BackCurrencies could undermine calm in markets
US dollar has gained sharply against the euro and yen, and jitters about Scottish independence have hit the pound
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Currency markets are back in the news as the US dollar has gained sharply against the euro and yen, and jitters about Scottish independence have hit the pound. So far, though, analysts are largely missing an important potential consequence of the gyrations: They could erode the broader financial stability that central banks have worked so hard to achieve.
For reasons I have discussed in previous columns, currency volatility is unlikely to subside anytime soon. The moves reflect growing economic and policy misalignments among the US, Europe and Japan. Divergences in such elements as growth, inflation and the direction of monetary policy are set to get bigger in the months ahead. In the case of Europe, they could be further complicated if negotiations with Russia over Ukraine fail to generate a lasting de-escalation of geopolitical tensions.
The intense suspense over the Scottish referendum is another factor contributing to foreign-exchange volatility. The British pound is being used by the anti-separation camp as a way to scare Scottish voters away from exiting the 307-year-old union. This week, Mark Carney, the governor of the Bank of England, joined the debate by warning that “a currency union is incompatible with sovereignty."
Carney is right that an independent Scotland would be taking on a lot of economic and financial challenges if it were to tie its new currency rigidly to sterling — or even adopt sterling as its de facto national currency — without having proper fiscal integration with what remains of the UK. Other than for short-term public-relations reasons, it makes no sense for Scottish separatists to commit so much of their credibility to the economically weak argument of maintaining sterling as their currency should voters opt for independence.
All these political and economic drivers have contributed to a 4% appreciation in the dollar against the currencies of major US trading partners so far this quarter. The US currency has gained even more against the euro, yen and pound.
There are various ways that higher currency volatility can spill into other financial markets. It can alter the risk and reward profiles of cross-border investments — such as carry trades in which investors borrow money in one currency to buy assets in another. It can lead to losses in unhedged international equity exposures. The larger these effects, the greater the risk of generalized market selloffs as overly extended portfolios adjust to the new volatility reality.
The longer currencies are on the move, the more likely that they will threaten policy makers’ (so far impressive) ability to repress market volatility, both realized and implied. As such, they could undermine a central objective of central-bank policy in advanced economies — one that has benefited financial markets immensely. Bloomberg
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