Currency analysts are lamenting an avalanche of cheap money from the US Federal Reserve, which they say has created bizarre conditions in which exchange rates track stocks rather than economic fundamentals.
For decades, strategists have analysed exchange rates on the basis of the outlook for growth and interest rates in the countries concerned. Generally, the better the prospects, the better the currency can be expected to perform.
But that relationship has broken down since March’s market rout, analysts say. As the global economy moves towards one of its worst recessions in history, currencies that are usually most sensitive to growth have become the best performers against the US dollar.
The Australian dollar, for example, which usually weakens when demand drops, has gained about 18 per cent against its US counterpart over that period — despite Covid-19 disruption to global trade hitting the export-dependent economy hard. Sterling, meanwhile, has climbed about 9 per cent despite difficult Brexit negotiations, mounting UK unemployment and a collapse in economic output. The OECD predicts the UK will suffer the largest contraction this year among advanced economies.
Ben Randol, a currency strategist at Bank of America, said fundamental economic indicators have not mattered for currencies since the Fed’s series of interventions in March. Instead, US equity markets have become the significant driver of the value of the dollar, which has weakened as stocks have soared.
The situation was “antithetical to the way FX markets are supposed to work,” said Mr Randol.
“FX trading has been reduced to a leap of faith in the Fed ‘put’,” he added, alluding to the belief that the central bank will always be on hand with measures to alleviate shocks to asset prices. “Macro factors . . . and terms of trade have simply not been relevant.”
According to the bank’s analysis, the correlation between equity prices and major currencies is at its strongest for 15 years, turning currency pairs into a “blatant reflection” of US stock markets.
Dominic Bunning, a currency strategist at HSBC, agrees that the relationship between the two has been unusually close since March, meaning that “as the S&P 500 falls, the dollar rallies . . . as the S&P 500 recovers, the dollar sells off”.
Analysts say it is very rare for stocks and currencies to move in near-lockstep for a sustained period. Mr Randol said the last time equity prices appeared to drive exchange rates was during a two-week period in August 2014, and before then, in September 2009, when the dollar weakened and equity markets rebounded. But the global economy had already shown signs of a recovery by that point in the last financial crisis. Today, the economic data is still deteriorating.
Strategists attribute the recent moves to the radical actions of central banks and governments to fend off the worst effects of the pandemic. Since the start of the Covid-19 crisis, interest rates in major economies have been slashed to near zero, wiping out an important metric for assessing currencies. At the same time, governments around the world implemented lockdowns, creating huge uncertainty about the path of the global economy that has forced analysts to scrap their previous projections.
At the height of the volatility, and as analysts lacked a lot of their usual valuation inputs, central banks’ vast bond-buying programmes gave investors something to fix on. Ugo Lancioni, head of global currency at Neuberger Berman, said: “After 11 years of [quantitative easing] we know that it lifts asset prices even if fundamentals are not there yet.”
The combination of rate cuts, asset-purchasing programmes and massive fiscal stimulus sparked a dramatic rally in share prices — which dragged foreign exchange markets along too. HSBC’s Mr Bunning said: “With too much to digest and vast lingering uncertainty, FX fell into the welcoming arms of [risk sentiment].”
Normal market relationships may be starting to re-establish themselves. Analysts say interest rate differentials are starting to play a bigger role again, with investors distinguishing between currencies as the various relief programmes from central banks sink in.
But without a clearer understanding of the economic impact of Covid-19, or a resolution of tensions between the US and China, broader sentiment will continue to drive the currency market, said Neil Williams, a senior economic adviser at asset manager Federated Hermes.
“I find there is a lack of consensus and everyone is confused about the world,” said Neuberger Berman’s Mr Lancioni. “The big challenge is figuring out the right value for the dollar and I don’t think the market has got there yet.”