Author: Robin Bew

Location: London

Date: 2013-03-04

Two of the most striking developments have been the declines in the Japanese yen and the British pound. The yen has fallen by about 16% against the US dollar since the end of September last year, and the pound has fallen by close to 7% against the US dollar in the past eight weeks. Fluctuations in global risk appetite, and in particular in confidence in the euro, have been the defining force in shaping currency movements in the past couple of years. But the recent sharp depreciations in the yen and the pound represent something of a departure from this pattern.

In both cases, domestic factors have been significant drivers of these currencies' depreciation. For example, while the easing of financial stresses in the euro zone since mid-2012 has reduced the yen's appeal as a safe-haven currency, this alone does not explain the yen's fall. Rather, the pivotal moment for the yen was Japan's general election on December 16th, which resulted in a change of government and a new direction for economic policy.

As is so often the case, foreign-exchange markets priced in many of these changes before the fact. In the run-up to the election, the yen weakened as currency traders anticipated a victory for the Liberal Democratic Party (LDP). The currency has fallen further since the start of 2013 as the LDP has duly assumed power and started fulfilling its campaign promises. Most notably, it has exerted pressure on the Bank of Japan (BOJ)—as it threatened to do—to ease monetary policy further. The central bank responded at its January policy meeting by committing to a 2% inflation target and by announcing an open-ended programme of quantitative easing (QE). Both changes are significant, even though the new QE programme will not take effect until 2014. The government has also announced fiscal stimulus measures, underscoring its commitment to ending Japan's decades-long deflationary cycle.

In the UK, too, the currency's movements reflect a combination of domestic and global forces. During periods of market stress the pound had caught a bid as a relative safe haven. As the euro zone crisis has eased, mainly because of the success of efforts by the European Central Bank (ECB), the pound has lost this safe-haven appeal: it weakened steadily against the euro from July 2012 to the end of last year. Yet its descent against the European single currency has steepened since the start of 2013; recently it has also started depreciating sharply against the US dollar. In large part this reflects efforts by the monetary policy committee of the Bank of England to "talk down" the pound, as well as unexpected signs that the committee is more open to further QE than previously thought. Weak GDP data, rising concerns about the impact of austerity on economic growth and related uncertainty over future fiscal policy given slow progress in reducing the budget deficit have also contributed to the decline in sterling. Some observers doubtless also interpret the UK's loss of its AAA sovereign rating—following a downgrade by Moody's, a credit ratings agency—as negative for sterling. However, we prefer to see the downgrade as reflecting pre-existing pressures on the pound and on the UK economy rather than as a market-moving event per se.

All roads lead to Rome

If the declines in the yen and the pound mark new directions, the prevailing global narrative of the past couple of years probably remains intact. This dynamic, in which investors alternate between "risk on" and "risk off" positions, has partly manifested itself in fluctuations in the euro/US dollar exchange rate. The dollar weakened against the euro between July 2012 and January 2013 as the ECB's defence of the European single currency—most notably its promise of unlimited intervention in sovereign bond markets—eased fears of a disorderly break-up of the euro zone. The euro was further bolstered as European banks started to repay loans that the ECB had provided in late 2011 and early 2012 as part of its debt-crisis response. However, since the start of February this year markets have gone into reverse, and the euro has given up part of its gains, falling from around US$1.37:€1 to US$1.30:€1.

Political uncertainty in Italy has been a factor in this reversal. The approach of the February 24th-25th general election heightened concerns about governability and thus about the country's ability to implement economic reforms needed to boost competitiveness. The inconclusive result of the election is likely to compound such fears, keeping downward pressure on the euro. The other side of the same coin is the improving economic picture in the US, along with the easing of short-term fears over the "fiscal cliff" and federal "debt ceiling". Both of these issues had the potential to seriously disrupt US financial markets in early 2013, but in the event the problems did not materialise as initially feared.

Tangled strands

The outlook for currency markets in the rest of 2013 is uncertain. Fluctuations in global risk appetite will remain a fundamental driver of exchange-rate movements, but market signals may well be confused by myriad other developments.

On the plus side for the euro, we expect the recession in the euro zone as a whole to end by the middle of 2013—albeit with any recovery likely to remain weak and skewed heavily towards Germany. Yet we also expect the US economy to pick up from mid-year, and the relative effects on currency movements of one recovery versus the other are hard to predict. A complicating factor is the dollar's safe-haven status, which can cause it to move inversely to US economic fundamentals and could therefore prompt a shift away from the dollar as risk appetite improves. The euro, in contrast, tends to behave more like a risk asset (rising, like equities, when sentiment improves and falling when sentiment weakens).

There are many other events on the horizon that have the potential to cause turbulence in foreign-exchange markets this year. Failure by Italy to form a stable post-election government is an obvious risk, and the approach of the German federal election in September clouds prospects for co-operation between euro member states on policies affecting the future of the currency union. The possibility of renewed financial turmoil in peripheral euro zone markets will, in any event, remain a constant threat in the background, capable of erupting whenever data cast doubt on economic recovery or fiscal consolidation prospects.

Elsewhere, currency investors must worry about the imminent approach of automatic public spending cuts in the US that could impinge on growth prospects. In Japan, the government's commitment to stronger stimulus, while admirable in theory, may not have the desired effect in practice. Monetary policy remains in flux because of an ongoing management transition at the BOJ. Even if this transition goes to plan, it is far from clear whether the BOJ is capable of meeting its new 2% inflation target. With all of the Big Four central banks involved in asset-purchase programmes to varying degrees, messaging on their plans for QE will also be important. All these factors could play into global currency markets in the short term.

In the longer term, the US economy looks the most resilient of the major OECD currency areas to (slow) interest-rate rises. If this occurs in a context of a narrowing current-account deficit (reflecting the impact of shale energy on the US balance of payments and possibly a renaissance of US manufacturing), the better relative returns on US-dollar assets should be positive for the dollar's value.

 

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