Despite the geopolitical situation worldwide becoming more volatile, FX markets have stayed relatively idle, leaving speakers at the Profit & Loss Forex Network London event to wonder what has caused this disparity.
In recent months, news of geopolitical volatility – from Brexit woes to an intensifying trade war between China and the United States – has dominated the headlines. Yet while this volatility has been reflected in many financial markets, with energy prices being a prime example, it seems to have had little impact on currencies.
Todd Elmer, senior G10 FX strategist at Citigroup, argued that the reason for this is because central bank monetary policies have stayed more in-synch than was generally anticipated.
“Certainly we are seeing lag in FX volatility compared to other asset classes,” he said. “There had been this expectation that we were going to see a divergence in policy across the world, reflecting economies starting to take off, but we’ve had the opposite. So long as policymakers continue to pursue this extremely easy policy, I think that that is going to suppress volatility… I don’t actually envision a significant pickup anytime soon.”
Megan Greene, who is a senior fellow at the Centre for Business and Government at the Harvard Kennedy School and was previously chief economist at John Hancock, noted that there are specific reasons why the volatile energy prices didn’t translate to big FX market moves. For one, she explained that energy usage has become much more efficient, meaning that oil prices need to go significantly higher in order to create a drag on the US economy now. That’s why, said Greene, when oil prices fell so low in 2015 and 2016 it didn’t provide much stimulus in terms of those prices feeding through into inflation.
“In so far as growth and inflation expectations are an input into the forex markets, volatility in energy prices aren’t going to feed through the same way they used to,” she added.
Taking a more micro view of what’s happening in FX, Juliette Declercq, founder – global macro strategist at JDI Research, claimed that “there’s really been an effort to kill volatility before talks between the US and China end in a deal” and predicted that once talks has been concluded volatility would catch up with the market.
Meanwhile, Van Luu, head of currency and fixed income strategy at Russell Investments, said that although he was surprised by how low volatility has been in the FX markets, there is a logical explanation for why this has occurred.
“The market is clearly playing the Goldilocks scenario where the Fed has pivoted from being very hawkish to being very dovish. And in that kind of pause environment, the low volatility makes sense,” he explained.
Luu continued: “In the Goldilocks scenario carry trades work very well, the developed market carry strategy has performed nearly 4% year-to-date. Low volatility is very bad for trend strategies, but I think the best set up is to have a combination of the two because then you can benefit from either a continuation of the low volatility regime or a pickup of volatility.”
The value of hedging
Given the lack of FX volatility, the question was put to the panellists about whether firms should cut back on hedging their currency exposures.
Greene responded that there are a number of risks associated with such a change in approach, pointing to recent trade tensions as one in particular. Although she predicted that the US and China will agree a new trade deal, Greene said that any such deal is likely to be “fairly superficial” and that it won’t mean and end to the recent trade tensions.
“I don’t think that trade will stay off the table, I don’t think a détente will last. Also, if there is a détente between the US and China that means that our trade department in the US has more bandwidth to focus on other things. And president Trump really cares about bilateral trade imbalances. So he’s going to look at countries who have a bilateral trade surplus with the US and the top of the list is Japan and Germany. This means that car tariffs and potential agricultural tariffs on the EU are all in play. So I think that trade actually remains a really big risk, in which case if you haven’t hedged then that’s a bad call,” she commented.
Declercq was similarly critical of the Trump administration’s fixation on trade imbalances and predicted that a stronger dollar should drive currency hedging for firms with USD exposures.
“I think trying to fix trade balances is a bit of a ludicrous idea, there’s a clear reason why the US has a trade balance deficit and part of it is the strength of the dollar. So one way to actually fix the trade balance would be to actually fix the dollar,” she said.
Declercq agreed that any trade deal between the US and China will be largely superficial, adding: “Eventually what will have to be addressed is the strength of the dollar and whether that is done through firing power alone or putting pressure on the Fed, I don’t know. But that’s really what I would be hedging now if I was a corporation.”
Luu agreed with the stronger dollar view in general, but also said that he doesn’t see room for it to go too much higher.
“When it comes to hedging, I think we have an unusual situation where for dollar investors there’s a strong tailwind from hedging back to US dollars. There’s about a 2.5% per annum interest rate differential in favour of the dollar, so it seems from a carry perspective that it’s quite attractive for dollar investors to hedge back into their own currency. That’s also attractive from a risk perspective because the US dollar is a risk-off currency, meaning that when global equity markets tank the US dollar goes up. So having dollar exposure is also attractive in case of a bad scenario like that,” he said.
Comments on the ongoing trade war between the United States and China inevitably led to questions surrounding what would happen if China, the largest holder of US Treasuries in the world, began selling these assets.
Elmer predicted that China is unlikely to try and rapidly divest itself of its US Treasuries in response to the perceived trade aggression from the US because, quite simply, it would be difficult to do so.
“Historically, when we look at what China has done with its Treasuries, the shifts in holdings tend to occur tectonically. One of the things this shows is that it’s very difficult to move out of the dollar from a practical perspective because there just aren’t many better alternatives at this point. If we think about the areas where [China] can invest, there’s only a relatively small range of assets that would meet their requirements as alternatives to Treasuries,” he commented.
However, Elmer also said that he expects China to begin diversifying its reserve holdings more, noting that any trade deal with the US might include a stipulation requiring China to have a stronger, or at least more stable currency, which would incentivise it to sell dollars in favour of euros and other currencies in order to ensure that its own currency isn’t appreciating on a relative basis.
“That can exert some downward pressure on the dollar,” he said. “As far as the targets of where that money is shifting, I think Europe is the area where there is a lot of breathing room to add back some exposure.”
Van Luu agreed, commenting that the erratic behavior of Trump could motivate countries with large reserve pools – namely countries with US military alliances, including South Korea, Japan and Taiwan – to start diversifying away from the dollar.
“I think that motivation exists,” Luu said. “The share of US dollar in international reserves is higher than is justified by purely economic reasons. The problem is, there is no really clear alternative. If Europe would get its act together, with regard to political reform and structural reform, then I think it would be a much more formidable competitor to the US dollar.”
US reserve status remains safe
Indeed, the role of the US dollar as a reserve currency became a subject of discussion during the panel session, as it was noted that the latest figures from the International Monetary Fund (IMF) show that the dollar percentage of central bank reserves has dropped by 4.5% since 2016.
Despite this, USD remains the largest reserve currency by some distance and the panellists were sceptical that this position is likely to come under threat any time soon.
“Yes, the dollar’s percentage of global central reserves has fallen a bit, it’s around 60% and second place is the euro at around 20%. It’s a pretty big gap, and there just isn’t an alternative. Also network effects really matter, so companies want to do business in dollars because other companies do business in dollars. And so I think the only way that the dollar will lose global reserve currency status is if the US decides it doesn’t want it any more,” said Greene, adding that this last scenario was unlikely to happen any time soon.
Elmer argued that context is important when examining the US dollar’s role as the global reserve currency, pointing out that in the 20 years since many Asian countries started building up their currency reserves they’ve only managed to diversify away from the dollar by less than 10%. One thing that he did say was unusual about the recent decline in the dollar share of reserve portfolios is that it has occurred during a period of dollar strength.
“What that implies is that reserve managers have been actively moving out of the dollar,” commented Elmer. “And sure enough, if you adjust the data for FX valuation and asset price valuation, the act of buying non-dollar currencies has been running at historically high levels. But this is very much a marginal trend at this point, I think it shows that reserve managers are amongst the more sensitive subset of investors to political changes.”
He subsequently concluded: “We aren’t seeing any widespread crisis of confidence in the US dollar as a store of value at this point. If anything, it’s been the opposite because private sector investors have been rushing into higher beta US assets even predating the Trump administration.”