Looking for divergence in monetary policy

So much of the narrative around currency movements focuses on interest rates that we could be forgiven for thinking that monetary policy is the only issue that dictates FX volatility. But it is a red herring. Monetary policy is not nearly as important as everybody thinks.

As a relative price, currencies move most when there is divergence between countries, not convergence. But, with the exception of Japan, monetary policy screams convergence and has done so for some time. G10 central banks all lifted rates together and are now engaged in the process of cutting rates together. Of course, there is some slight divergence as central banks might go a bit faster or slower than one another, but as long as they are all pushing in the same direction, there’s not enough divergence to create major currency trends.

Indeed, this is largely why currencies have been in very narrow ranges in the last year, or more, particularly euro/US dollar. The only place to find divergence has been in Japan and this is why the yen has been the sole currency that’s really moved in recent years. So, when we see market commentary that talks exclusively about G10 monetary policy and how this might lead to currency volatility, we roll our eyes and, instead, look for where there might be divergence, not convergence.

Divergence in monetary policy is pretty rare because there’s a significant global element to inflation, just as we have seen during the supply-chain disruptions of recent years. This might change in time should the growth of protectionism continue to such an extent that domestic factors increasingly dictate national inflation, but we are a long way from this point right now and, in the Standard Bank’s view, will probably never get there.

As we have mentioned before, there’s perhaps only one sense in which convergent monetary policy can lead to notable currency volatility. But it is confined to the US dollar and relates to the fact that the currency’s dominant global financing role bestows specific importance on Fed policy cycles.

For instance, Fed easing cycles are often more likely to be accompanied by a lower dollar if rate cuts ease the global financial cycle, generate risk taking and causing investors to ditch ‘safe’ assets such as the US dollar. This weakness can occur even if Fed rate cuts are at a similar pace to others. The converse is the case in a Fed tightening cycle.

But even this influence on currencies is pretty limit ed. Instead ‘real’ divergence is needed to get currencies moving. For instance, the sort of divergence we saw at the start of the war in Ukraine when energy consumers, like much of Europe, was hit by an adverse terms of trade shock because of surging energy prices, at the same time as energy producers, like the US benefitted from a positive terms of trade shock.

What is important here is to distinguish between events, often shocks, that cause divergence and those that do not. For instance, the pandemic was a symmetric shock; it affected everybody in the same way and so had little currency connotation. Hence, the key to forecasting significant currency change is to look for divergence. Some of this divergence might be forecastable in advance but some is not, like the war in Ukraine.

Right now, the clearest potential for divergence in the Standard Bank’s view lies with the US election and, more specifically the threat of tariffs should former president Trump win on November 5^th. These have the scope to create divergence in a number of ways; on inflation, monetary policy, economic growth and more. Of course, if the US announces global tariffs of 10%-plus and 60%-plus on China there will be retaliation that brings back some convergence. But this will take time and may not even happen.

“We don’t know whether Trump will win. But, as far as we are concerned, this is what currency traders should focus on, as it could lead to at least a short-term rise in the dollar, rather than the convergence that we see in monetary policy between all but one of the advanced developed countries,” said the Standard Bank.