Diverging central bank policies create potential for trending forex markets
A very clear divergence has emerged between the major central banks, those that are beginning to think about inflationary risks and those that are still wary of deflation – for the forex markets that spells the potential for trends.
Of the big central banks, the Bank of England looks to be at the most advanced stage. It's quantitative easing programme has already stopped and it is now preparing the UK for interest rate rises. This has created a nice run for GBP versus USD and the EUR. The US Federal Reserve is a bit further behind as it is still winding down its QE programme, but sometime next year it could also be tightening.
Meanwhile, the Bank of Japan is still committed to its huge QE programme and to reinflating the Japanese economy. However, May CPI hit 3.4% and Q1 GDP expanded at an annualised 6.7% – both racy numbers. If they prove to be a trend – that's by no means assured – then the BoJ will soon be joining the BoE and Fed in reining in its ultra lose monetary policy.
And now for the laggard – the ECB
That leaves the European Central Bank – the laggard of the majors – to ramp up more aggressive measures to kick start the Eurozone economy and fend off potential deflationary pressures. This is in contrast to its previous actions which were dedicated to holding the EUR together and bailing out struggling Eurozone banks.
ECB President Mario Draghi and his colleagues have observed the monetary stimulus actions of the Fed, BoE and BoJ – all largely judged a success by the markets so far. And with Eurozone inflation at just 0.5% the ECB has the opportunity to pursue more aggressive stimulus plans of its own
One of the ECB's key lending rates is now negative, there is a desire to give banks four years cheap credit facilities to incentivise them to lend more and to develop an asset backed market to fund businesses. Outright QE is still only an option at this stage – in effect Draghi appears to want any stimulus to go directly to the real economy rather than funding equity and bond market rallies as seen with the Fed's actions.
Given these four central banks are at different stages in the monetary cycle there are clear opportunities for trending forex markets. This will be all the more so if the four economies concerned start to grow sustainably. It will remove pressure for 'currency cars' to promote exports.
At some point EUR & JPY will rally
The rally potential for GBP and USD is well understood by the markets with the prospect of tightening monetary policy in the US and UK increasingly being priced in.
However, as the ECB and BoJ advance in their monetary cycles markets will begin to price in less lose monetary policies presenting an opportunity for EUR and JPY to rally from relatively low levels. The more the world economy improves the faster those monetary cycles could turn and that could happen in a 12-18 month time frame.
Those traders who get in early on those trends when they turn stand to do well.
By Justin Pugsley, Markets Analyst
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