It is the central bankers who have become all powerful in this crisis. Politicians lack the ability to do much with fiscal policy, and the need to appease voters makes structural reform difficult. Thus it has been largely left to monetary policy to prop up the financial system, avoid economic chaos and hopefully eventually stimulate growth. But this has caused an over reliance on central banker’s actions and words. And the FX market is just one of many that are now dominated by Central Banks.

So are traditional currency valuation tools and models becoming obsolete? The old rules governing a currency’s value ignored?

So one of the most surprising FX facts over the recent crisis has been the relative resilience of the euro (especially given the market has adopted a short euro position). Since mid 2009, the Euro has been range bound against sterling despite poor EZ economic data, fears of a currency breakup, Greek default etc. And also its been relatively strong against the Dollar too. But why? Clearly the key here is the term relative. One of the biggest reasons for euro resilience has been the policies pursued by the Federal Reserve in the US and the Bank of England, namely Quantitative Easing. Money Printing has contributed particularly to Sterling and USD weakness / debasement.

In terms of the pound relative to the euro, sterling is significantly weaker than its long term average. However, at some parts of the crisis, sterling strengthened as it was perceived as a “non euro safe haven” but what little strength there was has never lasted. Why? Because of QE – aggressively loose monetary policy weakens support for the Pound. At the beginning of this year when UK economic data was weak and a triple dip expected, Sterling fell dramatically from buying $1.62 at the beginning of January to just $1.49 by mid March. However since then, better economic data and the mid May optimism from Governor King on the UK economy helped Sterling to strengthen back to over $1.57. Carney’s arrival and his dovish speech four days into the job, caused sterling to fall again back down to below $1.49 (from which it has recovered). All moves dominated by expectations of Bank of England policy.

The US entered the crisis before all else and has emerged out of the crisis earlier. The economy last year grew by 2.2%, the strongest in the G7. And yet in 2012 the Dollar was the second weakest currency in the G10 after the Yen. It is no coincidence that QE “infinity” of $85bn a month started in Autumn 2012. When the US financial disaster first hit in late 2007 / 2008, the Dollar hit an all time low, and yet despite its safe haven status and a US recovery, the Dollar has since remained in a fairly weak position. It is becoming apparent that the introduction of QE by the Fed in 2008 has had a remarkable depressive long term effect on the USD.

Let’s take a look at one of the biggest trades of the nine months – yen devaluation. Up to the arrival of Prime Minister Abe, the main theme throughout the crisis had been Yen strength thanks to its safe haven status (irrespective of the low yield on the yen). However Abenomics has changed all that. The Yen has fallen from 78 yen per dollar to around 100 Yen to the Dollar in the last three quarters. In fact the USD/JPY level hit 99 in April- the lowest level since since 2007. This rapid weakness is mainly due to the expectation of a much more aggressive monetary policy from the BoJ (as well as global investors turning risk on). On April 4 the BoJ pledged to double its government bond holdings in just two years. This didn’t weaken the Yen further, partly because an aggressive BoJ move had been anticipated but also because of Dollar weakness thanks to weak US 2Q data.

The FX markets are overly dominated by what Central Bankers say and do. In some ways this is not a surprise – trillions have been spent on QE and interest rates are at record lows, seriously affecting how investors and traders act. Monetary policy is an almighty force and of course it is controlled by Central Bankers. Secondly the US, Eurozone, UK and Japan are all fighting similar wars (the after effects of an asset price bubble, a damaged financial industry and excessive debt) with similar weapons (ZIRP and QE). Therefore close examination of those in charge of these very similar policies is needed to try and differentiate between different currency blocks.

But even given the dominance of Central Bankers, there is also some evidence that old fashioned currency models are still relevant. For example one of the reasons why the Euro may have been strong is that the EuroZone as a whole has a large current account surplus (albeit mainly thanks to German exports). And although the BofE is happy to ignore inflation in setting its monetary policy, maybe the recent years of high inflation has contributed to Sterling weakness. And there is plenty of evidence that differences in interest rates are still driving some currency pairs (the main economic model for currency valuation uses differences in real interest rates).

So looking at the following chart, it shows (orange line) the USD/JPY exchange rate. The blue line is the 2 year yield spread between Japan and US (difference in two year borrowing costs between the two countries). Quite clearly the two were highly correlated – higher American interest rates ensured Dollar strength by attracting money into Dollars. However as the chart shows, the relationship broke down once Abenomics arrived.

louise 1

The following chart is the 2 year German US yield spread (in orange) and the EUR/USD exchange rate (in blue). Again clearly interest rates differentials dominate this currency pair.

louise 2

Currently Germany is borrowing around 0.25% cheaper than the US for two year money and so the orange line is below zero at -25bp (scale on left). This coincides with a EUR/USD ex rate of 1.30 (scale on right). When German rates were 1.25% higher than the US in 2011 though, the Euro was much higher, at around EUR/USD 1.50.

However although there are fundamental reasons why interest rates affect currencies, these charts may just show that central bankers are dominating the bond and FX markets as much as each other!

The problem is that markets are highly complex and what drives them day to day, minute by minute is not easy to determine. Correlation and causality are always problematic. That may be why so many forex traders rely on technical strategies and not fundamentals (more on technical trading strategies in a future column).

The recent market shake up has been caused by the Fed’s talk of potential “tapering” and not outright tightening (which is not expected for another few years). This just shows just how manipulated and distorted markets have become that they react so wildly at just the threat of slowing down of US QE. It highlights that the reversal of QE and ZIRP globally will be the greatest challenge that markets (and economies) face over the medium term. Central Banker’s domination will continue for the foreseeable future..

Way back in the 80s I also had a haircut like Curt Smith, lead singer of Tears for Fears – curly on top and short on the sides. I thought it was a great idea at the time. QE clearly also appeared to also be a great idea at the time (when the financial world was in meltdown post Lehman). But just like my haircut, the passage of time can change a previously strongly held view (and no I am not posting a photo of me with my 80s haircut).

If anyone has any subjects, explanations etc they wish me to write about in future columns please just ask.