We live in stirring times. The president of the European Central Bank, Mario Draghi, crossed the monetary policy Rubicon and cut one of the euro area’s key interest rates into negative territory.
This is dramatic stuff; even the most economically oblivious are likely to recognise that negative interest rates are a radical policy.
At the same time, the United States Federal Reserve is gracefully gliding out of its quantitative policy position and by October that money printing process is likely to be effectively at an end.
The question from most investors is what next for US monetary policy?.
The answer is likely to be an increase in US interest rates, and those increases may start earlier and take place faster than many investors assume. The Bank of England has been even more explicit in signaling a desire to tighten interest rates sooner than financial investors had expected.
Euro area monetary policy and Anglo-Saxon monetary policy are taking different directions – radically so. It has been a decade since the Federal Reserve last embarked on a tightening cycle, and euro area rates have never gone negative before.
The bias in discussions is whether the Fed and the ECB both do more than is currently expected; the difference is that “more” for the Fed means “more tightening”, while “more” for the ECB means “more policy accommodation”.
With the expectations and the reality of the direction of interest rates diverging in this manner, the instinct of most in financial markets is to assume that the euro will weaken against the US dollar.
A weaker euro has been forecast by financial markets for some time — and financial markets have been spectacularly wrong in their forecasts. The euro weakened a little in the wake of the nudges and hints on policy from ECB president Draghi but it still remains at a high level.
How can this be explained? How is it that the euro is not behaving the way everyone says it should?
A key part of the explanation for the euro’s defiance of divergent monetary policy lies in a revolution that has taken place in the world economy. Put simply, globalisation has collapsed dramatically since 2007, and that collapse in globalisation has profound implications for financial markets.
The collapse in globalisation is nothing to do with global trade. Global exports (as a share of the world economy) are at a higher level than they were in 2007 – here, there has been a complete recovery. Instead, the collapse has taken place in the realm of global capital flows.
Global capital flows (again as a share of the world economy) are running at roughly a third of their pre-crisis peak, and around half the levels seen in the decade before the global financial crisis.
The collapse of global capital flows has been brought about by several factors coming together. Investors, in particular banks, are more regulated than before the crisis.
With that regulation has come about a bias to investment in domestic markets – in some cases as an unintended consequence of regulation. In some cases as a direct policy objective. In addition, the more political nature of several developed financial markets has acted as a deterrent to international investors who are likely to have less understanding of politics in remote markets.
When capital flows were abundant, an economy with a current account deficit did not have too many problems finding the capital inflows necessary to finance the current account position.
Only a tiny proportion of the huge amount of capital sloshing around the world had to be diverted to provide the funding. Now, with capital flows reduced to a thin trickle, a current account deficit country has to work a lot harder to attract the capital they need.
Crudely put, it is three times more difficult to finance a current account deficit, now that capital flows are one-third their pre-crisis levels.
This helps to explain the euro. The euro area is a current account surplus area. The US is a current account deficit area. The interest rate differential argues for a weaker euro.
The current account position argues for a stronger euro. These two forces battle it out in the foreign exchange markets, and the result is less euro weakness than many had expected.
This new model for foreign exchange has implications that reach far beyond the errors of euro/dollar forecasting.
Reduced capital flows means reduced capital inflows into Asian markets – something that has already slowed the pace of foreign exchange reserve accumulation. Reduced capital flow may mean a less efficient global allocation of capital resources.
Global capital flows have been hidden from the headlines, but the collapse of globalisation may turn out to be one of the most important economic changes of the past decade.
The writer is Senior Global Economist at UBS Investment Bank.
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