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Market Update
JUN
2016
A Conversation about Currencies
David Cleary, CFA, Managing Director, Portfolio Manager/Analyst
Yvette Klevan, Managing Director, Portfolio Manager/Analyst
Aristotel Kondili, Director, Research Analyst
The last two years have been characterized by significant moves in foreign exchange (FX) markets. A key trend during this
period has been a consistent strengthening of the US dollar since mid-2014, which seems to be easing recently. On the
other hand, emerging markets currencies have suffered against the backdrop of a challenging environment in many of those
economies and capital markets. Investors have been especially surprised by the depreciation of the yuan. In terms of developed
markets, the euro and yen have been subject to fluctuations on the back of global monetary policy decisions.
We believe it is instructive for investors—whether stock pickers or asset allocators—to address some of the most relevant
questions in today’s FX markets, which we discuss in the pages that follow. David Cleary, from Lazard’s US fixed income
team and asset allocation platform, leads the discussion through questions posed to Yvette Klevan (Global Fixed Income) and
Aristotel Kondili (Emerging Income). For additional context see the “Key Indicators on FX Trends” on page 2.
David Cleary: F
or several years now, the US dollar has been king. Are we now entering a new currency
regime where the dollar strength is no longer the predominant trend?
Aristotel Kondili: US dollar strength, based on the US economy’s macro-fundamentals, has been highly disruptive for
much of the rest of the world; exacerbating weakness in commodities, tightening liquidity in many emerging markets, and
amplifying the strains on China’s de facto US dollar peg. In our view, the change in the US dollar trajectory has been driven by
three factors. First, the Fed has become more sensitive to US dollar strength, highlighting its contribution to the tightening of
financial conditions. While further rate hikes are possible, US interest rate support is likely to be diminished especially if the
rate-hiking trajectory proves to be short.
The second factor is the risk premium associated with China’s FX outlook. Fears of a one-off yuan depreciation caused most
emerging markets currencies to weaken early in 2016. The yuan has stabilized, though, and its risk premium has been priced
out of the options and forward markets. This has allowed emerging markets currencies to recover against the US dollar.
The final factor causing a change in the US dollar trajectory has been commodity prices. After over two years of weakness,
commodities and commodity-related currencies have seen a significant recovery so far in 2016. Brent oil prices have rallied 50%
from their January lows and iron ore prices have rebounded by over 60% to the April high and about 30% through 6 June.
Consequently, most of the top-performing currencies year to date in G10 countries and emerging markets are commodity
currencies, which have all rallied against the US dollar. In addition, the recent revealed preference of the European Central
Bank (ECB) for limited further policy rate cuts and of the Bank of Japan (BoJ) for significant further yen depreciation no longer
entails a strong trend in the US dollar.
Yvette Klevan: We expect more volatility and choppy trading within current ranges given the long list of global macro
risks—so no—the US dollar will not necessarily be king. Technical factors such as flows and liquidity will be as important as
fundamentals, but we believe commodity prices will continue to dominate currency movements, and oil prices are now trading
higher thus leading to a weaker US dollar. Furthermore, investors have tilted back towards a dovish Fed (softer US dollar) and
given strong US economic data plus inflation pressures building, we believe the recent US dollar weakness could reverse to some
degree in the second half of 2016—potentially a period of risk aversion.
LR26793
2
Key Indicators on FX Trends
Broad US Dollar Strength, 2012–2015
Return versus USD (%)
10
0
-10
-20
-40
2013
2012
-30
Japanese
Yen
Swiss
Franc
Chinese
Yuan
Indian
Rupee
2015
2014
British
Pound
South Singapore Swedish
Korean
Dollar
Krona
Won
Euro
Australian New
Mexican
Dollar
Zealand
Peso
Dollar
Norwe- Canadian South
African
gian
Dollar
Krone
Rand
Brazilian
Real
The US Dollar Has Generally Weakened in 2016
Return versus USD (%)
16
8
0
-8
Mexican
Peso
British
Pound
Chinese
Yuan
Indian
Rupee
South
Korean
Won
New Australian South
Zealand
Dollar
African
Dollar
Rand
Swiss
Franc
Swedish
Krona
Euro
Singapore Canadian Norwe- Japanese Brazilian
Dollar
Dollar
gian
Yen
Real
Krone
Historically, US Dollar Appreciation Has Subsided after Rate Hikes
Trade Weighted Dollar Index, 100 =Rate Hike Date
104
100
1999
96
2015
92
1994
2004
1986
88
-30
0
30
60
90
120
150
180
210
240
Days, 0=Rate Hike Date
Commodity Prices Dropped as the US Dollar Climbed
Index, 2 January 2014 =100
125
USD Trade Weighted Index
100
CRB Commodities Index
75
50
Brent Oil
25
0
Jan 2014
May 2014
Sep 2014
Jan 2015
May 2015
Sep 2015
Jan 2016
May 2016
Dates: Broad USD Strength, 31 December 2015; USD Has Weakened in 2016, 31 December 2015 to 7 June 2016; USD and Rate Hikes, 3 June 2016; Commodities Prices Dropped as
USD Climbed, 20 May 2016.
The information is not representative of any product or strategy managed by Lazard. The performance quoted represents past performance. Past performance is not a reliable indicator of
future results.
Source: Bloomberg
3
DC: F
undamentally, do all roads lead to Fed policy or are there other factors at play which determine relative
currency strength?
YK: The G4 central banks (Fed, BoE, ECB, and BoJ)1 are all important, but as the “central bank to the world,” it seems apparent that many
roads do lead to the Fed. Fed policy affects investor behavior related to many segments of the market, and perhaps most importantly, can
influence the direction of the US dollar. Over longer periods of time, there can be many factors which impact specific currency pairs; however,
we believe the recent weakening of the US dollar has largely been a function of a reversal of prior expectations for future Fed rate hikes and a
significant rally in oil and commodity prices.
AK: The FX markets are trading on the back of the idea that the Fed will avoid driving the US dollar significantly higher through aggressive
rate increases. Not only does US dollar strength tighten domestic financial conditions, but it has also exacerbated many of the problems
afflicting emerging markets currencies. US dollar strength increased the urgency for emerging markets corporates to hedge their US dollar
liabilities—especially in China, where capital outflows had already complicated efforts to manage yuan depreciation. Emerging markets FX
volatility aggravated global risk aversion, and the Federal Open Market Committee (FOMC) has become more sensitive to the feedback
loop of global market volatility back to the US economy. Even if the FOMC were to deliver a second rate hike in the second quarter of
2016, there is not a strong case to be made that the US dollar would rally meaningfully, as it did in the fourth quarter of 2015 leading up to
the first rate hike.
DC: T
he US dollar’s ascent relative to both the yen and euro appears to have stalled, in spite of increasingly
divergent monetary policies and rate regimes. Why do you think that is so?
YK: The euro and yen have shared the “safe haven” spotlight with the US dollar since the middle of 2015, and we expect this trend to
continue unless US interest rates move significantly higher diverging from Europe, Japan, and the rest of the world. Some potential reasons
for this trend include: unwind of the “carry trade,”2 as European and Japanese investors stop positions on riskier investments abroad and
bring the proceeds home; strong current account surpluses; and the end of the line for monetary policy expansion in both regions.
AK: Sizable output gaps in the euro zone and Japan should keep inflation and inflation expectations subdued and add to the pressure on the
ECB and BoJ to ease further, undercutting the demand for euro and yen. However, recently the yen has been helped by both risk aversion
and investors' belief that the BoJ has limited room to change the yen’s trajectory. That said, with risks to growth and inflation in Japan
still on the downside, the BoJ will probably announce more quantitative and qualitative easing (QQE) and a further rate cut into negative
territory ahead of the upper house elections in July 2016.
As the ECB shifts away from the FX devaluation channel towards direct easing of credit and liquidity conditions in the euro zone via credit
purchases and bank targeted longer-term refinancing operations (TLTROs), the net effect should still be negative for the euro. Also, the
long-term outlook should remain negative. Foreign demand for euro-denominated funding should intensify after the ECB starts corporate
bond purchases. The euro looks undervalued given the euro zone’s current account surplus but we are not seeing the flows that typically
support current account surplus currencies. Instead, foreign borrowers in euro are helping recycle euro zone excess savings abroad while euro
zone exporters seem to delay long-euro hedges.
DC: T
he yen and euro often strengthen during market sell-offs and periods of risk-off. This is counterintuitive.
Why is it so?
YK: Given the low and even negative yields in parts of Europe and Japan, investors are incentivized to borrow (short) euro and yen and
invest abroad—the carry trade. This strategy is very sensitive to volatility as daily movements in some currencies can eliminate the excess
yield advantage and therefore, as volatility picks up (very often related to risk-off periods), investors sell the higher yielding, higher beta
investments and cover their shorts (euro and yen). By extension, Japanese and European investors are investing their excess savings overseas
in an effort to find higher yielding alternatives. They typically repatriate (i.e., buy euros and yen) during periods of increased volatility. We
also respect the strong correlation between the yen and the Nikkei 225 Index, and downward pressure on the Japanese equity market has
also contributed to a stronger yen.
AK: Safe-haven currencies tend to have low interest rates, a strong net foreign asset position, and deep and liquid financial markets. Japan
and the euro zone meet these criteria. The yen reaction is the most evident of the two. The yen is widely considered a safe-haven currency
and one that appreciates when global investors’ behavior becomes more risk-averse or economic fundamentals are more uncertain. Risk-off
appreciations of the yen are driven by massive increases in financial inflows recorded in the balance of payments following spikes in the VIX,
as Japanese residents reduce their rate of accumulation of foreign assets and foreign investors increase their rate of accumulation of Japanese
assets (capital flight).
4
Since 2008, the yen has appreciated against the US dollar, in effective terms, in the aftermath of various shocks. A few examples of such
yen reaction function were evident recently. First, the global financial crisis was associated with a large real exchange rate appreciation of
over 20%. Second, in May 2010, higher market distress about peripheral European sovereigns led to a large jump in the VIX, followed by
a 10% yen appreciation against the euro within a matter of weeks. Third, following the Great East Japan Earthquake, the yen appreciated
further on account of expectations about sizable repatriation of foreign assets by insurance companies, which in fact subsequently did not
occur. These examples illustrate that appreciation of the yen during episodes of increased global risk aversion is recurrent. They also illustrate
why we believe that persistent yen strengthening due to safe-haven demand is troubling to the BoJ, as a weak currency is a key part of
Abenomics. This means that there is a much stronger reaction function out of the BoJ relating to their yen policy. The BoJ will continue to
cut rates and expand QQE to loosen policy and weaken the yen—our forecast is that the yen will reach 120 (yen per US dollar) by the end
of 2016.
DC: F
or some time now, emerging markets currencies have been under significant pressure. Chicken or egg…
is it a function of weak local economies and commodity weakness or are emerging markets economies and
commodities weak because of the strong dollar?
YK: We believe emerging markets currency weakness has been a function of deteriorating fundamentals (especially in the case of commodity
producers/exporters) and lack of structural reforms in certain countries. The strong US dollar puts pressure on countries that have increased
offshore debt issuance and are forced to manage the currency mismatch. De-risking by certain sovereign wealth funds has increased flows
and liquidation, exacerbating the price movements. The overall slow global trade environment is weighing on all countries, but especially on
emerging markets.
AK: If we examine correlations, in the midst of the US dollar rally between June 2014 and the first quarter of 2015, the US dollar rallied
against almost all currencies at the same time that global risk assets (equities) were rallying. This was true for the US dollar against both G10
and emerging markets currencies. Recently, though, these correlations have changed. Rallies in risk assets are now being associated with
US dollar weakness against emerging markets FX—especially Asia ex-Japan. This change in US dollar correlations is an important sign of
stability in risk sentiment. Investors are more likely to embrace emerging markets FX and commodity-related FX during times of positive
sentiment. The implication for the US dollar is that the days of broad-based gains against all currencies are behind us.
DC: Is the recent reversal in EM currencies sustainable?
YK: We believe that more volatility is to be expected. The recent risk rally benefiting emerging markets currencies was likely based more on
capitulation of overstretched valuations rather than fundamental improvements. Looking forward, the emerging markets currency landscape
is mixed, presenting tactical opportunities for positioning on a selective basis.
AK: Emerging markets currencies are, on average, undervalued on a trade-weighted basis. They are not as undervalued as during the early
2000s but neither are they as expensive as they were during 2010–2013. Moreover, outside of Japan and Europe, we have a dovish Fed (US
dollar negative), good US data, a rising US equity market (risk positive), and stability/rally in commodities (good for commodity currencies
and local markets). That does not leave much for the US dollar to rally against. Financial markets focus on the second derivative (the change
in the rate of change)—emerging markets GDP growth has been weakening in tandem with commodities and emerging markets currencies
and equities. The current account surplus and GDP growth advantage of emerging markets over developed markets has been shrinking year
after year, but both should potentially stabilize or even slightly improve this year.
DC: What about China? Is a managed depreciation of the yuan inevitable?
AK: The new emphasis on a trade-weighted basket approach for the yuan’s “soft peg,” combined with China’s existing capital controls,
should reduce one-way expectations (in either direction) for the yuan. This should help to limit outflows, which were a headache for
policymakers in 2015—net outflows reduced domestic money supply, forcing policymakers to cut the reserve requirement ratio (RRR)
to counter this effect. Policymakers have now adopted a clear pro-growth stance, which was underscored at the recent National People’s
Congress (NPC) meetings.
Going forward, we believe China’s authorities should be able to continue to maintain a soft peg for the yuan’s trade-weighted value, at an
index level of around 100 for the new China Foreign Exchange Trade System (CFETS) effective exchange rate (EER) index. This is the level
of the yuan’s trade-weighted value that prevailed at end-2014 and is likely not too far from what the IMF judges as “fair value” for China’s
currency. While the index has fallen almost 2% below this level in April–May, it could likely be a tactical move by the authorities to allow
some of the broader US dollar weakness to spill over into the CFETS EER. This creates space for the yuan to rebound modestly in tradeweighted terms (in a mean-reverting move back to 100 on the index) as expectations of Fed policy tightening rebuild.
Market Update
YK: China has been carefully managing the valuation of their currency. Chinese authorities are very focused on creating more “two-way
flows” because they are most concerned with the outflows in recent years, which have been overwhelming any inflows. Reserves spent
to defend the currency may have peaked, and policymakers will look for other ways to manage or stabilize the yuan such as through the
(contentious) inclusion of local bond markets in widely used bond indices, which would not only bring in “passive” flows but also diversify
their investor base.
Conclusion
Over the past several years, the US dollar’s strength has been so predominant that many investors have completely discounted it. Yet today,
it appears as if fundamental data and trends appear to be more mixed and continued dollar strength is not assured. Negative interest rates
in Europe and Japan as well as a dramatically changed picture in commodity markets complicate foreign exchange markets and will likely
lead to less visible, more volatile trends. In our view, active fundamentally driven viewpoints will be required in order to navigate this new
currency paradigm.
This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management.
Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a
robust exchange of ideas throughout the firm.
Notes
1 BoE = Bank of England, ECB = European Central Bank, BoJ = Bank of Japan.
2 Carry trade definition (Bloomberg): A strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a
higher interest rate.
Important Information
Published on 16 June 2016.
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