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FX Markets Beyond ZIRP In 2020

It might be seen by some as lazy or formulaic to kick off 2020 with a quick recap of the 2010s, and then a few broad predictions about what direction the beginning of this decade is going to take.

And that’s exactly what we’re going to be doing but hopefully you’ll stick with this anyway.

As far as major currency markets are concerned, the 2010s were defined by central bank action. The immediate reaction to the financial crises of the late 2000s may have brought about the first wave of quantitative easing, but it was the 2010s when it was fully embraced (although you could argue that the first wave came in April-June 1932 when the US Federal Reserve carried out large-scale open market operations but given differences in Fed structure/policy transmission mechanisms/other stuff on which Milton Friedman is a better source of information than this email let’s not start arguing about QE1, QE2, QE3 etc.).

Through the decade the Fed, the Bank of England, the European Central Bank and the Bank of Japan saw their balance sheets expand at a huge rate (particularly when taken as a percentage of GDP) while holding down record low or negative interest rates. The ability to borrow very very cheaply in USD, GBP, EUR and JPY helped to spur domestic equity markets, but also drive hot money flows as investors borrowed in these cheap developed market currencies and benefitted from the carry trade on higher yielding emerging markets. While the Yen has long been a preferred funding currency for carry trades, the Euro has also increasingly become driven by carry dynamics. USD 3-month yields may had come under pressure over the last six months, but they’re still just under 1.9 percent. By comparison the Eurozone rate is at -0.41 percent for the same period meaning that if you have the option of parking cash in either of the two currencies, the US yield makes dollars far more attractive.


So where does this leave us in terms of where central bank policy lies right now, and more importantly where is that policy is going to drive currency direction? The Fear Versus Greed analysis is a simplistic but often useful prism through which to see asset prices. Dollar receives plenty of support on the fear side as a haven asset (perversely even when it’s the US scaring markets). But on the greed side of things it’s how much you’re being rewarded for holding a particular currency where central banks have the biggest effect.


The Fed has made noises about moving to a long-term tightening trajectory and a shrinking of its balance sheet. Admittedly so has the ECB, but the time between Mario Draghi suggesting in Autumn 2018 that they were considering hiking rates and the time that they realised that the Eurozone economy was a very long way from having the resilience to absorb a rate hike was so small that they would have to start a new European scientific agency just to be able to measure it. However the resulting response in the repo market was enough for the Fed to quickly return to pumping cash and kicking rate hikes into the long grass.

If the latest Fed minutes are anything to go by, then it’s likely that will continue through the whole of this year – the Fed’s dot plot showed no rate hikes in 2020 and just one in 2021, with the Bank stressing that the: “current stance of monetary policy is appropriate to support sustained expansion of economic activity.” Ignore much of the excitable chatter whenever there’s a bit of short-term transitory economic weakness – the Fed will not be rushed into a rate move, particularly when inflation is running below its 2 percent target rate. It is far from ignorant of the difficulties of unwinding its balance sheet in an orderly manner as well as returning an economy to the world of headline interest rate policy. If anything markets are increasingly pricing in a cut all the way back down to zero before the year is out.


While the Bank of England’s expansion of its balance sheet, its commitment to ultra-low rates over an extended period as well as its Monetary Policy Committee’s conservative approach to monetary policy are not vastly different on first reading to that of the Federal Open Market Committee, we think that the BoE is far more likely to move to a tightening trajectory in 2020 than its peers (indeed it is already trimming its balance sheet). Of course, any moves are going to be predicated on the form of the United Kingdom’s withdrawal from the European Union. It’s something that still has capacity for injecting some volatility, but it is a very long way from a scenario that would trigger a rate cut. The MPC may have had dissenting voices last year, notably from voting member Michael Saunders, we feel that the result of the general election in December, the resulting ability of the ruling majority to be effective, and the change in tone from European leaders faced with a UK Prime Minister armed with a big majority and a fixed-term parliament means that both actual and perceived risks to business activity very much reduced compared with where we were in September last year (underlined by the forward-facing components of recent UK PMI data).

Of course the biggie when it comes to the BoE moving is going to be that 2 percent inflation level. Post-Brexit vote sterling weakness helped to drive inflation up above 3 percent in 2017, but fading impact of this depreciation on goods price inflation has dragged this down to 1.5 percent. However the increase in core services inflation as a pass-through of improved pay conditions shows the impact of the UK labour market.


What had been a consistently robust aspect of UK data – wage growth looked soft in December although the ONS estimated that total pay grew by 1.5 percent in real terms, and annual growth in regular pay was estimated to be 1.8 percent. This was somewhat skewed on a year-on-year basis by unusually high bonus payments in 2018. The biggest component of fixed costs borne by businesses is often salaries, and they are not going to be quick to increase those fixed costs in times of uncertainty. But should Brexit progress ease uncertainty in retail and in hospitality – sectors accounting for a large part of the softness in recent data – expect to see some pass through into upside inflationary pressures.

While we have been long-term bullish on sterling, that upside is going to remain capped as long as the Bank of England holds current rates. But into the second half of this year, exacerbated differential in rate policy against its major peers could stop the Bank of England’s monetary policy statement being one of the less sexy events on the economic calendar.

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