A new forex driver?

Financial Mirror (Cyprus) - - FRONT PAGE - By Louis Gave

For­eign ex­change mar­kets are se­rial monogamists. The cur­rency ex­change rate be­tween two economies can be driven by fac­tors such as dif­fer­ences in their re­spec­tive in­ter­est rates, mon­e­tary poli­cies, pur­chas­ing par­ity lev­els, re­turn on in­vested cap­i­tal, cur­rent ac­count deficits, trade bal­ances and in­fla­tion rates. But at any point in time, only one sin­gle fac­tor is likely to be the pri­mary driver of per­for­mance, which is why cur­rency mar­kets tend to trend nicely. In the late 2000s, for ex­am­ple, in­vestors seemed to fo­cus dis­pro­por­tion­ately on the US cur­rent ac­count deficit and this drove the US dol­lar down. By the early part of this decade, and with struc­tural growth be­com­ing more scarce, the fo­cus shifted to struc­tural re­turns on in­vested cap­i­tal; this al­lowed the dol­lar to stop fall­ing. The “ta­per tantrum” of 2013, fol­lowed by the launch of quan­ti­ta­tive eas­ing pro­grams in Ja­pan and Europe meant that the fo­cus of for­eign ex­change mar­kets shifted to dif­fer­ences in mon­e­tary pol­icy; a shift which ob­vi­ously fa­vored the US dol­lar and brings us neatly to to­day’s sit­u­a­tion.

In re­cent weeks, we have seen both the Bank of Ja­pan and the Euro­pean Cen­tral Bank sur­prise in­vestors with very dovish poli­cies and state­ments. Yet, while a wider “mon­e­tary pol­icy gap” be­tween the US and de­vel­oped mar­kets should have fa­vored the US cur­rency, the dol­lar has in fact stopped ris­ing, and on a YoY ba­sis is al­most flat (see chart). This begs the ques­tion: are for­eign ex­change mar­kets in the process of find­ing a new cen­tral driver, and if so, which one?

The first com­ment must be that it is early days to make such a call with any con­vic­tion. How­ever, the log­i­cal case can be made that the next driver of cur­rency mar­kets will be dif­fer­ences in in­fla­tion rates. The one ob­vi­ous pol­icy trend in prac­ti­cally ev­ery de­vel­oped econ­omy is that cen­tral banks will not get in front of the in­fla­tion curve for a long while to come.

In­stead,

cen­tral

banks

are

ac­tively

seek­ing

in­fla­tion ev­ery­where at a time when bond yields are at record lows and la­bor mar­kets are broadly pick­ing up. For any fixed in­come in­vestor, this is a scary com­bi­na­tion: low bond yields mean that bond­hold­ers have lit­tle mar­gin of safety, while the ac­tivism of cen­tral banks means they have no one fight­ing in their cor­ner. Hence, a ner­vous fixed in­come in­vestor to­day can seek out (i) yield pro­tec­tion or (ii) de­fla­tion pro­tec­tion. No one will want to de­ploy cap­i­tal into a low yield­ing bond mar­ket where ac­cel­er­at­ing.

If the fo­cus of for­eign ex­change mar­kets is in­deed evolv­ing away from dif­fer­ences in mon­e­tary pol­icy to dif­fer­ences in in­fla­tion, then Chi­nese bonds, de­spite cur­rent bear­ish­ness, start to look pretty good. In­deed, the ad­vent of zom­bie com­pa­nies in China and with them cap­i­tal mis­al­lo­ca­tion means that de­fla­tion­ary forces are likely to in­ten­sify. And in­vestors in Chi­nese bonds still get some yield pro­tec­tion. Of course, in­vestors must deal with the fact the past nine months has shown Chi­nese pol­icy-mak­ers at their worst: se­cre­tive, para­noid (kid­nap­ping book­sell­ers in Hong Kong) and clumsy. The re­join­der must be that in re­cent weeks, the “pol­icy-stum­bling” ba­ton may have been passed to other coun­tries. From the BoJ sur­pris­ing the mar­ket with neg­a­tive in­ter­est rates, to the UK flirt­ing with Brexit, to the com­plete sham­bles of the Euro­pean Union’s re­sponse/an­tic­i­pa­tion of the im­mi­gra­tion cri­sis. And lastly there is the pos­si­bil­ity of a Don­ald Trump pres­i­dency.

On this last point, we imag­ine that Xi Jin­ping will be hop­ing for a Trump win in Novem­ber. Af­ter all, not only has the Repub­li­can fron­trun­ner openly cast doubt on whether the US should de­fend Ja­pan, but he also ad­vo­cates for Amer­ica re­treat­ing be­hind a great wall. Bet­ter still, Trump may even shelve the Trans-Pa­cific Part­ner­ship (China views the TPP as an “anti-China” trade pact). If Xi’s top pol­icy goal re­ally is to es­tab­lish Bei­jing at the cen­ter of a new Asian

in­fla­tion

is im­pe­rial do­main then what could be bet­ter than a Trump pres­i­dency and a broad re­treat from Asia by the US? A Trump pres­i­dency would al­low China to tell ev­ery Asian coun­try: do you want to be with us, or with Bozo the clown over there who is openly dis­dain­ful of you and is pub­licly say­ing that he will not come to your as­sis­tance?

The lat­ter point is not bullish the US dol­lar. Lastly, this brings us to an­other pos­si­bil­ity; that as the US political sit­u­a­tion gets messier, a fu­ture driver of ex­change rates will be shifts in the global geopo­lit­i­cal sit­u­a­tion. Such shifts are very chal­leng­ing to an­tic­i­pate.

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