Morning Commentary: Exchange Rates in a World Without Policy Differentiations

A daily summary and commentary of events and factors that affect the global markets, with a particular emphasis on the foreign exchange markets.

Exchange Rates in a World Without Policy Differentiations Share this story: Andrew Kositkun Foreign Exchange Head Trader

The pandemic of 2020 was a macro shock for the ages. While the source and the severity of this shock were unforeseen, the resulting reaction went pretty much as expected. Heading into 2020, the expectation was for central bank officials to lose their appetite for negative interest rates and for current account imbalances to take on greater FX influence in a low interest rate world that lacks the normal push-pull of short-term capital flows due to interest rate differentials. With the benefit of hindsight, we know that central banks responded to the pandemic in dramatic fashion with sweeping rate cuts and rapid balance sheet expansion. Notably, no central bank with negative interest rates cut them further, and central banks with positive rates swiftly took them to zero but did not go negative. As a result of this, interest rate differentials compressed in favor of already low-yielding current account surplus currencies (see Europe and Japan) and against formerly high-yielding current account deficit currencies, including the U.S. dollar. In the absence of interest rate differentials to draw capital flows, current account imbalances became a more prominent, if not the most prominent, FX macro determinant and are likely to remain an enduring multiyear legacy of COVID-19. Specifically as to the U.S., the country has one of the largest external financing needs in all of the G10, and as such, the U.S. dollar should remain under persistent, albeit not necessarily acute, balance-of-payment pressure as the Fed follows through on its lower-for-much-longer rate plan in pursuit of an inflation overshoot. On the other side of the coin, currencies that stand to benefit the most are those that combine current account surpluses with relatively higher yield. As would be expected, these currencies are limited in number, with the Chinese yuan a standout in this regard. Interestingly, a review of 2020 not only showed the current account to have the strongest correlation to FX performance, it also showed QE to have a counterintuitive impact, as currencies with the largest QE programs did better and vice versa. This muted impact from QE on FX likely resulted from the lack of significant term premium left to be extracted; and many central banks are growing their balance sheets in unison, making the relative differences in balance sheet policy less pronounced than in prior periods. HERE ARE THE KEY NEWS STORIES FROM OVERNIGHT: On the virus front, the push-pull dynamic between vaccine distribution and the worsening virus outlook continues, with the U.K., Germany, Thailand and Japan all stepping up containment measures. Given this, markets have started the year off on a positive note, continuing the trend of looking through near-term risks and focusing on medium-term optimism. The new Congress was sworn in over the weekend, with Nancy Pelosi re-elected as speaker of the House with no official challenger. Democrats hold a narrow 222-211 majority, the smallest majority for either party in 20 years. As for the Senate, its final composition will be determined by the two runoff elections in Georgia tomorrow. While odds for the Democrats have improved, flipping both of these Senate seats would be an unexpected result. Japanese Prime Minister Yoshihide Suga is considering declaring a state of emergency for Tokyo and surrounding areas amid record-high virus numbers. While details are still unclear, local media reports suggest changes could begin as early as this week and last for a month. China’s manufacturing PMI data came in softer than expected at 53.0 versus expectations for a 54.7 print. While this latest print adds to signs the economy is losing momentum, the Chinese economy continues to recover. OPEC+ members are meeting today to decide whether to boost production in February or maintain production levels to aid the recovery. Russia has been pushing to increase production, with Saudi Arabia expressing more caution.

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