FX markets always have a narrative. Right now the obvious one is that strength of the $ can be attributed to a simple relative interest rates model, so it’s all about the Fed. But they may also be telling us that the spike in prices is less worrying for markets than the spike in volatility which is forcing deleveraging across fixed income and alternatives – and thus the bid for $ may reflect distress. It may also be warning us that the Fed may be targeting a negative wealth effect (and hence markets). Furthermore, the scale and the timing of the sell off in currencies may also be alerting us that Russia has created a new Petro Currency, with the Ruble the best performing currency in March, with longer term implications for markets. The longer momentum works to drive direction in FX markets, the more of these narratives will appear and spill over into other markets

Foreign Exchange (FX) markets are the ultimate of what we call ‘Noise Trades’. As explained in the about page on Market Thinking, their bread and butter is to use huge leverage to take a position and then create a ‘narrative’ to pull others into the same trade for a short term ‘turn’. The more momentum that develops in the trade, the more compelling and ‘true’ the narrative is assumed to be. Right up until it isn’t and the momentum, as well as the narrative, flips. As previously observed, the narrative is the most compelling when the last trader is ‘in’, leaving the public regarding the markets as ‘mad’ when they no longer follow the ‘obvious fundamentals’.

As such, while it pays to be aware of the narrative, we need to watch the momentum much more and, importantly, be wary of allowing the narrative to infect other (non FX) markets. There is often an important message from the FX markets, but it is rarely just the one you are being given at the time.

Narrative 1. It’s US Rates

The simplest explanation for the recent strength of the $ is that the Fed is tightening rates at the short end and yield hungry institutional investors are selling Yen and Euros and buying short dated Treasuries. Certainly the visuals suggest correlation – if not causation.

US Short Rates attracting overseas flows?

There is no doubt that for long periods in the past, the yield hungry Japanese investors have tended to chase the $ higher when relative rates are rising and vice versa. We also show the Euro (inverted) where, with still essentially zero rates at home, yield hungry European investors may well also be chasing short rates in the US.

As such, the simple message is that the higher the inflation print and/or the stronger the US economy, the more aggressive the Fed will be, but that they will back off if the inflation rate falls. We are not so sure. The fact that the Fed are saying they are now tightening to stop inflation by aggressively slowing an economy which they believe to have been ‘over-stimulated’ when in fact the inflation we are seeing it is more likely to be a result of the Covid policies first disrupting supply chains and then releasing pent up demand, is, to us, the biggest risk markets face at the moment.

A policy that for years focused on maintaining a positive wealth effect (for the 1%) that only created inflation where that money creation was going – ie the financial markets – is now being flipped on its head as a combination of a recovery from artificially suppressed demand and policy induced supply constraints has produced a record spike in commodity prices. There is a very real risk that the Fed stick with their models and now actually target a negative wealth effect, i.e keep tightening until they get a collapse in the S&P500. The evidence of the death of the Fed Put would seriously unsettle markets.

The current strength of the $ against everything may well then be a ‘least ugly’ contest in terms of economic fundamentals, the message the FX market may be telling us is that far from rates rising meaning there is too much growth, the growth is already slowing, fast, but the Fed are going to keep making cash more attractive until the stock markets fall.

Narrative 2: It’s about widespread deleveraging across Fixed Income and Alternatives

However, the size and strength of the recent moves in FX suggests that there is also something else going on. Sharp moves in FX like this suggest forced buyers, or distressed sellers and it may be that the FX market is telling us that the continued uncertainty in markets – centred on Ukraine, but also fueled by China’s renewed quixotic and economically destructive pursuit of zero Covid – is leading to some significant deleveraging across international markets.

As previously noted, strict risk management tools mean that many institutional investors are simply not allowed to hold volatile assets any more, making them forced sellers when volatility rises – as it has done recently for both commodities and bonds. To the extent that these positions are leveraged (as most of them are, hence the strict volatility limits), then most likely they are funded by a short US$ position. It follows then, that ‘offshore’ leverage being closed down creates a ‘bid’ for the $. As such, the FX markets may be warning us of some distress and deleveraging.

Chart 1. Everything weaker against the $ suggests closing US$ funding positions across the ‘alternative’ space.

(Note that there are two groups; Euro and Sterling are quoted in $ per Euro or Pound, while the Yen and the Yuan are Yen or Yuan per $ and thus ‘weakness’ against the $ means the lines are going down and up on the chart respectively.)

For perspective, we have indexed the currencies to 100 a year ago, and thus we can see the Euro is 13% weaker, while the Yen is now 20% weaker against the $. Most of this has occurred in the last month, a lot of which we believe will be through balance sheet leverage being taken down, not just in fixed income, but across the whole ‘alternative’ space that has grown up under QE. The idea of a cross currency and a duration mismatch carry trade (borrowing US $ short to ‘lend long’ in Euros, Yen, Yuan or Sterling assets) will be causing a lot of sleepless nights. Equally, we have seen in the past that where, for example, there is $ debt offshore in China against onshore assets in Yuan, any move in the $ can be exaggerated by those $ loans being closed.

Narrative 3. It’s about Commodities

In the real world, there is also the issue of Commodities. Energy is still largely priced in $s and while spot prices have been gyrating wildly for oil, higher absolute $ prices for most commodities (especially gas) due to supply disruptions mean that overseas buyers need more $s to buy the same amount of any commodity, so the demand for and the price of $s goes up also. Commodity markets are used to the $ and prices being inverted because of the simple arbitrage in financial markets themselves – $ weaker, oil cheaper to non dollar consumers. However, as the chart shows, while Oil is up 39% year to date in $ terms (Gold line), converting into the Dollar trade weighted index (DXY) terms it is up 50%. Great if you were an investor, less good if you are a consumer and part of the reason the US is winning the least ugly contest.

Of course, while macro pundits talk all the time about the DXY, you don’t ever actually trade the basket, you trade the underlying crosses and while the Euro and Sterling price for Oil tracks the DXY pretty closely, we are focusing here in the chart more on the Yen and the Yuan.

Chart 2: The Oil price inflation depends on your currency

The Yuan has sold off in the last few weeks, but was broadly tracking the $, by contrast the sell of in the Yen has been dramatic and taken it to multi year highs (lows) against the US$. Here, the FX markets are telling us that the hit from rising commodity prices is going to be felt hardest outside of the US – and that by reacting to this by buying $s, FX markets are going to make things even worse.

Narrative 3. It’s about the Ruble

Not quite everything sold off against the $ last month, for as shown in chart 3 and we suspect it is no coincidence that the big moves up in DXY began at exactly the same time as the Ruble reversed aggressively from the earlier, dramatic, selloff that came in the immediate aftermath of the invasion and the accompanying sanctions.

Chart 3. Ruble Rallies, Yen sells off

Of course this turnaround came when Russia not only demanded that countries pay for their Gas in Roubles, but also declared in Mid March that it would be a buyer of Gold at Rub 5000 a gram, or around Rub 155,517 an ounce. Divide that by the price of gold and you get a floor price for the Ruble in effect, somewhere around 75, which is effectively where we have come back to. Note that the Russians have subsequently said they will negotiate rather than fix the gold price – Russia is a major gold producer, along with most other resources – but the job is now done. In effect the FX markets are telling us that Russia has created a new Petro Currency with a degree of Gold backing.

In effect, the last month has seen the Birth of the Petro Ruble, the best performing currency in the world.

This week, Putin was said to be ‘blackmailing Europe’ and ‘weaponising energy’ by ‘cutting off gas supplies to Poland and Bulgaria, but, once again, peering through the Propaganda, we see that he is simply enforcing previous demands for payment in Rubles. Cognitive dissonance is probably the best way to describe the EU leaders who are demanding that Russia sell them energy in return for Euros which, thanks to the sanctions would then immediately be frozen! Requiring customers of Russian gas companies to open an account with GazProm bank and exchange Euros for Rubles in order to buy gas keeps the Russian International Banking system open and makes the Ruble somewhat similar now to the Yuan as a semi convertible currency.

Narrative 4; It’s the mo, bro

FX are also momentum markets we should not forget and while there is plenty of (valid) narrative about why the Euro and Sterling should continue lower, as well as the Yen, the real reason they will go lower in the near term is that they are simply continuing their short term trends. They will keep going down until they stop – usually when everyone is convinced they will never recover. Past experience suggests that the interest rate and economic narratives will persist and remain largely negative and that this will spread into other markets in the near term.

Our model portfolios, whether analysed by Confidence Indicator or, inversely, risk levels, remain heavily skewed to cash at the moment.

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