Tags: currency | economy | interest rates | global tensions

Why Currencies Are Poised for More Shifts

Monday, 04 Aug 2014 01:02 PM

By Mohamed A. El-Erian

The world’s major currencies, which had traded in a relatively stable range, are now in motion — buffeted by different regional growth and interest rates as well as a simmering brew of geopolitical tensions.

Differences are particularly noticeable between the U.S. and Europe, and how far apart currencies in those regions move will be a function of monetary policy at the European Central Bank (while the ECB meets this week, its major policy actions are likely to come in autumn).

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Last week’s economic data confirmed that the euro area and the U.S. are on quite different growth trajectories. Their banking systems are also in different stages of healing. The U.S. is growing faster and mending more quickly, so we should expect a widening diversion in monetary policies. Look for a gradually less accommodating Federal Reserve while the ECB seeks to further loosen its monetary and credit policies. In short, the dollar should continue to appreciate against the euro.

Geopolitical factors also favor a stronger dollar, largely because Europe is more economically and financially exposed to developments in Ukraine and the Middle East than the U.S. Moreover, the euro once enjoyed support from global traders chasing yields on peripheral eurozone bonds — but there is less capital at work in that realm now.

The key to the magnitude of these currency moves is in the hands of the ECB. If investors get the sense that the ECB is indeed loosening monetary policy further, as I believe it will, the euro could easily break through important resistance levels. Indeed, the euro could find itself trading below $1.30 after having flirted with the $1.40 range just three months ago.

Such a move would be further reinforced by two technical factors.

When investing in equities, many international investors do so without hedging their currency exposures — meaning they do not separate the risk from investing in global equities from possible losses (or gains) that could materialize due to currency moves. As such, sharp currency depreciations can also trigger significant equity sales, which, in turn, add fuel to currency moves.

Lower policy interest rates will also make the euro more desirable as a funding currency for traders, further causing capital markets to move away from investments in the euro area's government bonds and distressed credits.

I expect all of this to occur in the months to come, particularly when the ECB decides to take additional steps this autumn to loosen monetary policy — actions that it will deem necessary to help Europe grow and avoid deflation.

By itself, the policy move will not be enough to place Europe back on the path of high growth and robust job creation. But it will be sufficient to cause unusually calm and orderly currency markets to become much more volatile.

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