Currency movements have been a big driver of investment returns over the past 18 months, including three trends in particular: A rising U.S. dollar, a selloff in emerging market (EM) currencies and a weakening yuan, according to BlackRock research. The members of the BlackRock Investment Institute recently discussed the factors behind these trends and debated whether they’re likely to continue in 2016. Here’s where we ended up.
Has the era of U.S. dollar appreciation ended?
In the aftermath of the global financial crisis, broad changes in global investor risk sentiment were important drivers of currency movements, at times driving more than 50 percent of the fluctuations, according to BlackRock analysis. See the chart below.
Things started to change in 2014, with the prospect of monetary policy divergence. As the Federal Reserve (Fed) prepared for “liftoff” while the European Central Bank (ECB) and Bank of Japan (BoJ) eased further, policy sensitive two-year yields reflected growing expected policy divergence. See the chart below.
This was the key driver of the dollar’s sustained appreciation against the euro and the yen in 2014. However, by early 2015, the dollar’s rise petered out. The policy divergence theme has since appeared largely baked into currency values, even as central bank policies have continued to diverge. Surprises about the pace of divergence have led to many (range-bound) reversals, but the dollar has been broadly flat against both currencies over the last year. See the chart below.
Looking forward, the dollar has room to rise further. Trends tend to last for a long time in currency markets. The big question is what could lead to another burst of sustained appreciation. News about the pace of Fed normalization, or ECB and BoJ easing, will continue to influence the dollar. This was evident mid-month when the dollar fell after the Fed cut the number of rate hikes it expects to make in 2016.
But ongoing policy divergence is already expected. More is needed to experience another leg of sustained dollar appreciation. This “more” could be a substantial change in the monetary policy regime; for instance, a faster Fed normalization path than expected. Or, with the U.S. economy in structurally better shape than many other economies, a reduction in perceived global risks could be another catalyst. At the same time, with risks to the global economy and markets looming (think Brexit, global deflation fears, China devaluation, etc…), risk-off sentiment could also reassert itself as a driver of dollar strength.
Will EM currencies continue to depreciate?
In contrast to the movements of the euro and the yen, EM currency depreciation has been ongoing. EM currencies overall have lost a third of their value since 2013 on a trade-weighted basis, triggered by serial downgrades to EM growth projections, a tightening of global dollar liquidity and falling oil prices. See the chart below.
This downward adjustment in EM currencies has already been significant, of an order of magnitude seen in previous financial crises. Lately, EM currencies appear to have halted their free fall and some are showing signs of bottoming out.
Whether this turnaround is for real is a matter of debate. On the one hand, EM currencies look cheap. Many appear to have overshot from a fundamental point of view—they have fallen enough to mend trade and current account balances. A stabilization in oil prices would also support currencies of oil exporting countries. On the other hand, the nascent recovery appears mostly a reflection of dollar weakness—not EM strength. A strong dollar has been, and still is, the main foe of EM currency appreciation. Expectations of a more rapid pace of Fed rate hikes would challenge this recovery, as would another round of global risk-off moves. Plus, some EM currencies arguably overshot on the upside during the commodity boom years.
But there is a “sweet spot” of ongoing dollar appreciation for EM currencies and markets. This scenario is one where financial market volatility is contained and U.S. growth is strong enough to support the global outlook, but U.S. inflation remains subdued enough to keep the Fed from a significantly more rapid rate normalization path.
Is a big yuan devaluation on the horizon?
The fate of the Chinese yuan is the biggest wild card around the currency outlook. A big devaluation would be a major shock for EMs and would lead to a global risk-off sentiment in markets. The Chinese authorities don’t seem to want this scenario. In fact, they have focused a lot of resources on preventing a big devaluation from happening. But the risk centers on what the Chinese people want to do with their capital. As long as they keep it in China, the risk is contained. But if the Chinese decide to move their capital out of the country, this exodus will put further pressure on the yuan with accelerating outflows. This cycle can quickly become self-fulfilling and once you reach that point, authorities’ intentions become irrelevant.
However, a big devaluation isn’t BlackRock’s base case. This is mainly because we think it’s in no one’s interest, a view corroborated by the communiqué out of the recent G20 meeting in Shanghai.In the near term, there’s plenty authorities can do to slow the capital outflows while allowing a mild yuan depreciation of 5 percent to 10 percent over the next year. That said, a strong dollar appreciation could prove challenging, and this will test the Chinese authorities’ determination to stay ahead of the devaluation curve.
Jean Boivin, PhD, is head of economic and markets research at the Blackrock Investment Institute. He is a regular contributor to The Blog.