How will FED and ECB’s new policy strategies impact major currencies?

The ECB has not just suggested that policy will be easier than before, as its inflation target is now 2% and not “close to, but below 2%”.

With this in mind, it might seem that the currency implications of these changes are very limit  ed; perhaps even nonexistent. However, Mr. Steve Barrow, Head of Standard Bank G10 Strategy is not so sure that this is the case.

In Mr. Steve Barrow’s view, while both strategy changes seem similar, they are more likely to lead to a weaker euro relative to the dollar. This is for two (related) reasons. The first is that the ECB’s key refinancing rate is likely to be stuck at the zero lower bound for longer, and the second is that the ECB is more explicit than the Fed about the timing of any removal of monetary accommodation.

“Put these two together and we think it pushes the euro even further towards that key funding status for carry trades that usually results in currencies being weaker than interest rate differentials imply. We know from years of research that, contrary to interest rate parity theory, buying higher-yielding currencies via funding from low yielders, like the yen, does produce positive returns. Hence, if the euro moves towards becoming a more heavily used funding currency for carry trades it seems more likely to underperform other currencies once carry costs/earnings are included. In our view the euro has been moving in this direction even before the ECB’s change in monetary policy strategy. This has happened because key policy rates have already fallen to the lower bound and appear somewhat stuck at this level. If we compare the euro’s funding status with arguably the most significant funding currency – the yen – we see that the relationship has changed over the last decade, or so, as euro zone rates have plumbed the depths”, Mr. Steve Barrow said.

In fact, Yen-funded and euro funded carry trades were done since 2000. It is clear from this that the last 20 years has seen much higher returns for holders of yen-funded carry trades that euro-funded trades. But since 2010, when euro zone rates really started to tumble, we see that carry trade returns are very similar whether funded out of the yen or the euro. More simply put, it seems that the euro could have become a more avidly used funding currency and, in the Standard Bank’s view, the ECB’s monetary policy strategy change will just continue this momentum. For not only does it suggest that the zero refi rate will persist for some time. It also makes pretty explicit the conditions required to take back monetary accommodation.

One is that the ECB must forecast that inflation will rise to levels consistent with the 2% CPI target by the middle of the forecast period. Another is that inflation should be forecast as consistent with the target through the remainder of the forecast period (which is three years), and a third is that there must be realised progress in underlying inflation that is consistent with achievement of the 2% target.

In other words, the ECB has not just suggested that policy will be easier than before, as its inflation target is now 2% and not “close to, but below 2%” but also that traders and investors can be very clear about when policy might become less accommodative.

Knowing when policy is likely to change is like manna from heaven for carry traders. They don’t want to be holding higher yielding currencies funded out of the euro if the ECB suddenly and unexpectedly puts an end to its zero-rate policy. Such shocks can cause carry trades to unwind very violently, as we’ve sometimes seen with dollar-funded carry trades in the past. The Fed has also moved to make its future intentions clearer but, in our view, they are not as clear as the ECB and, unlike the ECB, policy rates don’t seem stuck at the zero lower bound. The Bank of Japan has been stuck at the zero lower bound for some considerable time and the yen has become a significant funding currency for carry trades as a result. The ECB could have pushed the euro in this direction to an even greater extent than before and that could cost the euro, at least in total return terms against higher-yielding currencies, forecasted Mr. Steve Barrow.