Prepare for the return of the G10 currency war

RBC says at least four events this week herald the re-emergence of the theme. First, the Federal Reserve stepped up its quantitative easing programme – a move that many see as an attempt to engineer a weaker USD. Second, recent sessions have seen renewed intervention from Asian central banks. Third, the Swiss National Bank (SNB) reaffirmed its commitment to its EURCHF floor.

And fourth, Mervyn King, Bank of England (BoE) governor, commented that his concern “is that in 2013 what we will see is the growth of actively managed exchange rates as an alternative to the use of domestic monetary policy … and you can see, month by month, the addition of the number of countries who feel active exchange-rate management, always of course to push their exchange rate down, is growing.”

Adam Cole, head of FX strategy at RBC, says physical intervention is most commonly associated with EM rather than G10 FX, and only the SNB has gone so far as making the exchange rate its principal policy tool, but there are other examples of more subtle shifts that support King’s assertion.

To demonstrate this, RBC have constructed verbal intervention indices for G10 central banks, trawling through three years of monetary policy statements and assessments to find all references to their domestic currencies.

In many cases, says Cole, these will be nothing more than factual observations (for example, “the trade-weighted exchange rate has appreciated”). Often, he says, currency strength is perceived to be a “headwind” or responsible for lower inflation.

“A central bank may warn against further appreciation, saying it would defer rate rises and, in isolated cases, currency strength may even drive a decision to ease policy,” says Cole.

RBC says quantifying these verbal references is unavoidably subjective, particularly across different central banks. However, the bank says it tries to be as objective as possible by creating a scorecard that runs from zero to 10, where zero is no relevant mention/mere observation and 10 is explicitly setting monetary policy to achieve a certain exchange rate.

Cole explains: “What we are trying to discover is whether central banks show any currency bias in setting policy – that is, do central banks with strong or appreciating currencies factor that in to their rate-setting decisions and do they use their policy statements as a way of verbally intervening in the currency?”

RBC finds the Reserve Bank of Australia consistently shows the lowest level of concern on currency strength regardless of the level of AUD. The Reserve Bank of New Zealand, in contrast, appears to be the most sensitive to the rate of change of the currency, and is quick to raise the level of verbal intervention one month and drop it the next, in response to NZD appreciation or depreciation.

Besides the SNB, and its obvious focus on CHF, the Norges Bank shows the highest overall level of concern, according to RBC, often warning about the effect of NOK strength and directly linking this to the possibility of rate cuts, while the Riksbank has shown spikes – such as the surprise cut in September, which appeared to be linked to SEK strength through the summer.

RBC excluded the Federal Reserve, European Central Bank and the BoE from its indices as they did not make any relevant currency references during the sample period. The Bank of Japan is also excluded for similar reasons – the country’s ministry of finance is responsible for currency policy.

RBC found that its intervention index has been rising steadily during the past three years, demonstrating an increasing level of currency discomfort across G10 central banks.

“On the face of it then, it would seem that G10 is doomed to follow EM central banks down the path of rising intervention or at least exchange rate driven policy,” says Cole.