The milkshake is curdled

Published: Fri 06 January 2023
Updated: Fri 06 January 2023
By steve

In Markets.


Currency commentary

Money is a complicated thing. Ratios of values of complicated things are … doubly complicated. There is no shortage of economic literature on what FX rates should be, but no economist ever got rich by using economic theory to position his FX exposure.

Well, possibly Keynes actually did. As I understand it, he positioned himself in anticipation of countries going off the gold standard. He knew a lot about the pain that a country suffers from fixing its exchange rate to gold, or to that of a economy which is not closely coupled to the country of issue, but Keynes was operating a lot time ago, and all tradeable currencies now are freely floating.

It’s not that the theories do not have a lot of validity. It’s just that the market rates largely reflex the entirety of the observable factors that feed into an FX rate, for example the terms of trade: the relative movements of prices in the two countries (specifically, the import and export prices). For example, if gold trades for $150 an oz. in the USA and £100 an oz. in the UK, and gold can be freely traded between the two countries, it’s a good guess that the price of one GBP will soon reach $1.50. But the real world is a lot messier than that.

Recent commentary focusses on how the dollar is strong, because the Fed is hiking more aggressively than other central banks, and so commodity prices are being trashed. Well the following chart shows that this simply hasn’t been the case since the end of Sept 2022.

DXY The dollar has been relatively weak, on a trade-weighted basis, and yet commodities have not rallied. The dollar is going down. If I were paid anything to explain this, I’d attribute it to the Fed’s tightening cycle being ahead of other central banks, resulting in an expectation that US rates will peak sooner than Eurozone ones, for example. Because I’m not, I can admit to complete ignorance. But the chart about does have the look of a trend that is going to continue down for a while. A country like the USA has powerful corporate lobbyists. I’m pretty certain that they just love the direction in which the dollar is heading, and that the Fed is not unaffected by politics, however much it protests that it is not.

For what it’s worth, I rather like the look of South American commodity currencies, such as the Mexican Peso or the Brazilian Real. These countries have been burned by severe inflation in recent memory, and have responded quickly to kill it. Rates are high, but sustainable, and with commodity prices likely to rise as inflation continues to rage in the West, they must be worth a look. NOT INVESTMENT ADVICE.

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