Major currencies may see upheaval in 2016
If benign US inflationary pressures curtail the length of the Fed’s tightening cycle, next year might see the euro end up stronger against both the dollar and the yen
If monetary policy settings are the tectonic plates upon which currencies rest, there could well be upheaval in 2016 as major central banks react to the fluid global economic situation.
Although the Federal Reserve has thus far left US rates unchanged at near zero, various Fed policymakers continue to articulate the case for a possible increase in interest rates this year even after September’s disappointing US jobs data.
But as the French bank Societe Generale (SocGen) pointed out on October 7, the slide in US break-even expectations suggests “bond investors are signalling to us that they don’t believe the Fed is in control anymore” while “the Fed by contrast is brushing aside the market’s deflation concerns.”
What if the bond investors are correct? While that would not necessarily rule out a Fed rate hike from its emergency policy settings level, it would reinforce the US central bank’s consistent message that after a lift-off in interest rates any further moves would only follow a shallow trajectory.
But it would likely also mean that the duration of the Fed’s tightening cycle might be abbreviated, a possibility explored in detail in HSBC’s October Currency Outlook. “We think it will not be long after the Fed begins its tightening journey before the market is forced to ask ‘are we there yet?’” the bank said.
If “are we there yet?” arises due to the absence of inflationary pressures that would justify further increases in US interest rates, “then this allows [the Fed] to leave the US economic growth expansion unshackled. It would see the [dollar] weaken markedly as US rate expectations are pared,” HSBC wrote.
In that case, broad dollar weakness would include the greenback depreciating in value versus the euro and the Japanese yen, as well as against emerging market currencies, but neither the European Central Bank (ECB) nor the Bank of Japan (BoJ) would necessarily welcome such a move in their respective currencies when local economic prospects might still be cloudy.
“Building evidence of disappointing economic growth in Japan will continue to increase pressure on the BoJ to deliver further monetary easing,” the Bank of Tokyo-Mitsubishi UFJ (BTMU) said on October 8.
“Let us be blunt - the Bank of Japan has failed in its objective of two years ago to push
core CPI (ex-fresh food) back to 2 per cent,” said SocGen arguing that with the BoJ’s failure to meet its target and a weak Japanese economy, more quantitative easing (QE) in Japan is inevitable and that “there is no going back now”.
Yet Japan’s central bank has not yet provided a clear signal that it intends to act, though as BTMU has said, that “also leaves the yen more vulnerable should the BoJ surprise the market and ease policy further at the end of the month”.
SocGen believes Japan’s “government will try to declare a complete exit from deflation by the time the upper house election is held next summer as a signal of the success of Abenomics. For this to materialise, we expect the government and the BoJ to re-accelerate its monetary and fiscal policies as soon as possible”.
That throws up the intriguing possibility that Japan could be adopting policy settings that should see the yen weaken, as a side effect, into 2016 just as benign US inflation prospects truncate the Fed’s tightening cycle and, if HSBC is correct, weigh on the dollar.
But if, in this scenario, the evolution of US and Japanese monetary policy could be seen as weighing on both the value of the dollar and the yen, what of the euro? HSBC’s view is clear, the euro will “rise, don’t be surprised”.
While the ECB’s existing quantitative easing programme is more modest than Japan has, or the Fed had, its room for manoeuvre is arguably also more constrained.
“No other central bank engaged in QE must consider more than one sovereign, leaving the ECB constrained by self-imposed technical restrictions,” HSBC said, potentially leaving the ECB able to talk the QE talk, but with “limited ability to walk the walk” and as a consequence leaving the euro vulnerable to upside pressure.
While this hypothesis is admittedly contingent on benign US inflationary pressures curtailing the length of the Fed’s tightening cycle, if it does play out, next year might see the euro end up stronger against both the dollar and the yen as a result of the monetary policy settings, in Frankfurt, Tokyo and Washington, grinding against each other.