Wednesday, April 11, 2007

The Rule of Four Point Two

Macro Man has largely stayed away from currencies recently. Not only has the FX carry component of the beta plus portfolio been neutral for most of the last six weeks (though it is perilously close to re-entering the carry trade at nosebleed levels), but the occasional foray into FX alpha trading has proven unsuccessful since early in the year.

Part of this has been the breakdown in the effectiveness of proxy trades, which was a costly feature of March. Part of it has been the lack of volatility- G3 FX vols remain at or near all time lows. Part of it has been the stretched valuations of many of the more popular EM currency trades (TRY and BRL, I’m lookin’ at you) combined with a seasonal tendency towards underperformance. And part of it has been the degree to which central banks continue to dominate the landscape, whether via reserve accumulation or via diversification/maintenance of reserve portfolio benchmarks. It’s difficult to get terribly excited about throwing loads of risk at a market whose hegemonic participants have a tendency to push things away from where the private sector would prefer to take them.

Nevertheless, the currency market is throwing up a couple of interesting talking points. A number of currency pairs are at, near, or just through critical long-term technical levels:

* GBP/USD 2.00
* AUD/USD 0.80
* AUD/JPY 100
* AUD/CHF 1.00
* USD/NOK 6.00
* EUR/USD 1.3670

The obvious features here are dollar weakness and carry currency strength. Carry currency strength is largely down to low volatilities, benign global asset market conditions, and ample liquidity. If gold were at $620, the SPX at 1400, and US 10 year yields at 5%, Macro Man suspects that the Aussie dollar, for example, would be a heckuva lot lower than it is now. Failing those developments, however, there may not be much to stand in the way of further strength.

The dollar, of course, is the real issue that could provoke renewed interest in currency markets. It’s remarkable how little fanfare has accompanied the dollar’s descent towards multiyear/multi-decade lows against a number of non-funding currencies. Part of the lack of clamour is simply a function of the fact that the greenback spent all of Q1 tracing out a range against, say, the euro. Indeed, EUR/USD is only 1.5% above where it closed 2006.

However, EUR/USD has shown a remarkable tendency over the past few years to consolidate within a fairly narrow range before exploding higher. Granted, there has been a declining marginal return from each range breakout, but the repetitive pattern is nevertheless instructive. Macro Man has dubbed this behavioural pattern the “Rule of Four Point Two.”

Consider the following:

* In the summer of 2004, EUR/USD traded in a 4.2% range before central bank buying helped drive a breakout which extended 12 big figures

* In Q1 2006, EUR/USD traded in a 4.5% range before central bank buying helped drive a breakout which extended 6 big figures

* In summer 2006, EUR/USD traded in a 4.2% range before central bank buying helped drive a breakout which extended 4 big figures

* In Q1 2007, the range in EUR/USD was 4.2%, which we’ve now breached, with reports suggesting increased central bank activity
Now, a glance at the chart above will suggest that Macro Man is to some extent fitting his facts to the story. In the first two instances mentioned, EUR/USD had made a prior, lower, low before settling into the 4.2% +- range for a few months. But let’s face it: “The Rule of Four Point Two” sounds better than “The Rule of Four to Six Percent”. In any event, those narrower ranges were actively felt and traded by the market, so it’s a liberty that Macro Man feels justified in taking.

What does it all mean? Macro Man senses a growing risk that the dollar could be susceptible to one of its periodic step shifts lower against the euro. He feels that central banks are behaving like sharks circling a dying soon as one commits, they will all pounce and the result will be a frenzy. Whether this should happen is almost beside the point, though rate spreads suggest that most of the dollar’s recent weakness has been justified. Perhaps a shocking trade figure on Friday could energize the market?

While Macro Man is leery of buying euros at the current nosebleed levels, and particularly ahead of Thursday’s ECB meeting and the weekend G7, he nevertheless feels that a potential run on the dollar is an opportunity that should not be missed. He therefore executes an initial purchase of €10 million at 1.3425 spot basis, 1.3436 to May 3. If the trade pans out, risk will likely be added on top. 1.3250 will serve as an initial review level. Although GBP offers superior carry, Macro Man is reticent about buying ahead of “the deuce”, particularly as cable has been paid up today on the potential non-story of a “UK HIA.”

Elsewhere in currency land, Brad Setser had an interesting post yesterday on the RMB and China’s trade surplus. Brad suggests that shifts in the USD/RMB rate overstate the degree of RMB appreciation, and that burgeoning exports to Europe suggest a reasonable sensitivity to the EUR/CNY rate.

Macro Man decided to do a little digging to discover the extent of the difference between USD/RMB and an export-weighted currency index. The results are set out in the charts below.
It has certainly been the case that the RMB has weakened over the entirety of the period in which China’s trade surplus has exploded. Its export-weighted TWI is some 5% below the level prevailing at the beginning of 2002, while the dollar is some 7% lower.

That having been said, the RMB TWI has appreciated since the currency was “floated”, albeit not as much as the straight RMB/USD rate. However, since last May the rate of appreciation has been broadly similar versus the TWI and against the dollar. How can this be when the buck is so much lower against the euro, sterling, etc? It’s down to export weights. The US and Hong Kong dollars represent half of China’s exports, and the RMB has obviously strengthened against those. Japan and South Korea are the fourth and fifth largest export destinations, respectively, and the RMB has appreciated quite a bit against those as well. So while Macro Man feels comfortable castigating China for its FX reserve policy, he doesn’t think that RMB “weakness” has been a prime mover of rampant trade surplus growth (other than weakness relative to where the private sector would set the rate.) For what it’s worth, Macro Man feels that China’s transformation from an importer to an exporter of metals (steel and aluminum) has been a key factor in the recent surplus blow-out.



Anonymous said...

Macroman -- interesting post. you attribute all the recent dollar moves out of its previous trading ranges to CBs. I thought I was the one who was CB obsessed.

re: the Chinese TWI, is this something you ginned up yourself or is it one of the standard indexes? I ask b/c there is always a question of how to treat HK. China exports a lot to HK -- but HK then exports most of that to the world. I played with my own index v. the g-3 ($/ yen/ euro as a proxy for europe for a while), but using US and European and Japanese data to set the weights (a process that understates X to China b/c of X through HK but picks up M). That generally increases the euro/ europe's weight, as some of the HK trade is reallocated to europe.

In broad terms, though, it is clear that the RMB has appreciated in nominal terms v. the yen and $ and GCC since mid 05, and depreciated v the euro, thai baht, korean won and brazilian real ...

then remember that reported Chinese inflation is lower than reported us inflation, and that undercuts some of the move in real terms.

the WB's real index has a bigger fall through the end of 05 (a 15%) fall -- and then a rally in early 05 on the back of the $'s rally/ the RMB's initial 2% move and then a bit more stability, as the rMB's move v $ is offset by its move v euro/ rest of asia. in real terms, on their chart, the rMB is about 10% below its 02 level -- v 5% on your chart. See p. 26 (exhibit 22) --

brad setser

Macro Man said...

Hey Brad

Obviously, the CBs were not the only particpants in the last few episodes of dollar weakness- far from it. However, there has clearly been a sense in London that a shift in behaviour from official names has accompanied/catalyzed the last few upside breakouts in EUR/USD- namely, they shift from buying on the bid to paying the offer.

One of the more interesting outcomes of the recent poll was to observe the geogrpahical breakdown. It seems quite clear that CBs are much more active in European trading than in New York- which makes sense, I suppose, given that London morning is Asian afternoon, whereas the New York session is during the evening/nighttime in Asia.

The index was something I knocked up myself in about half an hour, so it is clearly not exhaustive. Bear in mind that it focused on exports only; a blended TWI would likely have different weights. The HKD is indeed a sticky wicket, but I decided to take the weighting at face value; after all, at least some of China's ex-US trade is invoiced in dollars, so a heavy weighting for a USD proxy probably doesn't detract from the accuracy. It's an interesting point, actually; have you got any idea what % of China's ex-commodity trade is priced/invoiced in dollars?

BlueEventHorizon said...

Just curious MacroMan, what do you think of Deutsche Banks assertion that the Euro is 14% over-valued while yielding 3.75%, the USD undervalues by 7% while yielding 5.25%. Add to that the massively one-sided concensus of dollar-bears and euro-bulls and you have a recipe for a surprise move in favor of the dollar vs the Euro with a little carry to boot.

Macro Man said...

I think PPP for the EUR/USD exchange rate is about 1.10, which jives with the DB view of relative valuation.

And if valuation were the sole, the primary, or even a significant determinant of exchange rate movements over the near-to-medium term, then EUR/USD would be a slam-dunk sale.

Unfortunately, that's not the case. Similarly, the market is fixating not on the current carry premium that the dollar enjoys, but rather that which it will enjoy at some point in the future- call it the end of this year. And in that case, the market is pricing in a $ interest rate premium of roughly 0.75%.

Even that, one could argue (and I have), should be enough to support the dollar against the euro. However, there are two large players in the market who, for all intents and purposes, aren't terribly bothered by by small shifts in relative yield.

C/A surplus central banks, who are accruing FX reserves like Britney Spears accrues tabloid headlines, need to maintain portfolio benchmarks- which causes them to sell tens of billions of dollars/buy euros per quarter. Every once in a while, they all move at once and the EUR/USD rate shoots up a few percent in a manner of days. This is what I am fearful of at the moment.

Corporates also have hedging requirements, and there's a reasonable chance that further dollar weakness could force the hand of underhedged European exporters. summary, I have a lot of sympathy for your argument intellectually. However, acting on that impulse has, by and large, been an unprofitable proposition for the past six months. At some point, the dollar will be a screaming buy- but I think that that will come when we have solid evidence of either a re-acceleration of the economy that credibly raises the prospect of a further Fed tightening, or of a recession that causes all the overvalued things in the world to fall back to earth.

The soft landing scenario is the one where the CBs will exert the most influence, and sadly that's where we're likely to be for another month or two yet.

Anonymous said...

love "central banks buying reserves like Britney spears acrues tabloid headlines" -- i appreciate a good one liner ...

I personally would be a bit suspicious of the argument that the US$ is 7% undervalued -- most of those calculations are 7% undervalued v trend or v. PPP or v. a set of variables that predicts XR moves but leaves out the CA deficit. if you work off the current account deficit, the US $ is overvalued on a broad basis (that doesn't mean overvalued v the euro). And certainly if you compare private flows v. the US CAD, there is a bit of a problem .. as net private flows are way too small to cover the CAD. ergo -- without CB help, the $ would fall v most currencies, tho not necessarily v the euro. I obviously have some intellectual skin in this game, but i am deeply skeptical of arguments that the currency of a country with an underfinanced current account deficit is undervalued.

m-man -- i think about 80% of China's trade is invoiced in $. Not sure it matters tho -- if you are in europe and you can swap your euros for dollars, you can still buy a lot more Chinese imports now than before. what matters to a european importer is the euro cost of Chinese goods, and that fell.

your calculation -- by not adjusting for HK on the export side (Where it counts) and not using imports in the weights will necessarily tend to produce a larger $ weight than other ways of doing the calculation. relatively speaking, both europe and japan export more to china than the US, so including imports in the trade weights ups their share. and on the Chinese side, the HK distortion really impacts the export data -- effectively exports to europe via HK are treated as exports to the dollar block, which isn't totally true.

brad setser

Charles Butler said...


Combining my observations on the downside protection seemingly enjoyed by euromarkets relative to US, and yours on the EUR/USD, I come up with long ESX/short ES - ratio around 3:2.

No pretensions here to be anything more than a sports fan...

Macro Man said...

There's nothing I love more than a good spread trade, but I'll have to plead ignorance here. I assume ESX is Eurostoxx....what is ES?

I am so used to the (quirky) Bloomberg index tickers that I have don't know what more conventional index abbreviations are any more....

Charles Butler said...


That would be Eurostoxx/S&P mini.


Charles said...

It's only a theory, eh. (Ahem).