David Powell BI Chief Economics, Bloomberg Intelligence
Driven by shifts in sentiment, policy, and fundamentals, turnover in the FX market averages $5.1 trillion a day.
Mapping short- to long-term influences
The price of one currency in terms of another - otherwise known as the exchange rate - is determined, like that of any other, by supply and demand. In the short-term, that balance is mainly shaped by market sentiment, measurable through risk reversals skews and positioning in the futures market. Over the medium-term, capital flows, influenced by monetary and fiscal policies, play a major role. In the long-term, money supply, trade balances and other structural factors are dominant.
The flow diagram, adapted from a book by Bloomberg Intelligence FX Strategist Michael Rosenberg, provides a stylized map of how those factors influence exchange rates.
Exchange rate determination roadmap
How risk reversals track shifts in FX market sentiment
Short-term movements in the FX market are driven by sentiment and traders can be fickle. A recent example: the wild ups and downs (mainly downs) of the pound as the U.K. negotiate a Brexit deal. To gauge sentiment traders monitor risk reversals. The number is derived by subtracting the price paid for a put (expressed in units of implied volatility) from the price of a call with the same delta and strike.
Intuitively, risk reversals measure how much more it costs to insure against a currency rising than falling. Risk reversals can be structurally high or low so the best way to examine them is using z-scores. As the chart shows, options traders have been willing to pay more to insure against a fall of sterling than a rise in recent months.
Risk reversals show Sterling sentiment sours
How outsized futures positions anticipate FX reversals
When a popular trade begins to look too crowded, sentiment can shift rapidly. The U.S. Commodity Futures Trading Commission publishes weekly data on the holdings of non-commercial agents. The aggregate position of futures and options is the most highly correlated with spot prices. The correlation is contemporaneous and there's a three-day publishing lag on the CFTC data. That means the time series tells us more about what's happened in the past than what will happen in the future.
That said, a large build-up in a position that stoked a move in a currency could be a sign that the potential for reversal is high. As the chart shows, an increase in long positions in early 2018 preceded a steep decline of the euro versus the dollar.
Positioning correlated with exchange rates
Bloomberg Economic's safe-haven rankings - analytic port in an FX storm
Contributing Bloomberg Economist Yuuki Masujima
When sentiment sours, traders seek shelter. The yen and Swiss franc are most likely to appreciate when volatility picks up and the Canadian dollar is most vulnerable, according to our safe-haven currency rankings. The annual ranking is based on a rolling regression of FX movements against the VIX and interest rate differentials. The more a currency appreciates when volatility rises, holding rate differentials constant, the higher its safe haven ranking.
The tendency for the yen to appreciate in risk-off periods was on show during the global financial crisis and the escalation of trade wars. Its safe haven status has strengthened since 2007. Bitcoin has gone from close to safe haven status in 2013 to nothing close in 2018. For more details, click on the text tab.
Ranking shows strong demand for Yen, Swiss Franc
Mapping path from monetary, fiscal policy to FX outcomes
Over the medium term, monetary and fiscal policies play a major role in driving FX. The most positive combination for a currency is restrictive monetary and expansionary fiscal policy. Both put upward pressure on interest rates, attracting capital inflows. The most negative mix is expansionary monetary and restrictive fiscal conditions. The impact of other combinations (expansionary monetary and expansionary fiscal policy, for example) are ambiguous - a reflection of offsetting effects.
Capital flows aren’t only driven by yields. Any significant move in asset prices can have the same impact. A stock market boom might also attract foreign investors, putting upward pressure on the currency. A good example is the dollar during the dot-com boom. China’s twenty-year property boom also attracted hot-money inflows.
Restrictive monetary policy boosts currency
How unconventional monetary policy moves FX markets
In a world of unconventional monetary policy, it's not just central bank policy rates that move exchange rates. Quantitative easing, which aims to support growth by managing long-term borrowing costs, affects FX markets through the impact on long-term rate differentials. The size of the monetary base relative to GDP is an additional useful metric: the higher the ratio, the greater the currency drop. Forward-looking markets mean the main impact of QE largely takes place when the announcement is made - not when the buying takes place.
The relationship between fiscal policy and the currency is not always so straight forward either. When bond yields rise because the solvency of a country is in doubt, currencies are generally on the way down. Investors become more worried about the return of capital than the return on capital.
Euro weakens as market anticipates asset purchases
How money supply drives currency moves
The supply of a currency is determined by how much money the central bank prints. Money supply growth drives inflation. (As Milton Friedman famously said, "Inflation is always and everywhere a monetary phenomenon.") Inflation differentials are the primary determinant of exchange rates in the purchasing power parity model - one of the most basic and commonly used gauges of where currencies should be trading. The basic idea - high inflation reduces the purchasing power of a currency and so its value goes down.
In an extreme example, unrestricted money creation can result in hyperinflation and currency collapse. That’s what happened in Venezuela in 2018 and Zimbabwe a decade ago. That’s not always how it plays out, though. For a long period, China combined rapid money supply growth and an appreciating yuan.
Printing money debases Venezuela's currency
How current account balances shape FX outcomes
In the long term, the current account is an important driver of FX moves. A surplus - which in general means more exports than imports - creates greater demand for a currency and pressure for appreciation. A deficit means the reverse. The IMF bases its overall assessment of exchange rates on its current account model. The Peterson Institute's Fundamental Equilibrium Exchange Rate model is also based on current accounts.
In 2007, it was China’s 10% of GDP surplus that was the basis of Peterson economists’ call for a 40% revaluation of the yuan. In 2018, with the surplus reduced to less than 1%, the yuan looks closer to fair value. One problem with using current accounts to anticipate currency moves - it’s not clear if the current account drives the currency, or the currency drives the current account.
C/A surplus puts upward pressure on currencies
The path from high to foreign debt to currency crisis
Persistent current account deficits can cause currency crises. The build-up of debt to foreigners - reflected in the net international investment position - raises doubt about a country's ability to service its obligations, especially when funds are borrowed in a foreign currency. Latin America has seen a series of these crises, starting with Mexico in the early 1980s. The currencies of Argentina and Turkey plunged in 2018. The Asian financial crisis of 1997 provides a textbook example.
Credit booms, especially in Indonesia, South Korea and Thailand, were financed by loans from abroad in other currencies. Foreign investors eventually became spooked and withdrew their money. Central banks ran low on reserves as they tried to defend their currency pegs and ultimately abandoned them. Exchange rates subsequently plummeted.
FX crisis - currency moves and C/A balances
Managing volatility in the FX market - a central bank's toolkit
Sharp currency moves can destabilize the economy. Central banks have a suite of instruments for smoothing ups and downs. The first line of defense is jawboning - expressing discontent and hinting at action. The next is active intervention - buying or selling to influence the exchange rate. Central banks accumulate reserves for this purpose. With daily turnover of $5.1 trillion in the FX market, though, reserves can prove inadequate. Sometimes capital controls are required.
Other interventions are also used. At times of yuan weakness, the PBoC has imposed reserve requirements on investors - making it more expensive to trade the currency. In 2017, Malaysia temporarily banned offshore trading of the ringgit. Central banks sometimes intervene in the forward market to move the currency without immediately expending reserves.
Emerging market countries pile up reserves
From peg to float - the many flavors of FX regimes
Exchange rate regimes differ. At one end of the spectrum, the dollar and sterling are free floating. At the other, the Hong Kong dollar and Saudi riyal are pegged to the dollar. In between are a variety of arrangements. China is managing a long transition from a dollar peg, to a crawling peg, to a managed float. The Singapore dollar is managed against a basket of currencies.
A fixed exchange rate provides certainty for trade and investment, at the expense of the capacity to absorb shocks and run an independent monetary policy. As Robert Mundell pointed out long ago, a country can only have two of the following: free movement of capital; a fixed exchange rate; and, independent monetary policy.
Exchange rates regimes vary across G-20
Indonesia rupiah reprieve, not rebound, in sight
Contributing Bloomberg Economist Tamara Mast Henderson
There may be relief ahead for the Indonesian rupiah, which has taken a beating during the emerging market selloff. A number of factors suggest intense downward pressure could start to abate. Authorities have announced measures to rein in the current account deficit - reducing the risk of capital controls and easing concerns about funding the gap. Real yields on rupiah-denominated government debt have surged - increasing the appeal relative to peers. Risk perception may have also been overblown.
Even so, a material reversal in the rupiah could have to wait until 2Q 2019 - once Indonesian elections are out of the way and the outlook for the growth differential with the U.S. starts to improve. Until then, Bank Indonesia is likely to remain vigilant.
Rupiah is trading near a 20-year low
Cheap or dear? Yuan value depends who you are
The International Monetary Fund has concluded the Chinese yuan is fairly valued from a medium-term perspective - maybe even undervalued. That could give the Trump administration some justification for its trade war. However, our analysis suggests the yuan is overvalued and a fall looks more likely than a gain in the near term.
Our model is more relevant for investors concerned with the near-term direction of the currency.
China's current account surplus needs to decline
India's rupee rally has room to run, with path set by oil
Contributing Bloomberg Economist Abhishek Gupta
India's rupee has regained some lost momentum with a sharp pullback in oil prices. We think the rally will extend, if Brent remains around $60 per barrel. Falling oil prices reduce India's net oil import bill and help in narrowing the current account deficit. India's equity and debt also become more attractive to foreign investors, as growth prospects improve and inflation pressures ease. The result: a smaller current account deficit is financed by increased inflows on the capital account driving up the currency.
Rupee rally to continue if oil remains low
Assuming Brent at $60 per barrel all the way into fiscal 2020, our forecasting model projects the rupee to rise as far as 67 per dollar by March 2020 subject to seasonal variations along the way. If Brent rises to $70 per barrel, our model projects a range of 70-72 rupees per dollar.
Philippine peso faced eyes of two storms
Typhoon Mangkhut, super-typhoon, closed in on the Philippines in September last year,
which threatened to push costly food prices even higher. At the same time, Philippine markets started to feel more of the maelstrom from emerging-market contagion and an unrelenting increase in inflation. Philippine government bond yields have surged and the peso has broken through the 54.00 level against the U.S. dollar. Both bonds and the peso probably have more room to slide. This would put more pressure on the central bank to raise interest rates further.
Philippine 5-year real yield remains negative
