How do you value pieces of paper? What creates currency? What makes the dollar a reserve currency?
There are several different models used to value currency, including Purchasing Power Parity and the BEER (Behavioral Equilibrium Exchange Rate) model, amongst others. There are several variables that go into those models, most notably conditional expectations, current rates, term premiums, national savings/investment, demographics, and interest rate differentials.
Danske Bank developed a Medium-Term Valuation FX model that takes the above variables into account, and uses them to determine the fair value of currencies. The most important ones are the GDP growth of the country, the difference in interest rates, and the relative terms of trade.
- Balassa-Samuelson (Penn) Effect: When there is GDP growth, there will be an appreciation in the exchange rate (higher productivity = increase in real exchange rate)
- Interest rate differential: The difference between two country’s interest rates. When a country has higher rates, we can assume that their currency will appreciate because people will put their money there to get a higher return.
- Terms of Trade: An improvement in the terms of trade (Exports – Imports) will “increase” economic growth, and thus result in currency appreciation. Reducing imports and increasing exports strengthens currency.
Images Via Federal Reserve, Bloomberg, and FRED
Those are just some of the many variables that go into valuing a currency. It’s become more difficult to predict the direction that currencies will move after we were taken off the gold standard 1971.
A fiat currency gives the Fed the tools to fight Recessions and prevent excessive inflation. But it also means that the dollar is free to fluctuate based on several different variables, and predicting the path that a currency is going to take is less clear than it used to be.
There are pros and cons to having a gold standard. Pros of the gold standard include creating accountability for the government and material backing of the currency. The government can’t excessively print, can’t run a huge deficit, and inflate their currency to extremes because it’s tied to an actual, physical good.
Cons of the gold standard are ironically also all of the above – manipulating the money supply through printing theoretically will save us from Recessions, running deficits equals short term growth, and some inflation is good, and is preferred at 2%, according to the Fed.
However, there are other unprecedented variables that can cause currencies to fluctuate – such as Twitter.
Trump’s tweet caused a 20% drop in the Lira. Of course, the Lira and Turkey have problems that have contribute to its fall outside of Twitter (such as a lack of liquidity, threats of sanction, and a refusal to hike rates). But the fact that something as simple can send a currency downwards is alarming. The Lira has recovered since then (with fears of another freefall coming soon), but the impact of tweeting on currency valuation makes it even more difficult to measure.
The Current Movement of the US Dollar: Tax Cuts and Rate Hikes
Trump has used Twitter several times to express his wish for a weaker dollar. Right now, we have a combination of expansionary fiscal policy and tight monetary policy. Trump instated the Tax Cuts and Jobs Act which slashed the corporate tax rate by 14 points and reduced the individual tax rate to 37%. This will increase the deficit by $1 Trillion over the next 10 years, according to the Joint Committee on Taxation.
We saw something similar back in 2004. There was a brief uptick in the dollar after Bush’s 2004 Tax Holiday, when the repatriation tax was reduced to 5.25%. The top 15 repatriating corporations brought back $150 billion during that holiday. They also cut their workforces by 21,000 over the three years following.
Image via Thomson Reuters
Trump’s bill is different in the fact that it isn’t so much of a holiday, as much of an effort to actually change tax law. Most companies plan to return the cash to investors, whether through the form of dividends or share buybacks (repatriation is marked at $200-450B by analyst estimates vs a total $3.5T forex market). In theory, this should boost the USD.
But it really isn’t that big of a deal. It isn’t really stimulating the economy. It might move the needle a little bit, but the money will come over in dollars, be distributed in dollars, and probably be reinvested in dollars. It is almost a net-zero effect. The dollar has responded to fiscal stimulus (tax cuts) like this before. But the issue with today is that the time frame for repatriation is 8 years long (no incentive to bring money back right away) and as discussed previously, most of the money is already dollar-denominated.
Most analysts agree that the news of the tax break caused some strength to show, but there are also consequences – such as increased debt. The government is already running a pretty large fiscal deficit. This tax break isn’t helping matters much. Concerns about the impact that the deficit might have on the dollar as a reserve currency, and the ability of the US to pay back its debt, will be much more important in determining the value of the dollar in the future.
On the flip side, we have tightening monetary policy. The Fed is hiking rates to slow the economy down. They’ve hiked rates twice this year, and are expected to hike again in September, according to their most recent minutes. Trade disputes are at the forefront of their discussion with “little doubt rates are going up on September 26, though the outlook gets a little dicier beyond then given trade policy risks” says Sal Guatieri, a senior economist at BMO.
The relationship between higher interest rates and a stronger dollar has gapped over recent years primarily because rates have been held artificially low for so long. There has only been a 28% correlation between interest rates and the trade weighted USD for the past 10 years. However, the dollar bounced after the most recent Fed meeting (due to some other outside variables as well, such as continued trade war discussions), so the stance of the dollar as a safe-haven currency (for the moment) is still strong.
Academically, you shouldn’t combine expansionary fiscal with tight monetary policy. It just doesn’t make sense. You net zero at the end – one is stimulating the economy, and one is slowing it down. And you end up with a much stronger currency on both ends.
What Does That Mean For US Markets?
The S&P 500 and the dollar vary between periods of positive and negative correlation. That means that positive movement in the dollar doesn’t always mean positive movement in indexes. For example, during the mid-1990’s (economic growth), the dollar and S&P 500 gained a respective 27% and 486%. However, during 2000 -2002 (economic downturn) the dollar was strong and equities were weak, with the dollar up 8% and the S&P 500 down 50%.
We have been a period of dollar strength since 2012, with the dollar gaining 16% and the S&P 500 gaining about 40% (and reaching new heights every day). US corporations have been posting record earnings. We just hit the longest bull run of all time. Everything looks great over here. So is a strong dollar a good thing?
The Contagion of Currency: Emerging Market Pain
It depends. It’s good for foreign companies doing business in the US and for travelers, but it hurts US exporters, and domestic companies that do business abroad. It also crushes Emerging Markets.
Emerging markets hurt when the dollar is stronger. This is for two reasons:
- EM’s have a lot of US dollar denominated debt. When the USD increases in value, that debt gets more expensive to repay.
- A stronger dollar positively correlates to lower commodity prices, which is what most emerging market economies rely on.
The dollar appreciation/depreciation cycles are shown in the graph below. Emerging markets, especially commodity oriented ones like the Latin American and Caribbean, South America, and East Europe, outperform when the dollar is weaker. When there is appreciation in the dollar, growth in those countries is stunted.
However, some countries are more insulated from the cyclicality of dollar movements – most particularly countries that focus on manufacturing rather than commodities, like Mexico and Emerging Asia. A stronger dollar hurts commodities, so if a country’s economy can surround something more stable (manufacturing) that will lead to more stable growth. A manufacturing economy is often more diversified in terms of exports, and thus, can reduce their overall risk exposure.
Image via VoxEU
However, a stronger dollar does weigh on GDP and domestic demand in these countries, which can affect their growth prospects. With more US interest rate hikes in the future, and the current strength of the dollar, this could be troublesome for future growth prospects in Emerging Markets, unless they can unlatch themselves from the US.
When Emerging Markets Emerge
However, Emerging Markets are not going to stay “Emerging” forever. One day, they have to become full-fledged markets – and some would argue that China already has. Their economies are growing – China had 6.6% GDP growth in 2017, outpaced only by India’s 7.2% growth. Compared to the growth rates of developed economies, most of which are under the world average of 2.7%, this is quite promising.
Image via Asia Development Bank
Growth will come from branching out of the traditional commodity-oriented markets, and embracing diversification in terms of exports. The Manufacturing markets (China, India, Mexico, South Korea, and Taiwan) have a sustained advantage over Commodity based markets (Brazil, Colombia, Russia, and Malaysia). Growth volatility is not as prevalent when there are a variety of different commodities to rely on.
Image via Advisor Perspectives
Emerging markets are broadening their reach, and are entering into more innovative sectors of the economy. This is a logical transition as their economies, and populations, continue to grow. Patent applications show that there is a dissent from the traditional emerging market that we think of, and a move towards true, long-term growth.
Image via Franklin Templeton
Conclusion
The dollar is in a period of relative strength, despite a near 1% loss for the week. The Fed seems intent on remaining on a path toward higher rates (despite concerns about a trade war and the economic fallout that might ensue). In fact, they are even thinking about changing their key phrase – “the stance of a monetary policy remains accommodative” to “the stance of a monetary policy remains accommodative for now”. Okay.
US stocks are on a bull-run that is absolutely ridiculous. Nothing can go up forever. There are conflicting fiscal and monetary policies are work, and Twitter has become the place to negotiate trade deals. The Atlanta FED is posting expectations for a 4.3% GDP growth in Q3 2018, which is unsustainable in the current macro-environment. Things have to slowdown (which will result in declines in both the dollar and the market indexes), or else the bubble will pop.
Emerging Markets are down 20% from their January highs, coming very close to bear market territory. They will have some headwinds to combat, such as tighter liquidity from the central banks, weak commodity prices, and a stronger dollar. They have further pressure from US trade policies, (which seem to be easing).
But emerging markets will be fine. Demographics are on their side. Younger populations create growth. They are learning from their financial mistakes, and creating alliances with one another (i.e. Belt and Road Initiative). Their economies are evolving, pursuing activities, such as tech, that will create long-term growth and that will make them rivals to developed economies in the future.
They are also cheap. The MSCI Emerging Markets Index trades at 11.1x forward earnings, which is far less than the All Country World Index of 14.7x and the US valuation of 16.7x (which also happens to be the most expensive of all the advanced economies at the moment). It’s time to implement the simple mantra of “Buy Low, Sell High”
Image via Bloomberg
Brazil has had a pretty big sell-off. The Brazilian ETF EWZ is currently trading at $31.79 and a 91% 30-day IV percentile. The short 30 put at the 32 delta strike price is currently selling for $102 with a 72% probability of profit, collecting $1.94 daily theta, with a breakeven of $28.99.
If you think that Emerging Markets as a whole will break out soon, and US markets and the dollar are both headed for a reversion to the mean, the iShares MSCI Emerging Markets Index ETF EEM is currently trading at $43.29, about $10 below its 52-week high. It’s also trading at a 66% 30-day IV percentile.
Disclaimer: These views are not investment advice, and should not be interpreted as such. These views are my own, and do not represent my employer. Trading has risk. Big risk. Make sure that you can balance your risk/reward, and trade small, and trade often.
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