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Currencies and the race to hike rates

June 2022

As major economies strain under cost of living pressures, central banks are getting more aggressive on interest rates. The difference in interest rates from country to country, otherwise known as interest rate differential, has a high bearing on currency performance and volatility. Here, we explain the current state of play and what to watch in the coming months.

Inflation pumping through the system

At the recent G7 finance leaders meeting in Germany on May 20, the head of the International Monetary Fund warned that more inflationary shocks were likely, and expressed concern that central banks might not be able to get inflation down without causing recessions.1

The numbers tell the tale of surging inflation, with readings consistently outstripping analysts’ expectations:

  • US headline consumer prices rose to 8.5 percent in March, the fastest year-on-year increase in over 40 years.
  • In April, UK annual inflation increased to 9.0 per cent, a 40-year high.
  • In the Euro Area, annual inflation jumped to 8.1 per cent in May, the seventh consecutive month of record highs since region-wide records began in 1997.
  • In Canada, annual inflation was 6.8 per cent in April, its highest reading since 1991.
  • In New Zealand, annual inflation rose to 6.9 per cent for the March quarter, the highest reading since 1990.
  • Australia recorded its largest annual inflation reading (5.1%) for the March quarter, the highest reading since 2000.
  • Japan, conversely, has not seen a significant rise in inflation thus far, and it remains at a similar level to before the pandemic. After decades of low growth and falling prices, Japanese businesses appear reluctant to pass on price increases.   

The worrying element for central bank policymakers is that these are rises in core inflation, a measure that strips out the inflation linked to food and energy, which is usually more volatile, demonstrating that the problem is far deeper than supply issues due to the pandemic or the war in Ukraine.

As interest rates go up, investors buy holdings in the currency where the yield is higher, and the increase in demand sees the currency gain in value.

Most central banks taking serious steps to hinder inflation

Recognizing the seriousness of the problem, central banks are moving rapidly to take the heat out of their economies.

  • The Bank of England has lifted interest rates four times in the last four months. 
  • The Reserve Bank of New Zealand has raised rates four times since October 2021.  
  • The US Federal Reserve in March delivered its first rate-hike since December 2018, and advised it will increase rates in half a per cent increments in June and July. Ultimately it expects rates to rise from 0.75% last month to around 2.5% by Christmas.2
  • The Bank of Canada raised rates half a percent in April — its biggest single rise in 22 years, and economists predict it will hike another 0.5% in June.
  • The Reserve Bank of Australia, late to the party, raised rates for the first time in early May.

Others want to wait and see

Those who have hiked are staring at high inflation amid fast growing economies with low unemployment. The picture is a bit different in other key jurisdictions;

  • The European Central Bank is yet to increase interest rates but has advised it will end its bond-buying program in the third quarter of the year before hiking rates.
  • The Bank of Japan will stay on its course of monetary easing, expecting inflation to stabilize around 1.9% in the current fiscal year, then slow to about one percent during the next fiscal year. It does intend to ease out of low interest rates and end its asset-buying program but gave no indication of when that might happen.3

How interest rates work to control inflation

By altering interest rates central banks can impact spending and its effect on how much things cost. 

Once central banks raise rates, the increased cost of borrowing is then passed on to consumers. Increased mortgage payments encourage saving in favor of spending and make it more expensive for businesses to invest. Higher rates also tend to depress the value of other assets like equities and property, reducing consumers’ perception of wealth, which makes them less confident about discretionary spending. 

But the tricky balance central banks must get right is not causing people to cut spending too much, otherwise it will start to reduce business investment which would push up unemployment, and potentially cause a recession.

What interest rate changes means for currencies

Generally, a currency tends to appreciate relative to a peer as the gap between interest rates widens. As interest rates go up, investors buy holdings in the currency where the yield is higher, and the increase in demand sees the currency gain in value. On the other hand, as investors sell off lower-yielding currencies, the drop in demand decreases currency value. 

That has certainly been the case with the US dollar versus the euro this year. For the past 20 years the Euro has been higher than the USD and the currencies were last at parity in 2002.

As noted earlier, the US Federal Reserve has been raising interest rates and flagging more aggressive rises to come. By contrast, the European Central Bank (ECB) has continued with its dovish (accommodative) stance, which means the gap between US and European interest rates has widened and will likely widen further. Furthermore, its economy is more directly affected by the war in Ukraine, and, as a net energy importer, more susceptible to its growth prospects being hit by supply challenges.

That has caused the Euro to slide as much as 7% against the USD this year, although recent statements by the ECB that it will “normalize” monetary policy4 have seen that slide reverse slightly.

Other currencies have lost value against the US dollar in 2022. By the end of May:

  • The yen had lost almost 10% against the US dollar, as the time frame for interest rate hikes from the Bank of Japan remains ambiguous.
  • The UK pound was off 6.5% amid concerns about economic strength in the country.
  • The New Zealand dollar was down 4.5% but has recently rallied strongly on much more aggressive tightening talk coming out of the NZ Reserve Bank.
  • Australia and Canada’s falls had been relatively contained at 1.5% and 0.5% falls respectively. Both those nations are large commodity exporters and their currencies are being supported as commodities remain at elevated levels.

What to watch for 

While central banks are increasingly talking up interest rates, perhaps in an attempt to talk their economies down, real world data is becoming the factor to watch.

Recessionary warning signs are already flashing in some countries as inflation starts to bite. 

  • In the UK, shoppers are curbing spending due to rising prices, with the Bank of England warning in mid May that the UK faces a “sharp economic slowdown”, due to soaring fuel, food and energy costs.5
  • The Eurozone only grew by 0.2 percent in the first quarter of 2022, and Italy went backwards.6
  • In the US, the picture is mixed, with inflation moderating at its currently high level, while home sales fell significantly in April as rates rose. At its recent board meeting, the US Federal Reserve expressed concern about “downside” risks to the economy.7

So, a very uneven picture at a time when highly unusual events, such as war and pandemic, continue to plague the global economy. Interest rate hikes continue to be the dominant driver, however each piece of economic data, much of it backward looking, will be scrutinized. With currency markets attuned to any surprises, there will be currency volatility ahead.

References​

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