What does faster growth mean for currencies?


Markets have welcomed the news overnight that China’s economy grew 6.9% on an annualised basis during the second quarter. Although Japanese markets were closed, the Hang Seng finished the session +0.31% and commodities (primarily zinc and iron ore) posted solid gains. Meanwhile, European bourses have started the week in positive territory as have US futures.

 

Unsurprisingly, the positive news has been accompanied by an air of cynicism from those who continue to question the accuracy and therefore validity of Chinese data. A closer look at the markets shows Chinese small caps down around 5% on the day to close at their lowest level since January 2015 amid concerns of regulatory scrutiny and deleveraging.

 

However you choose to interpret the data, it reignites the debate about whether the world’s central banks will embark on a journey towards tighter monetary policy. In last week’s report, we discussed whether inflationary pressures warranted higher interest rates. This week, we will take a closer look at global growth and discuss whether the world’s economy is stable enough to withstand the pressure associated with higher borrowing costs.

 

Last week, the Bank of Canada concluded that the Canadian economy is indeed robust enough and raised its key interest rate by 0.25% for the first time in almost seven years. In his accompanying statement, BoC Governor, Stephen Poloz, cited strong growth despite low inflation as justification for the move. After oil prices slumped in the second half of 2015, the economy was on the brink of recession, but strong consumer spending, exports and investments have resulted in a sharp turnaround in recent months with the economy reported to have expanded 3.7% (annualised) in Q1 2017.

 

The Federal Reserve have already began tightening policy (albeit in a relatively cautious manner) and so the question for us now is whether the Bank of England and the European Central Bank will be able to follow suit? Since early 2010, the UK economy has expanded at an average pace of 1.97% year on year, touching a high of 3.5% back in Q4 2015. In hindsight, the committee was right not to raise rates at the time as growth promptly fell back to 1.8% by Q3 2015 before slipping to 1.6% in Q1 2016. The latest data showed growth of 2.0% in Q1 2017 (the first estimate for Q2 is due on 26th July) but this time around, it is clear the MPC are seriously considering raising rates in the months ahead.

 

One question we keep asking ourselves is if the MPC didn’t feel able to raise rates back in 2014, how can they be sure that the time is right to do it now? The simple answer is they can’t, but the reputational risk of being wrong is dampened by the fact that others have already taken the plunge. Secondly, in a world of currency wars and a desire to boost competitiveness, the fact that others are doing the same reduces the risk of significant currency appreciation.

 

The same logic applies for the European Central Bank. Of course, an increased sense of political stability helps too, and while Draghi will almost certainly lag behind his peers when it comes to tighter policy, there is now a firm expectation within the market that his next move will be towards tighter as opposed to looser policy. Questions have been asked whether this is a coordinated approach towards tighter policy by the leading central bankers (similar to 2008 when the Bank of England, Federal Reserve, European Central Bank, Bank of Japan and Swiss National Bank all cut rates together). Clearly this isn’t the same, but there is certainly a ‘heard behavior’ going on.

 

What does this mean for currencies?

Ultimately, the market perception is that faster growth increases the likelihood of higher interest rates which in turn make a currency more attractive for investors. Until recently, the US dollar has been the best performing currency of late amid a widening interest rate differential over its peers. However, US GDP growth was the weakest of the four economies in question and most importantly, the short term trend points lower so how many more rate hikes can we expect? (and over what time frame?).

 

In the build up to last week’s Bank of Canada meeting, the CAD advanced on the expectation of a rate hike and has continued to advance since (the CAD has now gained 8% over its US namesake since early May). Meanwhile, both the pound and the euro have made ground over the dollar in recent weeks amid expectations that their interest rate differential with the greenback will start to narrow in the months ahead.

 

For the time being, we continue to remain marginally bearish on the dollar for this reason and expect the pound and euro to hold firm. The clear risk to both these currencies is that if a rate hike fails to materialise in the months ahead, both are likely to come under heavy pressure again as expectations are reversed. The same applies to the Canadian dollar although the risk here appears even greater given the emergence of asset bubbles, particularly in the real estate sector. If the Bank of Canada is slow to follow up with another hike, or worse, is forced to cut rates again in the event of a downturn, the Canadian dollar will become extremely vulnerable again.        

 

Author: Marc Cogliatti

 



 

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