As the second trading day of this week begins it is apparent that the market is enjoying a wave of optimism. Due to the distress in financial markets throughout the lockdown we have seen the cyclical price action of meandering sentiment feed through to the foreign exchange markets more strongly than ever. A light peppering of ‘good’ news has the capacity to drag up valuations across the fx spectrum. It is unsurprising therefore that yesterday’s €500bn zoom call and a little direction on the UK’s future trading regime had the ability to normalise distressed valuations in every corner of the globe. Part of the reason for this phenomenon is that dramatic valuations and heavy risk premiums entice investors and speculators to hold riskier currencies as general conditions improve.
If you were a buyer of Rand and a seller of US Dollars and you received a price from the market of 6.3 ZAR to the Dollar you’d rightfully be fairly disgusted. What about as a Mexican Peso buyer, would you accept 9.3 MXN in exchange for your Dollar? These two rates would represent a 65% and a 60% over pricing of the currency you are purchasing versus the prevailing markets rate so I would hope not. However, you might be amazed that these rates can be considered the true value of the respective currencies. The valuation of currencies is a challenging subject and there are numerous models designed to price FX crosses. Yet one of the best by virtue of its simplicity is the metric known as ‘PPP’.
Purchasing Power Parity, PPP, measures the value of two respective currencies given the different level of prices within two currency areas. The foreign exchange market emerged after all to facilitate the cross border exchange of goods and services denominated in two different currencies so why not use this variable to determine the rate between them. If a basket of generic goods in the United States costs $100 and the very same basket in South Africa and Mexico costs ZAR 630 and MXN 930 respectively, as they in fact do, then we might justifiably conclude that USDZAR should be 6.3 and USDMXN 9.3. One key reason the market rate for the respective currencies is more than double this is the risk premium surrounding both emerging market currencies. This risk premium was stretched even further by the Coronavirus pandemic so as conditions improve there is ample headroom for emerging market valuations to normalise.
Yesterday saw emerging market forex valuations improve as trading conditions improved. Global risk sentiment was bolstered by evidence of progress in the European initiative to create a recovery fund. Via video conference yesterday, France’s Emmanuel Macron and Germany’s Angela Merkel announced their support and joint vision for the €500bn European support fund. Under the plans the European Commission would engage with capital markets to raise cash at the European level that would then be used to support the economies of nations most severely affected by Coronavirus. The move simultaneously made leaps forward in the problem of common debt issuance in the Eurozone and the European response to Coronavirus. The announcement took some systemic risk off the table and improved global risk appetite.
Discussion and Analysis by Charles Porter