Aftershocks from political earthquakes in the UK and US are pulsing through the currency markets. Lynn Strongin Dodds reports.
In the not too distant past, foreign exchange (FX) markets were dominated by economic data and interest rate movements. Today, divergent central bank policy is a theme but politics has increasingly become a ruling force with the machinations over the US elections, the Brexit vote and a weakening Chinese economy wreaking havoc on currencies.
“What has been surprising is the way that FX markets have become more aligned with predictions of the outcome of an event,” says Hamish Pepper, a Barclays FX strategist. “This has not necessarily been the case historically. Perversely though, we have ended up with lower cross-asset volatility partly because the central banks in Europe as well as the Bank of England (BoE) showed they would be there to support the markets.”
For Chris Towner, chief economist and managing director at money transfer specialist HiFX Financial Services, 2016 is categorised an event risk year. “Brexit was unexpected and the impact on the market was far greater than, for example, when the UK fell out of the European Monetary Union in 1992 because the world has become so interconnected and politics has become all-encompassing.”
It is not surprising that against this backdrop investors have rushed into traditional safe havens such as the Swiss franc (SFr) and Japanese yen. Both currencies have a long history of being a place of refuge in times of turbulence. This may seem ironic in the yen’s case, partcularly given Japan’s stagnant economic environment, but paradoxically the world’s biggest debtor nation – whose public debt is more than twice the value of its GDP – is also its biggest creditor, a status Japan has kept for the past quarter-century. In addition, it runs a constant current account surplus, which is a trait that it shares with Switzerland.
A scenario similar to that in Europe has started to play out since the victory of US presidential Republican candidate Donald Trump over Democrat Hillary Clinton. The dollar fell sharply against G10 currencies after months of strengthening on the back of an outperforming economy and steadily growing employment. Support was also being lent by expectations that the Federal Reserve would increase interest rates after the election, but this is now being called into question due to fears over the effect Trump’s economic and trade policies would have on the country’s economy.
While some emerging markets rallied on the news of a delayed rate hike, others, such as the Mexican peso, tumbled 20% against the dollar. “Almost a third of Mexico’s GDP relies on its northern neighbour and Trump’s promise of a 35% tariff targeted at US companies that outsource abroad could be costly, particularly for the automotive industry,” says Michael Levy, frontier and emerging markets investment director at Barings. “Trump has also mentioned plans to renegotiate the North American Free Trade Agreement (NAFTA), another potentially worrying development.” The fallout of the US election for example, saw the SFr jump 0.4 % to 0.9740 while the yen gained 1.6% to ¥103.45 against the dollar.
As Peter Hensman, global strategist for the real return team at Newton Investment Management, notes: “US political uncertainty and the lowered prospects for tighter monetary policy can be expected to undermine the dollar against the other major currencies; the Japanese yen perhaps stands out as the currency most likely to benefit from this flight to quality.”
What about China? The offshore renminbi also suffered in 2016, sliding to a record low level of Rmb6.8040 against the dollar; but the currency had been losing steam this year over fears of a slower Chinese economy. Markets went into panic mode at the beginning of the year when the government announced growth of only 6.9% and although it has held firm at 6.7% in the three months ending in September, it is the lowest quarterly level since the 2008 global crisis.
Moreover, pressure on the currency had been building since October, when the International Monetary Fund included the renminbi in its special drawing right (SDR) basket. Some strategists suspect that the central bank has become more comfortable with letting the currency weaken following the SDR inclusion.
Analysts also expect the pound’s fortunes to vacillate until a clearer picture of the Brexit negotiations emerges. In essence, a soft Brexit would provide a fillip while a hard Brexit would have the reverse effect. The latter would see the UK relinquish full access to the single market as well as the customs union. Initially the country would revert back to the World Trade Organisation rules for trade with its former EU partners as it negotiates separate trade deals.
Just the mention of adopting this stance sends the currency into a tailspin as it did when UK prime minister Theresa May hinted in October that this could be the road taken. By the end of the month, the currency was in the unenviable position of being the world’s worst performer, dropping 6% against the dollar – the biggest decline since the 8.09% plunge in the aftermath of the Brexit vote and the 3.68% slide against the euro compared with the 7.89% nose dive in June. Overall, the pound has fallen by over 18% since April.
“We believe sterling can fall further given the UK’s balance of payments vulnerability and likely future constitutional uncertainty,” says Roger Hallam, CIO of currencies, JP Morgan Asset Management. “There remains a risk that sterling could overshoot significantly to the downside if Brexit negotiations go poorly, growth weakens sharply and the BoE is forced to ease more aggressively.”
Aside from investors taking cover, they have also taken advantage of the carry trade, which involves buying high-yielding currencies and selling lower-yielding ones. This has translated into purchasing the Indian rupee, Russian rouble and Indonesian rupiah and selling the euro or pound.
“The carry trade has come back in favour because if you look at the riskadjusted returns of developed market bonds they have been particularly poor and historically low,” says Pepper. “Portfolio managers are looking to FX to generate additional returns to supplement the full bond returns.”
Looking ahead, investors should continue to brace themselves for more FX markets turbulence. There is further political turmoil on the horizon with the fallout of the Italian referendum, the upcoming French presidential elections scheduled for next April and Germany’s federal elections due to be held in the autumn of 2017 to look forward to. As 2016 has shown, we can expect the unexpected.