Currency moves have been unusually muted in the first half of the year. For example, the Euro Trade-Weighted Index as measured by the Bank of England is merely 3% above its start of the year level, whereas the dollar index is just 3% lower over the same period. Why is this when there has been such a high degree of economic uncertainty?
It is true that earlier on in 2011 differing trends in currency trade-weighted indices did appear when headline inflationary pressures diverged, leading to alternative interest rate expectations. Since April, however, currencies have converged again as more evidence of a global economic soft patch has emerged. While there have been many factors to influence foreign exchange markets this year, in reality many of these drivers have influenced all major
countries in a similar manner. Consequently, currencies have traded more in line with differences in policy mandates rather than specific macro developments.
In the analysis below, we consider two factors in particular - interest rate expectations and market positioning.
The ECB, with its purer inflation mandate, has reacted to stronger macro data by raising interest rates, and so the euro has been the strongest of the major currencies. The Federal Reserve has the most balanced policy mandate, balancing both inflation and growth objective; hence it is most likely to look through energy-based inflationary pressures when employment gains remain slow. Consequently, the dollar has performed weakest. Between the two
extremes in policymaking terms the MPC has plotted a steadier path, so sterling is broadly unchanged year to date. In Japan, where inflation is still a goal rather than a problem, the monetary authorities remain strangely hesitant to pursue further expansionary policy measures, ensuring the yen's trade weighted measure has also remained stable.
Currency positioning is not excessive at the moment with different segments of the market offsetting each other. Currencies, like those of the dollar and of emerging markets, which the market believes to be good value, are also the currencies where forecasts are positive. In the same way, currencies that are expensive (the euro and the yen), are expected to fall through the year. Sterling is arguably quite close to fair value, and is not expected to move much this
year.
At Standard Life Investments, our main view is that sovereign credit problems will eventually hurt the Euro-area more than the US. While we understand that US fiscal dynamics and economic growth are also weak, we see the dollar's status as the main reserve currency (although this is steadily diminishing) effectively buying more time for the US Treasury to implement a long-term structural plan to improve US finances. Greece, Ireland, Portugal and other European countries do not have this luxury. We note that a ‘one size fits all' monetary policy is increasingly difficult to operate in Europe.
Our view expects that interest rates will be slower to normalise globally than the market continues to discount - rates will be ‘lower for longer'. When these expectations unwind the dollar will move out of the current basing pattern and will develop a slow grinding recovery. As the year progresses we think that such moves will be welcomed by European officials, as we expect a weaker euro to form part of the solution to the high debt/low growth European
dilemma.
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