Source: Refinitiv Datastream Date: 27/07/2021

The battle against the virus still has some way to go, but vaccinations have accelerated. In countries with high vaccination rates, the risk of significant curbs being reimposed has diminished, despite the fast spread of new variants. One of the main examples is the UK, where nearly 70% of the population have received at least one vaccine dose. While caseloads have rocketed back up to more than 40,000 per day this month, the number of new hospitalisations and deaths caused by the virus in this wave has, so far, been significantly lower than at the same stage in previous waves (Figure 2). The UK can be viewed as somewhat of a proxy for other developed nations with similar vaccination rates, particularly the US and most of the EU.

Figure 2: UK New COVID-19 Cases & Deaths [2nd Wave vs. 3rd Wave]

Source: Refinitiv Datastream Date: 27/07/2021

Countries with low vaccination rates, particularly emerging market ones, remain vulnerable. In many of them the new variants have resulted in a significant increase in contagion levels. India has been a prime example of this, although we’ve also seen a surge in infection in other countries in Southeast Asia as a result of the delta variant. Now that most of the populations have been vaccinated in the key economic areas, risks related to the spread of these variants have largely eased. For the most part, we are seeing idiosyncratic moves in exchange rates of those countries that are posting sharp increases in cases coupled with significant jumps in hospitalisations and deaths.

With vaccination programmes now in full swing, and inflationary pressures rising around the world, market attention has shifted towards the more conventional topic of monetary policy. Following the sharp increase in global inflation, we have witnessed a number of central banks becoming less dovish since the beginning of the year. A handful of emerging market ones have already begun the process of raising interest rates. In March, central banks in both Brazil and Russia commenced hiking cycles. Since then, both central banks have raised rates by a total of 225 basis points, while keeping the door open to further tightening.

We saw similar developments in Central and Eastern Europe in June, with central banks in both Hungary and Czech Republic hiking rates and suggesting they might continue doing so at upcoming meetings. In the case of Hungary, it was the first such move in a decade and was followed by a larger-than-expected hike in July. Mexico also tightened policy in the summer, with Banxico unexpectedly hiking its base rate by 25 basis points to 4.25% in June, although it’s unclear whether this marks the start of a tightening cycle.

The main developed economies have seen so far few actual steps towards monetary or fiscal tightening, but are seeing a tentative shift in tone nonetheless as inflationary pressures increase globally (Figure 3). A sharp increase in commodity prices, faster than expected rebounds in economic activity and a tightening in labour market conditions have forced major central banks to revise upwards their inflation projections. A number of policymakers expect the period of ultra-loose monetary policy to end sooner than previously thought.

Figure 3: G10 3-month Annualised Core Inflation Rate (latest available)

Source: Refinitiv Datastream Date: 27/07/2021

Looking at G10 countries, the Bank of Canada has already begun tapering its QE programme, reducing the pace of weekly purchases from CAD$4 billion to CAD$2 billion. The Bank of England slowed the pace of its weekly purchases from £4.4 billion from £3.4 billion in May, albeit emphasised that the action ‘should not be interpreted as a change in the stance of monetary policy’. Nonetheless, with the bank expecting inflation to reach 3% or more in late-2021, the need for tapering appears to have been brought forward. At its July meeting, the Reserve Bank of New Zealand also surprised investors by announcing it will end its NZ$100 billion QE programme effective on 23rd July.

Among the G10 nations, a handful have already started talking about increasing interest rates or are, at least, flirting with the idea. We think that Norway is likely to be the first to raise rates. Norway is, however, somewhat of an outlier given that it has among the most negative real rates in the G10 and hasn’t launched a QE programme during the pandemic period. The bank’s June communication suggests that a hike may be just around the corner. Øystein Olsen, Norges Bank Governor, stated after the meeting that ‘the policy rate will most likely be raised in September’. New Zealand’s QE announcement has also raised expectations of higher rates, possibly as soon as the bank’s August meeting. We think we’ll see at least these two announce their first hikes before the end of 2021, with more G10 central banks set to commence their hiking cycle in 2022. The currencies of those G10 countries on course to raise rates before the end of 2022 look well placed to outperform and are, indeed, among those that we expect to perform the best over our forecast horizon.

Figure 4: Expected Timing of G10 Interest Rate Hikes [based on market pricing*]

Source: Ebury/Bloomberg Date: 27/07/2021

*assumes 15 basis point hike for BoE and RBA, 25 basis points for rest

The most important monetary policy maker worldwide remains the Federal Reserve, sometimes described as ‘the world’s central bank’. The Fed’s policy stance is particularly important for those emerging market countries that are heavily dependent on external financing in US dollars. The FOMC’s June meeting delivered an unexpected hawkish shift, with most policymakers now pencilling in at least two interest rate hikes before the end of 2023. The market reacted by pushing the US dollar higher, at the expense of EM currencies. Fed policy tightening could pressure these currencies lower. The latest ‘dot plot’ suggests that higher interest rates may not be on the cards for at least another year-and-a-half or so (Figure 5), although we wouldn’t be surprised to see another upward shift in these projections in September.

Figure 5: FOMC ‘Dot Plot’ [June 2021]

Source: Refinitiv Datastream Date: 27/07/2021

We think that a tightening of monetary policy in the US could work in favour of the dollar, particularly against currencies of those countries whose central banks fail to follow suit. That being said, we think that many EM currencies should be able to withstand the depreciating pressure by engaging in their own tightening cycles. Indeed, the market is currently either pricing in a continuation or the start of a tightening cycle in most EM countries over the coming twelve months, particularly in Latin America and Europe. This supports our bullish view of these currencies over the medium-term. Moreover, the political pressure against policy tightening in the US suggests the gap between FOMC rhetoric and actual interest rate moves may be quite large. This would ensure that the rate gap with the US may grow in favour of EM currencies for some time yet.

We have listed below upcoming central bank monetary policy meeting dates for the G10 and key emerging market countries between now and the end of the year. Volatility in the FX market is likely to be heightened around the time of these decisions.

*NLT=no later than

Sources: Central bank websites, Bloomberg

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