This article was originally published on 8 April 2015 on ft.com.

D

ollar strength reflects global policy divergence, not direct intervention

What goes around comes around.

In September 2010, Guido Mantega, then Brazil’s finance minister, popularised the term “currency wars”. He claimed governments around the world ‒ led by the US ‒ were engaging in competitive devaluations of their currencies. Brazil and other emerging markets, which were doing better at the time, suffered overvalued currencies as a result.

Fast forward to today and the US dollar has appreciated on a trade-weighted basis at a faster pace for the past eight months than during any similar period since the end of the Bretton Woods system in 1971. This year, more than 20 central banks have eased monetary policy, including the European Central Bank, which at long last launched its quantitative easing programme. Meanwhile, at the US Federal Reserve’s press conference last month, Fed Chair Janet Yellen acknowledged that the US dollar’s strength was part of the reason for downward revisions in the Fed’s growth and inflation forecasts.

Is the Fed the casualty in a currency war? In truth, while a catchy phrase, it is not an altogether helpful one. The US dollar’s strength reflects fundamental economic and policy divergence versus the rest of the world, not direct exchange rate interventions. The euro’s weakness, of course, reflects the ECB’s QE, but this policy loosening is not an act of trade war: it is a reaction to the very real risk of entrenched deflation that the eurozone faces.

The US dollar aside, the main message from the Fed in March was that interest rate increases will be on the table, not in April, but at its June, September or December meetings. This cyclical divergence in policy is not surprising. The US is far more advanced in terms of its post 2008 crisis rehabilitation compared with other developed countries, and is a primary beneficiary of the decline in energy prices compared with the overall net negative impact on emerging markets.

Given that the low level of headline inflation and core inflation, one of the Fed’s preferred measures, is likely to remain below target this year and rise back to 2 per cent in 2016, the Fed has no need to tighten policy sharply.

We expect the Fed to start tightening policy in June, September or December, and to proceed at a fairly slow pace, with a rate rise only at every other meeting, at least at the outset. By removing the language on “patience” at its March meeting, the Fed has given itself the flexibility to act without pre-committing on the date. Our framework suggests the Fed is likely to move its target federal funds rate to 2 per cent to 2.5 per cent over the next couple of years.

It will do less than that if there are downside data surprises or an outsized market reaction to its tightening, and more if inflation were to surprise on the upside.

Cyclical divergence on fundamentals and on policy is likely to continue to support the US dollar. Conversely, low and indeed negative yields in Germany are likely to continue to encourage investors to look to higher yielding eurozone assets and also to rebalance their portfolios away from the eurozone, which will be reflected in continuing euro depreciation. Of course, a stronger US dollar contributes to tighter overall financial conditions in the US. But, to the extent that they reflect these global spillover effects, a lower level of yields and a flatter term structure work in the other direction.

Other factors, including US companies hedging euro cash piles they do not want to repatriate and a continued decline in the euro’s share of global central banks’ foreign exchange reserves, are likely to reinforce the trend. The dollar was appreciating at a rapid pace at the start of the year, before Ms Yellen’s March intervention. It is likely to continue to strengthen, especially as global markets focus on the impending Fed rate rise cycle, but at a more measured pace.

Emerging markets are likely to remain under pressure, reflecting the combination of the prospective Fed rate rise cycle, the US dollar’s strength, the lower level of commodity prices and a range of idiosyncratic country risks in what is a highly differentiated asset class. Reflecting myriad challenges for the country, the Brazilian real has depreciated by more than 40 per cent versus the US dollar since Mr Mantega’s currency war complaint in 2010.

Sometimes you have to be careful what you wish for.

The Author

Andrew Balls

CIO Global Fixed Income

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