05/28/2014 12:14 EDT | Updated 07/28/2014 05:59 EDT

Currencies Are Another Casualty of Quantitative Easing's Final Act

Just over a year ago, markets went into a tailspin. At that time then-Fed Chairman Bernanke made what was supposed to be a benign announcement that gave new meaning to the word "taper." Currencies were thrust into the mayhem well ahead of the statement becoming action, as markets tried to anticipate the pricing effects of this new monetary regime. Tapering is now well underway; how are currencies weathering the storm?

First, we have to understand why currencies became involved in the process. The trillions of greenbacks made available by quantitative easing (QE) blurred the distinction between developed and emerging markets, dulling investors' sense of risk. Suppression of yields on 'safer' bonds sent excess liquidity on an exaggerated, worldwide search for yield. Carry-trade activity -- borrowing in a low-yield currency to buy high-yield currency assets -- suppressed bond yields in many of the more risky emerging markets, and boosted their currencies to unsupportable heights. Tapering of QE brought much of this activity to a skidding halt, pummeling emerging market currencies.

Last autumn, EDC Economics ranked the countries most vulnerable to tapering. Of the top five then identified (Turkey, Sri Lanka, India, Vietnam, Poland), all but Turkey saw a more muted reaction once tapering actually began than they had experienced earlier in the year. Another group, popularly labeled the "fragile five," which in addition to Turkey and India includes Brazil, South Africa and Indonesia, have seen more dramatic effects. All have experienced double-digit drops in their currencies since last May and all except India continued to slide through the onset of tapering.

Where are markets retreating to? At first, it looked like a flight-to-quality centered on the greenback. But other developed currencies are participating. Despite sluggish Eurozone performance, and recent ECB indications of looser monetary conditions in the Zone, the euro is up 5 per cent against the USD since last May, and 1 per cent since the QE tapering began. Same goes for the Swiss franc. The benign movements of the USD against a broad basket of currencies, up only 1 per cent since tapering began and 3 per cent since last May, suggest that current currency shifts speak more to a re-pricing of risk than a wholesale flight back to the USD.

However, these are still early days. This kind of monetary tightening has never been done before, and there's likely lots more ahead. Tapering is expected to be complete by year-end, and at that point, the direction of policy becomes more problematic. If growth in the coming months meets or exceeds expectations, redirection of surplus cash from financial assets to real activity would swamp the amount of actual goods and services available, resulting in inflation. At this point, the Fed has few options: a net reduction of cash, higher interest rates, or a blend of the two. Whatever the choice, recent experience suggests a stronger greenback.

How does the loonie fare? Clearly, it has softened significantly against the USD over the past year. This is in part due to the general effects on the USD of QE, but is also related to commodities -- also a victim of QE. While not as volatile as the currencies of other commodity producers, notably the Aussie dollar, the loonie has seen movements over the past few months more in keeping with the fragile five than with the other developed markets. Tightening US monetary policy suggests that the dual effect of a stronger greenback and muted commodity prices will continue to weigh on the loonie for some time, keeping it in the low-90-cent-US range.

The bottom line? Global growth will require US monetary policy to go beyond mere tapering -- taking the world into virgin policy territory. Experience thus far suggests we should prepare for global currency volatility, favouring the more larger and more stable currencies. Canadian exporters can expect the softer loonie to persist over this period. If this movement causes our post-crisis 'halo-effect' to dim further, Canada's dollar may soften all the more.