Column: ‘Terminal inflation’ jostles with ‘terminal rate’ :Mike Dolan

LONDON, March 4 (Reuters) – Terminal inflation rates more than terminal interest rates may be a better guide to how world currencies surf the post-pandemic world and war-driven commodities shock.

As major central banks prepare to normalise super-loose monetary policies and near zero interest rates in the face of surging oil and food costs – driven by economies re-opening and spurred by Russia’s invasion of Ukraine – there’s much anxiety about just how high interest rates will need to go.

Markets talk of ‘terminal’ interest rates as the high point of the coming cycle. Even though the U.S. Federal Reserve, for example, points to a ‘neutral’ rate between 2-2.5%, and its determination to go higher if necessary, futures markets still doubt it and see rates topping out next year around 2% or below. read more

Getting this horizon right is critical for borrowers needing to plan and for stock and bond markets pricing ahead.

But for currencies, it’s long-term inflation differentials that should typically determine value over time.

And so where markets assume inflation rates end up – which is itself a function of their trust in either the willingness or ability of each central bank to get price rises back down to target – is as important as relative terminal interest rates.

And in some respects that peak interest rate will reflect what a central bank is willing to tolerate on the inflation front – not least if there’s a sharper trade-off between ever tighter policy and growth or employment over that timespan.

In a report last week Bank of America’s Athanasios Vamvakidis sketched out this arced trajectory of a higher U.S. dollar today quickly giving way as U.S. inflation dynamics erode it over time relative to Japan, the euro zone and Switzerland.

A more aggressive Fed tightening this year underpins the dollar against the euro now. But if U.S. inflation likely settles above the 2% longer term – as BofA forecast – and Europe’s and Japan’s subsides back below, it tallies with a return of euro/dollar’s exchange back as high as $1.20 by 2024.

“A lot depends on central bank credibility,” Vamvakidis wrote, arguing faith in central banks’ inflation fighting pedigree means higher inflation rates today sees higher interest rates follow and boosts the currency.

But beyond the short term? “With inflation currently above target in most of G10, the FX implications also depend on where countries will end up.”

“Countries with permanently higher inflation will also end up with weaker currencies,” wrote Vamvakidis.”Otherwise, countries with low inflation will keep becoming more competitive, with a permanent downward trend to their real exchange rate and an undervalued currency. Of course, the correlation goes both ways.

MONEY AND INFLATION

Of course there are myriad influences on exchanges rates over the short term – relative growth and interest rates, high-frequency economic soundings, fiscal policy mixes, shifting sentiment on geopolitics or elections, and the ebb and flow of speculative, investment or trade flows.

But just as inflation dictates the value of the dollar or euro in your pocket – by measuring how much bread and milk and goods and services you can buy with it year to year – it also affects the relative competitiveness of an economy and its businesses abroad – and hence its exchange rate.

Put another way, if higher inflation weakens the purchasing power of a currency domestically, then relatively higher inflation, alongside wage growth and input costs, weakens that currency externally as exchange rates shift to compensate for lost competitiveness. Or so the theory goes.

The issue goes to the heart of the ‘carry trade’ anomaly, where traders seek out short term bets by borrowing currencies with low funding rates to deposit in a higher yielding one – pocket the gap as long as the exchange rate doesn’t gyrate.

As these are typically short term bets, little heed is paid to the real reason why rates are higher in the first – and often it’s due to an chronic inflation problem.

As carry trades typically work in times of low volatility, we may be at a juncture. World FX markets have just been through a period of extraordinarily low volatility for the major currencies – partly because of years in which inflation rates and inflation expectations in the world’s biggest economies had all converged below 2% targets.

That world may now be ending.

The CVIX index (.DBCVIX) of implied volatility across the major currencies hit a record low on the eve of the pandemic – but had doubled since then. Even so, euro/dollar’s three-month implied vol remains below its 30-year average.

If inflation differentials take greater precedence over ‘carry’ in a more volatile work, what to look at?

As uncertain and frenetic as economic and political circumstances are right now, market assumptions of long-term inflation and ‘real’ inflation-adjusted rate differentials hove into view.

On that score, U.S. 10-year inflation expectations at more than 2.7% are more than a half percentage point higher than euro equivalents even as the Fed moves sooner than the European Central Bank to raise rates. But the oil price over Ukraine has seen the latter surge above 2% too.

A tough-talking Fed is getting currency traction today as the dollar zooms higher. But it may have to match words with action over the year ahead to keep it up here.

The author is editor-at-large for finance and markets at Reuters News. Any views expressed here are his own.

by Mike Dolan, Twitter: @reutersMikeD
Editing by Alexandra Hudson

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