27 Jul 2017 12:00pm

Central banks bump politics... for the time being

SPONSORED FEATURE: The UK’s referendum on membership of the EU was clearly the story that defined currency markets in 2016. But, in 2017, currency volatility sparked by central bank actions and interventions will become more pronounced, and companies have to juggle their hedging priorities and the outlook for foreign exchange markets

Caption: In 2017, currency volatility sparked by central bank actions and interventions will become more pronounced.

With the Federal Reserve, Bank of England and European Central Bank all now hinting they could reverse years of easy monetary policy, these will be the biggest factors and triggers for currency markets for the rest of this year.

The $4.5 trillion elephant in the room

Since the financial crisis, the Federal Reserve is the only major central bank to begin to normalise interest rates. Despite being ahead of the curve on rates, the Fed still faces the dilemma of holding a balance sheet worth close to 25% of the national GDP. While holding the $4.5 trillion worth of bonds, mortgage-backed securities and other financial instruments isn’t necessarily a problem, it effectively keeps US financial markets in emergency recovery mode; the Federal Reserve keeping its foot on the accelerator.

So far, the Fed has made clear that it has established a plan, method and technique for selling off some of these assets. What hasn’t been communicated is the start time of this program, despite the Fed stating that it would be put into action “relatively soon” – not the clearest of indications. Following these comments, economic data hasn’t leaned one way or the other – meaning there’s a real risk we won’t see further clarification anytime soon.

ECB fearful of tripping the recovery

On the other side of the channel, the European Central Bank is facing a set of economic conditions that are wholly unknown to a number of members on the governing council: the green shoots of an economic recovery. Across the Eurozone, GDP growth is accelerating, unemployment rates are dropping and healthy levels of inflation are emerging from Finland to Portugal. The ECB has to ensure that an economic escape velocity has been reached before record-low interest rates are withdrawn. To raise rates prematurely would put the hard-fought recovery at risk and could knock the Eurozone off course.

UK consumers have never been as sensitive as they are now

Here in the UK, the economic backdrop’s as uncertain as ever. The inconclusive election result has left businesses in the dark about the UK’s future relationship with the European Union and it’s the same story with the consumer. Pay packets are falling due to runaway inflation and low average pay rises, reliance on consumer credit is rising and the household savings ratio has fallen to the lowest level since records began – all issues that could arguably be dealt with through sensibly rising interest rates. These pressures are beginning to show at the Bank of England, with more and more members of the Monetary Policy Committee talking up the prospect of higher rates sooner rather than later – reflected in the recent uptick in sterling volatility.

What’s clear is that while markets will always take heed from politics and fiscal policy, it’s very easy for those with foreign exchange exposure to become complacent about the risks that emerge from arguably the most influential force in global markets: central banks. With exchange rates caught in the balance, SMEs are often unsure whether the current market rate will move for them, or against them. There are a number of strategies available to help companies navigate these risks, including the timing of spot contracts, buying forward and made-to-measure forward hedging strategies.