Between Sinking and Swimming
After a week that started with post G20 summit optimism over the trade war, unwound by projected signs of slowing economic growth, a growing US Trade deficit, and finishing with a lacklustre NFP and a record Chinese Trade surplus with the US, it is easy to believe that markets will continue to go nowhere fast into 2019. Indeed for many traders 2018 will go down as the year of the disastrous range. For others it will possibly be seen as a year where politicians shot themselves in the foot. But this disguises what really has been going on.
Whether one wants more justifiably to blame the trade war for premature fears of recession, the fact remains it FITS exactly with what happened in 1987 with the inevitable conclusion: a blowout and crash or now just a crash.
Slowing economic growth in the US that highlighted the gap between price expectations and reality (F) despite very obvious increasing trade tensions and a growing US trade and government deficit.
Yields and particularly short end rates starting reflect this fear and consequently eroding a strong but fragmented Dollar (I)
and sentiment both confused and nervous (S).
But it is the technical comparison that is arguably the most striking as last week continued the match to both the erratic 1987 final correction and top consolidations. (T)
It is perhaps easy to make a FIST of a market where most are seeking trend but the instruments will not deliver. The likes of the George Soros prodigy Druckenmiller recently claimed the inability to produce good returns (after years of making 30%+ p.a.) is because the market has changed, driven more by algos and HFTs. And yet the price action and drivers are no different—just the numbers—to 1987. I don’t recall traders back then making such excuses but I do recall different narratives and political themes (notably international tension in 1987) driving the market erratically and sometimes violently.
2018 is also another year in a long running competition where a currency war has been replaced by a trade war. Last weekend’s G20 reminded me of James Rickards’ book Currency Wars: The Making of the Next Global Crisis.
A typical but dated disaster scenario book about the role of G20 with respect to currency manipulation. Typical because it identifies one set of drivers that were topical at the time but dated because the narrative has changed. Currency devaluation through QE rhetoric even monetary policy has been replaced it seems by a trade war. But it is possibly still prescient. This very fact highlights how the market focuses one of several causes of a trend and neglects other drivers that are still significant but not to the forefront of the market’s psyche. It also ignores what really drives governments and sovereign instruments such as currencies. Governments may seek to devalue currencies to gain a competitive advantage and reduce a trade deficit such as the US sought through G5 Plaza in 1985 and UK did famously in 1967. They may even have a more specific Trump policy of restoring manufacturing. But their primary is sustained economic growth. It is perhaps no coincidence, regardless of the efficacies of government policy, currencies are influenced just as much by inflationary growth (and associated interest rates) as trade balances.
Economics students are taught that currencies move as a reflection of trade balances. Simplistically if a country such as China exports more than it imports there is higher demand for its goods or services and therefore its currency which should, other things being equal, appreciate until the trade account is balanced. Similarly if a country imports more then its currency should depreciate. There should therefore be a reasonably high correlation between a currency and the country’s current accounts as a percentage of GDP. And its not bad. Except, that for the last two years of relative weakness the Australian Dollar trade weighted index has been approximately in sync with its current account.
Both traditional yielding currency pairs USDCAD and USDJPY have also been in line (and at times leading) the current account.
Whereas the correlation between EURUSD and GBPUSD and their respected current accounts is weak.
And the EURUSD correlation to its trade weighted index almost appears to be inverted.
One reason for this could be a closer correlation certainly in GBPUSD’s case to the relative size of the current accounts for both the UK and US.
Perhaps excitingly GBPUSD appears, in isolation, to led by the relative size of the current accounts as a percentage of GDP promising a period of stability into strength?
At a stretch one could argue the same for EURUSD.
It is tempting to identify specific reasons for these varying relationships to provide clues for future currency movements. But this misses the point. There is just as close if not a closer relationship between inflationary growth and currencies with the change in nominal GDP appearing to lead the currency in most cases.
This should arguably not be a surprise nor should the implied relationship between economic growth and the current account. Demand for the assets of a country with higher inflationary growth should clearly be greater and vice versa. Whether this translates closely is a function of the yield or rather the expected yield and that is also a reflection of prevailing interest rates and expectations for inflationary growth and the interaction of these two economic variables.
Just because trade balances have an approximate relationship sometimes with some currencies doesn’t necessarily meant they are driving foreign exchange in those periods. There are many more factors at work. Donald Trump successfully talked the Dollar down last year not specifically to reduce the also growing trade deficit but to improve economic growth, particularly manufacturing and employment. When he successfully talked the Dollar back up there that didn’t imply the trade deficit would fall. Theoretically it should do the opposite.
Ever since Donald Trump was elected the focus and driver has been inflationary growth. This appears now to be slowing ominously at a time when stocks and the Dollar are expected to be seasonally strong. Just because the market expects it doesn’t necessarily mean it will happen. Just the opposite. It is when they have given up, that’s when it will happen.
Here’s to making the very best.
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