Trade Insight February 2015

Currency wars and volatility


Executive summary

  • January 2015 was a volatile month with markets unsettled by the uncertainty generated at the beginning of the month over European Central Bank Quantitative Easing (QE). This uncertainty was compounded by the removal of the Swiss franc’s currency peg to the euro by the Swiss National Bank.
  • Both events have put significant pressure on the euro during the first month of 2015 which Delta Economics expects to continue throughout the year. We are forecasting that the euro and US dollar may well reach parity by the end of the year, if not earlier if current trends continue.
  • Delta Economics is expecting the PMIs published at the beginning of February to be broadly in line with consensus expectations. We expect China’s PMI to fall back while we are expecting PMIs in Europe to improve slightly. It is too soon to herald a recovery but this is a positive start to 2015.
  • The Delta Economics Asset Trade Corridor Index (TCI-A) reflects the underlying volatility in markets with Information Ratios largely negative for equities and currencies. The TCI-A has produced an average monthly paper return of 1.3% over the past 19 months. The average return on an equally weighted portfolio in January 2015 was 2.2%.
  • We expect oil prices and the value of the euro to fall during February. We expect other commodity prices to rise (against consensus), equities to rise and the US dollar to strengthen against most major Emerging Market currencies. However, the tightest strategy that we use suggests a strong downside risk to all these calls because of the underlying volatility reflected in the information ratios.


Greeks bearing gifts? The consequence of January for the euro in 2015


Delta Economics is of the view that the euro will reach parity with the US dollar by 2015 and has the potential to fall lower if current volatility and pressures on the currency continues. This is for several reasons:

First, Delta Economics considers the euro to have been over-valued for some time, largely as a result of the German trade surplus. Although Europe needs German trade to be strong because of the supply chains that originate in Germany and spread out across Europe, the high value of the euro has made it harder for the internal imbalances of the eurozone to be corrected by export-led growth outside of Germany.

At the outset, markets viewed the eurozone with a degree of scepticism. By June 2001 one euro bought 0.85 US dollars. As time has gone by, eurozone performance has, inevitably perhaps, become more dominated by Germany pushing the value of the euro up and kicking the issues of intrinsic imbalances between Member States down the road. However, instead of resolving imbalances by everyone “becoming more like Germany”, a weaker currency simply reflects the fact that everyone isn’t like Germany.

Second, the fact that QE was necessary in the first place made it abundantly clear that the eurozone is far from a marriage of equals. The euro came under pressure ahead of the announcement and fell to new lows subsequently. But it is here where the facts start to conflict with policy expectations. Theoretically, a lower euro should boost the real economy through trade because exports should become cheaper. However, what we’ve actually seen over the years since the introduction of the euro is a high correlation between the euro’s value and the value of trade: in other words, when the euro goes up, so does trade (Figure 1).

We believe there are two explanations for this: in the first instance, European trade, dominated as it is by Germany France, Italy, the Netherlands and Belgium, is largely at the high end of supply and value chains and therefore does not respond particularly to changes in the value of the currency. Even for weaker nations more dependent on commodities, the importance of Europe-wide supply chains means that the relationship still holds. For example, the correlation of the value of the euro with Greek trade is 0.89.

Furthermore, the value of the euro is actually a signal by the markets about the strength of the European economy: when the economy and institutions seem strong, the value is high and vice versa. In other words, as discussed previously, trade is an important driver of the value of the euro because of its importance as a driver of economic performance in the eurozone generally. While trade is falling, and we are forecasting it will fall by 3.7% within the eurozone in 2015, so too can we expect the value of the euro to fall. The result is that policy can have very little effect on the real economy through currency manipulation.




Figure 1  |  Monthly value of eurozone exports, USDbn versus USD per euro spot, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg


The third reason why the value of the euro is likely to come under increased pressure is the outcome of the Greek election in January. Syriza is looking to renegotiate its debt and start the process of loosening the tight controls it has had over spending. It will not be helped by a lower-valued euro (Figure 2) because of its inter-dependency with trade in the eurozone as a whole through its role as a trade hub.




Figure 2  |  Monthly value of Greek total trade (USDm) versus USD per euro spot price, Last Price Monthly, June 2001-Dec 2015
Source  |  DeltaMetrics 2015, Bloomberg


Greece’s trade to GDP ratio is 0.4: in other words, there is a fairly strong pull of trade on Greece’s GDP. Oil is a critical part of this; the correlation between Greece’s trade and the oil price is 0.80 – largely because of the importance of oil in Greece’s total trade structure. Greece’s exports of refined oil, for example, are twice as high as the second-largest export sector – medicines.




Figure 3  |  Greece’s debt and the challenge of trade
Source  |  DeltaMetrics 2015


Greece’s trade is just 0.4% of Europe’s total trade; however, their trade is nevertheless important both because of the impact that it has on the prospective growth of the Greek economy and as a portent for the negotiations about debt restructuring, austerity and structural reform ahead. Put simply, if a low-valued euro is unlikely to help boost Greek (or eurozone for that matter) trade more generally, then there is little that monetary policy at a European level can do to help long-term growth in the peripheral nations. Greece’s debt is, according to Syriza, not repayable and imposes too many restrictions on the Greek economy. One option is to set debt repayments against growth targets but, given falling oil prices and falling intra-European trade, this looks ambitious.

The eurozone needs more than QE and a low value of the currency for growth. The eurozone’s peripheral nations’ struggle for growth is accentuated by the fact that they must trade in euros internally and externally. Given “austerity” constraints attached to their sovereign debt, this makes it very difficult to grow. There will continue to be sustained political dissent between Member States on the best way to resolve the issue of Greece, and there is a danger that the debate will spill over to other nations, like Spain, Ireland and Portugal.

The likely outcome of all of this is continued market pressure on the euro (Figure 4).




Figure 4  |  Monthly value of Eurozone exports versus USD per Euro spot price and linear forecast, Jan 2014-May 2016
Source  |  DeltaMetrics 2015, Bloomberg, Delta Economics analysis


The pressure on the euro over the last year has mostly been downwards. The Delta Economics asset price forecasting model, which is itself based on country-sector-partner trade flows, is indicating short positions on the euro for most of 2015. Even if the trend continues in a linear way as it has done over the past 12 months, this suggests parity by the end of the year.



Outlook for PMIs February 2015


The Trade Corridor Indices (TCIs) measure the trade flows of any one country and forecasts these forward using its proprietorial forecasting methodology. Each index is specific to the country it relates to in that the trade corridors and flows will differ for each country. The rate of change in the index is correlated with the Purchasing Managers’ Index (PMI) for that country.

The TCIs are based on actual data and although they are highly correlated are in no sense an alternative to the PMIs since the methodologies differ. PMIs, being survey-based, are sentiment indicators while the TCIs give an actual and a forecast indication of how underlying trade conditions, including trade finance, are moving. In other words, the TCIs provide a predictable and quantifiable view of how changes in the global economy are affecting trade at an individual country level.

Generally we are expecting manufacturing PMIs to move in line with consensus this month with very little movement on their December values. The only exception is French services where we are expecting a bigger increase in the service sector PMI compared to consensus. However, although the accuracy of the predictions has been reasonable over the past 12 months, the correlation is substantially lower.

The predictions are based on:

  • The correlation of a country’s top 500 trade corridors with that country’s Manufacturing PMI to create a trade corridor index associated with the PMIs/sentiment (TCI-S)
  • Correlation of the rate of change in that index (6 month moving average) with the Manufacturing PMI
  • The monthly change in the six-month moving average (positive change suggests PMIs will improve while negative suggests they will deteriorate).

Outlook for PMIs February 2015  |  Outlook risk

  • The above information is based on the PMI tickers as listed.
  • The predictive capacity of the model is strong, but not perfect as they are based on correlations rather than causal relationships
  • Note – the correlations and values given are against the Tickers listed and not with the Flash PMIs although the Flash PMIs follow similar patterns
  • Note – forecast values are indicative of scale of change only and should not be seen as absolute values



Figure 5  |  PMI outlook, February 2015
Source  |  Delta Economics



Trade Corridor Index Asset Price Calls



The Delta Economics TCI-based asset management strategy takes the top 500 trade corridors (trade between two countries by sector) against and asset price. It creates an optimum corridor index of those trade corridors each month and has been tracking its performance over the past 19 months. This is a systematic model and assets are included in the portfolio if one of the following conditions is met:

  • The signal strength, which measures the percentage of trade corridors that are pointing to a long or short call: this must be higher than 95%
  • The signal strength is greater than 85% and the Information Ratio (which measures the performance of that optimum corridor relative to benchmark returns) is greater than 0.5 (indicating good or very good back-tested performance)
  • Where there is a signal strength of 100 and only one corridor in the index, the Information Ratio must be above 0.5.

The returns, which are not optimised and based purely on an equally weighted portfolio strategy, were 2.2% in December 2014. This means that over the past 19 months, returns have averaged 1.3% per month with above average returns in 11 months.




Figure 6  |  TCI-A returns, June 2013-January 2015
Source  |  Delta Economics


The calls for February 2015 reflect underlying volatility in markets with Information Ratios largely negative or mildly positive. Although the TCI-As across a portfolio of assets produced a return of 0.7% in October, this was against a similar backdrop of low or negative Information Ratios, which arguably underpinned the correction in the middle of the month. Because of these low, even negative, IRs our portfolio suggestions potentially have substantial downside risk attached to them.





The short call on oil reflects continuing downward pressure on oil prices despite the mild rally at the end of January 2015. While the signal strength is low, the information ratio is high suggesting that this is a strong call. Similarly, the long call on Gold has weak information ratio but strong signal strength suggesting that Gold may continue its upward path as a hedge against deflation. Because of underlying uncertainties in the global economy and the fragility of commodity markets, the long calls on copper and steel appear contrary to market sentiment currently. However, our trade outlook for the world in 2015 is mildly more positive than it was during 2014 and Asia in particular is forecast to grow strongly. A long call on copper and steel suggests prices may start to increase during February as a lead indicator of manufacturing activity increases towards the end of Q1 2015.




Figure 7  |  Delta Economics TCI-A based strategy, commodity calls for February 2015
Source  |  Delta Economics analysis





We are expecting all equity markets to increase this month, but the signal strengths are weak and the Information Ratios largely negative. A long position arguably reflects the sustained flight to equities following European QE, but the negative information ratios reflect volatility and substantial downside risk.




Figure 8  |  Delta Economics TCI-A based strategy, equity calls for February 2015
Source  |  Delta Economics analysis






The calls generally suggest that the euro will continue its weaker path against the US dollar this month. The information ratio on this call is strong, but the signal strength relatively weak. Other emerging market currencies similarly paint a picture of a strengthening dollar as expectations of an increase in US interest rates later this year versus perceived weakness in Europe and Japan continue to stoke up its value.




Figure 9  |  Delta Economics TCI-A based strategy, equity calls for February 2015
Source  |  Delta Economics analysis



Delta Economics Trade Insight February 2015  |  Author  |  Rebecca Harding  |  CEO Delta Economics


Damned if they do…?

Why QE will not be enough for Europe  |  It is easy to view the Swiss National Bank (SNB)’s decision to drop its cap on the value of the Franc against the Euro as a harbinger of chaos to come. The immediate market reaction, pushing the Swiss Franc up by nearly 30%, arguably makes the currency case to support exporters less compelling for Quantitative Easing (QE). QE was always likely to depreciate the Euro, so if it has already depreciated, can it be justified on currency grounds?

We will probably never know whether the SNB’s decision was a Machiavellian one prompted by conversations held behind closed doors on the scale of QE to be undertaken by the ECB; nor will we know if it was insider knowledge of a concession to Germany: that individual sovereigns would be made responsible for their own debt. Heaven forbid, but the move could simply have been the SNB formulating policy on the basis of pure national interest. It would be possible to imagine a thought process that ran something like this: “If there is substantial QE, then there will be a run on the Euro. That will make it very expensive for us to maintain the cap and it will be better to have clarity now by instigating the drop in the Euro under Swiss-controlled conditions rather than leave it up to European policy makers.”

Who knows? But whatever prompted the move, it has done two things: first, it has thrown markets into confusion ahead of the ECB’s decision. In essence, unless the ECB introduces “substantial” QE, of say €1 trillion or more, the Euro could go into free-fall (if last week wasn’t free fall already). With this €1 trillion may well come conditions – Germany will not support QE if it means it is liable for others’ sovereign debt as the Eurozone’s paymaster and is likely to insist on the “concession” that sovereigns take responsibility for their own debt. A large announcement with strings attached is as bad for markets as a smaller announcement but with no strings attached: damned by markets if they do introduce QE.

But second, and more importantly for longer term Eurozone competitiveness, the move has also prompted more serious conversation on whether or not QE is the right thing to do for the Eurozone. It is not likely to be inflationary, not only because there is no evidence from the Bank of Japan (or indeed the Fed) that QE is inflationary, but also because oil prices have fallen so steeply that we are already in the throes of deflationary pressures if not outright deflation. While this may actually help producers, the fact is that it is arguably the perception of a threat of deflation that inhibits decision-making, not deflation itself.

What is clear is that the Eurozone needs to boost its demand urgently. Delta Economics is forecasting that intra-Eurozone trade will fall by 3.7% during 2015. This extends beyond oil prices because intra-European trade is predominantly in high-end sectors like automotives, pharmaceuticals, electronics & machinery. Markets know this and the Euro is therefore highly correlated over time with its trade at 0.84. In other words, month-by-month, if the value of the Euro appreciates against the US Dollar, trade in the short term will rise; if its value depreciates against the US Dollar trade will decrease (Figure 1).



Figure 1  |  Monthly value of Eurozone exports, USDbn vs USD per Euro, last price monthly, June 2001-December 2015
Source  |  DeltaMetrics 2015


The strong association between trade and the value of the currency is counter-intuitive and needs some interpretation. Normally, a drop in the value of the currency would suggest a rise in exports, but in the case of the Eurozone since 2001, the reverse appears to be the case. Rather than a Euro depreciation improving trade prospects, it actually diminishes them. While this is not causal, what it clearly demonstrates is the relationship between the markets and the Eurozone: the Euro is a currency that is traded on the basis of the strength of the Eurozone as a trading bloc. Where the Eurozone looks weaker, so the value of the currency falls.

This does not augur well either for the prospects of growth in the Eurozone or for the value of the currency. It certainly leads to the conclusion that more is required to boost Eurozone demand than simply purchasing government debt, indeed that QE may well be too little, too late. Falling oil prices may well provide a boost to companies by reducing producer prices but without strong demand in Eurozone there is little that producers can do to take advantage of low prices and low borrowing costs.

The days ahead of the announcement will be dominated by uncertainty and volatility for markets and businesses: that much is clear. Ahead of the announcement it is likely we will see further depreciation of the Euro to test the tensions between Germany and the ECB on further austerity measures. Alongside further drops in oil prices and perception of a deflationary threat, the uncertainties that this creates for business are manifest.

And this is the real paradox of ECB policy at the moment: if it instigates wholesale QE then it will prompt further depreciation of the Euro – whether it is unconditional or not. With conditions if the rumours prove true, the run on the Euro may start earlier. And yet, if the ECB decides to go for a smaller-scale QE or no QE against market expectations but to spend money on infrastructure instead, then there will also be a run on the Euro: damned if they do, and damned if they don’t.


Damned if they do…?: Why QE will not be enough for Europe  |  Trade View Author  |  Rebecca Harding  |  CEO