Back in the mid-noughties when I was working at RBS as their FX strategist, a couple of geeky guys came to see me. They wanted to know what the key drivers were of the FX market. I went through the normal parade of factors – value, terms of trade, yield spreads (real and nominal), politics, current account balance, risk appetite, momentum and so on, and tried to stress that the trick was deciding what they key factor was at any one time. But they asked me to pick what the most consistent driver was, particularly in the short-term, and I said yield spreads and risk appetite. I suspect they went away and built a high frequency trading model that may have made (or lost) the bank millions – these were the days when banks (especially RBS) liked to take risk.
Nowadays, I sometimes think that the whole market is trading this way, and has lost sight of all the longer term fundamental factors. Maybe everyone has gone away and built the same model, and the market has got locked into a world created in the noughties because everyone is trading as if the ideas that made sense then will make sense for all time. But it all looks a bit outdated in the current market. Yield spreads are generally very small, and the risk characteristics of currencies can change. For instance, the EUR was a reasonably risk positive currency back in the noughties, but the Eurozone now runs the largest current account surplus in the world and has seen huge net capital outflow over the last year to balance it. This suggests a much more risk negative characteristic, and that has to some extent been the case.
But it is the focus on infinitesimal differences in yield spreads that is the hardest to justify, especially when looked at in comparison to valuation measures. Tiny changes in central bank rates are used to justify large moves in currencies which are already misvalued. This is partly because there is no agreed way of measuring correct valuation in FX. And while FX is essentially mean reverting (in real terms) the time taken to revert to the mean can be long. But with all rates close to zero in the majors and most of the G10, valuation really ought to become a much more important driver of FX, as it will take a very long time to make any money on the carry gained from holding, say, GBP against the EUR.
While there is no agreed simple way of measuring correct valuation, history does give a reasonable guide. Real effective exchange rates do provide a good guide to value relative to history, though it is always possible that something has changed to create a deviation from historic norms. The G10 currency that looks most obviously undervalued relative to history is the Swedish krona. It is only around 5% away from all time lows, and is an illustration of how the market is driven by tiny interest rate differences which will not compensate for misvaluation in the longer run. The Riksbank have managed to drive the SEK down by setting negative rates, but the Swedish economy looks one of the healthiest in the developed world. Growth is likely to exceed 3% this year, inflation is only modestly below target, the current account is in significant (excessive) surplus, and unemployment is back down to pre-financial crisis levels. Despite this, the SEK is second only to GBP as the weakest G10 currency this year, presumably because of the combination of low yields and its undeserved status as a barometer of European risk sentiment. This seems to relate to the fact that Sweden is a small open economy with the Eurozone as its biggest trading partner, so can be expected to suffer both negative growth and current account impacts from weakness in the Eurozone. However, the Eurozone is not that weak at the moment, and Sweden seems to be doing fine anyway. The only problem that people seem to be able to point to is excessive household debt and an inflated property market, but Sweden are hardly alone in that, and the SEK offers much better value that those in a similar boat (the UK, Canada etc.).
It may be hard to hold onto a long SEK position because gains are likely to be slow and it can be vulnerable to negative risk spikes. To guard against his it may be worth holding a basket of long SEK vs GBP and EUR, though I would probably prefer to short CHF than EUR.
Here’s a chart of the SEK real trade-weighted index compared to GBP and CHF. Why should the SEK be this weak? It won’t last.