Economic and monetary divergence will drive FX markets this year
- Australia is latest central bank to announce surprise cut
- US then the UK will pull the rate trigger this year
- EUR will keep declining against USD and GBP
By Neil Staines
Men at work!
Last week we discussed the proliferation of central banks around the globe that have eased monetary policy, many in moves that surprised market expectations on timing, or even direction.
The motivation behind the long list of central banks likely centre around the desire to further stimulate demand (and in many cases weaken the currency) afforded by the recent oil-led drop in inflationary pressures.
The latest surprise comes from the Reserve Bank of Australia. It has cited both overvaluation of its currency and the desire to further boost demand as clear motivations for last night’s 25 basis point rate cut to 2.25%.
Over recent quarters, broad commodity price declines (not just oil but Australian export staples such as iron ore, copper and coal) have exacerbated a sharp decline in Australia’s terms of trade, which the RBA cited as “reducing income growth”.
“The early bird may get the worm, but it’s the second mouse that gets the cheese” Jeremy Paxman
The action by the RBA and the many other central banks that have eased policy in 2015 are very significant indicators of the evolution of what we see as the core driver of FX, and broader financial markets in 2015 – economic and monetary divergence.
While there is a race to the bottom for many central banks’ monetary policies, in the developed markets there are two exceptions, the US and the UK.
We have written at length about the prospects for the USD as the US economy outpaces its peers and the Fed move towards monetary normalisation. We have also debated the fact that the Federal Open Market Committee’s Summary of Economic Projections (SEPs) remain far more hawkish than the market pricing of US rate hikes, and our view that as we move further into 2015, it is increasingly likely that it is the market view that is revised up, not the other way round. This should support a further extension of the USD strengthening trend.
GBP, however, has had very little positive airtime of late, despite being the UK being the fastest growing major economy in 2014. One clear reason for this is the significant uncertainty surrounding the general election in May. While we concede that uncertainty is rarely a positive for a currency, and we would not aggressively counter this in the close proximity to the election, the economic prospects for the UK remain very positive in our view.
“Gang aft agley” Robert Burns
There has been a lot of airplay over recent months about two key negatives risks for the UK and GBP. First is the negative implications of continued deterioration in the Eurozone. In this regard, the recent announcement of quantitative easing should support the Eurozone, and as the Bank of England’s David Miles suggested last week “ECB actions will have an impact on the UK”.
The second is the impact and implications of energy price declines on inflation and inflation expectations. Our view remains, however, that there is a very big difference between the UK and the Eurozone, namely domestic demand. In the UK, where demand remains, the likely impact of “temporarily low inflation” (Mark Carney) is positive for demand, growth and ultimately interest rate expectations going forward. The same can not necessarily be said for the Eurozone or EUR.
The US is still likely to be the first to raise interest rates and we remain of the view that the first rate hike will be justified and implemented by June. However, in the UK, the market expects the interest rates to be held steady until 2016. Providing the election does not result in a hung parliament, or similar negative shock, we would expect Carney et al. to pull the trigger as early as Q3. In this scenario we would anticipate that the UK economy, and GBP, would indeed, get the cheese!
“Grief and pain for promised joy”? Robert Burns
At the current juncture, the EUR is taking stock after the declines of January. Greece’s activist finance minister appears to have tempered his all or nothing approach to debt negotiation in his pre-discussion tour of Europe. This has gone some way to calm fears of a Grexit, but the main problem in the Eurozone, lack of demand, remains. We expect further, perhaps more measured declines of the EUR over coming months, at least against the USD and GBP.
Footage of the east coast of America under snow brings back memories of the weather induced -2.1% GDP print for Q1 2014. However, a strong payroll number on Friday will likely ease those concerns. Tomorrow brings service sector and composite PMI data from the Eurozone, UK and US, before the likely non-event of the BoE meeting on Thursday.
– Edited by Oliver Morrison
Neil Staines is head of trading at The ECU Group