Thursday, April 26, 2007
Well, the champagne corks have popped. Of course, it was equity people doing most the partying, as the Dow Jones (why does anyone follow this index?) broke 13,000 for the first time ever yesterday. The currency folks’ champers went flat pretty quickly, as EUR/USD could only manage to hit the previous all time high to the very pip. Six months after the euro’s previous foray to 1.3667 against the dollar, it was trading below 1.20. Sadly for EUR/USD longs like Macro Man, the same trend has unfolded in the hours since EUR/USD traded above 1.3660 yesterday.
The last twenty four hours have seen some interesting facts emerge. First, the global growth story remains fairly intact and upbeat. In addition to solid sentiment readings in Germany and France, the US saw much better than expected durable goods data for March. Equities predictably had a ball.
However, signs of unease amongst beneficiaries of global activity appear to be growing. The Norgesbank surprisingly left rates on hold yesterday. While the attached statement suggested that the trajectory of monetary policy has actually not changed, that the bank failed to deliver a widely anticipated tightening perhaps indicates that they don’t want tightening financial conditions to bind too tightly while uncertainty remains.
Even more interesting was the RBNZ, which ratcheted rates to 7.75% but noted that kiwi strength was both “excessive” and “unjustified.” Leaving aside the obvious correlation between New Zealand’s nominal rates and currency strength, the language in the statement was significant because it repeats the criteria that the RBNZ has previously set for intervening in the currency market. As such, the statement must surely be taken as a shot across the bows of the market that further kiwi strength might see the RBNZ taking the other side of the trade. This morning, the NZD has broken an uptrend line against the dollar- could the little old kiwi be the catalyst for a correction in risk assets? Stranger things have happened. (Macro Man cannot help but note the irony of the RBNZ complaining about currency strength on the same day that news of a trade SURPLUS for March was released.)
Another central bank peeved at domestic currency strength is that of Brazil. As USD/BRL approaches its own version of “the deuce”, Bacen has stepped up its presence in the currency market and threatened to ease rates more aggressively. This prompted Macro Man to wonder about the degree of legitimate BRL overvaluation, which will ultimately dictate the success of Bacen’s intervention campaign.
A few years ago, Macro Man had played around with some PPP-style valuation models for Brazil, saved them into a spreadsheet, and then promptly forgot them. Essentially, he calculated a basic purchasing power parity for USD/BRL. Unsurprisingly, this simple model did not do terribly well in identifying an ex-post equilibrium for USD/BRL, and currently pegs fair value for the pair at 2.73. However, he also adjusted this basic calculation to account for terms of trade shocks; this model appeared to do a somewhat better job of identifying ex-post equilibrium levels for USD/BRL.
This work was carried out in late 2004; at the time, this adjusted model pegged fair value for USD/BRL at 2.66, modestly below the prevailing spot level of 2.90. Imagine Macro Man’s surprise, therefore, when he updated the work and found the TOT adjusted model had more or less tracked the USD/BRL spot rate over the past couple of years, currently assessing fair value at 2.07.
Doh! Although Macro Man has done fairly well out of Brazil (in his real job) over the past couple of years, he generally assume that the real was growing more overvalued below 2.40 and sized positions accordingly. Even more intriguingly, the size of the over/undervaluation according to the adjusted PPP model seems to bear a pretty reasonable relationship to the delta of Brazil’s trade balance. For the past year, the model has suggested that the real has been more or less fairly valued- and the trade balance has flatlined.
What are the implications for Bacen and its intervention policy? Well, for the last couple of years, they have been leaning into the wind, trying to stem a fundamentally justified appreciation of the real. However, barring a further positive terms of trade shock, a move in USD/BRL below the deuce will finally bring the real into overvalued territory. Not only should this begin to impact the trade account, but it also raises the likelihood that Bacen intervention tactics could finally gain some traction. Coupled with its evident resolve to accelerate rate cuts and go for growth, this suggests to Macro Man that fixed income and particularly equities are likely to be superior Brazil plays than the real. He will therefore trudge to the back of the queue of those waiting for a dip to enter these trades.