Interest Rate Outlook for 2011

With a new year upon us, currency traders are once again turning to the old crystal ball in an attempt to predict interest rate actions for the major economies. While there are many storylines to watch as 2011 unfolds, two narratives in particular are expected to garner the most attention – the long-awaited recovery in the US, and the ongoing credit crisis in the Eurozone.

US Economy to Stabilize But Remains Vulnerable

The final quarter of 2010 did provide reason for guarded optimism that the US economy was finally on the path to recovery. The Institute for Supply Management (ISM) Index confirmed that factory production continued to rise in December while the construction industry was also showing signs of life. Both sectors are integral to a sustained recovery.

On the negative side however, it is clear that the pace of recovery will be significantly slower than experienced in previous recoveries. The main reason for this is unemployment which stubbornly refuses to subside.
The year ended with an unemployment rate of 9.7 percent prompting Federal Reserve Chairman Ben Bernanke to admit that it could take four or five years before unemployment falls to the typical range of 5 to 6 percent. In response to the more pessimistic employment outlook, the Federal Reserve downgraded its 2011 forecast from a range of 3.4 to 4.2 percent, to a more modest 3.0 to 3.6 percent growth.

The fact that the Fed has reduced its growth projections for 2011 suggests there is now even less appetite for a hike in interest rates than just a few months ago. Bernanke has been very transparent saying on more than one occasion that the Fed is prepared to keep rates in the range of zero to 0.25 percent for an “extended” period of time if necessary.

With all this in mind, it is difficult to imagine the Fed will entertain thoughts of a rate increase in the near term. For these reasons, most analysts believe US interest rates will remain at the current level for at least the first half of 2011.

Debt Concerns Remain for Eurozone

First it was Greece requiring emergency funding to meet its debt obligations, and then it was Ireland. The big question now is, “who’s next”?

Most are betting on Portugal, but some money is also being placed on one of the larger economies such as Spain or even France. While we can’t say for sure which country will be next in line for emergency funding, or even if the need for another bailout is certain, what we can say is that just the rumor of another Eurozone insolvency will further hammer the reeling euro.

Germany, and to a lesser degree some of the northern countries including Finland, Sweden, and newly-admitted Estonia, are expected to lead the Eurozone countries in 2011. Still the majority of countries are expected to lag or even decline, and some of this will be the result of fiscal rebalancing to address severe budget deficits. Some analysts even worry that overly-zealous governments could cut too much, too quickly, thereby running the risk of tipping the Eurozone back into recession.

The more pressing matter however is the coming slowdown in demand for Germany’s exports many analysts suggest is unavoidable later this year.

Germany has been the brightest star in the Eurozone galaxy for 2010, but its luster is expected to diminish as its largest export markets in the US and Britain are both reeling from their own economic problems. In the US, the painfully slow reversal in job losses has consumers sitting on their hands, while growth is expected to stagnate in Britain as the government implements dramatic spending cuts with more tax increases in the works to deal with a huge deficit.

The likely outcome is that even if the Eurozone manages to fend off any further sovereign insolvencies, the economy is still expected to slow. This has the European Central Bank backing away from the rate hike trial balloon it floated during the third quarter when ECB President Jean-Claude Trichet hinted that a rate increase could soon be necessary. There has been no further talk of monetary tightening since then and most analysts believe the rate will remain at 1 percent well into 2011.

Great Britain Deals With Its Own Debt Problems

With the toppling of the Labor party in last fall’s election, it appears that the populace finally realized the need to gain control of the nation’s finances. While the election resulted in a coalition government led by the Conservative party and supported by the Liberal Democrats, targeting the growing debt was a central theme during the election.

Within a few weeks of being elected, the new government announced plans to reduce the deficit from ten percent of GDP, to somewhere in the range of two percent. This will necessitate cutting roughly 83 billion pounds (US$130 billion) from the budget.

The British economy has actually been increasing at an inflationary rate exceeding the two percent target rate for much of the past year. However, most of this activity is due to a recent increase in the VAT consumer tax and a sharp bump in energy prices. With deep government cutbacks coupled with more tax increases, consumer spending in other sectors will probably decline making it doubtful that the Bank of England will seek to increase lending rates until it becomes more apparent how the proposed spending cuts will affect the economy.

Yen Appreciation Remains Japan’s Top Currency Concern

Like Germany, Japan is an exporting nation, and as an exporting nation, Japan faces the delicate balance of currency valuation verses export sales. For Japan, the task facing the monetary authorities is to curtail the yen’s appreciation against the currencies of its two largest trading partners – namely, the dollar and the euro.

To be blunt, 2010 was yet another failing year as the yen made significant gains on both currencies.

At the beginning of 2010, one US dollar could purchase the equivalent of 92. 58 yen but by the end of the year, one dollar could purchase only 81.25 yen. This means that for the US consumer, the appreciation of the yen during 2010 represents a loss of buying power of more than 14 percent for the course of the year. Against the euro, the yen’s gains were even greater appreciating more than 20 percent.

When foreign buyers convert their own currency to the yen, this naturally increases overall demand for the currency. This demand alone has helped push the yen higher and over the years has enticed savers and investors to buy yen to avoid the volatility plaguing most other currencies in recent years, contributing even further to demand.

This phenomenon is not new and since the mid- 70s, the yen has continued to outpace the dollar. In 1975, one US dollar could buy over 300 yen compared to the 80 or so yen one dollar will buy in early 2011. It is this long track record of growth against the US dollar, that has contributed to the yen’s reputation as a “safe” store of value and is particularly attractive for investors.

To combat this, the Bank of Japan has maintained a low interest rate policy for more than two decades with the current rate paying just 0.03 percent interest. Even this drastic move has failed to reduce demand and with no change in yen demand expected this year, the Bank of Japan has little choice but to maintain its long-running low interest monetary policy.

Commodities to Push “Other” Dollars Higher

Boosted by demand in China for commodities including potash and other minerals as well as Canada’s crude oil sales to the US, the Canadian and Australian economies both made significant gains during 2010. As a result, Canada and Australia were the only major economies to raise interest rates during the year.

The two currencies certainly lived up to their billing as “commodity currencies” making strong gains against the greenback with both closing 2010 above parity with the US dollar. The Canadian dollar gained 5.3 percent during the year while the Aussie dollar jumped a whopping 13.6 percent.

To quell the impact rising commodity prices have had on their economies, both Central Banks found it necessary to invoke several rate increases during the past year. The Bank of Canada implemented three separate rate hikes bringing the overnight rate from 0.25 percent to 1 percent while Australia was even more aggressive lifting its benchmark interest rate to a class-leading 4.75 percent.

In recent months however, the rate of growth has slowed in both countries but particularly in Canada which has a greater dependence on the US market. Weaker demand for Canadian products in the US has translated to an easing of inflation and it appears that the Bank of Canada will maintain the current rate of 1 percent until the growth picture in Canada becomes clearer.

The China Syndrome

Not lost in this discussion, is the important role China will continue to play in the global economy in 2011. The People’s Bank of China deliberately keeps the yuan valued well below its true market price to enhance the competiveness of China’s exports. Much to America’s chagrin, it is unlikely that China is about to forego this tactic anytime soon. What could force China to rethink its yuan valuation policy however, is the threat of inflation and further efforts on China’s part to contain inflation is an important barometer to watch.

In the second half of 2010, China was forced to raise interest rates and allow the yuan to appreciate somewhat as the Bank of China tightened monetary policy to ease inflationary strains on the economy. Looking forward to 2011, inflation is expected to remain a worry and in addition to moves to limit “hot” foreign investment money from flooding the market, additional interest rate increases are very much in scope for the new year.

This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.