Pro-cyclical growth trends and currency risk

A major FX theme has been to hold emerging market currencies given a global recovery and clear pro-cyclical trends in 2010. Hold commodity country currencies, hold large exporters, hold those which have a higher currency beta. This emerging market story seems to be favored even if there is slower growth since the prospects for EM seem to better than the developed markets. International reserves are higher so that they will be able to sustain a slowdown better then past crises. Yet, this week sees the beginning of currency pessimism. First, the prospect of a China slowdown is expected to have a contagious effect around the rest of the world. Second, there is an increase worry of sovereign risk. Lower growth will lead to sustained deficits.

Cyclical trends and currency risk are closely tied to what will happen to interest rates. The rate changes will feedback on currency markets through capital flows, the carry trade. There are a number of potential scenarios that can be analyzed through growth and policy responses in 2010.

One likely scenario is a currency appreciation signaled through rising rates coupled with strong growth. Tightening monetary policy will lead to appreciation. We have already seen this in AUD and NOK. However, the other extreme would be a lowering of rates and slower growth which will be coupled with currency depreciation. This has been one of the scenarios earlier in the recession. We should expect depreciation under this story.

What is difficult are the two other potential rate-growth scenarios. One would be higher growth but lower rates while the other would be rising rates and slower growth. The higher growth and lower rates scenario is not very likely, but a fear would be a combination of lower growth and rising rates. This combination could occur if there is a financing risk premium in rates or the potential for stagflation. This combination could be realized in the US if we have below trend growth but rising bond rates. This would cause a a currency sell-off and create havoc form many interest rate currency models. The path of rates and growth is one of the key currency risks in 2010.