When the Reserve Bank of New Zealand raised interest rates by 50 basis points in April while most of the street economists were looking for a 25bp increase, the NZD sold off. In contrast, the Bank of Canada hiked by 50bp as widely expected and the CAD rallied.
According to BNP Paribas, this challenges the conventional belief that front-end rate differentials are the main drivers of FX. In a recent research note, the bank’s G10 FX strategist observed that markets were longer the CAD than the NZD ahead of their respective central bank decisions and concluded that markets were trading expectations regarding the level of terminal rates in this cycle.
Dominic Bunning, head of European FX research at HSBC, says the most obvious examples of currencies moving more in line with changes further out along the curve or the terminal rate include GBP, which has failed to benefit despite higher front-end pricing as the swap curve has inverted beyond the one- to two-year point.
The Fed and dollar cycle are driving G10 trends
Kenneth Broux, Societe Generale
“The NZD also failed to benefit from some of the 50bp rate hike delivered in this cycle when the Reserve Bank of New Zealand left its projections for the terminal rate largely unchanged,” he explains. “The AUD behaved in a similar way following the Royal Bank of Australia rate hike in June.”
The dollar is also being traded on expectations regarding the level of terminal rates in this cycle, says Kenneth Broux, head of corporate research, FX and rates at Societe Generale.
“As we have seen with the euro, AUD and the GBP, it doesn’t really matter how hawkish the ECB, RBA or BoE are in signalling their policy expectations because the Fed and dollar cycle are driving G10 trends,” he adds.
The higher correlation of some G10 currencies with equities and the safe-haven status of the dollar means those other currencies will lose out during periods of risk aversion, even if their central banks are hawkish.
“No one quite knows what the precise level of the neutral rate is, so trading off expectations of where the cycle ends (terminal rate) is fraught with uncertainty,” suggests Broux. “With the neutral rate, we mean the level of interest rates where the economy is not too hot or too cold. Right now, because of high inflation, we are in a regime where central banks in G10 must go at least to neutral – if not beyond – to bring inflation under control.”
This means the terminal rate will most likely be above the neutral rate, certainly in the case of the US because growth dynamics there are stronger and the labour market is tight. The Federal Reserve estimates neutral is 2.4% and market expectations are they will go above that to a terminal rate of 2.75% to 3%. If inflation does not slow in a sustainable fashion, expectations of the terminal rate could be revised upwards.
It is basically survival of the fittest at this point
Craig Erlam, Oanda
“This is good news for the dollar,” says Broux. “In contrast, the ECB has dodged the question on the level of the neutral rate and this makes it even harder for markets to price expectations for the terminal rate. Canada is more transparent, estimating neutral at between 2% and 3%.”
In theory, all currencies trade on information available to the market at a given time, so expectations are the major driver of the price action in the FX markets rather than the actual actions, suggests Ipek Ozkardeskaya, senior analyst at Swissquote.
“This is why forward guidance, communication strategy and credibility are crucial for a central bank in controlling the value of its currency,” she adds.
Whether a currency is performing well is partly dependent on the number of hikes it is expecting to undertake and the ability of the economy to sustain them, agrees Oanda’s senior market analyst Craig Erlam.
“The pound is having a terrible time, as is the New Zealand dollar,” he says. “It is basically survival of the fittest at this point and recent moves suggest most countries may ultimately end in recession regardless, after starting the [rate increase] process too late.”
Commodity currencies
SocGen’s Broux says the impact of front-end rate differentials has been noticeably lower for commodity currencies since correlations with other asset classes such as commodities or equities can be more powerful. “So the AUD is cheap but will struggle to appreciate if stocks/commodities retreat,” he adds.
The currencies of export-oriented developed countries or emerging economies have the potential to tighten their policies practically in line with the Fed, but this has not prevented them from being affected by a rising dollar.
AUD and CAD are especially well placed to benefit from any retreat in the dollar
Ipek Ozkardeskaya, Swissquote
“The currencies of commodity-exporting countries are weakening against the USD because investors demand higher bond yields,” says FxPro senior market analyst Alex Kuptsikevich.
“However, it is worth noting that currencies such as NZD, AUD and CAD have not experienced as much pressure as JPY, EUR and GBP, as export-oriented countries could fight inflation by containing the wage/price inflationary spiral rather than the import price spike.”
Commodity currencies used to be high beta and high yielding currencies, which is no longer the case since the central banks of commodity currencies cut their rates to near zero to combat economic meltdown.
“But with the US dollar coming to its upper limits in terms of hawkish Fed pricing, we shall see the commodity currencies outperform other G10 currencies – even more so as their central banks start raising the interest rates as well,” concludes Swissquote’s Ozkardeskaya. “AUD and CAD are especially well placed to benefit from any retreat in the dollar, to catch up with the soft pricing they underwent over the past year.”
