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Currencies in a Zero Interest Rate World

Special Report By Blu Putnam, Chief Economist, CME Group

April 2013

All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

The dynamics of currency markets have been altered significantly by the continued zero interest rate policies (ZIRP) and massive quantitative easing programs of the US Federal Reserve (Fed), European Central Bank (ECB), Bank of Japan (BoJ), and Bank of England (BoE). In this environment, our perspective is that exchange rate movements between members of the ZIRP club are likely to be determined by the interplay of domestic politics and economic growth, rather than relative interest rate policies. By contrast, exchange rates between ZIRP club members relative to emerging market nations and smaller industrial countries are more likely to be influenced by interest rate differentials and how interest rate policy might respond to currency movements. Moreover, the general state of play in the currency markets is likely to be greatly affected by whether global financial markets appear to be trading in a “risk-on” or a “risk-off” environment.
Politics Can Trump Fundamentals in the ZIRP Club
Exchange rates between any of the ZIRP club members of the US, Europe, UK, or Japan simply do not depend as much on interest rate differentials as they once did, because the differentials have disappeared and are not likely to reappear until years into the future. The BoJ invented the zero interest rate policy option in 1995, and Japan was considered a special case that could not happen in the US, UK, or Europe, until it did happen when the Great Recession struck in 2008. Now, in the post Great Recession world, there is effectively little difference in the interest rate policies of the US, UK, Europe, and Japan, although there are differences in how quantitative easing has been applied.

Figure 1.

There is not much difference in 10-year government bond yields either (Figure 2, below) for members of the ZIRP club. Yields on Japanese Government Bonds (JGBs) are lower than their counterparts in the US, UK, and Germany (the benchmark for Europe), but that is mainly because Japan has been battling deflation for 20 years and has had zero rates since 1995. As one can see in Figure 2, 10-year Government bond yields for the US, UK, and Germany are closely correlated and have converged since 2008 toward lower yields. In short, there is very little relevant information for exchange rate determination in the shape of the yield curve for these four major currencies. And, this is likely to continue through 2013, into 2014, and possibly beyond.

Figure 2.

With interest rates and yield curves having been severely diminished as relative determinants of exchange rates between members of the ZIRP club, market attention has shifted to the interplay of politics and economics. Let’s go through the four countries on a case by case basis to illustrate this point.
Euro (USD/EUR). The onset of the European sovereign debt crisis weakened the Euro relative to the US dollar. This slide was halted at USD 1.20 per Euro when in the summer of 2012 ECB President Mario Draghi vowed that the central bank would do whatever it took to preserve the single currency and to stabilize financial markets in Europe. Over the next six months, the Euro rallied back to USD 1.35, until the messy and inconclusive Italian elections reminded market participants that voters do not necessarily like the austerity imposed on them by technocrat governments and German-dominated European Union (EU) bail-out plans.
Europe has more electoral uncertainty ahead of it. Italian politics promise a steady stream of good theater, and the German elections in September 2013 may contain some surprises for market participants.
Chancellor Merkel’s Christian Democratic Union (CDU) looks sets to win more seats than in the 2009 election, yet not enough to form a government without a coalition partner. Chancellor Merkel’s problem is that her current partner, the Free Democratic Party (FDP), has lost voter support, at least according to the latest polls. There is a reasonably good chance that the FDP might be shutout of the Bundestag completely, or the FDP might just get a few seats, but not enough to push a Merkel-led coalition over the 50% mark. What that means is the Chancellor Merkel may need a new dance partner. The most likely partner is the Green Party, and it is not clear at all what the Greens might demand in policy initiatives to allow Chancellor Merkel to form a new governing coalition. Currency markets do not like uncertainty, especially when the Greens might tie Chancellor Merkel’s hands in dealing with the EU and debt bail-out plans. After all, many German voters would rather focus on their own internal economic and environmental issues rather than spend their hard-earned taxpayer money subsidizing weaker European countries.
Figure 3.

Japanese Yen (JPY/USD). The yen traded in a tight range over the summer of 2012, between 77-79 yen per US dollar. The slide of the yen started in the fall of 2012 when market participants realized that former Prime Minister Abe had a very good chance of winning a large majority in the December 2012 elections, and that he was quite serious about adopting an aggressive policy stance to achieve a 2% inflation target which would in part be accomplished by weakening the yen. Once Abe won the election convincingly, he immediately moved to put his team in place at the Ministry of Finance and later the Bank of Japan. Market participants had little choice but to take the new inflation target and the weak yen approach to heart. In short, the December 2012 elections changed the course of the yen.
Figure 4.

British pound (USD/GBP). In the aftermath of the financial crisis in 2008-2009, the voters in the UK in May 2010 dismissed the Labour party and a new Conservative Party-led coalition government was installed. This Tory-led government has consistently argued that strict austerity and smaller budget deficits are the best path to a more robust economy. Yet, several years later, as the UK economy continues to struggle and the decline in the budget deficit has been smaller in GDP terms than desired, the popularity of the Conservative Party has declined. The Labour Party now holds a majority in the opinion polls. Although elections are a long way off, scheduled for May 2015, market participants have come to question the commitment of the Conservative Party to its budget reduction plans, and the risks associated with owning British pounds have increased. In this case, as in the Japanese case, it is the interplay of weak economic growth leading to the possibility of political change that has worked to weaken the currency versus the US dollar.

Figure 5.

US Dollar (USD). Politics have been driving markets in the United States as well. During 2012, all eyes were on the Presidential election and whether the outcome would facilitate a fiscal policy compromise or whether the US would fall off the proverbial fiscal cliff of automatic tax hikes and spending cuts. While the initial reaction by markets to the victory by President Obama was to crush equities, it was not long before signs appeared that the fiscal cliff might be avoided. The New Year’s Day tax deal took the worst of the fiscal cliff off the table. The equity markets gained confidence, shifted to a “risk-on” mode, and have not looked back, which helped underpin US dollar strength against the Euro, pound, and yen in the early months of 2013.
Figure 6.

Certainly, economic fundamentals continue to play an important role in the determination of exchange rates of ZIRP club members among themselves. Yet, for currency analysts, the market interpretation seems to hinge on the political decisions that are influenced by economic data and not the economic trends themselves. This post-recession dynamic has forced currency analysts to spend more time studying political trends and handicapping potential shifts in party popularity, which is not necessarily the analytical strength of currency specialists. And, the nature of political decisions is much more of an on/off switch than the inherent evolution of fundamental economic trends. That is, political decisions or elections can lead to dramatically different exchange rate impacts depending on the outcome, which raises the potential for trend reversals and for quick and severe price jumps. All of this underscores the complexity of analyzing currency markets during the era of zero interest rate policies.


Emerging Market and Small Country Exchange Rates are All About Rate Differentials

Outside the ZIRP club, exchange rate determination analysis could not be more different. There is effectively a decision tree. The first question is whether one believes global markets in general are in a “risk-on” or “risk-off” mode. Emerging market nations and smaller industrial countries are generally considered more risky, so they may experience selling pressure and weakening currencies in a “risk-off” trading environment. Interestingly, there is also another factor as work. In a “risk-off” environment, market participants are usually deleveraging as they reduce risk-taking. Deleveraging means paying back the liabilities, which are mostly denominated in the zero-rate currencies, and selling the risky assets that may be located in emerging markets, smaller industrial countries, or simply further out the perceived risk spectrum. That is, deleveraging and reduced risk-taking tends to favor the currencies of the ZIRP club, since they are the “funding” currencies that are being repaid.
Once markets shift to greater risk-taking, the analysis puts a spotlight on the short-term interest rates of emerging market and smaller industrial countries. If currency market participants are willing to entertain the assumption that the exchange rate of a higher rate country versus the US dollar can remain stable, then the expected returns are determined by the interest rate differential. For example, a 6% interest rate for an emerging market country relative to a 0% short-term rate for the US, generates a 50 basis point (0.50%) return each month, assuming exchange rate stability, and that is without leverage. As more market participants in a “risk-on” world gravitate to this exposure, known as the FX carry trade, a reinforcing cycle can be created that leads to the emerging market currency appreciating, which adds to the potential returns.
Currency carry trades come with significant risks. For example, if global markets abruptly shift to “risk-off”, the resulting deleveraging activity can result in a sharp downward move in the emerging market currency on the long side of the carry trade that is being unwound. Months and months, even years, of accumulated profits from the interest rate carry can be wiped out in just days or weeks.
Another risk for the FX carry trade is associated with the possibility of the central bank of the emerging market or small industrial country cutting its short-term interest rate target. Rate cuts have the potential, if there are too many or too large, to cause some carry trade investors to cut their positions. Indeed, as FX carry trades gain favor, the risk of rate cuts rise, because many central banks are appropriately fearful that too much currency strength can have a negative impact on exports and economic growth. What ZIRP in the US, UK, Europe, and Japan has done has made central bank policy making in emerging market and small industrial countries incredibly more difficult.
For example, a country such as Brazil broke the links with its inflationary past by adopting a strict policy in the late 1990s of maintaining a comfortable premium for its short-term interest rate above the prevailing inflation rate. As Brazil has earned its credibility, it has also attracted capital inflows and in “risk-on” markets has become attractive to currency market participants for its relative high and stable interest rate policy. For Brazil, and countries like it, their central banks have been put in the position of having to narrow the gap between short-term rates and inflation more than they otherwise would have preferred to do. In effect, the zero rate policies of the US and other major countries are acting like a magnet, pulling rates down all over the world.
Figure 7.

Emerging market countries such as Mexico and India face the same pull for lower rates as Brazil. Smaller industrial countries such Australia, New Zealand, or Canada, already have modestly lower rates, but they feel the same pull for even lower rates. Arguably, when short-term rates fall as low as they are say in Canada at 1%, then these currencies are more likely to experience some weakness. Whereas relatively high rate currencies, such as India, have the potential for some currency appreciation even though they have much more inflation pressure than most other emerging market countries. In a “risk-on” market environment, wide short-term interest rate differentials have the potential to trump inflation pressures in the currency markets.


Appreciating the Risks and the Opportunities of a Zero Rate World

The realities imposed on currency markets by an extended period of zero interest rate policy from the US and other major nations have changed the dynamics of exchange rate determination. In summary, our research suggests the following:
 Exchange rates, between the currencies of the US, UK, Europe, and Japan, are influenced by the interplay of politics and economic growth aspirations since interest rate differentials are effectively non-existent.
 Political decisions and election outcomes, by their nature, are more on/off or either/or events, that may often lead to abrupt trend reversals when compared to the inherent evolution of economic fundamentals.

 Exchange rates between the US dollar relative to the currencies of emerging markets and small industrial countries are influenced first by the general tenor of global markets. That is, what matters is whether markets are generally characterized as “risk-on” or “risk-off”, with the emerging market and small country currencies generally weakening versus the US dollar in a “risk-off” environment.

 When global markets shift in the direction of greater risk-taking, emerging market and smaller industrial country currencies with their relatively high interest rates may gain favor as the long side of the FX carry trade.

 Considerable risks are associated with the FX carry trade, including the possibility of a return to “risk-off” markets in general or the possibility of rate cuts in the emerging market or smaller industrial country should their currency be perceived by their central bank as having appreciated too much and possibly hurting exports and economic growth.

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