FX: G10 & EM, published every Thursday, provides a detailed analysis of global foreign exchange movements in major and emerging economies around the world together with macro insights.
Geoff Yu
Time to Read: 5 minutes
EXHIBIT #1: U.K. WAGE GROWTH GAP VS. HEADLINE CPI
Source: BNY Markets, iFlow, Bloomberg
Our take
The Bank of England (BoE) is the only key Western European central bank expected to cut rates this week. There was a clear change in tone from the BoE’s Monetary Policy Committee (MPC) since the tariff-related stress shifted European growth expectations in April. As the ECB is now likely to move materially below neutral levels due to weaker growth, the BoE will be unwilling to entertain wider divergence in financial conditions between the U.K. and its largest trading partner. However, we believe the market is overemphasizing external conditions, while domestic data are unlikely to convince the MPC that the U.K. is on the cusp of entering a period of sustained deflation. Domestic inflation dynamics remain strongly detached from external conditions. Consequently, there is a high risk that the MPC vote will not be as comprehensive as the 8-1 tally expected by the market.
Forward Look
No cuts are expected in Sweden and Norway. Norges Bank has not cut rates at all in this cycle and the central bank consistently cites the tight labor market for its decision. We don’t see why the market shouldn’t continue to apply the same standard to the Bank of England. Furthermore, Governor Bailey has warned of an inflation “hump” in April due to price-resets in the new fiscal year, and there is particular pressure on the labor costs side due to the rise in employers’ national insurance contributions (NICs). As early as November last year when the policies were announced, BoE Chief Economist Huw Pill warned that “higher costs implied by the rising NICs…would be of obvious concern to us as that would be a perpetuation of higher inflation.” External developments have little bearing on NICs, apart from the loss of jobs in tariffed sectors which would lower overall employment levels. Meanwhile, wage growth remains robust due to tight labor markets and it is becoming less responsive to headline inflation levels (Exhibit #1). The breakdown in this relationship is taking place across Europe but is more acute in the U.K. and Norway. However, as stagflation remains a concern in these economies, we do not see direct asset allocation benefits either from higher nominal rates.
EXHIBIT #2: CNY, KRW AND TWD REER PERFORMANCE RELATIVE TO 5-YEAR AVERAGE
Source: BNY Markets, iFlow
Our take
In sharp contrast to European central banks, their counterparts in the Asia-Pacific region are now acting more forcefully to prevent financial conditions from tightening further through the currency channel. This week’s monetary easing salvo by the People’s Bank of China will only step up the pressure on regional peers to act, especially in the face of tariff uncertainty, which could further reduce national income due to loss of export earnings. Short-term flows into the currency and equity markets aside, we believe that these central banks are fully aware that valuations are clearly not in their favor: in the run-up to “liberation day,” real effective exchange rates (REER) in North Asia were all well below their five-year averages (Exhibit #2). This is the criteria we use in iFlow for valuations-based mean reversion and the risk to FX performance was clearly to the upside.
Forward look
We do not expect central banks in the region to tolerate strong appreciation in their currencies against the dollar. However, they must recognize that trying to inhibit REER adjustments will only exacerbate domestic imbalances. The obvious solution is allowing REERs to rise solely through the inflation channel, especially by lifting wages and domestic demand. We believe policymakers in the region recognize this is the only way forward in the longer term as the U.S. seeks to re-shore goods production, but since “liberation day”, fiscal plans are non-existent in the region. Even China’s fresh initiatives this week to support household consumption is largely based on expanding existing liquidity facilities, and fiscal authorities did not even participate in the press conference which made the relevant announcements. Now that official trade talks between China and the U.S. are taking place, there could be a temptation for these countries to kick the “economic restructuring can” down the road. In our view, this is not the optimal outcome for exporters and will only delay the necessary adjustments in REERs.
EXHIBIT #3: CHANGE IN 1-YEAR VOLATILITY SINCE FEBRUARY 20
Source: BNY Markets, iFlow
Our take
The foreign exchange options market seems to agree that long-term upward adjustment is inevitable. In the wake of recent gyrations in the TWD, implied volatility has moved across APAC FX options curves, including in 1-year options. Given these are heavily managed currencies and central banks technically have unlimited resources to prevent their currencies from strengthening, markets are essentially anticipating regime shifts. As there is no prospect of a structural pick-up in inflation levels to drive up real effective exchange rates, the changes must happen in nominal exchange rates.
Forward look
We are fully sympathetic to views that the currency regimes of exporters in the Asia-Pacific region require reassessment. However, this cannot happen in isolation. Currency arrangements are the consequence of economic structures, structures that the U.S. is currently trying to disrupt. The exporters have likely acknowledged the need for structural change, but the manner of change will be slow and suited to domestic socio-political structures. Consequently, we do not see the current moves in FX options markets as sustainable and time decay will likely cause these positions to unwind. Equity flows to capture income growth is the more sustainable way to price in economic change, and these are flows – which drive long-term positive valuation adjustment in currencies – local central banks and broader policymakers will welcome.
Markets have been quick to price in regime shifts in recent weeks, but we don’t believe the status quo in monetary or currency policies should be discarded so soon. From structural labor market supply constraints in Europe to long-standing currency regimes in APAC, some structures are far more durable than current expectations. Central banks are reacting tactically to short-term pressures and market participants should position accordingly. For now, long-term plays in FX offer very limited risk-reward.
