Rate spreads to remain the key driver of G10 FX – Nomura

Analysts at Nomura believe rate spreads and monetary policy stances will remain the key drivers of G10 FX into 2018, for three reasons. 

Key Quotes

 “First, a low volatility environment tends to increase the importance of rate spreads as the driver of the G10 FX market. Obviously, the sustainability of a low-volatility environment in the global financial market needs to be kept in check, but our main scenario is that global economic expansion continues into 2018. There will be event risks ahead and an occasional risk-off type reaction is unlikely to be avoidable, but given the benign global economic environment, we think volatility will be contained. Consequently, the importance of rate spreads will remain intact.” 

“Second, higher FX sensitivity to rate spreads is also explained by smaller divergence in the interest rate level among G10 economies. After the financial crisis, most central banks lowered their policy rate to the lowest ever, and the size of rate differential among them has shrunk. As a result, a small change in policy rate and yield could have more significance on FX markets than previously.”

“Third, the lift-off of the policy rate and/or an exit from unconventional monetary easing can have non-linear impacts on FX markets. Before the taper tantrum in May 2013, the correlation between USD and US rates were negative or neutral. However, after then Fed Chair Bernanke’s comments on the possibility of earlier tapering, USD started reacting positively to higher US rates. We also observed much higher sensitivity of EUR to euro area rates this year (particularly in longer-end tenors), as the ECB normalisation attracts market interest. In 2017, the BoE and BoC also entered their tightening cycles, and there will be more G10 central banks entering their normalisation phase in 2018. According to our measures, output gaps across the regions have been closing.”