Betting on UK current account-sterling relationship a risky business
Debate rages whether current accounts drive FX moves in developed markets or whether it’s a case of correlation, rather than causation.
The role current-account deficits play in predicting FX moves has long been the subject of debate.
Investors’ fixation with trade balances was the principal driver of the sell-off in emerging-market (EM) currencies in the first two months of the year, with deficit nations underperforming.
While investors reckon factors such as productivity gains will be the primary driver for EM currencies in the long-term, during global bouts of risk aversion EM deficit nations tend to underperform if deficits are financed by foreign portfolio flows.
However, betting on the role of current accounts driving FX moves in developed markets (DMs) remains a risky business, since it’s often unclear whether currency strengthening during improvements in a given country’s terms of trade, and vice versa, is a case of correlation or causation.
For example, Barclays concluded in a research paper last year, with respect to the weakening of the yen in February at the same time the country ran a non-seasonally adjusted deficit for two consecutive months for the first time since the 1980s, that the Bank of Japan’s new 2% inflation-target announcement was the primary driver for JPY weakness.
So, should investors be concerned about the sterling’s prospects, given the UK’s sizeable deficit at 4.4% of GDP in the first quarter, and the fact it has been generated principally to finance consumption-led growth rather than financing investment?
“A current-account deficit is neither a good thing nor a bad thing,” says David Bloom, global head of FX strategy at HSBC. “It is simply a way of financing an economy.
“It is what that money is spent on that is interesting, whether it is used to finance consumption or for investment. When consumption rises more than investment, that can be a problem because that may not be sustainable.”
Without investment, traders might wonder where the UK is going to get the money to repay its creditors.
“The idea is the UK always has the crown jewels, there is always something the UK has that others want, but in reality there is no difference between the situation in the UK and in many emerging markets,” says Bloom.
In fact there is evidence that suggests the relationship between current-account deficits and FX is fundamentally different for G10 currencies than EM currencies.
“Current-account deficits usually don’t matter for developed markets,” says Adam Cole, global head of FX strategy at RBC Capital Markets.
A systematic model trading G10 FX on the basis of current-account deficits, long surplus currencies and short those with deficits, with positions proportionate to the sizes of those surpluses and deficits and continually rebalanced, will consistently lose money, he says.
“If you run that same model but use a basket of emerging-markets currencies you see three-to-five-year cycles where it does deliver positive returns, as it has for the last five years – with a burst of extremely good performance last year at the time of the taper tantrum,” says Cole.
“The periods when it doesn’t work are those periods you might characterize as irrational exuberance, when currencies with weak fundamentals have outperformed those with stronger fundamentals.”
Geoffrey Yu, G10 FX strategist at UBS, adds: “Emerging markets are most exposed because of their intrinsic dependence on portfolio flows to fund the current-account deficit and lack of institutional capacity to adjust in time.”
However, Bloom suggests extraordinary measures taken to support the global economy might have changed market dynamics. Assumptions that held up in the past might no longer be relevant.
“There is something very wrong with the UK economy,” says Bloom. “Consumption is increasing much faster than investment. Unemployment is falling but wages aren’t increasing. When investors realize this recovery isn’t as powerful as they hoped, confidence will turn.
“But for now the people financing the current-account deficit are ignoring the future and focusing on the short term.”
Academics have studied the relationship between current-account deficits and FX to determine if there is a particular level above which debt becomes unsustainable. No convincing answer has been found and the relationship appears to be driven more by sentiment than hard numbers.
“A commonly held view is that current-account surpluses indicate an undervalued currency while deficits indicate an overvalued currency,” says Barclays.
However, it notes, a deficit run by a young economy, such as Australia or India, to fund investment is different to one run by a mature economy, such as the US or UK, to fund consumption.
The worry is that changes of sentiment are unpredictable.
“Noticing a high current-account deficit can be a bit like noticing the emperor has no clothes,” says Bloom. “It’s not a problem until it’s a problem, but when sentiment changes it can be sudden and aggressive.”
At such times, traders tend not to have time to analyze the numbers or determine whether the current-account deficit is being used to finance consumption or investment, looking only at its size.
“It only makes that kind of distinction when the market is calm,” says Bloom.
In today’s benign market, Turkey and India, in particular, enjoy market confidence. Turkey dramatically increased interest rates by 450 basis points to attract investment and protect its currency, and has seen its deficit fall. In India, the new government has lifted hopes for its economy.
However, while investors are scrutinizing EMs, DMs are getting the benefit of the doubt. The biggest question mark concerns the UK, where traders disagree what the implications of the huge deficit will be.
“I would perhaps also include the UK and New Zealand as ‘at risk’ G10 currencies, but in my years covering GBP, calling it to fall on the back of a CAD has never worked and probably will never work,” says Yu.
“This is where the institutional contrast between DM and EM really start to show – you won’t worry about the UK expropriating assets to fund any financing gap; the same cannot be said about all emerging markets.”
Cole adds: “The UK’s deficit is not necessarily a cause for concern. Our model shows developed economy currencies have little correlation with deficits, and anyway this deficit is quite unusual in that it is largely down to public sector debt, not a domestic demand boom, as it has usually been in the past when the deficit has been this high.
“It is a fiscal issue, meaning a monetary response will not work. The only way to get rid of it is austerity.”
Source: RBC Capital Markets