Dollars & Sense Be patient, USD bears and JPY bulls by Kelvin Lau, Economist, Global Research   USD: More upside correction to come We are USD bears over the medium to long-term. However, near-term market dynamics suggest the USD may do well in the short-term. The USD index has staged an impulsive rally since late January, on the back of an aggressive rise in US interest rate expectations. Indeed, strong US economic performance of late and the continued hawkish comments from Fed officials helped justify such readjustments in expectations. Indeed, we have also raised our Fed Funds Target Rate forecast - we now expect it to peak in Q2, at 5.00%, as compared with 4.75% by end-March previously. Together with the fact that the longer end of the US Treasury yield curve has yet to fully adjust itself accordingly, interest rate differentials still act in favour of the USD in the near-term. Chances are that our medium-term USD weakness call may take a while longer before materialising. That said, with market expectations moving ahead of the actual Fed moves, the futures market is now already close to pricing in a full 50bps hike from now until end-Q2/early Q3, and therefore we may not need to wait until end-Q2 to see the peak of the current USD rally. Indeed, one may argue that expectations can always overshoot. Yet even if we do see that happening, such a phenomenon will be temporary in nature, unless the fundamental picture suggests the need for a fine-tuning in our core Fed rate scenario. In any case, our belief is that once the dust settles over Fed expectations, USD weakness will resume. By then, interest rate differentials will move back in favour of those currencies that are still going for monetary tightening (e.g. the EUR and the JPY). With no signs of resolution in sight, structural concerns will also return to haunt the USD sooner or later. Our full year view is for the EUR and the JPY to strengthen and for commodity currencies to underperform against the USD. JPY: Waiting for a major comeback We are also bullish on Asian currencies, seeing them as the main beneficiaries of our USD bearish story. They, for the most part, remain very undervalued, as confirmed by their strong external surpluses. Moreover, domestic demand and interest rates have been rising, and the influence from portfolio inflows has been positive. Indeed, that is exactly what we have seen since the turn of the year, but with one eye-catching exception and that is the JPY, which has been diverging from other Asian currencies up until early February. We see a high chance that the JPY will play catch-up going forward. With speculators currently sitting on large net short JPY positions, and the increasing repatriation by Japanese institutional investors and persistent inflows by foreign equity fund managers, we believe that the JPY is well positioned to stage a strong comeback, both against the USD as well as other Asian currencies. Here, any signal from the Bank of Japan on the removal of the extraordinary quantitative easing policy (something we expect to happen in H1 2006) could well kick-start this new trend. But for now, Japanese retail investors are still eager to bring their money overseas, and foreign speculators are still favouring JPY-funded carry trades (i.e. short JPY and use it to fund long positions in high-yielding currencies). Watch out for a reversal in the latter, as high-yielding currencies (in Asia and elsewhere) could take a blow as and when the JPY tide turns for the better.