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I take stock of the situation in Forex

What to do with Eur-Usd? What do you think about a short of Usd-Jpy? The Bank of England is raising rates in the UK at every meeting, I would like to invest in the pound, what do you think? These are just some of the questions I have received over the last few days. I have answered them all privately, however, I would like to take these questions as a starting point to take stock of situation in currencies.

After a few years of low volatility and zero or near-zero rates, with the pandemic, inflation started to rise due to a sharp drop in demand and unprecedented inflows of liquidity through supportive monetary policy measures. The outbreak of the conflict between Ukraine and Russia has only increased a problem that was already present and poorly managed.

With inflation ever-increasing, several central banks began a monetary policy of austerity by repeatedly raising interest rates. The US has planned 11 rate hikes over the 2022-2023 period, the Bank of England has already raised rates three times this year, from 0.10% to 0.75%. Other nations such as Canada and New Zealand have started or are in the process of raising interest rates.

This policy of "raising interest rates to fight inflation," if on the one hand will not fight inflation, as inflation is generated not by an increase in consumption but by an increase in costs and commodities, on the other hand, it is bringing back the carry trade.

What is the carry trade?

In Forex, the carry trade is a strategy as old as the financial markets. It involves borrowing money in countries with a low-yielding currency and investing it in financial instruments (rarely in real assets, usually government bonds) in countries with a high-yielding currency. The profit obtained is equal to the difference between the return on the investment and the cost of financing.

In these first three and almost half months of 2022, on the one hand, there were still accommodating central banks that left rates unchanged, on the other hand, central banks that, as mentioned, repeatedly raised interest rates. This has meant that institutional investors would return to the carry trade strategy, selling JPY, CHF and even EUR and buying USD, AUD, and NZD.

Let me show you a chart, below you can see Usd-Jpy (in green) along with the VIX Index (in red).

The Yen, like the Swiss Franc, is a safe haven currency. When there is uncertainty in the markets, when there is fear, the Yen is bought. As you can see from the chart above, whenever the VIX Index rises (especially above 30) Usd-Jpy is sold and falls. That is, except in February, when despite the rise in the VIX Index, Usd-Jpy began a strong bullish movement that led the currency pair to gain over 9% in just over three weeks.

Institutional investors sold Yen and bought Dollars, attracted by the prospect of negative rates in Japan for a long time to come and the myriad of rate hikes planned by the Federal Reserve. But not only the Yen. As you can see from the chart below, the CHF, JPY and EUR were the three currencies that lost the most against the dollar last week.

The other event that affected currencies was the outbreak of war in Ukraine on 24 February. The currency most affected was the Euro since it is used as payment for Ukrainian and Russian commodities by Eurozone countries. The war has driven up the cost of many commodities, benefiting the so-called commodity currencies, i.e., those economies that rely on the export of raw materials such as Australia and New Zealand.

I will conclude by briefly analysing the various currencies in a little more detail.

JPY. Japan is in the opposite situation to other nations: it has low inflation (1%). The Bank of Japan is apparently ready to make unlimited bond purchases (currently only a proposal). This would allow the BoJ to maintain its control over the yield curve. If this were to actually happen, it would lead to a sharp increase in liquidity and, consequently, a devaluation of the Yen. Negative rates (-0.1%) for a long time to come will encourage carry trade.

CHF. The last thing the Swiss National Bank wants is a strong Franc, especially against the Euro. Already with Eur-Chf below 1.10 the SNB is buying Euros and selling Francs, so I cannot imagine how the members must have felt seeing the currency pair briefly below par. Rates are negative (0.75%) and will remain so for many months to come. The Swiss Franc is a safe-haven currency as well as being used for carry trade against other higher-yielding European currencies.

EUR. The ECB adopted a more aggressive stance, with bond purchases expected to end in Q3. However, no further policy commitment has been made, stating instead that management should remain flexible. Even with record inflation at 7.5% and tapering in place, we will see nothing new, which could hurt demand for the EUR as other major central banks are raising rates (carry trade). It is the currency most affected by the outbreak of war in Ukraine. It also has the sword of Damocles of today's French elections hanging over it. The polls say Macron and Le Pen are tied. The victory of Marine Le Pen, a right-wing nationalist, combined with a left-wing German, Olaf Scholz, could increase uncertainty in Europe and this would have a negative impact on the Euro.

USD. Inflation in the United States is expected to reach 8.3% in March, a new 40-year high, up from 7.9% in February, due to rising energy, food and fuel prices that continue to plague household incomes. Whether inflation continues to rise from now on will depend more on commodity prices than on what the Fed does with interest rates. Higher-than-expected inflation could push the US dollar even higher.

CAD. The BoC will most likely raise rates by 50 basis points at its meeting on 13 April. Recent GDP figures show that the economy is gaining momentum and unemployment is at a five-year low, while inflation has risen to 5.7%, the highest in three decades. Harsh statements that the BoC "will act forcefully" by BoC Deputy Governor Sharon Kozicki raised fears of an outsized move.

AUD e NZD. Two commodities currencies. The economies of Australia and New Zealand are based on commodity exports. The war in Ukraine has led to a sharp rise in the prices of many commodities, which has benefited the Australian and New Zealand dollars. In addition, with the lockdown in Shanghai and Covid's cases increasing day by day, there are fears of further disruptions to the supply chain. This could lead to further price increases for certain raw materials.

GBP. The Bank of England, in order to combat rising inflation, has already raised interest rates three times in early 2022, from 0.1% to 0.75%, and does not yet seem intent on stopping. However, this has not yet brought great benefits to the Pound, which in the first three months of 2022, with the exception of the yen, has lost against all the other major currencies, including the euro (on 31 March the Eur-Gbp reached its highest level of the year).

Today I take some questions I received as a starting point to take stock of situation in currencies. After a few years of low volatility and zero or near-zero rates, with the pandemic, inflation started to rise due to

David Carli
David Carli
David is a financial analyst with over 27 years of experience (two years as a fund manager) in currencies and commodities. He collaborates with a major European commodity investment company and is the author of several successful books about trading and financial markets.

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