The value is in EUR

The short term focus in FX has been on central banks. The lack of BoJ action,  diminishing expectations of action from the Fed, and the ECB approaching the limits of easing have all contributed to a strong JPY and EUR and weaker USD, while today saw the RBA sucked into the anti-deflation battle once again, halting the AUD recovery. The rationale for focusing so much on minor changes in central bank policy seems to me to be very flawed, and the scale of the reactions on the face of it looks excessive. But what appears to be excessive volatility in reaction to minor news may in fact be something else. It may be a reflection of very out of line initial valuations. As the market’s love of the USD and the story of widening yield spreads fades, recent sharp moves may reflect a realisation that valuations may be a long way out of line if the focus is changing. This is important for anyone looking beyond the short term, and even short term traders should be aware that with the long term USD uptrend under threat, the dominant paradigm may be shifting.

The simplest way of looking at value in FX is to consider real trade-weighted indices. These provide a comparison of the real value of currencies over time. I have put together a chart using BIS data rebased to February 1987 – the data of the Louvre accord when the major countries tried to stabilise currencies. This is not necessarily representative of fair value for reasons I will elaborate on later, but is a reasonable place to start. On this basis, the JPY looks the cheapest of the major currencies, and the Swiss franc the most expensive. The USD went from cheap in 2013 to expensive by the end of 2014 and extended its valuation though 2015. GBP also looks expensive on this basis, albeit a little less so than it was, while the EUR is on the cheap side.


But valuation on this basis misses out two key factors. First, the possibility of structural change and second the cyclical movements in currencies that result from movements in yield spreads. Of course, the latter is by its nature a temporary phenomenon, and cyclical movements in currencies always looks excessively volatile based on yield spreads. The increased attraction of higher yields makes a currency more attractive, but currency moves typically substantially overcompensate for the increased expected return. This is why a change in market sentiment can conversely produce an apparently excessive reaction in the opposite direction, as in the recent move in the JPY.

However, structural changes can and should have a sustained impact on currency valuations. I tend to look at this in terms of movements in the current account. Currencies with big current account surpluses tend to be more highly valued than those with a deficit, as a current account surplus represents a persistent flow into the currency which needs to be offset by capital flows in the opposite direction, encouraged by a higher currency. Changes in the terms of trade are one major factor that can change the structural current account position, but other factors can also have an impact.

In the current situation, the most notable current account changes in recent years have been the rise in the Eurozone current account surplus, the rise in the UK deficit, and the decline, and more recently recovery, in the Japanese surplus. These are important changes, because the history of the real exchange rate index has to be coloured by such structural changes. So the weakness in the JPY we have seen until recently was in part justified by the deterioration in the Japanese current account position. However, the recent improvement suggests some scope for the JPY to recover, especially since the weakness had in any case overshot somewhat. Meanwhile, the big rise in the Eurozone current account surplus justifies a stronger EUR valuation, and the converse is true for the UK.

Now, movements in the current account are also cyclical, with stronger growth economies typically having bigger deficits, and cyclically improving current account positions are not normally positive for a currency, because they are usually accompanied by independent capital outflows towards higher growth economies, usually because of higher or rising yields. But when the relative growth underperformance stops, the surplus doesn’t quickly disappear, and the surplus may become the dominant factor. This is the situation now in the Eurozone. The EUR not only looks cheap on valuation, it is even cheaper when the recent current account improvement is taken into account, and currently the Eurozone is also actually growing faster than the US or the UK (at least in Q1 2016). So something of a perfect storm for the EUR.

As for the JPY, while it looks the cheapest currency compared to history, it is probably less cheap than the EUR when the recent structural changes are taken into account. This is illustrated in the chart below.



So in the longer term I would see plenty of further upside for the EUR. However, in the short to medium term, the USD and GBP could recover if relatively strong US and UK growth returns and yield spreads resume the widening trend. Nevertheless, while his could happen in the next few quarters, I see little scope for this to continue longer term as cyclically adjusted budget positions in the US, and particularly the UK, need to be reined in. In comparison, the Eurozone has potential to expand budgets being that much further below trend output and full employment.



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