Market Overview

6 March 2020

An Interest Rate Cut "Competition" is Starring in the Currency Show

The world's leading central banks have completed a series of intense mutual consultations at the beginning of a hard week by launching concerted actions. At least, in theory, these measures could revive the weakening economic activity and provide some stimulus for the global financial system. In real life when factories are stopped because of quarantine or some important business conferences are cancelled, consumers appear less in public places. These fast monetary policy moves do not directly impact economy but rather have an impact on investors' blind choice, which is to consider more rational places to save their money.


Abstracting now from the motivation of all the present central banks actions, as it was described before each cut in the key interest rate serves as a "locomotive" dragging several "waggons", including a direct reduction in yields of Treasury bonds, often by an even greater amount. This means not only a cost squeeze of servicing public debt to ease the burden for the Treasury of dedicated countries, but it also reduces the allure of these countries' public debt in the eyes of many investors. For this reason, the demand for a particular currency for which the central bank reduces rates, may also lessen, compared to the demand for other currencies, and a currency with a reduced rate may potentially become cheaper.


That is the main cause and effect liaison or the causal nexus lying on the surface. However, all correlations are not that simple. For example, if the interest rate is still attractive for investors, even after it has been lowered, bond buyers may start to invest even more in bonds of a particular country that is going to lower interest rates further, because it could be even less profitable to buy these bonds later. On the other hand, investors may have alternative priorities: not to get income, but to protect themselves from certain risks, the scale of which is actively being inflated in the media as it constantly focuses on the probability of a pandemic caused by the coronavirus.


Based on this model the logic behind how the interest rate cut "competition" between the central banks is affecting the dynamics of many currencies at the moment becomes clearer.


The People's Bank of China (PBoC) was the first to lower its loan prime rate in mid-February. The Chinese monetary regulator injected a lot of money liquidity into the economy to support their fairly well controlled stock markets, as the interest rates in China are still higher than three %, so the Chinese yuan experienced only a brief weakness and quickly regained its early losses. The situation with the US, the Canadian Dollar, the Australian Dollar and the European currency is quite different.


The Reserve Bank of Australia (RBA) lowered the interest rate by only 25 basis points. RBA has not indicated any further cuts and pointed to the likely lowering of interest rates by the US Federal Reserve (Fed) and by some other central banks as one of the excuses for the RBA's action. Later that evening the Federal Reserve cut its interest rate by 50 basis points in emergency. So, the Fed softened its policy more than the RBA and earlier than expected. Moreover, the money markets had already priced the Fed's next possible rate cut to happen on March 18, according to the Chicago Mercantile Exchange (CME) futures data which points to the fact that many investors bet that the Fed will follow with even more cuts in April or June if the stock markets do not have a chance to completely recover by that time. As a result, the AUD/USD has received little supported this week, despite the close dependence of Australia on the delivery of commodities to China.


Another even more striking example is the double interest rate cut by the Bank of Canada (BoC) on Wednesday, which was only one day after the Fed's move. This move almost completely brought about a status quo and erased the effects of the Fed's decision. So, USD/CAD hasn't moved much since the interest cut but the EUR/CAD climbed higher from the 1.49 to the 1.51 area over the last two trading sessions and it's trading more than four % higher versus the levels last week.


The Euro also continues to extend gains against the Greenback. The reason behind this lies in the comments made by some senior officials of the European Central Bank (ECB) as they seem to be reluctant to the idea of any further move to drive the interest rate deeper into negative territory. It could be fair to come to the conclusion that the interest rates and the extremely dovish monetary policy in the Eurozone may not give any serious room for downside manoeuvre, even if the ECB would like to join the crowd.


So, the ECB's Governing Council member Robert Holzmann, Austria's central bank chief, remarked by saying: "ECB must stay vigilant, but not overreact". The ECB policymaker also added that he "would not support an interest rate cut to insulate the Eurozone from the effects of the epidemic but he could consider giving firms ultra cheap loans." When he was asked if targeted loans to businesses were necessary, Holzmann reacted by saying: "this is definitely an area which will be under consideration, but at the moment I don't think there is an urgency to move there." At the same time, sources close to the discussion told Reuters that the ECB was working on loans to help businesses, primarily small and medium sized enterprises. Holzmann expressed the opinion that monetary policy actions are secondary to fiscal support, and he sees no urgency even for the TLTRO auctions (additional money liquidity to the banks) that are going to be "under consideration next week".


One more ECB's Governing Council member and Belgium's central bank governor Pierre Wunsch said: "ECB needs to be very vigilant but it doesn't have to act on every negative shock... Euro economy is not in recession and jobs are still being created". One of the arguments against more stimulus is that rates that are too low could reduce lending margins to a point where banks simply stop lending. Lending at very low rates could also inflate asset bubbles. Wunsch, a newcomer to the 25-member Governing Council, accepted that these were legitimate concerns.


Such public statements inspired a number of investors to redirect their cash to European bonds, even despite negative interest rates in some "core" EU countries, while the yields of benchmark US ten-year Treasuries dropped sharply with new record lows of 0.77% this morning. The yield on this US benchmark bond was 1.9% in the middle of December 2019, not to mention 3.2% in the fall of 2018.


The incoming Governor of the Bank of England (BoE) Andrew Bailey suggested that "an immediate policy move" from the BoE may "not be on the cards". The possibility of a brief delay in a BoE rate cut has allowed the British Pound to edge back to firmer levels. The UK budget is expected to focus on "levelling up" and "unleashing" the UK economy. There are now reports that it will instead focus on measures aimed to protect and support parts of the economy most likely to be affected by a coronavirus epidemic. The EU chief Brexit negotiator Michel Barnier remarked yesterday that: "there are many serious divergences with UK, difficulties of end of transition period are being underestimated" as the UK "doesn't want a level-playing field in deal". Given the risks on the EU and UK trading negotiations, the Pound's strength could be temporary, but at least for now the Cable costs higher than it was before the Fed's move.


Thus, as a "side effect ", unless it was intended as the main idea, interest rate cuts have created a situation where the interest rates of different countries do not vary very much from one another. The Forex market is now taking into account the dynamics of possible subsequent changes in interest rates for the main world currencies that are already taking place and are expected soon.


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