December 5, 2019 | By: Tom Nakamura

Currency (Tug of) War

3.5 min read

Emerging market currencies are likely to provide the best opportunity in 2020.

 

Currencies are in a tug-of-war. Pulling from one side of the rope is ample central bank liquidity, partial progress and healing of trade war issues, and muted inflation pressures which together buoy global growth expectations. At face value, these factors would be expected to create a natural tailwind for many emerging market (EM) currencies as well as currencies with pro-cyclical tendencies, such as the Canadian dollar, Australian dollar and the Norwegian krone.

Tugging against these strengthening factors, however, are recession worries amplified by fragile growth, ongoing trade disputes and fears of ineffective monetary policy stimulus. In this environment, foreign exchange (FX) markets are more likely to be range-bound, with a slight bias in favour of safe-haven currencies such as the U.S. dollar, Japanese yen and Swiss franc.

So, what side gives? Perhaps the former, at least to start the year. With global growth still likely to be muted, there simply isn’t enough economic improvement to “float all boats.” But that’s not where the tug-of-war necessarily ends.

While the players have changed, competing forces have been at play for several years now, resulting in uninspiring growth and inflation, as well as compressed FX volatility.

In currency markets, when sentiment is relatively balanced, and volatility is low, it is carry (or the yield differential) that tends to drive exchange rates. With the U.S. having the highest deposit rate in the G10, the U.S. dollar has enjoyed the dual benefits of being a high-carry currency in addition to its traditional role of being a safe-haven currency. However, as the tug-of-war unfolds, the greenback’s dominance may diminish.

 

USD Approaching Two Decades of Strength
$altTag
$altTag
Broad U.S. nominal effective exchange rate
BISBUSH Index (United States Nominal Effective Exchange Rate Broad) G3 Monthly
Copyright© 2019 Bloomberg Finance L.P. November 21, 2019.

Source: Bank of International Settlements (BIS)

U.S. elections are another key factor that will contribute to uncertainty. A re-election of President Trump could raise questions of whether his second term will be characterized by a more tempered approach to diplomacy or by an unfettered pursuit of ideology. On the other hand, reaction to a Democrat winning the White House will depend on who is at the top of the ticket; a centrist may be benign for markets, but a left-leaning leader is likely to create concern for U.S. growth prospects and be negative long term for the U.S. dollar.

Recent events in Hong Kong, Chile and Bolivia offer a reminder that social unrest is unfolding across the globe. Stalled improvements in quality of life and technology that enables the mobilization of like-minded citizens have made such episodes more commonplace. Discerning between currencies of countries where governments are either proactive or are effective and timely in their reactions will allow investors to capitalize on opportunities, particularly in emerging markets.

In our view, EM currencies are likely to provide the best opportunity in 2020. Many of the concerns noted have strong or outsized impacts on EM currencies. Absent a strong, broad trend in the U.S. dollar, selective exposures to EM currencies is our preferred approach to take in the coming year.

Tom Nakamura is a Vice-President and Portfolio Manager, Currency Strategy and Co-Head of Fixed Income at AGF Investments Inc. He is a regular contributor to AGF Perspectives.

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