Forex Markets Focus on Central Banks

1:31 PM // 0 comments // Unknown // Category: Forex Over the last year and increasingly over the last few months, Central Banks around the world have taken center stage in currency markets. First, came the ignition of the currency war and the consequent volley of forex interventions. Then came the prospect of monetary tightening and the unwinding of quantitative easing measures. As if that wasn’t enough to keep them busy, Central Banks have been forced to assume more prominent roles in regulating financial markets and drafting economic policy. With so much to do, perhaps it’s no wonder that Jean-Claude Trichet, head of the ECB, will leave his post at the end of this year!
You can expect the currency wars to continue until the quantitative easing programs instituted by the G4 are withdrawn. The Fed’s $600 Billion Treasury bond buying program officially ends in June, at which point its balance sheet will near $3 Trillion. The European Central Bank has injected an equally large hunk of cash into the Eurozone economy. Despite inflation that may soon exceed 5%, the Bank of England voted not to sell its cache of QE assets, while the Bank of Japan is actually ratcheting up its program as a result of the earthquake-induced catastrophe. Whether or not this manifests itself in higher inflation, investors have signaled their distaste by bidding up the price of gold to a new record high.

Then there are the prospective rate hikes, cascading across the world. Last week, the European Central Bank became the first in the G4 to hike rates (though market rates have hardly budged). The Reserve Bank of Australia, however, was the first of the majors to hike rates. Since October 2009, it has raised its benchmark by 175 basis points; its 4.75% cash rate is easily the highest in the industrialized world. The Bank of Canada started hiking in June 2010, but has kept its benchmark on hold at 1% since September. The Reserve Bank of New Zealand lowered its benchmark to a record low 2.5% as a result of serious earthquakes and economic weakness.
Going forward, expectations are for all Central Banks to continue (or begin) hiking rates at a gradual pace over the next couple years. If forecasts prove to be accurate, the US Federal Funds Rate will stand around .5% at the beginning of 2012, tied with Switzerland, and ahead of only Japan. The UK Rate will stand slightly above 1%, while the Eurozone and Canadian benchmarks will be closer to 2%. The RBA cash rate should exceed 5%. Rates in emerging markets will probably be even higher, as all four BRIC countries (Russia, Brazil, China, India) should be well into the tightening cycles.

On the one hand, there is reason to believe that the pace of rate hikes will be slower than expected. Economic growth remains tepid across the industrialized world, and Central Banks are wary about spooking their economies with premature rate hikes. Besides, Fed watchers may have learned a lesson as a result of a brief bout of over-excitement in 2010 that ultimately led to nothing. The Economist has reported that, “Markets habitually assign too much weight to the hawks, however. The real power at the Fed rests with its leaders…At present they are sanguine about inflation and worried about unemployment, which means a rate rise this year is unlikely.”  Even the ECB disappointed traders by (deliberately) adopting a soft stance in the press release that accompanied its recent rate hike.
On the other hand, a recent paper published by the Bank for International Settlements (BIS) showed that the markets’ track record of forecasting inflation is weak. As you can see from the chart below, they tend to reflect the general trend in inflation, but underestimate when the direction changes suddenly. (This is perhaps similar to the “fat-tail” problem, whereby extreme aberrations in asset price returns are poorly accounted for in financial models). If you apply this to the current economic environment, it suggests that inflation will probably be much higher-than-expected, and Central Banks will be forced to compensate by hiking rates a faster pace.
Finally, in their newfound roles as economic policymakers, Central Banks are increasingly engaged in macroprudential policy. The Economist reports that, “Central banks and regulators in emerging economies have already imposed a host of measures to cool property prices and capital inflows.” These measures are worth watching because their chief aim is to indirectly reduce inflation. If they are successful, it will limit the need for interest rate hikes and reduce upward pressure on their currencies.
In short, given the enhanced ability of Central Banks to dictate exchange rates, traders with long-term outlooks may need to adjust their strategies accordingly. That means not only knowing who is expected to raise interest rates – as well as when and by how much – but also monitoring the use of their other tools, such as balance sheet expansion, efforts to cool asset price bubbles, and deliberate manipulation of exchange rates.