Intro: Short-term currency fluctuations can be driven by several factors that may or may not correspond to fundamental developments. However, the most important variable, particularly in developed markets, is the trend of real interest rates.
The Trend of Real Interest Rates/Bond Yields: Real interest rates and bond yields are the most important drivers of currency fluctuations in the short term. Crucially, it is the change in real interest rates spreads between two countries, not the absolute level, that matters. If real rate interest rate differentials between Germany and the US for instance rises from -2% to -1%, although it is still lower, the rise should act as a positive force for the euro. The following chart shows the close correlation between EURUSD and real bond yield differentials. The fact that the euro is elevated relative to real yield differentials suggests that it will face depreciatory pressure.
In emerging markets, on the other hand, changes in real interest rates and bond yields tend to be less important drivers of currency movements. The reason is that real yield changes tend to reflect shifts in default risk. A higher risk of default, as measured by credit default swap spreads (CDS) will mean investors require a higher real interest rate to compensate for the added risk, and vice versa. The following chart shows how the decline in real interest rates in Brazil has been driven by falling default risk. For EM currencies, it is important to look at real bond yields adjusted for default risk to gain insight into whether a currency should face appreciatory or depreciatory pressures.
Central Bank Currency Policy: If a currency is heavily managed this will give an indication of policymakers’ willingness to support or weaken their currency. The level of reserves (relative to GDP, imports, and external debt) meanwhile, indicates the central bank’s ability to intervene. Even a central bank with a strong willingness to prevent depreciation may not have the ability to do so if it has too few reserves to be able to buy enough local currency to prevent market forces leading to depreciation. Even expectations that a central bank will run out of reserves can create speculative attacks that overwhelm them. Generally speaking, though, speculative attacks tend to merely expedite currency weakness which would have eventually resulted anyway.
Chart Pattern: This is a key factor driving the swings we see in currency market valuations across time. This does not mean that there’s a magic formula that we can use such as only buying when markets are above their 200 day moving averages, or the Relative Strength Index is between some parameters. However, what it does mean is that markets have a tendency to exhibit certain predictable patterns and ‘the trend is your friend’.
Credit Spreads: In EMs, perceptions of default risk can drive FX moves as increased default risk will mean investors will fear not getting their money back, regardless of how high real rates are, and the currency will face depreciatory pressure. So, any rise in CDS spreads may signal impending currency weakness, and vice versa.
Terms of Trade: The relative prices of exports and imports can be a key currency driver, particularly for major commodity exporters/importers. A rising oil price will put upside pressure on an oil exporting currency, for instance. As the chart below shows, the AUD has closely tracked the countries terms of trade over recent years.
Sentiment/Positioning: The ‘prevailing wisdom’ should always be viewed from a contrarian perspective. If speculators/financial media are heavily positioned or expecting a particular currency to appreciate, this means there is potential for them to reverse their positions. If everyone is bullish, for instance, there is no one left to buy.
Sentiment is often an area of confusion as it can seem counterintuitive. Sentiment should always be viewed from a contrarian perspective. This is not to say that sentiment has to be bearish in order for a currency to appreciate; currencies can still appreciate amid very bullish sentiment. The point is that, all else equal, the more bearish sentiment is, the more there is potential for investors to change their minds and turn bullish, supporting the currency. The ideal situation would be if the currency has great fundamentals and a bullish trend, but speculative sentiment remains bearish, as there is a strong likelihood that speculators would turn bullish, adding fuel to the rally.
