Asian currencies are close to fair value and likely to see only moderate appreciation against the US dollar next year, believes Bank of America-Merrill Lynch, although there is an increased risk of dollar depreciation further down the line.

In a press conference held in Hong Kong yesterday, the US bank outlined its expectations for the global economy, Asian equity markets, currencies and interest rates for 2011.

Chief Asia economist Timothy James Bond underlined the “remarkable” economic imbalances between the developed world and emerging Asia, driven in part by the surge in capital flows into the region on the back on loose monetary policy in the West.

Foreign exchange strategist Adarsh Sinha pointed to expectations that monetary policy would continue to remain constrained in US, UK, Europe and Japan.

The bank anticipates a healthy dose of fiscal consolidation in peripheral European economies, but not as much tightening in the US as had been expected prior to the recent moves by president Barack Obama to negotiate keeping a series of tax cuts in place for two more years.

Sinha suggests this development is important for Asia both in terms of the impact on the US dollar and on US bond yields.

“Arguably the reason you have seen capital flows into Asia is that US yields have been very low compared to the rest of the world,” he says. “US yields have started moving higher, so to some extent that could constrain a lot of capital moving into Asia.”

Since the tax deal was put forward, the short-term impact on the dollar – which has been range-bound against major currencies – has been largely positive, with an upwards revision in growth expectations for the US, real yields going up and increasing expectations that there will not be a third round of quantitative easing from the Federal Reserve.

“As a result, we have a bullish dollar forecast against most major currencies for 2011,” says Sinha. “But I think further out, over the next couple of years, this could potentially be a big problem for the US economy and for the US dollar as well.

“There has been very little commitment [in the US] to cutting spending or raising taxes further down the line. So there could be an inflection point at which the market and investors start worrying about the sustainability of the US fiscal position.”

Sinha points out that spending cuts and tax increases will become more difficult to implement the closer the US gets to the next scheduled presidential election in 2012.

“The US dollar is still the global reserve currency and in a way it attracts less risk premium compared with other currencies as a consequence,” he adds. “Nonetheless, we think there is a point in the next couple of years when the US dollar will turn.

“We do expect it to appreciate during 2011, but at some point, probably in 2012, if we don’t get any additional promises on spending cuts and tax increases further down the line, then certainly there is a risk we could get dollar depreciation against Asian and major currencies as well.”

The Australian dollar had been the world’s best performing currency since the beginning of 2009, on the back of such things as the China growth story and rising commodity prices.

But given that inflation in China is moving higher very quickly, Sinha suspects that a lot of investors will start to view the Aussie dollar as a good hedge to their investments in Asia.

Further policy tightening in China next year could come in the form of currency appreciation, raising interest rates or quantitative measures such as raising reserve requirements, for example.

“If the tightening comes via the currency, it tends to be positive for the Aussie dollar,” notes Sinha. “However, if they tighten policy via interest rates, which is looking increasingly likely, that tends to be negative for the Aussie dollar.”

The bank is recommending going long on the Singapore dollar against a basket of yen, euro and Taiwan dollar as a proxy for the Asia growth story accompanied by policy-tightening bias.

In terms of its outlook for Asian equities, BoA-Merrill forecasts low double-digit total returns over the next 12 months, with Asian stocks no longer cheap.

Sadiq Currimbhoy, head of Asia-Pacific investment strategy, suggests there is a slither of hope that Japanese equities could do reasonably well next year.

“There are two markets in Asia in which we like the equity-to-bond relationships,” he says, “with dividend yields higher than bond yields in both Japan and Singapore.”

One trade the bank has on now is going long-Japan short-China.

BoA-Merrill is underweight in general on equities in Australia, China and the Philippines, neutral Hong Kong, and overweight Taiwan, India and Singapore.

From a sector perspective, it favours consumer, healthcare, technology and telecommunications. It is underweight on industrial, materials and energy.