Setback risks for international USD lending

July 4, 2015

The BIS annual report emphasizes the dollar’s pervasive influence on international financial conditions. Post-crisis non-conventional Fed easing has spurred a global credit expansion, including economies that did not need it. Conversely, Fed tightening would reverse easy financing on a global scale, including countries that are ill prepared for it. FX depreciation is unlikely to insulate small and emerging economies from credit tightening.

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Rules of thumb for banking and currency crisis risk

June 27, 2015

A new ECB paper explores macroeconomic indicators for banking and currency crises over the past 40 years. Banking crises arose mostly in constellations of [i] low credit-deposit spreads and high short-term rates (over 11%) or [iii] high credit-deposit spreads (over 270 bps) and flat or inverted yield curves. Housing price growth has also been a warning signal. Currency crises ensued from exchange rate overvaluation (more 2.7% above trend) and high short-term interest rates (over 10%).

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The nature and risks of EM FX carry trades

May 16, 2015

A new BIS paper provides important lessons for EMFX carry trades, using Latin America as a case study. First, FX carry opportunities depend on market structure and regulation. Second, observed carry typically contains a classic interest rate differential and an arbitrage premium that reflects the state of on-shore and off-shore markets. Third, liquidity shortages and FX proxy hedging constitute major setback risks.

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Why and when central banks intervene in FX markets

April 5, 2015

A new BIS paper summarizes motives and impact of FX interventions. Most importantly it looks at the conditions under which such interventions are effective (and hence likely). The strongest case for interventions arises when [i] the central bank has a clear view about an exchange rate misalignment, and [ii] the intervention would not go against the interest rate differential.

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The evolution of China’s monetary policy

March 15, 2015

China’s economy has long relied on compressed interest rates in conjunction with strict capital controls and a tightly managed exchange rate. A new ADBI paper suggests, however, that modest liberalization and gradual internationalization of the renminbi since 2005 have lessened state control over financial parameters. Inconsistencies and risks of market dislocations have become more evident.

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The misinterpretation of exchange rate fundamentals

February 7, 2015

Exchange rates are pulled about by countless factors. There is a tendency to focus on standard fundamentals that happened to coincide with recent exchange rate moves. This has given rise to the “scapegoat theory of exchange rates”. It is nicely explained in a recent Bank of Italy paper. It implies caution in respect to popular “FX themes” in broker research that may lead to distortions, crowded positions and setback risk.

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FX risk and local EM bond yields

January 17, 2015

A BIS paper shows significant positive correlation of implied FX volatility and local EM bond yields. Empirically the causality runs mostly from FX to bonds, probably because currency risk is a key factor of foreign bond holdings. However, there can also be reverse causality, when FX derivatives are used as proxy hedge in a bond market turmoil. Since FX volatility is stationary, extreme values can indicate value in local EM bonds.

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Official flows and consequences for FX markets

November 8, 2014

A new IMF paper shows empirically that official currency interventions affect external imbalances and, by implication, exchange rate misalignments. There is a short-term flow impact, which is strongest when capital mobility is low. And there is a medium-term portfolio balance impact, which is strongest when capital mobility is high. Both effects are intuitive and offer lessons for FX trading strategies.

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Self-fulfilling and self-destructing FX carry trades

November 2, 2014

When foreign exchange trading meets inflation-targeting self-fulfilling investment strategies are possible. A technical paper by Plantin and Shin shows that positive FX carry encourages capital inflows that reduce inflation and allow monetary policy to condone a domestic asset market boom. Thereby FX carry strategies create their own implicit subsidy and self-validating flows. Conversely, a reversal of such flows is self-destructing.

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Disaster risk and currency returns

November 1, 2014

A paper by Farhi and Gabaix explains how fear of global crisis leads to outperformance of risky versus less risky currencies. Carry trades have worked historically, because high risk premia conditioned both high interest rates and subsequent revaluation. As a practical conclusion, gaps between perceived risk (often based on historical variances and correlation) and actual fundamental risk (as indicated by fundamental macro factors) are key value generators in FX strategies.

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Macrosynergy is a London based macroeconomic research and technology company whose founders have developed and employed macro quantamental investment strategies in liquid, tradable asset classes, across many markets and for a variety of different factors to generate competitive, uncorrelated investment returns for institutional investors for two decades. Our quantitative-fundamental (quantamental) computing system tracks a broad range of real-time macroeconomic trends in developed and emerging countries, transforming them into macro systematic quantamental investment strategies. In June 2020 Macrosynergy and J.P. Morgan started a collaboration to scale the quantamental system and to popularize tradable economics across financial markets.

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