Core currencies could win as dilemma over high inflation spreads

Core currencies could well prove the winners as the dilemma over how to deal with rising inflation rates and slowing growth spreads around the globe. Until now, the problem of stagflation appeared to one largely for the major economies – with the US Federal Reserve, the Bank of England and the European Central Bank uncertain over whether or not to start raising interest rates. This ensured that at least some markets outside the major economies remained attractive, with investors putting their funds elsewhere and major currencies suffering from the steady outflows. However, the problem has clearly now spread and asset markets, which once appeared as safe havens, are no longer proving so attractive. "The economic decoupling case no longer holds," said Hans Redeker, head of global foreign exchange research at BNP Paribas in London. "As the global economy offers less and less bright spots, funds are heading back home, hitting peripheral and benefiting core currencies," Redeker said. In fact, some suggest that emerging market and Asian economies could be most at risk. "The inflation 'shock' plays badly for emerging market equities," said Steve Pearson, senior currency strategist with Bank of Scotland in London. He noted that the Morgan Stanley composite emerging market index is down 13 per cent since global equities started to fall again in mid-May. This compares with a 9.5 per cent decline in the S&P 500 in the US. Callum Henderson, head of global foreign exchange strategy with Standard Chartered in Singapore, said the impact on global markets of rising yields, rising volatility and downside growth surprises is clear. "This is a particularly toxic mixture for emerging market countries and regions that have external deficits and are therefore dependent on portfolio inflows," he said. A sign of how quickly sentiment is deteriorating came from news that consumer confidence in New Zealand had slumped to a 17-year low as high interest rates, soaring energy and food prices and a slowdown in the housing market affect the economy. Today is likely to bring only more bad news in the form of first-quarter gross domestic product data, which according to economists at ABN-Amro "is expected to bring a negative reading". This comes as both the euro and the dollar show a certain amount of resilience as the Fed and the ECB continue to debate whether they can afford to tighten monetary policy at a time when most measures of economic growth, including business and consumer confidence on both sides of the Atlantic, are deteriorating even faster than many had expected. James Knightley, an international economist with ING Financial Markets in London, said he is even more cautious on the US growth outlook than the Fed is and believes that a "serious downturn is still a very strong possibility". But, it is the possibility that the economic downturn elsewhere may be even severe that could help currencies such as dollar from coming under additional selling pressure at this stage. "The re-emergence of inflation has ended this [delusional] sense of economic utopia," said Standard Chartered's Henderson, noting that it has ended with even higher inflation pressure in Asia than in the US. "Asian central banks, having sat on their hands, are now finally starting to deal with the inflation problem, raising interest rates and reserve requirements and intervening to limit local currency depreciation," Henderson reported. The stagflation dilemma was very much at the forefront of the market early yesterday as it continued to pore over the Fed's latest policy statement late Wednesday. Although the Fed left its rates unchanged at two per cent, it suggested that inflation concerns had edged higher and that a rate hike remains in the offing. Meanwhile, the yen fell to a record low against the euro as the ECB prepares to raise interest rates and Japanese workers look to use their summer bonuses to buy overseas assets offering higher yields.