How will the central bank’s tightening impact currencies?

BoE Governor Bailey said that the market should not naturally assume a string of base rate hikes just because the bank has hiked for two meetings in a row.

As we, and many others, have said very often, the pandemic is a symmetric shock. All countries are impacted in the same way as everybody got COVID. As a result, the policies used to try to combat the worst effects of the pandemic have been very similar, the growth trajectories have been similar, and the inflationary consequences have been shared. So, currencies, which tend to move when big asymmetries occur, have been pretty stable. This seems unlikely to change.

This point has been made pretty clear again by the Bank of England and ECB's recent meetings. The market no longer seems to be thinking that the dollar will soar on the basis of Fed rate hikes and inactivity elsewhere. Instead, the dollar is on the back foot again because there is monetary activity elsewhere. The Bank of England hiked rates for the second month in a row. This time it was 25-bps, not 10-bps, and it would have been 50- bps if one of the five members voting for 25-bps had called for 50-bps instead. In the euro zone, ECB President Lagarde could not discuss a rate hike, but could make it clear that if next month’ ECB forecasts suggest above-target inflation in coming years, the bank could be prompted to act in the future. This inflation is pretty common in most countries, with only some exceptions in Asia of note, and China in particular, given the way that it is dealing with the pandemic and other constraints on the economy.

The upshot is that just about all central banks will be lifting rates; just at different speeds. And this does not give the FX market much room to trade the discrepancies. It is different to the last tightening cycle we saw from the Fed, for instance, where the Fed was hiking while most other central banks were still frozen. This time, just about all were thawed. Differences in the timing and extent of tightening might give currency investors something to play with, but the message we’d take away is that those relying on interest rate differentials to justify their currency calls, such as a stronger dollar, are likely to be found wanting. Instead, if broadly coordinated monetary tightening is going to have any significant currency effect, it is likely to be because central banks as a whole go much faster and harder, or slower and softer than generally anticipated. For this will cause volatility in asset prices, such as stocks and currencies, which are more likely to move in a risk-on or risk-off fashion.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy said if central banks have to push rates much higher and much faster than generally anticipated, there’s a risk that asset prices will implode and benefit safe currencies such as the dollar, yen, and Swiss franc. Conversely, if inflation risks prove more muted and central banks can go a bit more easily than currently assumed, the onus will be on risky currencies, such as those in emerging markets, to make gains against safe currencies. On this score, we are still concerned that central banks are behind the inflation curve and many financial markets are further back still.

For example, BoE Governor Bailey said that the market should not naturally assume a string of base rate hikes just because the bank has hiked for two meetings in a row. The OIS market seems to be saying that the bank could push base rates up to the 1.25%-1.5% region over the next year, or so, and then its work will be done.

However, Mr. Steve Barrow doesn’t think it is going to be that easy. It seems to him that the BoE, a bit like the Fed, is really thinking that it will just have to push rates up moderately to keep the demand side of the economy in check and wait for the real anti-inflation work to be done by rebounding supply as global supply chain issues ease. But there’s a big question mark over this. It is a view that has failed so far, and if it continues to fail in the future because supply problems persist and second-round effects, such as rising wages, take hold, then rates will have to rise by more than the markets currently suggest. Some central banks will respond more strongly to this course of events than others, but, as we’ve said, it won’t be rate divergence that is the key; instead, it will be whether central banks as a whole mess up or not. Right now, it seems best to assume that they will mess up.