International borrowing and the US dollar

  • Some market participants are worried about the ever rising market value of US borrowing vis-à-vis the rest of the world – as measured by the Net International Investment Position
  • Currency depreciation can function as an effective method of adjustment following an increase in external borrowing
  • However, there are reasons to be cautious about this line of thinking, especially with respect to the US dollar. These include asset valuation effects, and the role of the US as a global facilitator of excess saving.

The economic factors which help to explain the US dollar’s behaviour are numerous, and often vary depending on the underlying macro and political environment at hand. Historically we observe that the US dollar typically moves in 7-10 year cycles around its fair value, where relative economic performance and associated monetary and fiscal policy momentum has been the primary catalyst for such trends. Shorter term gyrations within cycles, on the other hand, are often the result of idiosyncratic political risks or episodic “risk-on” or “risk-off” behaviour within global markets. Creating these dynamics is the interplay between an outsized US debt market, and the perception of the US dollar as a “safe haven” asset, which drives demand for the currency.

A somewhat related issue, receiving attention in the financial media recently, is the ever rising level of US borrowing vis-à-vis the rest of the world – as measured by the Net International Investment Position (NIIP) – and the possibility that this, in and of itself, could signal a sustained bout of US dollar weakness. As of September 2017 the US had claims on foreign debt, equity and other assets amounting to 140% of GDP, compared to 181% (of US GDP) invested by the rest of the world in US markets. This leads to a US net international borrowing position of 41% of GDP, or $7.8 trillion.

Indeed, following an increase in external borrowing, currency depreciation can function as an effective method of adjustment; a cheaper currency can simultaneously boost exports and limit imports, reducing a country’s reliance on external funding. Not only that, if a country borrows in domestic currency and has assets in foreign currency, a currency depreciation can make the net stock of external debt appear more manageable overnight via an FX revaluation effect – as was the case following sterling’s depreciation after the Brexit vote. Chart 1 overleaf demonstrates since 2007 the overall impact of market values on the US investment position. The FX market risk is, of course, borne by the international lender, and like most markets, investors will expect a higher yield should this become a regular occurrence. For these reasons, a country’s investment position contains valuable information regarding the vulnerability and required returns of a currency.

However, there are reasons to be cautious about this line of thinking, especially with respect to the US dollar. As described earlier, the NIIP is affected by FX revaluations (along with local asset price revaluations), and the recent deterioration of the investment position has been driven in part by an appreciation of the US dollar (Chart 2). A worsening US NIIP is then a symptom of a stronger US dollar, making it difficult to assign ensuing currency weakness to the NIIP alone. Additionally, the need for depreciation would imply the US is borrowing in excess of its ability to attract funding. In fact, annual borrowings from the rest of the world – measured by the current account deficit – peaked in the run up to the global financial crisis at 6% of GDP, as abundant global savings were used to purchase US assets (mainly via a glut of Asian savings and oil exporters’ petrodollars). The dollar has since risen, which may suggest the US was not, and is not, overextended, but is merely facilitating global excess saving.

With a less than concrete link between the US NIIP and currency weakness, we recommend assessing the US dollar’s prospects by also considering macro factors which capture reliable sources of return inherent in the currency market. This would involve incorporating factors such as valuations, relative interest rates, and momentum into any currency analysis.

Sources: Record, Bureau of Economic Analysis, Macrobond.

Causes and implications of the Hong Kong dollar’s 2017 decline

  • In light of the currency board arrangement which pegs the HKD to the USD at a level of 7.80, the Hong Kong dollar’s decline this year represents a sizeable exchange rate move.
  • In this blog post we investigate the causes and discuss the implications for the Hong Kong Monetary Authority’s currency arrangement.


Since the beginning of 2017 the Hong Kong dollar has depreciated by 0.8% versus the US dollar. In light of the currency board arrangement in place which pegs the HKD to the USD at a level of 7.80, this is a sizeable exchange rate move. Weakness in the HKD appears to be driven mainly by diverging interest rate differentials which are a symptom of excess money in the Hong Kong banking system. Although speculative pressure has appeared limited thus far, signs of bets against the currency are beginning to emerge. However, according to the Hong Kong Monetary Authority (HKMA), the move is “…not a concern”, and absent a deliberate shift in monetary policy from the HKMA after more than 30 years, the HKMA look willing to defend the upper bound at 7.85. In fact, some market participants think that the HKMA have already stepped in to tighten liquidity and reduce pressures emerging from widening interest rate differentials with the US.

Explaining HKD weakness

We believe the recent upwards movement of USDHKD can be mostly explained by a widening HIBOR-LIBOR spread (relative interest rates). This interest rate difference has made HKD an attractive funding currency for carry trades since the start of 2017, causing capital outflows and exchange rate depreciation. In June, HKMA chief executive, Norman Chan, warned that this could happen; capital outflows would increase if the interest rate differential continued to widen. This widening differential, which is relatively unusual given the HKMAs commitment to peg the HKD to the USD, appears to be explained by the existence of excess liquidity in the banking system and a competitive mortgage market; banks, flush with capital and competing for mortgage loans and other business, are reluctant to raise rates. Thus, while the HKMA has been gradually raising the base rate in accordance with the Fed’s FFR target, Hong Kong interbank rates have not risen commensurately.

Implications for the USDHKD peg

With regard to the USDHKD peg, these developments appear unlikely to change the behaviour of the HKMA materially. Firstly, weakness in the HKD of this magnitude is not unprecedented, with similar levels being reached in 2008 and throughout the 80s and early 90s. The HKMA echoed this sentiment publicly, stating “the recent weakening of the HKD is not a concern to the HKMA”. Secondly, the HKMA has a sizeable level of foreign currency reserves ($400bn and 125% of GDP) at its disposal to defend the peg, should interest rates diverge further. Thirdly, most of the exchange rate move (so far) appears to have been driven by diverging interest rates, not a speculative attack on the fundamental value of the currency. Normally, when there are heightened expectations of HKD weakness, buying US dollars forward becomes more expensive. For most of 2017, this has not been the case and buying US dollars forward has actually become progressively cheaper (in terms of forward points) and as a result of diverging deposit rates the headwind for HKD based hedgers has become stronger.

That said, over the last week we have begun to see some indication of speculative pressure emerging. The ‘cross currency basis’ can normally be used as a measure of this pressure and indicates how far FX forward prices are diverging from covered interest parity pricing. The existence of a US dollar liquidity shortage complicates the analysis, however we observe that the USDHKD cross currency basis has fallen sharply since the beginning of the month. As this move was absent from other USD currency pairs, it may suggest carry speculators could have specifically used the forward market to go long USD.

Earlier this week the HKMA announced it will issue $HK 40bn of Exchange Fund Bills, which led to a sharp appreciation of the HKD; the market interpreted this as the first signs of the HKMA draining liquidity in order to increase interest rates and deter bets against the HKD. If bets against the HKD persist, or the exchange rate moves closer to the 7.85 upper bound, we would expect the HKMA be proactive in the defence of the currency board, absent any structural shifts in the setting of its monetary policy.

Source: HKMA, Federal Reserve, Bloomberg, Record.

Recent trends in the RMB

This year the RMB has bucked its recent trend and remained broadly stable against the US dollar for the first half of 2017. As the Trump reflation trade has unwound to some degree, and the dollar retraced, the RMB has seen some depreciation against its main trade partners. For policymakers in China this is a convenient outcome, though there exists a delicate balance to maintain. Too fast a depreciation risks discrediting recent emphasis on ‘relative stability’ and the recent change to the PBoC’s fixing mechanism looks to be a reflection of this need.

Key RMB movements so far in 2017

Up until the end of May, the CNY traded in a narrow range against the US dollar, though at the beginning of March a gap opened up between the trade-weighted US dollar and the direct bilateral USDCNY exchange rate (figure 1). While sentiment on China this year has improved on a relative basis, market participants still worry about a number of issues including softer growth, financial instability, and the impact of deleveraging, which has encouraged this disconnect. A flat USDCNY exchange rate in the face of a depreciating dollar more generally, has therefore led to a decline in the trade-weighted RMB index (figure 2).

A healthy easing

To policymakers, this is not a bad outcome. Firstly, a trade-weighted depreciation provides some much needed offsetting stimulus to counterbalance rising lending rates and efforts by officials to crack down on leverage in the economy, which will weigh on growth (figure 3). Secondly, China has battled both speculative and domestic outflows, and depleted around a quarter of its reserves in the process. A weak dollar but stable China/US bilateral exchange rate allows for a supportive depreciation, while helping to discourage capital outflows and replenish currency reserves (figure 4). Admittedly, it is difficult to tell whether the recent stabilisation in capital outflows is indeed down to improved domestic sentiment or more effective capital control measures.

The new fixing mechanism for CNY

While a trade-weighted depreciation is certainly convenient, PBoC officials will be keen to maintain perceptions of ‘relative stability’, whether that be against a currency basket, or against the US dollar (the emphasis appears to change depending on the dollar’s trend). In line with this objective, towards the end of May, the PBoC unexpectedly changed its USDCNY fixing mechanism, adding a counter-cyclical adjustment factor. Previously, the fix was determined by two components primarily; the prior day’s close in USDCNY and an adjustment factor which aims to keep the trade-weighted RMB stable.

The first component helps to explain why USDCNY and the DXY index recently diverged, and the new countercyclical adjustment factor aims to promote two-way flexibility but prevent these kinds of unwarranted divergences in the future. In the days running up to the fixing change, USDCNY fixings came in far below what previous market closes implied, and the recent change could partly be an ex-post rationalisation of these lower fixes. In effect, this new methodology gives the PBoC a greater degree of discretion over the fixing rate, should it judge USDCNY to be diverging from fundamentals.

Total returns tell an alternative story

The recent depreciation of the RMB index has been part of a longer-term adjustment to macro adjustment under which the RMB has depreciated on a trade-weighted basis by around 8.5% since the start of 2016. However, from the perspective of exposure to Chinese currency risk, it is essential to assess returns on a total returns basis which include the accrual interest rate differentials, rather than the spot performance independently.

While the CNY has depreciated by 4.7% and 5.0% against the US dollar and G4 currencies respectively since the start of January 2016, total returns for the same period were positive at around 1.4% and 2.3%, respectively. The RMB has therefore compensated holders on a total return basis via a higher nominal interest rate. According to prevailing forward currency curves, this interest rate differential is expected to persist into the future and if so, will continue to form an important component of return for the RMB.

Czech that out ! A story foretold in FX markets

  • We assess the implications of the removal of the CZK to EUR peg on April 6 2017 and what this means for how central banks manage peg removals going forward.

The CNB announced earlier today that they abandoned their commitment to the EURCZK floor at 27 CZK per EUR whilst also saying that they will only intervene to prevent “excessive” exchange rate moves. The initial reaction has been muted, with a modest CZK appreciation circa 1.4% against the EUR at the time of writing, but additional pressure from the re-establishment of short EURCZK positions might cause CZK to appreciate over the medium term especially seeing as CNB Governor Rusnok stated in this press conference that this was likely the beginning of a tightening cycle. Furthermore, from a fundamental macro point of view, Purchasing Power Parity (PPP) would suggest a stronger CZK vs almost all major currencies including EUR.

At this point, it is reasonable to ask how this compares to January 15 2015, when the Swiss National Bank undertook a similar task when confronted with the need to remove the EURCHF floor. While the initial conditions are different, i.e. CZK is a much less traded currency, and not at the neuralgic centre of the FX markets as the Franc, there are lessons to be learned even at this early stage in terms of how central banks remove pegs.

First, the Czech National Bank (CNB) must be congratulated in the way it managed to cause minimal disruption from the de-pegging, whether one looks at spot moves, implied volatility, liquidity air pockets below 27 and simply good old fashioned market sentiment, where participants seem to have taken this move in their stride. The key to why this was successful in avoiding market stress and further collateral damage was to do with the CNB’s extremely transparent and well telegraphed communication about the end of the peg arrangements. Market participants had been repeatedly told the conditions under which the peg might go, namely, inflation hitting the target of 2% and staying consistently above it, something that has been the case since late last year (see chart below). Since the beginning of 2017, CNB officials repeatedly told the market in no uncertain terms (for what is usually stale central bank speak) that there was a very real possibility that they might remove the peg at any point this year (the latest pronouncement being Governor Rusnok in the local media muting in March that the most likely timing of exit is still “the middle of 2017”.

This increasingly targeted, transparent and focused “forward guidance” (to borrow a phrase) begun to be significantly priced into EURCZK forwards as early as 2016, and pricing became even more acute in 2017, so that the “carry cost” of a long 1m EURCZK forward in March was about 3.5% (annualised) and 80bps (annualised) at the 12m horizon. In essence, CNB policy was extremely adept at dissuading long CZK speculators (with little natural CZK asset exposure) from taking large trading positions given that the opportunities for profit and loss were finely balanced should the peg break. Market equilibrium pricing resulted in what was beginning to look like a zero profit trade at inception, given the expectation of CZK appreciation once the peg was removed.

By pre-committing itself to the “time” dimension, the CNB managed to avoid a large market dislocation. This is something that the SNB refused to do, and, by keeping its options open in terms of when to remove the peg perhaps in avertedly ended up sacrificing the “volatility” dimension of the final outcome once the peg was removed. Not all pegs are created equal (the SNB’s task was arguably an order of magnitude more complicated given the need to recycle Switzerland’s large current account surpluses outside the CHF zone and the sizable headwinds this resulted in), yet the lessons to be learned will certainly serve future central bankers, perhaps in Croatia, or even Denmark and Hong Kong as well.

FX markets in the Trump era

  • Since the US presidential election on November 9th, markets have generally welcomed the more conciliatory tone from the President-elect Donald Trump.
  • How might the changing economic environment affect currency hedging decisions, and what does this mean for currency returns?

Since the US presidential election on November 9th, markets have welcomed the more conciliatory tone from the President-elect Donald Trump. Contrary to expectations, developed market equities have outperformed, while bond markets have sold off on the back of infrastructure-inspired growth expectations and a step up in nominal and real yields. The US dollar has been the beneficiary; since the election, the US dollar has gained against almost all developed market currencies (although, as British Prime Minister Theresa May sought to soothe businesses’ Brexit concerns, the dollar fell marginally against the pound sterling). The Japanese yen has been the worst hit as the Bank of Japan’s recent commitment to zero percent yields has amplified the impact of a US yield curve steepening.

Emerging market (EM) currencies have received no exemption from the dollar’s rally, though declines are not dissimilar to those witnessed in developed markets. Unsurprisingly, losses have been most pronounced in the Mexican peso, while other currencies also expected to suffer from protectionist policies, such as the Taiwanese dollar and Indonesian rupiah, have not fared as badly. The relatively muted reaction in other emerging market currencies is likely the result of healthy national balance sheets and co-ordinated central bank action; according to several measures, reserve adequacy had risen following the rout in 2014/15, and these reserves were utilized effectively to promote stability while the market adjusted to a new equilibrium.


spot-currency-performance-1 spot-currency-performance-2

How might this affect the decision to hedge?

The election of Donald Trump has had a profound impact on markets and may mark the beginning of a new economic era; one which emphasises fiscal policy, protectionism, and entrepreneurialism. The consequent evolution of correlations, volatility, and interest-rate differentials in the currency markets will affect the trade-offs involved with any hedging program.

We note that the US dollar has begun behaving in a more risk-on fashion of late (foreign currency and equities have moved inversely) while volatility is elevated and interest rates have repriced upwards quite significantly. The evolution of currency/equity correlations is the most uncertain factor. On one hand, the expected change of the US dollar from a low-yielding to high-yielding currency and the resultant reallocation of global risk capital could encourage pro-cyclical behaviour in USD. Additionally, economic theory[1] would suggest that a shift in policy focus away from monetary tools towards fiscal policy would increase medium-term correlation between risky assets and the US dollar. On the other hand, however, we expect US Treasuries and other USD assets to maintain their safe-haven status among investors, contributing to counter-cyclical behaviour in USD.

How do these factors affect the decision to hedge? We find that in aggregate a US dollar-based investor hedging Eurozone equities will benefit from the changing environment outlined above. Changing correlations could mean that currency hedging becomes less able to reduce portfolio volatility, but higher US interest rates would increase the excess return added by a hedging program, such that an investor’s risk-adjusted return is still boosted by currency hedging.

Using Eurozone equities as an example, in the charts below we evaluate for an optimal hedge ratio, both from the perspective of volatility and risk-adjusted return. The increase in future currency volatility implied by the option market suggests the need to hedge more, especially if the current correlation levels[2] (between Eurozone equities and EURUSD) persist at around -0.2 (left panel, light green line). However, this correlation has been on a strong downward trend since late-2014, which likely reflects changing attitudes to risk as interest rates in the US normalize. If falling equity/currency correlations intensify, portfolio volatility would be reduced by hedging less than 100%, then from a volatility perspective the optimal point at which to hedge will be lower (left panel, dark green line). However, the changing interest rate environment (sustained low rates in the Eurozone and Japan and elsewhere, with expected increases in the US) also has an effect on risk-adjusted return.

In the ‘new normal’ era of lower returns, we find that any additional returns over and above the equity risk premium have a larger impact on risk-adjusted return. For a US dollar-based investor, this means that the higher future interest rate differential (implied by interest rate swaps), earned via hedging back to the US dollar helps to offset the increased volatility at higher hedge ratios. In the second chart below we show that the risk-adjusted return increases with more hedging. Therefore, considering portfolio volatility and risk-adjusted return in combination, a 50% hedge ratio would be a sensible choice under this regime change, and could increase risk-adjusted return relative to being unhedged by up to 25%[3].



Market volatility presents opportunities in currency

The election of Trump and the higher potential of both anticipated extreme events (e.g. Brexit, other European elections) and unknown extreme events (e.g., the Swiss floor) will present interesting opportunities within currency. Positioning a currency portfolio towards various FX risk premia enables an investor to undertake specific and well understood risks, and to exploit inefficiencies within the market. Many of these risk premia extend across asset classes, including carry, momentum, value, and structural opportunities in emerging markets.

The most important takeaway from the election is that the political shake-up underway implies more extreme policy moves and a greater degree of cross-country economic dispersion. We believe this helps to expand the opportunity set within currency in a number of ways. As real interest rate distributions become wider, carry returns will tend to increase; moreover, the trends in real interest rates are a major explanatory factor in medium-term currency moves which momentum strategies can exploit. This, in turn, can lead to dislocations from fair value, which provide favourable conditions for value strategies.

In emerging market currencies, further rises in US interest rates following Trump’s election could come as a headwind to short-term performance if investors redeploy capital based on relative yield opportunities, and if EM corporates begin to re-examine hard currency borrowing decisions. That said, the medium to long-run drivers of EM currency returns – productivity growth and real interest rate differentials – are expected to remain positive relative to the US and other core developed market currencies. Short-term drawdowns therefore present more favourable entry points for investment in emerging markets, while investing against a diversified basket of short developed market currencies can insulate against country-specific shocks and enhance return.


[1] In the Mundell Fleming economic model fiscal expansion under a flexible exchange rate regime leads to currency appreciation.

[2] Correlation is measured on a 36-month basis between hedged Eurozone equity returns and long euro short US dollar currency returns.

[3] Calculated analytically based on the given assumptions and the formula for variance of a portfolio consisting of two components (A=FX; B= asset; W = 100%)

Assumed volatilities based on 1-year current and forward option implied volatility. Assumed interest rates based on 1-year current and forward swap rates. Assumed local EMU equity return based on EUR risk free rate plus 3.5% expected equity risk premium.



Record is authorised and regulated by the Financial Conduct Authority in the UK, registered as an Investment Adviser with the Securities and Exchange Commission in the US and registered as a Commodity Trading Adviser (swaps only) with the US Commodity Futures Trading Commission, is an Exempt International Adviser with the Ontario and Alberta Securities Commissions in Canada, is registered as exempt with the Australian Securities & Investment Commission.

This material has been published for professional investors & consultants. All data, unless otherwise stated in the footnote of the relevant page is as at 20 December 2016 and may have changed since. Issued in the UK by Record Currency Management Limited. This material is provided for informational purposes only and is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities, Record Currency Management Ltd products or investment services. There is no guarantee that any of the strategies and techniques will lead to superior investment performance. All beliefs based on statistical observation must be viewed in the context that past performance is no guide to the future. There is no guarantee that the manager will be able to meet return objectives and tracking error targets. Changes in rates of exchange between currencies will cause the value of investments to decrease or increase. Before making a decision to invest, you should satisfy yourself that the product is suitable for you by your own assessment or by seeking professional advice. Your individual facts and circumstances have not been taken into consideration in the production of this document.

Hedging risk warnings

Hedging foreign exchange risk is typically undertaken at periodic rebalance points so that exposures and hedges are rebalanced to reflect the new information. Interim drift between hedged positions will take place because of market movements or because of tactical asset allocation changes in the currency composition of the underlying assets. In addition, hedges are generally rebalanced around certain tolerance levels. These factors will create divergence between the hedge returns and the currency impact on the underlying assets. In addition dealing costs must be taken into account. Further divergence can be caused by proxy hedges where the proxy currency and the underlying currency move relative to one another. Finally, it is generally the case that not all currencies in the portfolio will be hedged or proxied. This is typically the case where there the cost of hedging or the lack of a proxy currency becomes a factor. The nature of hedging means that there will be intermittent cash flows which can be large monetary amounts positive and negative. Actual account set up will depend on each client’s unique requirements to manage cash flows.


The Multi-Strategy product involves passive allocation to strategies during which positions are bought and held. Exposure is maintained to the selections between the periodic rebalancing dates and is not altered due to market factors. The Multi-Strategy product is made up of an allocation to a number of the underlying strategies which may also be invested on a standalone basis.

Emerging Market Strategy

Emerging Market currencies are typically subject to greater country-specific risks than developed market currencies. As a result of this and other factors, Emerging Market currency pairs are typically more volatile than developed market currency pairs. In addition, many (although not all) Emerging Market currencies are invested in through Non-Deliverable Forwards (NDFs), which are cash settled, and the pricing of which is less deterministic than for deliverable forwards. Investment in Emerging Markets tends to be more volatile than more mature markets and the value of your investments could in some circumstances move sharply either up or down. In some circumstances currencies may become illiquid which may constrain the investment manager’s ability to realise the investment. Political risks and adverse economic circumstances are more likely to arise putting the value of your investment at risk.

A rational currency allocation

  • Do market capitalisation driven weights make sense from a currency perspective? If not, how can we go about getting closer to a more balanced and optimal currency mix as part of international asset allocation?

Much has been written about the long-term, zero-sum game nature of a random allocation to currencies (via international equity and bond exposures). We do not wish to revisit this debate here suffice to say that, in general, an allocation to developed market currencies arising as a consequence of an international investment will tend to introduce an extra source of volatility for no discernible return over the long run, certainly from a US Dollar perspective.

What about for emerging market currencies?

We would contend that because of the Balassa-Samuelson effect, countries that are on a growth convergence path to developed market GDP (per capita) levels will see their exchange rates appreciate in real terms over time. Thus, any particular allocation to EM currencies via international debt and equity investing will also add value to, for example, an American or Japanese investor over time. While this may indeed be the case, can we do better? To put it slightly differently, do market capitalisation benchmark driven weights make sense from a currency perspective? We would argue they do not, simply because currencies are fungible and the likely appreciation path of a currency is independent of its relative economic size if there are indeed productivity advances to be experienced.

Consider the table below which ranks the constituent countries of the MSCI EM index by their weight in such an index (first column) and associates these with a “fair value” valuation (second column) versus the US Dollar.

How do we determine valuation or fair value here? We estimate this using a cross-sectional linear regression of 59 countries. The regression estimates the observed relationship between productivity growth rates and the spot exchange rate relative to Purchasing Power Parity (PPP is sourced from the OECD). Using the regression outputs (intercept and coefficient), we generate ‘productivity adjusted’ purchasing power parity exchange rates for MSCI EM countries using respective GDP per capita levels as inputs. The newly adjusted fair values are then evaluated against prevailing spot exchange rates to arrive at a final valuation estimate. This methodology attempts to correct for the main pitfall in Purchasing Power Parity valuations for emerging market currencies, whereby less developed countries exhibit structurally weaker exchange rates. In the table below, valuations are calculated as the overvaluation of the real exchange rate versus the “fair value” as described above and a negative valuation indicates undervaluation.

Now, if we look at the MSCI EM weighted valuation (valuation times country weight in the index) for each of the countries in the table, we arrive at an overall overvaluation of EM currencies to the tune of 1.7% as of September 2016 (fourth 4). What is more revealing is that a simple re-allocation of these weights to equal weights results in an undervaluation of EM currencies to the tune of 8.5%. In other words, passively buying the MSCI EM index results in a much more expensive currency mix than would otherwise be implied by a simple, equally weighed exposure.

The key takeaway here is that while an equally weighted EM currency exposure is by no means definitive or optimal in itself, exposure to a more diversified and growth oriented currency mix is a big step towards achieving that optimality. We refer to this exercise, in general terms, as currency recalibration : it has spurned further and fruitful research into combinations of valuation, carry and momentum (core factors) that are able to deliver enhanced portfolio efficiency relative to the currency mix embedded in market cap driven investing.



Source: Macrobond, OECD, IMF WEO, Record.

Where are we in the dollar cycle?

  • The US dollar is at an inflection point. Can the dollar’s cycle continue in the face of convergent economic fundamentals and central bank coordination?

US policy rate normalisation does not guarantee dollar strength – real interest rate support crucial

The US dollar is at an inflection point. On one hand the real exchange rate is yet to comfortably pass its long run average, implying further room for appreciation, while on the other the humdrum chorus of gloomy global economics and a false hopes for US rate normalisation could threaten to pour water on the fire. Indeed, Fed watching has become a favourite pastime for many, presumably in the hope of uncovering clues as to the dollar’s next step, however focusing on the Fed alone is unlikely to uncover the dollar’s secrets. Unfortunately, Fed normalisation cycles alone have never truly been enough to predict a sustained appreciation in the US dollar, and there is no discernible relationship between US rate normalisation, and the nominal or real exchange rate (figure 1). This is natural as currency is and always will be a relative concept.

With this in mind, and given small differences in the level of development between the US and most other developed markets, real interest rate differentials can help us to determine the dollar’s true attractiveness and in turn explain a good deal of behaviour in the medium run (in fact, interest rates and price differentials form the basis for most currency valuation models).  Increasing real interest rates (ceteris paribus, of course) help drive the dollar higher but this effect is more prominent in longer-dated real interest rates than shorted dated. The message one could take is that short term real interest rate normalisation is a necessary but not necessarily sufficient condition for dollar strength, and the US dollar’s destiny may be determined more by elusive long-run forces, in other words natural real interest rates.



Figure 1 and figure 2. Source: Macrobond, J.P. Morgan

Is there scope for real rate divergence?

In view of the theory that US dollar appreciation requires an ascension of US real interest rates relative to the rest of the world, the US dollar cycle may have hit a stumbling block. Declining natural real interest rates have been a global phenomenon (the BIS here and BoE  here have written extensively on this topic), with lower growth, a savings glut and rising inequality as cited culprits. For significant divergence in the long-end of the curve, these fundamentals in the US need to improve. This will be a challenge; even the Federal Reserve has been forced into submission by the secular stagnation thesis as the bank’s long-run projections of interest rates have continued to shift towards that of the market. A similar reality is also evident in the short end of the curve; forward guidance, global economic coordination and increased responsiveness to shocks by central banks are creating fewer economic surprises, fewer opportunities for divergence, and are suppressing interest rate and currency volatility (figure 3).


Figure 3. Source: Bloomberg, Macrobond, Citi Economic Surprise Index

Can the world cope with a stronger dollar?

While the bar for a stronger dollar would seem high, we believe the US can cope with a stronger dollar, and economic impacts should not hold the cycle back. The US economy is relatively closed with trade making up only 30% of GDP, therefore a stronger dollar is unlikely to pose a large threat to growth via the trade route. Additionally, we should not be too concerned about the currency’s impact on inflation in the US; currency pass-through to inflation is  the lowest among G10 economies (figure 4), in part due to the limited degree of openness but also because the vast majority of US imports are denominated in dollars, limiting the impact on inflation to volume effects only (as foreign imports are diverted elsewhere). 

We think that the rest of the world can too cope with and may indeed benefit from a stronger dollar. Firstly, most developed economies are not troubled by high inflation and would likely welcome a boost in price levels. In particular, the Bank of Japan and European Central Bank are plagued by currency strength and diminishing returns to ever expanding easing programs. In the Emerging Markets, a stronger dollar is not quite what it used to be; most sovereigns have reduced hard currency borrowing significantly, and while in some countries corporates may still be exposed to fx liability risk, EM central banks boast larger foreign currency reserves than in previous hiking cycles, and governors that are more adequately equipped skill-wise to deal with all the economic shocks that a stronger dollar would bring. 


Figure 4. Source: “The International Price System” , Gita Gopinath (2015). Eurozone is an average of Italy, France and Germany

Have currency markets become more choppy recently?

  • Are currency markets stuck in a period of short-term mean reversion? If so, what’s driving this and what are the implications for investors?

One straightforward way to look at the level of mean-reversion (‘side-wayness’ as opposed to ‘trendiness’) in an asset over a given period is to look at the so-called Vertical Horizontal Filter (VHF). In essence, this measure computes the difference between the highest and lowest level in the asset price and divides this by how many ‘steps’ it took on the path to get there. The VHF measure was developed in the early 1990s and a low measure would indicate a choppy market, whereas a high measure would indicate a trending phase. In terms of our own preferred definition, mathematically it is : VHF = (Max({Spot in 250 days}) – Min({Spot in 250 days})) / (SUM_{t=2}^{250} (Spot(t) – Spot(t-1))). In other words,  the numerator is the absolute value of the highest close minus the lowest close over the course of a year. The denominator is the sum of the absolute value of the difference between each day’s price and the previous day’s price over this same year.

Below we show the VHF measure for the most liquid currency relationship, namely, the EURUSD cross. The chart shows that we have been in a mean reversion period for most of this year, with effectively this pair trapped in the 1.05 to 1.15 range. Why so? We argue that the Fed backtracking over the trimming of their second rate rise this year has had an impact in dampening further prospects for US Dollar appreciation. At the same time, although the Eurozone has engaged in an expanded QE programme, inflation remains low, and so real interest rate differentials between Europe and the US are not large. The market is now, we believe, pricing in new normal or “neutral” real interest rate (1%) that is much lower than in the past (2%-3%) and this is reflected in flat forward curves in interest rates. This applies to both currency blocks. What do we need for this mean reversion to stop and a new equilibrium to be found? We believe that real rate expectations need to be dislodged from their current static equilibrium and, if so, most currency pairs, including EURUSD will find new equilibrium levels as real interest rate differentials act as drivers of spot rates going forward, something that has been driving Emerging Market currencies of late in fact.