Morning Brief – Further Ahead

Further Ahead

One of the best determinants of short-term currency movements comes from interest rate differentials. So-called ‘hot money’ that flows through the global economy seeking short term higher yields are often responsible for the intra-day, week and month currency fluctuations that we are all accustomed to. However, interest rate differentials often fail to be a true determinant of currency valuations and deviations over the medium and long-run, several years down the line.

The reason for that is fairly straightforward. Interest rate differentials that persist over months and years are, 99% of the time, used to counterbalance fundamental structural imbalances within the economy. At least in developed economies interest rates are almost exclusively mandated instruments of a central bank to target stability within the price level. Early monetarist economics will tell you that interest rates are a way to control and smooth the business cycle of Economics 101, however, this is by and large a thing of the past.

Over the medium run therefore, any gains to be made from interest rate differentials are unwound by the fundamental aspect of the economy they are in place to eliminate. In the case of the price level, the higher inflation rate being targeted by higher interest rates will erode the value of the currency holding at a comparable rate to the return provided by interest. It is only in the short-run therefore where changing interest rates attract money seeking to profit from yields before other real-economy aspects catch up with it.

A better determinant of medium-term currency valuations comes from growth and in particular, the terms of trade one country holds versus its trading partners. Terms of trade are measured by comparing the price of exports with the price of imports and how that ratio changes over time. When a country’s predisposition to international trade and its status as an importer or exporter of specific types of goods and services changes, so too does its currency’s fortunes.

In today’s world, characterised by rising energy prices, those nations that are net importers of energy are those facing deteriorating terms of trade and therefore currency outlook. Interestingly, given the changing nature of the United States’ relationship with energy over the past two decades, this model also suggests the US Dollar isn’t as overvalued as you might think. As a net exporter of energy, its current valuation is not too far out of line with its medium-term fair value.

It is the Canadian, Kiwi and Aussie Dollars alongside the battered Japanese Yen that show the biggest under valuation in the market versus the US Dollar within the G10 currency space. The former three nations have enjoyed improving terms of trade given their role in the export of raw material. The Japanese Yen’s status as the second most undervalued currency versus USD is as a result of the punishing price action it has seen this year and last, largely driven in turn by interest rates and politics. The most overvalued currency is the Swiss Franc using this model.

Discussion and Analysis by Charles Porter

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