Diverging paths could create turbulence in currency markets

Economy July 23, 2014 00:00

By Komsorn Prakobphol

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In the wake of the 2008 financial crisis, central banks around the world cut interest rates to near zero and injected massive amounts of liquidity into financial markets in a concerted effort to shore up financial systems and support economic recovery.

Six years later, some economies have recovered more strongly than others and we are at the point where the world’s main central banks may go their separate ways in terms of monetary policy. 
The US has been withdrawing monetary support to its economy since December last year when the Fed started to wind down its quantitative-easing (QE) programme in light of robust improvement in the country’s labour and property markets. 
The US unemployment rate has been declining and is approaching the Fed’s target at 6.1 per cent, while CPI inflation has picked up rapidly to 2.1 per cent from just above 1 per cent in March. Many expect the Fed to end QE in October this year and to raise its interest-rate target by the first half of 2015.
The Bank of Japan and the European Central Bank, on the other hand, are still muddling through the early stage of economic recovery, and are hence maintaining their easing bias. 
Weak euro-zone inflation has stirred market expectations of further stimulus measures from the European Central Bank, while the Bank of Japan has also hinted that it will step up its QE programme if inflation fails to hit the target.
The divergence in policies could most likely create upward pressure on the dollar and US bond yields. It also runs the risk of creating turbulence in emerging-market currencies, similar to what happened in the third quarter of 2013 and in January this year. 
Volatility in emerging-market stocks and bonds could rise in tandem with currency markets. Most vulnerable are countries that run a large current-account deficit and hold small foreign reserves, such as Brazil, South Africa and Turkey, and to a lesser extent India and Indonesia.
Export-driven economies such as South Korea, Taiwan and Japan could benefit from this trend as a strong dollar supports profit-margin expansion for exporters and a large current-account surplus and ample foreign reserves help limit fund outflow. 
Komsorn Prakobphol is a senior investment strategist at Tisco Economic Strategy Unit. He can be reached via www.tiscowealth.com or www.komsorn@tisco.co.th.