It feels as if FX markets have been in a state of paralysis for the past 3 months, fixated on the potential for Fed tapering of its monthly asset purchases (tapering). Think back to early July and it’s clear that something has gone astray. Back then, the tapering talk was gathering pace. At the same time, both the Bank of England and European Central Bank pushed back against the rise in market interest rates, the BoE mentioning the change in expectations in their statement (which caused market interest rates to fall) and the ECB moving to a more explicit form of forward guidance at their early July meeting.
At this point, the bigger trend followers in FX were thinking things were pretty much nailed. An improving US economy causing the Fed to move slowly move to the exits, with the UK and Eurozone pushing back against the winds from across the Atlantic, convinced that their domestic economies were not strong enough to shoulder rising market interest rates and the growing perception that they would follow suit. Dollar bears were in short supply.
But in FX, more than any other market, things are never that clear cut. Since then, the euro has appreciated vs. the dollar by around 3.5%. For sterling, it’s been nearly 6%. The market has fought against the policy dynamics in the US (tapering still not seen as done deal this week) and also the UK (expecting earlier rate hike than Bank by considerable margin). In a near zero rate world, interest rate dynamics (including expectations of future changes) struggle to play such a dominant role in determining currency rates. You can also see this with the dollar’s relationship vs. the Fed’s balance sheet. I wrote about this earlier in the year in relation to currencies in general (see “Proving the new FX regime”), but for the dollar the relationship has been weak and is weakening. Never forget that the dollar is around 3% higher since the start of the current pace of asset purchases (December 2012) and was only modestly negative in the first two months.
So the message is don’t over-play linking the fate of the dollar with QE. The relationship is weak at best and the dollar has been far more strongly correlated to data surprises of late than changes in the Fed’s balance sheet. We expect to see a USD 15 bln reduction in the monthly amount of asset purchases from the Fed this week. This is not fully in the price and would initially be dollar positive, but such a move could struggle to be sustained. Furthermore, with markets more sensitive to funding positions (i.e. reliant on overseas capital), any fresh negative impact on emerging market FX is likely to be countered by gains in the euro, which is currently running a positive and rising current account surplus.