How to Trade Currencies When Inflation Bites and Central Banks Stay Put
Just because a country's inflation picks up doesn't mean a central bank will raise interest rates - but currency investors can still make money. Here's how.
Tolstoy said that "Happy families are all alike; every unhappy family is unhappy in its own way." Every central bank contends with inflation in its own way, too.
OK, Tolstoy didn't say that last part, but it's true. Australia on Tuesday left interest rates unchanged even though consumer prices rose 3.3% for the first quarter, above the central bank's target zone. And in Turkey, the central bank governor declined to raise interest rates last week despite raising the forecast for annual inflation to 6.9%. But the European Central Bank seems poised to raise rates for a second time this year even though inflation is running under 3%.
This excellent graphic from the Wall Street Journal gives you a sense of how central banks have or have not been raising rates over the last several years.
The good news for currency investors is that you can do well buying currencies when inflation picks up but interest rate hikes aren't imminent, so long as other factors are in play.
Here's how, from two currency experts.
"Most central banks, including those in Asia and emerging markets, see that most of their inflation is coming from imported commodities," says Steven Englander, head of G10 foreign exchange strategy at Citigroup. "So they tighten, but not enough to slow their economies down," he told me.
In other words, you get a country like Australia refraining from a rate hike - but the currency is still strengthening.
So how should you invest in that environment?
Here's what Englander has to say:
Right now, "The message across global markets is that no central bank wants to tighten enough to really squeeze their economy. So we end up in a risk-on situation."
That's a negative for the U.S. dollar - and potentially a positive for the Aussie, the kiwi, and for that matter, the Turkish lira.
"The more comfortable you are with the idea that there won't be a big monetary squeeze, the more you go up the risk curve where there is more support," Englander says. In other words, take a page from Willie Sutton and follow the money, er, capital flows, almost regardless of interest rate policy.
Marc Chandler, global head of currency strategy at Brown Brothers Harriman, points out that central banks confronting inflation don't necessarily need to raise interest rates if their currencies are strong.
"Currency appreciation is a headwind on an economy," he told me. Chandler predicts that if the Aussie dollar moves to $1.12, as a number of analysts believe it could, the Reserve Bank of Australia may not even feel a need to raise interest rates since the currency would put a sufficient brake on economic activity without stifling growth.
"Australia has a relatively small economy that's relatively open, and concerns about inflation and about raising interest rates," he says. The central bank "is walking a fine line. They don't have a lot of degrees of freedom."
So there you have it. Interest rate hikes don't always follow inflation, especially in developing or export-driven economies. But when a country has strong growth prospects, and investors have an appetite for risk, you can still find profitable currency trades when inflation strikes, even when central banks aren't responding predictably. Just be sure you have the right time horizon if a currency has been strengthening for a while - and get going.
Tune In: CNBC's "Money in Motion Currency Trading" airs on Fridays at 5:30pm.
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