In-depth Analysis

What does it mean for traders when two reserve currencies post double-digit percentage losses?

FX traders, especially those that focus on the majors, tend to think of an average market move as being in fractions of a percentage point. Even a volatile pair like AUDUSD rarely moves by more than 100 basis points within a 24 hour period. 

For example, over the last three months, we have only seen 11 out of 65 trading days, where the AUDUSD pair moved by more than 1.0%. 

Though that said, on 6 of those occasions it moved by more than 1.50%. 

So when it does move outside of normal bounds, it moves rapidly.

The Aussie dollar is a commodity currency at heart and a play on Asian trade and commerce, and trade with China in particular. But it has only weakened by 8.0% versus the US dollar over the year to date. 

Whereas the euro, the world’s second-largest currency and theoretically one of its most stable and liquid trading instruments, has fallen by -13.64%, against the greenback year to date. 

In any other year that move would probably be the major talking point within the FX markets. However, in 2022, there is a challenger for the title of most discussed FX rate and that is dollar yen or USDJPY. 

The yen has weakened by -19.0% this year against the dollar, and though it hasn’t had as much intraday volatility as AUDUSD over the last three months. It has traded lower on 43 out of the last 65 trading days. Clear evidence if any were needed that it is in a sustained down trend.

For its part, the euro has lost ground versus the dollar on 35 out of the last 65 trading days.

That’s meant that the single european currency has traded below parity with the US dollar this week, whilst dollar yen is banging on the door of 140,with the yen making new 20 year lows against the US currency.

Why is this happening?

The obvious answer is dollar strength. The US dollar index is up by 13.43% year to date and by 17.46% over the last 52 weeks. Of course that doesn’t tell us the whole story. 

The dollar is a safe haven currency, but then historically so were the euro and the yen. The real answer lies with our old friend monetary policy divergence. 

All charts are from Trading Economics

 

For years one of the major drivers of FX rates was interest rate differentials. 

Both in absolute terms and in terms of their direction of travel. The rule of thumb being that the currency with the highest rate of interest, would be the stronger of the two, in any pair or cross.

That rule was supported by the movement of international capital, which flowed to wherever it would receive the highest return, for a proportionate amount of risk. But when interest rates around the globe, or at least within the major developed economies, were at zero there was little to differentiate between currencies on that basis.

However as we can see in the chart above that is no longer the case. 

Whilst rates in Europe and Japan are at or below zero, those in the USA are sitting at +1.75% and are set to climb higher from here, with Fed funds futures pricing in an 83% chance of a +1.0%  US rate rise when the Federal Reserve governors meet in two weeks time.

Earlier in the year I wrote about the challenges that the Japanese economy faces. 

See  The continuous freefall of the Yen  and four months on nothing has really changed. In fact the BOJ’s refusal to defend the currency has probably made things worse, as continuing yen weakness is driving up the prices of imports such as food  and fuel 

The ECB on the other hand is wrestling with a different set of problems namely that a common monetary policy doesn’t work across the disparate states of of the Eurozone. 

One size does not fit all and no two economies within the monetary union are the same, added to which their is little or no alignment on fiscal policy and funding among its members.

That means that we end up with charts like this 

And this 

Both the inflation chart and the chart of 10-year bond yields (a proxy for the borrowing costs of nation states) demonstrate the fragmentation within the Eurozone. If there were truly a single market in Europe then that shouldn’t be happening.

However the Euro is only 50% of the pie as far as European integration is concerned and while that’s the case then its value will reflect the uncertainty surrounding the future of the EU as a going concern.

Germany was once the backbone of the EU and the Eurozone but its economy is in disarray  and there are genuine prospects of energy shortages this winter, under which industry would adopt short working weeks.

In the chart below we see how Germany’s balance of trade has fallen as energy prices and inflation have risen. As with Japan a weaker currency makes exports cheaper to foreign buyers, but it also drives up the cost of imports, of which energy is major component. 

It’s hard to imagine that there will be a happy ending here, particularly while the war in Ukraine continues.

 

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