It wasn't long ago that it seemed as if inflation was an out-of-control freight train that was threatening to destroy the world's buying power for years to come. However, thanks to some aggressive action by central banks around the world, the price pressure monster appears to be under control once again. In the space of just over 12 months, the US Federal Reserve has raised its effective funds rate by over 400 basis points (bps) to levels not seen since 2007. Meanwhile, the euro area's ECB has hiked its own lending rate by 250 bps, with the Bank of England opting for an increase of 300 bps over the same period.
Raising rates to combat inflation is a classic central bank play almost as old as time. The underlying logic is that as the cost of borrowing money increases, the value of existing cash stabilises. This is great in theory, but in a world as overleveraged as today's, it also poses a significant risk to the wider economy as businesses and ordinary citizens' debt burdens are exacerbated by additional interest payments. For now, the strategy seems to be working satisfactorily, but what will be the effects of this ongoing hike cycle on the already tense global currency markets?
Fed up with inflation
There are no two ways about it: the US Federal Reserve has come down the hardest on price pressure and has undoubtedly been the most hawkish of the Big Three central banks globally. This was largely due to the fact that it had more leeway in terms of already having the highest rates in the Western world before the hyperinflation of 2021-2022 set in. What's more, it has also enjoyed the privilege of energy security during a particularly tough time for Europe. Since energy is used to produce, well, everything, the 5-to-10-fold rises in energy prices had a much more pronounced effect on the EU consumer price index than its US counterpart.
In any case, the US regulator delivered on analyst expectations yesterday (1 February 2023) when it raised rates by another 50 bps to take the overnight lending rate to between 4.75-5%. And while Fed Chairman Jerome Powell noted that the tightening monetary policy had been effective in bringing down price pressure, he also stated that inflation "remains too high", pledging to "stay the course until the job is done". The effect of this was a strengthening of US Treasury bond yields, with the 10-year T-bill sliding 13 bps to a four-month low of 3.4%. Meanwhile, the dollar remained fairly flat as this rate increase had been more or less fully priced in already.
Lagarde back on track
The European regulator has received some criticism for being too dovish with its monetary policy as the EU has faced severe inflation in recent months and still trails its counterparts in the US and Britain by 100-200 bps. This is due to a combination of a lower starting point following years of zero rates and a keen consideration for ordinary debtors. Nevertheless, the ECB delivered on its promise to raise rates a further 50 bp, bringing its aggregate rate to 2.5%. ECB President Christine Lagarde has even gone as far as to commit to "at least one more" rate hike before the year's end, which will certainly give some solace to the EU hawks.
This also gives us some insight into the euro area regulator's "terminal rate" target, which Lagarde initially stated to be 3.5-3.75%. The ECB Governing Council also affirmed that the APP portfolio will decline by an average of €15 billion per month from the beginning of March until the end of June 2023, in line with December's claims. The euro did dip slightly on the announcement, highlighting that some market participants are somewhat doubtful that this will be achievable in the medium term.
BoE presses on with policy
Since Brexit, Britain has certainly erred more towards its trans-Atlantic cousin's monetary policy than that of its European neighbour. However, it would be remiss to ignore that the BoE was the first major central bank to begin the post-pandemic shift to tightening. From that point on, though, the UK has been playing catch up with the Fed to match the US regulator's 50-75 bps rate hikes. As the analysts predicted, February was no different as the UK regulator announced it had increased its lending rate by 50 bps increase in line with Powell's across the pond. Many analysts and economists, however, will be on the lookout for signals that this tenth consecutive rate rise will prove one of the BoE's last.
One confounding factor for the UK is its relatively higher inflation rate compared to the US and, indeed, the EU. Inflation remains above 10% in the island nation, which behoves a more aggressively hawkish position than in countries that have already brought price pressure down to single digits. For now, the pound remains steady, with this decision already largely baked into its exchange rates.
The future for forex
This past year or so has been an uncharacteristically volatile time for currency markets. The epitome of this had to be the historic passing of EUR/USD parity when the US dollar was briefly worth more than the euro. Thankfully, sound central bank policies on both sides of the water have helped bring the Fibre back into more familiar (and stable) territory. As the geopolitical and general economic climate continues to calm, we should expect asymmetric USD demand to disappear, allowing the other majors to recover.
After hitting a 20-year low in September 2022, the European single currency has made a fourth consecutive monthly gain as energy prices return to more sustainable levels and the ECB maintains its hawkish stance. EUR/USD currently stands at 1.10, and its lack of movement in and around these key rate decisions is a testament to its long-term outlook. The Cable, on the other hand, did move slightly just following Powell's post-meeting comments on Wednesday, 1 February 2023, but quickly fell back to its pre-meeting level of 1.23 the next day. With all the world's major central banks seemingly on the same page, we can expect a period of more typical stability in the forex market.
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