As central bank policies diverge, watch for greater movement in currencies than interest rates.
Synchronous global expansions can feed on themselves and produce periods of stronger growth — and indications of this have increased since last month. Evidence is mounting that the cycle is both quite robust across countries. Indeed, trade is now starting to grow more quickly.
Is growth about to reach the tipping point where wages accelerate and central banks risk falling behind the curve, leading to a decisive move upward in rates? The answer is no.
Exchange rates are the pressure valves
Certainly, some central banks are beginning to feel a little more confident about the outlook for their economies and their inflation targets. This is most clear in the case of the Bank of Canada, the Bank of England, and the Fed. But it’s not a uniform view, and this is important.
With the Bank of Japan (BoJ) holding its fire, and the European Central Bank (ECB) signaling it will be very slow to follow the Fed, it seems likely that any move by a central bank to tighten will result in a bigger move in currency exchange rates than in interest rates. Evidence includes the 12% move in the Canadian dollar from late April to early September, the 6% move in the euro versus the U.S. dollar from January to August as people began to price in the end of the European Central Bank’s (ECB) quantitative easing (QE), and the 3% move in the U.S. dollar in September as the Fed communicated plans for its balance sheet and the possibility of a further hike in December.
It seems likely that any move by a central bank to tighten will result in a bigger move in currency exchange rates than in interest rates.
Therefore, in the absence of an increase in global inflationary pressures, we think it likely that exchange-rate movements will be redistributing demand and supply, making it difficult for the more aggressive central banks to do very much at all. But with growth continuing at a reasonable pace, the environment seems likely to remain favorable for risky assets if the North Korean crisis does not worsen significantly.
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Against a backdrop of continued political challenges around the world, the global economy continues to do well and markets seem more encouraged by the growth than they are disconcerted by the political volatility.