Capital Flows Outstrip Trade Flows and that is Where to Look for Drivers of FX

Policymakers have often said that exchange rates should reflect fundamentals. What does that really mean? Can they do anything but that? It begs the question of which fundamental factors they should reflect. Therein lies the rub. 

We are still struck by the latest Bank for International Settlements figures. Their survey found that the average daily turnover in the foreign exchange market was $7.5 trillion a day. World trade last year was about $22.5 trillion. The foreign exchange market sees that every three days. Nevertheless, many still see trade as the factor that exchange rates should bring into balance. Many observers are surprised when the Chinese yuan depreciates, as it has this year, despite a huge trade surplus ($730 bln through October, a 43% increase from the first 10 months of 2021).

At the same time, most accounts of the dollar's strength since January 6, 2021 (yes, that January 6 when the Dollar Index bottomed and the euro peaked) say little, if anything, about the US trade deficit. Through September this year, the deficit was nearly $746 bln (up from $620 bln in the same period last year). Instead, the dollar's strength seems most often attributed to the aggressive tightening, real and anticipated, by the Federal Reserve. Given the relative size of the market for capital and the market for goods and services, we tend to emphasize drivers of capital to understand and anticipate exchange rate movements.

Put this in concrete terms. That $730 bln trade surplus China recorded this year through October is swamped by the Chinese yuan's $500 bln a day turnover. Moreover, Chinese exports are not the same as the demand for the yuan. This is because most of China's trade is not conducted in yuan.

From a different but consistent perspective, Antonia Foglia (from Belgrave Capital and Banco del Ceresio) argued in the Financial Times recently that hedging the dollar exposure of the some $14 trillion of US bonds owned by foreign investors, is an important, even if overlooked, driver of the dollar's exchange rate. However, given this year's precipitous decline in US bonds, the dollar hedges need to be reduced, which entails buying the dollar and selling the local currency. He estimates that roughly half of the US Treasuries are in official hands and are not likely hedged, and he conservatively estimates that half are owned by the private sector and half again are hedged. The 20% decline in the value of Treasuries this year translates into around $700 bln of hedge-related dollar buying.

We have made a parallel argument regarding the Japanese yen's so-called safe haven status. Observers have often seen that the yen strengthens risk-assets decline. However, it is difficult to know the difference between buying to go long and buying to cover a short. We argue that the yen has often been used as a funding currency. With near-zero interest rates, it is borrowed, and the proceeds are used to buy higher-yielding and/or more volatile assets. When that higher-yielding or volatile asset goes south, the funding currency is bought back, and the position is unwound. This gives the illusion of a safe haven when something entirely different is taking place.

II

Last week was a watershed. The softer-than-expected US CPI figures and the inversion of the 3-month-18-month bills, a part of the curve that Fed Chair Powell had drawn attention are part of the macro developments that helped mark the end of the dollar's historic rally. We thought it had already topped against sterling when the pound plummeted to record lows at the end of September, and our conviction was growing that the greenback had peaked against the Canadian dollar when CAD1.35 gave way. Position adjustment may trump fundamentals in the near term, but the dollar looks oversold for the first time in months.  

While US producer prices may draw some attention, the focus in the week ahead will be on the real sector. Helped by stronger auto sales (14.9 mln, best since January and nearly 15% above Oct 2021), retail sales are expected to rise by around 1% after a flat report in September. The core measure, which excludes autos, gasoline, building materials, and food services, is rising by 0.3%. Retail sales pick up about 40% of consumption, which has been softening. It averaged 1.2% a month in Q1, 0.8% in Q2, and 0.3% in Q3.

On the other hand, industrial production is expected to have slowed from 0.4% in September to 0.1% in October. Such a print would bring down the three-month moving average to about 0.14%, its lowest since last September. Yet, industrial capacity utilization remains at elevated levels. In September, it was slightly above the last cyclical high set in August 2018. Indeed, it has not been this high (80.34%) since the Great Financial Crisis, when it peaked a little above 81%.

It is the interest-rate-sensitive housing market that the tightening of financial conditions is being felt most acutely. Housing starts look to break the sawtooth pattern of alternating between increases and decreases this year with back-to-back declines. On average, starts have fallen 1.9% a month on average this year through September. In the Jan-Sept period last year, housing starts fell by an average of 0.2%. As a result, existing home sales likely fell for the ninth consecutive month in October. It is the most prolonged slump since the Great Financial Crisis, though inventory levels were around four times higher back then. Limited inventory now compounds the problem of higher mortgage rates. 

China reports October, industrial production, retail sales, investment, and surveyed jobless rate on November 14. The economy appears to be stabilizing at what is historically considered soft levels. The median forecast in Bloomberg's survey sees the world's second-largest economy expanding by 1.5% quarter-over-quarter in Q4. It is expected to begin a streak of quarterly increases of 1.0%-1.2%. The market is more interested in modifications of its Covid regime, especially given the flare-up of cases, but also additional efforts to support the economy. If the one-year Medium Term Lending Facility rate (2.75%) is not reduced and/or the volume is not increased (from CNY500 bln), speculation of a cut in reserve requirements will likely be heightened.

The fact that the UK economy is set to contract for the next several quarters may remove some of the market sensitivity of the UK's high-frequency data. At the same time, it may heighten the focus on the inflation reports. The BOE expects CPI to peak shortly but is still committed to tightening financial conditions. The central bank meets in the middle of December. The swaps market has a 50 bp hike discounted and a little bit more, perhaps conditional on the fiscal statement due November 17. An austere budget of tax increases and spending cuts is likely, though, at this late date, there still seem to be several unresolved issues. The latest talk suggests that the tax rate of the top bracket may be increased or its threshold lowered. There has also been talk that the National Health Insurance tax on employers may be raised. An increase in the inheritance tax may be under consideration, as well.

The eurozone's September trade deficit is a good reminder of the deterioration in its external balance this year. With Q3 GDP already released and set to be updated, the trade balance may be short of practical importance. The eurozone recorded a trade deficit of almost 229 bln euros through August. In the first eight months of 2021, the trade surplus was about 124 bln euros. With the largest economy in the eurozone, Germany, headed for recession, the ZEW survey may not be very interesting. The expectations component fell to its lowest level in August since the Great Financial Crisis, a ticked up slightly in October. The assessment of the current situation has continued to deteriorate. It has risen twice since September 2021. At -72.2 in October, it was the poorest assessment since August 2020.

While existing home sales in the US through September have fallen by about 23% this year, existing home sales in Canada have slowed by more than 35%. They have slowed for seven consecutive months. Canadian housing starts have fared considerably better. They rose a modest 2.5% last year and are up by a quarter this year. Housing starts rose by the most this year in September, with a 10.8% surge. Typically, a pullback the following month is recorded after such a significant increase.

Yet, the highlight of the week will be Canada's October CPI reading. The headline has slowed since peaking in June at 8.1%. It stood at 6.9% in September. It is likely to have decelerated again last month, helped by a favorable comparison to last October when Canada's CPI rose by 0.7%. Looking forward, the base effect is less friendly in November and December. The underlying core measures have been stickier. The Bank of Canada has three, averaging 5.3% in August and September, which is 0.2% off the peak seen in June and July.

In the US, average hourly earnings slipped below 5% year-over-year for the first time since last December, and average pay (permanent workers) in Canada rose 5.5% in October. After the Bank of Canada hiked rates by half a point instead of 75 bp on October 26, the market immediately anticipated a 25 bp hike at the last meeting of the year (December 7). However, the strength of the employment report and wages prodded the market into thinking a 50 bp hike was more likely. A firm CPI report would likely push the market more in that direction.

Australia reports its October employment figures. The job market down under was fairly steady until Q3. In Q4 21, and the first two quarters of this year, Australia grew full-time positions by 54.0k to almost 57k a quarter. In Q3, it lost full about 1k full-time jobs. This probably overstates the case and was largely the result of a sharp drop in July, the first loss of full-time positions since last October. Indeed, an average of 34k full-time people were hired in August and September. The Reserve Bank of Australia meets on December 6. The swaps market does not have a quarter-point hike fully discounted. Yet it sees the terminal cash target rate around 4% in a year compared with the 2.85% prevailing now. 

Lastly, two international gatherings will attract attention in the coming days. The first is the Asia Pacific Economic Cooperation (APEC) which meets in Bali November 14-15. US President Biden will likely miss it due to a granddaughter's wedding, but the highlight may be a meeting between Japan's Prime Minister Kishida and China's Xi. They have not met since Kishida become prime minister. Former Prime Minister Abe visited Beijing in 2019, and there were plans for Xi to come to Japan in 2020 but were disrupted by Covid. Regional security is a crucial issue for Japan. Its own security is seen at risk if China were to move on Taiwan. Tokyo appears close to a defense agreement with the UK and possibly the Philippines.

The G20 meets in Bangkok November 18-19. The host, Indonesia, is neutral and invited Russia's Putin and Ukraine's Zelenskyy. Recall that earlier this year, Biden called for Russia to be removed from the G20. Ukraine is not a member of the G20, and Zelenskyy said he would not attend if Putin did. The latest reports suggest Putin will not attend. Reports suggest Biden intends to meet with Xi at the G20 meeting. Taiwan and trade are obviously the two most salient issues. It would be the first face-to-face meeting since Biden was elected two years ago. Biden may hope to repeat Nixon's tactic of putting more space between Moscow and Beijing, and Putin's invasion of Ukraine has done Xi no favors. NATO is stronger, Europe is tied more tightly to the US via energy and defense,  and Japan and Australia, to name two, are even more wary of China's regional ambitions. Still, given what appears to be a bipartisan consensus in the US of the strategic challenge posed by Beijing, it is not clear what the US can offer China to induce a change in behavior.  

The statement issued afterward will likely demonstrate the old adage that a camel is a horse made in committee. With several countries not wanting to take sides on key issues, judging from the voting patterns at the UN, the G20 may be downgraded by the US in favor of the G7 again. 

Disclaimer