Currency moves in an unsynchronized world

There are many factors that can cause a particular currency pair such as the Euro-Dollar to move from one level to another but the biggest driver tends to be interest rate differentials. This therefore puts the status of global financial markets in a very interesting position because after seven years of coordinated and synchronised behaviour (since the financial crisis in 2008), G20 countries are facing different economic challenges and thus the actions taken by their central banks are starting to vary.

In the UK and U.S., economic growth rates have improved to pre-2008 levels, unemployment rates have come down significantly, and inflation is muted (but this is probably only temporary as recent oil price changes work their way through the year on year calculation). Hence, the level of interest rates in both these countries now needs to be adjusted upwards and the odds are that the Federal Reserve (FED) will do exactly that in June 2015 whilst the Bank of England is likely to follow later in the year (assuming the British economy is not derailed by the election process or outcome). Juxtapose that with Europe, Japan, Australia, Canada and Switzerland, where the European Central Bank (ECB) and Bank of Japan (BOJ) have taken interest rates to such a low level that they are now having to use alternative policy tools (Quantitative Easing (QE) to try and stimulate growth and inflation. The Reserve Bank of Australia and the Bank of Canada both recently surprised financial markets by cutting interest rates (contrary to market expectations), and the Swiss National Bank surprised by moving interest rates into negative territory and removing the Euro Swiss peg at 1.200. All this is the result of a two-speed global economy and unfortunately the faster team (UK & U.S.) needs to normalise policy accommodation (hike interest rates) and the weaker team is still looking to stimulate or provide some downside protection to their respective economies.

Focusing on the U.S. and Europe, an analysis of 3 month interest rate differentials indicates that the spread between the FED and ECB’s target rates will move from 0.35% in June 2015 to 2.00% in December 2017. That is a significant difference and actually probably still underestimates the true magnitude of ‘policy’ difference between the two central banks because during this same time period, the ECB will be increasing the size of its balance sheet as a result of QE whilst the FED is likely to see the size of its balance sheet gradually fall due to bonds maturing. As such, the move observed in the EURUSD exchange rate over the last 12 months is likely to be only part of a bigger realignment. The quickness in the move in EURUSD from 1.40 to 1.13 was probably due in a large part to the actions taken by the ECB. However, the next step in the realignment is likely to be driven by the U.S. side of the equation and specifically the speed and timing of the FED’s actions to normalize interest rates. Of course, situations like Greece/Ukraine are likely to have some impact on this move in either direction, but they are likely to be temporary. MCB Investment Management’s fixed income and currency team are forecasting that the EURUSD exchange rate will reach 1.12 by the middle of the year and 1.04 by the end of 2015.

EURUSD will reach 1.04 later this year. Interestingly, a move to 1.04 opens the door to levels that have not been seen since 1999 – 2002 when the Euro became to tradable currency.

Looking a bit wider, the MCB team also expects the Japanese yen and to a lesser extent the Australian and Canadian dollars to see similar depreciations against the USD into the middle of the year (USDJPY 125, AUSUSD 0.76, and USDCAD 1.23) and have identified 135, 0.74, and 1.27 respectively as levels to be reached by year end. Even in the UK where the BOE is expected to hike rates, the team still expects the GBPUSD rate to move lower to 1.44 by year end because the big picture theme is a USD led one.

This strong dollar environment in financial markets is not limited to developed markets only. African currencies are also being impacted significantly by it. Out of a selection of 12 African countries that we believe are investible, all 12 have seen their currencies depreciate against the USD during the last 12 month period (Ghanaian Cedi by the most - 26%, and South African Rand by the least - 6%). Even Mauritius has seen its rupee depreciate by 10% during this same period.

The MCB investment team expects this appreciating USD environment to continue in 2015 and 2016 because of the direction policy makers are heading in (detailed above). From a USD investor’s perspective, it would therefore be important to either have a USD heavy portfolio, or at least take into account that any other currency that you invest in is likely to depreciate against the USD and thus the return from the underlying investment should provide adequate compensation. If instead you are a MUR based investor, the key would be to identify those countries whose currency is expected to do better than the rupee and so a need to have an allocation in USD still stands but there would probably be some others also.