Why are currencies calm amid rates repricing?
- Front-end rates have been volatile recently, as central banks have been priced to tighten in response to inflation fears, and as position liquidation from hedge funds has exacerbated market movements.
- In contrast, volatility in the major currencies is stuck around multi-decade lows and currency markets have struggled to reconcile divergent signals from near term central bank pricing and longer-term forward rates.
- We believe that ultimately the US dollar is likely to benefit most from tightening policy, but that a more significant appreciation is likely to require both a rise in longer-term real rates in the US and a moderation in near-term pricing for the European Central Bank (ECB).
Over the last few months markets have priced significant additional policy tightening from global central banks in response to a widespread acceleration in inflation. This phenomenon has been global in nature, catalysed by changes in outlook and policy from smaller central banks but also affecting the largest markets. Some of the most significant increases in front-end rates have occurred in markets where central banks continue to signal no intention to raise rates within their own forecast horizons. Press reports and feedback from our trading counterparties indicate that the repricing in rates has been amplified by investors such as macro hedge funds abandoning positions predicated on protracted easy policy.
Against this backdrop, the relative stability in exchange rates is striking (Exhibit 1). There are a variety of potential explanations, from the more limited divergence in interest rates amid a global rise in yields to the more nuanced implications of muted increases in longer end rates seeing curves flatten and real rates fall.
Exhibit 1 – Comparatively low z-scores of 3 month moves in FX compared to rates
When we consider our framework for the influence of interest rates on currencies a few observations stand out.
Firstly, we have studied the effect of curve dynamics on currencies through hindsight-based modelling techniques and concluded that front-end rates are typically the more reliable driver of foreign exchange (FX) movements, though confidence is lower when curves twist. Our work in this area suggests that the currencies with credible near term prospects for rate hikes such as the US, Canada, New Zealand and the UK should gain most from the global reflationary dynamic. There is little doubt though that a rise in longer term forward rates in these “hiker” markets would provide a more emphatic positive signal for these currencies and enable currency volatility to rise.
Exhibit 2 – Rate spread divergence at short tenors for hiker versus non hiker currencies, but stability in longer-term forward rates
Secondly, our shadow rate framework provides some justification for the resilience of the lowest yielding currencies where the central banks have engaged in the most significant unconventional policies (Exhibit 3). Our approach uses shadow rate methodology developed by central bank research teams to measure the equivalent impact of these unconventional polices, and the models suggest that even pricing modest rate hikes over the next couple of years is comparable to much larger hikes in markets where unconventional polices have already been scaled back. This broad conclusion is validated by our balance of payments analysis, where we have identified very large capital outflows from these lowest yielding markets over the last decade and any repatriation flow could be extremely significant for currency markets.
Exhibit 3 – Significant rises in shadow rate measures in the eurozone and Switzerland
Finally, our investment process incorporates a broader assessment of the cyclical outlook beyond the movement in interest rates. It is striking how some of the moves in central bank pricing have diverged from our assessment of relative economic conditions, and so we ensure that our forward looking views on the sustainability of current rate pricing are also incorporated in our currency views. We broadly see fundamental justification for the path of rates priced into North American currencies, while currencies of countries where rate rises are likely to take longer to be delivered such as Australia, the eurozone and Sweden1 rank less favourably.
Following another US upside inflation surprise in October, the US dollar has pushed towards the upper end of recent ranges. We continue to see scope for modest further gains for the US dollar against low yielding currencies. US dollar gains are likely to be limited by the weakness of the US balance of payments position and the stability of the renminbi, which acts as an important anchor for global currency markets. We believe a larger appreciation in the US dollar would require a clearer alignment of favourable rate spreads, including longer-term real and nominal rates spreads, along with a repricing of an ECB exit from unconventional monetary policy.