Currency interventions here to stay?

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At time of writing, investors and market commentators are focused on the impact of (still) high inflation and subsequent monetary policy decisions on bond markets but they appear to have overlooked the potential consequences for currency risk. Yet, in our view, the new economic era we have entered entails not only more uncertainty and volatility in interest rates but also greater fluctuations in exchange rates. Hence, we believe understanding currency moves and how they impact economies can be an important asset in navigating increasingly volatile markets.

The growing risk of currency intervention

Currency intervention is a monetary policy action taken to moderate the pace or extent to which a currency appreciates or depreciates. This is done by changing the supply of the local currency and actively buying or selling foreign currencies at scale to reach the desired exchange rate. It is most often undertaken when the level of the local currency exchange rate is deemed to have moved out of alignment with underlying economic fundamentals. Policymakers buy or sell national reserves to stabilise the economy and control inflation by putting a stop to what is perceived to be excessive currency strengthening or weakening. While the line between currency intervention and manipulation can sometimes be blurred, large-scale interventions generally aim to address a broadly recognised imbalance in markets and often involve international cooperation or agreement. Occasionally, however, governments are accused of outright manipulation, attempting to unofficially distort the value of their currency to achieve a specific economic objective, most notably to (re)gain competitiveness in global markets and boost exports.

Lessons from the past
To be clear, intervention by policymakers to prop up or strategically devalue a currency is not new. As an example, in 1992, the UK withdrew sterling from the European Exchange Rate Mechanism (ERM) in a bid to stop speculative selling of the currency (an event known as “Black Wednesday”). At the time, the UK was slowly emerging from a steep recession caused by factors such as low competitiveness, high inflation and persistent current account deficits. However, policymakers kept interest rates high to prop up the value of sterling. When market participants became concerned that the currency’s exchange rate did not reflect these weaknesses, the monetary authorities responded with further rate hikes and then large-scale currency interventions. When these rate hikes and interventions became unsustainable, the UK abandoned the ERM, prompting a large-scale devaluation (Figure 1). While a brutal shock, it ultimately increased the UK’s competitiveness in global markets and spurred economic growth.

Figure 1

Similarly, other ERM currencies, most notably the Italian lira and Spanish peseta, went through various rounds of devaluations against the German mark, enabling them to maintain export competitiveness. And back in the 1980s, the G7 countries sought a strategic devaluation of the US dollar through coordinated efforts (the Plaza and Louvre Accords), with the aim of addressing major imbalances in the global economy.

What does this mean for investors?

Since the introduction of the euro, active currency intervention has mostly occurred in emerging markets, most notably in Argentina and Turkey. Among developed economies, the use of active currency management has been limited to Switzerland, as the safe-haven status of the Swiss franc has, at times, posed a risk for the Swiss economy and the effectiveness of its monetary policy.

However, intervention has become more frequent in the last two years. We have seen Japan’s Ministry of Finance step into markets with tens of billions of US dollars to shore up the value of the Japanese yen while the Chinese authorities appear to be allowing the renminbi to float more freely in global markets in an attempt to devalue the currency and improve competitiveness. There has even been speculation that some Trump advisers are in favour of including currency intervention in the US government’s economic toolkit, should the Republican Party regain control of the administration. While on the surface implausible, such a move would be bold and unprecedented in recent history.

The inevitable conclusion is that once a critical mass of countries engage in active currency manipulation, a sort of prisoner’s dilemma ensues: there is no advantage in not taking part. This has potentially significant implications for investors and allocators:

Investments in global fixed income markets can continue to provide significant benefits in an environment of higher currency volatility, including diversification from domestic markets. In this context, increased currency volatility needn’t be only a risk to hedge. It can present opportunities for consistent alpha generation too.
Equity investors without a hedging programme may find their gains eroded in the event of significant currency moves.
The disintermediation of the US dollar as the global reserve currency seems unlikely for now but is an increasing tail risk.