Sunday, 22 September 2019

What makes a currency powerful?

The BIS Triennial Central Bank Survey of foreign exchange turnover was released last week. There were, perhaps, two main headline for the press to report. Firstly, the Age of the Dollar persists, and secondly, London still dominates.

The dollar is one of the two currencies traded in 88.3% of transactions, far ahead of the second-placed currency, the euro (which is one-half of 32.3%). The top four currencies are the same as they were in the 2004 survey (the Swiss franc has been replaced in the top five by the Australian dollar) and the dollar's share has marginally increased in that period (from 88.0%).  The UK's share of the OTC foreign exchange market has risen from 32% in 2004 to 43.1% now, while the US' share has fallen from 19.1% to 16.5%.

The fact that the FX market is still, as Brexit approaches, centered on London may at least mean that I don't have to move country again quite yet. There's a lot that should be written about changing nature of the industry and the challenges it - and the City - faces, but that's not today's story, which has two parts. Firstly, that the dollar's dominance is intact and what that means, and secondly that which currencies are used to transact foreign exchange doesn't really correlate very closely with which economies dominate global trade now. In both cases, China looms large.

On the surface, China is a 'loser' in this survey, at least to the extent that ambitions of challenging the dollar (in any make, shape or form) as the dominant global currency, are not being realised very fast. 0.1% of global FX trading took place in China in the last survey, much the same as was the case in 2004. The yuan meanwhile was involved in 0.1% of FX trades in 2004, and has risen to 4.3% now, taking it from 29th to 8th place in the overall rankings. That's progress, but it's still not to a dominant place.

There's no doubt that controlling the world's reserve currency has benefits for the US. For example,  long-term capital flows into the US regularly lag the size of the current account deficit, because there are plenty of central bank flows to make up the difference was others try to prevent their currency from appreciating. Of course, the downside to that is evident now, as the dollar is overvalued when the President, at least, wishes it wasn't.  More strategically important, is the ability of the US to leverage the dollar's status, for example by imposing fines on any firm which flouts US sanctions and allows dollars to flow in and out of prescribed countries. That allows the US to impose its geopolitical policy on there to a degree that isn't necessarily repaired the other way round. In turn, it irks any in Europe and Asia. Having more clout in Asia in particular, was one reason for the Chinese authorities to promote the use of the yuan in the first place.

What has happened with the euro however, demonstrates clearly how difficult it is to challenge the dollar's status. Back in 1992, the dollar was one-half of 82% of all transaction, while the second-placed Deutsche mark was involved in 39.6%. So the mark, back in 1992, had a bigger share than the euro does now -  in second place with 32.3%. Is being in second place, meanwhile, much use? It's hard to see how it really helps the ECB or the Eurozone in general. On that basis, any ambitions that China might have to establish the yuan as a really big part of the FX market, regionally or globally, is a tall order - and might not really be worth the effort.

But the size of the FX market, where, in what instruments and which currencies it takes, isn't the only measure of size that matters. 

In another part of the BIS website, you can also find the calculations for real and nominal efective exchange rates, and  the trade weights the BIS uses to calculate them. Back in 2004, China's share of global trade was a little below Japan's, and a little above the UK's. The US and the Eurozone were miles ahead of everyone else. Now, China is between the eurozone and the US, in second place in a market dominated by three really big players and a lot of smaller followers-on.

This means that China now has a big weighting in other countries' real effective exchange rates. And so, what happens to the Chinese yuan matters a lot. The table below shows how much of a weight each of the top 5 global currencies has in the effective exchange rates of the others. So, to take a politically-charged example, the pound is an important currency in Europe, with a weighting of 10.5% in the euro's trade-weighted value, but that's nowhere near the importance of the euro to the UK, with its 45% weighting. A major disruption to UK-Eurozone trade can hurt Europe, but would hurt the UK more.

If I just add up how much these 5 currencies matter for each other in total, I find that the euro is ore important than the others in driving effective exchange rates, but the yuan is more important than the dollar.

Why does this matter? Because China's currency policy may be becoming less passive (or more passive-aggressive). Between 2004 and 2016 the Chinese allowed the currency to appreciate in real terms by 60%, importing disinflation and exporting inflation to the rest of us. Re-orienting the economy away from exports and towards domestic source software growth played a part. Since mid-2016 however, the yuan has lost about 10% of its real value. That doesn't mean that the value of the currencyhas been manipulated, just that as the economy has slowed and the dollar has appreciated, the Chinese haven't always seen fit to intervene to keep the yuan strong to the same extent as they used to intervene to slow the pace of its appreciation.

The result has been that the other major currencies have all done better, in real effective terms, than a glance at bilateral exchange rates might suggest. The euro isn't as weak as a look at EUR/USD suggests, for example. But for the Chinese authorities, what this brings is clout. What the yuan's value does matters much more at a global level now, than it did before. Which begs another question - which would you rather focus on, the seemingly unattainable goal of grabbing some of the dollar's exorbitant privilege, or how to run your own currency policy to better effect, now that it affects even the biggest economies in the world?

Sunday, 11 August 2019

“The dollar tends to fluctuate between been too high and being about right, but it has never been too low” Joe Gagnon

“Forget Tariffs. Here’s a better way to close the trade gap.” That’s the title of an article in Barron’s by Matthew Klein in which he argues in favour of a proposal by Senators Tammy Baldwin and Josh Hawley to require the Federal Reserve to keep the current account balanced around zero over 5-year periods. For the record, the US current account has been in deficit on average, by just over 2% GDP since the end the Bretton Woods era. 

The view behind the Baldwin-Hawley Bill is that the US current account deficit is a product of Americans consistently spending more than they earn, not because of profligacy on their part but because of foreigners consuming less than they produce (and saving as a result), dumping the excess into the US market and displacing US output (and jobs, and income). These over-saving foreigners enthusiastically reinvest the money they earn back into the US and the upshot is that the dollar has been consistently overvalued. Mr Klein cites Joe Gagnon, a former Fed economist who now works for the Peterson Institute, observing that “The dollar tends to fluctuate between being too high and being about right, but it has never been too low”. 

That’s an interesting statement, though it requires a caveat because what a currency being ‘too high’ means is up for interpretation. Broadly, there are two ways of looking at it, which come to different conclusions. The first is ‘PPP’-style valuation, which measures relative prices. That’s the valuation which matters if you’re tapping away on a keyboard by a swimming pool in a foreign country before heading out to dinner. The second is to look at where exchange rates are relative to a fundamental equilibrium that would be consistent with the current account being in balance (along with the rest of the economy) over the medium term.  

On a PPP basis, the dollar has been a bit more than 10% overvalued on average over the last 20 years against the currencies of its top five trading counterparts.  Perhaps unsurprisingly, the currency which has been, on average, most undervalued on a PPP basis against the dollar is the Chinese yuan. Today, the dollar is not only overvalued against all that group (yen euro, yuan, Mexican peso and Canadian dollar), but the only major currencies which are overvalued relative to the dollar are the Swiss franc and Norwegian krone, which are pretty much always overvalued on PPP. 

Fair enough: on the basis of PPP, the dollar is unambiguously overvalued today. It’s a very expensive foreign holiday destination, especially if you’re British! On the other hand, back on 2011, when the Brazilian Finance Minister was complaining about currency wars and the dollar was anchored by QE, the dollar was undervalued against all the major currencies except for the Turkish Lira, Korean won and Mexican peso.

The most-accepted alternative measure of valuation is FEER, which looks at how much a country’s real effective exchange rate needs to adjust to be consistent with medium-term balance. In June the IMF conducted its 2018 External Balance Assessment and concluded that the dollar was 8% overvalued at the end of last year. It’s worth noting that the euro is also overvalued on this measure, by 6% (because the current account surplus is entirely due to the weakness of the economy, rather than the valuation of the currency). The most undervalued currencies, according to the IMF, were the Japanese yen, Malaysian ringgit, Turkish lira and Mexican peso. The Chinese yuan is about right and among the G10 currencies, Sterling and Swedish krona stand out as being undervalued. 

The IMF hadn’t stated doing its external balance assessment back in 2011, when the dollar reached its post 2000 low. However, the Peterson Institute, where Mr Gagnon works, didn’t just make one assessment that year, it made two - in April and November (the dollar’s low was in July). And indeed, they concluded that the dollar was overvalued by 8 ½% in April, and 9.3% in REER terms in November. On which basis, it was still nearly 8% overvalued at its low point. The PIIE position therefore, might reasonable reflect Mr Gagnon’s that the dollar is sometimes overvalued, sometimes fairly valued but never undervalued – at least on a FEER basis. The yuan was 16% undervalued in 2011 meanwhile, and al the Asian ‘Tiger’ economies had very undervalued currencies. The euro was fairly valued (when EUR/USD was around 1.40). 

The easy conclusion is that however we look at it, the dollar is overvalued now. And that is the view of the US administration, alongside anyone who thinks the US current account deficit is a product of foreigners ‘dumping’ their exports in the US at the expense of American workers.

I’m instinctively wary of that argument. Apart from anything, any argument that says the Swiss franc is undervalued fails to pass the common-sense test.  In particular though, pinning all the blame for the US current account deficit on foreign rather than US behaviour, seems nearly as unfair as blaming everyone else for the UK’s (even larger) current account deficit. The US’ position in the global financial system means that, to varying degrees, we all import US monetary policy and that suits the US just fine when the dollar is cheaper (or less overvalued, if you will) but after the rest of the world was bludgeoned into boosting demand as the US ran very accommodative fiscal policy under President Reagan, and even when the dollar lost half its value between the 1985 peak and the end of the decade, the US still barley got the current account back into balance. The patsies then were the Japanese who embarked on policies to boost domestic demand that ended up with housing and equity bubbles, the hangover from which we call ‘Japanification’. Maybe it was all worth it to ‘win’ the Cold War, but the strong dollar of the mid 1980s was a product of US fiscal and monetary policy far, far more than it was the result of anything that anyone else was doing.  

From a policy perspective, the US solution to its problem is the same as the one facing others when they find their exchange rates in the wrong place because of US policy. Global interest rates and bond yields are correlated and the US, because it has enjoyed stronger growth than other major economies, has higher rates and higher yields than others too. And so it has a strong currency. This is exacerbated by easy fiscal policy. If the US wants a weaker dollar (and a smaller current account deficits, for that matter) it needs tighter fiscal policy and easier Fed policy, dragging US yields down to everyone else’s levels. If it wants to run domestic policies with no regard for anyone else, as it has always done, it may find out that like everyone else, it can’t go on doing that for ever. And if we find out that the US economic out-performance is unsustainable in a joined-up global economy (one that is suffering from a trade downturn as well as self-inflicted harm in the UK and the Eurozone)  then we may indeed find that the next trough in US rates and yields is lower than the last one and not that dissimilar to what other major economies are already seeing. 

Sunday, 11 November 2018

11-11-11 2018. George, Thomas and Roland.....

My paternal grandfather was the youngest of six children born to Ambrose and Henrietta Juckes. Ambrose was the son of a Shropshire farmer, who became a doctor and spent much of his working life in Horsham, in Sussex.

Ambrose and Henrietta's four sons were dispatched to King's Canterbury. The eldest, Ralph, went on to Cambridge and then signed up for the Royal Engineers. The second, George, went to St Bart's to study medicine and on to Cambridge before signing up with the Rifle Brigade. The third son, Thomas, finished school in the summer of 1914 and signed up for the Sussex Regiment. The fourth, Richard, was 16 years old when the war ended. He survived the war along with his two sisters and Ralph, who was awarded the Military Cross in 1916, by which time both his brothers had been killed in 1915  Richard was my grandfather and told me stories of long summers in the 1920s when he rode horses, played cricket and tennis. It seemed idyllic when described that way, but perhaps not so much for the broken-hearted mother of two dead sons.

Ralph and Richard both become schoolmasters and after the second world war, farmers in Gloucestershire. Ralph's eldest son, Roland, joined the Royal Engineers like his father, and was also awarded the Military Cross, in 1944, but died soon after the commendation was made. My father, eldest son of the youngest of the Dr Ambrose Juckes' sons, was too young to fight in that war, and so her survived and so here I am. A beneficiary of the good fortune to have a grandfather too young for the first war and a father too young for the second. My mother's father signed up for the first war by lying about his age and survived but that's a story for another day. My father had four brothers and between them, they had seven sons and eight daughters, none of whom have had to fight in any wars at all. Not that there haven't been wars and sacrifices since 1945 - but by their scale they haven't caused the same devastation to a generation of young British men as the two big wars did.

Nor has anything we have done since wreaked the kind of economic devastation that the two wars did. I enjoyed David Smith's column in the Sunday Times this morning. If you don't like the paywall here's the link to his webpage. Citing Nick Crafts of Warwick University, he writes... 

“Britain incurred 715,000 military deaths (with more than twice that number wounded) and the destruction of 3.6% of its human capital, 10% of its domestic and 24% of its overseas assets, and spent well over 25% of its GDP on the war effort between 1915 and 1918.” 

But, as he points out, this was only part of the effect, as “economic damage continued to accrue throughout the 1920s and beyond”. The Great War ushered in a period of high unemployment and high government debt, with the last of the latter not paid off until three years ago under George Osborne’s chancellorship. Government debt rose above 100% of GDP in 1916 and did not come back down below that level (having hit 259% of GDP in the immediate aftermath of WW2) until 1963.

100 years after the Armistice, 10 years after the start of the global financial crisis,  and 4 1/2 months away from our self-imposed exit from the European Union, I can't hep thinking that the lesson for policy-makers is walls that it's better not to absolutely mess things up, than to search for some impossible utopia.

These three share my name and my heritage and made sacrifices on my behalf long before I was born. So I won't forget them.

The memorial to Thomas Roland Juckes, next to Le Pont du Capitaine Juckes, in Bures sur Dives.

Sunday, 16 September 2018

Sunday, 25 June 2017

A change of plan? Random thoughts prompted by Tony Yates.

Tony Yates wrote a post on his blog on Friday- Balance sheet shrinkage: so soon?  - asking why the Fed is considering reducing the size of its balance sheet, while interest rates are still very low. People who spend their days staring at screens and messing around in financial market impact tend to think more about what policy-makers will do and what it will mean for markets, than about why they are doing something. Maybe shrinking the balance sheet is the lesser of two evils (the other being to go on increasing interest rates at the current pace in the face of low inflation. Or perhaps they just think the markets are in a good state to cope with them acting now, and it's just a pragmatic decision. But it does suggest that the Fed, at least, is still uncertain about the long-term implications of carrying a lot of assets on its balance sheet.

In the beginning, central banks' first steps into the murky waters of 'QE' were tentative. They clearly wanted to buy as much as necessary but as little as possible, frightened of long-term side-effects that they couldn't yet contemplate. The same was true of negative interest rates. But as time has gone on, we and they (the Fed et al) have started feel that we understand the impact of central bank intervention in bond markets little more. And yes, a little knowledge really can be very dangerous!

When the Fed first bought bonds, there was a flurry of research papers trying to gauge how big the impact would be on bond yields, particularly he yield on longer-dated Treasuries. Disentangling the relative importance of the bond-buying from the accompanying (super-low) interest rates, along with the longer-term economic consequences of the financial crisis (modest growth in GDP, low wage growth and below-target inflation inter alia) was never going to be straight-forward.  But it's been easier for the sell-side research community to get its head around what bond-buying meant for the yield spread between government debt and the other bonds that investors were being crowded into.  These three charts, posted on twitter over the last few weeks from research reports written by BofA Merrill Lynch and Citi's Matt King, sum up the state of thinking.

 1) The net supply of bonds to the private sector investor universe has dwindled to almost nothing, if central bank buying is subtracted. A disaster if you are trying to get some decent yield into your pension portfolio, a recipe for investors to go hunting in ever more exotic places in their search for yield. Hundred-year Argentina bonds anyone?

2)  A similar story from Matt King -  if the Fed stats selling, global bond issuance goes from just below zero in 2016, and a few hundred billion dollars in 2017, to $1.5trn in 2018.  And in the third picture, which is a blow-up of the top-right chart in the second, you can see the conclusion he reaches: less buying of bonds by the Fed et al is bad for corporate bonds and implies wider spreads.

Note that these aren't just charts of Fed bond-buying. They show global asset purchases, and maybe that too plays a part in Fed thinking: If what markets are sensitive to is the collective actions of central banks, maybe it's better to be first to shed excess assets, rather than waiting for the ECB, BOJ and Bank of England to join in, by which time any impact on credit spreads (and on absolute yields) will already be being felt and Fed action would exacerbate it.

I also think it's interesting to consider that the actions of the Fed affect markets differently than the action of other central banks. The next chart highlights the challenge facing the ECB and comes from their latest Economic Bulletin showing the impact of ECB bond-buying on various investor communities.

The ECB estimates that the Eurosystem owns EUR 1.1trn more government bonds than they would have otherwise, as a result of activities between March 2015 and march 2017. A little more than half of that has come as a result of crowding out European banks and investors, and a little under half has come as a result of crowding out foreign investors. It doesn't take a huge leap of faith to conclude that where the main impact of goal bond-buying globally (and Fed buying in particular) has been on credit spreads, the impact of the ECB being has also been felt in the currency market, as foreign investors were squeezed out of euro-denominated  assets (and Europeans were squeezed out of euros, for that matter).

Where does that leave me, as I ponder Tony's question - has the Fed changed its plan and if so, why? Tony's implicit conclusion is that the Fed has changed its plan and he suggests hostility from politicians as a possible reason. Two more spring to mind if I think the Fed is, in part, simply being pragmatic.

Firstly, they might have changed course because the possible effects of running down the balance sheet - somewhat higher longer-dated yields, wider credit spreads, and maybe a knock-on to equity markets -  would suit them. In a world where they face criticism for raising rates at the same time as they make little or no progress towards hitting their inflation target, maybe it's easier to shift attention slightly to the balance sheet. They always wanted to normalise it, and there's reasonable evidence that buying bonds has distorted asset markets. So why not do so that at a time when credit spreads are tight, global bond market are buoyant and the equity market is making new highs? Secondly, they'd much rather be the first major central bank to run down its holdings, than the last. Better not to sell into a crowded market.

The ECB faces a different problem. Concerns about the euro rising as they back scale bank bond-buying, just as it fell when they instigated the programme, seem hard to get around unless they just opt not to taper, and not to even think about thinking about raising rates.

Monday, 17 April 2017

Ben Bernanke and the case for lower for even longer

Michael Kiley and John Roberts, two Federal reserve economists,  have produced a beautiful paper on Monetary policy in a low-interest rate world which in turn prompted ex Fed Chairman (and easy policy champion par excellence) Ben Bernanke to write not one but two articles in Brookings last week:  How big a problem is the zero lower bound on interest rates? and The zero lower bound on interest rates: How should the Fed respond?

Mr Bernanke's man points can be summed up with a few quotes:

Using econometric models to simulate the performance of the U.S. economy, Kiley and Roberts (KR) find that, under certain assumptions, in the future short-term interest rates could be at zero as much as 30 to 40 percent of the time, hobbling the ability of the Fed to ease monetary policy when needed. As a result, their simulations predict that future economic performance will be poor on average, with inflation well below the Fed’s 2 percent target and output below its potential.

One potential solution to this problem, suggested by leading economists like Olivier Blanchard, is for the Fed to raise its inflation target.....There are, however, some reasons that raising the Fed’s inflation target might not be such a good idea....Another alternative would be to try to implement the optimal “make-up” strategy, in which the Fed commits to compensating for the effects of the ZLB by holding rates low for a time after the ZLB no longer binds, with the length of the make-up period explicitly depending on the severity of the ZLB episode. KR consider several policies of this type and show in their simulations that such policies reduce the frequency of ZLB episodes and largely eliminate their costs, while keeping average inflation close to 2 percent. 

The basic premise of the Kiley/Roberts paper is that if the 'neutral' real interest rate is as low as 1% (which is broadly what most analyses conclude), then the neutral nominal rate with a 2% inflation target is 3%. And if neutral rates in minimal terms are at 3%, rather than, say 6%, then the chances that rates ought to be below zero at some pint in the economic cycle are high. which, in turn, causes a huge problem if the zero lower bound makes getting inflation back up to target in economic downturn harder. And that means that there's a bias, with a risk that inflation will be below target more frequently and output below potential more frequently, risking a vicious spiral as the central bank fails to get output back on trend. Hence the Bernanke solution - a deliberate policy of keeping policy to easy into an economic upswing, temporarily ignoring upside inflationary risks. 

This is interesting because it seems (to me, anyway) that this is exactly what current fed policy looks like. Old-fashioned measures of a potential output suggest that with the economy at or close to full employment (the weakness of wage growth notwithstanding), there isn't much slack left. So rates 'ought' to be headed to neutral (3% in nominal terms) pretty briskly. And yet, while the FOMC 'dot-plot' does get to 3% 'in the longer run',  insouciance at the market pricing which undershoots the dots, and the tone of Fed commentary, both suggest that there is a deliberate bias not to rush. 
Measures of neutral real rates (mind you, however we look at them we're a long way below neutral). 

I have one fundamental issue with the whole argument however, and that's the idea that potential output is in some way related to inflation in the shortish-term. Downward-pressure on inflation from globalisation and more recently from technology,  means that 'potential output' needs to be thought of in terms that go beyond 'non-inflationary output'. 

This means that if measures of 'neutral' rates are trying to be consistent with steady low inflation, they will be inconsistent with wider stability, in asset prices, in the balance of payments and in debt levels in particular. Of course, that brings me back to Claudio Borio and the importance of a financial stability-oriented monetary policy framework. 

Two slightly more market-related conclusions are firstly that despite the BIS' work, and in contrast to other central banks, the Fed still has a bias deep within its core, to favour 'lower for longer' policies, and secondly  that the dollar's previous major bull markets have come when real rates in the US have been well-known above all measures of r*. To say that's not the case at the moment would be a huge under-statement. 


Saturday, 1 April 2017

The rise and rise of debt, correlation and commotion

The rise and rise of debt, correlation and commotion

Trilemma/dilemma + The Second Machine Age  + Financial Sector Drag vs Secular Stagnation  =

If economics is perceived as a dismal science then the onus on economists is to make it less so.
If I could only persuade my teenage children to read one book, one magazine article and one slide-show of a speech in order to pique their interest in the subject, I'd have them read the Economist on Helen Rey's Trilemma, look through the slides of Claudio Borio's speech to the NABE a few weeks ago, and then settle down to read Brynjolfsson and Mcafee's "The Second machine Age" over the Easter holidays.

The chart captures the whole of my career, which started after I left university in 1984. Lower and lower real interest rates, higher and higher debt levels.

Professor Rey argues, convincingly, that in today's connected global economy, if you have relatively free capital flows you can't have monetary independence whether you let you exchange rate float freely or not.  She observes, in the process, that asset price movements are correlate and are to a significant degree a function of the policies of the US Federal Reserve. Put it another way - Fed policy drives all markets, and increases asset correlation as well as leading us to a world where risk is either 'on' or 'off'.

Claudio Borio makes the simple observation that monetary policy which is consistent with equilibrium in the real economy but not in the financial sector, isn't an equilibrium interest rate at all. This is so obviously true it took a genius to point it out. If interest rate-setting central banks are only judged by a mandate of an inflation target and an economy at full employment,  they may have a tendency to set rates at levels which allow the kind of ever-upward march in debt levels seen in the chart. If they took the idea of financial stability seriously, they would set policy differently, but it's not directly part of their mandate and as we can all see at the moment, fear of too-low consumer price inflation is still delivering interest rats that risk increasing global debt.

The Second Machine Age is just a great book in its own right. But it does help explain why low unemployment might not be associated with wage-induced inflation and indeed why inflation might stay low regardless of where interest rates are set by the Fed, the ECB and any other central bank.

If technology is the main driver of subdued wage growth and inflation; if US interest rates are set at levels to keep inflation down when it's down anyway; and if the rest of us import Fed policy through the global finance system, then we can just get used to asset price volatility being depressed, asset prices being hyper-correlated, debt levels going up and the profit share of GDP in most countries. marching slowly higher. All with sporadic episodes when markets that can't adequately price risk are exposed to sudden re-pricing on (often politically-inspired) surprises.