This spring, just after the outbreak of the Russo-Ukrainian war, the Washington Institute of International Finance made a bold and special prediction: the euro is about to weaken significantly and pull back from $1.11 as the region heads toward a current account deficit.
Not many investors agreed with that. Data from the Commodity Futures Trading Commission indicates that there was a net “credit” speculative position in the markets at the time – in other words, investors were betting that the currency would strengthen – because the European Central Bank was raising interest rates.
But the euro is now valued at $0.98, and Europe’s traditional trade surplus has already turned into a current account deficit, due to the rising cost of energy imports and declining industrial exports.
The IIF’s forecast for the pound was equally insightful. In recent months, Robin Brooks, chief economist at the Institute of International Finance, has also warned that the pound appears to be overvalued – the equivalent of $1.35 at the time – as markets have been ignoring that the UK’s current account deficit has quietly risen above 8 per cent. Up from the 3 per cent level seen in recent years.
Last week, the British pound collapsed as needed to close to par with the dollar, after the UK government unveiled a surprise tax cut plan. Brooks argues: “These moves in the euro and sterling are not irrational or exaggerated. The fair values of both have shifted to reflect higher energy costs and much weaker trade balances.”
Indeed, Brooks believes that at current levels “the euro is still 10 per cent overvalued and the pound is 20 per cent overvalued”. Oh my God.
Moreover, his model indicates that the Turkish lira and the New Zealand dollar are also overvalued “by 15 and 22 percent, respectively,” while the Chinese renminbi, the Brazilian real, and the Norwegian krone are undervalued by 11 and 13 percent for the first and second currencies. A whopping 47 per cent of the kr.
Investors should pay attention, some foreign exchange analysts may mumble that this type of analysis seems too reactionary. Principles of economics have long argued that current account balances affect currency values, because they determine the degree to which a country must attract external financing.
However, the trading models used by asset managers in the modern era of ultra-loose monetary policy have usually focused on other issues that shape capital flows. Relative interest rates, for example, tend to be the most important, especially since investors engage in carry trades “borrowing in one currency with a lower interest rate to invest in higher-yielding assets in another.”
GMO Group recently indicated that “carrier trading witnessed a sudden recovery in performance.” “The fair value models you use, which give less weight to checking account balances, imply that the pound and the euro are undervalued rather than overvalued.”
There are also political risk and safety issues. The analysis of the Institute of International Finance indicates that the dollar was overvalued, given its current account deficit. But it has actually strengthened this year, as my colleague Martin Wolf has pointed out, because the dominance of US financial markets – and the currency – has made it a safe haven.
But while the dollar’s behavior shows that it is wrong to treat currency analysis as anything other than an art rather than a science, the sterling story shows something else: it is dangerous to ignore economic attractiveness.
One could argue, though, that the best way to frame the pound’s collapse last week is to think of the cartoon character, Will a Coyote. Just as this moving number comes off a cliff and keeps switching “like a cyclist” on the same rise – until he looks down and panics – investors have spent most of the year behaving as if sterling will stay high, because they trust British policymaking and interest rates The UK is on the rise, and now the economic gravity has taken hold.
If you believe in the mean regression principle, which underpins a lot of trading models – meaning that asset prices eventually resort to a recent mean after wild swings – then you can hope that sterling’s decline is temporary. But if you think that an 8 per cent current account deficit is putting the UK into a new era, the previous models may not apply.
In either case, investors should consider whether there are other places where score-settlement might occur.
The IIF chart underlines the tensions in the currency world. Debt data provides additional evidence. Remarkably, there has been little public debate in recent years about the startling fact that global debt has doubled since 2006 – and tripled since 2000. This happened because interest rates were so low.
But interest rates are now rising and the fiscal burden in many countries is rising sharply amid energy subsidies and pandemic spending (and in the UK, unexpected tax cuts).
There are also signs that investors are getting more nervous: quite apart from this week’s bond market and British government-secured bond market jitters, JPMorgan reports that global investors are now planning to allocate just 17 per cent of their portfolios to bonds. That’s remarkably low, given that it has suffered from overvaluation over the past 14 years.
This does not mean that investors should panic, but they should ask themselves why they have ignored data in charts, such as reports from the Institute of International Finance, for so long that sometimes economic attractiveness matters. Cheap money won’t keep Well e Kyoto afloat.