Currency minefield

Listen to this article


The dollar has been on a downward trajectory since March and the prospects of a near-term reversal of this trend does not look promising as signs of global economic recovery tempt investors into taking on more risk.

With the Federal Reserve unlikely to tighten monetary policy until next year, the search for yield has lifted the currencies of commodity-rich and export-led economies. Australia has already broken ranks and raised its interest rates, and speculation over which central bank will be next has driven currency markets this month.

Which currencies are likely to remain weak in the near term, and which will benefit most from recovery prospects and the removal of exceptional monetary conditions? Is the pound an even bigger basket case than the dollar? And is it too early to embark on monetary tightening?

Bilal Hafeez, global head of foreign exchange research at Deutsche Bank answered readers’ questions on Monday, October 19.

What prospects do you see for the Australian and Canadian currencies? There has been quite a recent run-up, yet Canada in particular would seem to be unable to stand a lower US dollar in regard to exports?
Bobby, Boulder Colorado

Bilal Hafeez: For now, both should perform well as global growth-sensitive currencies. The pace of gains will likely be more limited, though. In the case of the Australian dollar, markets appear to be getting ahead of themselves in terms of how aggressive the Reserve Bank of Australia will be in hiking interest rates. While, as you correctly allude to, policymakers will get concerned if the Canadian dollar strengthens too much.

Of all the many factors influencing the trend of the yen’s value against the dollar at the moment, which one is the strongest in your opinion?
Ron Vanden, Osaka, Japan

BH: Recently, there has been a strong relationship between US bond yields and dollar/yen, such that when bond yields fall then dollar/yen also falls. At a bigger picture level, I think we are also seeing the rise of the dollar carry trade and the demise of the yen carry trade as investors shift from borrowing in yen to borrowing in dollars.

After the release of the Inflation figures last week most economists said the pound would drop as interest rates would remain low for years. Yet a day later the pound has surged against the dollar and euro. Why is this? Is it likely the pound will strengthen even further against the euro with Europe having substantial amounts of toxic debt with the Baltic states?
George Walton, Leicestershire

BH: The same day the inflation data came out there were also comments from the Bank of England’s Deputy Governor Charles Bean that hinted the Bank’s asset purchase programme may end sooner than some think.

That helped the pound , despite the lower-than-expected inflation number.

So the pound actually strengthened because the market believed the Bank could keep rates low for less time than before. In terms of debt concerns, Sweden, rather than the eurozone, has large exposure to the Baltic states. Moreover, the overall fiscal deficit is likely to be larger in the UK than the eurozone in coming years, which may keep the pound broadly weak.

To what extent do you think the recent strength of euro in relation to the dollar in particular is due to a shift in reserve currencies versus speculation on the state of economic fundamentals and likely monetary policy stances?
Farhoud Moaddel, London

BH: I think it is important to note the difference between central bank reserve diversification and re-balancing. An example may help, an emerging market central bank may have 65 per cent of their reserves in dollars and the remaining 35 per cent in euros.

If they are diversifying than they reduce their share of dollars and increase their share in euros, which results on dollar selling and euro buying.

However, even if they do not diversify and keep the shares the same, there can still be dollar selling and euro buying if the overall size of reserves are increasing. That is because central banks intervene in dollars to maintain their currency pegs, but as 35 per cent of their reserves are in euros, they then have to sell 35 per cent of their intervention flows and buy euros in order to maintain their 65:35 split in dollars:euros in their reserves.

This is called the re-balancing effect.

Indeed, given the sharp increase in overall emerging central bank reserves over this year, the re-balancing effect has likely caused more of the euro appreciation than pure diversification. Fundamentals have also played an important role particularly as the US has amongst the lowest interest rates in the world.

On the subject of the pound, with Bank of England deputy governor Charles Bean recently saying that £164bn of the £175bn allocated to the asset purchase facility has already been spent, do you think it is likely that the monetary policy committee will not vote for a further £25bn?
Jason Rennie, Edinburgh

BH: At this stage, I think the full amount will be spent. It is worth remembering that is was only in the August MPC meeting that 3 members had actually voted for the programme to be expanded to £200bn.

Was Australia right to raise interest rates at this juncture? Was there a real danger that it could export inflation if it didn’t?
Norman Fossett, London

BH: Time will tell whether they were right! But the data in Australia did justify such a hike as inflation is fairly elevated and growth has picked up.

What is less clear is whether the market is correct in expecting over 200 basis points more of hikes in the next 12m – that seems too aggressive.

Australia as a relatively small economy would have little chance of exporting inflation to the rest of the world, so I doubt that was a motivation for them hiking.

Do you think Britain would be better off in the euro, or would be better off now if it had joined earlier?
Alan, London UK

BH: The next few years will give us great insights into this question. Spain, Ireland and the UK share many characteristics during the crisis: property bubbles, bank troubles (less so for Spain) and large fiscal deficits.

As the UK is outside the eurozone it was able to use a more aggressive monetary policy and a weak currency to stimulate the economy, whereas Ireland and Spain were not.

Consequently, we think the UK will outperform both Ireland and Spain in terms of growth over 2010.

So for now, staying out appears to have resulted in a better outcome for the UK. Though, the jury is still out for the longer-term picture.

Is sterling hamstrung by event risk until after the UK General Election next year? Do you think that if the Conservative Party wins it will put pressure on the Bank of England to remove exceptional measures more quickly?
Richard Samuels, Cornwall

BH: I don’t think the pound is being affected by the prospect of an election next year.

Moreover, especially in a world where central banks are buying government debt any hint that the Bank of England would lose any of its independence could have consequences for UK markets, so I doubt the Conservative Party would pressure the Bank of England.

If Australia’s move higher is followed quite quickly by the likes of Norway, South Korea and New Zealand, could any resultant pick up in carry trade activity further undermine the dollar, yen and sterling? What impact is this likely to have on recovery prospects?
Philip Love, Paris

BH: Carry trades are certainly back in currency markets, so those currencies would likely strengthen against the dollar, yen and sterling at least in the short-run.

The issue is that rates markets are priced for aggressive rate hikes by the likes of Australia and Norway and investors are already positioned in those currencies, so a lot of this story has been priced.

The currency strength in those currencies may impact growth to some extent, though as small open economies they are more affected by global growth trends, which would not be impacted by their rate hikes.

Can south-east Asian currency intervention actually achieve anything? China has been cleared of currency manipulation, but is it not largely responsible for the biggest imbalances in global reserves?
Xian Tse, Hong Kong

BH: Weak currencies have helped Asian exports and the accumulation of reserves did help prevent any 1997-style currency collapses , so there are some achievements that could be pointed to.

But as you point out, the currency regimes did also contribute to global imbalances along with other factors such as easy Fed monetary policy. Imbalances now have come down sharply thanks to the global recession, so the risks on that front are less acute than before the crisis.


Copyright The Financial Times Limited 2017. All rights reserved. You may share using our article tools. Please don't copy articles from and redistribute by email or post to the web.