The Daily Update - PART III: Convergence and Currencies

Extract from Bob Gay’s piece ‘Policy Blunders and Currencies’

Let us apply this simplified framework to today’s circumstances: a synchronised expansion in which most central banks are normalising monetary conditions toward what they believe to be a neutral policy stance. Granted, the BoJ and ECB are lagging behind, but the gradual trajectory of the Federal Reserve coupled with its reduced estimate of the new neutral rate (now less than 3%) have left both current and expected real interest rate differentials relatively small. As a result, lucrative carry trades now require a lot of leverage and have withered in the increasingly uncertain financial landscape.

If carry trades do not dominate financial flows, then intermediate-term fundamentals should play a more noticeable role. Two likely candidates are current account imbalances and inflation differentials. However, neither of these influences has proven to have much predictive power for exchange rates over periods as short as one to two years. Besides, global imbalances have shrunk over the past 10 years, and inflation differentials between emerging and developed countries have narrowed, both of which lend support to a quiescent environment for foreign exchange.

That leaves us with three other general categories of influences on expectations for exchange rates. First, initial conditions, notably full employment in the United States, make a huge difference in assessing the expected consequences of policy initiatives, especially fiscal policy. Debt and deficits will begin to matter more. Second, policies detrimental to productivity are red flags, given the widespread decline in potential growth. Third, the Fed's exodus from QE is bound to have some collateral damage. Likely candidates are anyone who is dependent on access to US dollars, notably heavily indebted countries and companies in the emerging world, as the Fed reins in the flood of dollars in the global marketplace.

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