investment insights

    FX markets and the Fed’s aggressive monetary policy

    FX markets and the Fed’s aggressive monetary policy
    Vasileios Gkionakis, PhD - Global Head of FX Strategy

    Vasileios Gkionakis, PhD

    Global Head of FX Strategy
    • For the past five years or so, movements in interest rate differentials meant very little for the US dollar.
    • However, the virus outbreak – and more recently the oil price war – have resulted in a relentless and brutal
      repricing lower of the Fed rate.
    • This decline in US yields brings them closer to a “level playing field” with zero or negative interest rates
      from major developed markets.
    • This has the potential to restore the importance of rate differentials as a driver for the FX market,
      and can be considered a game-changer.
    • Amongst the G10 majors, we revise higher our EURUSD forecasts and lower our USDJPY trajectory. We make some adjustment to our EURCHF targets but keep GBPUSD forecasts broadly unchanged.


    Virus spread, policy response, and oil price war wreaking havoc in markets

    Markets have gone into meltdown mode these past few weeks. Global equity markets have lost some 15% since mid-February and yields in the US are touching unprecedented levels (the 10-year yield is close to 0.5% and the 30-year paper is yielding just over 1%. On the morning of Monday, March 9, oil prices plummeted by around 30% in early trading, EURUSD cleared the 1.14 handle (now at 1.11), and the JPY rose by more than 3% against the USD to its highest level since 2016. Gold has continued its ascent, while EURCHF has been relatively stable, close to the 1.06 level.

    The initial trigger was the acceleration in ex-China COVID-19 cases in recent days (Italy has put its population in lock-down mode). If that were not enough to keep rattling markets, the dramatic collapse of OPEC-Russia oil negotiations last week resulted in what resembles a full-blown oil price war. Saudi Arabia slashed its oil prices and pledged to increase oil output in an attempt to capture market share. A rebound in energy prices will depend on how soon Russia returns to the negotiating table. That said, with Russia’s strategy appearing to be directed at the US and US shale producers, and with Saudi Arabia in turn responding to Russia’s decisions, the timing of a response that would put a floor under energy prices appears distant currently.

    The Fed (predominantly) and the OPEC-Russia fallout are leading the FX market to a pivotal point…

    The game-changers

    A number of developments that were not part of our initial central scenario and that are game-changers for currency markets have occurred. More specifically:

    1. As mentioned above, the COVID-19 cases ex-China accelerated in recent weeks, turning the virus outbreak into a more global phenomenon – one to which policy-makers need to respond. Outside China, the Federal Reserve (Fed) led the way. It is important to note that the Fed has more monetary policy space than other central banks, and hence more leeway to respond to global shocks. The Fed has already reduced rates by 50 bps at an emergency meeting on 3 March, and will likely cut further at its scheduled meeting later this month. In addition to the virus-related concerns, the plunge in oil prices will be a significant headwind to the US shale industry, and could translate into a tightening of financial conditions. Aside from the 50-bps cut delivered earlier in the month, the market is pricing another 80-90 bps of easing by year-end which, if it materialises, will bring the Fed funds rate very close to the zero bound – a far cry from what the market and we were expecting a month ago. At the same time, the monetary policy ammunition for many other central banks like the European Central Bank (which expanded its QE program but left interest rates unchanged), the Bank of Japan (BoJ), and the Swiss National Bank (SNB) is far more limited. In this sense, US-Rest of World (RoW) rate differentials are narrowing at an unusually rapid pace. This brings us to our second point.
    2. The USD’s carry advantage is being eroded rapidly, removing one important pillar of support for the dollar for the last few years. Since 2014, the link between interest rate differentials and G10 FX has broken down, but we think we are reaching a tipping point. More concretely, basic economics suggests that exchange rates are influenced by movements in rate differentials, as these reflect the relative prices of currencies. For example, if the rate of interest in country A increases more than its counterpart does in country B, then one should expect the currency of country A to appreciate against that of country B, via flows from country B to country A. This has worked relatively well in history, but this relationship has broken down since 2014-2015.

    2014 marked the start of the period when other major central banks (save for the Fed) resolved to adopt unconventional monetary policies (quantitative easing) and zero or even negative interest rates. Leaving out the econometric details, we have found empirical evidence suggesting that during this period, when one country - in this case the US – maintains rates sufficiently above zero, then movements in rate differentials become somewhat irrelevant as long as 1) the other economies are still operating in zero or negative interest-rate territory and 2) global growth does not accelerate. The intuition is as follows: it does not matter much if the positive-yielding interest rate falls a bit if it is sufficiently far from the zero bound (or if the negative-yielding interest rate rises a bit but remains close to or below zero). Investors will keep utilising zero/negative-yielding currencies to fund purchases of the positive-yielding currency. In reality, what has been happening for most of the last five years is that the USD remained stubbornly above the level suggested by rate differentials, in other words overvalued, because rate differentials themselves had become less relevant for traders and investors who mostly wanted to avoid owning negative-yielding currencies. Of course, the global cycle matters, which explains why the US dollar sold off significantly in 2017 when global activity accelerated.

    …one in which USD succumbs to the sizeable decline in US rates and comes under pressure

    However, it seems we are approaching a tipping point, with US yields now rapidly converging towards the zero bound. This means that the traditional importance of rate differentials in FX markets may gradually be restored as all interest rates converge : the correlations between the US dollar and interest rate differentials started rising again as US rates began their rapid fall towards 0%. If so, then current rate spreads suggest further downside for the US dollar.

    3) Third, the fallout between OPEC (Saudi Arabia) and Russia on oil production cuts and the decision of Saudi Arabia to slash its oil price and increase oil output are clearly pointing to a full-blown oil price war. Aside from introducing an additional stress factor in the market, such a move will hurt the US shale oil industry (which has an estimated marginal production cost between USD 45 and USD 50 per barrel). In late 2015, in a similar negotiation collapse on oil output cuts, the Brent crude price fell from USD 68/barrel to below USD 30/bbl. This move coincided with a big drop in the US manufacturing Purchasing Managers’ Index from 55 (the breakeven level is 50) to 47. If an agreement between OPEC and Russia is not resuscitated and finalised, then oil prices will be unable to rebound sustainably and the market will keep pressure on US yields, thereby hurting the dollar. Note that the correlation between oil and the dollar has shifted quite dramatically over the last few years as the US became less dependent on oil imports.

    We revise higher our EURUSD forecasts and lower our USDJPY targets

    Changes to our FX forecasts

    Needless to say, we are experiencing highly volatile and uncertain times, not least because the global economy is being hit by an unpredictable virus outbreak but also because the exact magnitude of policy response (mostly fiscal) is yet to be determined.

    With this in mind and considering our central scenario of a substantial but temporary shock to global growth and our analysis above, we make the following changes to our forecasts.

    Read more on our FX forecasts here

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