Flip-flopping Fed a challenge to monetary divergence trade
The Fed’s credibility has suffered significantly
As recently as the first quarter of this year, the task facing the world’s foreign exchange traders was a fairly straightforward one.
With the US Federal Reserve expected to begin raising interest rates sometime in the middle of this year and the European Central Bank (ECB) heading in the opposite direction by finally launching a programme of full-blown quantitative easing (QE), the so-called “monetary divergence trade” - buying the dollar and selling the euro - seemed like a one-way bet.
Between March 2014 and March 2015, the greenback surged 25 per cent against Europe’s single currency - and by a further 18 per cent against the yen partly because of the even more aggressive QE programme being undertaken by the Bank of Japan (BOJ) - as the divide between the two leading central banks in the developed world became more pronounced in the minds of investors.
Then, all of a sudden, the trade began to unravel.
The dollar weakened 8.6 per cent against the euro between mid-March and mid-May and has since been much more volatile, prompting HSBC to call an end to the dollar’s bull run and making large directional bets in foreign exchange markets - such as a strong dollar and further weakness in emerging market (EM) currencies - much more difficult.
A number of factors have made the foreign exchange landscape much trickier for traders and investors to navigate.
One of them is that the euro has not weakened since the ECB’s €60 billion-a-month asset purchase scheme got under way in early March, and has even strengthened nearly 2 per cent against the dollar. This is surprising given the renewed fears in the spring about Greece being forced out of the eurozone.
The euro’s resilience stems partly from its role as a funding currency for so-called “carry” trades (borrowing in a currency with low interest rates in order to buy higher-yielding ones, and pocketing the difference). When risks increase, like they did dramatically in early July when it looked like a Greek exit (“Grexit”) was imminent, investors unwind these bets, repatriating funds which, in this case, caused the euro to rise.
Yet the main reason why the divergence trade is no longer a one-way bet is because the Fed has not done enough to convince investors that it is determined to raise rates this year.
Although understandably data-dependent in conducting monetary policy, the Fed’s credibility has suffered significantly.
Just last month, the US central bank surprised markets by suddenly pointing to growing concerns about China’s economy (worries that are likely to persist for the foreseeable future) as a justification for keeping rates on hold, reinforcing the perception that a tightening in policy this year was extremely unlikely.
Yet on Wednesday, the Fed surprised markets once again by issuing a relatively hawkish statement which omitted previous warnings about external risks to the US economy and appeared to prepare the ground for a rate hike in December.
The Fed’s unexpectedly hawkish stance triggered a sell-off in US Treasuries and a renewed rise in the dollar, suggesting that the monetary divergence trade has yet to run its course.
Indeed even if the Fed flip-flops again and turns more dovish between now and December, the ECB is providing a solid underpinning to the divergence trade through its QE programme. On October 22, Europe’s monetary guardian hinted that it would provide another burst of monetary stimulus in December in order to combat the threat of deflation and help shore up a fragile eurozone economy increasingly at risk from the downturn in EMs.
Still, currency strategists are right to be cautious.
A stronger dollar has already taken its toll on the competitiveness of US exports and is making it more difficult for the Fed to raise rates. More importantly, the extremely subdued inflationary environment in the US - there is now a risk of further downward pressure on inflation due to China’s economic woes - and the rather patchy economic data over the past two months still leave ample scope for rates to remain unchanged in December.
Instead of a divergence trade, investors and traders are facing a volatility trade in which every piece of economic data - both in the US and in the eurozone - will have a strong bearing on sentiment in foreign exchange markets in the coming weeks and months.
The safe trading assumptions of 2014 are now a distant memory.
Nicholas Spiro is managing director of Spiro Sovereign Strategy