Jan

2

I do not focus on foreign currencies in my trading. And there are people here, such as Mr. John Floyd, who are far more knowledgeable about FX. So some of you may find these thoughts a bit simplistic; keep in mind I am an amateur!

I believe that a factor that makes a country's currency attractive to investors is the success (or lack thereof) that foreign investors have investing in the country in question. We can gauge this success by using ETF's that specialize in particular countries. For example SPY measures the performance of stock investors in the US, while EZU tracks investing in Eurozone stock markets.

What do we see? In recent months EZU has been performing better than SPY. For example in the last 6 months of 2022 SPY had a total return of 2.03% and EZU 9.56%. For 2022 as a whole SPY -18.38% and EZU -16.67%, two ugly numbers, but EZU did better. (These numbers will change between now and Dec 31, but not by much).

In my view this kind of comparison (especially given that Europe did poorly the previous few years, so it's a remarkable turnaround) will attract additional US investors to Europe, strengthening the currency. That is why I am bullish on EURUSD for the month of January 2023.

Bud Conrad responds:

Your logic is that if the stock market of a country rises, the currency of that country will rise in exchange rate. In the early days of this Speclist, the chair would ask me if I had "counted" the historical experience, which you cite for the last six months and year, but usually you need something like three cycles of inflection to get confidence.

The more usual comparison for currency strength are the Interest Rate Parity, using the futures market expected exchange rate and the difference in Interest rates.

And there the International Fisher Effect, also described here.

Often international traders look at trade balances for the country that has a trade surplus to be more attractive so the currency might rise. Trade surpluses mean they are a lender and not in debt to other countries. The US is the world's largest debtor, but the currency has been doing well.

John Floyd writes:

Doc makes the broadest, cleanest, and most accurate point about what drives currencies: what are expectations for return by BOTH domestic and foreign participants, and how does that drive investment flows into equities, FI, FDI, etc, which shows up in the BOP and Capital Account - on the other side of the ledge is the Current Account and the Errors and Omissions.

Admittedly I don’t know much about currencies and this is the area I know least about, but flow data is well researched and document by many at banks, independent research firms, IIF, IMF, BIS, etc. One challenge is it is often very much lagged, so Doc’s idea of looking at actual market instruments makes sense, and this is often particularly useful for emerging markets.

Capital account flows can fund a current account deficit for a very long period of time. Look at the US now or look at the Asian Currencies pre the crisis: errors and omissions become important given capital flight, particularly EM. Think Russia pre ’98 and Swiss bank accounts, etc.

As Doc well knows infinitely better than me, we need some more data and this can all be tested.

More broadly, outside of equity flows, Bud’s point of interest differentials will drive some capital flows. Also consider FDI from Europe to North America to diversify dependence on European energy costs and to friend shore manufacturing capacity.

And I would be remiss to not mention Italy (sorry Doc). Italy is in a Euro straightjacket that not even Houdini could get of. ECB is tightening with inflation at 10%, Italy 150% debt to GDP, Italian per capita GDP is barely higher than when joined Euro in 1999, Italy needs circa $250 billion in funding in 2023, 10 year yields in Italy up from 1 to 4.5%, all Italy issuance past few years was essentially bought by the ECB. This is not politically sustainable. Just look at the evolution of recent German politics. The ECB’s TPI is there but is intended for temporary dislocations and will require Italian political concessions. Oh and Italy is 10x Greece and the world’s 3rd largest sovereign debt market behind the US and Japan.

Read the full discussion here with additional contributors and charts.


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2 Comments so far

  1. stevo on January 7, 2023 10:46 pm

    David Turlington at State Street wrote a good paper on this.

  2. Monroe Trout Jr on January 11, 2023 1:50 pm

    Many conclusions following unsupported assumptions. Specially from Mr. Phillips. What happened with deflating ballyhoo and the scientific method?

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