COLUMN-Exit from ZIRP should have central banks on high FX alert: McGeever

(The opinions expressed here are those of the author, a columnist for Reuters.)

* G10 FX volatility:

* Global interest rates:

By Jamie McGeever

LONDON, July 24 (Reuters) – Remember currency wars? They may be back – not between rich and poor economies this time, but within the industrialized world.

As the G10 top economies finally emerge from a world of sluggish growth and near zero interest rate policies (ZIRP) at differing pace, pent-up exchange rate moves threaten to hit financial conditions, growth and inflation projections. And the scale of their impact may ultimately loop back and affect central bank decision-making itself.

When interest rates converged around zero three years ago, currency volatility hit its lowest ebb in years.

But FX rates are on the move again as central banks seek to ‘normalise’ monetary stances without coordination, much to the recent alarm of policymakers in Frankfurt, Tokyo, Canberra and Ottawa who are seeing their currencies rise sharply in value – moves which complicate their inflation-targeting goals.

We saw what happened when it became clear that the Fed would be the first major central bank to abandon ZIRP. A relatively modest four rate hikes propelled the dollar up as much as 30 percent against a basket of major currencies between mid-2014 and the turn of this year.

Will other currencies tread a similar path as their central banks move away from ZIRP, however gradually? Or will a re-convergence with U.S. rates compress volatility, as happened when ZIRP swept across the developed world after 2008?

The U.S. dollar is down 8 percent this year, on course for its worst year in a decade, as traders bet that the Federal Reserve is close to the end of its rate-hiking cycle.

This has pushed up the euro, yen, and Canadian, Australian and New Zealand dollars. Central banks in these jurisdictions, already struggling to meet their inflation targets as it is, will not be happy with steadily rising exchange rates.

Euro in Eye of the Storm

Economists at French investment bank BNP Paribas calculate that a 10 percent rise in a currency corresponds with a fall of anywhere between 0.2 and 0.9 percentage points in inflation. At the top end of that is New Zealand (0.9), and just above the average 0.4 is the euro zone (0.45).

Last week the Bank of Japan pushed back the date it expects to reach its 2 percent inflation target for the sixth time since it launched a huge asset-buying programme in 2013, and Reserve Bank of Australia officials struck a surprisingly dovish tone in various speeches.

At the epicentre of the global currency storm is Mario Draghi at the European Central Bank. Euro zone inflation is only 1.3 percent, well short of the ECB’s target of “close to, but below 2 percent”, and the euro is surging.

It’s up 11 percent against the dollar this year to a two-year high near $1.17 and up nearly 4 percent on a trade-weighted basis. Around a third of those gains has come since June 27 when a speech by Draghi in Sintra, Portugal, fueled market expectations that the ECB could announce a reduction of stimulus as soon as September.

Traders expected Draghi to warn markets about the euro’s strength at his press conference last week. But his remark that the exchange rate had received “some attention” hardly rattled markets, and the currency whooshed even higher.

The rising currency is not only a problem for the ECB. Companies across the 19-nation euro zone will feel the pain too.

According to Deutsche Bank, every 10 percent rise in the trade-weighted euro lowers earnings per share by 5 percent. The euro’s recent strength is “leaving its mark” on corporate earnings expectations, with full-year earnings revisions turning sharply negative over the past two weeks.

Strong corporate profits have gone hand in hand with the euro zone’s strong economy: both are growing at their fastest rate in six years. But it’s worth remembering what laid the foundations for that growth: a weak euro.

The single currency fell 13 percent over 2014-15, plumbing a 13-year low in April 2015. Together with a plunging oil price, negative ECB interest rates and aggressive bond buying, inflation briefly popped up to 2 percent this February.

But now oil is flatlining, the euro is up nearly 10 percent from that low, and bond yields are rising as markets anticipate the ECB flagging a policy shift later this year.

If the euro continues to rise – analysts at Societe Generale reckon it could be at $1.20 by the ECB’s next meeting on Sept. 7, given Draghi’s comments last week – the ECB faces a choice: does it talk down the euro, or delay the policy “normalization” process?

Absent any signals, traders are likely to continue pushing the euro higher and further tighten the bind on Draghi and co.

Reporting by Jamie McGeever; Editing by Mark Trevelyan

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