By Gilles Lejeune
Six years of widespread accommodative monetary policies have evened out market volatility. However, a disparate economic recovery can be expected to lead to greater divergence between the principal central banks, sparking a rebound in volatility. In these conditions, the forex market is an attractive market to favour.
This new environment has seen significantly diverging monetary policies from the major central banks. For example, we have the US on one end, where rates are beginning to normalise, to the eurozone on the other end of the scale where The ECB is only just intervening on monetary policy.
Those investors who are able to correctly distinguish between currencies according to their position in the monetary cycle, will be able to take advantage of this new paradigm.
The Fed, the Bank of Canada and, to a lesser extent, the Bank of England, are all close to gradually normalising their key rate, which should play a big role in supporting their currency. The situation looks clear concerning the Dollar, as after a long waiting period, the Fed should raise its key rate sometime in the third quarter.
However, certain risks may cast a shadow over the picture. In the absence of a global economic recovery, the excessive appreciation of the dollar would hurt the US economy and force the Fed to slow down its monetary normalisation cycle, and possibly stop in its tracks. As Canada’s economy strongly depends on its southern neighbour, the Bank of Canada will almost certainly wait for the Fed to start raising its rates before following suit.
The UK economy has already made a strong comeback, driven in large by the construction sector, and the BoE may follow in the Fed’s footsteps when it comes to raising its rates. However, domestic inflation has been struggling to inch its way above 1% since the year began. Furthermore, the UK is facing some uncertainties, particularly Brexit, which could slow the appreciation of the pound sterling.
Currencies such as the euro, the yen and the Swedish krona should continue to be influenced by current monetary easing programmes, aimed at supporting exports and promoting a rebound in inflation through the depreciation of their exchange rates.
Although growth has recently improved in Europe and Japan, the euro and yen cannot appreciate sustainably until the economic recovery and rising inflation have been confirmed.
Other economies, such as Australia and New Zealand, which had so far been getting through the financial crisis unscathed, are now facing a major slowdown in growth and inflation. These two economies are struggling against significantly over valued currencies relative to their long time equilibrium rate and are further penalised by slowing growth in China their main trading partner. In the coming months their central banks should end up reducing their key rate and intervening on the forex markets to devalue their currency.
Thus, the differences in monetary policy between the US and Europe and Japan should support the appreciation of the dollar. However, as the Fed is pretty much isolated against the other central banks, it will have to pay close attention to make sure the dollar doesn’t climb to fast, which could halt recovery. When it comes to rate hikes, the advantage rarely goes to the one taking the initiative.
And, although the Australian and New Zealand dollars still offer attractive returns, their central banks are aware of the danger of a very strong currency and can be expected to step in within the next few months. The appeal of these markets lies more in bonds, provided the forex risk associated with these investments is hedged.
Gilles Lejeune is global bond fund manager at Candriam Investors Group
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