There is no longer a single paradigm that explains the behaviour of all foreign exchange (FX). From 2000 to 2007, the carry model provided a one-size-fits-all mechanism for understanding currencies, but it was undone by the global financial crisis. It was quickly replaced by another universal model, that of ‘risk-on’ ‘risk-off’ (RORO), which provided the FX framework until early 2013, when its grip on currencies began to wane. Since then, markets have failed to find a successor.
The mistake has been to look for a single model that can be applied across the board. It simply does not exist anymore. Instead, the global currency market is made of three broad groupings or ‘buckets’. They are:
A. The carry candidates: predominantly G10 currencies, the key here is the outlook for the economy and implication for relative interest rates;
B. The diminished safe havens: the CHF and the JPY are no longer exclusively driven by the global risk mood;
C. The balance of payments club: largely but not exclusively emerging market foreign exchange (EM FX), where the current account balance and the outlook for capital account financing are the key FX drivers.
Far from complicating matters, the realisation that multiple models are in play actually makes life easier. When one accepts that there are different models for different currencies, it is simply a question of deciding which bucket, A, B or C, a particular currency belongs in and analysing its prospects accordingly.
The carry candidates
The grip of RORO on the FX market was most potent when we were moving from one crisis to another, and interpreting the resultant policy response or solution. Over the past year, the economic situation in developed market economies has begun to normalise. In the US, the Federal Reserve has started tapering its Quantitative easing (QE) programme. In Europe, economic data has generally been coming in better than expected. The conversation has moved on to recovery prospects and what this means for monetary policy and for the currency. In this way, the currency comes at the end of the economic discussion. It is not driving the economic debate – it is the residual.
The mistake has been to look for a single model that can be applied across the board. It simply does not exist anymore
The growing influence of cyclical considerations means carry is evident in the major traded currencies. The graph (below) shows GBP-USD plotted against expectations for where the differential between UK and US three-month rates will be at the end of 2015. We chose such a distant point because the Bank of England and Fed argue that rates will be on hold for some time to come. It shows that the exchange rate has begun to track the interest differential increasingly since mid-2013. The relationship is also evident in EUR. In addition, carry considerations are not confined to these G10 currencies’ behaviour against the USD. For example, AUD-NZD also track their expected interest rate differential closely. We are now back to the world when strong data drives rate expectations and that propels the currency higher.
Diminished safe havens
In the old world of RORO, the spectrum of choice was clear. The ‘risk-on’ AUD and NZD lay at one end, and the ‘risk-off’ safe havens of the CHF and JPY lay at the other.
The ability of the CHF and JPY to act as true safe havens has been increasingly undermined by local shifts in policy. In Switzerland, the introduction of the EUR-CHF floor in September 2011 means the CHF is no longer a clean safe haven. Since the introduction of the EUR-CHF floor, whenever the exchange rate has traded close to 1.20, the safe haven characteristics fade. Equally, when EUR-CHF moves away from 1.20, it begins to regain its safe haven characteristics. Overall, this means it is no longer the perfect ‘risk-off’ play. Moreover, since the shift to ‘Abenomics’ in the third quarter of 2012, and the associated rapid monetary expansion, the JPY has mainly traded on the basis of local factors rather than global considerations.
This then has an impact back onto some other currencies. For example, GBP up until recent EM FX sell-off has been a more ‘risk off’ currency than the JPY.
The balance of payments club
The balance of payments has always been a component of FX analysis, but in recent years it has been crowded out by other factors. Now it has once again become more prominent, principally for emerging markets.
The beauty of the balance of payments is that it always balances. The point is how this occurs. For many years the market was not bothered about the funding of the ever- growing current account balances of the EM world, particularly as the Fed had the liquidity taps on full blast. So there were ample capital flows to finance ever-increasing current account deficits.
However, on 22 May 2013, Fed Chairman at the time, Ben Bernanke, hinted at the beginning of the end to QE. We suddenly got two different shocks. The price of money rose aggressively as depicted by the 10-year bond yield. More important was the impact on global capital flows as money began to withdraw from some EM, partly in fear that future capital flows would dry up. This saw a complete change of heart and, suddenly and dramatically, current account deficits were seen as unsustainable.
The preoccupation with capital flows was evident in the relative performance of EM FX during the initial stages of tapering fears. For the most part, the demarcation between winners and losers was simply along the lines of who had a current account deficit and who had a current account surplus.
Understanding that current account balances are important for these currencies provides some basis for deciding where they may head next. HSBC EM FX forecasts still continue to broadly favour those currencies that are not reliant on external financing, thus reducing their sensitivity to the reduction in the quantity of money being provided by the US Fed. For this reason, we still favour PLN in the CEEMEA and the likes of KRW and TWD in Asia.
ABC method
In the end, therefore, the decision process on FX requires choosing the appropriate bucket. To make a macro decision about relative economic performance, choose bucket A. Go for bucket B to gauge the interplay between global and local drivers. And finally, choose bucket C to determine the inter-related forces at work between the currency, interest rates, the current account balance and capital flows – these lead to very different FX conclusions.
While each bucket has been discussed in isolation, it has to be made clear that they are linked and can impact each other. Furthermore, membership of one bucket is not cast in stone. Understanding which bucket a currency generally belongs in makes gauging their likely path much easier. How you visualise the different models may differ, but in the end we believe our bucket approach will help make understanding FX as easy as A, B, C.
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