A frequent client question concerns our preferences amongst the major currencies. Our existing ranking is the yen, then the euro, then the dollar and finally the pound. Why? Foreign exchange analysis involves a complicated mix of factors, including valuations, yield differentials, portfolio adjustments and psychology.
Valuations can be important drivers of currency movements, over longer time frames. Earlier this year, we estimated the US dollar was over-valued; however, the 9 percent decline in the trade weighted dollar since the start of the year, mainly against the euro, has made such valuation signals less significant. Nevertheless, we see the yen and, to a lesser extent, sterling as major currencies still some way from fair value. At times of risk aversion, say in relation to North Korea, the yen benefits.
It is certainly the case that interest rate differentials, bond yield gaps and the expectation of future changes in central bank signals can impact on currency flows. For example sterling-dollar or yen-dollar look broadly in line with such differentials. A gap has opened up, however, for the euro, with an exchange rate about €1.17/$ at the time of writing comparing with a bond spread which would suggest under 1.10 is more appropriate,
A third factor is changes in investor positions. Flows analysis shows that capital is moving away from the US, to some extent into emerging markets, more so into European equities. What is driving such cross-border flows? A simple way of describing the situation is that a pool of global capital moved into US assets in late summer 2016, boosted by the Trump election and the possibility of major tax reforms supporting the US economy. As confidence in such an outcome has ebbed away, so the better prospects for Europe, especially post Macron’s election, have revived investor spirits.
The risk, of course, is that such a trend goes too far – already worrying the ECB! Fund manager surveys show European equities are already one of the most overweight positions. We are assessing when Asia might see more interest.
What about sterling and the impact of Brexit? The importance of yield differential has rather fallen away over the past 15 months. The obvious explanation is that Brexit created a political risk premium in relation to the UK currency – with concerns about the possibility of a disorderly exit from the EU in 2019, or the danger that Brexit has a material impact on the trend rate of economic growth. The complex negotiations between Michel Barnier and David Davis will determine how this particular risk premium plays out.
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