SLI’s Lawson comments on currency swings and roundabouts
Jeremy Lawson, chief economist at Standard Life Investments (SLI) comments on the implications of recent monetary policy on currency markets.
The surge in the trade-weighted US exchange rate that began in July last year has been arrested in
recent weeks as the dollar has slid against most of the world’s major currencies. This is especially
the case against the emerging market and commodity currencies that had fallen the most since the
start of the summer.
The dollar has also depreciated modestly against the euro, the yen and the pound, though their troughs occurred much earlier in the year. The immediate catalyst for this near term currency realignment was the Fed’s September meeting, when officials signalled a slower and shallower path for the federal funds rate going forward, and pointed to external developments, including the sharp appreciation of the dollar, as the key reasons for delay.
For all the ink spilled about currency wars, the essential takeaway about global currency dynamics
is more prosaic. Floating currencies act as an automatic stabiliser, albeit one that often overshoots.
Economic strength and expectations of policy tightening lead to appreciation against the currencies
of countries that are economically and financially fragile, or where central banks are easing policy.
Indeed, the movements of the euro/dollar cross rate since the middle of 2014 have been highly
correlated with the changes in the spread between 2-year Treasury and bund yields. Thus, what can appear like the actions of central banks locked in a currency war is really just
the natural reaction of currency markets to diverging economic and policy fundamentals. However,
large and swift currency shifts can also sew the seeds of their own destruction.
As a number of Fed officials have acknowledged, the size and speed of the dollar’s rise is slowing progress toward both Fed mandates, but especially the price stability mandate. Domestic financial conditions have therefore tightened, without any increase in the Fed’s policy rates with dollar appreciation effectively substituting for traditional policy tightening. The dollar has potential to resume its upward trend over the coming months; we expect the ECB to ease policy before the end of the year, while fragilities in select emerging markets have not gone away.