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.

Why the U.S. labour market is not as tight as it looks


From a tightening labour market to inflation acceleration – how far left to go for the U.S. economy? (part 1 of 2)*

Since the Global Financial Crisis (GFC), US labour force participation has declined materially, suggesting a sizeable amount of additionally available labour supply, that is not fully captured in unemployment statistics, and considerable slack in the labour market. Indeed, President Trump has suggested that up to 100 million people not in employment could be put back to work.

35% of the participation decline can be attributed to the ageing demographics effect (“net ageing”), as the baby boomer generation reaches retirement age; a powerful secular trend that will continue to weigh on employment rates over the coming years. But, this blog finds that the shadow labour force (discouraged workers) also accounts for a large part of the shift in employment dynamics, and represents a significant source of transitory slack. If the shadow labour force reverted back to a level equivalent to 2007, participation could be boosted by 50 bps, with 800,000 people added to the workforce. Indeed, if the proportion of unemployed and discouraged workers were both to revert back to 2000 levels, around 2.6 million people could return to work, but this could take years to achieve. While it is plausible that a small potential supply of labour could be additionally found in groups of people currently in education, with family responsibilities or classified as disabled/ill, it is relatively unlikely.

100 million people returning to work is clearly implausible, but considerable slack does remain in the US labour market. Without knowing the true natural rate of unemployment, we cannot know for certain how much of the current ‘underemployment’ rate represents slack, but returning even 3 million Americans back to employment in a swift manner will represent a significant challenge for the Trump administration. Considerable labour market slack remains, and it could take several years to close the gap.

(*Part 2 will address the sensitivity of wages and prices to labour-market slack, and what this means for U.S. inflation and monetary policy.)

The lacklustre US labour-market recovery

Since the GFC, US employment dynamics have shifted considerably. The labour force participation rate has fallen by more than 3%, and has only curbed its decline in the past couple of years (Figure 1). Meanwhile, employment-to-population ratios have recovered only a small part of their 5% declines from the crisis, and still remain a long way from their pre-GFC levels (Figure 2).

Figure 1: Participation rate has collapsed…                                  Figure 2: …as has employment-to-population

Sources: Bloomberg, Worldbank

Despite the official unemployment rate having returned to pre-crisis levels (4.3% in May 2017), the above two measures suggest that there may still be considerable slack left in the US labour market. This blog sets out to explore the extent to which this may be the case.

An ageing population to blame?

Many have been quick to blame the slow labour-market recovery on demographics. One study by the Chicago Fed[1] suggested that around half of the post-1999 decline in the participation rate could be explained by long-running demographic patterns (and they are expected to continue). But is this an oversimplification of the problem?

There are some crude methods to strip out these demographic effects. One could look at the participation rate or employment-to-population ratio, for the 25-54 demographic only (Figure 3). Both data series show that, even when accounting for demographic shifts, (a) there is a significant gap yet to be bridged back to pre-crisis levels and (b) the trend is currently in that direction (back to pre-crisis). Indeed, to Neel Kashkari – President of the Minneapolis Fed and sole dissenter in the FOMC’s March vote – these measures are a clear sign of labour-market slack, and form a key part of his justification for voting against a further Federal Funds rate hike[2].

So, while a large part of the decline in participation is indeed likely due to ageing, other important factors are not always given full due consideration (notably, the effect of discouraged workers leaving the labour force, who could yet re-enter as economic activity picks back up).

Figure 3: A large employment gap yet to be closed

Sources: Macrobond, Bureau of Labor Statistics Current Population Survey

100 million Americans waiting on the sidelines?

In the run up to the US election, Donald Trump repeatedly claimed that there were 100 million people not in employment in the US. It was time to get Americans “off of welfare and back to work”! So who are these 100 million?

The oft-mentioned number refers to the sum of those officially “unemployed” (7 million) plus those ‘not in the labour force’ (95 million). In other words, it is the entire proportion of the US civilian non-institutional population (15+) that is not currently working, equal to around 40% (Figures 4 and 5).

Figure 4: 100m not in employment…                                           Figure 5: …40% of population (15+)

Sources: Bureau of Labor Statistics Current Population Survey.

The number is expectedly large, and has been growing for much of the past decade, but it includes a whole range of non-employed adults; from students to the retired, to those that are disabled or suffering from long-term illness. So it is unrealistic to expect all of these people to get a job. Instead, a detailed dissection of the numbers is essential.

Breaking it down

Figures 6 and 7 show a breakdown of those 95 million not in the labour force, while Figures 8 and 9 show the contribution from each segment to the change in the participation rate between 2007 and 2016. In total, there are five categories that could be driving spare capacity: (1) ageing/retirement, (2) in school or training, (3) disabled or ill, (4) ‘want a job’ (the shadow labour force), and (5) family responsibilities. So let’s take each one in turn…

Figure 6: Breakdown of ‘not in labour force’                                  Figure 7: Breakdown by age group

Sources: Federal Reserve Bank of Atlanta. As at December 2016.

Figure 8: Nine-year participation rate contribution                          Figure 9: Nine-year participation rate contribution

Sources: Record Currency Management, Federal Reserve Bank of Atlanta

  1. Ageing:

Retirement alone accounts for 27 million of those ‘not in the labour force’, and “ageing” represents some 210 bps of the participation rate decline over the past nine years – or 63% of the total change – perhaps unsurprisingly, as the baby boomers approach retirement age. But this number can be misleading; during the same period, it was offset by an increasing propensity to delay retirement until later in life, which actually boosted labour force participation by some 90 bps (Figure 8). Consequently, the net ageing effect in the last decade is closer to 120 bps (Figure 9). This is still the single largest contributor to the participation decline, but only accounts for 35% of it.

The ageing demographics effect is highly unlikely to reverse. 57% of all retirees are already 66+ (Figure 10), while 90% of the net-retirement effect on participation (2007-2016) has been driven by people in this age group. A counterbalancing, “delayed-retirement” effect is indeed at play, with a huge number of Americans now working much longer than past generations did. But this is already accounted for in the above net numbers. And, moreover, the vast majority of the delayed-retirement effect has so far come from the 56-65 demographic, with relatively few from the 66+ bucket delaying enough to offset demographic shifts (Figure 11).

Figure 10: Age distribution of retirees                                           Figure 11: Delayed retirement cannot offset ageing

Sources: Record Currency Management, Federal Reserve Bank of Atlanta

All in all, the data indeed suggest that delayed-retirement trends make future ageing effects less worrying than they would otherwise be. But it would be unrealistic to expect an acceleration in delayed retirement large enough to completely offset the ageing process and drive the participation rate higher. The majority of those who have already retired are not likely coming back, and ageing trends are set to continue for some time (Figure 12).

Figure 12: Ageing trends set to continue for decades

Sources: Record Currency Management, Federal Reserve Bank of Atlanta, U.S. Census Bureau. (Projected percentage based on U.S. Census Bureau rate of increase from 2015.)

  1. In school or training:

An increase in the rate of those in school or training accounts for some 90 bps of the participation decline. There are 13 million now in this category, with the vast majority aged 16-25 (Figure 13); and, unsurprisingly, the majority of the effect on participation also comes from this age bucket (Figure 14).

Figure 13: 16-25s account for most in education…                        Figure 14: …and majority of rise in education rate

Sources: Record Currency Management, Federal Reserve Bank of Atlanta

So could the increase in the education rate be a relic of the GFC, soon to revert as more jobs become available? Also unlikely.

Figure 15 shows that the percentage of 16-to-24-year-olds in school or training has been in a rising trend for quite some time. So the recent increase, since 2008, is not necessarily GFC related; in fact the rate of growth has been slower than pre-crisis. The 25+ age group, on the other hand, did see a disproportionate education-rate rise after 2008; but the absolute effect was small (10-20 bps at worst), and much of this spike has now been unwound, to revert close to the longer-term trend.

Figure 15: A long-term rising trend in the education rate

Sources: Federal Reserve Bank of Atlanta

Ultimately, all age groups have seen a long-term upward trend in school and training, suggesting that much of this change is secular in nature and not likely to revert. It is fair to assume that there will always be a certain proportion of people in education, and this proportion can be expected to rise as technological automation shifts the demand for labour toward higher-skill-based jobs. With this in mind, it is unlikely that the Trump administration can shift a significant proportion of people from education back into work.

  1. Disabled or ill:

People registered as disabled or ill account for 20 million of those not in the labour force and for 65 bps of the 9-year participation decline. While the distribution across age groups is fairly wide (Figure 16), the recent effect from an increased disabled-or-ill rate is largely driven by those aged 51 and over (Figure 17).

Figure 16: A wide distribution of disabled or ill…                           Figure 17: …but recent effect driven by 51+ group

Sources: Record Currency Management, Federal Reserve Bank of Atlanta

In fact, disability rates have been on the rise for some time, for all ages up to retirement age (Figure 18). Some might argue that this could be driven by an increase in fraudulent benefit claims, at a time when it is difficult to find a job. But any increase in fraudulent claims (if true) would be unlikely to amount to a large part of the disability rate effect; and the observed upward trend has largely continued in the past few years, even as the jobs recovery has been underway.

While it may be tempting to suggest that many classified as disabled or ill could be put back to work, 68% of the rise in this group since 2007 has come from the 55-64 age bucket. Whatever injuries they may or may not have, it is surely unlikely that a large proportion of them will come back to work before retiring.

Figure 18: Disability rates have been on the rise for some time

Sources: Federal Reserve Bank of Atlanta

If the rising trend in disability rates could be curbed, and the next wave of 55-64 year olds could revert to a disability rate two percentage points lower (the 2007 level), some 50 bps could theoretically be added back to the participation rate over the course of the next decade. But either way, in the short-to-medium term, the US administration would do well not to rely on getting this group “back to work”.

  1. Want a job (shadow labour force):

Beyond the 7.5 million officially recognised as “unemployed”, there are another 8 million in the “shadow labour force”, an important measure of underemployment. These are people who want a job but are not included in the official labour force. And this group strongly contributed towards the decline in labour force participation, particularly up to 2012 (a 100 bps contribution).

To be considered unemployed by the BLS, a person has to not only want a job but also be (1) available to work and (2) actively seeking employment. Some do not meet these criteria but are still relevant to labour-market slack statistics. For example, if an individual has actively sought work sometime in the previous year but not in the past four weeks, she is considered a “discouraged worker” who is only “marginally attached” to the labour market. She is part of the ‘shadow labour force’.

Various studies have found that the difference between the officially unemployed and others that want a job is not especially relevant; “all tend to search for work or find jobs at a higher rate than others outside of the labor force” (Atlanta Fed, 2017[3]). For that reason, this particular segment is by far the most important. All members of the shadow labour force essentially represent spare capacity in the US economy and, with the right allocation of resources, could theoretically be put to work in times of booming economic activity.

The shadow labour force is dispersed across all age groups, but especially weighted towards younger generations (Figure 19), with the 9-year participation rate effect also spread relatively evenly across all ages. Unlike the previous three non-participation categories, though, the shadow labour force has actually been in decline since 2012 (Figure 9). That is, while many fell out of the labour force into this category during 2007-2012, a large proportion of them have now come back to the workforce.

Figure 20 shows the effect of the shadow labour force on participation from 2007 to (a) 2012 and (b) 2016. In most age groups, half of the effect has already been reversed, as the job recovery has picked up momentum. And, as one might expect, the younger generations appear to be the most likely to be brought back in to the labour force (with older generations perhaps more likely to suffer from the adverse effects of not being in employment for a prolonged period of time).

Figure 19: A young shadow labour force…                                   Figure 20: …that is getting back to work

Sources: Record Currency Management, Federal Reserve Bank of Atlanta

Most encouraging of all, the rate of 16-20-year-olds in the shadow labour force has reversed entirely. At best, this may suggest that the jobs recovery could rapidly filter through, up the age groups, as the demand for labour continues to rise – potentially boosting participation by 50 bps or more. At worst, the younger generation are no longer likely to suffer as much as their predecessors from the acute lack of skills that has plagued those sitting on the side-lines for a prolonged period. And this means that higher rates of employment can now more easily persist, as these youngsters rise through the age groups in the long-run.

  1. Family responsibilities:

Finally, while some have also commentated on the likely contribution of stay-at-home parents to declining participation, this is the factor that least stands up to scrutiny. As Figures 8 and 9 show, reduced family responsibilities have actually contributed to a slight boost to the participation rate over the past nine years, with female participation benefiting the most.

So, this has not been a contributing factor over the past decade. But could it be a source of further labour market supply in the future? While one can safely assume that it will always be necessary for a certain proportion of the population to remain in this segment, there is some merit to the argument that the proportion could, hypothetically, be lower. With 25 million people currently staying at home for family responsibilities, even a 5% decline in this group – spurred by cheaper childcare measures, for example – could lead to more than 1 million joining the workforce. Ultimately though, the prospects of such a huge shift in behaviour are hard to measure and, in order to occur in the next few years, would likely require vast government-subsidy initiatives (of the likes there is no evidence to suggest will transpire) combined with a significant cultural shift on the part of the American people.

The ‘real’ rate of unemployment…

In summary, we have learned that much of the decline in the labour force participation rate since 2007 is unlikely to be fully reversed in the short-to-medium run – there are powerful secular trends at play.

But, equally, some of the decline is transitory. Beyond simply focussing on the official unemployment rate, discouraged workers in particular represent a significant addition to labour market slack. Combining 7 million unemployed with 6.5 million discouraged workers means that around 13.5 million people currently want a job (the ‘real’ rate of unemployment). And, if the shadow labour force was to revert back to a level equivalent to 2007, participation could be boosted by 50 bps, with 800,000 people added to the workforce.

A broader BLS measure of unemployment, known as U-6 (or the ‘underemployment rate’), captures a similar concept to the combination of ‘unemployed’ and discouraged workers described above. While U-3 is the official ‘unemployment’ rate, U-6 also includes: discouraged workers, all other marginally attached workers, and those workers who are part-time purely for economic reasons.

Figure 21 shows that, while the ‘unemployment’ rate (U-3) is now back at its 2007 lows (and only 50bps above its 2000 low), the U-6 underemployment rate remains 50bps above its 2007 level (and 1.6% above 2000). This suggests that plenty of slack remains before the US economy reaches full capacity. And the recent acceleration in the U-6 decline only further substantiates this.

Figure 21: Underemployment is a long way from its 2000 lows

Sources: Record Currency Management, Bloomberg, U.S. Bureau of Labor Statistics. To April 2016.

Taking the argument to the extreme, if we look to the lowest U-3 rate in history (2.5% in 1953) we can estimate a U-6 rate as low as 4% at that time (extrapolated based on a 1.6 ratio, due to lack of historical data). If “full” employment could, hypothetically, mean levels as low as the 1950s, there could be up to 4.5% of remaining slack.

…and the rest

As mentioned above, while it is plausible that a small potential supply of labour could be additionally found in those groups that are currently in education or disabled, it is fairly unlikely. No matter how deep we dig, there really aren’t many more people out there to put back to work!

Even if, under a very optimistic best-case scenario, an additional 10bp increase in the participation rate was generated from reducing the adult education and training rate, and an additional 20bp from bringing disabled and ill people back to work, this still only implies a maximum possible increase from these groups of around 750,000 people.

If a momentous childcare-subsidy programme was put in place, perhaps another 1 million or so could also be added; but, again, the prospects of this sort of cultural shift are very hard to measure.

Reality check: three million, not one hundred

So how many of those 100 million could really go back to work? Although the ‘real’ rate of unemployment is running at around 8.6% (U-6) – or 14 million people – this can never be brought down to zero, in any economy. Using the numbers calculated throughout this paper, Figure 22 summarises some scenarios that could be targeted in the U.S. for increased employment numbers, from the plausible to the not-so-plausible.

Figure 22: 2.6 million on the side-lines, not one hundred

Sources: Record Currency Management, Bloomberg, U.S. Bureau of Labor Statistics, Federal Reserve Bank of Atlanta

Without knowing the true natural (or equilibrium) rate of unemployment, we cannot know for certain how hot the U.S. economy would need to run in order to achieve any of the increased employment numbers in Figure 22. But adding back anything more than 2.6 million extra workers in the next few years (from those not currently employed) would appear to be a highly optimistic target. Even the 2.6 million target may be plausible but is still ambitious; this would mean driving the U-6 underemployment rate back to levels last seen in 2000, at the height of the Dot-com bubble, and could take years to achieve. Moreover, the Trump administration will also have to contend with longer-term demographic trends, which are shifting more and more of the American population into retirement. In short, no matter how aggressive Trump’s stimulus policies, getting even 3 million people “back to work” will be a tall order.



[1] Aaronson, D., Davis, J. and Hu, L. Explaining the Decline in the U.S. Labor Force Participation Rate. Chicago Fed Letter, No. 296, March 2012.

[2] Kashkari, N. Why I Dissented. Federal Reserve Bank of Minneapolis, March 2017.

[3] Federal Reserve Bank of Atlanta, 2017. Labor Force Participation Dynamics.

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.

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.




Asian “Currency Manipulation” : Mainly a US Concern ?

    • The US has had a long standing concern about what it perceives to be excessive “currency manipulation” on the part of some countries, especially in Asia. This concern is primarily driven by the large and persistent US current account deficit, which will necessitate significant relative currency adjustments for it to at least begin to unwind.
    • A problem with this view emanating from US officialdom is that the pass-through effects between currency movements and domestic inflation in the US has been shown to be weak, thus making the process of adjustment more drawn out at best, and ineffective at worst.

After many years of labelling some countries as de facto currency manipulators in its official statements, US officialdom has now begun to soften its rhetoric in respect of such labelling, especially regarding the Chinese Renminbi. In particular, the US has dropped its oft-repeated description of the Renminbi as “significantly undervalued”, probably in the hope of engaging in constructive negotiations with China (and the BRICs at large for that matter) when the IMF meets in November to decide whether to include the Renminbi as an SDR currency.

While this may be largely diplomatically motivated, the US nonetheless continues to have a material concern about the so-dubbed “currency manipulators” with leading candidates for the US presidency in 2016 sprinkling it in speeches and other fora in present times. We also note that this extends beyond officialdom and into K Street where American auto-makers and leading manufacturers list exchange rate policies across the world, particularly in Asia, as one of their main concerns.

Why this, in a sense, uniquely American pre-occupation with global monetary and currency regimes? After all the European Union conducts a larger volume of trade with China than does the US, for example. Furthermore, the US is a relatively closed economy and largely energy self-sufficient, thus potentially more insulated from FX-induced shocks.

To understand this in more detail, one of the main points to consider is that is that the US (unlike the Eurozone) is running a persistent current account deficit, which means it has more to gain from a rebalancing of the world economy emanating from relative currency adjustments than does the Eurozone. More poignantly, when Eurozone officialdom does make noises about excessive Euro strength, its tends to be about the EURUSD rate itself rather than about the EURCNY rate, for example. This makes sense as the USD is still the anchor of the world’s monetary and financial system, meaning that any Asian country seeking to influence its own currency value will do so against the US Dollar, so there is little point from the European perspective to be concerned about any emerging market currency exchange rate directly rather than through US Dollar lens.

The second point to consider is that the US has long had a manufacturing trade deficit, but especially in automobiles, an industry that tends to be vocal about excessive US Dollar strength. For example, exports of automobile vehicles, parts and engines to Japan amounted to 2.1 USD bn in 2014, whereas imports totalled 49.9 USD bn. While this deficit has narrowed somewhat in the last few years, this automobile trade deficit with Japan alone still represents almost 7% of the entire US trade deficit in goods for 2014.

Third, it is probably still the case that manufacturing blue-collar as opposed to service blue-collar workers still have an outsized impact on US politics relative to Europe. Linked to this is perhaps the reality that the broader benefits of a stronger currency for the general population via lower inflation are less visible in the US than in more open economies, for instance, the UK or Germany. Cheaper imports (the most visible impact of a stronger currency on the consumer surplus) perhaps features less prominently in the US debate than elsewhere.

The fact that the US has a lower currency-cum-inflation pass through has been well documented. Most recently, Harvard economist Gita Gopinath has made the case (convincingly in my view) that the US Dollar’s dominant position in global trade invoicing helps insulate domestic inflation from exchange-rate shocks (see here). As globalisation continues to make consumer markets more integrated and coupled with the rise of technology and price comparison feeds at a global level, it may be the case that the exchange rate–inflation nexus continues to weaken.

This also has significant implications for the potency of monetary policy in the developed world, which may have seen its effectiveness weakened not only by the broken transmission mechanism operating via the bank lending channel post the GFC and Great Recession, but also via this diminished FX-inflation pass through, which continues to be taught and communicated by academic economists and policy makers alike

In all, it would thus appear that from a US policy perspective a stronger USD may be a lose-lose situation, a view I think the Fed (covertly) shares.