My view on what's going on in the financial markets and the global economy, and a few other things that might interest me from time to time.

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  • tim@emorningcoffee.com

FOREX

Foreign exchange rates matter!


One of the things that I am not (amongst many others) is a foreign exchange expert. I know just enough to be dangerous, although in reality is I might know even less than that! For my US readers, foreign exchange might be a topic of limited interest since 30%-40% of Americans never leave their borders during their lifetime. As a result, they have less reason to care about what the US Dollar (“USD”) is worth vis-à-vis other currencies. For those living elsewhere who travel internationally more frequently, how much your domestic currency will buy of the foreign currency of the country which you are visiting is important. Of course, foreign exchange rates and their ramifications take on a different tone for those involved in business or interested in economics. Given the caveat that this is not my area of expertise, I still want to delve into the basics of foreign exchange, mainly because the strength of the USD has been a discussion point now since 2Q2021.


The main thing to understand is that foreign exchange is a relative game. In other words, the value of one currency vis-à-vis another (“currency pairing”) means that – by definition –if one currency is “strong” or “strengthening”, then the other is “weak” or “weakening”. From an economics perspective, the advantage of a strong currency is that imports are less expensive, and conversely, the disadvantage is that exports are more expensive. Therefore, a strong currency often dampens demand for products that are exported because they are less competitive from a price perspective. As an anecdote, the USD has historically been strong for reasons I will discuss below, and this has meant that US consumers and businesses import more than US businesses export, resulting in a net trade deficit for the US. The graph below from FRED illustrates the net trade deficit of the US since 1992.



As you can see, US net trade has been in a deficit position since this data has been available (1992). The annual net trade deficit of the US was around $40 bln/annum during the decade between the Great Recession and the onset of the pandemic. Since the pandemic, the huge amount of monetary and fiscal stimulus provided by the Federal Reserve and the US government, respectively, has led to consumers spending even more on imports, widening the trade deficit to nearly $110 bln/annum (rolling) in May 2022.


The graph below, also from FRED, shows the US current account progression over a similar period.



The current account is a more comprehensive measure of the flow of USDs into and out of the US, noting that net exports are the largest component. [1] The US current account deficit was 3.6% of GDP in 4Q2021.

The table to the right compares the net current account balance as a percent of GDP for the G7 countries and the Eurozone in 4Q2022 (source: OECD here). Perhaps not surprisingly, Germany traditionally runs the largest current account surplus as a percent of GDP, whilst the US runs the largest current account deficit. The Eurozone in aggregate also runs a positive current account as a percent of GDP.


As I will discuss in more detail below, recurring current account deficits should intuitively lead, inter alia, to a weaker currency, whilst recurring current account surpluses should lead to a stronger currency. However, foreign exchange rates are influenced by much more than just the net current account. The USD in particular enjoys the status of being the world’s most important reserve currency, so the US can easily finance its current account deficits through the issuance of US Treasuries without overly weakening the USD. In addition, the normal “offset” might intuitively be visible in higher yields on government bonds (to attract ample financing), but again, the USD’s special status means that yields on USTs remain low, artificially low in fact. You can read more about the US Dollar as a reserve currency in an article I wrote several months in E-MorningCoffee: “Will the US Dollar remain the global reserve currency?”


Most foreign exchange rates are presented in pairs, e.g. the Euro-to-the-Pound. As the most used

global currency, the USD is also monitored against a basket of currencies, which is known as the US Dollar Index (USDX). The USDX was established by the Federal Reserve in 1973 following the demise of Bretton Woods, linking the USD to a basket of currencies that roughly represented the major trading partners of the US at the time [2]. The mix of currencies underlying the UDSX are presented in the table below.


Because the EUR is such an influential component of the USDX, the USD normally weakens both against the basket (USDX) and the Euro simultaneously. I will discuss the current movements of the USD and the EUR further below since this is a relevant topic as I am writing this article. With this context, let’s look at what causes foreign exchange rates to change over time.


What causes foreign exchange rates to change?


Relative interest rates


Countries with higher interest rates, inter alia, tend to attract more foreign investor interest in their government bonds, and hence, their currency. The US has had relatively higher yields on its government bonds compared to those in the UK, Eurozone or Japan, so US Treasuries have been more attractive vis-à-vis government bonds in these other countries. This had led to USD strength. Countries with lower interest rates attract less interest from foreign investors in their government bonds, and in fact, can often be a net lender rather than a borrower Keep in mind that interest rates are mostly driven by the monetary and fiscal policies of a given country, with monetary policy being the most influential factor at the moment. For example, diverging central bank policies are the reason that the Yen has been weakening for so long – the Bank of Japan has, and remains, the most dovish of G7 central banks. The Euro has also been weakening most of this year because the ECB was a laggard vis-à-vis the Bank of England and Federal Reserve in tilting towards more hawkish rhetoric and actions to address rising inflation. However, the ECB has just recently taken on a more hawkish tone by suggesting that the overnight bank deposit rate could be increased as soon as July, and this managed to stabilise and modestly strengthen the Euro.


Relative strength of economy


Countries that have sound economic policies, stable governments and ample transparency tend to have stronger currencies relatively speaking than those that do not. Countries with strong economies also tend to have more attractive financial assets in which to invest, whether its stocks, bonds and / or real estate. Strong, transparent financial markets draw in foreign capital. Investors conversely tend to avoid investing in countries with lacklustre economies, weak or non-transparent financial markets or unstable political situations. You can probably see how economic strength also ties to the level of interest rates, mentioned in the first point. A generic example of this involves central banks in emerging markets countries that are under stress. Central banks in these countries will keep interest rates high – often very high – both to attract foreign capital and to avoid (domestic) capital flight into safer jurisdictions. Another example involves the UK. The UK Pound has been under intense pressure since the beginning of the year, declining from $1.35/£1.00 at the end of 2021 to $1.25/£1.00 currently (-7.4% YtD). Even though the Bank of England was the first major central bank to raise its bank borrowing rate (in December 2021), the UK economy is deemed to be in a much more precarious position than economies in many other countries, with a bout of potentially ugly stagflation likely by the second half of this year.

Balance of payments


The balance of payments of a country reflects the converse of a countries’ balance of trade, a topic I covered in the first half of this paper. To reiterate, if a country is importing more than it is exporting, then it runs a balance of trade deficit which needs to be financed. In cases where countries or common currency blocs (like the Eurozone) have a well-trusted currency, balance of trade deficits are usually easily financed in the international capital markets. The US is the perfect example, as it is a perineal trade deficit country that fortunately has insatiable demand for its government bonds.


Reserve / safe haven currencies


Contrary to popular belief, the USD is not the only reserve currency in the world, although it is the most widely held. The USD enjoys many advantages vis-à-vis other currencies because of a confluence of factors centred around the size, strength and diversity of the US economy and the stability of the US government. However, there are other currencies that are also considered to be “safe haven” currencies during times of global uncertainty, including the Swiss Franc and the Japanese Yen, for many of the same reasons that favour the USD as the “go to” reserve currency. Naturally, demand for these currencies during difficult situations causes them to appreciate. We saw this during the early stages of the pandemic.


Central bank manipulation: controls on convertibility / exchange controls


A central bank or government can also intervene in foreign exchange markets to influence the relative level of their country’s domestic currency vis-à-vis foreign currencies. This can occur two ways: either through manipulation of market supply, or by outright restrictions on convertibility. With respect to the former, a central bank or government can go into the marketplace and buy or sell its domestic government bonds to support a targeted exchange rate. It might seem silly to use this power to sell a currency and force down the exchange rate. However, as I mentioned at the beginning of this paper, a weak currency makes imports less attractive and exports more attractive, promoting the manufacture and export of domestically-produced goods and stimulating economic growth. Central banks (or governments) can also be more rigid by blatantly limiting capital flows into or out of the country, limiting convertibility of a currency or by fixing an exchange rate.


Limiting capital flows often manifests itself via limits on the purchase or sell of domestic bonds by foreigners, preventing the domestic currency from leaving the country. Limiting or restricting convertibility used to refer to the convertibility of fiat currency into gold, a practice which no longer exists. However, countries can still restrict or prohibit convertibility of their domestic currency into foreign currencies, a way of limiting market forces from having their way. Rigid fixed exchange rates can result in the development of a “black market” in the currency in question, often off-shore, which more accurately reflects the real exchange rate based on demand and supply of the currency (than the official fixed rate).


China is an example of a country that uses open-market manipulation to maintain its exchange rate in narrow range, perhaps considered by some to be an informal fixed-rate exchange rate. This has been China’s practice for many years, much to the chagrin of its trading partners. The exchange rate for the Chinese Yuan has been held artificially low for years, resulting in Chinese exports being less expensive in the global marketplace. This has been a major factor contributing to the strong economic growth of China for many years. As a result, non-Chinese competitors are unable to compete in the global marketplace as effectively as they might otherwise would. In 2021, China accounted for around one-third ($355 million) of the total net current account deficit of the US (of $1.1 trillion).


What does a weaker US Dollar mean for the global economy?


We appear to have recently reached in inflection point for the USD, which has been steadily strengthening since May 2021. As you can see in the graph below from YahooFinance, the USD strengthened sharply during February and March 2020 at the onset of the pandemic, reflecting the safe haven destination of the currency.

The USD then drifted slowly back towards the $90 level over the next 13-14 months, which appears to be around the mid-point of its trading range since 1988. However, the currency started steadily appreciating again in May 2021, reaching $105 on May 13th, before cooling off in the last two weeks. The USD has weakened slightly the last two weeks mainly – in my opinion – because the ECB has slowly become more hawkish, suggesting that it will bring forward its tightening tilt. Concurrently, the US equity market has continued to be under stress, so foreign investors might be leaving US equities for US Treasuries (currency agnostic), or abandoning US markets altogether (USD negative).


The US does not have an official exchange rate policy and is arguably in a position to be fairly nonchalant about the strength or weakness of the USD compared to most other countries. Having said this, I imagine US companies that export goods or services would welcome a weaker USD, which will make their products more competitive globally. Higher demand for exports could offer a partial offset as higher interest rates in the US start to crimp US consumer demand.


A weaker USD also has effects on commodities priced in USD, like oil and gold. As the USD weakens, prices of commodities linked to the USD typically increase, as you can see in the graph below illustrating the level of the S&P-GSCI Commodity Index Future vs the US Dollar Index.

Of course, this is a simplistic illustration since commodities like oil, iron ore, gold and so on each move to their own specific supply and demand attributes. Still, the inverse relationship between the level of the US Dollar and commodity prices is very apparent over time


Conclusion


I hope at least some of my readers know more about foreign exchange than me, because I have just about exhausted my knowledge and understanding. I welcome your comments in this respect, as I think input into this important topic – especially as we reach a USD inflection point – would make this article much more interesting to other readers.


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[1] The current account is a more comprehensive measure than net exports and includes foreign aid, foreign direct investment into the US from abroad (including investment in stocks and bonds), and net remittances, amongst other things. See more about the current account in Investopedia here.


[2] With the launch of the Euro in 1999, the USD basket was changed to incorporate the Euro whilst five former Eurozone currencies, including the French Franc and German Mark, were melded into the Euro for purposes of constructing the basket.


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