FX divergence

In the seemingly dull and tectonic world of central banking, we’ve seen some big shifts today in Europe, which have had a big impact on currencies, even though interest rates and bond purchasing programs were unchanged. Very belatedly, both the European Central Bank and Bank of England are now both trying to guide markets and take them on as well.

When a central bank cuts rates to zero (or very close to it), its options start running out. This is why we’ve seen a plethora of “non-conventional” policy measures undertaken. Quantitative easing has been the most visible, with central banks buying government bonds and other assets via the creation of central bank reserves. But there have been plenty of others, such as the ECB’s unlimited liquidity providing operations and its various bond-buying programs (which some dispute as to whether these are actually monetary policy operations).

One other is forward guidance, in other words the bank giving an indication of how long and under what conditions rates are likely to remain low. It was discussed in Bernanke’s musings prior to the financial crisis and was adopted by the Fed (in its first of several forms) in December 2008. This being the case, you have to ask why both central banks chose to introduce different but explicit forms of forward guidance today.

For the Bank of England, it was not a major surprise to see a statement (previously rarely seen on ‘no change’ days) and we already had a strong steer in March that they were to consider ‘intermediate targets’. The bit that knocked interest rates lower (and hence sterling) was the Bank’s reference to the fact that the recent rise in the path of implied interest rates (in other words, market pricing of rate increases) “was not warranted by the recent developments in the domestic economy”. This marks a strong break with the past, during which the Bank would always shy away from directly commenting on how the market was pricing future policy.

As for the ECB, it was only in April when the President said “We do not pre-commit on interest rates”. Three months later, he said the ECB “expects the key ECB interest rates to remain at present or lower levels for an extended period of time”. But what both decisions tell us is that the Eurozone (and UK) are at very different stages of the cycle as compared to the US. Furthermore, Europe is more intolerant of rising interest rates, especially when the pressure comes from the backwash caused by the Fed’s steering of markets towards ‘tapering’, which has pushed up bond yields by around half a percentage point over the past month.

What is a shame is that both central banks did not choose to do this earlier, as a means of offering more assurance for businesses and households during the worst of the financial crisis, rather than as a reaction to events from elsewhere. But for the UK especially, this could have been made when central bankers could have been more certain in their ability to keep rates low for longer (we’re likely to get more explicit guidance in August). The UK data has been better than expected recently, albeit with higher inflation as well.

For FX, this further adds to the bullish dollar backdrop for the second half of the year that was already emerging through the first half. The Fed is preparing to withdraw stimulus at a time when inflation expectations are actually falling. In contrast, inflation expectations have risen in the UK today and are likely to rise further in the coming week, a negative backdrop for the currency. Cable is now set for a more sustained move below the 1.50 level thanks to Carney.

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