During times of market stress, currency movements can shift rather dramatically from a previously established pattern; this happened after the Global Financial Crisis, and it's happening in the new coronavirus normal. The pattern of change is quite different, but it can be usefully reduced down to a few key catalysts.
One can’t discuss this topic without mentioning central bank policy, so let's just get it out there. In 2008 when the Fed implemented quantitative easing, thereby lowering the cost of borrowing, it triggered a market reallocation based on this new cheaper funding. Many emerging market currencies would have benefited directly as well since a good dealing of their borrowing is done in USD.
For the sake of brevity, we won’t discuss adoption in other geographies or subsequent tweaks and shifts, except to explain that this year the Federal Reserve’s change in policy in response to the coronavirus was a rather dramatic one. Arguably the US was furthest along in its economic cycle when the virus hit, so the sudden drop to near-zero interest rates—and hints that it might make explicit promises about yields—has had an appropriately large impact on investor behaviour.
One of the impacts of particular interest is that foreign investors, which had used cheap EUR financing post-2015 when Fed interest rates started climbing, have now resumed USD borrowings. Theoretically, this should cause a sizable EUR appreciation and USD depreciation as borrowers repay EUR loans and open USD loans (buying EUR and selling USD). In fact, that's precisely what has been happening. After a risk aversion caused a spike in USD value in mid-March, the change in Fed policy has brought the trade-weighted currencies within close proximity.
Bottom line: This morning, Bloomberg suggested that the effects of this policy shift have still not entirely played out, though it should be a shift, not perpetual pressure. Obviously, there are a series of other factors at play as well. The EU’s upcoming 750bn emergency stimulus should also factor heavily towards EUR appreciation. In the US there is an early discussion on a further stimulus package of between 1tn - 3.5tn USD, which would further bolster the Dollar. It’s a complex dynamic, but its worth understanding how this recent policy shift has played its own part.
The week ahead
The Pound closed last week in the red, falling below the 1.10 level against the Euro and 1.26 level against the US Dollar. Early on last week, the trade-weighted Sterling index rejected its 100-daily moving average, prompting a rapid decline in the index, and failed to recover the week’s early losses. For the week ahead, UK-EU Brexit negotiations begin their first full round in six weeks, beginning on Monday evening. Meanwhile, Bank of England Monetary Policy Committee members will be speaking on Monday and Thursday. Although the economic data calendar is light this week, Brexit negotiation headlines could create some volatility later in the week.
Today, the trade-weighted Euro index extended its rally from last week, posting fresh 18-month highs with further gains in sight as the EU’s Recovery Fund edges nearer to an agreement. A major sticking point for the recovery fund was the notion of issuing grants to struggling nations, but the richer nations who initially opposed this have signalled they are willing to give ground. This Euro-positive news to kick the week off could push the Euro another leg higher, bringing it into the 1.15's against the US Dollar and deeper into single figures against Sterling. With not much in the way of economic data this week, the EU Summit which concludes today may be the Euro’s biggest driver this week.
The US Dollar closed another week lower against its major peers and is now over 2.0% lower on its trade-weighted index this month, and 1.4% away from 2020 lows. The US Dollar has been increasingly negatively correlated with US equity markets in recent weeks which are currently trading in the middle of a highly uncertain earnings seasons. Although equity markets have so far traded higher, despite an unpredictable upcoming earnings season, realised poor data risks reversing the trend in the US Dollar.
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