Currency investing, mean-reversion of real effective exchange rates (REER), and portfolio flows

There can be value investing in currency markets through using information on the Real Equilibrium Exchange Rate (REER) which is the trade-weighted average exchange rate adjusted for inflation differences. REER provides a better measure of currency equilibrium over the standard purchasing power parity model  against a numeraire like the dollar.

A shock to REER will show a strong tendency to mean-revert albeit with different speed of adjustments based on the size of the shock and potential portfolio flows. The adjustment of REER can actually occur in a matter of months based on the type of shock. A deviation or shock in the REER will usually lead to changes in interest rates that will generate portfolio flows that will lead to currency adjustments. Greater flows will speed the closing of any REER deviations. Hence, if there is a large deviation in REER, that make for attractive capital flows, there is an opportunity for return gains. It is an easy enhancement to a standard currency carry model. See "What Flows Around Comes Around: Mean Reversion and Portfolio Flows"

We have found that sorting by size of the deviation from a longer-term REER can allow for unique currency trade opportunities. Buy or sell those currencies that have the greatest deviations from some measure of fair value in this case REER. Wait for a trend in portfolio flows to place trade opportunities. 

There is growing information from some custody banks on portfolio flows that can be used reinforce any REER signals. This type of trading can be conducted in conjunction with trend and carry strategies. Measure the  REER dislocation, follow the portfolio flows, follow the trend, and trade the carry.