G20 Forex

The Trump and Xi Tango

As we go into the G20 Summit this weekend, markets continue an all too familiar theme of raising expectations into events, only to disappoint. Following this week, our series on how to trade a news-driven market may perhaps seem well timed given the event driven two-way volatility. Indeed the week after Thanksgiving and the projected Black Friday stock bottom we saw hopes of a positive G20 Trump/Xi meeting possibly dashed by the posturing/threat of further Trump tariffs. We also saw an unusually dogmatic Italian Government willing to compromise on their budget and give support to a beleaguered Euro. Oil came under further pressure as Saudi Arabia failed to confirm cuts. And dire Bank of England warnings of recession with a no deal Brexit keep pressure on the 15-month GBPUSD lows.

But the most noteworthy news was not Fed minutes but the Fed Chair’s speech the day before suggesting rates were “not on a preset path” and “close to neutral”. The similarity to the early stages of Ben Bernanke’s tenure remains striking. However hawkish Jerome Powell tries to sound, the market continues to interpret him as a dove. The net result was a powerful surge in stocks and a later reversal in the fortunes of the Dollar. One may be forgiven for believing this market is going nowhere fast but merely a series of news inspired move that take stops and fade back into the range. However the continued similarity to our 1987 Marker Map suggests this appearance may continue for a while but it is deceptive.

SPX 1987 Marker Top vs Correction

Whether this weekend’s meeting in Buenos Aires or indeed Trump’s private dinner with Xi can produce anything concrete or lasting on tariffs or indeed competitive currency rates remains to be seen. Here are our average fractals on previous G20 meetings.

G20 Previous Meeting Averages

But more importantly it serves to underline the historical significance of these meetings in a long history of attempted competitive currency manipulation. Different governments at different times have sought to use currencies to achieve a number of different policy goals, most notably to eradicate current account deficits. Most attempts at manipulation have largely failed in the longer term particularly to balance trade simply because the market and the global economy is too big for one government or currency to get its way. However, there are notable exceptions. Perhaps the greatest and most ironic was the G5 Plaza accord to devalue to Dollar in 1985, which we compared to Trump’s talking down the Dollar last year and which has continued the analogous trade war of 1987 with the trade war of 2018. In both cases the Dollar devaluation failed to reduce the trade deficit significantly, and led to protectionist policies in both instances.

Plaza Accord and Trump Rhetoric

The current Dollar recovery has been larger than in 1987 even though stocks still appear to be following this historical template.The impact however of a shift from devaluation to protectionism on the Dollar may be different to 1987 but appears in line with the historical average:

Averages of Previous Tariff policies

This begs the question why; what really moves foreign exchange market and why can a similar set of underling conditions can produce a different outcome in currency markets? As we pointed out last week the answer is both simple and complex.

The Complex Drivers of Currency Pairs:

All markets move due to a varying combination of FITS (fundamentals, intermarket relationships technical and sentiment). And although the fundamental drivers of a stock market or commodity may appear complex, this is simpler than the fundamental factors that determine currency rates and not just because there are two countries’ set of FITS. Although the market focuses on interest rate differentials (yields) as a major determinant of foreign exchanges, extensive research shows this is neither clear cut nor reliable. Indeed the separation of the EURUSD from its interest differential for much of 2017 into 2018 (what we called the sentiment gap encouraged by either Trump’s desire for a lower Dollar and expectations of ECB Taper) suggests there are other influences at play. There is just as much evidence to suggest trade deficits, budget deficits, other government policies or indeed the real economy can, at times, be equally or more important. And the interesting point is frequently they are not mutually exclusive either. That is, a currency pair can appear to correlate to both the interest rate differential and say the trade deficits. If you take this one step further to a more realistic model than the complexity increases significantly.

Matrix Forex Model

Currencies move relative to other currencies due to a number of interrelated factors. Interest rates and the effect they have on bond yields and indeed inflation are significant. But so is broader government or central bank policy in a bid to maintain steady economic growth an employment. In this respect, how governments ensure budget or trade deficits do not continue to grow, will not only have an influence on interest rates but also the real economy and therefore inflationary growth. The model and evidence we will provide over the coming weeks shows the main driver of currency markets is, in fact, expectations of inflationary growth. Furthermore the variables that people cite as the main drivers of foreign exchange rates (interest rates, yields, trade deficits) may often appear more salient but they are in fact secondary. This will serve as the basis of our Forex 2019 outlook to be published in the new year.

Interest rate policies that appear to influence currencies through bond (and other related asset yields) have an influence to the extent the market believes they will help maintain real growth and prevent inflation from undermining longer term growth and demand for the country’s assets. The same can be said of trade and government deficits. The relationship of these variables is both complex and subject to both negative and positive feedback loops. Excessive deficits may be a reflection of expansionist policies that would boost demand for a country’s assets and therefore currencies. But as the market will not see such deficits (consequently economic growth) as sustainable they are less likely to trust the return they receive from a country’s assets and therefore demand those assets and currency less. In theory, markets move until they and the underlying asset classes reach equilibrium point. Similarly, currencies move until there are no trade balances, the effective price of assets (allowing for currency movement) is the same and government deficits at least remain stable or sustained. Currencies therefore should serve to help maintain a balancing act. The complexity is however not just due to how these variables (economic growth, inflation, trade and government deficits and interest rates/yields) are balanced but expectations of each of those variables and how they interrelate. For most of the time currencies appear to move more in line with yields than anything else and those yields reflect what is going with government policy and the real economy. However, there are periods when currencies move out of synch with government policy or the underlying reality as reflected by economic releases and/or policy statements. This variance is because expectations of the data are different to the actual data that should move markets. The key, if there is one, to determining where currencies will move, is how best to capture those divergent expectations.

Here’s to making the very best.

Good Luck

Ed Matts
Matrix Trade

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