policy outlook. We expect the ECB will keep rates on hold in the remainder of this year and first half of 2009, and for £/€ to remain in a broad 1.20-1.25 range.

The trade-weighted US dollar rose for the second consecutive month, as Q2 growth was revised up to 3.3% (annualised). Growth is expected to moderate in the second half of the year, but the Fed has signalled that the next rate move is likely to be up. We expect the Fed to start raising interest rates in early 2009, with a total of 200bps of tightening next year. We have revised down our €/$ forecast to 1.37 by end-2008 and 1.32 by mid-2009

In other developed economies, Japanese growth contracted in Q2, but CPI inflation rose above 2% for the first time since 1998. We expect the BoJ to keep rates on hold at 0.5% until next year and forecast $/Y falling gradually towards 100 in the medium term. Australia reduced interest rates for the first time since 2001 and we have revised up our $/A$ forecast to 1.23 by end-2008.

Increased investor risk aversion led to declines in emerging market currencies in the past month, with Eastern European currencies weighed further by proximity to slowing eurozone growth prospects. Latin American currencies were also weighed by lower commodity prices, as oil prices fell towards $100 per barrel.

We expect emerging Asian currencies to outperform in the medium term, with rises forecast in the coming year for the Chinese renminbi, Indian rupee, South Korean won (despite recent volatilities) and Malaysian ringgit, among others. However, we expect further falls in the Polish zloty and Czech koruna, and a more mixed outlook for Latin American currencies.

Full report here

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