An existential cry has been sounded once again in the world of FX which has suddenly been reduced to trading short term signals in a fickle market. Shocking. Gone are the days of simple carry, Risk on-Risk off and easy reifying market stories. And it seems they are missed, almost as much as they were once bemoaned…
From HSBC’s ever excellent FX team:
The scramble for a fresh explanation for global market moves is on, but they all fall short because of contradictory moves in some markets. A China slowdown helps explain lower commodity prices and commodity FX, but seems inconsistent with US equities close to all-time highs. Abundant and growing global QE may explain this equity bullishness, but seems at odds with the decline in gold and other commodities. Perhaps the answer lies in a retreat in inflation expectations, but given this is widespread, it is questionable whether it should be a unifying theme for the relative world of FX, especially when Japan is reflating. Correlation analysis suggests carry has not strengthened or weakened as a theme.
It’s almost sweet. RoRo provided a comfort — you knew which currencies to pick up when risk was on/ off and all you had to do was decide which side of the dial was dominant:
HSBC suggest RoRo’s dominance fading (something not everybody agrees with) is a reflection of the decreasing volatility in equity markets, particularly the S&P500 which makes the influence of RORO on other assets less apparent, and the shifting role of the US dollar — it now benefits from good US data whereas before its safe haven role provoked the opposite reaction:
It may still retain a safe haven allure against internationally driven wobbles in the RORO dynamic, but at home it has reverted to being a conventional play on the US monetary policy outlook. This type of rule change is exactly what causes confusion.
Carry is still largely out of the picture bar where the yen is concerned:
China’s potential hard landing is making a less than totally convincing case as a global currency driver — for one, the strength of US corporates in the face of a what would be a serious threat to overseas earnings suggests that fears about a China-slowdown are not as wide as suggested.
Of course one might make the point that liquidity is the cause of US equity peaks. But, notes HSBC, the QE explanation trips up as a unifying theme as commodities and commodity currencies would not normally be expected to fall amid such a swathe of liquidity, particularly gold.
As an aside, there’s also the simple point that can’t be repeated enough: the effects of QE on currencies are not linear. As Nomura’s Richard Koo said recently explained…
For example, the US monetary base grew from 100 at the time of Lehman Shock to 347 today as mentioned earlier, but the money supply grew only from 100 to 135 during the same period. In the UK where the monetary base now stands at 433, the money supply is stuck at a pitiful 110. In the Eurozone, the monetary base is at 157 while the money supply is at 107. In Japan, the monetary base is at 150 while the money supply is at 113. If the relative supply or scarcity of currencies is supposed to determine the exchange rate, the above numbers suggest that the Euro should be the strongest, followed by the pound, the yen and the dollar.
Instead, foreign exchange dealers and traders, who probably do not have time to think about the complicated link between monetary base and money supply during balance sheet recessions, simply assumed the textbook case where monetary base and money supply are expected to move in tandem (which was indeed true before the bursting of the bubble). Thus they assumed implicitly that the market is flooded with British pounds and pushed it down to its lowest real effective rate in history by 2009.
The dollar, which recorded the largest increase in money supply during the period, remained stronger than the pound and the Euro. The Japanese yen, which had the second largest increase in money supply, became the strongest currencies of all, even though it had the lowest interest rates both at the long and the short end. The Euro which had the smallest money supply growth, replaced the pound to become the weakest of the four after 2012 (Exhibit 8).
An example of QE having the opposite of expected effect was provided by the Japanese case in 2003-04. At that time, Japan was the only country implementing quantitative easing as it increased monetary base from 100 in 2001 to 170 by 2004, all with zero interest rates. During the same period, the monetary base in the US increased to 130 and in the Eurozone to 120, and both had significantly higher interest rates than in Japan. Although the yen fell at first, the Japanese currency moved strongly higher in 2003, forcing the Japanese government to engage in the largest foreign exchange intervention in history amounting to 30 trillion yen to keep the yen from appreciating. This experience indicated that there is no guarantee that the exchange rate will weaken with a QE.
As more and more people began to realize that increases in monetary base via QE during balance sheet recessions do not mean equivalent increases in money supply, the hype over QEs in the FX market is likely to calm down. At the moment, however, that is not yet the case, as the sharp fall of the yen following the announcement of Abenomics with its commitment to monetary easing amply demonstrates.
Which leads us to inflation… something Izzy has picked up on already. A substantial fall in inflation expectations seems like one of the more reasonable explanations for the gold/commodity drop.
But, say HSBC, currencies are a relative game so if this inflation step-down is a global phenomenon then the impact on the relative merits of one currency versus another is diminished anyway:
Furthermore if inflation differentials were becoming more of a determinant for FX, we would expect to see this reflected in a higher correlation between interest rate differentials and the movements in FX. This is not the case. Chart 17 shows this average correlation for daily changes in USD-G10 currencies against changes in their respective 2-year government bond yield differentials We choose 2Y yields rather than short-term interest rates as the latter are constrained in many instances by policy being at or close to the zero interest rate bound. The conclusion is the same. The dominance of RORO may be on the retreat, but the declining red line shows that it is not being replaced by a more prominent role for carry
The point being made here is that since we don’t have a dominant theme there is rapid flipping of currency positions going on which limits the amount that currencies can move — no dominant theme means position sizes become smaller, stops tighter, and profits are taken more quickly.
It’s range trading and although it makes writing half-day currency reports that little bit more difficult — with “x rose 0.01 per cent on the back of [insert main page macro event here]” — it doesn’t seem like a terrible set-up.
Particularly when you remember that the unifying theory that was RoRo at its peak undermined the FX market by pushing those with a view towards equities where the effects of QE were marginally cleaner. “Bottom of the food chain,” was, I believe, the phrase.
