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Foreign Exchange

‘Only seven currencies float freely’; hail the new masters of the universe

Central banks are the “rulers of the FX universe”, with just seven currencies floating freely, according to RBS.

The bank says the free-float mantra that underpinned the period of Great Moderation has been challenged by heavy-handed meddling in FX markets since the global financial crisis of 2008, as growth has become the main policy preference for developed and developing nations. Imran Zaheer Ahmad, strategist at RBS, says the exchange rate is now seen as a key tool in central banks’ policy armoury to stimulate still-ailing economies.

“We have witnessed monetary stimulus from QE in G4 economies and heavy-handed intervention to depress exchange rates in emerging markets that seek to remain competitive,” he says.

“This has resulted in the rise of central bank power in FX markets, while the leverage and clout of institutional investors has waned.”

He notes the accumulation of FX reserves worldwide since 2008 has been about $3.4 trillion, almost matching the $4.8 trillion liquidity injection in the G4.


 EM FX reserve accumulation has matched G4 central bank asset accumulation (QE)

 
 Source: RBS, Bloomberg

The shift has seen traditional drivers for FX markets, such as rate spreads and balance-of-payment trends, take a back seat, while FX volatility has collapsed – albeit to levels still above those before the global financial crisis – as central banks moderate any dramatic exchange-rate moves. In the universe of 21 EM currencies and G10 currencies covered by RBS, the bank categorizes just seven that have stuck to their roots and float freely without interference.

They are ZAR, CZK, MXN, AUD, SEK, CAD and NZD.

RBS notes in addition that authorities have been “relatively hands-off” in PLN, MYR, NOK, PHP and ILS.

“We expect the market will naturally drift towards favouring trading this group of currencies as central bank event risk remains minimal,” says Ahmad.

“The natural response from market participants that no longer have the clout to take on central banks is to focus trading and investment activity around the hands-off currencies.

On the other hand, TRY, RUB, HUF, RON, CNY, SGD, THB, KRW, IDR, INR, CLP, BRL, COP, TWD and CHF are countries inclined to meddle, RBS says, while the G4 currencies – USD, EUR, GBP and JPY – have been affected by QE.

 Shift in FX regimes pre and post the global financial crisis

 
Source:RBS 

Ahmad says while the short G4-long EM trade has been frustrated in part by the intervention resolve of EM central banks, a restricted basket of EM free-floating currencies will prove more fruitful.

In addition, he says the shift also has implications for options, with volatility to remain suppressed in the “new currency meddlers” group. Ahmad recommends staying short of volatility in range structures in EURCHF, USDBRL, USDTRY and USDIDR.

“Volatility in the remaining pure free-floaters may present a contrarian opportunity as it has arguably become excessively cheap,” he adds.

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