Central Banks Respond to Global FX Market Volatility

In recent months, the volatility of foreign exchange (FX) markets has caught the eye of policymakers worldwide.

by Faruk Imamovic
Central Banks Respond to Global FX Market Volatility
© Getty Images/Chris McGrath

Amidst a backdrop of fluctuating U.S. interest rates, currencies in both Developed Markets (DMs) and Emerging Markets (EMs) have suffered. Various central banks outside the U.S. have approached this issue by either suggesting potential FX interventions or by adopting a more hawkish tone in their monetary policy communications. Japan, notably, is engaging in both strategies.

Tactical Shifts in Monetary Policy

Countries with a hawkish policy outlook are better positioned to combat FX depreciation. This includes nations that are poised to tighten monetary policies, exhibit a neutral or tightening bias, or have only slightly loosened their policies recently. For instance, Mexico has been highlighted for its proactive stance in Latin America. Analysts suggest that USD/MXN volatility should be sold during any new spikes, indicating a market strategy to bet against further weakening of the Mexican peso.

In the bustling world of international finance, stock markets have struggled to find solid footing. Following a reassessment of the horizon and magnitude of rate cuts in the U.S., stocks have failed to rally, even as bond yields have fallen. This paradoxical movement suggests a new equilibrium might soon emerge, characterized either by lower stock valuations coupled with higher yields, if the economy withstands the Fed’s jolt, or by significantly reduced valuations and yields if it does not.

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The Global Reaction to U.S. Policies

On the currency front, DM and especially EM currencies have seen notable declines against the U.S. dollar, reacting to the increased U.S. yields and a general risk-off sentiment worldwide. However, as of recent developments, non-U.S. central banks have started to take a more active role against FX weaknesses. Some policymakers have hinted at interventions in the FX market, which have led to overnight strengthening of currencies like the Japanese Yen (JPY) and the Korean Won (KRW).

In a significant development, a joint statement by U.S. Treasury Secretary Janet Yellen and the finance ministers of Japan and Korea has expressed serious concerns about the depreciation of the JPY and KRW. This indicates U.S. approval of interventions by the Bank of Japan (BoJ) and the Bank of Korea (BoK). Additionally, the G-7 finance ministers have reaffirmed commitments to FX policies aimed at mitigating the harmful effects of excessive volatility, offering Japan some leverage to defend the JPY.

China’s central bank, the People's Bank of China (PBoC), has also announced its intention to staunchly defend the Chinese Yuan (CNY) against undue speculation and volatility. However, the PBoC's strategy might involve controlled, gradual increases in the USD/CNY exchange rate in response to a strengthening USD, thus balancing between curbing speculation and enhancing China’s export competitiveness amid potential new U.S. tariffs.

Emerging Markets Facing a Tougher Road Ahead

According to S&P Global Ratings, the path to monetary policy normalization in EMs will be fraught with challenges, especially given the potential delay in the U.S. Fed's easing cycle. This could lead some EM central banks to pause rate cuts in the short term due to the dual pressures of recent FX depreciation and the consequential inflation pass-through.

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For now, central banks in both DMs and EMs that maintain a hawkish disposition are likely better equipped to manage FX depreciation pressures. This trend is exemplified by Mexico, which has already adopted a neutral policy bias and shown reluctance to initiate early easing.

Central Bank Strategies: A Closer Look at Japan and Mexico

Japan's Delicate Balance

Japan stands out in its approach to managing the JPY. Historically, Japan has not shied away from direct market interventions. The last significant intervention occurred in the fourth quarter of 2022 when the Bank of Japan (BoJ) actively bought Yen to curb its depreciation. The Japanese central bank is currently in a position where it can adjust its monetary policy without the typical constraints of losing credibility. This flexibility could involve raising policy rates or tapering its extensive purchases of Japanese Government Bonds (JGBs). Such monetary tightening, while delicate, might be necessary to sustain the Yen's value without resorting to continual market interventions. Presently, market analysts maintain a cautious stance, holding the USD/JPY exchange rate at 155, close to current levels, anticipating no severe deviation in the short term.

Mexico's Proactive Defense

In contrast to Japan, Mexico has employed a mix of communication tactics and policy maneuvers to bolster the MXN. The remarks by Banxico’s Deputy Governor Jonathan Heath have been particularly poignant. By stating that the recent 25 basis points rate cut does not necessarily herald the start of an easing cycle, Heath signaled a more conservative approach towards future rate cuts, emphasizing the need to closely monitor inflation, especially service price inflation. This stance is seen as part of a broader strategy to strengthen the MXN by reducing the attractiveness of speculative attacks against it.

Moreover, Mexico's government fiscal policies have indirectly supported Banxico’s monetary stance. The expansionary fiscal approach has necessitated a cautious monetary policy to balance out inflationary pressures, thereby supporting the MXN. Traders have responded positively to these signals, leading to a drop in USD/MXN volatility as confidence in the peso's stability grows.

Brazil and Beyond: Emerging Markets in Flux

Brazil’s Central Bank (BCB) is another notable player in the Latin American economic landscape, grappling with its currency challenges. Governor Roberto Campos Neto's recent remarks underscore a heightened sense of caution amid global and domestic uncertainties. The anticipated reduction in the pace of monetary easing—from a 50 basis points reduction per policy meeting to 25—reflects a strategic pivot aimed at managing potential inflation risks linked to a weakening Brazilian Real (BRL). This adjustment also aligns with the BCB's intent to retain flexibility in policy-making, even at the risk of facing credibility issues, as it navigates through turbulent economic waters.

Emerging markets, more broadly, face a tough balancing act. The delay in the Fed's easing cycle might prompt EM central banks to adopt a more cautious approach in their monetary policy decisions. This is particularly relevant as they address the dual challenges of currency depreciation and the inflationary impact that follows. Central banks in these regions are increasingly using public communications to influence market expectations and stabilize their currencies without fully committing to drastic policy shifts.