Last week, we looked at the inflation/deflation debate in terms of its implications for monetary policy, and, by extension, for the global economy, over the coming months and years. This week, we turn to the specific theme of the currency market. What does inflation, and specifically the relative difference in inflation levels between countries, mean for their respective currencies, and can we use this information to forecast the likely direction of exchange rates?
In theory, the relationship between a country’s inflation rate and the value of its currency is a pretty straightforward one. As inflation represents a de facto decrease in the intrinsic value of the currency (you can buy less stuff per currency unit), a relative increase in inflation (or expected inflation) should decrease the value of the currency in terms of its peers. Similarly, deflation should be positive for the currency, as each currency unit now has additional purchasing power relative to its peers. Over the long term, this relationship between inflation and currency valuation does tend to hold up pretty well. For example, between 1900 and 2011, consumer prices in the UK increased by about 1% per year (0.96% to be exact) more than they did in the US. Over the same time period, the pound weakened against the dollar by almost the exact same amount (1.01% annualized depreciation, from $5 to $1.55).
So, this currency forecasting business seems pretty easy, right? Just buy the currencies whose countries are experiencing deflation, and sell those experiencing inflation. If only it were that simple. Let’s take another look at the British pound. Sterling has been one of the world’s best performing currencies since March, and is at its strongest level since 2010 against a basket of major currencies. However, the UK is also experiencing the highest level of inflation of all 28 EU member states (including the previously inflationary economies of countries like Hungary, Poland and Romania), at approximately double the EU average. In fact, the only OECD countries which are experiencing higher levels of inflation than the UK are Turkey (at 8.2%), Mexico (3.5%) and Iceland (3.8%). (Note: All three of these countries have experienced currency crises in the relatively recent past).
This apparent paradox, where higher inflation actually leads to a stronger currency, is not restricted to the pound. Take the following head-line from Bloomberg this morning (emphasis added):
“Canada’s dollar weakened the most in a month as slowing inflation…raised the possibility the central bank might reduce interest rates…”
Hmmm. Not only does falling inflation seem to correlate with currency weakness, it actually seems to be causing it as well. The reason for this apparent paradox is the phenomenon known in the financial markets as the ‘carry trade’, which involves the purchase of high yielding assets (or currencies) which are funded by the selling of low-yielding ones. As this trade involves buying currencies which offer higher nominal interest rates, which tend to go hand-in-hand with higher inflation rates, it actually leads to an appreciation of inflationary currencies relative to disinflationary ones, directly contradicting the long-term negative relation-ship between inflation and currency strength.
The more popular this trade becomes, the more inflation and currency strength become positively, rather than negatively, correlated. As such, it could be argued that the more speculative activity that is occurring in the market, the more carry trades are being made, and the more inflation and currency strength become positively related (benefiting GBP and emerging market currencies, whilst damaging currencies like the EUR and the CAD).
Going back to our original objective, how can we use expected inflation rates to try and predict the future direction of exchange rates, when we have two apparently counteracting forces at work? Long-term purchasing power parity (which indicates that inflation should be bad news for the currency, as per the long term performance of GBP against the USD) seems to tell us one thing, whilst the carry trade tells us the exact opposite, that inflation should support the currency (as counter-intuitive as this might seem).
The key to understanding this apparent conundrum is to understand the relationship between the carry trade and what is known as ‘currency crash risk’. In the vernacular of the trading world, carry traders are prone to regularly “going up by the stairs”, whilst occasionally “coming down by the elevator.” In other words, these strategies typically exhibit periods of gradual appreciation (when markets are calm), punctuated by sudden crashes (when markets are volatile). In other words, whilst it is true that over the long term inflation tends to weaken the currency, this long-term depreciation is actually characterized by long periods of gradual appreciation, punctuated by short bursts of significant depreciation.
Chart: VIX (red) and TED spread (blue) converge near 12 month lows; warning sign for the carry trade?
How do we go about using this knowledge in a practical way? Well, it is important to try and as-certain whether we are currently exposed to a ‘carry-friendly’ market or not. In this regard, there are a couple of things to look out for. First of all, the carry trade tends to be closely related to global risk appetite. The higher the risk appetite, the more popular the carry trade becomes. In addition (and perhaps counter intuitively) this also means than when risk appetite is at its highest, the expected returns for the carry trade are at their lowest (as the trade becomes crowded). Using the VIX (implied volatility of S&P 500 equity index) as a proxy for risk appetite, we can see the global risk appetite is near its highest point this year (and indeed near its highest point since
Secondly, the carry trade (like most speculative trading strategies) is highly reliant on liquidity. This is particularly true in the FX market, as currency trades are frequently con-ducted by highly leveraged investors (the leverage is necessary due to the relatively small movements in currencies compared to other asset classes).
Using the TED spread (the spread between LIBOR and treasury bills) as a measure of market liquidity, we note that liquidity has been generally increasing throughout the year, and is currently near its 12 month low. Whilst this liquidity is good news for the carry trade on a contemporaneous basis, it also represents a warning sign on a forward looking perspective.
So, what’s the bottom line? Overall, and over the long term, macroeconomic fundamentals do drive currency valuations, and inflation is damaging for the currency. However, over the short run, this trend can be overpowered by the carry trade, which favours high inflation currencies. Whilst we are currently seeing a minor revival of the carry trade, exemplified by an exaggerated risk appetite and high levels of market liquidity (depressed VIX and TED spread) as a result of central bank intervention via quantitative easing, we do not expect these conditions to persist. In the short run, this could mean further weakness for the currencies of countries exhibiting relatively low inflation (e.g. CAD, EUR) and appreciation for GBP and emerging market currencies. How-ever, we expect this trend to be a temporary phenomenon (a conclusion supported by the high levels of global risk appetite and liquidity), and over longer time horizons (6 months+), we favour currencies with lower (expected) inflation rates (e.g. EUR, CAD).