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What is the new normal for FX markets?

PICTURES OF THE YEAR 2004 A Chilean boy plays soccer at the
REUTERS/Carlos Barria

How will the U.S. dollar fare and what will be the impact of weaker demand in China? These and other topics are tackled in a webinar and whitepaper featuring Thomson Reuters Market Impact Group experts.

When it comes to assessing the outlook for foreign exchange, markets need to start adjusting to a new normal — if they haven’t already. Interest rates in negative territory and a lower oil price that hurts equity markets rather than boosts performance have been challenging the usual set of rules and assumptions.

Add in local factors such as the Brexit referendum and there have been plenty of debating points for panelists on the Thomson Reuters Market Impact Group at the start of a volatile 2016.

In the webinar, subjects for discussion ranged from China’s weakness and the outlook for U.S. interest rates through to the impact of lower commodity prices on emerging markets and the merits of negative interest rates in Europe and Japan.


Despite doubts about China’s growth data, it is clear that it has slowed — and this slowdown has been in place for a while. Eric Burroughs, Editor & Managing Analyst, Reuters Buzz expects the yuan, and by extension CNH [offshore renminbi], to weaken about 5-10% in 2016 as China starts to loosen its grip on the currency.

Ron Leven, FX Pre-Trade Strategist, said that one of the big dilemmas in China — and one of the main pressures in the market — is that the yuan is substantially overvalued in real terms. The overvaluation is a byproduct of many years of relatively high Chinese inflation and the link to a strengthening U.S. dollar.

Since China is a minor importer and has modest global asset exposure, the main impact of China weakness will be continued pressure on commodity prices. Some countries will feel a strong impact from weaker demand in China. But the net impact on global growth is marginal.

United States

Historically, low commodity prices have been good for broad equity market performance in the U.S. However we’re now seeing an unusual environment in which commodity prices are actually hurting equity performance.

Leven said there are two factors at play here: “Commodity prices are being viewed as a barometer for the overall global economic environment, and, more importantly, the December rate hike [in interest rates] has created a fundamental shift in perceptions of the Fed.” Leven explained that the shift came in the market perceiving that it will have to readjust to a higher risk environment.

Although the Federal Reserve is still sending signals that it’s going to raise rates, projections are that it’s going to be two years before the inflation rate starts to approach the Fed target.


What will drive the dollar in 2016? Leven explained that what the Fed does isn’t so important; rather, it’s what the markets expect the Fed to do. He further explained that if we do continue to see slow growth, the market may continue to reassess the prospects for longer-term rate hikes. This could lead to some dollar softness in the second half of the year but the USD will likely hold on to most of its gains.

Commodities, Commodity FX & Emerging Markets

While we have come to find that historically low commodity prices are a ‘new normal,’ Burroughs said that commodities will likely find a bottom at some point this year.

For this reason, says Burroughs, we can start thinking about emerging markets and those that would benefit should the sell-offs in commodities begin to calm down. While some emerging market (EM) countries may be seeing current account boons from weak commodity prices, if commodity prices stabilize, others will benefit.

Burroughs said: “EM FX have had to endure a changed FX policy stance from China as well as the much anticipated Fed lift-off. Despite these events we saw EM FX relatively stable given the backdrop of a strengthening dollar.

“Where the weakness was more severe, local factors were at work such as ZAR [South African rand] and BRL [Brazilian real] or the RUB [Russian ruble]. For 2016 the sensitivity to Asian EM FX to CNY [renminbi] will be something to keep an eye on, with MYR [Malaysian ringgit] standing out as one of the more vulnerable currencies.”


Europe and the UK

Divyang Shah, Global Macro Strategist, IFR Markets, explained that from a macro perspective, the story is still low, persistent inflation. “Even though the European Central Bank talks about a mild recovery, it’s still a difficult recovery to observe, which is understandably why they are doing more quantitative easing (QE),” said Shah.

An adjustment in Fed expectations as the market has priced out rate hikes has helped EUR/USD stay stable, “but we haven’t seen the kind of moves that you would expect since the QE [ECB] program kicked off last year,” Shah added.

He explained that this is due to euro zone domestic investors who have not been moving their funds aggressively abroad. If this outflow does start to appear, U.S. dollar strength could turn “from a glacial trend to a more violent move to the downside”.

Shah said that we’re still on the lookout for how much easing the ECB has to do and whether they can take a different path to the Bank of Japan over the last two decades.

Meanwhile, sterling promises to weaken versus the U.S. dollar in a volatile and messy way, not least because of near-term Brexit referendum concerns. The chart below shows implied volatilities on GBP in response to the Brexit issue.

Burroughs explained that we’re already at a relatively steep vol [volatility] curve, pricing in risks around Brexit and the Scottish Referendum. Says Burroughs, “As we saw around the UK general election in 2015, vols get to a level where it gets too expensive to hedge, which in itself creates potential for volatility once the event risk happens that market participants must be positioned on.

So we’re already seeing something of a squeeze in the GBP/USD and we’ll see continued volatility in GBP in particular.”


Japan & Asia-Pacific

Japan’s adoption of negative interest rates in January was a seemingly bold move that surprised markets. However, Ron Leven pointed out that “over the last year and a half the BoJ and the Japanese government have had a habit of over-promising and under-delivering on policy”.

Furthermore, there is murkiness in terms of how the negative interest rates will actually be implemented; it will certainly be phased in over time and won’t be applied to all current account balances.

Despite limitations around implementing the negative interest rate, Shah added that the BoJ’s move is significant because the central banks that are adopting negative interest rates and QE are in uncharted territory. Shah explained: “The BoJ has thrown out the past 20 years of focusing solely on QE and zero interest rates.”

Although implementation is starting small, as QE is expanded further each quarter, the negative rate will affect a larger proportion of current account deposits. “We have to remember that in Japan there’s this preference for keeping money in deposits and that hasn’t really changed.” Shah said. “It’ll be interesting to see if negative rates change that flow.”

Download the full report, 2016 FX Outlook: What does the new normal look like? from the latest Market Impact Group webinar

If you would like to contact the Thomson Reuters experts featured in this report, please email:


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