Liquid Insight: The Taylor Rule and FX Carry

Research evidence excerpt

Liquid Insight: The Taylor Rule and FX Carry

The G10 rates redress

Carry has become the dominant trading theme for G10 FX for the coming months

against the backdrop of declining FX volatility and global central banks grappling with

the impact of the terms of trade shock. Lessons appear to have been learnt from

previous supply side shocks: large interest rate increases are not the prescription for the

current macro conundrum and the bulk of our G10 central bank forecasts predict modest

tightening to commence in the coming months. Part of this is a reflection that central

banks had only recently emerged from a tightening cycle, and policy rates in some

countries are at or close to restrictive territory. A modest tightening cycle is therefore

likely to limit recessionary tail risks, an environment which is conducive to lower

volatility. Of course, with the US-Iran conflict still unresolved, the risks remain tilted to

the downside for growth and re-emergence of stagflationary risks. But it seems clear

that markets have a willingness to price central banks beyond the conflict.

A key theme from central banks has been a focus on financial conditions and policy rule

measures such as the Taylor Rule, which we think could be an important anchor for

markets particularly the interaction between inflation and activity. The Bank of England

for example has leveraged heavily on the Taylor Rule at its recent policy meeting when

outlining three scenarios which could determine the outlook for UK rates. The key

question for many is whether current rates are restrictive or whether adjustments are

needed. Top of that list is the US where the ongoing strength in US data has led to a

debate on whether the Fed should be contemplating hikes rather than cuts.