Evergrande’s situation in China, persistently rising commodity prices, rising inflation in the United States, labor and supply shortages in several economies, the evolution of the pandemic, and central bank interventionism should support the growth of uncertainty in the markets. The “100 dollars” question is what will happen to interest rate differentials between different economies in the context of pandemic, or its end?
A default by the Chinese group Evergrande would be dangerous for the Chinese real estate market, a sector representing nearly a quarter of this economy. While exports can offset the sector’s problems, this strength stems from global supply backlogs and pandemic-related orders, a situation that is expected to be resolved in 2022.
The eurozone, meanwhile, has emerged from recession and GDP growth is expected to be around 2%. Nothing can justify for the moment a rise in interest rates soon with the commitment of the European Central Bank to continue its liquidity injections and inflation that we see returning below 2%.
However, in Britain, with industrial production accelerating growth, labour market pressure, and inflation expected to cross the 4% mark, observers expect the Bank of England to raise its policy rate.
In Canada, strong consumption growth, supply chain problems, product shortages and rising oil prices are pushing inflation higher. On the other hand, the Bank of Canada is rather categorical, it considers that this inflationary surge is transitory. That attitude seems to be shared by the European Central Bank.
The United States, for its part, is not expected to raise rates before the end of 2022, the relative weakness of the US Dollar should continue, especially against the currencies of countries strong in raw materials. Moreover, the European Union indicating its desire to keep interest rates at their current levels until 2025, businesses should expect a strong British Pound and a relatively weaker Euro.
Inflation is also on the rise in emerging countries. The latter must act firmly because the risk of inflation getting out of control in these countries is higher. However, some nations with in-demand commodities (such as Russia with gas and oil) could see their currencies appreciate.
There is a downside however on all those expectations. A series of economic problems generate strong hesitations in the currency markets even if interest rate differentials change. There is a chronic shortage of raw materials and goods in different business sectors in addition to a significant delay in order books worldwide.
In short, the macroeconomic context is characterized by a deep shortage of goods combined with a system of central banks, that, for several years, has been constantly injecting money into economies. Therefore, this generalized surplus of liquidity combined with a limited supply of products, can do no other than push prices up. In addition, labour shortages are pushing wages higher. When these increases become too strong, companies increase the prices charged to their customers… Another support for inflation.
The new “100 dollars” question becomes: How will inflation affect currencies? Central bank’s handling of inflation adds to a very significant level of uncertainty, as the world is barely recovering from the economic impact of the pandemic. Market operators are worried.
The European Central Bank does not envisage tightening its monetary policy, while the Bank of England and the US Federal Reserve point to the contrary. The Bank of Canada is “observing” the transition to a post-pandemic economy. It does not see supply chain disruptions and price pressure as a reason to tighten monetary policy.
The Central Bank of China (PBOC), with the Evergrande saga and recent fears of a slowdown in its economy due to a credit and energy crisis (coal and natural gas shortages) in the country, must take more measures and inject more and more funds. For the time being, inflation in China remains low but is not without upside risks.
However, while some sectors remain fragile, the global recovery is V-shaped. The volatility of commodity prices, the uncertainty surrounding the monetary policies of individual central banks in the face of recent fluctuations of inflation, and the resulting increasing currency volatility are of concern. It will be necessary to relearn how to trade in a context of inflation; it has been more than 20 years since this problem came off the radar screen.
In fact, free trade restrictions caused by a new covid-19 surge (another unexpected increase in energy prices or continued labour shortages) would likely create significant difficulties for growth and for the currencies of the most affected countries, despite the actions of central banks, at least in the short term. The phasing out of quantitative easing and the realignment of inter-country interest rate differentials will be to watch as central banks will have divergent monetary policies.
In the face of this growing uncertainty, you must be able to follow your hedging strategy to ensure that it remains effective. In this sense, building your currency risk management strategy should be as simple as possible. Complications slow down processes, restrict resources and can lead to costly errors.
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