Going back to basics in the FX market

The FX market is still an area of finance that is not well understood. Along with arcane terminology, the models often employed in the FX market have a spotty history of forecasting. They have a history of not working, yet are trotted out on a regular basis with a confidence that they can provide useful information.

That being said, all is not lost. There is strong research that suggests that even if models have a spotty history as measured by a low R-squared, they can have value within a portfolio. There are optimization approaches that can take into account model uncertainty and reduce the risk of a wrong forecast. We have found these techniques useful. Even with a poor history, going back to these simple models helps isolate what may be important factors driving the FX market.

Purchasing power parity is one of the key concepts that is supposed to drive the FX markets in the long-run, yet it often fails as an effective tool in the short-run. It can only be used for long-term valuation and even then it should be considered with suspicion. 

Nevertheless, PPP can also give useful information on one of the key relationships in the currency markets. We have recently looked at PPP and found some interesting non-linear relationships which do make sense. While PPP seems to hold well when there is relatively high inflation or more importantly when there is a high differential in inflation between two countries, it fails when there is little differential in inflation across countries. This should not be unexpected. When the noise of the market is greater than the differential signal that could come from inflation, there is little explanatory power or relationship between these variables. The real exchange rate is relatively unchanged and factors such as financial flows or interest rates will be the key drivers. While there has been a little more movement in exchange rates than can be explained by the recent differentials in inflation, the inflation spreads are still not enough to make PPP a useful indicator.

More importantly, short-term changes in inflation relative to exchange rates actually show some of the wrong expected signs. We found this very unusual given that the expected signs were in place in the 80's and early half of the 90's. However, a close inspection suggests that inflation targeting may be associated with these unexpected relationships. 

If there is higher than expected inflation in a country and they target a lower inflation, there is the expectation that the central bank will increase interest rates which may lead to a currency appreciation, Investors will be driven by the financial rates and not by the pure inflation. Put differently, inflation above the target is not expected to last and is discounted. This could provide us with the wrong regression signs for monthly inflation.

In a era of inflation targeting, some of the old approaches to explaining exchange rates may have to be adjusted to account for expected central bank action. It is not that PPP does not hold, but that the basic equations may be signaling something else.