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I visited the FXWeek North American conference across the street from my office. It is interesting that the issue of FX as an asset class is still being discussed as a topic. This issue just will not go away. While I think of it as an asset class, there are still many who are skeptical; nevertheless, we can change the focus from asset class to factors and then foreign exchange becomes more unique and useful. If the idea is that you would like to buy unique investment factors, currencies are good place to gain return and diversification.  In fact, some of the well-known factors that are applicable in equities or fixed income also apply to currencies but with a different return profile uncorrelated with other asset classes. What are the factors that can be the focus of foreign exchange? The usual suspects apply to foreign exchange - carry, momentum, value, and volatility. Exploiting carry in FX is different than in the fixed income markets. It may be related to global risk but it has...

What drives the FX markets? This is a critical but complex issue for any investor who needs to look at this asset class. The usually approach is to develop a model with a some key fundamental factors like rates, inflation, or money and then see what the reduced form empirical relationships show significant relationships. However, this problem can be looked at with a more primal lens through the use of principal components. Using this approach, it is possible to determine how many common factors may drive currencies. Researchers have found that there are two principal components that can drive these markets. See "Common risk factors in currency markets"  by Lustig, Rousssanov and Verdelhan . The main first principal component can explain about 70% of the variation is related to risks versus the dollar. These are the usual risks investors often thing about with respect to currencies. What is more interesting the second principal component that seems to do a very good job of exp...

There is a long tradition of believing that exchange rates cannot be forecast with economic fundamentals. The power of fundamental models to beat a random walk always been poor albeit trend and carry models have proven to be successful. A new research paper from the BIS, "When the walk is not random: commodity prices and exchange rates" , suggests that currencies that are highly tied to commodity exports do not follow a random walk but are closely tied to the market prices of their exports.  There have been researchers who have tried to look at commodity prices and currencies but have not done the careful work of creating country-specific indices that reflect their exports and thus their terms of trade. When country specific indices are created there is a forecasting link at short-term horizons that extend out to two months. You can track these export weighted commodity price indices and be able to do better than a random walk.  More importantly, these forecasts do better...

There is a long history of showing that tracking trends or sorting by momentum in currencies will lead to good return performance.  Trends are viewed as one of the three key drivers for explaining currency returns along with carry and fundamental value. Currency returns are tied closely with the short-term interest differential or carry, deviations from fair value as measured by some variation of purchasing power parity and past return performance. The view is that fundamental models have done poorly in these markets so using price-based systems is the best way to extract returns. A new study shows that currency returns are tied to trends in economic fundamentals. Put simply, the trend in macro variables will lead to price trends. This makes perfect sense in the trend-follower's world, but they choose to focus on price and not worry about the fundamentals. The choice of which economic variables to follow may be problematic. Instead, prices are viewed as primal to the process. What ...

New Zealand dollar action is a canary (kiwi) in a coal mine. The central bank lowered rates by 25 bps to 2.25 percent which led to an immediate sharp currency decline. The currency has bumped up against a ceiling over the last few months and is now back in the middle of its range since the fall. Last spring and summer the NZD was declining based on potential Fed action.  As a small open economy that is tied to commodities and Asian trade, the NZD cannot afford to have an appreciating exchange rate. Interest rate action will have an immediate effect on exchange rates. The currency had appreciated about 4% since the central bank's December policy meeting projection.  Lowering rates is just a further sign that open economies have to take action versus the negative rate countries or face declining exports, rising currencies, and slower growth. The negative rate countries like Japan are exporting their deflation problems to the rest of the world. New Zealand just acted in a manner ...

Most investors have likely past over the stories on the IMF's inclusion of the Chinese Renminbi in the basket for SDR's. The change in SDR weights will take effect next year. This is boring stuff for even some specialists in international finance, but in reality, it is going to have a great impact around the globe. SDR's are a supplemental international reserve asset which is allocated to IMF members in quotas as an alternative reserve asset to dollars, gold or other currencies held by a central bank. It is used as the IMF's unit of account and as method of payment across central banks. To be considered as a member of the SDR basket sends a clear signal to the financial world that you are an important currency in the global marketplace. To be a member of the basket, an currency has to be "widely used" and "freely usable". As the largest exporter in the world, the Chinese currency is widely used and notable in trade discussions. The second criteria of...

December will set the tone for the direction of the dollar in 2016. The ECB will meet this week and there is a high likelihood that it will increase the scope of their QE program. They are preaching the QE religion like a camp revival although there are some side comments of doubt whether monetary policy alone will be enough to help the economy. The Fed will then have its FOMC meeting which will likely announce an increase in the Fed funds rate. Any uncertainty will be with the language used and the expectations of further increases in 2016.  The differentials between longer rates between the EU and the US are at the highest levels since the introduction of the Euro. Clearly, there is little to stop the dollar from going higher especially with European rates negative for maturities out a few years. There is no reason to hold a Euro fixed income asset. We further expect that the BOJ will have to rethink their policies given Japan is back in a recession. The PBOC has been loosening r...

One of the key themes in 2015 has been the decline in the foreign reserve stockpile by EM central banks. EM central banks have been selling to help support their currencies from a free fall that will lead to private capital outflows. These banks added to reserves to stop exchange rates from rising in the period from Asian crisis until this year. They are now engaged in what some are calling "quantitative tightening". There have been good arguments that suggest that there is no quantitative tightening effect in the sense of being the opposite of QE, but there will be spill-over with global credit.  With the Fed deciding to raise rates perhaps at the December meeting, monetary liquidity will be the  key issue in 2016. The ECB is likely at their next meeting to flood more money in the system. So we will have EM central bank foreign reserve effects which will spill-over to EM domestic markets and DM QE and rate effects which will also spill-over to global credit and exchange mark...