Gold stays solid as currencies soften

Forecasting currency movements is difficult at the best of times given the forex market's tendency to "charge one way and then the other... with the same fickleness as a teenager follows fashion", as Hugo Dixon of Breakingviews once put it. Throw in the enormous volatility in global markets amid the credit crunch and it becomes even harder.

Nonetheless, one forex theme of late 2009 seems unlikely to have run its course just yet: a strengthening in the dollar and the yen as investors flee risk and the global outlook worsens. Global data are getting uglier and uglier, and while the British government has now made a second attempt to shore up its banking system, and US moves look likely to follow, the banking sector is far from sorted out. With plenty more losses to come from the financial sector, the "overall trend of risk aversion" is set to continue, says Michael Klawitter of Dresdner Kleinwort. He sees scope over the next few weeks for the yen to strengthen to 112 to the euro, from 118 now.

As far as the pound is concerned, "the greater the focus on UK banks, the weaker the pound is likely to be", says David Woo of Barclays Capital. No wonder then that with banks firmly in the spotlight, thanks to this week's rescue package, sterling received another pounding hitting a six-and-a-half-year low of $1.39 against the greenback and a record low versus the yen. The measures highlighted the weakness of the economy, says Woo, and point to greater government borrowing. Investors may begin to wonder if the government can "really afford all these measures", says Audrey Childe-Freeman of Brown Brothers Harriman.

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The rescue package also allows the Bank of England to engage in quantitative easing, effectively printing money, which boosts the money supply and raises the prospect of inflation. The likelihood of British interest rates heading even lower, given the "deflationary threat posed by the unprecedented credit boom", also bodes ill for sterling, says Christopher Wood of CLSA. Klawitter has pencilled in a slide to $1.20, while commodities guru Jim Rogers this week urged investors to sell sterling.

The euro, meanwhile, is under pressure due to dwindling faith in the notion that the eurozone is going to suffer less damage than America in this downturn, says FAZ.net. The strains inherent in European Monetary Union amid a downturn are also increasingly evident. As the "harsh reality" of the European slowdown becomes increasingly clear, the euro will tumble to $1.20, Morgan Stanley's Stephen Jen wrote last week. That implies a drop of around 8% from current levels.

Note, however, that the strengthening yen is inflicting "real damage" on Japanese exports, and the Bank of Japan is likely to begin intervening in the currency market to weaken it this year. So the "path of yen strengthening may be a far rockier one in the months ahead", says Saxo Bank.

The longer-term outlook for the dollar is clouded by the fact that aggressive Federal Reserve moves to boost the economy look set to devalue the currency by creating inflation. Indeed, no country wants a strong currency in this global downturn, and all central banks may be tempted to inflate away their debt, says David Hale of David Hale Global Economics in the FT. Enter "that ancient form of money" and ultimate store of value: gold. Precious metals consultancy GFMS expects a new record high above $1,000 an ounce as investors begin to worry about the collapse of the dollar in America and alternative currencies continue to grapple with problems of their own.