It’s been a strange world for currencies as well as for bonds and interest rates since the Western crash. Countries and central banks that used to worry about their currencies falling too much have all seemed to welcome weakness in their counters, hoping that will stimulate exports and allow a bit more inflation.
Four of the main currencies in the world that form the World Bank’s basket for Special Drawing Rights, the yen, dollar, sterling and the euro have had extensive programmes of money creation, bond buying and interest rate lowering. Only the renminbi, recently admitted as the fifth currency in the World Bank top basket, has not undertaken special monetary measures designed to lower the currency and create extra inflation.
By definition not all the currencies can depreciate against each other. These five represent a big proportion of the total world currency pool. For a long period the dollar was the strongest. In recent months this has reversed, with the dollar falling against all the other four currencies in the SDR package.
Sterling took a knock following the EU referendum vote, but has risen in recent weeks. It is now 10 per cent above its lows against the dollar, and 12 per cent above its low against the yen. It has been the euro’s turn to be the strongest performer.
So why is the euro now doing so well and why is the dollar so weak? The markets watch and judge central bank policy daily. They are expecting news from the European Central Bank (ECB) that it will cut and then eliminate its aggressive programme of creating money and buying bonds. If all other things are equal, this would lead to some strengthening of the currency, which was discounting further euro creation and monetary loosening. Mario Draghi was very careful at his last news conference to stress no decisions have yet been taken about such a change of approach. The markets think he will, nonetheless, have to rein in a bit next year.
Conversely, markets had priced in further monetary tightening, higher interest rates, and repayment of bonds owned by the state in the US. Instead they are now witnessing some backing off from such policy changes. The near certainty of a further rate rise this year has vanished, to be replaced by a strong view that rates will not go up again in 2017. This has led them to sell the dollar. They are responding to the clear wish of the President to have a weaker dollar, and the knowledge that new appointments at the Federal Reserve Board may well reflect his view that they need lower rates for longer and a cheaper currency.
China does not want a trade and currency war with the US and has acquiesced in the idea that the renminbi was a bit low against the US. Both sides seem happy with the devaluation of the dollar so far this year.
What does the future hold? For the immediate future it looks like more of the same. At some point markets will ask if the fall of the dollar has gone far enough. You do get a better interest rate on holding dollar deposits than on yen or euro ones where short rates remain negative. The US is still closer to ending abnormal monetary measures than the euro area or Japan.
Paradoxically, the more the euro strengthens, the less likely is early action to raise rates or stop bond buying. The euro area has taken a long time to respond to monetary stimulus. The recovery is still recent in the weaker parts of the zone. There is still no evidence of too many inflationary pressures in Germany and the other strong areas. All this suggests there are limits to how far the euro can go on rising.
John Redwood is Charles Stanley’s chief global economist