Foreign Exchange : New volatility regime

Six years of widespread accommodative monetary policies have tended to even out market volatility. However, a disparate economic recovery can be expected to lead to greater divergence between the principal central banks, sparking a rebound in volatility. In those conditions, the forex market is an attractive market to favour.

It has taken six years for the euro zone to finally be hit by the wave of expansionary monetary policies that inundated the world after the fall of Lehman Brothers. Six years in which, one by one, the world's major central banks implemented exceptional measures to stimulate growth and breathe some life into their productive facilities.

Although the ECB's recent activism is justified by the sluggish state of the European economy on the verge of deflation, its intervention comes at a time when other areas of the world appear to be on the path to economic recovery, particularly the United States, where the Fed is expected to raise its rates for the first time in over ten years.

New volatility regime

This kind of divergence in terms of economic pathways and monetary policies has created an unprecedented environment since the beginning of the financial crisis, and has recently caused volatility to spike on the asset markets. On the plus side, this increase in the "cost" of risk is synonymous with new opportunities on the forex market, and should enhance the appeal of currencies for investors.

So what's the best way to take advantage of the opportunities created by this new paradigm? We propose distinguishing between currencies according to their position in the monetary cycle.

Fed taking the initiative …

The Fed, the Bank of Canada and, to a lesser extent, the Bank of England, are all close to gradually normalising their key rate, which should play a big role in supporting their currency. The situation looks clear as far the US dollar is concerned. After a long waiting period, the Fed should raise its key rate some time in the third quarter. However, certain risks may cast a shadow over the picture: in the absence of a global economic recovery, the excessive appreciation of the dollar would hurt the US economy and force the Fed to slow down its monetary normalisation cycle - and possibly stop it in its tracks.

In Canada, whose economy strongly depends on its southern neighbour, the Bank of Canada will almost certainly wait for the Fed to start raising its rates before following suit.

The UK economy has already made a strong comeback, driven in large part by the construction sector, and the BoE may also follow in the Fed's footsteps when it comes to raising its rates. That said, domestic inflation has been struggling to inch its way above 1% since the year began. Furthermore, the recent victory of the Conservatives in the general election once again raised the spectre of a referendum on the country's participation in the EU. These uncertainties could slow the appreciation of the pound sterling.

… but will be alone in raising rates

Currencies such as the euro, the yen and the Swedish krona should continue to be influenced by current monetary easing programmes, aimed at supporting exports and promoting a rebound in inflation through the depreciation of their exchange rates.

Although growth has recently improved in Europe and Japan (+1.0% and 2.4%, respectively, in Q1), the euro and yen cannot appreciate sustainably until the economic recovery and rising inflation have been confirmed.

Other economies, which had so far been getting through the financial crisis unscathed, are now facing a major slowdown in growth and inflation. Such is the case, for example, in Australia and New Zealand, which are also struggling against significantly overvalued currencies relative to their long-term equilibrium rate. These economies, which are highly dependent on one another, are penalised by slowing growth in China, their main trading partner. In the coming months, their central banks should end up reducing their key rate and/or intervening on the forex markets to devalue their currency.

Using forex to get the most out of economic divergences

In conclusion, the advent of diverging economic and monetary paths in the world's principal economic regions marks the end of the very low-volatility period in the financial markets over the past six years. This situation is unprecedented since the beginning of the financial crisis, but is a source of attractive opportunities for the forex market.

The differences in monetary policy between the US, on the one hand, and Europe and Japan, on the other, should support the appreciation of the dollar. However, the Fed is pretty much isolated against the other central banks: it will have to pay very close attention to make sure the dollar doesn't climb too fast, which could nip the fledgling economic recovery in the bud. When it comes to rate hikes, the advantage rarely goes to the one taking the initiative.

And although the Australian and New Zealand dollars still offer attractive returns, their central banks are aware of the danger of a very strong currency and can be expected to step in within the next few months. The appeal of these markets lies more in bonds, provided the forex risk associated with these investments is hedged.

Gilles Lejeune
Global Bond Fund Manager