Asset Management | Asset of the month: EUR/USD

Delta Economics’ asset price forecasting model is giving strong indications that the euro will weaken in April, in line with the model’s predictions that there will be EUR/USD parity by the end of 2015. We forecast a highly volatile month for the euro, with high resistance given that parity is a psychological barrier, particularly in light of the upcoming UK elections and continuing anxiety around a Grexit.

We suggest short positions for the current month and expect that the euro could go as low as 1.01 against the dollar in April. Our analyses show it could reach 1.0035 at an extreme.

The weakness of the euro is a direct product of the confusion created by the European Central Bank’s implementation of Quantitative Easing in March, seen as both too little, too late, and given broader uncertainty around the effectiveness of the strategy. Further, a weak euro is linked to a strong USD, in turn a product of the anticipation of a rise in interest rates, as well as weaknesses evident in Asian markets. The dollar will strengthen further nearing parity, which Delta Economics’ expects to see after April.

Medium term nervousness around sustained Greek membership of the eurozone and contagion effects of any debt renegotiation is putting further downwards pressure on the euro: this pressure is likely to intensify in the coming few weeks. We expect major movements in the market at the start of April, with high volatility throughout the month.




Three reasons why the Fed should not raise rates  |  The rampant US dollar went relatively unnoticed until the end of last week as the world’s attention was diverted towards Europe and the start of Quantitative Easing (QE). It gained almost 4% against the so-called “BRICSA” and “MINT” currencies, the South Korean won and the Thai baht in the first two weeks of March. Since these countries have almost $US 870bn in dollar-denominated debt, all of a sudden the dollar’s strength appears to be the world’s weakness in the long term. And as markets are increasingly expecting a small increase in US interest rates in June, the Fed should at least consider the international consequences of that decision.

Quite apart from anything else, it highlights just how integrated the post-crisis world is through the global financial and trading systems and, increasingly, monetary policy as well. At its extreme, there is no such thing as “national” monetary policy: Central Banks, including the Fed, do not set interest rates for a closed economy. Their actions have global repercussions and at no time in recent economic history has this been clearer as June, and therefore the prospect for a hike in Fed rates, gets closer.

Delta Economics is of the view that if the Fed raised interest rates it would be damaging the prospects for long- term economic growth in the US. This is not because the US economy is weak. Rather, it is because the risk of sovereign default on the dollar denominated debt becomes greater as the dollar gets stronger. Beyond the simple cost of repayment, there are three things that make default likelier and therefore the consequences for the US economy more severe.


1. Currency depreciation does not necessarily lead to export growth

First, it cannot be assumed that there is an automatic link between currency depreciation and greater exports. The Thai baht, for example, shows how for some countries there is an inverse relationship between the currency’s value and its trade: as the spot rate decreases (in other words the baht appreciates) trade increases (Figure 1a). This is also the case for some of the other, most indebted, Emerging Market economies: for example, Brazil ($188bn debt), China ($213,7bn), South Korea ($82.3bn) and Thailand ($14.6tn) (Figure 1b ).


2015-03-17_fedUp_fig01a_v03 2015-03-18_fedUp_fig01b_v05


Figure 1a  |  Monthly value of Thailand’s exports versus USDTHB, Last Price Monthly, June 2001-Dec 2015 (forecast)
Source  |  DeltaMetrics 2015, Bloomberg

Figure 1b  |  Selected Emerging Market currencies’ correlation with trade growth, June 2001-March 2015
Source  |  Delta Economics analysis


Conversely, the positive correlations are not as strong as they should be for a country to benefit from a depreciation in its currency. For South Africa and Russia there is a very low correlation indeed, while for Indonesia, India and Turkey the correlations are higher but still moderate. Only Nigeria and Mexico have stronger correlations between the value of their currency and trade. This suggests that they are in highly competitive markets (such as oil and intermediate manufactured goods) where the responsiveness of trade to a change in the value of the currency is likely to be higher.

However small a rise in Fed interest rates may be, the dollar’s value would increase and therefore make emerging market debt more expensive. Because there is not a clear-cut and positive impact on trade, Emerging Market economies are unlikely to have the export-led growth effects that will make that debt affordable.


2. Oil Price Losers

The dominance of oil in the structure of Emerging Market trade is made obvious by the extraordinarily high correlation between oil prices and total trade (Figure 2).




Figure 2  |  Correlation of total trade with oil prices, selected Emerging Market economies, June 2001-March 2015
Source  |  Delta Economics analysis


The lowest correlation of trade with oil price is China at 0.81, but for countries like Indonesia and Mexico the correlation is much higher at 0.90 and 0.89, respectively. What this suggests is that trade will increase as oil prices rise and vice versa. This is simply a reflection of the importance of oil in the structure of trade of Emerging Economies: because of its dominance, its correlation with the price of oil is very strong.

But because of the oil dependency of trade for many Emerging Markets, the fact that trade will drop in real terms means that all nations are potential losers from the fall in oil prices. This is either because their revenues from oil exports have dropped or because their trade overall has dropped. Again, this makes it tougher for any export-led growth to materialise.


3. Over-valued EM equities

The story of Emerging Market equity growth in the period since the financial crisis is one of expectations exceeding outcomes. The extraordinary recovery of trade and economic growth after the crisis pulled capital into Emerging Markets in anticipation of growth in the future. The strong correlation of most Emerging Market equities with trade through the 2001-2015 period illustrates the strength of these expectations manifested in investments in Emerging Market equities.




Figure 3  |  Correlation between emerging market equities and exports, June 2001-March 2015
Source  |  Delta Economics analysis


Interestingly, only China and Nigeria exhibit weaker relationships between their markets and trade. However, China’s trade is 0.94 correlated with the Hang Seng Index and Nigeria’s market is proportionately under-developed through the time period.

What this shows is that if trade falls back, there is a strong likelihood that Emerging Market equities will also fall. Consequently, this will reduce the amount of capital flows into these economies. Again, the net effect is to dampen economic strength but, equally, potentially to create a self-fulfilling prophecy: trade effects feed lower capital flows which in turn lead to a decline in trade because of a lower capital base.


So what does the Fed do?

The Fed should not raise interest rates unless it is prepared to write off the emerging market debt that is denominated in US dollars. Monetary policy has become international as well as national and it may well be that the United States’ long-term interests are not served by a strong US dollar. Emerging Market trade, oil prices and the value of Emerging Market currencies, and over-valued EM equities may seem unorthodox reasons for keeping interest rates on hold. But in the long term, it is the US that will lose if the debts cannot be repaid.

BRIC through a window

Why Russia’s attempt to decouple from the dollar is a defensive strategy  |  Gazprom’s decision to price oil trade with China in Roubles or Yuan rather than US Dollars effectively demonstrated the power that the BRIC countries want to exert over world trade. It has profound implications for trade finance, not least because a cry for decoupling emerging currencies from their dollar-dependency resounded across emerging Asia, and France, last week. The issue is that, as global pressure on interest rates in the US build and as tapering continues, the threats to Emerging Economies of US Dollar-denominated debt increases. It has not been a great year so far for Emerging Market currencies and the signals for a stellar recovery in the second part of 2014 are not strong.

France worries about this because of its increasing reliance on countries like Brazil for oil, and perhaps because it wants to bang the drum for the Euro. But Russia’s decision is arguably a defensive one – it is protecting its own oil trade interests with China as its relationships with Europe and the US become more strained. The value of the Rouble against the US Dollar is barely correlated with world trade, Chinese trade or even the oil price and, as a result, it is seeking to integrate itself into the world trade system through closer ties with China. The effect will be the strengthening of the Yuan, and ironically the Euro, as trade finance currencies and while it might serve to weaken the hegemony of the US Dollar in trade terms, it will have little impact on the value of the Rouble.

The reason for this is simple. There are two currencies that are very strongly correlated with world trade: the Yuan and the Euro, as shown in Figure 1.



Figure 1 | World export trade values (USDbn) versus USD-Yuan, Last Price Monthly, June 2001-June 2014
Source | DeltaMetrics 2014, Bloomberg


The correlation between the value of the Yuan and world exports is -0.91: in other words, as it weakens against the US Dollar, world exports increase and vice versa. This is of little surprise to any observer of world trade: the Yuan is a managed currency and it has been a bone of contention in trade negotiations between the US and China that its artificial weakness has kept Chinese exports strong. Indeed, as the currency has been allowed to strengthen over the past couple of years, world trade has slowed. This is not just simply a reflection of the dominance of Chinese exports in world trade. China’s trade is highly currency elastic – it exports intermediate manufactured goods that are very price sensitive and so trade will also be highly influenced by the value of its currency.

But there is more than just global trade at stake from Russia’s point of view. Russia needs to secure markets for its oil exports if it is to undermine the effects of first, any sanctions that may arise from the continuing crisis in Ukraine and second, the reduced dependency of Europe on Russian oil and gas. Its obvious trade partner is China and, indeed, Russian exports of oil and gas to China are forecast to grow annually by around 9% each year to 2020. China is resource hungry and, as a result, its trade is highly correlated with the oil price as well as with the value of its currency, as illustrated in Figure 2.



Figure 2  |  Value of Chinese exports versus NYSE Arca Oil Spot Last Price Monthly, June 2001-June 2014
Source | DeltaMetrics 2014, Bloomberg


The Rouble-Yuan currency spot is highly correlated with Chinese trade (0.75) and this potentially helps to explain why Russia is so interested in building up the ties between the two currencies through oil trade in particular. It strengthens the likelihood of the Yuan increasing its importance as a currency for trade finance and protects Russian trade interests against the weakness of the Rouble-USD exchange rate in other markets.

The only other currency where the correlations with Chinese trade, world trade and oil are as strong is the Euro, as Figure 3 suggests.



Figure 3  |  Correlations of major currencies with world exports, Chinese exports and the NYSE Arca oil spot price. June 2001-June 2014
Source  |  Delta Economics analysis, 2014


Apart from the strong correlations with trade and oil prices of the Yuan-US dollar price, the table also shows how important the Euro is as a trade currency. Past trade views have commented on the fact that the Euro is a trading currency that responds to economic fundamentals and not a currency that is used for speculation. Russia’s move towards the Yuan and away from the dollar will not strengthen the rouble, since its value against the dollar is barely correlated with trade and only weakly correlated with oil prices. However, it could serve equally to serve the purpose of strengthening the Euro as a trade finance currency.

The reason for this is because of the strong correlation between the Real-USD value and both world trade and Chinese trade and the oil price. While not as strong as the Euro value alone, there is something important that is emerging in terms of Brazil’s role in the trade finance system. Brazil’s exports to China are forecast to grow at above 11% for the next four years, and much of this trade is commodity-based – soya and oil in particular. Similarly, France’s imports of oil and gas from Brazil, for example, are set to increase in double digits annually over the next five years and exports to Brazil from Europe are forecast to grow at similar rates to exports to China over the next five years.

This helps to explain, perhaps, why there was a call from France in the last week to loosen ties with the US Dollar as well. Figure 4 shows that France’s trade is, in comparison with German trade, weakly associated with the value of the Euro versus the USD.



Figure 4  |  Correlations of key currencies against French and German exports, June 2001-June 2014
Source  |  Delta Economics Analysis, 2014


Perhaps more importantly, French exports are more correlated with the value of the Yuan versus the US Dollar, albeit more weakly than German exports. A logical conclusion is that it is in the interests of all exporters from the Eurozone for the Yuan to be a more dominant trade finance currency as it will help their trade, and hence the value of the Euro.

Russia’s move away from the US Dollar has a deep resonance across the trade finance system. First, it will encourage the Chinese government to decouple the currency from the dollar and allow it to trade in currency markets more freely which, in and for itself has to be a good thing for the global trading system. Second, it means that trade, and hence trade finance, will increasingly be denominated in Yuan, and arguably Euros as well, reducing the importance of the Dollar as a trade finance currency. Again, this is welcome on the grounds that it supports free trade.

And third, given the fragile relationship geo-politically between Russia and the US at the moment, it also makes it more important that the US engages in trade talks with Asia. If the Yuan and the Euro become more important as a trade finance currencies, then the US cannot afford to be isolationist in the way it handles its trade negotiations. Whichever way this is looked at, Russia has just thrown a BRIC through the window of the US’s current trade stance.