How macroeconomics will drive FX markets coming out of the pandemic - Capital Economics
The Chief Economist’s Note

How macroeconomics will drive FX markets coming out of the pandemic

Our new FX Markets service, which we launched last week, brings a fresh approach to analysing currency markets by looking at them through a macro lens. 

Currency markets are notoriously difficult to forecast. This is partly because of the need to anticipate moves on both sides of the exchange rate. For example, forecasting moves in dollar/euro requires taking a view on the prospects for the US and euro-zone economies. In addition, exchange rates respond to global factors such as commodity prices and broader sentiment in financial markets. This adds an additional level of complexity compared to forecasting the prices of, say, bonds or equities. Focusing on the macroeconomic drivers of currency markets can help to cut through some of the fog and provides a much-needed analytical framework.

There are several obvious macro drivers of currency markets over the short term. But the key point is that the relative importance of each of these tends to shift through the economic cycle. For example, both in global economic downturns and in the early stages of recovery, shifts in risk appetite tend to dominate currency moves (supporting safe haven currencies on the way down and favouring “high beta” currencies on the way up). Once the recovery is established and risk premia return to ‘normal’, however, currency moves tend to be driven by other macro factors, notably interest rate differentials. Understanding and anticipating the transition between these different phases, or “regimes”, is therefore crucial to anticipating movements in exchange rates. Likewise, it is important to have a deep and well-rounded view of monetary policy shifts across all the world’s economies – not just Fed and ECB policy.

A macro framework can also help to identify those currencies in need of a more fundamental adjustment over the medium term. An important aspect of this is the interplay between the current account position and conditions in the real economy. Economies that run persistent and large current account deficits may eventually need a weaker real exchange rate in order to put their external positions on a stable footing. The same is true of economies that run smaller current deficits but are operating at well below full employment. Pinning down the exact timing of such adjustments is obviously difficult but large current account deficits usually presage significant, and often sudden, currency corrections.

Finally, macroeconomic factors also underpin shifts in currency markets over the long term. In particular, productivity differentials are a key driver of real exchange rates over a long horizon. Economies that experience comparatively rapid productivity growth tend to experience an appreciation of their real exchange rates. Conversely, those with weaker productivity growth tend to see their real exchange rates depreciate. This is the so-called “Balassa-Samuelson” effect, and it explains why many fast-growing emerging economies tend to experience real exchange rate appreciation over the long run.

Putting all of this together provides an analytical framework for thinking about currency markets over different time horizons. In the short-term, the broadening out of the post-pandemic recovery suggests that we are moving from a regime that is centred on risk appetite to one centred on rate differentials. That in turn should mean that, having weakened since the middle of last year, the US dollar reverses course and strengthens over the next 6-12 months as US growth and inflation rebound more strongly than elsewhere.

Further out, we think that balance of payment dynamics are likely to undermine some EM currencies. Turkey is already going through significant economic turbulence and most signs suggest the lira exchange rate still needs to fall further to generate sufficient adjustment. Over the medium term, we think the South African rand also looks too strong for the country’s underlying external fundamentals. And over the long-term, it is likely that productivity differentials will favour the Chinese renminbi, the Indian rupee, and the currencies of other fast-growing economies in emerging Asia over the US dollar, yen and euro.

You can read more about all of this – including our ten top calls for currency markets – on the FX Markets service. If you’re not already receiving it, sign up here.