Currency markets have been calm for an extended period, making the pursuit of international profit this year a little less volatile. Mohamed El-Erian hopes investors enjoyed the smooth ride while it lasted. The celebrated commentator suggests the way ahead could get bumpy.
"The biggest threat to investors may come from the foreign-exchange market rather than the stretched prices of equity and bond markets," Mr. El-Erian, the former Pimco CEO who now is the chief economic adviser at German insurer and asset manager Allianz SE, wrote Wednesday in the Financial Times.
For a while, the world's biggest advanced economies were sputtering together. Weak economic growth in the United States, Europe, Japan and Britain prompted the central banks in each of those jurisdictions to simultaneously keep interest rates extremely low. That left little incentive to make big bets on any of the world's main reserve currencies. Arbitrage opportunities were few and the fundamentals were equally uninspiring. Investors sought profit in equities instead, pushing stock markets in the U.S. and elsewhere to record highs.
But the monetary policy of the Big Four central banks is starting to diverge. The U.S. Federal Reserve and the Bank of England are starting to talk about raising interest rates for the first time in years, while the European Central Bank and the Bank of Japan say they will press on with aggressive stimulus measures in a bid to revive their stagnant economies. By the middle of next year, there's every reason to think there will be a gap between interest rates in the U.S. and Britain and rates in Europe and Japan. The more convinced that traders and investors become of that future, the more they will start betting on it in the present. Volatility could ensue.
Adrian Miller, head of fixed-income strategy at GMP Securities in New York, says the bond markets already are getting choppy. Bond yields rose last week after the minutes of the Fed's July policy meeting and a speech by chair Janet Yellen acknowledged that the economy's surprising strength could prompt an interest rate increase sooner than expected. Then ECB President Mario Draghi and Bank of Japan governor Haruhiko Kuroda made clear they were sticking with stimulus. European bond yields dropped to all-time lows. The gap between U.S. and German 10-year government debt is the widest since the spring of 1999, according to Mr. Miller.
"Today's global monetary policy landscape is like a giant playground," Mr. Miller wrote in a research note Wednesday. "In the middle of the playground are four mammoth central banks engaged in a tug-o-war with two pulling for an exit to long-term unconventional monetary accommodations without significant market dislocation while the other two are pulling for additional stimulus measures."
There's no telling where this could lead. The U.S. dollar stands to strengthen, which could be good for Canadian exporters if hedge funds and other investors decide the greenback makes for a better bet than the loonie. Or they could decide Canada is a good investment, given yields in Japan and the euro zone stand to be very low for a very long time. Investors looking for Group of Seven exposure could like Canada, where the central bank's benchmark lending rate is 1 per cent.
Or everything could work out just fine. That's the position of James Bullard, president of the Federal Reserve Bank of St. Louis and a leading voice on the Fed's policy committee. The Fed is edging closer to higher interest rates because the world's biggest economy is growing – that's a good thing for everyone. The ECB has been accused of doing too little to revive economic growth; if it's on the verge of deploying additional stimulus measures, that could boost global demand. A stronger European economy is good for everyone, too.
"It could turn out rather well," Mr. Bullard said in an interview on the weekend. "All of that seems like it could be handled," he said of divergent monetary policies.
It would be glorious if financial markets traded only off economic fundamentals. That could be hoping for too much. There will be an early test next week. The ECB, the Bank of England and the Bank of Japan all hold policy meetings a week from Thursday. Then on Friday, the U.S. will release its latest hiring data, which are the main determinant for Fed policy. It could be a rough return from summer vacation.