Monetary policy normalization poses FX challenge; introducing a new regime for currency investors

Peter Garnham
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The expectation for the normalization of monetary policies in advanced economies has been one of the most important drivers in the FX market in recent months and has thrown up a challenge for currency investors.

That has been the case since late May when Ben Bernanke, Federal Reserve chairman, first floated the idea of scaling back US monetary stimulus.

As a consequence, uncertainty has risen over the timing and pace of the Fed’s plans to taper its quantitative easing (QE) programme, increasing borrowing costs globally and causing spikes in volatility for currency investors.

Athanasios Vamvakidis, FX strategist at Bank of America Merrill Lynch (BAML), says it is no wonder that determining how to position in FX for the potential normalization of global monetary policies presents a challenge.

“It is the first time in the history of the global economy that central banks will have to withdraw so much liquidity, simply because it is the first time that they have created so much liquidity,” he says.

The question of monetary normalization has become one of when and how fast among G10 economies, according to Vamvakidis, with the US likely to lead the way.

“No matter how cautious central banks are, uncertainty is likely to lead to [FX] volatility spikes,” he says.

“Moreover, changes in expectations about the Fed’s QE tapering affect monetary conditions in countries that are in a less-favourable position in the business cycle, forcing their central banks to react and resulting in currency volatility.”

Indeed, that effect can be seen from the July meetings of the Bank of England and the European Central Bank, at which both sought to distance themselves from the more hawkish bias emanating from the Fed.

Unusually, both central banks issued forward guidance on interest rates in a bid to beat down expectations of monetary tightening in the UK and the eurozone.

In both cases, their currencies reacted violently, with the pound and the euro dropping sharply against the dollar.

Given the risk that uncertainty over the timing and pace of Fed tapering could trigger more volatility spikes, BAML has constructed estimates of monetary conditions in the advanced economies to determine the appropriate monetary policy stance of G10 central banks to provide a guide for currency investors.

The theory being that if monetary conditions outside the US change in response to changes in expectations about normalization of US monetary policy, those estimates can inform investors over the likely responses of other central banks and, hence, the risk to their currencies.

BAML used eight different measures to proxy for monetary conditions and the appropriate monetary policy stance in the G10, and ranked them according to the need for tighter monetary tightening, with a lower number signalling a higher requirement for tighter conditions.

As the table below shows, they include the gap from the 2007 per capita real GDP, the gap from the pre-crisis trend in per capita GDP and the output gap in per cent of potential GDP.

 Ranking of G10 currencies based on measures of the appropriate monetary policy stance

The results suggest, in relative terms, monetary conditions are loose in New Zealand, Australia and Norway, and are tight in the eurozone, UK and Switzerland. Japan, Canada, Sweden and the US sit in between, with relatively appropriate monetary conditions.

Thus, keeping everything else constant, the euro, pound and sterling would have been weaker and the New Zealand dollar, Australian dollar and Norwegian krone would have been stronger if monetary conditions were more appropriate.

Assuming central banks do not want their policies to deviate further from what the estimates deem as appropriate, Vamvakidis says FX investors have a fairly simple rule of thumb.

“During Fed-triggered tightening of global monetary conditions, investors should sell the rallies in the euro, sterling and the Swiss franc,” he says. “During Fed-triggered loosening of global monetary conditions, investors should buy the dips in the New Zealand dollar, Australian dollar and the Norwegian krone.”

If that is the medium-term conclusion from the analysis, BAML also sought to see if there were short-term opportunities for investors by correlating its ranking against what the market is pricing in for interest changes during the next 12 months.

In theory, that correlation should be negative, since the lower the ranking the more rate hikes the market should expect. However, as can be seen from the chart below, deviations from that negative correlation could indicate the risk of a short-term correction in FX prices.

Indeed, the chart shows there might be upside risks for AUDNZD, given that monetary conditions in Australia and New Zealand are similar, but the market might be pricing too much monetary loosening in the former and too much monetary tightening in the latter.

Similarly, there might be downside risks for the euro, sterling and the Swiss franc, and upside risks for the Norwegian krone, yen and Canadian dollar, given the market is pricing in similar monetary policies going forward, despite different monetary conditions.

Of course, the analysis comes with caveats, not least market positioning, central bank reserve diversification flows and central bank mandate limitations.

Still, as central banks start to remove the unprecedented amount of liquidity pumped into the financial system since the financial crisis, it at least provides a framework with which currency investors can start to analyze the brave new world.