PM Perspectives: Interest-Rate Outlook, Fundamentals Present Potential Currency Upside
Co-Head of Global Bonds Chris Diaz sees opportunity for certain currencies to recover over the next three to 12 months on a likelihood that central banks will raise interest rates to control growth and inflation.
- Norwegian krone, Czech koruna and Colombian peso have weakened because of unfair association with emerging markets such as Turkey and Argentina.
- Strong economies will encourage central banks to raise rates.
- UK pound may still face Brexit-related pressure.
Chris Diaz: Interest rate differentials, differentials in central bank expectations, differences in growth, inflation, all of these factors suggest to us that both currencies of Norway and the Czech Republic should be a bit stronger than they are today.
In the case of Norway, inflation has been increasing. Growth remains around potential. It is a country that is very sensitive to the price of oil. Oil prices have not only stabilized, but they have now been increasing. We would expect that the central bank is going to raise rates in September and likely continue to raise rates in the foreseeable future. Now, the Norwegian krone has reached its weakest level relative to the euro.
We believe that is the case for a number of reasons, one of which is that it is a G10 currency that has a tendency to be more highly correlated with riskier currencies like emerging market currencies. It is often considered a commodity currency or a commodity exporting currency, primarily due to the large deposits of oil in the North Sea that it exports.
The Norwegian krone has traded in kind with those currencies, but we think the economy is quite different and frankly very different from what is going on in the eurozone. And for those reasons, we think the currency is grossly undervalued.
The Czech koruna has suffered from, one, being considered an emerging market currency. Additionally, the Czech Republic is sensitive to the auto industry. And with the threats that have come out of the Trump administration regarding tariffs in the auto industry, it certainly would be a country that could be impacted fairly significantly. Now, we think that the likelihood of those auto tariffs is probably fairly low, and the fundamental situation is quite strong in the country. Growth has been fairly stable. Unemployment is at its lowest level of the cycle. Wages are increasing very rapidly, north of 6%, which we believe ultimately will feed into inflation. It is going to force the central bank to raise rates at a more significant pace than really the rest of the world. So, when we look at the Czech koruna, the Norwegian krone, interest rate differentials look like they all will favor these two countries, not only over large developing countries but over large emerging countries, as well.
Some of these currencies are 10%, 15%, 20% undervalued now. We think there is certainly room for a level of correction that would provide meaningful impact.
So, call it three to 12 months, we would expect to see some correction in the price of the currency payers. But it certainly could get weaker in the near term as these issues persist.
There are certainly other countries, currencies that are reacting to factors other than fundamentals. Certainly, in the G10, the UK, the pound is one of those currencies where we continue to deal with Brexit-related issues. If we have what is a so-called hard Brexit, it is our view that that could lead ultimately to a bad economic outcome in the UK, could lead to a recession, and could have significant currency implications, regardless of what the economic data is telling us, regardless of what is happening in interest rates.
One country where we are favorably inclined is Colombia. There have been some parallels drawn that it has some of the same issues that some of the weaker countries have. We would disagree. There is not a funding issue in Colombia. A lot of their debt is not denominated in U.S. dollars and in euros the way it is in, say, Turkey. The fundamentals are much stronger. Growth outlook is better. Credible central bank, credible government, market-friendly government, committed to fiscal discipline. And frankly, the currency looks deeply undervalued relative to the price of oil, which is a significant and material export for the country. We think that that potentially could be another opportunity for investors in the coming months.
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G10 or Group of Ten is a group of developed market countries that cooperate on economic and monetary matters.