28 October 2021
Hikers vs non-hikers: the FX impact
As inflation remains a key focus for markets, we examine central bank actions through the lens of the currency markets.
Inflation has spiked across many developed market economies and, as discussed in previous Bond Bulletins, the debate over the transitory nature of inflation and its effect on economic growth continues. Output price purchasing managers’ indices (PMIs) in the US, UK and eurozone are all increasing and supply chains are still troublesome, with suppliers’ delivery times worsening. Similarly, the September Harmonised Indices of Consumer Prices (HICP) in the eurozone showed different measures of inflation are all rising, with surveys also pointing towards higher inflation. However, the reaction of central banks to this data has varied. Over the past year, central banks have fallen into two groups: hikers and non-hikers. The European Central Bank (ECB) is a non-hiker, due to the significance of prior misses of the inflation target. However, with the highest level of inflation since the 2008 financial crisis, investors are questioning the ECB’s ability to restrain market expectations of a tightening monetary environment. As an example, in reaction to the Reserve Bank of Australia’s (RBA) meeting earlier this week, the market continues to price in tighter monetary policy despite dovish actions from the RBA. In contrast, the Federal Reserve (Fed) has shown a greater willingness to tighten monetary conditions and still has the ability to tighten monetary policy further, given the higher level of comparative tightening priced in by the market in countries such as the UK, Canada and Australia.
Conventional wisdom suggests that the currencies with increasing policy rates outperform those with lower rates. However, it is important to consider the underlying details of why policy rates are changing before coming to this conclusion. FX markets have been relatively quiet when compared to rates markets, perhaps due to the flattening of the yield curve and terminal rate pricing not varying significantly. Historically, changes in the front end of the yield curve have provided greater insight into changes in currency valuation, however, as central banks start to hike, investors should be aware of the implications of potential curve inversion.
Market anticipation of rate hikes has differed by country: the US, Canada and the UK are priced for multiple hikes over the coming years whereas Japan, Switzerland and the eurozone remain clear laggards in tightening monetary policy. Currency market (FX) pricing has reflected this with the currency appreciation of the hikers vs the non-hikers during 2021. At current valuations, the US dollar appears overvalued when measured on a real effective exchange rate basis; this can be viewed as moderate when compared to longer-term measures, although it is also worth applying the increase in energy exports and the dramatic increase in energy prices over the past year, which could distort the equilibrium fair value of the US dollar.
Currencies of hikers have appreciated vs non-hikers in 2021
Market positioning, as measured by our proprietary surveys, suggests that investors hold a more constructive position to the hiking group of currencies (USD, GBP, CAD) vs the non-hikers (EUR, CHF, JPY). This is further supported by recent decreases in positioning in non-hikers, as measured by Commodity and Futures Trading Commission data. While long hiker-vs-non-hiker positioning does not appear to be near extreme levels, investors should be cautious of engaging further simple hiker-vs-non-hiker positions, given the potential for the view to be fully priced into the market.
What does this mean for fixed income investors?
In fixed income markets, we remain of the opinion that short duration is the most beneficial position for investors, with monetary policy expected to tighten. With regards to FX, we favour long positions in US dollar vs the euro as a consequence of this central bank divergence, which we believe will be a significant driver of FX returns in the short term, especially if the Fed decides to increase the momentum of its monetary tightening. A more idiosyncratic approach is required for the broader theme of hikers vs non-hikers. While central bank actions will undoubtedly be a consideration of currency prices, we will be looking to utilise a mosaic of other factors, such as valuations, terms of trade and Covid developments, as we enter the winter season in the northern hemisphere.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum