This spring, just after Russia’s invasion of Ukraine, Washington’s Institute of International Finance made a bold and idiosyncratic prediction: the euro was about to weaken dramatically from its $1.11 level because the region was heading for a current account deficit.
Not many investors agreed. Data from the Commodity Futures Trading Commission suggests that there was a net “long” speculative position in the markets then — in other words, investors were betting the currency would strengthen — because the European Central Bank was raising interest rates.
But the euro is now worth $0.98, and Europe’s traditional trade surplus has indeed turned into a current account deficit, due to the soaring cost of energy imports and falling industrial exports.
The IIF’s projections about sterling have been equally prescient. In recent months, Robin Brooks, IIF chief economist, has also warned that the pound looked overvalued at its then $1.35 level, since markets were ignoring that the UK current account deficit had quietly risen above 8 per cent, from the 3 per cent levels seen in recent years.
This week the British pound duly crashed to near-parity with the dollar, after the UK government unveiled a surprise tax-cutting plan. “These moves [in the euro and sterling] aren’t irrational or overshooting,” argues Brooks. “The fair values of both have shifted to reflect higher energy costs and far weaker trade balances.”
Indeed, Brooks thinks that at present levels “the euro is still 10 per cent overvalued [and] the pound is 20 per cent overvalued”. Yikes.
Moreover, his model suggests that the Turkish lira and New Zealand dollar are also overvalued (by 15 and 22 per cent respectively), while the Chinese renminbi, Brazilian real and Norwegian krone are undervalued by 11, 13 and a whopping 47 per cent.
Investors should take note. Some foreign exchange analysts might mutter that this type of analysis looks very retro. Economics 101 has always argued that current account balances affect currency values because they determine the degree to which a country has to attract external financing.
However, the trading models used by asset managers in the recent era of ultra-loose monetary policy have typically focused on other issues shaping capital flows. Relative interest rates, say, have tended to dominate debate, particularly since investors have been engaging in carry trades (borrowing cheaply in one currency to invest in higher-yielding assets in another).
And “the carry trade has had a sudden resurgence in performance”, as the GMO group recently noted. (The fair value models it uses, which give less weight to current account balances, imply that sterling and the euro are under — not over — valued.)
Then there are the issues of political risk and safety. The IIF’s 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 American capital markets — and currency — has made it a safe haven.
But while the behaviour of the dollar shows that it is a mistake to treat currency analysis as anything other than an art, not a science, the sterling saga shows something else: it is even more dangerous to ignore economic gravity.
After all, arguably the best way to frame this week’s sterling crash is to think of the Wile E Coyote cartoon character. Just as that animated figure runs off a cliff and keeps peddling at the same height — until he looks down and panics — investors have spent most of the year acting as if the pound were destined to stay elevated, because they trusted British policymaking and rising UK rates. Now economic gravity has taken hold.
If you believe in the mean regression principle which underpins many trading models — that asset prices eventually resort to a recent mean after a wild swing — then it is possible to hope that sterling’s slump will be temporary. But if you think that an 8 per cent current account deficit puts the UK in a new era, past models may not apply.
Either way, investors should ponder if there are other places where a reckoning might occur.
The IIF chart highlights strains 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 is because interest rates were ultra-low.
But now rates are rising and the fiscal burden in many countries is soaring amid energy subsidies and pandemic spending (and, in the UK, unexpected tax cuts).
There are also signs that investors are getting more nervous: quite apart from this week’s visible Treasury and gilt market tensions, JPMorgan reports that global investors now plan to allocate a mere 17 per cent of their portfolios to bonds. This is a remarkably low level, given they have been overweight for the past 14 years.
This does not mean that investors should panic. But they should ask themselves why they ignored the data in charts such as the IIF reports for so long. Sometimes economic gravity matters. Cheap money will not always keep Wile E Coyote afloat.