US deflation would likely imply higher USD

- Deflation is a potential scenario for currency markets "We take a very preliminary stab at considering the possible FX implications of such a scenario for G10 currencies. Risks on the deflation side have clearly been growing and our US economics team would characterize the odds of a return to QE in the next year as 35%, which is a substantial risk of such a bad outcome."
- We consider two different deflation scenarios "We consider two possible scenarios for the US in such a deflation environment: the “recoupling” scenario where deflation becomes widespread outside of the US, and the “decoupling” one where deflation starts and stays in the US. But our base case is that if deflation starts in the US, it will not stay limited to the US."
- Our base case deflation scenario: recoupling "Unlike Japan, which has been in deflation on its own, the US would wind up pulling the developed world into similar deflationary straits. Intuitively, this scenario feels like the most likely deflationary scenario for the US, in our opinion, given the central importance of the American economy to both the global growth picture and global financial markets."
- US-specific deflation could be quite USD-negative "The Fed would be implementing another massive round of quantitative easing as other banks either stand pat or normalize their own rates. Interest rate differentials would wind up tilted against the USD. In this state, the dollar would be viewed as the chief funding currency, replaying the great yen carry trade of 2005-2007."
- One commonality in both of our scenarios: more QE "In either case, there would likely be additional action out of the Federal Reserve for additional quantitative easing. Short term reaction depends crucially on policy: re-emergence of QE could mean a frenetic but short term USD sell-off, similar to what to December 2008. It is hard to overlook such an event given how frantic and powerful such moves can be; the move from 1.24 to 1.44 in that December 2008 episode was both stunning and deeply concerning. However, the persistence of such a move depends on the scenario."
- Limited currency lessons from Japan "While Japan has been in deflation, essentially by themselves, nominal JPY has bounced around a fair amount. But since the rest of the world joined Japan in financial, macro and banking dysfunction, deflation has become more entrenched and the risk properties more enhanced. There has also been a stronger JPY in both nominal and real terms."

Merrill Lynch FX Spotlight 20100813

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