The Curious Case of Strong Currencies With Negative Interest Rates

Poor Fundamentals & Strong Currencies Make For Confused Markets in 2016

Confused Investor
interest rates traditionally indicate the strength of an economy and therefore its currency. In 2016, the near opposite has occurred.

"The road we're on is coming to an end," 

Mohammed El-Erian speaking about persistent low-growth, low inflation, and low-interest-rate path in developed economies

If you were to begin working at a Forex brokerage, one of the first things you learn is that a central bank's set reference rate helps explain the strength of an economy. This is especially the case in a developed market where signs of inflation getting out of control to tend to be less of a concern.

Therefore, one would expect that central banks such as the Bank of Japan, the European Central Bank, the Riksbank in Sweden, and the Switzerland National Bank would have weakened their currency by pushing reference rates below zero or into negative territory. 

That hasn't happened.

So far, 2016 has seen an opposite effect of these currencies against other majors like the US dollar, which appears to show a new narrative developing this year separate from what we've seen in years past. This development means that currencies with fundamentals so bad that central banks are taking interest rates negative to practically beg the economic producers to start borrowing and grow the economy have strong currencies. You would be forgiven as a trader if you thought this was some bizarre episode of the twilight zone.

So why has this all happened?

Understanding the Strength of Negative Rate Currencies

Capital and trade flows help explain a lot of variance in the value of global currency exchange rates.

Capital flows tend to do with large investors moving money around the world looking for the safest risk-adjusted return. In other words, institutions like pension funds and mutual funds send billions of dollars to the place they think offers the best opportunity for them to meet the objective of their investors.

A classic historical example has been Japan. Japan’s pension funds, which have been some of the largest in the world are famous for sending large amounts of money overseas into other government bonds that yield higher returns for a similar amount of security or rating and seek other investments. Typically, there are two sides of the risk sentiment spectrum, risk on and risk off. If you think of it as a switch, risk on indicates an environment where return and appreciation of the underlying asset are the greatest concern. When the switch is flipped, risk off shows an environment where safety and capital protection is the biggest concern.

A unique characteristic of the economies of negative interest rates, Europe, Japan, Switzerland, and Sweden is that they are all positive Current Account economies. In simple terms, a positive current account or trade surplus shows they are receiving more money is an economy from exports and they are spending or on imports. With a large current account surplus, these economies are stuck in an odd juxtaposition of stronger interest rates at a time where central banks have moved their interest rate policy into negative territory.

Now, these central banks with strong currencies and negative interest rates are seeing an environment where their nation’s savings are much larger than its investment, and therefore, there is little need to attract capital from other markets.

This is nearly the exact opposite environment many emerging markets find themselves in and why they were in a world of pain when the dollar strengthened so aggressively in the second half 2014.

Economic narratives rarely turn on the dime, but with this argues is that these currencies could continue to increase further if their current account surplus continues to grow. Only until the investment flows out of the country become larger than the saving amount should the currency see significant depreciation that many expected. Additionally, the new narrative of the US dollar further drops the likelihood of significant depreciation of these negative rate currencies. This development means until we see either a stronger dollar or significant capital flows out of these countries, we likely will not see the drops that many expected when the negative rates were announced.

Understanding the Opportunities

A big surprise in markets in 2016 has been the reemergence of Emerging Markets or EMs. After China started to pull off the accelerator of state-driven economic growth, emerging markets immediately felt the pinch. For nearly three straight years, emerging market currencies were in decline and especially against the US Dollar. Now that China is active again, more on that below, emerging markets and commodities have caught the attention of hedge funds and individual traders like you and me.

While the current market is not without risks as you’ll soon see, the large account surpluses in economies with negative interest rates mentioned above might happily send significant amounts of capital to emerging markets and commodity-rich economies like they did in 2009 to 2011. Such a move, if it developed, could see not only WTI crude oil retrace much of its losses, but also continue to see capital flow back into emerging market projects that were left for dead after the dollar started its strong rise in China reduced its demand.      

 Regarding emerging markets, not only are they a potential value play, but the interest rates and potential rewards (please don’t ignore the ever-present risks of defaults) make EMs a hotbed of investment activity. Central Banks will likely have to be more aggressive than initially perceived to be when they start hiking rates. In other words, when inflation begins to show up, if the slope of inflation is more aggressive than expected, negative interest rates may require more aggressive central banks.

Understanding the Risks and Fears That Current Environment Has Produced

The understandable fear in 2016, the market has not behaved as many thought it would. At the start of the year, we saw significant dollar strength in equity market weakness alongside commodity weakness. Since February 11, there has been a complete opening range reversal of a great magnitude such that dollar is now weaker, and commodities, stocks, and emerging markets are having an incredible run.

One of the unique events in 2016 has been the surprising strength of Haven assets like gold and negative interest rate currencies such as the EUR, JPY, & SEK. Looking at these currencies against the dollar, we have seen consistent week over week strength from February to April. While many traders as per the Commitment of Traders report from the CFTC have left the long dollar position trade, many still wonder whether or not the US dollar will eventually move higher or whether the Federal Reserve has done an excellent job putting a cap on dollar strength. The fear is that the negative rate currencies that have shown strength for a majority of 2016 so far could get a good deal stronger. In other words, with the run-up and commodities at the end of the first quarter and so far in the second quarter of 2016, it is reasonable to think we could soon see an aggressive repricing of inflation expectations.

A majority of central bank moves have been made over the last two years due to a lack of inflation, and with the 70+ percent rise in major commodities like oil and iron ore this year it is reasonable to believe, and inflation scare could shock markets. The confusion lies in what will happen to these strong currencies with weak fundamentals when the fundamentals become more favorable. 2016 has felt like the twilight zone because weak fundamentals had not led to weak currencies as many suspects and other common correlations have broken down as well between equities and foreign exchange. Repricing Risk of Dovish Central Banks The risk of shock that could come from dovish central banks, central banks with an easy money bias, is likely the greatest risk in terms of probable causes of volatility in 2016.

Since 2014, much of the volatility within FX, aside from the amazing Swiss National Bank removal of the peg due in part to an increasingly weak euro, has been comprised of a strengthening dollar and weakening currencies elsewhere due to poor inflation readings. The ‘low-inflation’ story has become so ingrained in markets and common among central bank rate announcement meetings that many central banks have painted themselves into a corner of providing so much easy money that inflation might sneak up on them in a way not expected given how long we saw deflationary pressures.

A sudden surprise of aggressive inflation has historically been met with rising interest rates by central banks. To be fair, central bankers have brought about such easy money policies in hopes that such inflation would arise in the first place. However, it is uncertain given the scale of quantitative easing, how fast inflation will show up, and if central bankers will be able to manage it around 2% (their mandated target) or if there is a potential of inflation screaming pass that level. Given the strength we’ve already seen in currencies with negative interest rates, the natural question is what will happen if the central bankers of these already strong currencies switch from Uber-doves to neutral to outright Hawks to control inflation. So far, I do not believe anybody has a sufficient answer for how this will play out other than significant volatility because we’ve never been in such a coordinated easing environment where inflation could soon catch many by surprise.

A Manic/Depressant Rate-of-Change Market

Trading the foreign exchange market has been both excellent and frustrating over the last two years. There is one indicator that helps explain what we’ve seen in foreign-exchange since 2014 it would be the simple but telling Rate of Change indicator. From July 2014 to March 2015, the positive rate of change on the US dollar was the most aggressive we have seen since the dollar index bottomed in summer of 2011 and during the throes of the great financial crisis in 2008.

The frustration mentioned above is the fact that the rate of change is so aggressive and quick or rather flat. In other words, this market shifts unusually aggressively from strong trend to directionless movement or range bound. From February, a majority of the aggressive, positive rate of change has been for commodity currencies, and the Japanese yen whereas the aggressive negative rate of change has been on the US dollar and the British pound in anticipation of the European Union referendum on June 23.

As a trader, it is important to admit when you are wrong in this type of market and get out or flips your position in the direction of the breakout quick. While this is not trading advice, staying in a market that is moving aggressively against you is especially painful in this environment. The pain is multiplied by leverage but is mainly caused by the longevity of moves in the direction of the trend. One powerful example has been the Canadian dollar, which is fallen by over 2000 pips in a little over 60 days from January 20 to mid-April.

What’s Going On With China in 2016? Big Things

Another shock to the market in 2016 has been and likely will continue to be the recovery in China. In January, the People’s Bank of China began the first trading day of the year by weakening the Yuan in a similar fashion that they did in August. The initial weakening in August since the first wave of deflationary fear across the world and you want evaluation was a popular target of blame for the Black Monday on August 24.  China promoted the narrative of transitioning from a state-run manufacturing-based economy to a discretionary-based economy fear ran rampant that commodity demand would fall off the cliff and that emerging markets may have lost their largest customers. At the time, regardless of the commodity, it appeared to be in a bear market due to fear that reduced demand from China would severely expose the imbalance of oversupply and under demand in the commodity market. However, in February, China decided to turn back on the stimulus in a similar fashion to early 2009.

One of the most impressive stories regarding a turnaround in China is seen in the iron ore market. Not only is our speculators betting it up, but the increase in construction in China has led to a particular iron ore contract that mainly focuses on Chinese infrastructure growth is up nearly 60% on the year.  Now, what is uncertain is how long the stimulus will last and what effect this will continue to have commodity prices, which are a key driver of inflation.

When China announced stimulus in early 2009, few thought they would carry the stimulus through to 2011, but in doing so, they gave the global economy an excellent lift. The potential for a repeat performance is causing many to wonder if the economic cycle is turning, and if so, will central banks be ready to get on board. What To Watch Going Forward Given the rise of major commodities like iron ore and oil, the significant economic release to watch going forward will be inflation readings. If you have the ability, you can look at five-year five year or 5Y5Y forwards, which is a standard instrument used to add anticipated inflation on top of the five-year note of any specific economy like the United States. Since mid-2014, the 5Y5Y has tracked alongside commodity currencies like the Australian dollar very well. Additionally, since WTI crude oil bottomed in mid-February,5Y5Y has turned up as well.

 An aggressive move higher would likely get the attention of other central banks, which is when the volatility should get cranking if the bankers acknowledge an aggressive reversal action should inflation heat up too quickly.  Given the role that commodities play and inflation and subsequently the role demand from China plays in commodity value, it is possible that were about to see a large shift in the global economy narrative that will shake up the foreign exchange market. Should this happen, the near guarantee would be a resumption of the aggressive rate of changes as future rate expectations get repriced but how individual currencies react to the event is lesser-known. Thankfully, this is the beauty of technical analysis where you can keep an eye on the charts to confirm or invalidate trade ideas and to help you manage risk.

Happy trading and good luck!