How the Global Economy Is Affecting the Foreign Exchange

August 7, 2015

The global economy has a lot to tell us about how major currencies are moving—find out how the dollar, renminbi, kroner, peso and euro have been affected by economic shifts.

The Federal Reserve appears committed to raising interest rates later this year, which may open the window for further gains by the US Dollar sometime this winter. If the Fed raises rates before the end of the year, as many anticipate, the US will likely—briefly—become the sole G10 nation that’s tightening its monetary policy. And as real interest rates in the US move into positive territory, the dollar could build upon its already strong position; however, the prospect of European tightening in 2016 may limit the potential for additional gains.

As the US economy rebounds from a slow start in early 2015 and continues to gain momentum, many analysts anticipate that the Federal Reserve may begin the long process of normalizing interest rates before the new year. If the economy continues to create jobs at its current rate, mounting inflationary pressure could compel the Fed to take action as soon as September. Futures markets anticipate an initial hike of 50 basis points coming this fall, with the possibility of an additional 50-point hike in the following months.

Anticipating the Fed’s actions in 2016 is more difficult—interest rates have hovered near zero for so long that no one can predict how the economy will respond to this fall's first—but likely modest—hike. The Fed has set a long-term target for interest rates at 4 percent, but the timing for further normalization depends on the resilience of inflation after interest rates begin to rise. If the economy continues gaining momentum into the spring of 2016 and the labor market tightens further, the Fed may feel justified in pursuing a relatively quick series of hikes; conversely, if inflationary pressure melts in the face of positive real interest rates, the timing of normalization could be extended indefinitely.

Although the dollar may gain value immediately following the initial rate hike, the window for its rise may prove short-lived. If further rate hikes are delayed until late 2016, tightening policies in Europe have the potential to restore balance to currency markets. The European Central Bank has indicated that it will begin tapering its asset purchasing program in the summer or fall of next year, and the Bank of England is preparing to raise interest rates much sooner, perhaps as early as this winter. If the rest of the developed world moves closer into alignment with US policy, the dollar’s potential for further gains may be curtailed—which will likely be welcome news for exporters who have been hurt by the rising dollar.

China Slumps, and Commodities Slide

The Chinese stock market suffered a steep decline in July, retreating sharply after several months of skyrocketing share prices. Although the market’s tumble will likely do little to diminish China's extraordinary potential for long-term growth, the slowdown has sent commodity prices sliding. Commodities futures reflect expectations that Chinese demand will likely remain weak throughout the winter, with China’s economic growth likely slowing to 6 percent in the new year.

The decline has yet to push the Chinese Renminbi downward, but falling demand has hurt the balance of trade for commodities exporters. Australia and Brazil have felt the pinch from weak Chinese demand for steel. The fall of iron ore prices—from $60 to $50 per ton—has hurt the balance of trade for exporters, pushing their currencies down. Korea, which has strong trading ties to China, saw its currency fall 3 percent in the wake of the Chinese stock market’s fall.

Oil Slips, Punishing Exporters

Following last year's price collapse, a persistent global oil oversupply has prevented prices from recovering, which has put downward pressure on exporters' currencies. Oil briefly flirted with $60 per barrel this spring before falling back to $52 in June, and capital investment in the world's oilfields remains weak.

The Norwegian Kroner lost 5 percent against the US Dollar last month, making the oil-rich nation's currency the worst performing in the developed world in June. And undoubtedly, Norway’s underlying economic problems are likely compounding the damage from cheap oil—the Kroner’s slide may also be attributed to the Norges Bank's decision to cut interest rates in the face of falling industrial output and slumping retail sales.

Soft oil prices also spoiled the highly anticipated opening of Mexican oilfields to direct foreign investment. Mexico had hoped to auction off up to $17 billion in oilfield assets to foreign investors; the auction had the potential to nearly double the nation's total foreign direct investment for the year. Instead, only two of 14 lots were sold, raising a disappointing $2.6 billion. Weakening GDP growth and lackluster inflation are likely to further slow the Mexican Peso’s recovery from last year’s oil-price collapse.

Greece Stays—and So Do Its Problems

The euro hardly budged in reaction to the Greek bailout, a sign that Greece's ongoing crisis has lost the potential to surprise investors. Private sector investors have largely unwound their exposure to Greek debt, limiting the bailout’s potential to roil markets. Although Greece has secured its place in the eurozone for the time being, its ability to meet expectations in the long term remains unclear. Fortunately, the political fallout from the crisis has been limited to Greece itself—support for Euroskeptic parties elsewhere in Europe remains limited, and anxiety over the currency union’s future viability has largely been quelled.

Source: J.P. Morgan Global FX Strategy & Global EM Research, Key Currency Views, published July 17, 2015.