Six years ago, in the wake of the global financial crisis, we undertook a study on the effects of unconventional monetary policy on the currency market. Central banks are now attempting to reverse these policies, so we revisited this work to suggest the likely implications for future exchange rate trends.
Conventional policy currency recap
The relationship between interest rates and currencies is thought to be well understood. Assuming a world where capital flows are many times greater than trade flows and where the central banks retain a high degree of inflation credibility, higher and/or rising interest rates are a positive driver for a currency. In the first eight years of the new millennium, when central bank independence was deemed to have mastered inflation control, higher yielding currencies outperformed lower yielding currencies, enabling investors to produce returns in the region of 4% per annum.
It was found that currencies with ultra-low interest rates and extensive QE could appreciate when investors are actively shunning risk.
Unconventional policies – fears and reality
At the outset, many industry observers viewed quantitative easing (QE) as a modern version of money printing – a policy that would lead to an inflationary spiral and cause rapid currency debasement. Indeed, currencies often weakened ahead of unconventional policy making. Of course these moves might also partly reflect conventional currency relationships, including speculation that interest rates would fall towards zero – with weakness a consequence of the lower return rather than just the fear of excessive money creation.
Chart 1: ASI Long-term Expected Return Forecast*
That view of QE proved to be naïve. The reality of currency performance during the years of QE was more complex, with at least two other drivers overwhelming the money printing risk. First, wide swings in risk appetite had a powerful effect on currency values. It was found that currencies with ultra-low interest rates and extensive QE could appreciate when investors are actively shunning risk. In addition, the breakdown of the normal monetary transmission mechanism between official policy making and risk appetite meant that debasement simply didn’t occur.
For the most part, it has been larger countries whose currencies are seen as funding sources in order to buy higher yielding currencies that have implemented these unconventional policies. So we tested the theory that QE will create carry currency outperformance, and we are able to reject it. The G10 Carry index actually fell 29% from the beginning of 2008 at an annualised decline of 3.2% - despite a 19% index rebound during the globally coordinated monetary and fiscal stimulus policies of 2009. QE does not, therefore, lead to currency weakness in periods where risk appetite is low, volatility is above average and interest rate differentials have fallen – because global QE is only likely to be a dominant policy during periods of exceptional economic uncertainty.
Tapering towards the exit
But what will happen during the next phase of this still extraordinary economic environment? It would be convenient to assume a similar outcome to the QE build up i.e. that the reduction of central bank balance sheets will make little difference as QE will only be unwound when the global economy improves sufficiently. Unfortunately recent trading behaviour would highlight risks to that assumption as higher yielding currency performance - both within emerging markets and the G10 - has deteriorated abruptly. Accordingly, a more detailed analysis is necessary.
QE withdrawal does matter – beware false rallies
Of the four currency areas analysed, the US Federal Reserve (Fed) and the European Central Bank (ECB) have been the most clear about policy changes, with the Fed very much in the lead. Our analysis concludes that in both Europe and the US, currency appreciation is clearly visible with moves more reliable when economic improvements justify the move. We also believe that the market is reacting more quickly to ECB and Bank of Japan decisions than it did to the Fed moves. This “learning” development risks creating false rallies in currencies whose economies do not yet justify the additional financial tightening that currency appreciation can bring.
Chart 2: Dollar and euro anchors
But there’s a lot else going on – beware QE being one’s sole focus:
QE decisions in Japan look mostly technical in nature, given the increasing scarcity of assets to purchase, rather than as a result of policy success. While it is impossible to perfectly isolate the “exit from unconventional policy” driver from all other currency drivers in any of the cases, it does look as if the UK situation is mostly driven by the Brexit negotiations and therefore offers limited information for this study.
Recent performance of the Euro and the US dollar, suggests some cauction is still merited elsewhere:
How much does this matter across the currency market as a whole? Both the Japanese yen and sterling’s trade weight indices remain low in historical terms but the euro and US dollar versions are above their long-term averages, partly driven by prospects of QE exit. Their currencies have received a boost from this process already and when both trade weighted indices have been strong at the same time, the riskier currency baskets have tended to suffer.