Markets are torn into two; some believe higher inflation is here to stay, and some think otherwise. According to the analysts, the result can significantly affect currency markets.
The 10-year US Treasury yield touched the recent high of 1.56% last week as essential inflation data indicated consumer prices hiking to record highs in the US and the eurozone.
The central bank policymakers believe that higher inflation is transitory- the outcome of integrating soaring energy prices and global supply problems. As a result, investors have started seeking protection, major stock markets cracking winning streaks in September after months.
According to Jonas Golterman, senior markets economist at Capital Economics, with the return of higher and unstable inflation across significant economies, the exchange rate volatility suffers too. This ultimately depreciated the currencies in the highest inflation-hit countries.
Furthermore, Goltermann added that regardless of the fact that the near-term relationship of inflation differentials and exchange rates is weak, when it comes to long time horizons, the countries with higher inflation experience depreciation of their nominal exchange rates.
“This effect does end up dominating other variables like exchange rates, trading terms, and relative productivity.”
Developed markets have experienced low and stable inflation in the last two decades, au contraire the high inflation period of the 1970s and 80s, which led to a more significant disparity across geographies.
Generally, the country with higher inflation saw a weakening of nominal exchange rates. In response, central banks tightened policy, which led to quite an appreciation although temporary, noted Goltermann. As a result, exchange rate volatility was significantly higher in significant currencies as compared to recent years.
Nominal exchange rates show the value of a foreign currency against a unit of the domestic currency. Real exchange rates, on the other hand, indicate the value of a country’s goods and services in exchange for that of a foreign country.
US, UK, Canada, and Australia
Capital Economics has a similar opinion when talking about inflation to Wharton finance professor Jeremy Siegel, who stated that inflation poses a far greater risk than Fed believes.
Gotlermann noted that developed economies and predominantly the US, UK, Canada, and Australia are at a higher risk of sustained higher inflation. This indicates that the currencies of these currencies will weaken in nominal terms as compared to European and Asian economies, where inflation is expected to remain subdued.
Golterman projected that emerging markets like Brazil, Colombia, Indonesia, Philippines, and Africa are vulnerable to inflation pickup and currency depreciation, similar to Argentina and Turkey, which have suffered years of double-digit inflation.
The long-term depreciation is likely to affect the volatility due to added uncertainty of inflation outcomes and monetary policy response, resulting in significant swings in currency markets, he added.
The ground of argument is that majority of the policymakers will keep real interest rates low to power the economic boom and lower high debt levels gradually, Goltermann said.
He further added that the efforts of central banks to push down inflation by tightening the policies can lead to greater volatility.