What would monetary policy divergence mean for the markets?

November 23, 2015 09:13

In my last article we looked at the probable path of US interest rates, should the Federal Reserve decide to action a rate hike at its December meeting, or early in 2016. Of course the prospects for US interest rates are only one side of the coin and we need to consider what is likely to happen to interest rates, in other economies, to get the complete picture and inform our trading decisions / projections.

Over the seven years or so, since the credit crunch and the great recession that followed. We have become used to a certain amount of central bank coordination. With interest rates and monetary policy moving in the same general direction in many of the world's major economies.

There was of course a common cause at work here, namely the need to stabilise the markets, add liquidity (cash) to replace the funding vacuum, caused by the Credit Crunch and the implosion in banks' balance sheets and activities that resulted. Then more recently we saw an attempt to stimulate economic activity via Quantitative Easing or QE. Whereby Central banks print money to purchase Government bonds and other securities. In the hope that the sale proceeds will be reinvested in other assets and the economy, thus promoting growth.

Whilst central banks can and do cooperate in times of crisis we must never forget they are at heart partisans, who can and do act in their own (countries) self-interest (see the SNB actions in Jan 2015 if in any doubt).

The time may now have come for the world's leading central bank the US Federal Reserve, to take its own path and breakaway or diverge from the monetary policy route being followed by the European Central Bank (ECB), the Bank of Japan (BOJ), the Bank of England (BOE) and others.

Markets are forward looking

As we know financial markets are not static nor are they nostalgic, instead they look forward and attempt to price in the "cause and effect" of events at least six months into the future. With that in mind FX markets have started to discount the likelihood of monetary policy divergence between the Eurozone and the USA, in expectation of a further cut to Eurozone interest rates (alongside additional QE) and the probability of a rise in US rates, as the Fed starts down the road to normalisation.

The chart below plots Dollar Index (a trade weighted measure of the value of the US currency: green line) against the Euro Index (a similar measure for the European single currency: blue line) as we can observe since September this year there has been a sharp deviation between the two measures. With the Dollar appreciating and the Euro selling off as the markets made their judgement.

Remember that interest rate expectations/economic prospects are key metrics in the formation of Forex rates or prices, within the market.

Dollar Index vs Euro Index (source Investors intelligence)

What might this mean for the Euro?

To answer that question we need to examine the relationship between Eurozone interest rates and the single currency. As we mentioned recently deposit rates at the ECB have turned negative. That means that eligible banks effectively have to pay the ECB for the privilege of placing their excess funds on deposit.

Why has this happened?

As we have noted already, markets are forward looking and they have priced in the next ECB rate move, which they believe will be a cut, effectively moving ECB policy rates into negative territory.

The chart below shows this move very clearly. The blue line is the EUR USD exchange rate whilst the green line represents three month Euribor futures that track the cost or interest rate any "AAA" borrower would pay to borrow Euros over a three month term.

Euribor rates are calculated by subtracting the Euribor price from a hundred. So that if Euribor futures were trading at 98 then three month Euribor rates are 2% (100% -98% =2%)

However in the chart below the Euribor price has moved above 100 to close at 100.155 as of Tuesday evening .That leaves us with the following sum to establish current three month interest rates:

3 month Euribor = 100% -100.155% = - 0.155%

EUR USD vs Three month Euribor Futures (source Investors intelligence)

Downward pressure & additional supply

The net effect of a negative interest rate is to make investors think twice about holding a currency, which they effectively have to pay to control, rather than receive a positive return as a reward for their investment. In these circumstances we would expect to see sellers of the Euro who in turn would buy an asset which offered a positive return or the expectation of one. In this instance the US Dollar.

Remember as well that any additional ECB QE will likely increase the supply of Euros over and above the €60 bln per month the ECB is currently printing and spending. Once again putting downward pressure on the price of the Euro in the global foreign exchange markets.

This is not necessarily a sell signal in itself as much of this information is already priced in. Indeed if we look at the chart above we can see that RSI or Relative Strength reading for the EUR USD is at the oversold boundary of 30. Which could imply that a rally of some sort was due in an "oversold instrument". However I note that this RSI reading for the Euro has tested well below thirty on four separate occasions in the last 15 months.

Outlook for 2016

The markets will be making similar comparisons and calculations about the relative values of the Yen, of the Pound Sterling, the Chinese Yuan, as well as the Danish and Swedish Krona, Swiss Franc and New Zealand Dollar. All of which are subject to continuing monetary easing versus the dollars tightening.

One thing looks certain 2016 should be anything but dull as far as Forex markets are concerned.

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