SEPTEMBER Forecast Summary... 2 Currencies Strategy... 3 East Asia The Subcontinent...6 The Americas..7 Europe/Africa...

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1 C O N T E N T S Forecast Summary... 2 Currencies Strategy... 3 East Asia The Subcontinent...6 The Americas..7 Europe/Africa SEPTEMBER 2006 EUR/USD is expected to stay in a tight range for a few more weeks but we think that the next big move will be a US dollar rally. On the US side, rate expectations probably won t move much for a while. But we believe that the bond market is wrong in having priced-in a Fed rate cut in the first half of The process to come of pricing this expectation out, should eventually lift the USD. On the euro side, an early October ECB rate hike is a done-deal, and a hike in December (to 3.5%) is very likely. This should support the EUR but won t be a surprise. In addition, any 2007 ECB hikes will come through more slowly. News-flow, we suspect, will tend to pull the EUR weaker. At some point in 2007 we believe EUR/USD will drop close to $1.20. The Fed watered down, but still retained, its tightening bias at yesterday s FOMC meeting. Rates were left unchanged at 5.25% and are likely to stay at 5.25% in at least the next two FOMC meetings (October th and December 12 th ). We think that the majority on the Fed, for some time to come, will stay more concerned about inflation being too high than economic growth being too low. We have been wrong over the summer but still see the JPY appreciating and moving the most of major currencies over the next few weeks. We are aware that going long JPY is painful and expensive if the currency does not rise. But we expect Japanese economic data to improve and, unlike most in the market, still see the BOJ hiking rates again by end A CNY trading-band widening also looks likely sooner rather than later. The risk is we are wrong on the data if BOJ rate hike expectations move back further, then EUR/JPY could easily move to new highs say by end The CAD should stay under pressure on the dollar-bloc side. We would sell the crosses see page three. The AUD should hold up best, with another rate hike imminent, and as metals prices stabilise. In emerging markets, we would target Asian currencies and the MXN over the longer run on the view that the US should have a softlanding. The Thai baht should rise near term as military coup concerns fade and capital inflows increase into Asia s cheapest equity market. But we think that the TRY summer rally is now largely over. This Currencies report appears every month and is distributed by . Also published by is Economics for Investment - Weekly. The hard copy Economics for Investment is printed and distributed every two months. Please ask your Relationship Manager if you would like to receive them. All of the Economics for Investment publications can now be accessed on This publication is for information only and is not to be construed as an offer to buy or sell investments. American Express Bank Ltd., whilst considering the contents to be reliable, takes no responsibility for any individual investment decisions based thereon. These represent the views of American Express Bank as of the date of this publication; these views may change over time and without notice. GLOBAL ECONOMICS UNIT John Calverley, Kevin Grice, Sarah Hewin, Giriraj Singh Distribution: Michael Chester address: aeb.economics@aexp.com AMERICAN EXPRESS BANK LTD. 60 Buckingham Palace Road, London, SW1W 0RR (No. FC1863, BR301). Incorporated with Limited Liability in the State of Connecticut, USA and registered with the Secretary of State, Hartford, Connecticut, USA with its head office in New York, USA. American Express Bank Ltd.("the Bank") is authorised and regulated by the Financial Services Authority ("FSA"). The Bank is entered in the FSA's Register and its Register number is The FSA's Register can be accessed at The Bank's registered VAT number is GB September 21, 2006

2 Economics for Investment Currencies EAST ASIA Spot per US$ 21/09/06 CURRENCY FORECAST SUMMARY 3 month forecast per US$ % Change* 3 month interest rate, % Implied return, 3 months, %** Large devaluation risk, %*** 12 month forecast per US$ % Change* Japanese Yen/US$ Japanese Yen/Euro Australian Dollar Chinese Renminbi Hong Kong Dollar Indonesia Rupiah Korean Won Korean Won/JPY New Zealand Dollar Australian Dollar/NZD Philippine Peso Singapore Dollar Taiwan Dollar Thai Baht THE SUBCONTINENT Indian Rupee THE AMERICAS Canadian Dollar Argentine Peso Brazilian Real Mexican Peso EUROPE/MIDDLE EAST/AFRICA Euro UK Pound/US$ UK Pound/Euro Swiss Franc/US$ Swiss Franc/Euro Hungarian Forint Hungarian Forint/Euro Polish Zloty Polish Zloty/Euro Russian Rouble Turkish Lira Turkish Lira/Euro South African Rand South African Rand/Euro * -ve = depreciation, +ve = appreciation, ** return on USD investment in currency over 3 months, *** defined as a 10% or more devaluation against the US$ over three months. American Express Bank Ltd. 2 EFI Currencies September 2006

3 GFM Currencies Strategy NZD/CAD The recent drop in commodity prices opens up a carry play on the NZD/CAD cross (current 0.74). If key support at / holds and the trend reversal is confirmed, target /0.7930, with / key risks ENERGY PRICES: DOWN SHARPLY, NEGATIVE FOR THE CAD $/Barrel Oil Natural Gas (r/h scale) $/MMBTU 16 Source: DATASTREAM YIELD PICK-UP: SUPPORTIVE OF NZD % NZD/CAD New Zealand 3-month rate Canadian 3-month rate NZD/CAD Sourc e: DATASTREAM The commodity markets have been making headlines recently sometimes for all the wrong reasons as hedge funds seem to be getting themselves into hot water again. Hedge funds (some at least) appear to have forgotten that the word hedge can actually mean more than just leveraged. Commodity price trends will be interesting in the future. For instance, if gold continues to fall away then the gold currencies like the ZAR, AUD, NZD, and CAD may be in play again. Copper has ties to the CLP (Chilean Peso), while oil currencies are clearly the Gulf/Middle East OPEC members, Russia and over the last few years, the CAD. Positives? If commodity currencies do come off the boil (or sell off further in the case of the ZAR) then a semiconvoluted argument could have the CNY and other end producers doing quite well. If they have managed to move their prices higher to account for higher input costs, and the input costs collapse, but their prices don t, that should mean more profits, right? Hmmm. This sort of argument though is probably behind some of the rally in the INR over the last few weeks, and could bolster that currency further. On a cross play in the majors, taking the view that some of the strength in the NZD is due to the relatively high yield on offer and this may remain the case for awhile, selling the CAD could appeal if one thinks that oil prices (and natural gas etc.) will continue to fall away. The cross itself pays over 3% in the 3mth depo, which is attractive, and taking the view that the USD trend is the broad tide, should be able to at least trade in a flat range. Looking at the actual cross itself though and the CAD soared from to from April 2005 to June 2006, climbing back to now (see chart). The 250-day moving average comes in at and should be a useful trend barometer. With a basing pattern in place (wedge, inverse head and shoulders or V - all the same at this stage) then watch the pullbacks to see if this really is a reversal or a long term trading range being established. Dips towards the area should find buyers (20-day ma) with the 60-day ma near offering further support below this. On the charts the /00 low from July 31 and the /20 low from June 29 mark the key lows/risk levels to hold, with targets, if this is a reversal, placed at /0.7930/ (38.2%, 50% and 61.8% retracements of the fall from the high, respectively). The 0.82 to 0.83 area is key former support, and should offer resistance if reached. For now, gauge the pullbacks, if support holds above and and higher begin to break, then the cross should be able to regain some key ground and pay a positive carry in the process J F M A M J J A S O N D J F M A M J J A S Analysis from: Gerry Celaya, Redtower Research Sourc e: DATASTREAM American Express Bank Ltd. 3 EFI Currencies September 2006

4 EAST ASIA CURRENCIES JAPANESE YEN Spot Month Forecast 113 The yen, yet again, has disappointed our forecasts and has been pulled lower by diminished expectations over BOJ tightening (on the CPI methodology change), increased capital outflow into foreign bond markets, and a renewed focus on the carry trade. But we still expect sustained JPY gains. Soft Q2 GDP growth of only 1.0% pa probably overstated the pressure on Japan s upswing. We expect economic data to improve over the next few weeks and still see the BOJ hiking rates again by end 2006 in either October or December. This should lift JPY bond yields and reduce capital outflow. The main risk is more weak data especially a disappointing Tankan survey of business sentiment in early October. Large devaluation risk*: 10% AUSTRALIAN DOLLAR Spot Month Forecast 0.77 The Aussie has dropped, as expected, on lower commodity prices and as markets have cut the odds on another RBA rate hike. We now expect the AUD to rally again over the next few weeks. Commodity prices will most likely stabilise after recent large declines. We also still expect that the RBA will hike rates again, most likely in early November. This should hit local bonds and further lift the AUD-USD yield premium. Q2 GDP growth was soft, up only 0.3% on Q1, but Q3 data has brought stronger home loans, higher consumer confidence, and continued very good employment growth. Q3 consumer prices (published Oct. 25 th ) will be very important but inflation will likely have stayed above the 1-3% pa target. Large devaluation risk*: 10% CHINESE RENMINBI Spot Month Forecast 7.76 Policy tightening is finally having some impact in slowing the economy investment, industrial production, and credit growth all eased back in August. This means that significant new tightening measures are unlikely for a while but a widening of the CNY s trading band still looks inevitable and, probably, will happen sooner (in the next three months?) rather than later. China s August trade surplus increased to a new record ($18.8bn) and, with imports on a softer track, looks set to reach another record high in September. In addition, recent Beijing moves to move the CNY/USD rate around (both up and down) make sustained appreciation less of a one-way bet once the trading band is widened. Large devaluation risk*: 5% HONG KONG DOLLAR Spot Month Forecast 7.78 Hong Kong money market rates have moved down and 3 month rates are now around 100bps below US equivalents. As in 2004, lower Hong Kong rates may reflect strong domestic liquidity but uncertainty over the HKD peg has also probably risen with the CNY/USD rate appreciating towards We expect the renminbi to reach 7.78 in around 3 months time, but there is virtually no chance that the HKD peg will be changed. Therefore, Hong Kong rates should eventually move up to US levels. The economy is slowing, as elsewhere in Asia, but a major downturn looks unlikely given that unemployment should stay low, the well-supported property market, and the prospect of stable HK prime rates. Large devaluation risk*: 5% American Express Bank Ltd. 4 EFI Currencies September 2006

5 EAST ASIA CURRENCIES INDONESIA RUPIAH Spot Month Forecast 9000 BI rates dropped to 11.25% in September and, with inflation now likely to fall to around 7% pa by end 2006 from 14.9% now, more cuts are on the way. Rates should fall 50bps in October and drop to 9.75% by year end. Lower rates should boost consumer spending and, as a first sign of this, August motor-cycle sales rose strongly. The authorities are reluctant to allow the IDR to rise too far and BI seems to be targeting a real (inflation-adjusted) interest rate of around 200bps. The main IDR devaluation risk is that this real rate is too low. But the rally in the IDR bond market probably has further to go, with 10-year yields likely to drop 50-75bps (from 11.1% now). Near term this should boost capital inflow and the IDR. Large devaluation risk*: 15% SOUTH KOREAN WON Spot Month Forecast 935 The KRW has risen and will likely rise further against the USD and JPY. Economic data remains downbeat, with industrial output down to a 5 month low, consumer confidence at an 18-month low, and services soft as well. But we continue to expect a soft-landing. Foreign demand should hold up and unemployment is low. The government also has the fiscal flexibility to boost public spending, and may well do so ahead of December 2007 elections. Finally, with inflation within target and the housing market slowing down, rates are likely to stay on prolonged hold into 2007 at a relatively low 4.5%. The worst of the slowdown looks over. Better economic data and increased confidence should lift Korean stocks and the KRW. Large devaluation risk*: 10% NEW ZEALAND DOLLAR Spot Month Forecast 0.64 We have been wrong and the Kiwi has climbed on RBNZ hints that rates may rise. The RBNZ is more hawkish because the strength of housing and employment has stopped consumer spending from pulling back enough to ensure that inflation (4% pa) moves down to their 1-3% target range in We think that the RBNZ is too bullish on the economic outlook and expect GDP growth to stay very sluggish, climbing only 1-2% pa in The next move in official rates (now 7.25%) should be down, not up. But the first cut now looks unlikely before the second half of next year. The NZD will stay higher for longer near term, but the next move should still be more renewed slippage against the USD and the AUD. Large devaluation risk*: 15% PHILIPPINE PESO Spot Month Forecast 49.5 We expected a further PHP rally but the currency has surged and looks likely to stay strong. The bond market remains attractive and should keep attracting capital inflow. Central bank rates were left unchanged this week, at 7.5%, but inflation has slowed to 6.3% pa and should slow further. GDP growth is also likely to come under some pressure. Whilst agriculture and exports boosted first half of 2006 GDP growth to % pa, consumer spending has weakened and exports will likely slow in the second half of this year as global growth eases. Therefore, BSP rates should fall from early 2007, bringing a bonds rally. Remittance inflows should also stay strong whilst the fiscal improvement looks solid and is unlikely to unwind any time soon. Large devaluation risk*: 15% American Express Bank Ltd. 5 EFI Currencies September 2006

6 EAST ASIA / SUBCONTINENT CURRENCIES SINGAPORE DOLLAR Spot Month Forecast 1.55 The steady appreciation of the SGD has seen inflation fall to 1.1% pa in July even though economic growth has stayed strong. Some cyclical ups and downs are inevitable but real GDP growth remains on track to climb around 7% pa in 2006, which is well-above trend for Singapore, on the back on a good exports performance, low unemployment, and the continued solid performance of tourism. The developing US and regional economic slowdown is a threat but provided foreign demand does not slow too much (which is what we expect), Singapore s economy should hold strong in The MAS should retain its policy of modest SGD appreciation in its October monetary policy review. Large devaluation risk*: 5% TAIWAN DOLLAR Spot Month Forecast 33.5 The TWD has slipped, as expected, and is likely to stay soft, although the central bank will move to head off sharp moves (either way). Political protests are mounting against President Chen Shui-bian and, combined with the credit card debt issue, are pulling back domestic demand consumption spending, as well as business investment. But exports continue to hold up well. Exports slowed in August but were still up 17% pa. Continued good demand from China, which we expect, should keep exports strong. But 2006 GDP growth will likely slow to around 3.8%, after 4.1% last year. There is little inflation but official rates are very low as well another 13bps hike (to 2.65%) is likely in late September. Large devaluation risk*: 15% THAI BAHT Spot Month Forecast 36.5 The military takeover will hit confidence but probably won t have a lasting economic impact. Thai markets, and the baht, should perform strongly over the next few weeks. The economy and external accounts are far stronger than in Prolonged political gridlock has also already had a big negative impact on confidence and GDP growth. Provided, as is likely, the timetable for a return to democracy (linked probably to some political reforms) is implemented, the economy should quickly recover. Inflation has slowed and there is also a good chance that the next move in rates will be down. The main risk is prolonged military rule/political unrest, but this risk looks low. Large devaluation risk*: 15% INDIAN RUPEE Spot Month Forecast 45.0 Economic growth will likely remain in the 8% pa region in the April- June quarter (data published Sept. 29 th ) and the 12.4% pa rise in July industrial production points to GDP growth holding strong in the second half of But wholesale price inflation has climbed to around 5% pa, with consumer prices rising even faster. In addition, credit growth has accelerated again to around 33% pa. Benchmark rates should be hiked another 25bps at the end of October (from 6.0%) and will likely rise again (by another 25bps) in January Rising rates and the Asian currency appreciation we expect should pull the rupee stronger still, although any upside may be limited by subdued equity market capital inflows. We see little upside for the Sensex over the next few months. Large devaluation risk*: 10% American Express Bank Ltd. 6 EFI Currencies September 2006

7 AMERICAS CURRENCIES CANADIAN DOLLAR Spot Month Forecast 1.15 The CAD has been under pressure as the economy has stalled, the US slowdown has continued, and on lower commodity prices. We expect more CAD weakness over the next few weeks, even though commodity prices will most likely stabilise for a while. Canadian Q2 GDP growth slowed to 2% pa, well below trend, and is likely to stay close to 2% into July/August data has brought a reduced trade surplus, further employment declines, and softer business sentiment. Worries over the US slowdown (30-35% of Canada s economy is directly or indirectly linked to the US) will also probably intensify for a time. The BoC kept rates on hold in September (at 4.25%) and is likely to stay on hold into Large devaluation risk*: 10% ARGENTINE PESO Spot Month Forecast 3.15 The ARS has continued to slip and we expect further depreciation as the economy deteriorates. Three years of very strong growth means that capacity use is very tight, but worries over increased state intervention are curbing private investment. Q2 GDP growth dropped to 7.9% pa, the slowest expansion for two years, and July industrial output was soft as well. Inflation also remains an issue - still up 10.7% pa in August. The government s price agreements approach has stopped inflation accelerating further but tighter monetary and fiscal policies still look necessary to bring the inflation rate down sharply. Central bank USD buying to boost fx reserves will also tend to hold the ARS weak. Large devaluation risk*: 10% BRAZILIAN REAL Spot Month Forecast 2.15 We expect the BRL to rally over the next few weeks but then see sustained weakness back towards 2.50 in GDP growth remains disappointing and, whilst inflation should stay low, wages are picking up. This means that 25bps rate cuts are most likely from now on. We expect another cut in October and see the SELIC rate falling to 13.75% by end 2006 (now 14.25%) and to % during President Lula has a good chance of winning the October 1 st election in a first round but we expect a more difficult second term. Lula s congressional support could be weak and it will be difficult to keep public spending under control and push new reforms to reduce the tax burden and lift economic growth. Large devaluation risk*: 15% MEXICAN PESO Spot Month Forecast The peso has been volatile and weaker, as expected. We now anticipate sustained MXN gains. Mexico GDP growth strong at 5-6% pa in Q1 and Q2 - will likely slow in the second half of But, provided the US has the soft-landing we expect, Mexico should have a soft landing as well. This should support the peso. Inflation should stay low and in line with target despite August s acceleration to 3.5% pa. Therefore, we suspect that Mexican rates will fall from December by 25bps (to 6.75%). Felipe Calderon has now been formally confirmed as the new president and there is even a chance that structural reforms make some progress in the new congress. The main devaluation risk is that AMLO s election protests persist. Large devaluation risk*: 15% American Express Bank Ltd. 7 EFI Currencies September 2006

8 EUROPE CURRENCIES per euro EURO Spot Month Forecast 1.27 The Euro-zone economy continues to do well, but indicators (confidence and purchasing managers surveys) point to a moderating pace of growth in the second half of 2006 as global demand slows, after strong, above-trend GDP growth of 3.3% pa in the first half of The ECB has indicated that it will continue to tighten rates, in response to above-target inflation and still-rapid credit growth, with the next hike in October and rates (probably) rising to 3.5-4% by mid But higher Euro-zone rates are largely factored into markets, and any further upside for the euro looks limited from here. The dollar should benefit from the Fed retaining a tightening bias while ECB rate hikes come to an end in Large devaluation risk*: 10% UK POUND Spot Month Forecast 1.84 Sterling should ease weaker against the euro and the dollar. Recent data have been firm, pointing to another 25bps UK rate hike (from 4.75% now), most likely in November. But the economy still faces headwinds and inflation is unlikely to become an entrenched problem. 5% UK rates are already priced in, whilst the hikes to come from the ECB look more certain and should continue into 2007, in the process shrinking the pound s yield pick up. Therefore we expect sterling to weaken against the euro, moving to GBP0.69/EUR in coming weeks. Against the dollar, sterling should follow the usual EUR correlations, stabilising near term, before falling below USD1.80/GBP in 2007 (if we are right on EUR/USD). Large devaluation risk*: 10% SWISS FRANC Spot Month Forecast 1.24 The economy is strong and further rate hikes, in December and next March, look likely, following mid-september s 25bps rate increase. But the Swiss franc has sold off sharply against the euro on dovish comments from the SNB, suggesting that they are not too concerned about inflation risks. Euro-zone interest rates are expected to rise faster than Swiss rates, widening the euro s yield advantage. Nevertheless, EUR/CHF is now at its highest level in over 6 years, which does not look justified by Switzerland s strong fundamentals and continued global geo-political risks. We expect the CHF to recover some of its losses against the euro, but to weaken against the dollar on further USD strength. Large devaluation risk*: 10% HUNGARIAN FORINT Spot Month Forecast 215 The forint has been hit by rioting over the government s leaked admission that it lied about the state of Hungary s public finances, and, earlier, by a delay to the targeted euro adopting date. We have raised the large devaluation probability further to reflect the political uncertainty and the risk that austerity severely damages growth. But, with the true state of Hungary s problems now out in the open, the rationale for fiscal tightening is clear and should give added impetus to the government s tightening programme. Further hikes on accelerating inflation should take Hungarian rates to the highest in the region and, with a gradual improvement in the twin deficits, stabilise EUR/HUF in the range. Rates look set to rise a further 75bps by year end, to 8%. Large devaluation risk*: 30% American Express Bank Ltd. 8 EFI Currencies September 2006

9 EUROPE/AFRICA CURRENCIES per euro POLISH ZLOTY Spot Month Forecast 2.99 The zloty is weaker than a month ago, on wrangles within the ruling coalition over next year s budget, and due to rising inflation and a consequent sell-off in the local bonds market. But the return of Zyta Gilowska as Finance Minister and Deputy PM would help to keep spending pressures under control. Other economic fundamentals also still look OK. The economy is strong, up 5.5% pa in Q2, though growth has probably peaked. In addition, the external accounts are in reasonable shape, financed by strong FDI inflows. Interest rates look set to rise in the first half of 2007, but are still relatively low for the region. The zloty will stay vulnerable to politics and its low yield, but should recover in coming weeks. Large devaluation risk*: 15% RUSSIAN ROUBLE Spot Month Forecast Source: Dat ast ream Inflation has accelerated over the summer, on drought-related higher food prices, and rising energy costs. The oil industry is under pressure to prevent further price hikes as the government tries to keep inflation within its 9% pa target. But RUB appreciation will stay the prime tool against inflation, even though the policy has been criticised by politicians because of its squeeze on competitiveness. Nevertheless, the economy is strong, with double-digit annual gains in construction and retail sales. Looser fiscal policy ahead of the 2007 parliamentary/2008 Presidential elections should sustain the momentum, despite the recent drop in oil prices. The main risk is a further sharp fall in oil prices. Large devaluation risk*: 5% TURKISH LIRA Spot Month Forecast 1.48 Higher interest rates should pull growth weaker in the second half of 2006 after 7.5% GDP growth in Q2. We believe the fall in EUR/TRY (lira rally) is largely over now even though economic fundamentals are improving. Government finances were in surplus in January-August and the external deficit should improve soon. Terrorism fears have hurt tourism, but slowing growth should pull back imports, whilst exports are more competitive. Finally, inflation should be back in single digits soon (though seasonal pressures will keep inflation high next month). The key lira risks are political. EU negotiations are on rocky ground, Middle-East risks remain high, and next year s elections will keep investors cautious. Large devaluation risk*: 25% SOUTH AFRICAN RAND Spot Month Forecast 6.80 The rand has sold off sharply, against our expectations, on worries over the external deficit, gold and, more recently, Hungary contagion and domestic politics (the dismissal of Zuma corruption charges). The economy is overheating, with business confidence, manufacturing and government infrastructure spending strong. Household spending remains supported by rapid credit growth, with the impact of the 100bps rate hikes since June yet to feed through. Rates look set to rise by another 100bps by year-end (next rate hike likely at the SARB s October 11 th meeting), to counter rising inflation pressures. The rand will stay vulnerable to more bad news on the external deficit. But gold should be more supportive in coming weeks as well. The sell-off looks overdone. Large devaluation risk*: 20% American Express Bank Ltd. 9 EFI Currencies September 2006