Forex markets are about to learn a lesson by defying economic gravity

This spring, just after Russia invaded Ukraine, the Institute of International Finance in Washington made a bold and idiosyncratic prediction: the euro was about to weaken dramatically against its $1.11 level because the region was heading into a current account deficit.

Few investors agreed. Data from the Commodity Futures Trading Commission suggests that there was then a net “long” speculative position in the markets – in other words, investors were betting that the currency would strengthen – because the European Central Bank was raising rates. of interest.

But the euro is now worth $0.98 and Europe’s traditional trade surplus has indeed turned into a current account deficit, due to soaring energy import costs and falling industrial exports.

The IIF’s projections for the pound sterling were equally prescient. In recent months, Robin Brooks, chief economist at the IIF, has also warned that the pound appears to be overvalued at its then level of $1.35, as markets were unaware that Britain’s current account deficit had quietly exceeded 8 %, compared to 3% in recent years.

This week, the pound duly crashed to near parity with the dollar, after the UK government unveiled a surprise tax cut plan. “These movements [in the euro and sterling] are not irrational or excessive”, supports Brooks. “The fair values ​​of both have changed to reflect higher energy costs and much weaker trade balances.”

Indeed, Brooks believes that at current levels “the euro is still overvalued by 10% [and] the pound is overvalued by 20%. Yeah.

Moreover, his model suggests that the Turkish lira and New Zealand dollar are also overvalued (by 15 and 22% respectively), while the Chinese renminbi, Brazilian real and Norwegian krone are undervalued by 11, 13 and a whopping 47%.

Investors should take note of this. Some forex analysts might mumble that this type of analysis looks very retro. Economics 101 has always argued that current account balances affect monetary values ​​because they determine the extent to which a country should attract external financing.

However, the trading models used by asset managers in the recent era of ultra-loose monetary policy have generally focused on other issues that shape capital flows. Relative interest rates, for example, have tended to dominate the debate, especially since investors have engaged in carry trades (borrowing cheaply in one currency to invest in higher-yielding assets in another). other).

And “the carry trade experienced a sudden upturn in performance”, as the GMO group recently observed. (The fair value models he uses, which give less weight to current account balances, imply that the pound and euro are undervalued, not overvalued.)

Then there are the issues of political risk and security. The IIF analysis suggests that the dollar was overvalued, given its current account deficit. But it has actually strengthened this year since, as my colleague Martin Wolf has pointed out, the dominance of US capital markets – and the currency – has made it a safe haven.

But while the behavior of the dollar shows that it is a mistake to treat monetary analysis as more than an art, not a science, the saga of the pound sterling shows something else: it is even more dangerous to ignore economic gravity.

After all, perhaps the best way to frame this week’s sterling crash is to think of the cartoon character Wile E Coyote. Much like this animated character runs off a cliff and keeps pedaling the same height – until he looks down and panics – investors have spent most of the year acting as if the pound is destined to remain high, as they trusted British policy-making and the rise of the United Kingdom. rates. Now economic gravity has set in.

If you believe in the principle of mean regression that underlies many trading models – that asset prices end up resorting to a recent average after a wild swing – then it is possible to hope that the fall of the pound sterling will be temporary. But if you think an 8% current account deficit puts the UK in a new era, past patterns may not apply.

Either way, investors should consider whether there are other places where a calculation could take place.

The IIF chart highlights the tensions in the currency world. Debt data offers additional clues. There has been remarkably little public debate in recent years about the astonishing fact that global debt has doubled since 2006 – and tripled since 2000. That’s because interest rates were extremely low.

But now rates are rising and the tax burden in many countries is skyrocketing amid energy subsidies and pandemic spending (and, in the UK, unexpected tax cuts).

There are also signs that investors are getting more nervous: regardless of visible tensions in the Treasury and gilt market this week, JPMorgan reports that global investors now plan to allocate just 17% of their portfolios to bonds. This is a remarkably low level, considering they have been overweight for 14 years.

That doesn’t mean investors should panic. But they should ask themselves why they ignored data from charts like IIF reports for so long. Sometimes economic gravity matters. Cheap money won’t always keep Wile E Coyote afloat.

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