High inflation has finally increased the pressure on US policymakers to raise interest rates more aggressively than the usual quarter-point hike – on May 5, it unveiled a 50 basis-point rise, after the annual increase in consumer prices hit 8.5% in March, the highest level since the 1980s.
As for the impact on the foreign exchange market, JPMorgan analysts note that commodity currencies have historically been more insulated from higher US yields, but suggest that lower-yielding currencies that are commodity importers and where the central bank is expected to be less hawkish than the US Federal Reserve are vulnerable.
John Velis, FX and macro strategist Americas at BNY Mellon, says a number of Asia-Pacific currencies fall into this category, where central banks are behind the curve and could falter as the USD strengthens further.
“In contrast, we think LatAm currencies are in a good place, considering how soon and how much central banks in the region have turned hawkish and how much they have lifted rates,” he adds.
Steve Sosnick, chief strategist at Interactive Brokers, has a different perspective. He suggests emerging-market currencies in the Americas are vulnerable to US rate hikes since their economies are too tightly tied to the global economy and generally too fragile to withstand sharp rate hikes without some pain.
Vulnerable yen
Among the G10 currencies, the yen has proven particularly vulnerable of late, with the Bank of Japan perhaps the only remaining dovish outlier amongst developed markets central banks.
“In the emerging market space, our colleagues have been emphasising that the emerging market FX complex should be broadly more insulated from rising US yields than in the past,” says Shreyas Gopal, FX strategist at Deutsche Bank Research. “Nevertheless, we expect underperformance in some Asian currencies such as INR and PHP, where vulnerabilities are compounded by weakening trade balances.”
Themistoklis Fiotakis, global head of FX and EM macro strategy at Barclays, agrees that the yen is the currency most vulnerable to higher US yields and thinks this will remain the case until the Bank of Japan becomes hawkish, which seems unlikely to happen any time soon.
If higher US risks create worries of substantial demand destruction, then a lot of the commodity currencies which are now immune to risk wobbles will also need to correct
Themistoklis Fiotakis, Barclays
“If higher US risks create worries of substantial demand destruction, then a lot of the commodity currencies which are now immune to risk wobbles will also need to correct,” he says. “Yet although we see some risks to risk premia, we do not forecast an imminent demand collapse globally.”
Citi notes that a 100bp widening in US-Japan five-year yields pushes up USD/JPY by just over 4% – and US rates are by far the most important driver of USD/JPY rates.
Ebrahim Rahbari, global head of FX analysis at Citi, says: “In emerging market FX, USD/MXN has historically been the most closely linked to US rates, although that relationship has been more volatile of late as other factors – such as commodity exposure, valuations, and carry – have partly offset the US interest rate effect.”
Euro differential
The interest-rate differential will also worsen for many European currencies. While expectations for a strong European recovery would be expected to become the dominant trade once there appears to be a path to an end of the war in Ukraine, JPMorgan has forecast a fall in EUR/USD.
At Swissquote, senior analyst Ipek Ozkardeskaya says: “The currencies that are the most vulnerable to the rising US rates are the ones that maintain a relatively dovish policy stance faced with the gravity of the inflation situation.
“In this respect, the euro as well as the yen will certainly feel the heavier impact of the growing divergence between the Fed’s hawkish shift and a much softer stance from the ECB and the Bank of Japan.”
While the ECB is also under pressure from rising inflation, with eurozone price rises expected to peak at 8% by the middle of the year, inflation in Japan is much less alarming for domestic policymakers, giving the Bank of Japan the potential to provide more support to the economy rather than fighting inflation with higher rates.
BNP Paribas models show that low-yielding currencies such as the Swiss franc and the yen are most vulnerable to higher US yields.
“This is consistent with the price action we have observed and helps explain why JPY has weakened so much recently,” says the bank’s FX strategist, Alexander Jekov.
While EUR/USD has been largely resilient to the spike in US yields thus far, in the longer run sensitivity remains intact, according to JPMorgan. The firm sees a bias towards a fall in the rate.
