How will monetary policy changes impact the FX market?

Some countries will start to lift rates before the Fed

EUR/USD has remained inside a 1.15-1.25 range since the COVID-19 pandemic broke early last year and, for the moment at least, it seems likely that the euro will stay in the lower half of this range with the dollar similarly restrained against other currencies. While the stability of the dollar and resultant low level of volatility should offer some support to higher-yielding currencies via the carry trade there seem to be a number of impediments.

For one, the developed world has very few currencies that offer a significant pick-up over the lower-yielding currencies. Secondly, difficulties with the pandemic seem to be weighing on some of the carry-trade favourites, like the Australian dollar. And thirdly, although FX volatility is low, Mr.Steve Barrow, Head of Standard Bank G10 Strategy said that traders and investors would have little confidence in taking carry trades, not least the fear that tapering by the Fed either late this year or early next year could unleash a new taper tantrum similar to the one we saw in 2013.

Finally, and most recently, the scope for geopolitical tensions to increase has possibly been raised by the tensions in Afghanistan. In time, Mr. Steve Barrow thinks that this list of concerns will disappear; some countries will start to lift rates before the Fed, fears around the pandemic will subside, Fed tapering will produce a “sell the fact” fall in the dollar, and geopolitical strains from the return of the Taliban in Afghanistan will subside.

Tensions in Afghanistan could create a wider risk-off sentiment in the FX market

Another point we would make is that the debt ceiling problem in the US could turn out to be trickier to solve than many times in the past given that the Democrats are trying to push through a huge USD 3.5tr “soft” infrastructure plan at the same time. Before now debt ceiling strains have not spilled over to asset prices in a significant way but, if Congress will fail to lift the ceiling, the process of doing so could cause some wobbles in the dollar. “All told, it leaves us feeling that when this 1.15-1.20 range for euro/dollar breaks decisively, it will be to the higher side and the euro will move up towards 1.30, with similar strength for other currencies against the dollar, such as a move towards 1.50 for sterling/dollar”, Mr. Steve Barrow forecasted.

Some developed-country central banks could start to lift rates before the Fed. That’s something that did not happen before the Fed’s 2015-2018 rate-hike cycle; a fact that seemed to give the dollar an advantage at the time. In the upcoming tightening cycle, it looks as if the Reserve Bank of New Zealand (RBNZ) could be the first of the significant developed-country central banks to hike rates this week, followed by Norges Bank next month. This being said, there’s limit  ed evidence that such prospects are pushing these currencies ahead very significantly.

For instance, if we look at the NZ dollar, not only are policy rates likely to rise first, but the country has enjoyed a pretty stellar response to coronavirus with the unemployment rate, for instance, already back to pre-Covid levels. But despite this, the currency has only had a middling performance this year. For instance, it has largely flatlined against the dollar inside a 0.69-0.73 range for much of the time. This may reflect something Mr. Steve Barrow has spoken about before which is that coronavirus is a symmetric shock and, as such, finding “winners” and “losers” can be difficult, not least because some “winners” like Australia some time ago, can end up looking like “losers” as the pandemic takes a grip again. Because of this, it seems that investors are reticent to buy into any Covid success story and that’s left most currencies pretty trendless so far in 2021.

“The question now is whether the confidence of policymakers in hiking policy rates emboldens traders and investors to bet a bit more in their currencies. It might, but we also have to bear in mind that many central banks that do hike rates, such as the RBNZ, will be very mindful of the possible currency connotations and may well make verbal efforts to ensure that their currencies do not become too strong as a result”, Mr. Steve Barrow stressed.