The foreign exchange market tends to be the most forward-looking market, even more so than interest rates. FX markets are deep, liquid, subject to changes based on world trade, the deltas in global economic activity and differences in central bank policy.
Capital will flow to the area in which the highest return can be generated per unit of risk as it pertains to economic activity or back into the US dollar as world trade volumes decline given the status as a world reserve currency.
Small emerging market countries that run a trade surplus use the flow of US dollars to support their local currency, and when world trade declines, as we have seen over the past several months, there is less in terms of “ammo” to support the local currency and typically the emerging market currency depreciates against the dollar.
When global growth accelerates, or when global investors think global growth will accelerate, capital will flow outside of the US into higher return areas. This involves more risk as investors are worried about depreciation. This is why when world trade slows, or the Federal Reserves raises interest rates, capital flows back into the United States.
Late in 2018, the Federal Reserve was raising interest rates aggressively, and the 5-year Treasury rate moved as high as 3.10%. Not only could you receive over 3% in the US, but the Fed also signaled that more rate hikes were to come. This sparked major declines in emerging market currencies throughout 2018.
As the Federal Reserve pivoted, canceled the additional three rate hikes and outlined a path to end quantitative tightening “QT,” interest rates fell almost 100 basis points on the short end of the curve and emerging market currencies stabilized.
It doesn’t come as a large surprised that with global trade impacted from ongoing negotiations that the hideout, for the time being, is the US dollar, but one market to watch as it pertains to global expectations of world trade and growth is the FX market.
I have a heatmap of over 40 currencies, all quoted against the US dollar, that I use to spot outlier trends or gauge the general trends in currencies around the world. Most investors quote the DXY index, but that is just a basket of major currencies such as the Euro, Yen, and Pound. The trends in the smaller currencies are often more important as it pertains to capital flowing into higher return areas of the globe or trends in world trade.
Below is a heatmap of most currencies that trade against the dollar, sorted by the 12-month change. As the table shows, the Bloomberg Dollar Index is at the very top of the list, up over 6% in the past year and the basket of emerging market currencies (highlighted in yellow) is still near the bottom of the list.
Many parallels are being made to 2016 and the reacceleration in global growth and while that may occur, perhaps after trade resolutions, the trends in the FX market are suggesting that analog may be premature.
This is not to say the US market or economy cannot do well but it still may be early to fly into emerging markets unless you are looking to front-run some of the data which comes with a higher profit potential but greater risk as well.
If we look at the same chart but sorted over six months, we can see the stabilization mentioned above after the pivot from the Fed, but there is still significant dollar strength.
Several EM currencies have appreciated a few points, but EM currencies as a basket are up just 0.6% in the past six months.
To highlight this point, if we take the same chart but see what it looked like in July of 2016, when US interest rates bottomed and the global economy definitively started to recover, we can see that the US Dollar Index was almost at the bottom of the list in terms of six month performance, EM currencies as a basket were up over 7% and near the top of the list and several high beta currencies were up double digits in just six months.
Emerging market currencies have shown signs of stabilizing in recent months with the JPMorgan EM Currency Index up 0.6% in the past few months. At the very least, these currencies have stopped depreciating.
While I take a very holistic view on the global economy and would never make a decision based on one market or one indicator, one strong indication of global growth would be a continued appreciation of emerging market currencies.
When studying the US dollar, look beyond the DXY for a more comprehensive view of how the greenback is interacting with the rest of the world.