With domestic equity indexes soaring to all-time highs in recent months, many have become infatuated with the stock market and the countless opportunities it offers both at home and abroad. As a result, the commodity and bond markets have come under pressure in light of improving economic growth expectations. One particular asset class, however, remains largely ignored by the headlines, but its sheer size of nearly $4 trillion warrants a closer look from any seasoned investor: meet the Foreign Exchange market [see The Ultimate Guide To Currency ETF Trading].
Currency investors are well aware of the global impact that exchange rate fluctuations can have on asset classes, and that’s why paying attention to this market can offer insights that are otherwise overlooked by those focused solely on stocks or bonds. In fact, the foreign exchange market often offers valuable clues as to where stocks may be headed, because it is inherently driven by monetary policy, which is arguably the single largest driver of the business cycle [Download 101 ETF Lessons Every Financial Advisor Should Learn].
Central Bank Policy: What We Know & What May Happen
“Easy” monetary policy has bolstered U.S. markets into uncharted territory since 2009 and the recent “taper scare” served as a reminder of just how quickly the tides can turn on Wall Street at the slightest sign of a shift in the Federal Reserve’s policy. In light of this recent volatility surrounding the potential bond-taper by the Fed, below we recap the current monetary policy for five of the most prominent central banks, highlighting their current stance and how looming uncertainty may affect their respective currencies in the near future.
To start off, below we review how each of these major currencies has performed since the peak of the financial crisis:
- U.S. Dollar (UUP)
- Euro (FXE)
- British Pound (FXB)
- Japanese Yen (FXY)
- Aussie Dollar (FXA)
U.S. Federal Reserve
Issued on July 31st, 2013, the latest FOMC policy statement notes that the central bank will continue to maintain a very accommodative policy; specifically, the federal fund rate is locked at 0-0.25% while bond-repurchases total approximately $85 billion per month, split fairly equally between agency mortgage-backed securities and longer-term Treasuries. This “loose” policy has devalued the U.S. dollar over the past four years; however, recent hints of the “free money” era drawing to a close has bolstered the greenback higher [see also 5 ETFs Getting Crushed By The Surging U.S. Dollar].
With everyone now anticipating a small pullback in bond repurchases to be announced in September at the next Fed meeting, two potential surprises could throw a wrench into the mix. First, policymakers may decide to taper more than previously stated if inflation proves to be a bigger concern than previously projected. On the other hand, the Fed may decide not to taper just yet, assuming that economic conditions worsen and put strain on the already anemic recovery at hand.
European Central Bank
The ECB has rates locked in at 0.5% and has pledged to keep borrowing costs low as the debt burdened currency bloc has just recently started to show signs of life. Following the most recent ECB rate decision in July, bank President Draghi reiterated the bank’s “accommodative stance”; however, he also hinted that a rate hike should be ruled out as a possibility if greater inflation pressures emerge [see ETF Plays As The End Of QE Nears].
The euro has been oscillating back and forth all year as “easy” monetary policy has collided with a hopeful economic outlook. The recent shift to reflationary policies, in lieu of pursuing austerity, has offered some strength for the currency. The biggest question mark going forward here is whether the recovery can gather steam, with inflation risks taking a backseat at least in the short-term.
Bank of England
The U.K.’s interest rate stands at 0.50% and the central bank recently announced that its bond-repurchases would total approximately $571 billion. Policymakers overseas are worried that a premature taper would endanger the fragile recovery while critics claim that the country is in the early stages of a credit bubble and tighter monetary policy is a must.
The British pound remains in negative territory YTD, although the BoE’s reassurance of “easy” policy has bolstered the currency over the past month. The biggest question mark here is whether or not policymakers will be able to loosen policy further just as the economy has started to show signs of recovery amid rising inflation fears.
Bank of Japan
The current benchmark rate in Japan is 0.10%, showcasing the “very easy” monetary policy enacted by the BoJ. The latest policy statement from the central bank revealed plans to increase the monetary base at an annual pace of about 60-70 trillion yen; government bond-repurchases are expected to increase at an annual pace of about 50 trillion yen [see How To Invest Overseas Without Currency Risk].
The Japanese yen has seen strenuous headwinds in the foreign exchange market as policymakers have fought to devalue the exporter’s currency; as a result, growth has picked up moderately, prompting BoJ officials to maintain the current policy as it finally appears to be translating into meaningful economic improvements. The biggest risk here is whether or not policymakers can stick to the “very loose” policy as growth continues to pick up in the face of rising inflation fears.
Reserve Bank of Australia
While all of the above central banks have been sticking to “easy” monetary policies for quite some time now, the Reserve Bank of Australia appears to be late to the trend as this bank has only recently started to embrace a more accommodative stance. Following the most recent bank meeting, officials decided to lower the cash rate to 2.50%, marking the second rate cut this year. Australia was quick to start raising rates in mid-2009 when much of the developed world was still stabilizing following the financial crisis; however, the recent slowdown in China and sluggish growth in Europe and the U.S. have brought this commodity-centric nation to the very brink of recession.
The biggest risk here is what policymakers can try to further stimulate growth as weakness in the nation’s prominent mining sector is expected to persist. A worsening unemployment rate has also caused concern for policymakers and may prompt further monetary easing; the Aussie dollar is already down upwards of 10% YTD, although further downside is very probable as “easy” policies likely aren’t tightening anytime soon.
The Bottom Line
Despite the critics, the Federal Reserve appears to be the clear leader here when it comes to setting policy. Fed officials received a lot of heat (and still do) when Quantitative Easing was first introduced in late 2008; however, it is becoming quite clear that austerity does not work, as evidenced by the fact that European and Japanase policymakers are embracing “easy” monetary policies in an effort to spur growth. Investors should keep an eye on how the various monetary policies change as economic conditions improve because shifts in central bank policy have a meaningful impact on asset classes across the globe, and not just on the home currency and domestic stock market.
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Disclosure: No positions at time of writing.
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