We have seen the USD Index undergoing sideways trading since August, as cyclical positives such as strong economic data and rising Fed expectations counter the structural negatives. Our theme for Q4, however, is for the USD to weaken, potentially in a significant way. With upcoming data likely to suffer on the back of damages done by Hurricane Katrina, and the market at this point in time already pricing in a 4% Fed funds rate call by year-end which is in line with our core Fed view, support from cyclical positives looks set to wane going forward.

Our bearish USD call is also based on the premise of the so-called “seasonal” factors. The concept of USD weakness in Q4 is by no means new as it has been the case for four out of the last five years. In Q4, net portfolio inflows typically slow relative to the current account deficit. On the trade side, the US current account deficit will be exacerbated by rising oil prices. On the capital side, tax- and repatriation-related outflows reduce net inflows. The impact of Home Investment Act should be limited as much of what will be repatriated back to the US is already in USD. The delicate balance between cyclical positives and structural negatives could gradually tip in favour of a weaker USD in Q4, prompting us to see EUR/USD and USD/JPY reaching 1.29 and 104 respectively by year-end.

For Asian currencies, we also see further support stemming from a potential return of market speculation on further CNY policy changes. The People’s Bank of China announced on September 23 it would allow the interbank exchange rate trading band of the CNY against non-USD currencies (EUR, JPY and HKD) to widen from +/-1.5% per day to +/-3% per day. Banks are also now free to set the bid/ask spread they charge their clients for CNY against non-USD currencies. This is a technical fine-tuning of China’s exchange rate system, in our view, with minor impact on the USD/CNY exchange rate as well as the economy itself in the near future. However, market speculation could nonetheless revive as a result, especially ahead of important international meetings such as the G20 finance ministers’ meeting in Beijing in mid-October. If true, Asian currencies that have a high correlation with the CNY NDF will be in a good position to reap the benefits.