As we enjoy a short period of relative calm in the markets (most g7 central banks have recently made rate announcements, US and China talks on hold until October, Brexit still making headlines but no firm announcements are expected soon) we thought it might be worth looking at some of the main factors driving currencies; where things stand today, where we think they may go in the future, and thus the likely trajectory of currencies versus the USD.
What are the main drivers of currencies?
While there are clearly idiosyncratic factors depending on which currency pair you’re considering, in general USD crosses are driven primarily by three factors;
• The general trend in the USD. According to the most recent survey by the BIS, trading in the FX markets totaled $5.1 trillion per day. The USD remains the dominant vehicle currency, being on one side of 88% of all trades. Clearly whatever the general USD trend is, virtually all USD currency pairs will follow.
• Carry and how this carry changes over time. For this discuss we defined carry as the benefit or detriment that one experiences in selling a currency forward against the USD. If a country’s interest rate for a given period are lower than the US interest rate for that same tenor, the USD denominated fund or corporation will enjoy a positive carry by hedging that exposure.
• Value. Like most asset markets, over- and under-valuation in FX markets tend to correct over time. In FX markets this is a relative measure, and whilst there are many different ways to calculate value, we used a blended measure of purchasing power parity to determine this.
Where are we today?
The USD Trend
The USD has been trending higher against most currency pairs since the beginning of 2018 (see Chart 1). This has been down to many factors, including having higher interest rats than most of it’s trading partners (with the notable exception of China), having a stronger economy than these same partners, and benefitting from ‘safe haven status’ in turbulent times. In periods of high uncertainty (which equals high risk) capital tends to flow to those countries that will be best able to weather any storm. Due to the depth of their financial markets and the regulations that have been put in place to make the US markets resilient, the USD tends to be one of the bigger beneficiaries when the market seeks out safe havens.
Chart 1: USD Index
What will change this situation? Christine Lagarde, the outgoing President of the IMF, has said on many occasions, that risk to global trade, like that brought about by the US-China Trade War, is the biggest threat to the global economy. While there seems to be a lull in the verbal and tariff battle between the two countries, at least until talks resume in October, it seems very clear that neither country is willing to give ground, and so trade wars will continue. Add to this the uncertainty brought about by Brexit and the impact that will ultimately have on both the UK and Europe, as well as the historically high asset valuations in many asset classes, and risks remain very high. The risks to the global economy can also be seen in the shape of the yield curve across the major countries. A common school of thought says that if 10-year yields fall below 2-year yields, it is a sure sign of an impending recession in that country. As can be seen by Chart 2, Canada is already there, and the other countries are barely in positive territory. As long as these risks remain, safe haven assets will remain highly valued.
Chart 2: 10-yr yields minus 2-yr yields
What is carry currently, and how is this likely to change in the future?
As the US economy is outperforming the vast majority of it’s G7 partners, and after the financial crisis was the first and fastest to raise interest rates, US interest rates are currently higher than the majority of its trading partners. As a result, those USD denominated funds or corporates enjoy a positive pick-up when hedging using the FX forward market. While this has been the case for some time, we have seen a significant narrowing of this spread against Canada, Europe and the UK (Chart 3).
Chart 3: 1 Yr Carry vs USD
As can been seen from the chart above, since 2016, all of the four currencies versus the USD enjoyed positive carry (albeit very minor for JPY). This peaked towards the end of 2018 and has since come lower. At the end of 2018 a USD fund hedging a EUR investment benefitted from 340 basis points of carry. That number s now 250 bps, as the US cut rates well before the ECB. As the market adjusts their expectations of further rate cuts in the US, we may see this carry move higher once again. If that’s the case we will see more hedgers take advantage of buying USD forward against various currencies, thereby buoying the USD further.
How is the USD valued against its major trading partners?
Using a blend of various measures of purchasing power party to estimate the under- or over-valuation of the USD vs its peers, it can be seen from Table 1 that the factors above have resulted in the USD being over-valued. Overvaluation can extend to varying percentages and last for varying periods before reverting to fair value, depending on the currency pair. However, in general it’s fair to say that for most pairs, an over- or under-valuation of 20% or more tends not to be sustainable, and we typically see this as an indicator that the pair will reverse the situation over the coming months. Right now however, we do not see extremes of valuation (aside from the USD vs the Nordic countries) so this does not give us a clear indication of an impending USD sell off, although it is something worth watching.
Table 1: USD value versus its peers as measured by the spot rate
Source: Validus Risk Management
So, Where Does This Leave Us?
The best indication of the direction that a currency pair is likely to take today, is the direction it moved yesterday. That is to say, if a currency pair is trending higher, it tends to continue to do so until something happens to change the direction of travel. The USD trend is higher, the carry incentivizes those with FX exposures to buy USD in the forward market, and for those looking to make an investment to do so in USD’s as the interest rate pick-up is higher than the majority of its peers and this spread looks set to widen further, and the USD is not so over-valued at present that we are concerned about a near-term correction. Based on these factors alone, the USD looks set to continue to strengthen versus its peers.
However, should risk be taken out of the markets (US and China settle their trade issues, there is an orderly end to the Brexit situation, the rise of populism doesn’t result in a global trade tensions escalating, etch), then it is possible that we see the bull trend in the USD begin to come to an end. There are those in the market that believe that the USD bear trend began at the start of 2017, and in fact the USD Index has not reached the level seen at that time so perhaps they are correct. However, for now, it’s hard to argue their side.