By Blu Putnam
Major central bank policies are diverging. Elevated exchange rate volatility may reflect the intensifying divergences.
The U.S. Federal Reserve has provided guidance that it expects to end its asset purchases by March 2022, and then commence the process of increasing short-term interest rates toward a more neutral policy. Federal funds futures markets suggest four rate hikes of a quarter percentage point, each with the possibility of occurring in 2022.
The European Central Bank (ECB) has indicated it plans on continuing versions of its asset purchase programs through 2022 and into 2023, and thinks it is much too early to contemplate increasing short-term rates. Currently, the ECB’s overnight deposit policy rate is in negative territory, and futures markets suggest the ECB policy rate could stay below zero all the way through 2022.
The Bank of Japan is welcoming the possibility of some inflation pressure, to break the back of several decades of consumers embracing the psychology of deflation. Asset purchases could likely continue, and no changes are anticipated in the near-zero interest rate policy.
The differentials in 10-year yield on government bonds are telling. U.S. 10-year Treasuries yield 1.8% more than German 10-year bonds and 1.6% more than the yield on 10-Year Japanese government bonds (or JGBs).
With exchange rates, many factors are influential, including geopolitical risks, relative economic growth, and a country’s ability to attract global capital flows. Differences in central bank policies, however, are always considered a key factor in modeling exchange rates.
Monetary policy is likely to be a headwind for the Japanese yen and the euro against the U.S. dollar, given the upcoming short-term interest rate hikes anticipated by the Fed. 2022 may possibly usher in more currency volatility than has been seen in a decade as central bank policies increasingly diverge.
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