Last Friday saw the Central Bank of the Argentine Republic put the monetary policy dilemmas of every other country into perspective as it raised interest rates to an eye-watering 40%. While not an unprecedented level for the benchmark interest rate – which has averaged 61.5% since 1979 and hit an all time high of 1389.88% in 1990 – the hike nevertheless took markets on the blind side. For a brief period, the peso’s previously inexorable slide was arrested as investors digested an increase to the key borrowing rate of over 12% in eight days. Regrettably, though, even this appears not to have been enough to shore up the beleaguered currency. Pressure on the peso resumed on Tuesday, and at the time of writing President Mauricio Macri is reported to be in talks with the International Monetary Fund to arrange a precautionary credit line of up to $30 billion in order avert a financial crisis.
The pattern that Argentina is currently working its way through is no less painful for its familiarity. As in the UK in 1992, or Malaysia in 1997 – or indeed in Argentina itself as recently as 2002 – a country’s currency comes under pressure due to overseas speculators and external factors that are largely outside its control. The government, whether as a result of commitments to a currency peg or due to a social contract with its electorate, is not willing to countenance the devaluation of its currency. In an effort to prevent this, it raises interest rates to levels far above those that the economy could tolerate, and attempts to support the exchange rate further by using up its foreign currency reserves. Fully aware that this position is unsustainable, the speculators press their advantage. Eventually, the government is forced to concede defeat, but frequently not before its monetary policy has forced the country into recession. The absurd interest rates are abandoned, and the currency devalues anyway.
In this case, the ‘external factor’ piling pressure onto the peso is the return of US dollar strength, and the Argentinian peso is by no means the only currency affected. Emerging market currencies as a group have had their worst start to a quarter since 2015: since the end of March, the Russian rouble has fallen 9.7% against the dollar, the Turkish lira 7.8%, and the Mexican peso 7.2%. While each country has its own domestic issues that could justify the decline, the real culprit is a greenback that has risen sharply over the last fortnight, to its strongest level since December. Sure enough, it is not just emerging market currencies that have been hit: the euro also hit its 2018 low against the dollar this week.
What is the reason for this sudden Bull Run by a currency that, at the start of the year, most market commentators agreed would spend 2018 in retreat? There is no shortage of plausible-sounding explanations. Both Treasury yields and expectations that the Federal Reserve will increase rates have been on the rise, eroding the incentive to convert dollars into higher yielding currencies. Prospects of a trade war between President Trump and the rest of the world may cast as much of a shadow over the US economy as any other, but in the short term they will drive up commodity prices, and thereby demand for the dollar. Even America’s withdrawal from the Iran nuclear deal has the potential to restrict the oil supply, pushing its price up and reinforcing this effect.
As this bulletin argued back in January
, though, the simplest and most compelling explanation for the dollar’s recent strength is the level of the consensus three months ago that it would move in the opposite direction. Foreign exchange rates do not waste time in ‘baking in’ the views of the market, which means that by the time there is a consensus view that a move is bound to happen, it has probably already been overdone.
Turning back to the present, the important point is that tremors in US trade and monetary policy will not stop sending shockwaves around the world any time soon. Argentina’s current situation should hopefully have focussed policy makers’ minds on the extent of the damage this can cause if they do not act in time.
To choose one example, with the Bank of England’s Monetary Policy Committer prepares to meet on Thursday, they are no longer expected to raise UK interest rates: the market-implied probability of them doing so has fallen from over 90% a few weeks ago to just 12% today, in the face of lacklustre GDP growth figures. Officially, just like Argentina’s central bank, the MPC’s mandate is to set interest rates to target a set level of inflation rather than to prevent a devaluation of the currency. That said, it remains to be seen whether they would follow through on this in the face of a severe sterling crisis, and the wider the gap between US and UK interest rates, the less remote this prospect gets.
Successive Federal Reserve Chairs have remarked on the difficulties involved in taking away the punch bowl just as the party is warming up. But as emerging market central bankers – not to mention pub landlords – know, it is infinitely preferable to being forced to do so at a point in the evening where the guests have lost their sense of decorum.
Upcoming Economic Releases
In spite of the shortened week, there will be a flurry of macroeconomic data released on Thursday:
• ECB economic bulletin
• Bank of England’s ‘Super Thursday’, with the MPC’s decision on interest rates (no change expected from current level of 0.5%), the quarterly inflation report, and the Bank’s latest view on the state of the UK economy
• US CPI inflation figures (expected to pick up slightly to 2.5% after last month’s 2.4%)
• US real average weekly earnings
• Finally, Friday will see the release of the US import and export price indexes for April. Only small increases are expected this month, but fractious trade talks between the US and China will mean that these figures are put under an increasingly strong spotlight in the coming month