Intro: Over the long term there are four main factors that determine currency performance; the starting valuation, the rate of inflation, real GDP growth, and real interest rates; with the latter being intimately linked. While inflation is the most important factor driving nominal returns, real GDP growth is the major factor driving total return performance due in large part to its impact on real interest rates.
Currency Valuations: Currency valuations tend to mean revert over the long term so as global competitiveness does not stray too far from the country’s economic fundamentals. Therefore, a currency that is overvalued will face steady long-term depreciatory pressure, and vice versa. An easy valuation tool is the Real Effective Exchange Rate (REER). If the REER is trading significantly above its 10-year moving average, it will tend to face downward pressure. Often, currency overvaluation manifests in a widening current account deficit as the currency is driven by speculative inflows that allow the country to increase imports. Over time the reduction in competitiveness results in downward pressure on the currency.
Another valuation metric is based on the close correlation between GDP per capita and price levels across countries. Wealthier countries tend to have stronger currencies and vice versa. A country which are particularly expensive relative to their level of GDP per capital in purchasing power parity terms will tend to suffer gradual depreciatory pressure in order to prevent an unsustainable loss of competitiveness. It is worth noting however that if a country has high real interest rates, it will tend to appear overvalued relative to its GDP per capita because investors will bid up the currency to take advantage of favourable investment returns, effectively meaning that the overvaluation is justified.
Inflation: High inflation will tend to undermine a currency’s value as it must decline in order to maintain export competitiveness. This is the most important factor driving long-term currency movements. If a currency does not depreciate amid high inflation, it would eventually become unsustainably overvalued as imports outstrip exports.
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. For instance, as average price levels are higher in more developed countries, the faster an economy grows and the wealthier it becomes, the stronger the currency will tend to be. As the chart above shows, stronger growth enables a shift from the lower left to the upper right.
Real GDP Growth Impacts Total Return Performance
While improved competitiveness explains why stronger real GDP growth benefits nominal currency performance to some extent, the main positive impact of strong real GDP growth comes from higher real interest rates which benefit total return performance. Real interest rates tend to be closely related to real GDP growth over the long term as explained here. While real interest rates can be significantly below real GDP growth, they are very rarely consistently above real GDP meaning that strong growth is a necessary condition for high real interest rates. The importance of high real interest rates on total return currency performance cannot be overstated as the chart below illustrates.