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USDMXN way out of line with fundamentals

I am far from being an expert on Mexico, but I am aware of the basic story behind the weakness of the MXN in the last few years. General USD strength, concerns about protectionism under Trump and weakness in the oil price have all contributed, while related NAFTA negotiations and the election this year are helping to prevent a major recovery. But the extent of MXN weakness just looks way out of line with the available evidence. Of course, it is possible that trade arrangements with the US become more problematic, but the MXN is around 25% weaker than you would expect relative to “normal” valuation. That is, USD/MXN has typically traded around 70% above PPP in the last 20 years. With PPP currently around 8.90, this suggests the “normal” level would be around 15.15. The current price near 19 just seems to price in all but the very worst bad news, so that the risks from here lie overwhelmingly on the upside for the MXN.

The chart below illustrates just how far away from normal the MXN is. The only time in the last 30 years that we saw the MXN as weak as this was during the “Tequila crisis” of 1994/1995. This was a proper crisis. The current account started off with a deficit of nearly 6% of GDP and the liberalisation of markets led to a devaluation of the peso, a loss of confidence in the economy, a balance of payments crisis, a 6% decline in GDP in 1995 and ultimately a US led bailout. The current situation is comparatively benign. While the current account deficit has increased, it is not in worrying territory, and growth, though a little weaker than desirable, is reasonable. GDP per capita is around 30% higher relative to the US now than it was then. There are of course concerns surrounding the relationship with the US, but markets in general are no longer expecting Trump to carry through his more aggressive threats.

I’m not going to predict the outcomes of NAFTA negotiations, or the Mexican elections. As I say, I’m no expert on these issues. But valuations say that the MXN is substantially undervalued unless we get a replay of the Tequila Crisis, and even the pessimists aren’t forecasting that.

 

usdmxn

Source: OECD

Mexico current account

Source: World Bank, OECD

 

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Rate hike won’t sustain GBP strength

I’ll make this short because I’ve covered this ground in this blog before, but recent gains in GBP in response to the latest inflation data and the more hawkish tone from the Bank of England at the September meeting make it worthwhile to go over it once again.

First, the basics. Higher inflation, other things equal, should mean a currency goes down, not up, in order to maintain the relative price level. The fact that currencies tend to rise in the short run with upside surprises in inflation is an anomaly seemingly based on a combination of money illusion and a historic expectation that higher inflation will trigger a response from the central bank that will actually mean higher real interest rates. This seems to be a distant memory of the 1970s and 80s, because it is hard to find occasions in the more recent past where higher inflation has triggered higher real rates (as opposed to just higher nominal rates) in the major economies. Of course, real rates have been falling steadily for years as a result of structural as opposed to cyclical factors, but even the cyclical upturns have seen precious little rise in real rates (see the FX market needs to rethink inflation, November 18 2016).

All this is relevant to the recent reaction to UK news. Inflation is above target and still rising, mainly in response to the decline in GBP seen after the Brexit vote. The MPC is now considering a rate rise in response. But the rate rise will come nowhere near full compensation for the rise in inflation seen since the Brexit vote. Real rates have fallen, and even if we see a 0.25% rise in the base rate soon they will still be well below where they were not just before the Brexit vote, but immediately after the BoE cut in rates after the vote (see chart below). While inflation has also risen elsewhere, it has not moved as much, and UK real rates remain unattractive, and will remain unattractive even if they move modestly higher.

Real UK base rate

uk real rates

Source: Bank of England

On top of this, there is the question of whether higher real rates in these circumstances, if they were to come, should be seen as positive for GBP. In general, higher real rates are theoretically positive for a currency, but in the current UK situation Carney’s speech yesterday makes it clear that his case for higher rates is based primarily on the expected inflationary consequences of Brexit. This is not the usual cyclical impact of rising demand, but a structural change that will reduce both demand and supply and raise prices, at least in the short run, with Brexit effectively acting as a de-globalisation. Carney’s case for higher real rates essentially rests on the belief that the Brexit impact on supply will be greater than the impact on demand. This is debatable (as he himself admits) and it is hard to instinctively see this as positive for GBP, because real rates will be rising because of reduced potential output due to reduced efficiency and lower productivity. Any benefit from higher portfolio inflows to seek out the higher real rates seems likely to be offset by reduced inward direct investment as a result.

In summary, the case for GBP gains based on a more hawkish BoE seems very weak. Any rise in nominal rates looks unlikely to translate into a rise in real rates, and to the extent that real rates are higher than they would have been, it will likely only reflect the Bank’s concern that Brexit is going to undermine potential UK output growth by reducing productivity and undermining existing supply chains. Of course, that doesn’t mean GBP will reverse recent gains quickly (the market can remain irrational longer than you can remain solvent), but looking at the charts suggests to me that 1.38 would be a very good area to sell GBP/USD, while anything below 0.87 looks a buying area for EUR/GBP.

Riksbank policy – dangerous, myopic and unsustainable.

I’ve seen some fairly odd decisions made by various central banks in my 30 odd years in the markets. But they normally have some sort of explanation, even if you don’t agree with it. But in the case of the Riksbank decision last week, I honestly cannot understand the rationale for not only leaving rates and asset purchases unchanged, but also leaving projections for future policy unchanged, with the first rate hike not expected until 2018. It is frankly utterly bizarre, and smacks of an ill-conceived desire to maintain a weak currency – a desire that has no justification whatsoever given Sweden’s macroeconomic circumstances.

Even at the July meeting, it was quite hard to justify the super easy stance of the Riksbank. The economy has been growing at 3% +, the employment rate was at record levels, and inflation was only modestly below target. But despite having the strongest economy in the G10 Sweden was running one of the easiest monetary policies, with the repo rate at -0.5% and asset purchases continuing. At the September meeting the Riksbank had to consider the news that GDP growth had accelerated to 4% y/y in Q2, and inflation had risen to 2.4% on their targeted CPIF measure, above the 2% target for the first time since 2010. But the Riksbank decided not only to continue with their hyper-easy policy, but didn’t change the view that they wouldn’t raise rates until the second half of 2018. Why? Well according to the Riksbank:-

” For inflation to stabilise close to 2 per cent, it is important that economic activity continues to be strong and has an impact on price development. It is also important that the krona exchange rate does not appreciate too quickly.”

In their report the Riksbank accept that growth is stronger than expected, inflation higher than expected (and above target), resource utilisation is approaching historic highs, and the employment rate and household debt at record levels, but they still want to keep rates at historic lows. The only reason they appear to have is that they don’t want the currency to rise too fast as this would endanger the inflation target. This seems to me to be an incredibly short-sighted policy, which has been shown to be unstable and dangerous in many places in the past, the UK most notably.

Sweden is a very open economy, and the currency certainly will have a significant impact on inflation in the short-term. But in the end keeping interest rates at a level that is inappropriate for the economy in an attempt to prevent currency strength is courting disaster. The result will likely be continued strong growth in the short run, further rises in household debt and above target inflation. When the brakes do have to be applied they will have the be applied that much harder, sending the currency up that much quicker. Or if the Riksbank choose not to apply the brakes, perhaps because inflation doesn’t rise too much, they result will ultimately be that the excessive debt burden causes a crash.

This isn’t just about Sweden, it’s also about the weakness of the policy of inflation targeting. The inflation process may well have changed significantly in recent years, with wage growth failing to ignite despite low and falling unemployment in Sweden and the Anglo-Saxon economies. The path from policy to the economy to inflation has not only changed, it may be almost completely blocked. Inflation is being determined elsewhere by other factors. Setting interest rates to control inflation in the short to medium term is becoming a ridiculous endeavour, and attempts to control inflation by controlling the currency are taking huge risks with the economy.

But it’s not even the case that the Swedish krona is particularly strong. The Riksbank likes to use the nominal KIX index, which shows the SEK slightly on the strong side of recent averages, and they cite the recent rally as one of the reasons for their decision in September. But measures of the real exchange rate show it to be very much on the weak side of historical norms. Attempts by the Riksbank to stop it rising are ultimately futile. Sooner or later it will return to normal levels, and it is better to allow it when the economy is strong and running a substantial trade surplus. A strong currency is a good thing – it makes consumers richer. They will be able to spend more without increasing their debt, and the trade surplus might come down. Instead, the Riksbank are following an unsustainable and dangerous policy, tying their policy to a region (the Eurozone) which is years behind Sweden in its recovery.

sek

Source: Riksbank, BIS

EUR/USD – Echoes of 2002

EUR/USD has bottomed out for the foreseeable future. At the beginning of the year I thought we might have another go at breaching parity on the back of further expectations of Fed tightening spurred by expectations of stimulative fiscal policy (and possibly protectionist measures) from Trump. The downside was nevertheless quite limited because the EUR was starting from very undervalued levels from a long-term perspective. Dips to parity even then looked likely to be a long-term buying opportunity. But with the break above 2015 and 2016 highs seen in July, the base looks to be confirmed technically, and the chances of a dip back below 1.05 – or even 1.10 – now looks like a long shot. The picture now looks quite similar to 2002 when the break through the 2001 and 2000 highs was the start of a 6 year rally of more than 70 figures to the highs in 2008.

Euro bears will be inclined to point out that the EUR was a lot lower then, but in reality the situations are not that different. In 2002 EUR/USD Purchasing Power Parity (according to the OECD) was around 1.17. Now it is 1.33. So, as the chart below shows, the difference from PPP at the lows in 2000 was not that much greater than it was at the lows in January this year. A little over 30 figures then, just under 30 figures this year.

eurusd and ppp

Source:OECD, FX Economics

Then, as now, the rally in EUR/USD frankly looked overdue. The case for the extreme USD strength in the early 2000s was based on a combination of the safe haven status of the USD, the uncertainty about the viability of the newly created EUR and the fallout from the 2000 crash. But by 2002 the major economies were all in the process of recovery and yield spreads, which are usually a reliable determinant for EUR/USD (and its precursor USD/DEM) were suggesting EUR/USD was substantially undervalued. Things are different now in that the yield spread doesn’t show a clear case for a higher EUR (though the US yield advantage is less clear when looked at in real terms).

eurusd and tnotebund

Source: Bloomberg, FX Economics

However, whereas the Euro area then was a region which only had a broadly balanced current account, it now has a massive current account surplus of around 4% of GDP (similar to the US current account deficit at more than $400bn). In the past couple of years this has been more than offset by portfolio and direct investment flows out of the Eurozone, and reports suggest that sovereign wealth funds have substantially reduced EUR weightings since rates turned negative. However, with monetary accommodation now looking more likely to be reduced, and European equities looking considerably cheaper than those in the US, these capital flows may well start to reverse before long.

This doesn’t mean EUR/USD is about to embark on a 70 figure rally over the next 6 years (as it did in 2002) and hit 1.75 in 2023. For the recent recovery to extend much further we are likely to need a significant narrowing in yield spreads, and this may still take some time as the ECB aren’t likely to be in a big hurry to remove accommodation. It is unlikely that the ECB are going to be too concerned about the run up in the EUR seen so far – it is quite minor on a multi-year scale, and the EUR remains quite cheap by long-term standards, but the pace of recovery may be a concern, because that will impinge on inflation in the short run. This could slow any ECB tightening, but the ECB must accept the likelihood of a long run EUR recovery. Nevertheless, EUR/USD should now be seen as a buy on the dip from a long term perspective. 1.10 looks unlikely to be breached again, so anything near 1.15 should be a buying opportunity.

Germany’s trade surplus is down to Germany not the ECB

In a speech in Berlin yesterday, Merkel said the German trade surplus was propelled by two factors over which the government had no influence, namely the euro’s exchange rate and the oil price. Well, there’s some truth in that, but not much. It’s fair to say that a weak euro probably does increase the trade surplus, though the impact of the exchange rate is quite delayed and weak. And a lower oil price does reduce the oil deficit, but there is still a substantial deficit in oil so you can hardly blame this for a trade surplus.  These factors may have led to a higher trade surplus than would otherwise have been the case, but they are not the primary cause of the large and persistent German trade surplus. That much is obvious just by looking at the German trade and current account surpluses in recent years. Yes, the surplus has increased a little in the last few years in response to the lower euro and the lower oil price, and is expected to be 8.8% of GDP in 2017. But the current account surplus was already 6.8% of GDP 10 years ago in 2007 and 7.1% of GDP 5 years ago in 2012. In 2007, the euro was around 10% higher in real effective terms (for Germany) than it is now, and the oil price was around $70 a barrel. In 2012 the euro was actually not very far from current levels in real effective terms (though stronger against the USD), and the oil price averaged around $110 per barrel. The German trade and current account surpluses were nevertheless still very large. Merkel’s attempts to claim that they are a function of a weak euro and a high oil price just won’t wash.

german stuff

Source: OECD

Merkel’s comments are an attempt to evade criticism of German policy, which have come most recently from the US but have been heard before in Europe. She is arguing that the problem is out of her control because she doesn’t want to take the measures necessary to reduce Germany’s trade surplus. What could be done? It is not an easy problem to solve, but she could make some contribution with easier fiscal policy. Her fiscal stance has been very conservative and makes Britain’s attempts at austerity look spendthrift. The German budget is expected to show a 0.5% of GDP surplus in 2017, following similar surpluses in the previous 3 years. This is certainly on the austere side, and government debt has been falling fairly rapidly as a result, expected to hit just 65% of GDP this year, back to 2008 levels after seeing a peak of 81.2% in 2010. Of course, the original target for this debt level was 60% of GDP, but much higher levels are sustainable with much lower real interest rates. The Eurozone average government debt is over 90% of GDP.

german stuff1

Source: BIS

However, the big problem is really the private sector rather than the public sector. The private sector save too much (or don’t invest enough). The proper monetary policy response to this is to keep interest rates as low as possible, so on that basis the ECB are doing exactly the right thing. But more could be done with fiscal policy in Germany, either with stimulative tax cuts, or more government spending. This would both directly encourage imports and, by forcing up wages and prices, would lead to improved lower real interest rates and reduced German competitiveness. Part of the reason for the big German trade surplus is the big wage competitiveness advantage built up in the aftermath of the creation of the euro. That’s why Germany has been running big trade and current account surpluses since the mid 2000s.

But Merkel doesn’t really want to do this. She doesn’t want to undermine Germany’s competitive advantage with the rest of Europe (as well as the rest of the world). She doesn’t want to run a less austere budgetary policy and alienate the conservative wing of the CDU. So she’s blaming the ECB and the oil price. The rest of Europe need to tell her she’s wrong. I see no chance that Draghi or the ECB will take any notice of her, so logically there is little reason for the Euro to benefit directly from her comments.  But with the political and economic winds behind it, there is little reason to oppose euro strength anyway. The CHF and GBP look the most vulnerable of the major currencies in this environment, though the USD could also suffer if rate expectations drop away significantly.

german stuff2

Source: EU Commission

The UK needs a weak pound

UK Chancellor Philip Hammond welcomed the rise in the pound that accompanied the announcement of the UK election last month. He should be careful about cheerleading GBP strength, because right now the UK is more in need of a weak pound than it has been for a long time, and a significant recovery in GBP could be a big problem for the UK economy.

The UK economic situation is dangerous, not only because of Brexit, but because of the perilous position of the UK’s consumer finances. This is well illustrated by the chart below showing the financial balances of the three sectors of the UK economy, balanced by the position with the rest of the world.

sector balances

Source: ONS

The UK household deficit is at record levels, and as can be seen from the chart, the existence of a deficit is a rarity, seen only briefly in the late 80s and then for a few years in the mid 2000s. It is a danger signal. In both cases, the deficit was followed by a recession, as consumers retrenched, as can be seen from the chart below.

householdbalance and GDP

Source: ONS

The process see in the past is instructive. Most of the time, GDP grows as the household balance moves towards deficit, fuelled by deficit spending. However, when the household balance moves into deficit, it tends to reverse, and this has historically led to a recession. If this is not to happen this time around, the inevitable reversal in the household balance must be accomplished slowly while other sectors are adding to growth. With the government constrained by longer term budget issues, this really only leaves investment and net exports. This makes the danger from Brexit fairly obvious. If firms are worried about access to the single market then investment in the UK may be curtailed. Longer term, the terms of Brexit will be key for net exports, but shorter term, the export sector looks likely to be the healthiest, as UK exporters benefit from the combination of a lower pound and strengthening Eurozone domestic demand. But this is why a significant recovery in the pound is not desirable. It would both undermine export growth and discourage investment.

Is a recession inevitable when households retrench? Not necessarily – it will depend on the conditions. In 2000 when the dotcom bubble burst the UK avoided recession in spite of a very extended household sector which did retrench, because rate cuts encouraged firms to borrow. But this underlines how important business confidence is in the current UK cyclical situation. With no rate cuts available to encourage businesses or households to spend, confidence in the future is key if spending is to be maintained.

All this makes the timing of Brexit look extremely inopportune. In the mid 2000s, the household sector ran a financial deficit for a few years before the crash, but the crash was all the more severe when it came for that reason. If growth is maintained in the coming years ahead of Brexit, the situation will be similar when Brexit actually happens. If Brexit hurts exports and investment, there will be no safety net.

Policywise, this should make it clear to the government that “no deal” with the EU is not an option. The fear is that they will  believe their own publicity and see limited economic damage if they fail to get a deal. Or take the view that, politically at least, falling back on the WTO will be favourable to accepting a deal that is like EU membership only worse. Hopefully sense prevails.

But in the meantime, the UK economy needs to be managed into a position where it can deal with a potential shock. This means managing a retrenchment of household finances now – while exports are strong enough to offset the negative growth impact. Unfortunately, it is hard to think of a policy mix that will achieve the desired outcome of slower consumer spending with strong exports and investment. Higher rates would help increase saving, but would also likely undesirably boost the pound. Higher taxes wouldn’t reduce the household deficit, only consumer spending, but would give the government more scope to react to shocks in the future, so are probably desirable. Direct restrictions on consumer borrowing might also make sense. But a stronger pound would not be helpful. Hammond should not be talking it up.

UK retail sales – the beginning of a slump?

Unusually I think it’s worth highlighting a monthly release. There is a lot of randomness in most monthly data and UK retail sales is one of the most vulnerable to monthly glitches, often because of seasonality problems. However, if you look at a 3 month average of sales the trend has been quite clear in recent years, until the last couple of months where it looks like everything fell off a cliff.

uk retail

Source: ONS, FX Economics

Now, it’s as well to be cautious in interpreting such sharp moves in retail sales, especially around the turn of the year when Christmas effects can be unpredictable. The plunge we have seen is really based on just a couple of months data. But as can be seen from the series, it is rare for the 3m/3m trend to move so sharply. If we see a similar story in March it would be fair to conclude that there has been a clear weakening in the trend.

Which leads me to the March data due for release tomorrow, Friday April 21. Looking at the screens today, the market median expectation for retail sales is for a m/m decline of 0.2% in the headline number, and a 0.4% decline in the core. Now, this seems to me to be quite a pessimistic forecast. The impact on the 3m/3m growth rate would be minimal, as shown below.

UK retail march

Source: ONS, FX Economics

Retail sales only makes up around 40% of personal consumption, but even so, a 1.2% decline in a quarter is quite a serious slump. Even if we assume the rest of spending carried on as before at the 0.7% q/q rate seen in Q4, then this would still mean negative consumer spending growth in Q1. As I was last month, I am a little sceptical that spending has been quite that weak. Last month we got a rise of 1.4% m/m, which was still far too little to prevent a sharp weakening in the 3m/3m trend, but was nevertheless well above the monthly forecasts. Markets saw this as good news, simply because the outcome was better than expected on the month, but it’s very hard to see how this sharp weakening in the retail sales trend is actually positive news for GBP. This month we may get more of the same. It would take something above a 3% m/m gain to prevent retail sales falling q/q in Q1. But a better than expected outcome of a 1% rise or so seems quite likely, as this would still mean a fall of 0.75% q/q. But surveys don’t suggest any major recovery, with the BRC survey showing the weakest quarter since May 2011 for non-food sales.

So we might get a knee jerk positive reaction because the monthly forecasts once again look quite weak and the m/m rise may be better than forecast. But any positive GBP reaction could prove a selling opportunity for GBP as the strength of the UK economy that Theresa May and the IMF have been telling us about in the last week looks to have come to something of a shuddering halt in Q1. Who knows, this may be another reason that May has called an election now. There are initial signs of a slowdown, and she may want to get an election in now in case they become more obvious in the coming months and years. We are in the sweet spot when it seems consumer confidence is still high, or at least was until Q1, exports are getting some support from a weak pound and there are as yet no negative consequences of Brexit to deal with. Things might not look so rosy in a few months.