Currency Correlations, Part II: Canadian Dollar Begins its Decline

In April, I wrote a post entitled, “Economic Theory Implies Canadian Dollar will Fall,” in which I argued that the currency’s impressive rise was belied by fundamentals. It seems the gods of forex read that post; since then, the Loonie has fallen 3% against the US dollar alone. Based on my reading of the tea leaves, the loonie will fall further over the coming months, and finish the year below parity.

My contention is basically that investors are falsely treating the Loonie is a high-yield growth currency, and hence, bidding up its value. There are a few reasons why I believe this viewpoint is completely erroneous. First of all, Canada’s economy is both plain and mature. While it is indeed rich in natural resources would seem to make it stand-out, commodities exports account for only a small portion of GDP. Given that the US absorbs 75% of its exports, it’s no accident that Canada’s economic fortunes are tied closely to the US. Finally, Canadian interest rates are pretty mediocre, which means there is neither a strong monetary nor an economic impetus for buying the Loonie against the dollar.

While Canadian GDP and inflation have exceeded analysts’ predictions, the consensus expectation is still for the Bank of Canada to hold off on tightening until September or so. Even the most bullish forecasts show a benchmark interest rate of only 1.75% by the end of 2011 and perhaps 3% at the end of 2012. In other words, it will be a long time before the Loonie becomes a viable target currency for the carry trade.
According to OECD models, the Canadian dollar is overvalued by 17% against the Dollar on a purchasing power parity (ppp). While it is generally dubious to apply this concept to currency markets, I think it’s reasonable to invoke it when analyzing the USD/CAD. The two economies share more than just a border. As I said, their economies are closely intertwined, and goods, services (and people!) move freely between the two. Thus, you would expect that large discrepancies in prices should disappear over the medium-term. In fact, the Canadian trade balance recently slipped into deficit for the first time in 40 years (corresponding with the Loonie’s record high level), which shows just how quickly consumers can shift their attention south of the border. That means that either Canadian prices have to decline (something which retailers are always reluctant to effect) or the Loonie must drop further against the Dollar.

Of course, there is a mitigating factor: the US dollar may fall even faster than the loonie. While it would seem impossible to tease apart the loonie’s rise from the dollar’s fall (since a rise in CADUSD inherently reflects both), we can still make an educated guess. For example, consider that the Canadian dollar is strongly correlated (i.e. greater than 80 or less than -80 in the chart above) with almost every other major currency, relative to the US dollar. If the correlation was low, than it would imply that the Canadian dollar is fluctuating (in this case falling) for endemic reasons. In this case, however, the almost perfect correlation with the majors shows that it is almost definitely a US dollar spike rather than a Canadian dollar correction.
Whether this trend continues then, depends more on the health of the US dollar and less on what investors think about the loonie.

Risk Still Dominates Forex. The Dollar as “Safe Haven” is Back!

Well over two years have passed since the collapse of Lehman Brothers and the accompanying climax of the credit crisis. Most economies have emerged from recession, stocks have recovered, credit markets are strong, and commodities prices are well on their way to new record highs. And yet, even the most cursory scanning of headlines reveals that all is not well in forex markets. Hardly a week goes by without a report of “risk averse” investors flocking to “safe haven” currencies.

As you can see from the chart below, forex volatility has risen steadily since the Japanese earthquake/tsunami in March. Ignoring the spike of the day (clearly visible in the chart), volatility is nearing a 2011 high.What’s driving this trend? Bank of America Merrill Lynch calls it the “known unknown.” In a word: uncertainty. Fiscal pressures are mounting across the G7. The Eurozone’s woes are certainly the most pressing, but that doesn’t mean the debt situation in the US, UK, and Japan are any less serious. There is also general economic uncertainty, over whether economic recovery can be sustained, or whether it will flag in the absence of government or monetary stimulus. Speaking of which, investors are struggling to get a grip on how the end of quantitative easing will impact exchange rates, and when and to what extent central banks will have to raise interest rates. Commodity prices and too much cash in the system are driving price inflation, and it’s unclear how long the Fed, ECB, etc. will continue to play chicken with monetary policy.

Every time doubt is cast into the system – whether from a natural disaster, monetary press release, surprise economic indicator, ratings downgrade – investors have been quick to flock back into so-called safe haven currencies, showing that appearances aside, they are still relatively on edge. Even the flipside of this phenomenon – risk appetite – is really just another manifestation of risk aversion. In other words, if traders weren’t still so nervous about the prospect of another crisis, they would have no reasons to constantly tweak their risk exposure and reevaluate their appetite for risk.
Over the last few weeks, the US dollar has been reborn as a preeminent safe haven currency, having previously surrendered that role to the Swiss Franc and Japanese Yen. Both of these currencies have already touched record highs against the dollar in 2011. For all of the concern over quantitative easing and runaway inflation and low interest rates and surging national debt and economic stagnation and high unemployment (and the list certainly goes on…), the dollar is still the go-to currency in times of serious risk aversion. Its capital markets are still the deepest and broadest, and the indestructible Treasury security is still the world’s most secure and liquid investment asset. When the Fed ceases its purchases of Treasuries (in June), US long-term rates should rise, further entrenching the dollar’s safe haven status. In fact, the size of US capital markets is a double-edge sword; since the US is able to absorb many times as much risk-averse capital as Japan (and especially Switzerland, sudden jumps in the dollar due to risk aversion will always be understated compared to the franc and yen.

On the other side of this equation stands virtually every other currency: commodity currencies, emerging market currencies, and the British pound and euro. When safe haven currencies go up (because of risk aversion), other currencies will typically fall, though some currencies will certainly be impacted more than others. The highest-yielding currencies, for example, are typically bought on that basis, and not necessarily for fundamental reasons. (The Australian Dollar and Brazilian Real are somewhere in between, featuring good fundamentals and high short-term interest rates). As volatility is the sworn enemy of the carry trade, these currencies are usually the first to fall when the markets are gripped by a bout of risk aversion.
Of course, it’s nearly impossible to anticipate ebbs and flows in risk appetite. Still, just being aware how these fluctuations will manifest themselves in forex markets means that you will be a step ahead when they take place.

Are Forex Markets Underpricing Volatility?

This question has been raised by several market commentators, including The Wall Street Journal. Its recent analysis, entitled “Currency Investors: What, Me Worry?” wondered whether the forex markets might not have become too complacent about risk and have seriously underestimated the possibility of another shock.

First, some basics. There are two principal volatility measurements: implied

volatility and realized volatility. The former is so-called because it must be deduced indirectly. In the Black-Scholes model for pricing options, volatility is the only unknown variable and thus is implied by current market prices. It serves as a proxy for investor expectations for volatility over the period for which the option is valid. Realized volatility is of course the actual volatility that is observed in currency markets, calculated based on the size of fluctuations over a given period of time. When fluctuations are greater (whether upward or downward), volatility is said to be high.

 

For short time frames, implied volatility tends to be very close to realized volatility. For longer time-frames, however, this is not necessarily the case: “The long-dated implied volatilities are often driven to extreme values by one-sided demand or supply – the difference between implied and realised volatilities this causes is particularly large during periods of risk aversion in the market…making implied volatility a particularly poor proxy for realised volatility during periods of market unrest.” In practice, this is reflected by higher prices for long-dated put or call options (depending on the direction of the move that investors are trying to hedge against).

 

Indeed, most volatility metrics are well below their historical averages and are rapidly closing in on pre-credit crisis levels. This is true for the JP Morgan G7 3-month forex volatility index, the S&P VIX, as well as for specific currencies. Mataf.net (whose content manager I interviewed yesterday) contains replete short-term and long-term data for a few dozen currency pairs, and you can see that almost all of them feature the same downward trend. According to the WSJ, “Investors believe there is a 66% chance each day for the next month that the euro and pound will move no more than 0.6% and 0.5%, respectively—both limited moves.” In addition, “A gauge of the euro’s ‘realized’ volatility, which measures how much daily changes deviate from their recent average, is only 8.6%, lower than its 11% rolling one-year average.”

Of course, some commentators don’t see any problem here. They see it both as a positive indication that the markets have returned to normal following the financial crisis, and as a reflection of the correlation that has developed between stock prices and forex markets. (You can see from the chart below the strong inverse correlation between the S&P and the US dollar). According to Deutsche Bank, “Most news that should have shocked the market this year has not managed to do so for sufficiently long to make volatility rise sustainably. Our analytical models tell us that we are indeed moving to a low volatility environment again.”

 

On the other side of the debate is a growing consensus of investors that sees a pendulum that has swung too far. “I just don’t see how volatility will not increase quite substantially,” said one money manager. “There is significant potential for shocks to the system that currency volatility levels suggest the market is not prepared for,” added another, citing higher commodities prices and inflation, growing public debt, and the imminent end of the Fed’s QE2 monetary stimulus.

 

To be sure, volatility has started to tick up over the last month. This trend has also been reflected in options prices: “Many investors have avoided buying short-dated currency options this year, instead focusing on longer-dated protection, a phenomenon called a ‘steep volatility curve’…that trend has slowed a bit, with investors moving to hedge against near-term yen, euro and dollar swings.”

 

Currency traders should start to think about making a few adjustments. Those that think that volatility will continue to rise and/or that the markets are currently underpricing risk can employ a volatility strangle strategy, buying way out-of-the-money puts and calls. The options will pay off if there is a big move in either direction, with no downside risk. Those that think that volatility will continue declining or at least remain at current low levels can make use of the carry trade. Those pairs where interest rate differentials are highest and volatility levels are lowest represent the best candidates. BNP Paribas is also reportedly developing a product that will make it easier for traders to make volatility bets without having to rely on indirect means.

Emerging Market Currency Correlations Break Down

A picture is truly worth a thousand words. [That probably means I should stop writing lengthy blog posts and instead stick to posting charts and other graphics, but that's a different story...] Take a look at the chart below, which shows a handful of emerging market (“EM”) currencies, all paired against the US dollar. At this time last year, you can see that all of the pairs were basically rising and falling in tandem. One year later, the disparity between the best and worst performers is already significant. In this post, I want to offer an explanation as to why this is the case, and what we can expect going forward.


In the immediate wake of the credit crisis, I think that investors were somewhat unwilling to make concentrated bets on specific market sectors and specific assets, as part of a new framework for managing risk. To the extent that they wanted exposure to emerging markets, then, they would achieve this through buying broad-based indexes and baskets of currencies. As a result of this indiscriminate investing, prices for emerging market stocks, bonds, currencies, and other assets all rose simultaneously, which rarely happens.
Around November of last year, that started to change. The currency wars were in full swing, inflation was rising, and there were doubts over whether EM central banks would have the stomach to tighten monetary policy, lest it increase the appreciation pressures on their respective currencies. EM stock and bond markets sputtered, and EM currencies dropped across the board. Shortly thereafter, I posted Emerging Market Currencies Still Have Room to Rise, and currencies resumed their upward march. It wasn’t until recently, however, that bond and stock prices followed suit.

What changed? In a nutshell, emerging market central banks have gotten serious about tackling inflation. That’s not to say that they raised interest rates and accepted currency appreciation as an inevitable byproduct. On the contrary, they have adopted so-called macroprudential measures (quickly becoming one of the buzzwords of 2011!), with the goal of heading off inflation without influencing broader economic growth. Most EM central banks have sought to achieve this by raising their required reserve ratios (see chart above), limiting the amount of money that banks can lend out. In this way, they sought to curtail access to credit and limit growth in the money supply without inviting a flood of yield-seeking investors from abroad. Other central banks have gone ahead and hiked interest rates (namely Brazil), but have used taxes and other types of capital controls to discourage speculators.
You can see from the chart of the JP Morgan Emerging Market Bond Index (EMBI+) below that EM bond markets have rallied, which is the opposite of what you would normally expect from a tightening of monetary policy. However, since EM central banks have thus far implemented tightening without directly influencing interest rates, bond yields haven’t risen as you might expect. In addition, whereas sovereign credit ratings are falling in the G7 as a result of weak fiscal and economic outlooks, ratings are actually being raised for the developing world. As a result, EM yields are falling, and the EMBI+ spread to US Treasury securities is currently under 3 percentage points.

The primary impetus for buying emerging markets continues to come from interest rate differentials. Given that interest rates remain low (on both an historical and inflation-adjusted basis), however, it’s unclear whether support for EM currencies will remain in place, or is even justified. Furthermore, I wonder if demand isn’t being driven more by dollar weakness than by EM strength. If you re-cast the chart above relative to the euro, the performance of EM currencies is much less impressive, and in some cases, negative. This trend is likely to continue, as Ben Bernanke’s recent press conference confirmed that the Fed isn’t really close to hiking interest rates.
Ultimately, the outlook for EM currencies is tied closely to the outlook for inflation. If raising the required reserve ratios is enough to head off inflation (and other forces, such as rising commodity prices, abate), then EM central banks can probably avoid raising interest rates. In that case, you can probably expect a correction in forex markets, which will be amplified by rate hikes in the G7. On the other hand, if inflation continues to rise, broad EM interest rate hikes will become necessary, and the floodgates will have been opened to carry traders.Either way, the gap between the high-yielding currencies and the low-yielding ones will continue to widen. In answering the question that I posed above, I expect that regardless of what happens, investors will only become more discriminate. EM central banks are diverging in their conduct of monetary policy, and it no longer makes sense to treat all EM currencies as one homogeneous unit.

Where are Exchange Rates Headed? Look at the Data

At this point, it’s cliche to point to the so-called data deluge. While once there was too little data, now there is clearly too much, and that is no less true when it comes to data that is relevant to the forex markets. In theory, all data should be moving in the same direction. Or perhaps another way of expressing that idea would be to say that all data should tell a similar story, only from different angles. In reality, we know that’s not the case, and besides, one can usually engage in the reverse scientific method to find some data to support any hypothesis. If we are serious about finding the truth and not about proving a point, then, the question is: Which data should we be looking at?

I think the quarterly Bank of International Settlements (BIS) report is a good place to start. The report is not only a great-read for data junkies, but also represents a great snapshot of the current financial and economic state of the world. It’s all macro-level data, so there’s no question of topicality. (If anything, one could argue that the scope is too broad, since data is broken down no further than US, UK, EU, and Rest of World). The best part is that all of the raw data has already been organized and packaged, and the output is clearly presented and ready for interpretation.

Anyway, the stock market rally that began in 2010 has showed no signs of slowing down in 2011, with the US firmly leading the rest of the world. As is usually the case, this has corresponded with an outflow of cash from bond markets and a steady rise in long-term interest rates. However, emerging market equity and bond returns have started to flag, and as a result, the flow of capital into emerging markets has reversed after a record 2010. Without delving any deeper, the implication is clear: after 2+ years of weakness, developed world economies are now roaring back, while growth in emerging markets might be slowing.

Economic growth, combined with soaring commodities prices, is already producing inflation. (See my previous post for more on this subject). However, the markets expect that the ECB, BoE, and Fed (in that order) will all raise interest rates over the next two years. As a result, while investors expect inflation to rise over the next decade, they believe it will be contained by tighter monetary policy and moderate around 2-3% in industrialized countries.

The picture for emerging market economies is slightly less optimistic, however. If you accept the BIS’s use of China, India, and Brazil as representative of emerging markets as a whole, rising interest rates will help them avoid hyperinflation, but significant price inflation is still to be expected. I wonder then if the pickup in cross-border lending over this quarter won’t slow down due to expectations of diminishing real returns.

Any sudden optimism in the Dollar and Euro (and the Pound, to a lesser extent) must be tempered, however, by their serious fiscal problems and consequent volatility. As a result of the credit crisis (and pre-existing trends), government debt has risen substantially over the last three years, topping 100% of GDP for the US and 200% of GDP for Japan. Credit default swap rates (which represent the markets’ attempt to gauge the probability of default) have risen across the board. To date, gains have been highest for “fringe” countries, but regression analysis suggests that rates for pillar economies need to rise proportionately to account for the the bigger debt burden. According to a BIS analysis, US and UK banks are very exposed to Eurozone credit risk, which means a default by one of the PIGS would reverberate around the western world.

While I worry that such a basic analysis makes me appear shallow, I stand by this “20,000 foot” approach, with the caveat that it can only be used to make extremely general conclusions. (More specific conclusions naturally demand more specific data analysis!) They are that industrialized currencies (led by the Dollar and perhaps the Euro) might stage a comeback in 2011, due to stronger economic growth and higher interest rates. While GDP growth and interest rates will undoubtedly be higher in emerging markets, investors were extremely aggressive in pricing this in. An adjustment in theoretical models naturally demands a correction in actual emerging market exchange rates!

Record Commodities Prices and the Forex Markets

Propelled by economic recovery and the recent Mideast political turmoil, oil prices have firmly shaken off any lingering credit crisis weakness, and are headed towards a record high. Moreover, analysts are warning that due to certain fundamental changes to the global economy, prices will almost certainly remain high for the foreseeable future. The same goes for commodities. Whether directly or indirectly, the implications for forex market will be significant.


First of all, there is a direct impact on trade, and hence on the demand for particular currencies. Norway, Russia, Saudia Arabia, and a dozen other countries are witnessing record capital inflow expanding current account surpluses. If not for the fact that many of these countries peg their currencies to the Dollar and/or seem to suffer from myriad other issues, there currencies would almost surely appreciate. In fact, the Russian Rouble and Norwegian Krona have both begun to rise in recent months. On the other hand, Canada and Australia (and to a lesser extent, New Zealand) are experiencing rising trade deficits, which shows that their is not an automatic relationship between rising commodity prices and commodity currency strength.

Those countries that are net energy importers could experience some weakness in their currencies, as trade balances move against them. In fact, China just recorded its first quarterly trade deficit in seven years. Instead of viewing this in terms of a shift in economic structure, economists need to understand that this is due in no small part to rising raw materials prices. Either way, the People’s Bank of China (PBOC) will probably tighten control over the appreciation of the Chinese Yuan. Meanwhile, the nuclear crisis in Japan is almost certainly going to decrease interest in nuclear power, especially in the short-term. This will cause oil and natural gas prices to rise even further, and magnify the impact on global trade imbalances.

A bigger issue is whether rising commodities prices will spur inflation. With the notable exception of the Fed, all of the world’s Central Banks have now voiced concerns over energy prices. The European Central Bank (ECB), has gone so far as to preemptively raise its benchmark interest rate, even though Eurozone inflation is still quite low. In light of his spectacular failure to anticipate the housing crisis, Fed Chairman Ben Bernanke is being careful not to offer unambiguous views on the impact of high oil prices. Thus, he has warned that it could translate into decreased GDP growth and higher prices for consumers, but he has stopped short of labeling it a serious threat.
On the one hand, the US economy is undergone some significant structural changes since the last energy crisis, which could mitigate the impact of sustained high prices. “The energy intensity of the U.S. economy — that is, the energy required to produce $1 of GDP — has fallen by 50% since then as manufacturing has moved overseas or become more efficient. Also, the price of natural gas today has stayed low; in the past, oil and gas moved in tandem. And finally, ‘we’re closer to alternative sources of energy for our transportation,’ ” summarized Wharton Finance Professor Jeremy Siegal. From this standpoint, it’s understandable that every $10 increase in the price of oil causes GDP to drop by only .25%.
On the other hand, we’re not talking about a $10 increase in the price of oil, but rather a $50 or even $100 spike. In addition, while industry is not sensitive to high commodity prices, American consumers certainly are. From automobile gasoline to home eating oil to agricultural staples (you know things are bad when thieves are targeting produce!), commodities still represent a big portion of consumer spending. Thus, each 1 cent increase in the price of gas sucks $1 Billion from the economy. “If gas prices increased to $4.50 per gallon for more than two months, it would ‘pose a serious strain on households and could put the entire recovery in jeopardy. Once you get above $5, [there is] probably above a 50% chance that the economy could face a downturn.’ ”
Even if stagflation can be avoided, some degree of inflation seems inevitable. In fact, US CPI is now 2.7%, the highest level in 18 months and rising. It is similarly 2.7% in the Eurozone and Australia, where both Central Banks have started to become more aggressive about tightening monetary policy. In the end, no country will be spared from inflation if commodity prices remain high; the only difference will be one of extent.

Over the near-term, much depends on what happens in the Middle East, since an abatement in political tensions would cause energy prices to ease. Over the medium-term, the focus will be on Central Banks, to see if/how they deal with rising inflation. Will they raise interest rates and withdraw liquidity, or will they wait to act for fear of inhibiting economic recovery? Over the long-term, the pivotal issue is whether economies (especially China) can become less energy intensive or more diversified in their energy consumption.
At the moment, most economies are dangerously exposed, with China and the US topping the list. Russia, Norway, Brazil and a select few others will earn a net benefit from a boom in prices, while most others (notably Australia and Canada) are somewhere in the middle.