The reaction of the world's major currencies to potential changes in monetary policy hasn't been this strong in 15 years, according to strategists at HSBC.
Global equity markets have started 2016 with a thud amid continued weakness in China's currency, an echo of August's market meltdown, with the People's Bank of China reducing the yuan fixing rate to its lowest level since 2011. But exchange rate potency isn't just for central bankers who operate in economies with currency pegs, according to HSBC's strategists.
The foreign exchange team determined that an expected change in interest rate differentials between two countries from the Group of 10 nations is now accompanied by a much bigger move in the exchange rate:
In other words, the euro-U.S. dollar pair is more than three times more responsive to expected changes in interest rate differentials than it was in January 2007. No wonder, then, that monetary policymakers in the U.S. seem to have lately become more focused on the greenback and wary of its strength.
The chief implication of this "hypersensitivity," according to HSBC strategists led by Global Head of Currency Strategy David Bloom, is that a feedback loop between interest rate differentials, exchange rates, and inflation limits the scope for monetary policy divergence.
"Any sizable upward shift to interest rate expectations would come with a significant strengthening of the currency," they explain. "This would lead to disinflationary pressures—in effect, part of the economic tightening would come via the currency, thus negating much of the need for the tightening cycle which caused the currency strength in the first place."
A potential counterargument, as supplied by the Wall Street Journal's Paul Hannon, is that fluctuations in exchange rates have less impact on net exports due to the growth of global supply chains. Under this line of reasoning, changes in currency values have a smaller effect on the level of economic slack in a given country and, in turn, the underlying inflationary dynamics.
The rising import content in exports, however, does not imply that the efficacy of monetary policy has deteriorated. In fact, it's compatible with the increased responsiveness of currencies to expected interest rate differentials described by HSBC.
"If net exports are relatively insensitive to the exchange rate, the exchange rate will simply move more," wrote Miles Kimball, professor of economics at the University of Michigan. "Large fluctuations in the exchange rate are exactly what one should expect if net exports are relatively insensitive to movements in the exchange rate."
This interplay between monetary policy, exchange rates, and trade continues to be a contentious issue amid a backdrop of sluggish global economic growth, with charges levied that central banks are trying to nurse their respective countries back to full health by employing beggar-thy-neighbor policies.
But as former Fed Chairman Ben Bernanke pointed out in a blog post this week, to equate stimulative monetary policy with participation in a "currency war" omits another channel through which accommodation influences economic activity.
"Although monetary easing usually leads to a weaker currency and thus greater trade competitiveness, it also tends to increase domestic incomes, which in turn raises home demand for foreign goods and services," wrote Bernanke. "The net effect of the policy easing on other countries’ trade positions and rates of economic growth consequently depends on the relative magnitudes of the expenditure-augmenting effects of monetary easing (through higher domestic income) and the expenditure-switching effects (through a weaker currency)."
As such, the takeaway is relatively straightforward: The influence of central banks' expected policy paths on currency valuations has increased, and deservedly so.
”The currency market is correct to be obsessed with central bank policy and expected policy differentials," concluded HSBC.