Fundamental Analysis in Forex: Debt, Central Bank Intervention

Debt Analysis

The efficacy of debt as a fundamental analysis tool varies. During periods of economic growth, the markets tend to pay scant attention to rising debt levels. As long as the ratio of debt to GDP stays constant, investors operate under the implicit assumption that the economy will be able to grow its way out from under the burden of increased debt. As government spending is a component of economic output, it can even have a positive impact on currency performance, especially if it doesn’t crowd out private investment. When growth slows down, however, debt ratios tend to increase relative to GDP. This is exacerbated by declining tax revenues, the propensity of governments to increase spending during recessionary periods, and by consequent cuts in sovereign credit ratings.

Any time this happens, default can quickly become a self-fulfilling prophecy as governments find it impossible to take out new debt and refinance existing debt at affordable interest rates. Investors get nervous and respond by moving money offshore, causing rapid currency depreciation. In fact, this is exactly what transpired during the credit crisis. Debt had already risen to alarming levels, but it wasn’t until growth slowed down in 2008 that investors took stock of the bubble years. Iceland was singled out for its imprudence, and it wasn’t long before its banks were declared insolvent, its government defaulted on its debt, and the krona had to be temporarily replaced by the euro.

As far as fundamental analysis goes, there are a couple of ways in which debt is relevant. First of all, it can be used to forecast the likelihood of full-blown financial crises. The Economist, for instance, uses three indicators (budget deficit, net debt, and GDP growth minus the cost of finance) to rank countries in terms of the sustainability of their debt. Unsurprisingly, the four PIGS countries of Europe were near the top of the 2010 rankings. Then again, so were Japan and the United States! (See Table 5-1.)

Table 5-1 Countries Ranked by Sustainability of Debt Position in 2010 (Source: The Economist, Bloomberg LP„ EIU, OECD)

In this case, however, it is not debt itself which presages a crisis, but the ease with which such debt can be financed. The currency markets thus tend to view bond yields as being most representative of a country’s ability to deal with debt. A sudden increase in yields can signal the start of a potential crisis, and currency depreciation tends to follow. In addition, yields adjust in real-time while debt levels change incrementally. In the case of the Eurozone, sudden spikes in bond yields have often corresponded with depreciation in the euro. (See Figure 5-23.)

Figure 5-23. Portugal’s 10-year bond yield and EUR/USD, relative change (Source: Bloomberg L.P.)

Some pessimists have argued that both the actual and the potential increase in US debt levels could threaten the long-term viability of the US dollar. Alas, neither credit nor currency markets have priced in the possibility of US federal government default. And the historic downgrade of the US sovereign credit rating in August 2011 was met with yawns.

Finally, debt level comparisons have been used to buttress the case for buying emerging market currencies, whose net debt levels are much lower than their developed world counterparts. To be sure, this is yet another reason why emerging market currencies will continue their steady upward march over the next decade.

Monetary Policy and Central Bank Intervention

I’ve already talked about the role that central banks play in setting interest rates and tweaking money supply. Here I want to examine some of the other ways in which they can influence the forex markets.

First are the central banks’ open market operations. Open market operations are now arguably the most prominent weapon in a central bank’s arsenal. During periods of recession, when inflation is low, central banks can literally print money in order to fund purchases of financial securities. The central bank holds these securities on its balance sheet with the intention of selling them off once the economic pump has been fully primed and inflation has taken hold.

In the wake of the credit crisis, the world’s major central banks stunned the markets with the scope of their open market operations. The Fed’s program was particularly ambitious. In a process known as quantitative easing, the Fed purchased almost $3 trillion worth of financial securities in two discrete blocks. (See Figure 5-24.) Critics worried that the bank had sacrificed its independence, that it was enabling record US government borrowing, and that it would foment asset price bubbles and inflation. As a result, the currency markets punished the dollar severely after each round of quantitative easing was announced. Whether their concerns were justified ultimately depends on whether the Federal Reserve Bank can unwind the program (by selling the securities on its balance sheet back to private investors) when inflation picks up.

Figure 5-24. Federal Reserve Bank balance sheet

From the standpoint of fundamental analysis, there is an edge to be gained from correctly reading the tea leaves and predicting both the beginning and end of quantitative easing programs. Those that guess right and invest accordingly will be rewarded with profits. More importantly, fundamental analysts should understand how quantitative easing can indirectly impact forex markets in various ways, via a stronger stock market, lower bond yields, and potentially higher inflation.

Central banks can also attempt to guide their exchange rates through forex intervention. Most emerging market central banks are active (to varying degrees) in taking steps to push down their respective currencies, though countries in Latin America and Asia have been particularly aggressive. This is typically achieved by selling large chunks of their home currency on the spot market and can be supported with measures that penalize speculation by foreign investors. Some central banks have fixed intervention programs in place. Others spend large amounts on discrete occasions in a bid to overwhelm the markets. Still others engage in “verbal intervention” without ever directly entering the markets.

Beginning in 2009, central banks began intervening, one after another, in vain attempts to prevent their currencies from returning to pre-credit crisis levels. Even the major central banks contributed with a coordinated intervention on behalf of the yen, which had strengthened after the March 2011 earthquake. In November 2011, the central banks intervened again with a program of liquidity swaps that was designed to prop up the ailing euro. The Swiss National Bank, meanwhile, keeps threatening to renew its failed program to hold down the franc. After a multi-day appreciation, it intervened verbally and caused the CHF/EUR to raise by an unprecedented 1000 PIPs in a single trading session! (Note Figure 5-25.) To be sure, all intervention is doomed to fail over the long term. Over the short term, however, it can quite spur magnificent spikes.

Figure 5-25. Immediate and medium-term impact of SNB franc intervention

When central banks intervene, they inadvertently provide support for opposing currencies. In other words, a central bank cannot simply sell its home currency; it must simultaneously buy an opposing currency. As I explained in Chapter 3, this drives the accumulation of currency reserves. That most central banks disproportionately prefer USD-denominated assets is a huge source of support for the US dollar. While there are frequent indications that this could change, problems with the other major currencies (most recently with the euro) favor a continuation of the status quo. Emerging market currencies meanwhile remain subject to liquidity and other logistical complications that hinder their broad adoption as reserve currencies. Nevertheless, central banks collectively represent one of the largest long-term players in the forex markets, and fundamental analysts must closely monitor this situation for any signs of change.

Political Factors

The role of politics in financial markets has always been difficult to quantify. Generally speaking, elections and changes in political administrations tend to have only a psychological impact on forex markets. This is especially true in the case of the United States, where economic policy has not changed significantly over the last few decades. Free trade has been gradually embraced, tax rates have edged down slightly, corporations have become more profitable, budget deficits have become the norm as spending has surged, the business cycle is increasingly driven by financial factors, and so forth. To be sure, policy may shift to the right or to the left depending on which party holds power. For the most part, though, the overall trend has remained intact. As a result, elections tend to offer very little insight into how a particular currency will perform during the years that follow. Instead, financial-economic factors tend to carry more weight. As can be seen from Figure 5-26, former President Bill Clinton can claim the dubious distinction of being the only US president to witness an overall rise in the US dollar while in office. This was probably less due to the nuances of his economic policy, however, than the economic and stock market boom that began in the late 1990s and carried over into the presidency of George W Bush.

That’s not to say that politics are irrelevant. On the contrary, the whims of governments can cause significant gyrations in the forex markets. For example, the US dollar suffered mightily when the US Congress temporarily balked at raising the US borrowing limit in May 2011. Meanwhile, political developments in Europe continue to drive the euro, whose very existence seems to hinge on political life support.

Figure 5-26. USD Trade-weighted index and corresponding US president

Emerging market currencies are perhaps most sensitive to political developments, because their governments are more likely to pay attention to and take steps to influence the value of their currencies. While this task is supposed to be delegated to independent central banks, in practice it is subject to political meddling. For example, if the incumbent government of Brazil makes a strong export sector the cornerstone of its economic policy, it may instruct the Bank of Brazil to actively take steps to hold down the real. This practice reached an extreme from 2010-2011, as cash (spurred by loose monetary policies in industrialized countries) began to pour into emerging markets, causing their currencies to appreciate rapidly. Emerging market central banks fought back and, one after another, sought to devalue their respective currencies. Before long, a full-scale currency war had erupted, and emergency meetings of the G7 and G20 were convened. It wasn’t until late 2011 (when the European sovereign debt crisis flared up and risk appetite cratered) that the currency wars began to fade, once again underscoring that political factors are less important than financial-economic factors.

Conclusion

If there is any lesson to be learned from the preceding discussion, it is that there are no cut-and-dried rules in fundamental analysis. In understanding how numerous variables impact exchange rates, one must first understand the particular narrative that is guiding the markets at any given time. Whether risk appetite is strong or weak, whether a currency has or has not been targeted by carry traders, whether an interest rate change has been anticipated in advance are all factors that will ultimately determine the market reaction. Fundamental analysis merely provides a framework for understanding these narratives.