US Macro shocks and style factors - Important in explaining EM currency moves

 

Emerging market currencies are very much related to the behavior of the US economy. This link is well-known, but the timing of market reactions is often not well-connected. The authors of the recent paper, "Emerging Markets Currency Factors and US High-frequency Macroeconomic Shocks" solve this problem by using higher frequency market data to proxy for growth and money shocks in the US. Their study finds that 40% of the time series variation in an EM currency basket is related to changes in macro shocks or risk premium in the US which is more than double the impact seen with developed markets. 

The paper measures these macro relationships through decomposing the behavior of US stock and bond markets. The financial markets when looked at in concert can decompose drivers of macro shocks into two categories fundamental unanticipated shocks to growth and money and the risk premium of growth and money. 

Instead of using fundamental data which is often delayed, subject to revision, and not produced with any frequency, the authors look at relationships with stock and bond moves. For example, if there is a positive shock to both stock and bonds, markets are signaling a growth shock especially if the bond reaction is in the front-end of the yield curve. If the markets are moving in opposite directions, the markets are signaling a positive money shock which will form expectations of a future tightening. 

The general trends of stocks and bonds moving together or in opposite directions also provide signals on the market risk premium for growth and money, respectively called a common or hedge risk premium. In this case, it is critical to look at the relative move of the back end of the yield curve.

The authors also construct style factor portfolios for emerging market currencies (carry, momentum, macro momentum, value, and high dollar beta) and find that all have exposure to high frequency US macro shocks, but when combined in a portfolio, the macro exposure can eliminated. The authors also find that carry and macro momentum style factor portfolios create positive alpha. 

The conclusion is that emerging markets are US macro sensitive and holding a single style factor will not eliminate the risk from US shocks. This paper provides a simple way of tracking shocks without delay and can serve as an important tool for EM currency trading.

Currency trading making a comeback? The differences across countries say yes

The dollar and currency markets in general have been in a low volatility environment for an extended period. Trading opportunities have been infrequent and have been concentrated over short time periods. Periods of crisis like 2008 and 2020 caused large currency moves, but stability has generally ruled the markets. 

However, currency stability may be coming to end. As Fed QE ends and QT begins, the transition will lead to more volatility as investors adjust to the new monetary world. This process is already starting globally with QT beginning with other central banks. 

The new currency environment will be driven by several changes in global markets:

1. Low rates will be ending. The process may still be early, but rate differentials will widen as central banks reduce their stranglehold on rates.

2. Low and stable inflation environments will be ending. Even if some of the highs in inflation are reversed, inflation around the globe will be elevated and have greater dispersion.

3. Differentials in growth will increase. Growth rate differences have already increased and as policies change, growth differences will continue.

4. Similarity in central bank behavior is ending. Policy differences will increase especially in emerging markets.

5. The volatilities in traditional assets are moving higher.

6. Policy uncertainty is increasing as countries choose different policy paths to meet their circumstances.

Policy and economic differences will raise opportunities across all currency markets. 

 

Debt ceiling is a side show versus the riskiness of Treasury debt as measured by a discounted pricing model

The US has unusual fiscal dynamics with the regular battle over debt ceilings. A fight may occur, but eventually the addiction to debt continues. The drama unfolds; however, the ending is still much the same. Approval for an increase allows for another sequel to the current drama. For investors around the world, this does not make sense. We end with a potential crisis which adds uncertainty that is not necessary. There is still little fiscal prudence. Of course, deficits are necessary but so are surpluses over the long run. 

It is, however, more important to think through the strategic dynamics of debt and not the legislative tactics. In a recent working paper, The US Public Debt Valuation Puzzle, the debt problem is looked at from a different perspective. The authors attempt to price Treasury debt like any other asset using some classic asset pricing models. This provides some fresh perspective but also introduces a puzzle - why are rates so low when Treasuries should be considered a risky asset.  

From an asset price perspective, the market value of government debt should be equal to the present discounted value of fiscal surpluses. If the value of the debt exceeds the priced surplus claim, there is a debt gap. The authors find that the yields on Treasuries are lower than the relevant interest rates that investors should be earning on the risky claims. Hence, there is a puzzle for why there is this different.

The cyclical and long-term dynamics of spending and tax receipts makes for a risky claim. The primary surplus is pro-cyclical like stock dividends. Hence, Treasury debt has substantial business cycle risk and the relevant interest rate for discounting should have a risk premium. Debt occurs at inconvenient times from a consumption perspective. This risk premium is greater than what could be the convenience yield of holding Treasuries. 

The model and arguments presented may not make you money in the short-run, and the dynamics of buyers and sellers and the impact of the central bank are not considered, but the core arguments are useful. As long-term deficits increase and the cyclicality of deficits continue, there is less chance of future surpluses. The discount or appropriate interest rate for pricing these future claims should be higher. There should be a bias to higher real rates based on tax and spend behavior.

Market structure and high commodity prices - The continual pull to scale

There is the adage that the solution to low (high) commodity prices is low (high) prices. Prices change demand and supply, so low (high) prices will cut (raise) supply and raise (cut) demand. Prices will adjust. Market prices cycle between extremes with demand and supply lead to equilibrium adjustments. 

This commodity story is playing out today. Higher prices in oil and natural gas will lead to increased supply and a demand response. The adjustment may not be immediate, but there is clear mean reversion as producers and consumers change their behavior. 

Unfortunately, the story is more than a onetime adjustment in price. There are industry organization effects and restructuring of competitors. Price changes lead to a continual movement to economies of scale. Economies of scale are always lurking in the background when there are consistent price swings. Few industries become more fragmented as a response to market volatility. No firm becomes smaller by design. It is either increasing scale or elimination. 

With high price comes credit constraints that support large firms and hurts small firms. The same cargo that has to be financed for trade because more expensive. Lines of credit have to be increased even with higher value of collateral. Smaller trading firms are often unable to get this added financing at attractive terms. When prices are low, credit again may become scarce as the threat of bankruptcy increases for producers.  Of course, financing issues impact large firms, but the ability to weather these issues is easier when scale is already present. 

Logistical problems are also problems of scale. Failure for delivery, loading delays, and higher transportation cost all hurt the small firm that may not be as diversified as larger firms. Concentration of business makes the cost of logistical failure greater. 

Dispersion in price and logistical issues also lead to greater vertical integration by firms in order to control prices along the supply chain. Again, there is a movement to scale.

The movement to scale means more concentrated trading and less price transparency. This is never good for the investors involved in commodity trading.