FX Intervention
FX Intervention

FX Intervention

By Bob Elliot

For most investors currencies are a window into the way cross border capital flows impact asset markets. This week a series of readings about FX and the impacts on asset markets. We all know the dollar is strong, but how did we get here and what are the implications? A thread:

To understand the global FX system today you have to start with Bretton Woods 2. Starting back in the early 2000s Asian exporters provided cheap goods to the US. Their central banks recycled that income into US bonds to keep their FX competitive.

Bretton Woods: (frbsf.org)

Those flows into US bonds created the cheap capital that funded a lot of dollar borrowing globally in the mid-00s. For the US in particular, it kept long-term rates very low which fueled the housing bubble.

https://www.cfr.org/blog/end-bretton-woods-2

The boom in dollar borrowing created exposures globally. Even though many emerging markets didn’t have anything to do with the US housing market, their FX were int he crosshairs during the financial crisis as the dollar rose and USD liquidity tightened.

https://www.bis.org/publ/qtrpdf/r_qt1003f.pdf

By the mid 2010s the flush of dollar liquidity had largely gotten the world back to a Bretton Woods 2 type dynamic. That is until the PBOC decided the yuan was too strong and lost control of the FX to the downside.

What Drove China’s Large Reserve Sales? | Council on Foreign Relations (cfr.org)

This period provided an excellent picture of how the global currency system could impact US assets. Just as reserve accumulation had been positive to US assets in the mid-00s, sales of reserves dragged down US assets:

The PBOC propping up the CNY creates a direct drag on US assets. Selling US bonds to buy CNY is just like increasing QT, but much less orderly. A lesson from history. In 2015 the China faced BoP pressures. To support the FX, the PBOC sold a lot of US bonds. US stocks fell fast.

At the start of the selloff, US bonds actually fell despite the fact that stocks were falling as well (squint closely at the mkt action in late Aug / early Sep 2015). That was a pretty unusual dynamic and similar to today.

From Aug 2015 through the end of the year, US stocks fell 12% but long-duration bonds were close to flat. That’s a pretty unusual set of market dynamics that could be tied to PBOC sales of US bonds. In the fall of 2016 the dynamic emerged again, though was less pronounced.
Back then the PBOC did much of their action directly so it could be seen on their balance sheet. That extreme negative point is in January, which marked the bottom in US stocks, down almost 15%. Today the PBOC is more stealth with its actions. h/t @Brad_Setser
for the chart.

It’s critical to understand today’s BoP pressures on Asian FX will directly impact US asset prices. This is a self reinforcing dynamic that can be very disruptive. Initially hitting bonds, then stocks. I described the dynamic a couple weeks ago:

Quote:
” The dynamic is self reinforcing. Higher yields pressure the dollar higher, further exacerbating the pressure on EMFX and requiring more reserve sales. Typically only ends when there is a significant easing and with it a flood of capital back to EM. We are a long way from that.” Dated: August 22, 2022

The JPY is a critical factor. Easy BoJ policy is creating a drag on US assets by putting pressure on Asian FX particularly CNY. But to understand it you have to see all the global linkages. When you see the JPY move lower a few handles recognize that’s bad for US assets.

But that didn’t last for too long. Continued easy US monetary policy flowed into Asian economies and with it those central banks got back to the self-reinforcing business of intervening creating easy money globally.

https://www.cfr.org/blog/asian-intervention-foreign-exchange-market-back-bigly

Under the hood there were big changes going on in the FX markets which would make the US much more resilient than a lot of other economies. These shifts created the perfect storm for dollar strength as the US shifted to tighter policy.

(

One of the most important shifts in the global economy has been the shift of the US from being a large energy importer to one that is basically self sufficient (ht @Brad_Setser on the chart)

That is a radically different story than the energy dynamics particularly for the European economies. Of course there are specifics around gas, but the big thing is that they are major importers of energy all around. So are the East Asian economies.

Quote Robin Brooks:

“The weaker Euro and weaker Pound are about an adverse terms of trade shock that’s unprecedented in magnitude and duration. The Euro zone trade surplus, once seen as structural, has evaporated in the space of a few months (lhs), while the UK deficit has widened massively (rhs)…”

Result is that energy exporters are essentially taking money from EUR and East Asian economies and distributing that into global assets – which is tilted to the US/USD with the biggest stock, bond, deposit markets). Brad Setser has a nice thread highlighting Saudi moves here:

The big current account surpluses in the world today are in China, Russia and Saudi Arabia (and the GCC). Seems like the Saudis want keep their share of the global surplus too. Their “current account” break even oil price is only $60 a barrel.

Saudi production and oil export by volume numbers aren’t released quickly, so calculating the Saudi break even (the price that balances the current account) takes a bit of guess work. But it is clearly well below the current oil price.

The Saudi break even has been pretty constant since 2008, apart from a brief spending spree from 2012 to 2014. I assume that the Crown Prince’s big ambitions (Neom, etc) will raise imports over time, but it hasn’t really happened yet.

What has happened is a big shift in how the external surplus that the Saudis appear intent on maintaining through production cuts is managed — it no longer primarily goes into reserves. As

@jnordvig has noted, the Saudis now primarily buy equities.

OPEC decisions are of course primarily viewed through their impact on the oil market. But higher oil prices also have implications for global capital flows given the size of the Saudi surplus. And now, unlike in the past, the Saudis aren’t buying bonds …

End of Quote from Brad Setser)

This shift from a decade ago has all sorts of implications. Just to name a few – it supports the dollar vs energy importers. It supports US asset markets on a relative basis. And it highlights shifts in energy prices have significant global implications which must be understood.

Under the hood there were big changes going on in the FX markets which would make the US much more resilient than a lot of other economies. These shifts created the perfect storm for dollar strength as the US shifted to tighter policy.

Those shifts (and others) also changed a lot of who has the excess liquidity in the world and what they are doing with it. In short, a lot less of the excess liquidity is flowing into bond markets today than in the old Bretton Woods 2 days.

The strength in the dollar is now putting pressure across many central banks to need to intervene to support their exchange rates. The trouble is that in most cases such interventions don’t really work unless the underlying fundamental dynamics change.

This self-reinforcing dynamic is likely to continue. While the dollar’s rise is creating a lot of challenges globally, its not that big a deal to the US and if anything is helping the inflation fighting agenda:

The dollar’s rise matters much more to the rest of the world than to the US economy. The dollar can move significantly without concern from the Fed. But for the rest of the world, these moves create a significant bearish shock.

The dollar rise, like any exchange rate move in a large, domestically oriented economy, flows through in a couple different ways: – import prices go down – exporters margins get squeezed (and with it have pressure for weaker output) – Foreign production/sales earnings are lower.

The US is a bit unique because the vast majority of global trade is priced in dollars contractually. That means that shifts in the dollar don’t initially move either a) import prices or b) export prices earned. Over time as prices reset this matters, but that takes years.

So for the Fed running monetary policy from a domestic growth and inflation perspective they probably aren’t going to see much of a direct impact from even relatively sizable moves in the dollar.

The impact on *earnings* is more significant. Estimates are that 40pct of US public company revenues come from abroad. A fair amount of that is matched expenses in foreign currency. I’ve read earnings folks say for every 1% rise in the dollar earnings are hit 0.5% in total.

Still even there – a 20% move in the dollar in one year (very large) is a 10% hit on earnings all in. That matters, and should be accounted for, but it’s not an extreme dynamic. Side note that it creates lots of *diff* sector impacts.

The dollar’s rise has a magnified impact abroad because the dollar is the primary global borrowing currency. The result is many companies and countries have effective currency mismatches, having borrowed in dollars and earning local revenue.

Take a simple example. A company in period 1 has 20 local fx worth of profits and 100 local fx worth of debt outstanding denominated in dollars. Then the dollar rises 20%. The company now keeps earning 20 in local fx. But it’s debt has now risen to 120 dollars in local fx.

They’ve fallen behind. So what do they do? They have to be more profitable by cutting costs (or tax more in gov case) in one form or another, dragging on growth. Or they start scrambling to change any local fx into usd to pay off the debt. That only adds to fx pressure.

That’s the squeeze dynamic at play. All over the world there are countless companies and counties which have this basic mismatch and are facing this core issue. How big is it? Really big. Trillions big. And has been rising. [EUR overstated here because includes intra Europe]

Of course not all this borrowing is fx naked. Companies have dollar revenues selling to the us. Some have hedged the fx. Some have onshore us operations earning dollars. But there are a lot of entities that are mismatched globally.

The combination of rising rates and rising dollar puts the most pressure on the most mismatched companies and countries. That is where we will see the cracks of the tightening cycle emerge first. And already has to some extent in entities like Chinese real estate, etc.

Most importantly the Fed will not care unless it creates a systemic risk to the US (unlikely). What Connally said 50 years ago is as true now as it was then: “The dollar is our currency, but it’s your problem.”

Clarida on Bloomberg today just after the Fed hike asked about the dollar impact on Fed action. Don’t have exact quote but the gist was – Won’t make any impact on the Fed cause doesn’t matter for the US economy, but sure is an important thing for the rest of the world.

Decades ago I got into FX because I saw these markets provide an incredible lens into all the major dynamics going on in economies and financial markets. Even now I always start the day looking at the FX market action to get a pulse on what’s happening.

Few folks are going to trade FX as a source of alpha. But nearly all traders will be influenced by the impacts of FX and the cross-border capital flows that drive them. That’s why its so critical to understand these dynamics no matter what part of the markets you trade.

And many thanks to

@Brad_Setser for his decades of writing shedding light on the opaque world of FX dynamics and cross border flows, a small number of which I quoted above. Its world class insight usually reserved for hedge fund elites made available for everyone. Go follow him.

Central bank intervention does not work in large developed world FX markets. Markets are driven by fundamentals and are too big for central banks to make lasting impact. Actions incentivize trades against it and trying to prop up a currency is hard since limits are well known.

But don’t take my word for it, there are good case studies from the last 30 years. Impact is very short-term. June 17, 1998 caused a one day rally. Selloff continued for a month till AFC became acute / RUS crisis, both changed the fundamental dynamic and caused a rally.

Euro intervention in Sept 22, 2000 caused a brief uptick and then a return to new lows. And then came back to the same lows a year later.

I remember March 2011 very well. They hit the market hard to reverse the massive squeeze. Pretty transitory. A month later the market settled back to the mid-70s for awhile.

Of course UK ERM. A perfect case of trying to prop up the currency of a large liquid developed world currency market. Everyone knows it didn’t work. But more interesting is that as the BoE picked up their activity traders became shorter, making it self-defeating! Hint to MoF.

Where it did work it was small and 1-2 days. Could argue intervention occurred close to turning point levels. More likely price levels created fundamental pressures which marked the bottom. St. Louis Fed paper gives good background.

https://files.stlouisfed.org/files/htdocs/publications/review/11/09/303-324Neely.pdf

As an addendum to this, I would highlight cases in smaller or more structurally closed economies where central banks did hold the line. SNB and PBoC kept caps on their FX for a long time by accumulating huge reserves. PBoC has recently defended FX, though just getting started.