Inflation is working its way into FX pricing in major currencies, primarily through rising real interest rates as central banks become more hawkish in response to persistent inflation.
John Velis, FX and macro strategist Americas at BNY Mellon Markets, notes that since expectations around the US Federal Reserve began to move in a more hawkish direction, the US dollar index has risen over half a percentage point.
The way the major central banks choose to fight inflation … forms the foundation of what could be a volatile year in FX trading
Ipek Ozkardeskaya, Swissquote
“Given that so much of the inflation we see today is supply-side generated, we are watching input prices closely, as well as prices paid by firms,” he explains. “We are also keeping an eye on labour costs with limited supply resulting in higher wages.”
While there is inevitably a lot of focus on the dollar, other currencies have also done well. The pound has made strong gains against the euro thanks to the Bank of England raising rates in December and February, with more hikes expected this year.
“That is in stark contrast to the European Central Bank (ECB), which continues to push the transitory line, even if markets are pricing in a small 10 basis point hike later this year on the belief that it – like the others – will fold eventually,” says Oanda senior market analyst Craig Erlam.
The ECB has used slack in the labour market to support its view that inflation in Europe is transitory, although sovereign debt in the eurozone was given a shock last week by the ECB not ruling out the chance of a rate rise in 2022. And Ipek Ozkardeskaya, senior analyst at Swissquote, says the market is not convinced that the ECB will be able to hold out against raising interest rates for much longer.
“The way the major central banks choose to fight inflation – and how far they will go to achieve price stability – forms the foundation of what could be a volatile year in FX trading,” she says.
Active raises
While the growth of the dollar tends to hit the currencies of emerging countries hardest, FxPro senior financial analyst Alex Kuptsikevich notes that these countries were already actively raising rates last year without considering the price momentum to be temporary. The pressure on emerging market currencies has therefore been lower than the average for similar past cycles.
It is essential for the US and UK to monitor wage dynamics
Alex Kuptsikevich, FxPro
Traders are paying particularly close attention to energy prices and supply-chain issues, observes Naeem Aslam, chief market analyst at AvaTrade. Aslam expects inflation to remain high in the short term.
“We may not see inflation numbers coming off their highs for another quarter or two,” he says. “However, the fact that central banks are serious about controlling inflation means it is likely that we will see readings easing off in the longer term.”
HSBC’s head of European FX research, Dominic Bunning, reckons the key metric that markets will be looking at is whether medium- to longer-term inflation expectations have become unanchored. Looking at longer-term inflation forward swaps will give a good sense of whether inflation expectations are moving higher more aggressively.
“So far, there is little sign that this is the case, and while the expectations on these measures have risen in the last couple of years, there has been a recent period of stabilization,” he says. “We would also suggest looking at the sequential month-on-month inflation prints to see if price pressures remain persistent, as year-on-year numbers will remain elevated regardless due to base effects.”
Policy action
Consumer price inflation (CPI) remains the primary barometer among market observers. Normally, investors focus on core CPI as it filters out the most volatile food and energy prices, but since high energy prices are a big factor in rising global inflation, the CPI index is a useful proxy for what drives central bank decisions.
Others are examining forward-looking indicators of inflation levels to decipher whether or not current levels are transitory. According to StoneX FX trader David Willacy, some market observers are seeking to remove what could be determined to be idiosyncratic components that cause skewed CPI readings.
Given the recent hawkish pivot from the Fed, it is likely other central banks will follow suit
David Willacy, StoneX
Producer price inflation is worth a closer look, suggests Kuptsikevich.
“It is essential for the US and UK to monitor wage dynamics,” he says. “Accelerating their growth will give carte blanche for further rate hikes, indicating that the economy is coping with monetary policy tightening.”
Policymakers now accept that inflation will only be transitory if firm policy actions are taken in the short and medium term, adds Willacy.
“Given the recent hawkish pivot from the Fed, it is likely other central banks will follow suit. This is likely to bring inflation under some control,” he says.
In many markets inflation is expected to peak around the second quarter, but the picture is constantly evolving and there could still be surprises. As Erlam observes, if pressures ease enough, interest-rate expectations will be pared back a little. But until then, the greater risk is that more action may be needed, not less.
“The market expects that headline inflation will peak in the US and eurozone in Q1 and then begin to decelerate from the spring onwards, but there remains a large spread in views on how fast it comes off and ultimately to what level,” says Sam Lynton-Brown, head of global developed markets strategy and G10 FX strategy Europe at BNP Paribas.
