The Fed’s long-awaited hike in interest rates went off without a hitch, causing barely a ripple in the FX market. It should have, though. Looking at the “dot plot” of Committee members’ forecasts for interest rates, the FOMC took half a rate hike out of 2016 but left the path of rate increases after that pretty well unchanged. They are still far above where the market is – the FOMC is forecasting four rate hikes a year in both 2016 and 2017 and perhaps three in 2018, while the market is discounting only about half that. One side or the other will have to adjust its expectations. I expect that the market will have to move more towards the Fed’s view. That change in market expectations is likely to continue to support the dollar.
Although changes in Fed and ECB policy have been dominating the headlines, the People’s Bank of China (PBoC), the Chinese central bank, also appears to be changing its monetary policy. It has allowed the CNY to weaken for an unusually long 10 consecutive days. I say “allowed the CNY to weaken,” not “weakened the CNY,” because CNY appears to be following the drop in CNH, the offshore Chinese currency that is freely traded.
One reason China may be allowing this move is that the PBoC is taking a different approach to what’s called the “Impossible Trinity.” It’s impossible for a country to have a stable currency, an independent monetary policy and free movement of capital in and out of the country. Until now China has given up free movement of capital in order to keep control of its currency and monetary policy.
Now, however, the authorities seem to be giving up control of the currency in order to free up the movement of capital. This change agrees with comments from PBoC officials that they want to move the country from a managed floating FX regime to a more flexible, market-based exchange rate system.
The implications of a free(r)-floating CNY are positive for USD and negative for AUD, NZD and the other commodity currencies. In the first instance, that’s because as Chinese investors sell CNY, they are obviously going to buy some other currency, and the likelihood is that they are going to be buying USD first and foremost.
Secondly, assuming that they buy from the PBoC, which will run down its FX reserves, that means China will be selling US Treasury bonds and therefore pushing US interest rates up. Of course it will also be selling some of its reserves in other currencies, such as EUR, but the ECB will be only too happy to buy the EUR-denominated bonds, thereby preventing a rise in rates there.
Finally, a weaker CNY is likely to dampen domestic demand for imports, and that’s bad for commodity producers that sell to the country. AUD and NZD would probably be hardest hit. Other EM commodity currencies, such as BRL and CLP, would also be affected.
In sum, while the Fed is starting to tighten monetary policy, the PBoC may be loosening up its monetary conditions by allowing its currency to weaken against the dollar, among other measures. That could provide a tailwind for the dollar and a headwind for the commodity currencies in 2016.