G10: a roadmap for 2007

Global liquidity is expansive. Interest rates are below nominal growth, savings are high, corporate cashflows are strong and the global funnelling of money from Asian central banks and oil exporters to Western capital markets is intact. The liquidity cycle is closely linked to monetary policy. Given our call for unchanged rates in the US in the coming six months, a single hike from the ECB and BOE and a hesitant tightening cycle in Japan, we do not expect monetary policy to bring the feeling of easy liquidity to an end soon.

The global economy has performed well in recent years. The main issues today relate to a mid-cycle slowdown in global industry and the US housing correction. We look for modest industrial activity in the coming months, while expecting domestic demand to hold up well. There is little to suggest that a sharp deceleration in economic growth is at hand, mainly because both inflation and interest rates are low. There is also little evidence of budding price pressures from goods or labour markets, and we suspect that the benign effects of structural changes will continue to hold down inflation in the immediate future.

Volatility has fallen across markets and asset classes in recent years. Volatility does not appear to be unusually low, except when it comes to money-market rates. What sets this period apart is that volatility is low across the board, and that it has been low for longer than previously seen. Our view is that both financial and macroeconomic arguments help explain the decline in volatility. We also find that a good deal of the movement may be ascribed to structural arguments. Cyclical volatility could rise in 2007 if, for instance, the US experiences a hard landing, or the liquidity cycle takes a turn for the worse. A more likely outcome is that cyclical volatility will remain muted in 2007.

The combination of positive growth, low inflation, easy liquidity conditions and low volatility will favour the higher yielding currencies. Before believing in a sustained unwinding of carry trades, we would like to see signs of a synchronised G3 monetary policy-tightening and/or a pronounced reduction in risk-seeking. We continue to forecast weakness in JPY and CHF.

Conventional wisdom holds that the USD must fall to correct the US current account deficit. We consider this unlikely. A current account deficit is just a difference between domestic savings and investments. When these do not match, local real interest rates move, prompting international capital flows. In a world with increasingly free capital mobility, there is no need for current accounts to be in balance at all times. On a global scale, the tendency is for current account surpluses in Asia and among the oil exporting countries, and for deficits in the 'Anglosphere'. We expect this to continue into 2007, which implies a continued export of capital into the main financial centres in the West.

Central banks may continue to move out of holding reserves from USD, mainly into euro. However, total reserves will continue to grow in 2007, and central banks will buy more USD than any other currency.

In our opinion, the rise in EUR/USD in Q4 was the result of a cyclical adjustment of expectations on the US economic outlook, combined with poor year-end seasonals and a historical pattern of USD weakness following mid-term elections. Now, incoming US data seems consistent with an increase in personal spending that will eventually ensure the economy survives the housing correction as well as the global industrial slowdown. When the outlook brightens, the USD will once again be a high-yielding currency in a positive carry environment. Our forecast for EUR/USD by year-end is 1.25.