JANE FOLEY<br /><strong>RESEARCH DIRECTOR, FOREX.COM</strong><br /><br />EARLIER this week one news service ran the headline that out of the S&amp;P companies that have already announced their quarterly results, 71 per cent have produced positive surprises. These better earnings were consistent with a push into risky assets that not only supported the stock market but also knocked the Japanese yen and helped drive euro-dollar out of the 1.3800 to 1.4200 range that has dominated since early June. The move was further proof of the influence that equity markets are having on foreign exchange. <br /><br />There was a caveat attached to the amount of good news coming from corporate America, specifically this statistic only refers to the 12 per cent of companies announcing results, meaning that very little should be inferred from the apparently strong bias. That said, the world economy continues to produce signs of stability. Several Asian countries outstripped market expectations in terms of growth in the second quarter and developed countries appear to have slowed down the pace of deterioration. The US and even the UK could register modest growth in the final months of this year. <br /><br />Consistent with the more stable economic environment, markets have increased demand for risky assets. The S&amp;P 500 has risen almost 12 per cent over the past three months and the FTSE100 by a little over 12 per cent, though there is a long way to go before 2008 levels are reclaimed &ndash; the FTSE 100 is still 30 per cent lower than its 2008 high. In the FX market, demand for yen is a reasonable proxy for risk: euro-yen is presently 6.2 per cent above its level on 31 December, but is still 21 per cent below its 2008 high. Similarly, this year&rsquo;s gains in Australian dollar-Japanese yen have left it 35 per cent below its 2008 high while sterling-yen is still 30 per cent lower. <br /><br /><strong>CLEAR DIVIDES</strong><br />The market&rsquo;s current practice of putting relatively clear divides between currencies which are perceived to be either risky or safe haven is chiefly responsible for the recent correlations seen between some currency pairs and equity indices. Corporate earnings are seen as an early indicator of relative economic strength, which increases the relevance of equity market movements for FX at this point of the economic cycle. <br /><br />Assuming the global economy continues to stabilise, it is very likely that the most risky assets will be priced at higher levels by the end of the year. This implies that the present correlations between some equity indices and risky currencies will continue to retain some significance in the months ahead, although it would be dangerous to rely on these relationships for predictive purposes. But as individual countries evolve, attitudes towards relative risk will alter, flows will change course and equity markets will lose some of their present influence over the FX market. <br /><br /><strong>DOMINATING INFLUENCE</strong><br />As the recovery gets underway, relative inflation and interest rate prospects will come back into play as key factors in FX. Another key economic factor likely to be a dominating influence on currency and bond markets over the coming years will be the state of government deficits and debt. In the UK this topic threatens to be of particular influence, not least because the fiscal position is terrible but also because the proximity of next year&rsquo;s general election should ensure it will not escape scrutiny. <br /><br />Forecasts from the Economist Intelligence Unit suggest that both the US and the UK are on course to have budget deficits of above 13 per cent of GDP this year, far greater than any of the other G10 economies. This goes hand in hand with a large increase in debt issuance. In the first half of this year, risk aversion strengthened demand for safe haven assets such as government bonds and thus afforded the currencies of debt-issuing countries protection. <br /><br />In the months ahead, a strengthening in economic prospects and a resultant increase in risk appetite could see a faltering of this demand, particularly if bond supply is thought likely to be increased by a reversal in central banks&rsquo; QE programmes. Central banks will attempt to suppress a rise in long-term interest rates but in the UK this may be more problematic given the Standard and Poor&rsquo;s warning in May of a debt downgrade for the UK. <br /><br />For the forex market this all boils down to one factor &ndash; sterling may be subjected to another bout of weakness in the months ahead unless the electorate support a period of fiscal austerity. The pound is currently perceived to be a risky asset, so it ought to trade higher as equity indices recover, but the implications from the fiscal situation suggest that this trend should not be relied upon.