The largest threat to investors may be coming from the foreign exchange market instead of the stretched prices of equity and bond markets. Based on recent policy and technical signs, the forex market might already be on the exit of the unusual phase of lowered volatility.
After prolonged period of monetary policy alignment, advanced economies are now taking steps on increasing its contrasting paths. This ‘multi-track’ world of central banks is reflective on notable discrepancy in underlying economic performance.
The United States and the United Kingdom have the economic lead, registering concrete economic growth and consistent employment gains. Despite presently being frail, the Eurozone’s recovery is still under a pause doing very little to counter the alarmingly high employment in nations struggling to maintain the break with the U.S. and U.K. let alone be able to close it. Although, the burst of Japanese growth is beginning to feel like a forgotten memory.
The multi-speeds were best illustrated last week by several data and the contrasting narratives adopted in Jackson Hole by the ECB chairman and the Fed’s counterpart. The former’s main policy question is how and when to step further on the monetary policy accelerator. His remark’s sparked additional credit and monetary loosening which many suspect will be announced later this month or at the latest by October.
In contrast, and in spite of a well-telegraphed exit from asset purchases that will be concluded in October, with the increasing pressure to ease the foot further off the accelerator becoming more evident.
Although there is an agreement that the market conditions had moved noticeably closer to those regarded as normal in the longer run despite disagreement on the start of the increase of interest rates.
The monetary policy discrepancy is not accompanied by meaningful adjustments elsewhere in the economic policy stance. Weakened by political factors in the U.S. and Europe, both of which struggle to build momentum on the structural reforms required to ensure overall policy effectiveness and counter financial market excess.
Political constraints also affected responsive fiscal policy. Meanwhile, by affecting Europe more than the U.S., inauspicious geopolitical winds accentuate both political and economic divergences.
So far, all these divergences have been reflected generally in growing interest rate differentials. As an example, the discrepancy between rates on U.S. 10-year government bonds relative to their German peers extended to nearly 145 basis points by the end of last week as compared with 93 basis points over a year ago along with 108 basis points at the start of this year.
This is indeed quite a gap which furthered the widening and is more likely to be accompanied by pronounced currency moves including a continued strengthening of the dollar as against the euro and to a much lesser extent, the yen.
There are several good reasons why history warns against presumption that well-mannered and gradual currency adjustment will continue to subsist. Volatility in Forex markets has, elsewhere are being repressed by central banks.
However, this exceptionally low volatility is harder to maintain in light of increasing economic and policy divergence. Furthermore, weaker currencies are increasingly becoming more explicit targets of monetary policy in Japan and the Eurozone.
Despite the potential for technical tipping points, FX movements can be astonishingly sharp once they begin in earnest. Corporate hedging activity is sometimes pro-cyclical, meaning companies are more likely to safeguard themselves against adverse moves after the same started to hurt.