Interest rate differentials have traditionally driven the currency market, but now that every major central bank has lowered interest rates to zero, what will guide currencies? In short, it can be a mixture of how high the risk of future shutdowns are, relative growth benefits coming out of the crisis, global risk sentiment and politics. The defensive yen seems attractive in this brave new world as it no longer suffers from a serious drawback, while the dollar role as a haven may be challenged if other waves of infection hit America.
The lost driver
It was once interest rate differentials between two economies and expectations of how they could change, arguably the two most dominant factors behind exchange rate movements. But the world has changed dramatically in 2020, and so has the FX playbook. In the last few months, the major central banks lowered all interest rates to around zero to protect their economies from an impending recession. Not only have G10 rates converged around zero, but the expectation portion has mostly also expired: Nobody will raise interest rates for a long time.
Of course, small differences still exist. The Fed now has rates close to 0.25%, while the European Central Bank has them at -0.50%, so assuming similar inflation, the dollar still has a small interest rate advantage. But the key word here is small. The difference is not nearly as large as it was, and any future changes will also be minor, reducing the significance of this theme for currencies. In other words, the days when Fed or ECB interest rate decisions used to rock the foreign exchange market may be long gone.
The focus may change to which nations have handled the health care crisis most effectively. These economies will be able to reopen with a much lower risk of other waves of infection hitting, and therefore a much lower risk of another shutdown. This will mean a more sustainable improvement in the future. The main examples here are New Zealand and Australia, where new cases are extremely low lately.
America is on the opposite side of that spectrum. Most states are now partially reopened, but if someone excludes New York from the nationwide number, the outbreak elsewhere has not really reached its peak. It generates a high risk of future shutdowns, raising questions about how quickly the economy will recover if business activity is interrupted again in the future.
At the end of the day, it all boils down to the relative growth performance. Countries that are growing faster and coming out of this crisis are likely to see their currencies work best, and anything that allows – like additional stimulus packages – will be a positive FX signal.
But mind risk sentiment
In addition to growth considerations, the second most important driver of the foreign exchange market will be risk appetite. The dollar has acted as a safe haven during this crisis, which means that pairs like the euro / dollar and sterling / dollar tend to track stock markets today.
In this sense, the theme likely to dominate prior to the November US presidential election is the “new Cold War” between the United States and China. Even before the pandemic, the relationship between these superpowers was icy, but now things have escalated to a whole new level as President Trump blames the Beijing outbreak.
It is now clear that Trump’s election strategy is to launch a full political attack on China, so tensions are likely to escalate further direction into November. Whether this will happen through another round of customs, by blocking US pension funds from investing in Chinese stocks, or by restricting Chinese companies’ access to US capital markets, remains to be seen.
Staying in the political sphere will be another Brexit process to look at. Negotiations have been slow and fruitless amid the pandemic, but the British leader has been adamant that he will not request an extension of the transitional period that expires at the end of this year. If he changes his mind, he will have to request an extension by June 30 – otherwise a no-deal Brexit will become the default option again.
FX implications – the good and the bad
By adding everything, the yen seems the most attractive in this new FX world, at least for now. First, the fact that the rates are now at zero globally benefits the yen the most. For many years, the Japanese currency suffered a severe interest rate disadvantage because the Bank of Japan boasts the most aggressive stimulus program in the world. This disability has now been largely canceled.
Secondly, many risks lie on the horizon and the yen is the leading port currency. Markets are real at the moment thanks to a stream of stimulus and liquidity, but it may not last if other waves of infection hit, or US-China tensions flare up further, or if economic recovery is slower than the record comeback, that are currently hinted at by stock values.
Dollar defensive qualities have also been showing lately. However, the reserve currency has lost its significant yield advantage, and although safe harbor flows have prevented it from depreciating so far, that could change if the United States is hit by multiple waves of infection and forced into rolling shutdowns. Unfortunately, this is a non-negligible risk as America opens up while new infection numbers are still elevated.
Within the commodity currency, it is a more neutral situation. While Australia and New Zealand have fought the pandemic better than most, they are export-driven economies, so global development means just as much, if not more, than domestic. Therefore, boiling tensions between the US and China and dwindling global trade may keep a lid on their recovery.
It is also difficult to have any real confidence in the pound ahead of what promises to be yet another drama-packed round of Brexit talks. In addition, the UK is behind most nations in the opening.
But the real casualty may be China’s yuan. Yes, this exchange rate is mostly controlled, but if market forces begin to push it down as Trump becomes more hawkish, there is only so much that even the mighty Politburo can do. On the other hand, despite the high cost of the trade slowdown, the Chinese domestic economy appears to have the relative advantage of being the first to emerge from the shutdown as it was also the first to be hit by the virus.
Could the broken euro take advantage of all this? The fight against the EU and the lack of strong stimulus have ruined the single currency and, truth be told, there is not much to be optimistic about in the euro zone. However, should the dollar lose ground as a result of other waves, it could spur a mild recovery in the euro from depressed levels, especially if the EU finally delivers a serious stimulus package. Unfortunately, even in this case, this is unlikely to mark the beginning of a long, healthy rise in the euro cross, especially the euro / dollar.
All in all, there are still many challenges when economies reopen, and a lot depends on whether other waves hit. What seems more certain, however, is that geopolitical tensions are set to flare up, making a bad situation even worse.