Strong Dollar Policy?
This past week in Davos, at the World Economic Forum, the U.S. Treasury Secretary Steve Mnuchin, remarked that the recently weak dollar has been good for the economy. As the U.S. dollar dropped the most in almost a year, verbal daggers began to fly. Mnuchin was attacked for apparently abandoning the “strong dollar mantra” to which previous Treasury Secretaries adhered. Commerce Secretary Wilbur Ross, directly refuted the notion that the U.S. is abandoning the “strong dollar policy”. President Trump, despite comments during the election calling the dollar “overvalued”, stated that good economic fundamentals would cause the dollar to get “stronger and stronger”. Former Treasury Secretary Larry Summers felt compelled to write an op-ed piece in order to call Mnuchin out for his blasphemy (see Mnuchin fails on style and substance ). Some of the criticism from Summers is well-founded. Summers advised Mnuchin to say as little as possible about markets, which all politicians, and their appointed officials, would do well to heed. His admonitions about the ill effects of a weak currency, and markets’ tendency to overreact to official statements, are on the money as well.
In reality, this is all nothing but noise. Statements by the Treasury Secretary, the President, or any other official, that we have an official “strong dollar” policy has no bearing on whether our policies are actually fostering a stronger dollar. Besides that, most of the fundamentals which drive currencies cannot be directly affected by these officials. Technically speaking, the value of the dollar falls within the purview of the U.S. Treasury. It is the agency which intervenes in currency markets, when such intervention takes place. But the treasury has not intervened since 2000 (see Treasury FX Intervention ), when it purchased Euros (sold U.S. dollars) to stabilize the European single currency after a sharp drop. Intervention notwithstanding, virtually nothing in the treasury’s normal operations affects the fundamental drivers which determine the value of the U.S. dollar.
The theoretical cornerstone for currency analysis has historically relied on the concept of Purchasing Power Parity (see PPP ). There are two versions of the theory: absolute; and relative. Absolute PPP holds that a basket of goods should cost the same no matter in what country it is sold, or currency in which it is priced. In effect, arbitrage should cause currency cross-rates to converge to levels where arbitrage is no longer possible. In the real world, to the extent this theory holds, it’s over very long time horizons. Furthermore, analysis is heavily complicated due to tariffs, quotas, various transaction costs, and the fact that many services cannot be exported. Relative PPP promotes the idea that inflation differentials over time should be reflected in the FX rate. For example, if country A has an inflation rate 5% higher than country B, country A should see it’s currency depreciate -5% relative to country B. Within the concept of Relative PPP, we have the Real Effective Exchange Rate, which is a measure of a currency adjusting for inflation over time ( REER ). While the relative version of PPP seems to hold better than absolute, it still suffers from very long lags. History not only shows that currencies can deviate substantially (+20% or more) from PPP estimations, but also, a trend from overvaluation to undervaluation (or vice versa) often occurs over a period of a decade or more.
In addition to PPP, various theoretical models have been developed to explain exchange rate dynamics. Generally, these models focus on estimating some level at which fundamental forces are in balance. The macroeconomic-balance approach favored by the International Monetary Fund seeks to find a rate that equalizes a normal savings/investment balance in a country with its current account balance. Generally speaking, this is a good approach for the long-term.
The current account is the measure of net trade plus net factor income. The balance of payments (see BOP ) equation in economics requires that the current account be directly offset by the capital account (adjusting for statistical discrepancy). To simplify, the current account can be thought of as a measurement of income flows, while the capital account measures the investments which create the financial portion income flows (non-trade related). Since it is an accounting identity, it must hold. For example, a current account surplus (money flows in) must be offset by a capital account deficit (money flows out). By the same token, a current account deficit requires a capital account surplus. For anyone seeking to anticipate FX movements, it’s important to realize that the cause/effect relationship can flow in either direction. Exchange rate movements can be dominated by either the current account (mostly trade flows), or the capital account (investment flows) in any given period. A basic understanding of these forces is a good starting point to developing a method to forecast FX rates.
An Empirical Indicator Approach
Utilizing the theoretical insights outlined above, I have developed an indicator based on 10 different fundamental metrics. The metrics utilized include several balance of payment data series (scaled by GDP), along with Terms of Trade, International Reserves, and the Real Effective Exchange Rate. Terms of Trade is defined as the ratio of export prices to import prices. For ease of measurement, commodity prices are generally used, since those prices are easily observed. As previously noted, the Real Effective Exchange Rate (REER) is derived from the theory of Relative PPP, and seeks to measure the cumulative changes in the FX rate (nominal rate) against its inflation differentials averaged across a trade-weighted basket of major currencies. For example, a high REER would mean that a currency has not depreciated in line with a higher rate of inflation relative to other countries. International reserves is straightforward. A large amount of foreign currency reserves acts as a buffer against depreciation, since it would allow for intervention if necessary.
It’s important to note that some countries will always have a tendency to run either a current account surplus or deficit. While a CA deficit (surplus) would normally be associated with currency weakness (strength), this may not necessarily be the case. The macroeconomic-balance approach dictates that there needs to be a long-term equilibrium between the current account and a country’s “normal” savings/investment balance. Some countries, because of demographics, culture, or other reasons, will always run current account surpluses, due to a persistent excess of savings. Others typically run current account deficits caused by a dearth of savings. Neither of these situations, if in balance, will necessarily prompt exchange rate movement. Therefore, in constructing my indicator, I rely on levels and rates of change relative to history, rather than directly on the metrics themselves.
Chart 1 shows the U.S. dollar (DXY Index) versus my “Fundamental FX” indicator (F-FX). The F- FX runs between +100 and -100 (right axis), with more positive numbers being bullish, and negative numbers bearish. While not perfect (no indicator is), for almost all of the 32 currencies I follow, there is a strong positive correlation between the level of F-FX and currency movement over the next 6 to 12 months. This time frame bridges the gap between the very long-term nature of many fundamental models and shorter-term approaches, which tend to focus on technical analysis, or attempting to guess the timing of central bank policy changes, and their effect on interest rate differentials.
As can be seen from Chart 1, entering into 2017, the U.S. dollar F-FX indicator was below -50 on its way to -82 in March. This negative trend was led by weakening trade deficits, but more substantially, a real exchange rate in the 98th percentile for the last 10 years. Subsequently, the DXY fell -11% (102 to 91) from March to September. This happened despite the fact that the U.S. was the only major country where the central bank was tightening monetary policy.
U.S. Dollar (DXY) vs. F-FX Indicator
Certainly, shifts in monetary policy are a common catalyst for FX inflection points. In this era of unprecedented monetary policy, timing and anticipating moves may be more difficult than in the past. However, an understanding of the fundamental catalysts to currency moves can often presage central bank policy shifts. Chart 2 shows the Euro vs. its own F-FX indicator. It illustrates the same inverse relationship as seen in the DXY in real-time (with a positive correlation between F-FX and 6 to 12 forward moves in the currency). The reader may also notice that both the Euro and its F-FX show a strong inverse relationship to the DXY and its fundamental metric (the 2 charts are almost mirror images). This isn’t surprising given that the Euro makes up about 57% of the DXY index. The inverse relationship between the two fundamental indicators acts as further confirmation of the efficacy of the indicator.
Euro vs. F-FX Indicator
An interesting element illustrated in Chart 2 is the price action of the Euro from late 2015 through 2016. The European Central Bank (ECB) embarked on a massive Quantitative Easing (QE) program, along with negative interest rates, in an unprecedented move to stimulate the European economy. The F-FX indicator showed modestly negative fundamentals prior to this, but the massive depreciation in the Euro shifted fundamentals sharply positive by the time the Euro had dropped around -20% to around the 1.10 level. By that time, market sentiment had moved to an uber bearish zone. It seemed to many that the Euro was definitely going to 1.00 or lower. And yet, despite what could be the most aggressive monetary policy in history, which would usually be bearish for the currency, the Euro could not go lower than about 1.03. At that level, real economic forces, such as a +3% current account surplus (as a percentage of GDP), were completely nullifying speculative flows (a current account surplus requires an equal outflow of capital absent currency intervention).
As I have noted in previous posts, combining fundamental analysis with positioning can help investors anticipate significant market inflection points (see ’99 Redux ). Chart 3 shows the Euro vs. CME Net Speculators positions as a percentage of open interest. It’s pretty obvious from the chart, that large net long spec positions typically precede depreciation, while large net short positioning indicates higher potential for a rally. When periods of extreme positioning coincide with fundamentals applying pressure in the opposite direction, powerful FX moves usually ensue.
Euro vs. Futures Net Speculators as a Percentage of Open Interest
Source: CFTC and Bloomberg
Prior to the strong move higher in the Euro last year, the percentage of net specs in Euro futures was hovering around -30% of open interest. As the global economy accelerated in late 2016, with Eurozone growth improving to the highest level since 2010 over the last year, the table was set for rapid Euro appreciation, as shorts got squeezed, and capital flowed into Euro-denominated assets. The Euro is now up about +21% since the beginning of last year. Interestingly, based on the F-FX indicator (+10 for the Eurozone), that huge move has only gotten the Euro close to a neutral reading. And the ECB has yet to begin normalizing policy. Although, the case could be made that much of the move in the Euro was in anticipation of that normalization, actual tightening of monetary policy by the ECB could still power the Euro higher from here, taking it to an overvalued level.
Ignore the Noise
Talk about a “strong dollar” policy, or any other such political noise, certainly has the potential to move FX markets. But investors are better served by keeping their eyes on fundamentals and positioning. The U.S. dollar (DXY index) has dropped almost -15% since the beginning of last year. Currency fundamentals and FX positioning did a good job of signaling this move. In all likelihood, most of the dollar depreciation is probably behind us in the short-run, as the dollar is heavily oversold . So far, dollar depreciation has been dominated by the Euro. The next biggest weightings in the DXY are the Japanese Yen (13.6%) and the British Pound (11.9%). The pound has had a similar appreciation to the Euro (relative to the U.S. dollar), but the Yen has lagged. This last year’s dollar weakness has occurred in a strong risk-on environment. My next piece will focus on FX dynamics in a risk-off environment. Historically, in such an environment, the Yen is king.