Market Thinking

making sense of the narrative

Making sense of currencies

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The following post is a long form read about the principles of Market Thinking as applied to currencies. The short take-away is that most of the market’s mental models about currencies arise from a combination of theory and practical experience of the boom/bust behaviour of emerging markets over the last 75 years. Taken as snapshots, these models can appear confusing and contradictory; sometimes growth is good for an exchange rate, other times bad. Sometimes it is all about the current account, other times it doesn’t matter at all and only interest rates are important. Other times none of it seems to work. Not only do we try to make sense of which narrative works when, we also note that most developed market exchange rates move within a + or minus 10% range which means limited real world impact. And this includes Sterling over Brexit. Moreover, despite frequent attempts to treat China as an emerging market for FX purposes, it refuses to behave as such, leading to multiple failed narratives here too.

The currency markets are, quite literally, the biggest makes in the world by value and yet so often appear to trade in a random fashion, or at least in defiance of any so called fundamentals, to the extent that statistically the most accurate forecast of an exchange rate in 12 months time is its current spot rate. This is not to say that this is very accurate at all, just that it works better than the forward rate, (used for hedging) or any other method of forecasting. In fact, the flaw in the FX markets is their very size, the leverage that is almost instantly applied to any shift in the narrative means that large momentum trades can develop around a given perceived fundamental. As the momentum develops, the fundamental story appears ever more justified and the narrative becomes stronger. Indeed, it is most compelling just before the direction changes, after all there needs to be ‘a bigger fool’ to sell to and when they turn out not to be there or an ‘event’ happens, the ‘thing that we all knew to be certain’ to quote Mark Twain ‘turns out not to be so’.  And, to complete the aphorism, that rather than the thing you don’t know, is what kills you. 

It is for this reason that we refer to FX markets as ‘noise trades’, as the closer we get to a directional change, the louder the narrative noise becomes. However, rather than being all about the big macro driven currency speculators, we need to recognise that the daily business of the FX markets is run by highly leveraged banks and traders who are trading the ‘flow’ that comes from fundamental hedging behaviour, with the aim of harvesting lots of small directional-trade profits. It is always worth remembering that a so called ‘big figure move’ for these traders is actually the second decimal place, something that barely registers in the real world. The market trends then evolve organically, it either reverses as the directional hedging trade fades, or compounds as it triggers new fundamental hedging to take place and it is this that then brings in the macro speculators, who in turn bring in their narrative toolkit. Market Thinking is thus about trying to assess where we are in this process, what is mean reverting ‘noise’ and what is likely to trigger further hedging and a medium term trend.

To try and understand how to manage FX risk, therefore it is worth at least starting with the fundamentals, for some aspect of them is usually embedded in the noise and the narrative. Here we can go to Purchasing Power Parity, or PPP, which essentially states that the internal and external purchasing power of the currency should be the same. This makes sense, if five dollars buys a cup of coffee in Paris Texas, its exchange rate to euros should approximately be such that it also buys a cup of coffee in Paris France. Indeed, for many years the Economist magazine has run a ‘Big Mac Index’ that follows this very principle.

Now, while we know that not to be exactly true, it is the broader point about relative  growth and inflation that matters. If, for example, prices rise in the US but not in Europe, then the coffee or Big Mac in Europe suddenly looks great value, so US demand will switch there instead. However,  the coffee sellers in France now see that the price of the Big Macs they want to buy in Texas has gone up in $ terms and with no change in the exchange rate that means in Euro terms as well, so will demand more $ for their coffee, in other words the exchange rate will adjust down (for the $) to keep the prices of Big Macs and coffee in the US and Europe in line. Fundamentally then, relative domestic inflation means a depreciation of the currency. While obviously these examples are not really tradeable goods, the principle is the same and ultimately it is relative growth and inflation that drives PPP and thus the narratives that appear will often focus on these aspects of an economy,  in so far as it suits the directional trade at least.  

We can think of this in practical terms when applied to currencies of emerging markets, which tend to be the ‘purest’ form of currency trading in that there is much less of the hedging flows outside of the big five currencies of Dollar, Yen, Sterling, Euro and Swiss Franc and thus they are much more about fundamentals and speculation. Moreover, they are also almost entirely traded against the US $, with very little in the way of cross trades, due to the history of emerging markets themselves. To recap; under what became known as the Washington Consensus (WC),  the post war period saw US $ surpluses used to fund overseas investment through, inter alia, loans to emerging markets, notably in Latin and South America but also subsequently Asia. Among the conditions of the WC was that the exchange rate should be fully convertible and that loans would be in $ not local currency. Broadly, workers moved to plantations or extractive industries or left the farms and moved to towns and their production was largely for export to the west/US. So here we can see the theoretical flows and the development of mental models for markets. The Emerging economy then attracts capital inflows and the currency rises as $s are exchanged for pesos (for example). Economic growth is stimulated  and a current account surplus is generated as exports boom. This strong economic growth from loans and FDI then attracts other capital market participants, not least because the WC encourages privatisation of state monopolies such as Telcos, airlines, construction or other utilities and Wall Street capital is only too happy to participate. This means more demand for Pesos, the currency rises further and a correlation is noted between economic growth and currency strength.  

The next phase sees export earnings continue, albeit margins are now being squeezed as domestic costs are rising and products are sold in $, but higher wages and stronger exchange rate mean imports boom and the current account surplus starts to shrink. Pesos are now being swapped into $ and the currency starts to weaken. The correlation between economic growth and currency now seems to be inverted, so some market participants are caught out. Volatility in the currency then picks up which raises risk prima generally, so capital inflows slow, but now the domestic consumer is busy borrowing either directly or indirectly in $ to fund a consumer boom. We move from a strong economy with a rising currency to a strong economy with a falling one, not least because now PPP starts to come into play as domestic prices rise relative to overseas $ ones. 

The market notices the correlation between current account surplus (good for FX) and now a current account deficit (bad for FX), so the narrative switches to the Current account as a key high frequency indicator. In fact, they would be better off looking now at the Money Supply and the interest rate, for what tends to happen next is that the government, because it has borrowed in $s, has lost control of its money supply and a combination of a weaker currency and/or a tightening of US monetary policy (for domestic US reasons) has left it struggling to meet its $ interest payments. The solution of course is to issue domestic debt in pesos, which, necessarily require a higher coupon. At this point we tend to see a new flow of ‘hot money’ into the currency to play the spread between the cost at which the western (or as was often the case Japanese) trader can borrow money and the yield being offered by the emerging market government. 

Once again, the narrative has changed as the currency tends to switch back to positive as the flow overwhelms the fundamentals, so the narrative around current account deficit = bad appears to break and the emphasis either switches back to high nominal growth = good, ignoring what we know about PPP, or rather it tends, rather more simplistically, to focus on spread and carry. Thus growth that is seen to ‘need’ higher interest rates as it is inflationary is now seen as a good reason to buy the currency as the carry will now be bigger and money pours into the short end of the yield curve, pushing the cost of funding the government deficit even higher. There almost certainly is a government deficit by now, not least because ambitious government spending projects are now meeting the reality of slowing export earnings (as the previous currency strength and wages boom undermined the competitiveness of the export sector) and an over-leveraged consumer facing ever higher debt repayment costs. So in this phase we have the markets ‘rewarding failure’ and chasing ever higher short term rates, even as they destroy the balance sheets of the country.

We then finally get to the bust phase, where debtors start to default and all the hot money rushes for the exits. At this point currencies collapse really quickly and everything then implodes. Nobody can meet their $ debt obligations and the IMF and World Bank – ironically exactly the people behind the WC in the first place – have to step in. The markets notice the correlation between size of government deficit, bond yields and currencies and switch from high spread = good to high spread = bad, with a flight to quality and steady growth.  Suddenly it becomes all about low and stable real yields, not least because that is where all the hot money is now returning to. 

Thus in summary, during the course of the round trip from boom to bust in our emerging currency the models and narratives flip flop multiple times. We have growth and current account surpluses as good, then as imports increase the current account surplus shrinks and thus growth is now apparently bad for the currency. As such, the current account now appears to be ‘the best’ indicator, but this now fails since the very consumer borrowing that is driving imports also causes a domestic boom, attracting capital inflows and we are back to growth is now once again good for the currency. If this wasn’t confusing enough at a time when as inflation picks up, fundamentals are telling us the currency is overvalued on PPP, hot money is chasing the higher interest rates that come with the inflationary boom and PPP is turned on its head. The more a currency becomes fundamentally overvalued, the more attractive it becomes to the spread traders. Thus inflation and ensuing high interest rates now become the key indicator. Nobody cares about the current account or even the growth rate any more, its now all about rates. Finally, when everyone is looking at rates, it’s the balance sheet that matters (as ultimately it always does) and thus high yield, poor balance sheet countries go from being the hottest ticket in town, to closing on the opening night. Quality and stability become the watchwords and G7 currencies become the focus.

The point of this long explanation – and it can be applied to almost any and every emerging market over the last 70 years – is that the legacy of all this is a set of mental models that are incorporated into the narrative around the big 5 currency cross rates at any particular time, but because there is rarely any real boom bust economics in developed economies, these narratives rarely endure. This is partly because of the broader nature of the underlying economies, their lower import dependency, more stable central banks and and lower inflationary vulnerabilities, but also because the crucial cause of the instability, the WC requirement to borrow in $, is missing. Thus most major cross rates rarely move in more than a +or – 10% band, even though the narratives may try and push them. The recent ‘exception’ of course might be seen to be Sterling with Brexit, but even here if we were to centre Sterling-Dollar  around $1.35, then the swing towards ‘definite remain’ and then the panic towards ‘crashing out’ is pretty much captured in the $1.49 – $1.21 band 10% either side of that fair value since 2016.

The difference between emerging and developed economies is particularly important when the macro speculators are trying to apply their emerging market mental models to China, because they are expecting China to behave like an emerging market when actually from an FX point of view it is not, not least because it does not follow any of the rules of the WC – which of course is one of the reasons it is successful(!)  For example,  the current focus on the shrinking Chinese current account surplus as a ‘necessary reason’ for a currency depreciation assumes a domestic Chinese consumer debt financing imports – which simply isn’t the case. Equally, the focus of others on the amount of Debt (stock) to GDP (flow) as a reason to sell the currency is not only wrong in principle, but ignores the fact that the debt is almost entirely currency matched, ie not in $. Yet more speculators are saying that slowing growth is bad – even though it is still 6% in real terms – while others are saying that the trade war will force interest rates much lower (and thus the carry to collapse) when in fact that is a key feature in stopping US rates rising. In fact, the Chines Yuan has traded in a +or – 5% band against the US$ over the last 12 months and in a + or – 3% band against the SDR basket of currencies.

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