Real rates and inflation expectations drive any currency regime and trend

Changing real rates and inflationary expectations will have different effects on currency, commodity, and equity markets. While more localized patterns within an asset class may be different, tracking past behavior provides a set of well-defined priors. Investing against prior will require a special narrative to overcome the likely relationships.

We have been in a regime of low and declining real rates and inflation expectations rising which is often associated with dovish monetary policy. This is generally a poor dollar environment. If there is a Fed reaction that suggests a rising real rates, the dollar will move to a regime consistent with tightening policy. The higher real rates will have a more important impact on G10 currencies while higher inflation expectations will signal a better environment for EM currencies that may be commodity exporters to the US. Rising inflation and real rates would still be a risk-on environment.

If there are rising real rates suggested by Fed tightening and weakening inflation expectations, we will likely see a stronger dollar regime. The final combination of declining real rates and falling inflation expectations will signify a recession environment which will suggest a flight to dollar safety. The safety flight will dominate EM currency movement but will have a less clear effect G10 currencies. 

The switching in currency trends is all about changing regimes associated real rates and inflationary expectations. The simple 2x2 table is not a substitute for a specified model but it does focus any asset allocation discussion.