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2018-10-26Macro `n Cheese

Current currencies

- It’s alive! This week Roger is clearly preparing for Halloween carving out a couple of monstrosities of graphs. We pray they will not turn on their creator but instead be put to use for the sake of the common good.

The volatility on financial markets continue to be in focus for investors and commentators alike. However, we have seen similar developments – even worse – on a number of occasions after the global financial crisis. A nice way to illustrate this is to look at the volatility data from the Institute for International Monetary Affairs   (if you're a Macrobond user), which is divided into asset classes as well as geography. Admittedly, the publication next Monday might invalidate this claim, at least for a few of the asset classes, but that would require quite a ‘bump up’.

 

If anything stands out in terms of experienced volatility during the past few years, I would posit it is rather the long period of relative tranquility for most of 2017 and into 2018. The latest bout of volatility seems rather like a normalization (yes, another one), then anything else. Developed bond and equity markets volatilities are not even close to the numbers seen during the turmoil in the start of 2018, and Developed FX-markets vol is at its lowest since 2014 even. This contrasts not only with Emerging Markets’ FX-volatility, but also with normal patterns where FX-volatility is often a tad higher than for bonds and equities.


And this is what I wanted to take a look at today. Could it be that currencies are becoming more fundamentally driven as the unconventional policies of yesteryear are being relaxed? – It is by no means an exhaustive currency analysis even though the analysis was exhausting (a pair of graphical monstrosities), but it hopefully provides a couple of ‘nice-to-have’ charts for anyone contemplating current currency developments.

 

In the above pane, I have plotted the FED’s ‘major currencies’ USD-index (red line) consisting mainly of other developed countries. The blue lines are the spread between 2-yrs (light blue line) and 10-yrs (dark blue line) Treasury-rates and ditto trade-weighted interest rates. The lower pane does very much the same (yes, different colors) for the FED’s ‘broad’ FX-index (adding also of a number of developing nations to the ‘major’ aggregate).


For both the ‘narrow’ and ‘broad’ indices it seems as if it is mainly short-term rates that drive developments. Back in 2014, the ‘narrow’ 2-yr country-spread became positive and the USD posted a substantial strengthening. Recently, it is the ‘broad’ 2-yr country-spread that has entered positive territory, and this is also born out in the broad currency index. Undoubtedly, US interest rates have continued to rise, whereas rates elsewhere have by and large flat-lined as growth prospects seem to have deteriorated in many places. How this will pan out is still too early to say but given that it seems as if it is mainly US growth prospects that are driving interest rates, continued USD-appreciation cannot be excluded.

 

This is also reflected in the Current Account data. The headline C/A-deficit has, admittedly, been stable (in relation to GDP) but the US clearly manages to finance it without much effort as the Broad Balance of Payments[1] is more or less in balance. It will be some time before we receive new data, but I would be surprised if the improvement in the Broad Balance of Payments does not continue also in Q3.

 

So much for the USD, but how about that common currency we Europeans seem …ehrmm… less and less fond of? – Yes, that is a different story. Let us start by looking how Euro Area interest rates stack up against international competition.

[1] I have defined the BBoP as the Current Account deficit adjusted for direct and portfolio investment inflows. In the document you can interchange portfolio investments for portfolio equity flows (series are already added). This worsens the overall BBoP-stance slightly but accentuates the positive trends over the past few quarters.

 

 

My impression is that given the interest rate environment, the EUR is holding up surprisingly well! It could do much worse as country spreads are nowhere near becoming positive and the growth environment is challenging to say the least. In fact, can you spot the best performing Euro-country?

In the above pane, I have plotted the FED’s ‘major currencies’ USD-index (red line) consisting mainly of other developed countries. The blue lines are the spread between 2-yrs (light blue line) and 10-yrs (dark blue line) Treasury-rates and ditto trade-weighted interest rates. The lower pane does very much the same (yes, different colors) for the FED's ‘broad’ FX-index (adding also of a number of developing nations to the ‘major’ aggregate).

For both the ‘narrow’ and ‘broad’ indices it seems as if it is mainly short-term rates that drive developments. Back in 2014, the ‘narrow’ 2-yr country-spread became positive and the USD posted a substantial strengthening. Recently, it is the ‘broad’ 2-yr country-spread that has entered positive territory, and this is also born out in the broad currency index. Undoubtedly, US interest rates have continued to rise, whereas rates elsewhere have by and large flat-lined as growth prospects seem to have deteriorated in many places. How this will pan out is still too early to say but given that it seems as if it is mainly US growth prospects that are driving interest rates, continued USD-appreciation cannot be excluded.

This is also reflected in the Current Account data. The headline C/A-deficit has, admittedly, been stable (in relation to GDP) but the US clearly manages to finance it without much effort as the Broad Balance of Payments[1] is more or less in balance. It will be some time before we receive new data, but I would be surprised if the improvement in the Broad Balance of Payments does not continue also in Q3.

 

So much for the USD, but how about that common currency we Europeans seem …ehrmm… less and less fond of? – Yes, that is a different story. Let us start by looking how Euro Area interest rates stack up against international competition.

My impression is that given the interest rate environment, the EUR is holding up surprisingly well! It could do much worse as country spreads are nowhere near becoming positive and the growth environment is challenging to say the least. In fact, can you spot the best performing Euro-country?

 

 

– Yes, Ireland! And while Germany is performing well in comparison with many other Euro-countries, it is way below its recent (3 yrs) median and show a clear declining trend. Next on the list is Greece. The Euro Area is way below other developed markets. No, growth prospects are not a reason to be positive on the EUR.

Let’s swiftly turn to the current account. For if nothing else, the continental Europe is an export power house.

 

 

Indeed, the current account surplus was in excess of 3% of GDP in August 2018. Admittedly, this is in line with the average of recent years, but it is also more than 2 percentage points (p.p.) lower than in August 2017. What is worse is that since then, over the past twelve months, the BBoP has deteriorated significantly putting depreciation pressure on the common currency. This is not yet visible in broad exchange rate indices but more so in narrow definitions and, in particular, when looking at the EUR/USD.

To conclude, the USD looks strong and for good reasons. The EUR looks surprisingly strong, as we have a hard time understanding why it is at even today’s levels. Or maybe the current turmoil will ‘shake out’ the answer for us..?

 

[1] I have defined the BBoP as the Current Account deficit adjusted for direct and portfolio investment inflows. In the document you can interchange portfolio investments for portfolio equity flows (series are already added). This worsens the overall BBoP-stance slightly but accentuates the positive trends over the past few quarters.

 
 

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We don’t usually have views and opinions about economic and financial states of affairs, (not ones that we express publicly as a company, anyway). We do believe, however, that people can and do appreciate a variety of perspectives. What you’ve just read is the perspective of our resident chief economist. While we think he’s very smart, Macrobond Financial does not expressly endorse the views he presents here. And, as the old adage goes, you shouldn’t believe everything you read (not without finding the data, performing a few analyses and presenting it in a nice chart). We want to make it clear that we are not offering this information as investment advice. That being said, if you have the application you can easily check everything that’s mentioned here, and decide for yourself. If you don’t have the application, now you have a great reason to get it.