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By EV Forward

London - Developments in the international energy market are acting as a significant driver for shifts in country trade balances and movements in exchange rates for key global currencies. Generally, net energy importers such as the European Union and Japan have seen their Real Effective Exchange Rates (REER) fall this year, whereas net energy exporters like the U.S. have seen an appreciating or stable REER.

In our view, these trends are likely to be sustained: Oil and gas prices may eventually settle at higher levels, leading to a gradually lower contribution to overall inflation, yet energy could continue to act as a significant determinant of net export trends and the relative strength or weakness of currencies.

Energy price outlook

We expect energy prices to remain elevated for the foreseeable future, with supply shortages sustained by two principal factors: 1) Perhaps foremost in readers' minds is the potential for a long-lasting halt in Russia's supply of oil and gas to Europe; and 2) Underinvestment in oil exploration has become more pronounced in recent years, with more money flowing toward the sustainable energy transition, which represents a long-term structural shift.

Even if the Russia-Ukraine conflict concludes, the energy transition may prove to be a source of structural support for the U.S. dollar, while remaining a headwind for net energy importing currencies such as the euro, sterling and Japanese yen.

New regime for bonds

These dynamics are likely to impact bonds. Not only is the U.S. a net energy exporter, but a stronger currency also reduces imported inflation. This puts the U.S. at an advantage relative to the likes of the eurozone, whose weaker currency gives the European Central Bank further reason to tighten.

Indeed, the energy crisis is an ongoing issue for sovereigns in the region, which is likely to force central banks to remain hawkish to cool the economy, support foreign exchange and avoid an entrenchment of inflation expectations. We anticipate longer-term inflation expectations for both the U.S. and Europe to be at least 2.5% — meaningfully above averages over the last decade and suggesting that equilibrium bond yields are also likely to be higher.

By contrast, the Bank of Japan remains the outlier among developed market central banks, given its ultra-loose monetary policy. The widening U.S.-Japan yield differential and worsening terms of trade do not support the currency.

Bottom line: We expect to see elevated energy prices for the foreseeable future, with ongoing supply shortages. We believe these dynamics are likely to effect shifts in country trade balances and global currency exchange rates which, in turn, are likely to impact bond yields.

Andrew Harmstone
Portfolio Manager, Head of Global Balanced Risk Control (GBaR)
Senior Portfolio Manager, Global Multi-Asset