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Is Currency Defense Worth It? - Global Exchanges

FICC Podcasts August 30, 2022
FICC Podcasts August 30, 2022

 

In this week's episode, we discuss recent policy signals from various central banks and associated movements in FX markets.


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About Global Exchanges

BMO’s FX Strategists, Greg Anderson and Stephen Gallo, offer perspectives from strategy, sales and trading on the foreign exchange market, related financial markets, and the global economy.

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Greg Anderson:
Hi, welcome to episode 50 of Global Exchanges, a podcast about foreign exchange markets and related issues. In this week's episode, my co-host Stephen Gallo and I discuss recent policy signals from various central banks and associated movements in FX markets. The title of this episode is, is currency defense worth it?

Stephen Gallo:
Hi, I'm Stephen Gallo, a London based FX strategist. Welcome to Global Exchanges presented by BMO Capital Markets.

Greg Anderson:
Hi, I'm Greg Anderson, a New York based FX strategist. I'm Stephen's co-host.

Stephen Gallo:
In each weekly podcast like today's, we discuss our perspectives on the global economy and the foreign exchange market. We also bring in guests from the FX industry and from related financial markets like commodities.

Greg Anderson:
We strive to make this show as interactive as possible. So don't hesitate to reach out by going to bmocm.com/globalexchanges. Thanks for joining us.

Stephen Gallo:
Okay. It's the 30th of August 2022. Thanks for tuning into another episode of Global Exchanges. And Greg, I think this is a really important concept we're exploring here and the title, because as we discuss the issue, it will probably lead us to a partial explanation for why major currencies and also not so major currencies are finding it difficult to rally sustainably, despite the fact that central banks are tightening monetary policy through interest rate hikes and QT.

Greg Anderson:
So to frame our theoretical discussion to the current moment, last Friday and over the weekend, we got a sharp contrast in the monetary policy signals sent by ECB participants at Jackson Hole, and then by the BOJ's key participant Governor Kuroda. On Friday we had two ECB participants use their bully pulpit from the conference participation to advocate a 75 basis point rate hike in September, but on Saturday Kuroda who didn't have a speaker's or panel participant's role commented from the audience that the BOJ is not going to tighten monetary policy, despite headline CPI inflation printing above the BOJ's target and the yen weakened dramatically. It's a very stark contrast. So speaking about the BOJ, it would appear that Kuroda has absolutely no interest in defending the yen through monetary policy tools. But to me, the surprisingly hawkish ECB comment sure seemed like a move to defend the Euro in response to Euro dollar having moved back below parity, but maybe I'm misreading it a bit. So Stephen, do those ECB comments seem like currency defense to you?

Stephen Gallo:
I think it's a mild form of defense, Greg, because I don't think the ECB can simply walk back years of saying it doesn't target the Euro dollar exchange rate, and then simply start targeting the exchange rate either explicitly or implicitly. The way I see it, but of course, feel free to add your own thoughts, that's why we're here podcasting. There's a scale of central bank defense of a currency, which starts out with mild rhetoric, then maybe shifts to another level of more severe rhetoric, then possibly a monetary policy adjustment aimed directly at the currency. And then perhaps all the way on the other end of the scale, there's some type of physical intervention in the currency market. But right now I would say that the ECB is probably not in full on currency defense mode, rather they're hoping that its efforts to cool inflation domestically with tighter monetary policy will have the beneficial side effects, so to speak, of slowing Euro depreciation.

Greg Anderson:
But Euro depreciation is a contributor to European inflation. The expectation for tomorrow's flash Eurozone August CPI is 9.0%, and the July reading was 8.9% while the US CPI printed at 8.5% for July and it's likely to be somewhere in the low to mid eights for August. So we've got European inflation above US inflation. We haven't really seen that this century, and it's almost not the result of tighter labor and product markets in Europe than in the US. It's about the currency. So defending the currency is a key component of fighting inflation.

Stephen Gallo:
Yes, that's definitely true, Greg. A significant portion of Euro area imports are not invoiced in euros, but in USD. So higher raw material costs, energy costs, of course, can eventually pass through to CPI inflation, albeit with a lag due to hedging arrangements and various other factors. But here's the catch.

Stephen Gallo:
And I don't think it's only applicable to the ECB. It may even be more applicable to countries with less liquid, so-called smaller currencies than the Euro, but the more that the ECB focuses on the exchange rate pass through channel and supporting the Euro, the greater the possibility there is of tipping member states with fragile sovereign debt markets and other portions of the Euro area economy into a deeper recession. Unless, of course, we get really good news on inflation, inflation moderates rapidly at some point maybe later this year, which is a possibility we simply can't rule it out completely, but for the time being the ECB is caught between I think on the one hand doing what it thinks it needs to do to bring inflation under control, and on the other hand, hopefully benefit from the side effects of a less weak Euro.

Greg Anderson:
Okay. So if I read you right, I think what you're saying is that the ECB raising rates to undergird the Euro to fight inflation might not work, it might actually lead to a lower Euro than if they had simply gone softly with milder rate hikes that the European economy could clearly handle.

Stephen Gallo:
Greg, let me explain my thinking on this as simply as I can, basically, I think it's a gamble for them either way. If they're hiking aggressively into a deep economic slowdown risk aversion levels across markets remain elevated while they're doing this along with energy prices, and the impact of Fed QT does not wane. The ECB along with other European central banks may have a very difficult time defending their currencies through aggressive interest rate hikes alone. Would you want to be an asset allocator that's long up to his or her eyeballs in Euro denominated assets before this adjustment process is over, or would you rather be an investor waiting on the sidelines, looking to catch the bottom in a number of these markets, including the Euro? I personally think I'd rather be in the second category, but on the other hand, if the ECB is too soft with rate hikes, inflation could become embedded for even longer at high rates and still give the ECB that dreaded hard landing for the economy that they so much fear.

Greg Anderson:
So, Stephen, I think this leads us to an important discussion point, and that is why is it that the Euro is weakening? But where this is much more of a US dollar move than a Euro move, maybe the better question is why is the US dollar rallying this year? So let me throw out three possibilities. First one, the US dollar is rallying because the Fed is hiking faster than its peers. So interest rate differentials are widening in the US dollar's favor and pulling the green back higher. Second, the dollar is rowing because of risk aversion. With equities and commodities both showing rising global recession risks at some point over the next year.

Greg Anderson:
Possibility number three, the US dollar is rowing because the US is winning the reassuring contest, and that is causing capital to return to the US where that really isn't happening in places like Europe, Japan, and the UK, despite their similar efforts to bring production back home. So if the reason for the US dollar rally or Euro decline is answer number one, then raising rates to defend your currency could work. But if it's number two or number three, defending your currency could turn out to not work anyway, which seems to be Kuroda's view.

Stephen Gallo:
That's a great list, Greg. And going back to your first possibility, you mentioned about rate differentials. I think one rate differential worth looking at right now, even if you're just an FX investor, is the gap between the German 10 year sovereign yield and the US 10 year US Treasury yield. That gap has been narrowing recently and it's narrowing in favor of higher German yields. But I don't think that relative strength in German yields in this case is for so-called good reasons. I think it's related to stagflation risks and expectations for even more government fiscal intervention, without a lot of support from ECB buying. And so it's not really having any upward influence on the Euro at this stage.

Stephen Gallo:
And Greg, on your third possibility where you get to the issue of underlying capital flows causing dollar strength. If I can just point you to the predicament that Britain was in just before the 1967 Sterling devaluation, which took cable from $2 and 80 cents all the way down to 2,40, basically the government was supporting an unjustifiably high level for Sterling through various forms of intervention while the external deficit was getting larger. And eventually it just had to give up, let the currency go and accept the higher inflation for a time.

Stephen Gallo:
Now that situation is not exactly the same to what we have today, both in Britain and in the Euro area, but I don't think it's massively far off. And if there are underlying current account and capital flows, which are weighing on the Euro and other European currencies, can the ECB halt that dynamic with rate hikes? Maybe if the rate hikes are aggressive enough, it can attract capital that way by pushing up risk premia that way, but if they go down the super aggressive route, what about recession risks? What about asset prices? What about credit spreads? What about peripheral economies and their sovereign debt markets? So it's a very difficult situation.

Greg Anderson:
It sounds like you and I agree that a 75 basis point rate hike by the ECB might not be worth the risk. I guess we'll find out soon enough on September 8th, what Madame Lagarde and the majority of the governing council thinks. But Stephen, what are your thoughts between 75 basis points and 50 basis points for the ECB, and what's priced in again?

Stephen Gallo:
Okay. So your second point first I'll take, it's about 65 basis points priced into the OIS curve for the September ECB meeting, Greg, if I go off the current pricing right now on the 30th of August. The other thing you mentioned is a lot more complicated. I think that in this fragile market environment for the ECB, there are risks facing the Euro area and sovereign debt markets if the central bank moves in increments greater than 50 basis points and communicates a very Hawkeyes message, as long as the US dollar retains its bid tone, US economic data and the labor market inflation simply don't back down in terms of their strength.

Stephen Gallo:
So I think the decision to go 50 or 75 in September for the ECB will be dependent on what the August inflation data show, how credit markets respond, what financial conditions look like globally as more us data rolls in and where energy prices are trading. So look, let me simplify. Basically what I'm saying is that I think there's a counterintuitive route here for the ECB. If conditions are benign in global markets, I think the ECB has a stronger case for going more than 50 in order to catch up, but I'm not sure they have that same wiggle room to go more than 50 if financial conditions deteriorate significantly between now and September 8th.

Greg Anderson:
So Stephen, to broaden this currency defense discussion out past the majors, we've seen some interesting policy signals from China over the past couple of weeks, we got some tiny rate cuts on August 22nd, but then over the past week, we've had these strong fixings that seem to signal that China wants to stave off any further RMB weakness. What do you make of these Chinese policy signals?

Stephen Gallo:
So what I make of these signals, Greg, is okay, first off, I guess the good news in an environment that doesn't really have a lot of good news is that China is not in the position of having to defend its currency through tighter monetary policy, at least for now. If this were the situation that China were in today as big of an economy it is, we should all be really, really worried, but it's not. And I think one reason for this is it's moderately large current account surplus. So economies with large current account deficits are now wishing they were in China's shoes, so to speak. And I think what policy makers in China are instead doing is feeding stimulus to the economy and a targeted piecemeal approach, allowing PBOC policy to diverge from the Feds and then attempting to manage the pace of RMB depreciation on the way down as that policy diversions widens.

Stephen Gallo:
However, China does a lot of trade with economies that don't necessarily have as healthy balance of payments positions as China. And as those central banks tighten to defend their currencies, China will expect that its export markets will probably slow. And when it looks at the situation in Europe, it probably comes to the same conclusion, but maybe for somewhat different reasons. So in order to prevent, I think spillover from these issues to China's balance of payments, the current account, policy makers appear to be managing the RMB lower in an orderly fashion. And they probably see the global trade slow down as either well on its way or at least as a very high risk scenario, Greg.

Greg Anderson:
Thanks Stephen. So in our discussion of currency defense, I did want to bring up some success stories or at least thus far. The LATAM currencies were under pressure before the pandemic started. And then the pandemic pushed currencies like BRL and CLP to historic levels of weakness. Currency weakness, or US dollar strength in the way that participants in these economies look at it. It passes through to inflation faster and at a higher pass through percentage than in other economies. So this forced the central bank of Brazil, central bank of Chile, central bank of Mexico, the whole region really, to begin hiking rates six months ahead of the Fed and then to hike in big increments way ahead of the Fed.

Greg Anderson:
So now you're in change into the hiking cycle. We've got Brazil with a 13.75% base rate, Chile is at 9.75, Mexico's at 8.50, et cetera. And guess what? With rates at these levels, these currencies have been quite stable during the US dollar surge we've had thus far in Q3. In fact, Chilean peso, Brazilian real, Mex peso, they're all up on the quarter against the green back. So success, of course it remains to be seen what having rates this high does to economic growth in these countries. And we'll find that out over the next six months. So what do you think, Stephen, given an example of another currency with remarkable weakness, Korean won. Could Korea go that route to stave off won weakness?

Stephen Gallo:
Greg, I certainly do not think the BOK is going to go that far with raising rates. South Korea has not had a history of hyperinflation like many LATAM economies have had, and it's reformed its economic model into an export powerhouse since the Asian financial crisis. So it's on a better footing. That said, I'm not sure the Korean won or local asset prices are completely out of the woods yet, given the lagged impact of monetary tightening, local equity markets and also of their asset prices. So while we have seen evidence of investors dipping their feet into this market and trying to catch the bottom, so to speak, we may need more market friendly data on inflation, both domestically and internationally, as well as some indication that China's economy is rebounding before those inflows accelerate.

Stephen Gallo:
The other thing to keep in mind is that when you look at the PBOC and the BOJ and the BOK, really the BOK is the only one engaging in monetary tightening. So until the BOK is satisfied that they've reached the interest rate they're happy with, you will probably see less demand for some South Korean assets. That would be my take. So there's no way that the BOK, I think is going to go to Brazil like base rates, but they may have more work to do in order to shore up the Korean won.

Greg Anderson:
So just to summarize where we've tried to go in this discussion, hopefully we've made the point that raising rates to defend one's currency might not work. In fact, raising rates too aggressively might trigger greater recession fears and a weaker currency. And if core capital flows are what's pumping up the US dollar, trying to fight that with rate hikes is counterproductive, unless it also helps with an extreme inflation problem. The only way to have a high probability of success in defending one's currency via rate hikes is to raise the base rate to a level that's really high, like somewhere around 10% nominal in today's environment, and then to not engage in any other form of monetary expansion. It's just that, that extent of monetary tightness comes with a growth cost that most countries probably aren't willing to stomach.

Stephen Gallo:
Greg, you know what? You summed up the dilemma in this new era we're faced with really well. I don't think there's anything more to say at this stage other than good luck ECB, good luck BOE, we'll be tuning in for sure. Thanks for listening. Bye for now.

Greg Anderson:
Thanks for listening to Global Exchanges, listen to past episodes and find transcripts at bmocm.com/globalexchanges.

Stephen Gallo:
We'd love to hear what you thought of today's episode. You can send us an email or reach out to us on Bloomberg. You can listen to this show and subscribe on Apple Podcasts, Spotify, or your favorite podcast provider.

Greg Anderson:
This show and resources are supported by our team here at BMO, including the FICC macro strategy group and BMO's marketing team. This show is produced and edited by Puddle Creative.

Speaker 3:
The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates or subsidiaries. For full legal disclosure, visit bmocm.com/macrohorizons/legal.

Greg Anderson Global Head of FX Strategy
Stephen Gallo European Head of FX Strategy

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