Silicon Valley Bank's monthly Currency Outlook provides insight into today's foreign exchange markets and the global events that impact your cross-border transaction strategies.
Since 2008, we have lived with the ramifications of the central banks' policy of printing money to prevent another Great Depression, but in the current conditions, foreign exchange rates are more easily forecast than they were prior to mid- 2008.
The central banks' money printing manifested itself in more government debt issuance. In the U.S., the Federal Reserve bought a portion of this new issuance as they embarked on Quantitative Easing, which also consisted of buying securitized debt such as mortgage-backed securities. Under usual circumstances, investors would have bought the debt which would have taken the money out of circulation. However, the Fed's actions left this money in circulation and increased the liquidity, keeping interest rates low. The lower interest rates should have helped boost the economy since not as much money was consumed by interest.
How do these past actions and conditions relate to foreign exchange and the relative strength or weakness of currencies?
Typically cash flows determine the value of a currency. Cash flows consist of the balance of trade — surplus or deficit — and investment flows. Since 2008 the almost sole focus has been on the investment flows, which skewed the situation. As interest rates declined, the countries with the lower interest rates suffered weaker currencies vs. those with higher interest rates. Since the end of 2008, with little yield anywhere, the 'carry trade' — when an investor sells a low yielding currency and buys a higher-yielding currency to make more interest income — became very important.
The European Central Bank's Decisions and the Long-Lasting Impact on European Economy
Two years ago many were confused when the euro did not weaken during the European debt crisis. The European Central Bank (ECB) had been under the stewardship of Jean-Claude Trichet who refused to lower interest rates as the socialist structure of the European economy is supposed to act like a safety net. When the economy weakens it does so more slowly than the U.S.'s more capitalistic model. It is also slower to recover. Although this makes it difficult to judge the health of an economy, the head of a central bank should know how to calculate what allowances have to be made to obtain a clearer economic picture.
Trichet left the ECB in October 2011. Mario Draghi, an ex- Goldman Sachs alumnus who became head of the European Central Bank, took a 'do whatever it takes' stance to keep the euro from breaking apart, and immediately lowered interest rates.
The ECB's most recent move on June 13 took the ECB's deposit rate (the rate banks get for lodging funds with the ECB) to -0.1 percent, costing the banks to invest! They also lowered the base rate to +0.15 percent causing the euro to weaken.
The carry trade part of international investment cash flows is a short-term indicator of currency weakness or strength. When a higher-yielding currency lowers its interest rates, investors withdraw their funds quickly, but it is a long-term indicator when a currency is in a higher interest rate cycle, as with the New Zealand dollar at the moment. The yield on the 10-year government bond is 4.4 percent, having risen from 3.15 percent in May 2013; the New Zealand dollar rose from 0.7650 to 0.8750 in the same time period putting it just 1 percent away from its highest level since 1981. New Zealand is a great example of how interest rate differentials are a good long-term indicator of currency strength.
Interest rate differentials moves are clouded by all the extraneous noise created by macroeconomic data, geopolitical news and domestic political policy.
The charts below indicate two different situations. The pre-crash reactions to interest rate moves were 'normal.' The moves since the end of 2008 are different as the lack of yield and the fear of what happened left the markets in a situation where investors tried to frantically recoup losses, and make money to cover shortfalls. This led to volatile markets and the irrational investing in 10-year bonds of the PIIGS that returned over 8 percent. If it had not been for the end of Trichet's reign and Draghi's takeover, the European economic outcome euro would have been a lot worse.
The Effect on German Bonds
The yield on German bonds has declined as has the euro from 1.48 to 1.35 in the last three years. It is interesting to note that the German bund declined to its current yield level of 1.5 percent as more conservative investors moved their funds to interest rate safe havens such as German bunds, U.S. Treasuries, and British gilts in mid-2012. As the economy normalized, the safe haven bunds were sold, and the yields rose from 1.5 percent to nearly 2 percent. The recent policy changes from the ECB have the 10-year yield back to 1.35 percent and the euro is in a weakening trend with lower yield.
Japan's New Leader Changed the Status Quo
Since Prime Minister Shinzo Abe took over in December 2012, the changes in Japanese policy are reduced interest rates and added liquidity; these changes reduced the Japanese yield and the value of the yen which lost 20 percent in six months. However, exporters benefitted as the prices of Japanese goods overseas declined.
In 2008 at the start of the economic crisis, the yen strengthened as a beneficiary of safe haven cash flows. At this time, people wanted to keep their money safe and were not so concerned about yield; hence, the yen strengthened 25 percent from August 2008 to the end of 2008.
The UK's Austerity Route
The story of the UK's pound is interesting as the UK took a totally different path than Europe and Japan. The UK's property bubble burst was similar to the property bubbles that burst in the U.S., Ireland, and Spain. In Japan and the rest of Europe, the problems stemmed from too much government debt as a percentage of GDP and eventually the housing debt ended up cascading into government debt as they bailed out failing banks. The UK bailed out banks, but as a counterbalance, it cut back on government spending to avoid exploding its debt as the U.S. had done. The austerity imposed increased the pain of the downturn, but now the UK economy has resurrected in the last year and is the fastest growing economy in the G10. Interestingly, tech has been a large part of the economic recovery. The interest rate chart illustrates the strong similarities between the UK and U.S.'s 10-year interest rates.
Why is the pound so strong as compared to the dollar? The foreign exchange (FX) market and interest rate markets tend to value currencies and bond yields against the market expectation of where they are going to be, not where they are. At the moment, the Bank of England(BoE) is expected to raise interest rates before the Fed. Also, the (BoE head, Mark Carney, plans to tighten mortgage lending. What form this will take is unknown, but it will effectively tighten one part of their monetary policy.
The pound example demonstrates the importance of looking at interest rate, differential moves, and comparing economies and central bank expectations.
Future of the Yen, Pound, Euro and Dollar
Of the three featured currencies, interest rates are expected to stay very low in Japan but today's (6/27) inflation data showed Consumer Price Index (CPI) at 3.7 percent annualized. As much as PM Abe's policies were to reflate the economy, there comes a tipping point when inflation cannot be ignored. With household spending falling to 8 percent for the same year, the danger seems to be more stagflation than deflation. This may call for another policy change which may strengthen the weak yen.
The yen is the currency pushed by macroeconomics more than yield differences. This is unique to the yen as it is the only economy to have suffered deflation for 20 plus years.
Long-term, the euro should decline compared to the dollar and other currencies with higher interest rates than those in Europe.
The pound's interest rate policy is in the hands of Mark Carney. He was the Governor of the Bank of Canada from 2008 until he joined the Bank of England in July last year. Another Goldman Sachs alumnus, his economic views are conservative. He guided the Bank of Canada through the crisis unscathed. With Carney's track record and with the heating economy, look for the pound to strengthen against the yen and the euro more than against the U.S. dollar.
If the U.S. raises interest rates, that change is half of what to consider when assessing the other currencies value against the dollar. When the market factors in such a change, the currencies will start to move. They will not wait until the change in interest rates actually happen.
Using the interest rate picture to evaluate currency strength is a long-term indicator. There may be short-term reactions to economic data and geopolitical events that put the currencies on a different track for a short period before returning to the longer-term interest rate driven trend.
South African Rand (ZAR) - S&P downgraded the sovereign rating of South Africa to BBB- from BBB, and changed its outlook from negative to stable. CPI remains high at 6.6 percent Y/Y for May, due to a spike in food inflation. The longest strike in South African mining industry ended after the world's largest platinum company agreed to sign a deal with the main union. The ZAR was positive in the latter half of June; however, it closed flat on a monthly basis.
Russian Ruble (RUB) – - Manufacturing drove industrial production to grow 4.4 percent Y/Y, although investment continues to shrink at -2.6 percent Y/Y due to the impact of geopolitical tensions. Retail sales growth declined again to 2.1 percent Y/Y. It also continued to introduce more flexibility to the RUB, by further widening the non-intervention band inside the corridor from RUB 3.1 to RUB 5.1 and lowered the intervention level from US$ 1.5bn to US$ 1bn. RUB carried its strength onto June as well, gaining a 2.6 percent due to oil prices on Iraq instability and despite some weakness mid-way in June, caused by the relationship with the Ukraine.
Indian Rupee (INR)- Escalating tensions in Iraq continue to impact the INR. India imports nearly 80 percent of its oil requirements and Iraq is the second largest supplier of crude, after Saudi Arabia. The INR fell 1.7 percent in June as Brent crude climbed 4.1 percent. The rise in crude prices will affect the deficits and the inflation. INR underperformed compared to other currencies, closing 1.3 percent down.
Chinese Renminbi (CNY) - The PMI was stronger than expected at 51.0 for June, confirming a pick-up in growth. The government's effort to loosen its domestic policy stance was reflected in the May RMB and M2 loan growth, which were above market expectations. Retail sales growth quickened to 12.5 percent Y/Y in May from 12.1 percent in April. Industrial production growth increased to 8.8 percentY/Y in May, signaling a cyclical rebound. CNY rose 0.7 percent in June.
Brazilian Real (BRL) - Deceleration in the economy is expected to continue. Low employment levels due to the World Cup, are expected to change once the games end as more employers lay off temporary workers. Industrial production contracted 0.3 percent M/M in April, adding to the 0.5 percent M/M decline in March. Policy fundamentals, high inflation, stagnating growth and an overvalued currency should hinder further strengthening of the BRL, up 1.3 percent during June.
Thai Baht (THB) - The Bank of Thailand kept rates on hold at 2 percent. The disappointing growth in Q1 due to a contraction in domestic demand, tourism and political uncertainty, prompted the Bank to downgrade its 2014 GDP forecast to 1.5 percent from 2.7 percent. Political unrest has caused a decline in private consumption, and investment. Tourism, a major economic driver in Thailand, with receipts amounting to $42 billion annually has dropped to nearly 5 percent Y/Y in the first four months of the year. Despite unrest in Thailand, the currency managed to hold on to gains in June, closing 1.1 percent above the previous month.
Mexican Peso (MXN) - Real GDP expanded 0.5 percent Y/Y in April, pointing to a gradual recovery in the economy. Unemployment in May was slightly higher. The MPC surprised the market with a strong 50bp rate cut, and further emphasized that additional rate cuts in the near term are very unlikely. MXN sentiment has been negative for the best part of June, with the currency closing in the red at -1.2 percent.
South Korean Won (KRW) - The Bank of Korea continued to keep its monetary policy on hold at 2.5 percent. Headline inflation was up at 1.7 percent Y/Y in May, from 1.5 percent Y/Y in April, but core inflation trended down to 2.2 percent Y/Y. May export growth fell to -0.9 percent Y/Y from 9 percent in April, mainly due to changes in the number of working days. Sluggish currency movement were witnessed in the KRW, with gains at just 0.6 percent for June.
Singapore Dollar (SGD) - Headline inflation rose in May at 2.7 percent Y/Y, largely due to base effects in private transportation, which is expected to normalize in the latter half of the year. Non-oil domestic exports contracted 6.6 percent Y/Y in May. Manufacturing production is gradually slowing, expanding only 4.6 percent in April. Flat movement in SGD witnessed the currency close positively at 0.5 percent, most of which was in the first half of June.
Swiss Franc (CHF) - The SNB continued with its 3-month interest rate target range at 0-0.25 percent. The Bank reaffirmed its decision to defend the EUR-CHF floor of 1.20 and added that it would do so with the “utmost determination.” Headline CPI inflation rose to +0.2 percent Y/Y in May, driven largely by gasoline prices. PMI rose to 54 in June from 52.5, its lowest level since June 2013. CHF witnessed a good comeback in the second half of June, gaining 0.2 percent.
Australian Dollar (AUD) -The RBA emphasized that interest rates would be on hold for some time, relaying a neutral bias and cautiously optimistic tone in its June board meeting minutes. Consumer sentiment slumped this month in response to the federal budget. The unemployment rate remained unchanged at 5.8 percent, predominantly due to the retracement of the participation rate. AUD slowly ramped higher for most of June, gaining 2 percent.
Canadian Dollar (CAD) - Headline CPI inflation surprised to the upside, coming in at 2.3 percent Y/Y in May, largely on rising energy prices. Inflation will pose a challenge to the Bank of Canada, which adopted a dovish stance. The unemployment rate was 7 percent for May, with full-time employment falling by 29.1K while the economy added 54.9K part-time jobs. Despite a weak start to June, CAD displayed equal gains the in the last 3 weeks of the month, as oil prices rose. posting a strong 2.3 percent gain for June.
British Pound Sterling (GBP) - The BoE unanimously voted to keep interest rates on hold in the June meeting. Meeting minutes were less hawkish after Carney's comments. Retail sales volumes fell 0.5 percent M/M in May. Despite this drop, the average levels in April and May were 1.7 percent above the Q1 average. Manufacturing continues to remain strong with CBI monthly survey showing the third highest reading for order books in the last 25 years. The number of people in work rose by 345K (1.1 percent) Q/Q and 780K (2.6 percent Y/Y) in Feb-April, the highest Q/Q gain in employment since data began 40 years ago. GBP was up 2.3 percent at the close of month.
Japanese Yen (JPY) - Japan posted a trade deficit of ¥909.0bn for May, wider than the April deficit of ¥ 811.7tn. The BoJ kept its monetary policy unchanged, and noted that the economy “has continued to recover moderately as a trend.” The Cabinet Office revised its Jan-Mar GDP numbers to 1.5 percent Q/Q, and 6.7 percent annualized growth. The Abe administration released a draft version of its growth strategy, emphasizing productivity in the overall economy. The JPY closed June up 0.5 percent.
Euro (EUR) - The Euro area composite PMI fell from 52.2 to 51.8 in June, the weakest since November 2013. Weaker PMI's from Germany and France were the main contributors. Industrial production expanded 0.8 percent M/M in April, +1.4 percent Y/Y. Manufacturing output expanded by +0.6 percent M/M while energy production rose more sharply by 2.5 percent. The unemployment rate was unchanged at 11.7 percent. The EUR closed at +0.4 percent.
New Zealand Dollar (NZD) - The New Zealand economy expanded by 1.0 percent Q/Q and 3.8 percent Y/Y in 1Q2014, driven mainly by construction in both residential and non-residential sectors. The Trade balance rose to a surplus of NZ$2,232mn. The RBZ hiked the OCR by a further 25bps to 3.25%. The subsequent statement from the Bank did not hint at any pause in the tightening cycle. Despite a flat start, the NZD was the strongest performing currency during the month with a whopping 3.8 percent gain.
Israeli Shekel (ILS) - The Bank of Israel kept rates on hold at 0.75. The Q1 2014 GDP was revised to +2.7 percent Q/Q annually, up from +2.1 percent. GDP of the business sector was revised to +1.5 percent Q/Q annually, up from +0.4 percent. PMI is steadily increasing with May numbers at 55.6, up from 51.4 in April and 48.9 in March. May CPI was unchanged from April at 1.0 percent Y/Y. ILS made steady gains during the month, and the momentum picked up towards the end of June, closing at a +1.4%.
Danish Krone (NOK) - The Norges Bank left its policy rates unchanged at 1.5 percent; however, it changed its expected rate hike from the "summer of 2015" to end-2015. The drop in electricity prices continues to impact the headline inflation, which is declining after peaking in August 2013 at +3.2 percent Y/Y. CPI inflation in May was at +1.8 percent Y/Y. The PMI was unchanged at 49.6 in June. Manufacturing output remained flat for April. One more currency that faced the heat was NOK, closing at a -2.6 percent, with most of the damage in mid-June.
The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates. This material, including without limitation the statistical information herein, is provided for informational purposes only. The material is based in part upon information from third-party sources that we believe to be reliable, but which has not been independently verified by us and, as such, we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decisions. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction.
Foreign exchange transactions can be highly risky, and losses may occur in short periods of time if there is an adverse movement of exchange rates. Exchange rates can be highly volatile and are impacted by numerous economic, political and social factors, as well as supply and demand and governmental intervention, control and adjustments. Investments in financial instruments carry significant risk, including the possible loss of the principal amount invested. Before entering any foreign exchange transaction, you should obtain advice from your own tax, financial, legal and other advisors, and only make investment decisions on the basis of your own objectives, experience and resources.