“There is no such thing as a free market in fixed income anymore” states George Saravelos, Global Head of FX Research, in a new research report.
All developed central banks have cut rates to zero and buying trillions of assets. Inflation is very low. So essentially a global liquidity trap may be in the making. Deutsche Bank fixed income strategists argue that we are in a world of de facto yield curve control and
managed global yields. This should naturally mean a collapse in fixed income volatility, as documented in Japan's experience of controlling the JGB market.
In a world of international yield curve control and administered asset prices, what does that mean for FX?
If central banks can’t change yields or inflation, nothing changes in exchange rates either. In effect, this will serve to greatly diminish FX volatility originating from bond markets. Central bank interest rate announcements will lose relevance for FX, just like the Bank of Japan has lost relevance for the yen in Japan. But lower “monetary” volatility may mean higher volatility elsewhere. Exchange rates also react to financial and real economy shocks. Central banks that lose power to cushion shocks could lead to much higher volatility in FX. If the Fed or ECB were absent during the Lehman or Eurozone crises, FX dislocations would have been much higher.
The world’s key central banks have all said that they’ll do whatever it takes to restore economic growth to cushion the recession, and against the backdrop of low inflation and bond yields, it seems they have unlimited firepower – at least in the near term.
In a matter of weeks policymakers have become a backstop for private-sector credit markets. At the extreme, central banks could become permanent command economy agents administering equity and credit prices, aggressively subduing financial shocks. It would be a bi-polar world of financial repression with high real economy volatility but very low financial volatility. A "zombie" market.
Policymakers can always impact FX via selling infinite amounts of their own currencies. If central bank focus returns to FX this could be a new source of volatility. The SNB’s huge intervention program is a case in point. The current environment may eventually sow the seeds for “beggar thy neighbour” policies similar to the 1920s Great Depression.
So with the massive stimulus the world is beginning to receive, what are we to take away from how could the current environment may impact exchange rate volatility?
It’s ambivalent and depends on how far central banks are willing to go in pursuit of financial repression. The more central bankers control global asset prices, the more this could offset higher real economy volatility on exchange rates resulting from the exhaustion of policy space.
If you are a client of Deutsche Bank Research click here to read the full report from George Saravelos, Global Head of FX Research titled ‘The end of the free market: impact on currencies and beyond’
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