Here’s one for the RBA from GS. A guide to the five points of currency warring:
- Watch for Sudden Policy Shifts – In a regime where stability is achieved via offsetting forces, a sudden change in one of these forces will lead to potentially rapid moves. Changes often result from a major policy shift, as for example seen in Japan about a year ago. The period of Sterling weakness early in the year was another example, where a central bank suddenly increased the focus on the exchange rate. A policy shift that hurt EM deficit currencies this year, in particular, was the move towards Tapering by the Fed. Changes to one of the normally offsetting forces are quite similar to revaluation or devaluations in traditional exchange rate regimes.
- Watch Genuine Appreciation Trends – In a world where every country wants to prevent its currency from strengthening, those who actually favour a stronger currency will not face many offsetting pressures. Obviously this is conditional on stronger underlying fundamentals. In order to control the speed of appreciation, frequent smoothing operations can be necessary. This may create a scenario of relatively slow appreciation, combined with very low volatility, which in turn would imply a high Sharpe Ratio. China’s steady Renminbi appreciation remains a case in point. And in recent times the Korean Won as well.
- Watch Policy Constraints – There may also be countries that face continued appreciation pressures but operate under policy constraints that do not allow them to respond fully. In these situations policymakers may not be able to fully prevent appreciation. The constraints could appear in various forms. Would the ECB have been able to cut rates with higher inflation rates? A strict inflation mandate reduces the flexibility for policy makers to respond to currency movements, in particular when they reflect positive growth shocks. External policy pressures could be a constraint. The discussions at the G7 may have been a factor that limited Japan’s ability to weaken the JPY further and could become a constraint in case the JPY starts to strengthen again. The US Treasury report on currencies certainly hints in that direction.
- Watch Carry – If policymakers aim at anchoring the exchange rate in nominal terms and succeed, this does not automatically imply that there are no return opportunities. As long as interest rates differentials persist there will be carry opportunities. And again relatively low volatility may be a welcome feature which raises Sharpe ratios. How long will the RBA be able to sustain an interest rate differential of more than 2% to most other developed economies in such a scenario?
- Watch Quasi Currencies – Finally there is even an argument that competitive devaluations could boost precious metals. That view is based on the simplification that gold, for example, is a “homeless” currency without a central bank that tries to block its appreciation. Another way of saying the same is that many asset prices may rise in response to continued and competitive monetary easing, which is a key feature of such a non-collaborative exchange rate mechanism.
Into the breach…Capt’ Glenn!
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