There can be no doubt that for the most part 2009 has been a year for risk trades, not withstanding the sell off into year end. The policy successes in preventing a systemic crisis and the massive flood of USD liquidity injected globally kept the USD under pressure for most of the year and the currency became a victim of this success. Risk appetite is likely to improve only gradually over coming months given the still significant obstacles to recovery in the months ahead. This will coincide with the declining influence of risk on FX markets.
2010 will not be as straightforward and whilst risk will dominate early in the year interest rate differentials will gain influence in driving currencies as the year progresses. The problem for the USD is that market expectations for the timing of the beginning of US interest rate hikes is likely to prove premature as the Fed is set to hold off until at least late 2010/early 2011 before raising interest rates. The liquidity tap will stay open for some time, and risk trades will still find further support at least in the early part of 2010, whilst the USD will come under renewed pressure.
The ECB will be much quicker in closing its liquidity tap than the Fed and arguably an earlier reduction in credit easing and interest rate hikes compared to the Fed would favour a stronger EUR. However, the EUR is already very overvalued and a relatively aggressive ECB policy is unwarranted. Consequently rather than benefiting from more favourable relative interest rate expectations, the EUR could be punished and the EUR is set to decline over much of 2010 following a brief rally in Q1 2010, with EUR/USD set to fall over the year.
Japan is moving in the opposite direction to the ECB. FX intervention is firmly on the table though the risk is limited unless USD/JPY drops back to around 85.00. Even at current levels the JPY is overvalued but for it to resume weakness it will need to regain the role of funding currency of choice, a title that the USD has assumed. Efforts by the BoJ to combat deflation will likely help result in fuelling some depreciation of the JPY and it is likely to be the worst performing major currency over 2010, with a move back up to around USD/JPY in prospect.
The issue of global rebalancing will need to involve currencies but the currency adjustments necessary will not be forthcoming in 2010. USD weakness early in the year will be mostly exhibited against freely floating major currencies which will bear the brunt of USD weakness. However, the bulk of adjustment is needed in Asian currencies and there is little sign that central banks in the region will allow a rapid appreciation. China holds the key and a gradual appreciation in the CNY over 2010 suggests little incentive to allow other Asian currencies to appreciate strongly.
So in many ways 2010 will be one of two halves for currency markets and this has the potential to reignite some volatility in FX markets. High beta risk trades including the AUD, NZD, NOK and many emerging currencies will see further upside in H1 as the USD falls further. Gains in risk currencies will look even more impressive when played against the JPY and/or CHF than vs. USD given that they will succumb to growing pressure in the months ahead as their usage as funding currencies increases.
Ongoing rate hikes in Australia and Norway and the likely beginning of the process to raise rates in New Zealand early next year will mean that these currencies will also have the additional support of yield to drive them higher unlike the JPY. There is a limit to most things however, and eventually the USD will recover some of its lost ground against risk currencies, as it undergoes a cyclical recovery over H2 2010.