Icon Economics provides independent macroeconomic and financial market analysis on Asian and Global markets, with a focus on FX markets. Our approach is grounded in our understanding of free-market economic theory and the fundamental drivers of FX rates, combined with a detailed knowledge of regional economies. We pride ourselves on cutting through the noise to provide straightforward, actionable analysis that focuses on forecasting the future, not merely explaining the past or extrapolating the present.
History repeats, this time is rarely different, and economic freedom creates prosperity. It has been said that those who do not learn the lessons of history are doomed to repeat them, while those who do learn the lessons of history are doomed to sit idly by while others repeat them. Rather than sitting idly by we stand on the shoulders of giants to provide those crucial insights that are often lacking in mainstream economic research.
As Western governments increasingly embrace socialist policies and actively discourage saving via negative interest rates, the high savings rates and increased economic freedom across Asia bode well for the relative economic outperformance and long-term currency strength. We aim to provide reliable insights allowing businesses and individuals to navigate short- and long-term cycles.
Ignore the Consensus
Mainstream economists and the financial media can cloud the ability of businesses and investors to see turning points in economic and financial market cycles. Factors such as career risk and business risk create a strong tendency for herd behavior. This makes it almost impossible for mainstream economists to predict future trends, particularly negative surprises.
In addition to a lack of willingness to go against the consensus, mainstream economists’ narrow focus on ‘demand’ in lieu of a more fundamental understanding of the dynamics at play driving production means explaining recent past economic trends and extrapolating them all too often passes for insight.
Our analysis focuses heavily on complex interplay between economic and market fundamentals which helps us to anticipate major turning points. Our willingness to go against the herd reflects our strong belief in our methodology and keen awareness that the consensus is usually wrong. We aim to prepare our clients for those economic events that we often hear that ‘nobody could have predicted.’
Whether it is the outlook for the Chinese yuan or the Vietnamese dong, our understanding of the fundamental drivers of currency performance is at the center of our approach. In the short term, real interest rate changes primarily drive currency markets, in addition to other factors. In the longer term, the level of real interest rates, real GDP growth, inflation, and the starting valuation of the currency are the key factors. Our unique methodology brings all these factors into play to provide reliable and actionable analysis.
Short-term currency fluctuations are driven by several factors, the most important of which is real interest rate changes, which is why we focus heavily on central bank central bank intelligence to formulate out short-term views. Below is a list of factors that go into our short-term currency forecasts:
Key Drivers of Short-Term Currency Moves
- Real Interest Rate Changes: Real interest rate changes, rather than absolute levels, tend to be the main driver of currency pairs in the short term, particularly in Developed Markets. In the case of Emerging Markets, we incorporate default risk into the equation using our ‘Risk-Adjusted Real Yield’ metric to allow for direct comparisons between EM and DM currencies.
- Policy Bias: Central bank members and to a lesser extent politicians can have a material impact on currency movements beyond the fundamental drivers. If a central bank actively wants to weaken its currency, there is no theoretical limit to prevent them from weakening it. Conversely, a central bank in favour of a stronger currency will act as a potential tailwind.
- Technical Outlook/Chart pattern: Currency markets have a tendency to trend due in part to herd behaviour on behalf of traders, meaning that chart patterns can give useful insight into the near-term outlook for a currency pair.
- Sentiment/Positioning: If the consensus is heavily skewed towards a particular direction it can act as a contrarian indicator. If everyone is bullish, for instance, there is no one left to buy, raising the odds of currency weakness.
- Terms of Trade: The relative prices of a country’s exports and imports can be a key currency driver, particularly for major commodity exporters/importers. A rising oil price will tend to put upside pressure on an oil exporting currency, for instance.
Over the long term there are three main factors that determine currency performance; the starting valuation, the rate of real GDP growth, and the rate of inflation. All three are intimately related.
Key Drivers of Long-Term Currency Trends
Currency Valuations: Wealthier countries tend to have stronger currencies due to higher levels of productivity due to the greater level of productivity in the tradable sector of the economy. The chart below shows the strong correlation between GDP per capita and how expensive a country is.
Currency valuations tend to mean revert over the long term, so a currency that is overvalued will face depreciatory pressure, and vice versa. The reason being that if a country is particularly expensive relative to its GDP per capita, its exports will tend to become uncompetitive compared with imports, and vice versa. Over time the reduction in competitiveness results in downward pressure on the currency.
We utilize various currency valuation methods including real effective exchange rates, average price levels relative to GDP per capita, and other purchasing power parity metrics to provide a starting point for our FX forecasts, providing crucial context with which to assess other variables.
Real GDP Growth: High real GDP growth increases the fair value of a currency over time as the country becomes more competitive as productivity increases. This allows the currency to gradually appreciate without becoming overvalued.
Our proprietary Productivity Indices allow us to assess five areas that play a role in determining long term productivity growth: Political Stability, Financial Stability, Economic Freedom, the Business Environment, and Human Capital. These figures are regressed against GDP per capita to give an expected long-term productivity growth rate. Other factors such as the contribution of savaings growth and labour force growth are included to provide a long-term economic growth forecast.
Proprietary Economic Growth Forecasting Methodology
Inflation: High inflation will tend to undermine a currency’s value as it must depreciate in nominal terms in order to maintain export competitiveness. If a currency does not depreciate amid high inflation, it would eventually become unsustainably overvalued as imports outstrip exports.
Key Drivers of Long-Term Inflation
We forecast inflation based on tried and tested measures known to drive long-term inflation trends, which include real GDP growth, external debt, government debt, money supply growth, government debt growth, and real interest rates.
Real Interest Rates: If a country has a higher real interest rate relative to another, that currency will tend to outperform in total return terms. i.e. considering interest rate gains because whatever downside pressure arises from inflation will be more than offset by the higher nominal interest rate. Higher real interest rates also typically reflect a stronger real GDP growth outlook.