A public service announcement regarding currency baskets

In a move that surprised exactly no one, the IMF board rubber-stamped China's entry into the SDR yesterday.  They even helpfully announced the weights to the new SDR, which will go live on October 1 of next year.  Unfortunately, they did not provide a primer for how currency baskets work, which led to a raft of inaccurate commentary on the changes from the "current" weights.  This sort of thing gets Macro Man's goat, particularly when he has taken the trouble to calculate and publish the current weights the day before.   As a public service, therefore, he will provide a brief explanation of how currency basket valuation works.  Not only will this make you a scintillating cocktail party conversationalist, but it will also provide a handy reference for the next SDR review in 2021. 

The SDR, like the ecu before it, is comprised of fixed currency amounts.  These amounts are determined by an initial weighting, such as those announced yesterday, and the level of prevailing exchange rates during some sort of reference window.  In the case of the new SDR, that will be the average FX rates during July-September 2016.  In the case of the current SDR. it was the average FX rate during October-December 2010.  In the table below, the FX rates, weights, and USD/SDR rate are all given.  The SDR rate is then multiplied by the weights to generate a USD equivalent, which is then adjusted by the FX rates to give the initial currency units per SDR.


Because the currency amounts in the basket are then fixed but exchange rates continue to float, there is ironically no guarantee that the SDR will ever be comprised of the exact weights announced by the IMF, since it is unlikely each FX spot rate will trade at the exact level of its average during the reference window.  Indeed, by the time the current SDR launched at the beginning of 2011, the euro's weight had already fallen to 36.39% thanks to a decline in the spot rate to 1.3240.  Fast forward five years, and the current weights are as follows:



Note that for this calculation, the only givens are the currency units per SDR and the FX rates.  We can then calculate USD equivalent amounts, which we sum to generate the USD/SDR rate and the relative weightings.   Astute readers will notice a strong similarity between these weights and those published in this space yesterday (and a large discrepancy between these weights and those referenced by numerous financial media rent-a-quotes.)

So how will the new basket look?   Obviously we don't know what the FX rates will be next year (the Magic 8-ball is acting up again, alas), but using the current FX rates and the weights announced by the IMF the calculations look like this: 




Note how the number of yen per SDR has increased even though the yen's weight has declined from the current SDR.   That, my friends, is the impact of exchange rate movements.  All of this is different, meanwhile, from the DXY, which uses fixed weights and calculates changes in the index based on the weighted geometric mean of changes in the relevant FX rates.

Armed with this knowledge, you're sure to be a hit at your next dinner party.   Top off your explanation with a rendition of the old joke about the Kalman filter, the histogram, and the donkey and you're sure to be the talk of the social circuit this holiday season!

Although Macro Man would like to think that yesterday's admonition to take a bit of profit in USD/CNH was behind the recent decline, the reality is more prosaic- it seems as if the authorities have sold a cartload.   Whether this was to dampen the recent widening of the onshore/offshore spread, or merely a bit of financial diplomacy around the big SDR announcement remains to be seen; as has been the case for some time, the noise surrounding any development in China dwarfs the signal.    Something tells your author that Nigel Tufnel would have made a good China analyst....



 
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Anonymous
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December 1, 2015 at 8:28 AM ×

Chinese bond market,, are traders front running an expected state purchase of corp debt??

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Polemic
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December 1, 2015 at 8:59 AM ×

Thanks MM. I would imagine that many Journos reading that have just torn up their SDR piece, tried to rewrite it, worked out that most folks won't understand it and torn it up again and have instead decided to republish n article on how large total debt is if you add it all up but ignore the asset side.

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Leftback
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December 1, 2015 at 4:31 PM ×

People. We will revisit Team Macro Man's Law of ISMs in a bit...

First, I will tell you something about the US economy. It is almost flat on its back here. The manufacturing sector is in a mild recession. If you don't believe my madness look at the ISM manufacturing data that was just released today. Look at the PMIs from the Midwest, like Chicago and Milwaukee. The Midwest, with its manufacturing base is in a recession. Deere laid off workers, Caterpillar doing the same. Now the service sector may be doing better, but that frequently lags manufacturing a bit, and also reflects economic activity in different areas of the country as well as the economy.

Now, Team Macro Man's Law of ISMs states this, quite unequivocally, that the Fed will not tighten after a very weak ISM. Polemic has repeated this Law often, and as far as I know it has not failed to date. So I am jumping off the One and Done bandwagon right here - and for the time being I am joining the Yellen Does A Carney crowd. It's a motley crew of skeptics and nut cases, gold bugs and pragmatists, but we are all throwing rotten tomatoes at the USD rally.

As the recent run-up in Spoos has been driven by accumulation of all things dollar-denominated, a rash of very weak data might find a lot of people out of position in several different areas of the capital markets if there is a sharp reversal. In particular, we have repeatedly warned punters not to be short US10y. Let's do a Thought Experiment. Let's say the October jobs number was a huge outlier, it is revised by -50k or more and November comes in tepid, say 135k. Do you really want to be arsehole long the USD and short 10s? Do you really think this is not possible after seeing the ISM? Do ya feel lucky, punk?

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Anonymous
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December 1, 2015 at 4:40 PM ×

LB ... and if the punk doesn't feel lucky, then whither REITs, gold, commodities, and EM?

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abee crombie
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December 1, 2015 at 4:43 PM ×

Nice point LB. I'm sure we will be reading articles about how the fed has never tightened (my guess w/o looking at the data yet) with ISM below 50. Certainly the ISM prices paid have never been this low at the start of a hiking cycle. China PMI wasnt great either, though at least it didnt decline as much as the US numbers. The always volatile Chicago PMI was horrible yesterday as well

Just when I thought I had figured out what was going on, this monkey wrench is thrown in. Though perhaps the PMIs are just a month behind the numbers? Industrials in US, EU and Japan all doing very well.

LB, you are correct, if NFP dissapoints, USD is in for rude turn around. But there is still so much going on this week, with ADP and ISM Services before. Gonna be a December to remember

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Leftback
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December 1, 2015 at 4:59 PM ×

Yes, Abee, it isn't just one data point. Inventories have been creeping up for months and months now, and entire regions of the US seem to be in a mild recession. Texas (oil and nat gas), North Dakota (shale), Milwaukee, Chicago (manufacturing) seem to be fairly obvious at this point.

Starting to like gold here, just a bit. If US jobs numbers do come in weaker, then the industrial commodities and the miners might easily take yet another bath here before the end of the year. Ready for some REITs? The tax sales are coming....

Be careful out there, this week might be treacherous. We are about 50% still in the hammock, about 25% long US fixed income here and about 25% global equities. Short US10y and long USDJPY looks like lazy sunbathing to me.

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washedup
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December 1, 2015 at 6:14 PM ×

LB/Abee/Pol/Anon:
Of course the US is on the brink of very low growth if not outright recession - I don't care about payrolls, thats about as lagging an indicator as you will find - the services stuff is a bit more nuanced and some of that does reflect structural strength and a continuing global transition into services led growth that has accelerated in the last 3-4 years.

WTF was the US Fed expecting anyway after using 50 year old useless economic models to forecast the economy? That the Chinese plus derivative EM economies that went from 5% to 25% of world GDP would continue to have the same impact on US manufacturing as they did in the 80's, when trade as a percentage of GDP was 1/10th of now? Or that the euro would be allowed to fall 35% to near parity with USD and the much celebrated growth differential from 2010-2013 would simply persist because of American 'ingenuity'? We ain't that much smarter than everyone else folks, but thanks for the thought.

US consumer spending you say? Cool - we'll see if laid off oil rig workers that find work as waiters want to spend as much as they did before.

Sorry for the rant - made the mistake of watching CNBC after a long time today - should have stuck to the numbers.

FWIW I think the Fed will hike unless spoos fall 10% or more in the next 2 weeks - they look like complete ass-clowns if they don't, and they seem rather image conscious these days.

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Anonymous
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December 1, 2015 at 6:27 PM ×

@washedup:

Ass clownery not withstanding, I do believe Old Yeller when she says her Fed is data driven. For true "scientists", the data is all that matters. Personal ego is irrelevant. Should the data between now and the meeting indicate a more obvious slowing, I want to believe that the "scientists" at the Fed will back off.

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Anonymous
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December 1, 2015 at 6:42 PM ×

@LB

Normally I would agree with you. But with too many events this week and next week, ISM may be low on everyone's radar, or at least low on Central Bankers' minds. Unless NFP is below 100k, my bet is on Fed's raising rate this month.

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Macro Man
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December 1, 2015 at 6:46 PM ×

The Fed as scientists, LOL. They've spent the better part of six years cherry-picking the data that supports their pre-determined course of action...pretty much the opposite of science. Anyhow, any real scientist would emphasize empirical evidence more and models much, much less.

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Anonymous
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December 1, 2015 at 6:57 PM ×

@macro:

Agreed - they've cherry-picked the data for years now. Who can forget the galling betrayal of a 6.5% unemployment threshold for raising rates? Yeah - that didn't happen.

This time feels different. In the relatively benign economic climate of 2015 (as seen by the Fed), where Bernanke is on the rubber-chicken circuit making money, I am thinking the Fed might be more rules driven. And hence my opinion that the "scientists" will react to the "data".

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Mr. T
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December 1, 2015 at 8:16 PM ×

I think this hike was not supposed to be a real hike anyways? I'm in the "they will raise" camp, but it does not really matter. Slightly higher rates for borrowers who don't need the money. DXY looks extended but I thought that 10 points lower too.

You can't cut hundred-billion plus dollars in commodity capex cuts without it showing up somewhere. I'll take a 48 ISM m-print over the mess in Brazil any day.

Personally, I'm finding much better setups lately than all year.

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Anonymous
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December 1, 2015 at 8:24 PM ×

i think fed boxed in a corner...best they hope is to convince market 1 and done....the curve pancaking flat as well

re spoos......eco slowing, earnings revenue growth gone negative, credit markets stinking ( no its not just energy),margins sky high as is the dollar, and fed looking to tighten....if you told me this at the start of 2015 my best guess for spoos would have been 18handle and here we are knocking at 2100......YOURS or what???!!
personally think we get a false break to the upside that stops out a lot of people and then you just give it...im short some and looking to add if this plays out

thoughts on spoos here chaps?

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Anonymous
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December 1, 2015 at 9:03 PM ×

The Fed are neither scientists or real central bankers, they are just political lackeys. The Government tells them what to do, they find some date to fit. The Government wants to print endless money to buy votes, and the Fed will be told to make this happen. At the same time, the Fed and Government will do everything they can to stoke inflation to wipe out the huge debt they've created. Understand this, and you will be able to easily predict their course of action.

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abee crombie
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December 1, 2015 at 9:41 PM ×

@ MrT, I think the Fed's credibility matters a lot, not the actual rate hike. If they hike and we dont see a pickup in economic activity in the next 2 or 3 months, the markets (spoos) are gonna punish them hard and the long end will flatten big time. Then when they have to back track, the dollar will go on a big roller coaster the other way.

Personally I am not ready to jump to the conclusion that the economy is getting so much worse. But clearly it isnt getting as better as I thought it would. To be fair, EU and Japan PMI's were better. China flat.

Yes NFP is a lagging indicator, but the market moves on it. If it dissapoints expectations for december will come down big time, leaving the Fed in a tough spot for credibility.

No idea on Spoos. Industrials starting to rally nicely, which is a good sign for eco growth. Also have the year end drift. But if the markets do sell off hard, this time you load up on the AMZN's FB's .. they should come down hard, IMO

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Anonymous
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December 2, 2015 at 2:05 AM ×

Total US debt now $18.827 trillion. Without a debt ceiling, the current gang in power will easily blow through 20 trillion by end of 2016. So now every 8 years the U.S. is doubling it's debt.

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Anonymous
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December 2, 2015 at 3:52 AM ×

Between 2007 & Q2 '15 ALL market participants EXCEPT non-financial corp. were NET SELLERS of $163B of stocks. Non-financial Corps were NET BUYERS of $2.965T. There I said it.

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