How To Analyze The Currency Markets

that's true. It certainly feels like well, from my position in this part of the world, in Hong Kong, very close to China, it feels like a lot of the emerging market volatility and weakness has definitely been pinned on the dollar recently, right exactly. And it's also kind of weird because basically everything is priced in dollars, so I've always had a hard time wrapping my head around what is a move move in the US dollar versus what is other stuff moving around price of the US dollars?

That makes sense? Oh no, this sounds like a currencies episode. And you know that currencies are my least favorite thing to talk about because, as you point out, everything is always relative, right. It's kind of like if you're standing on Earth, then you say, oh, the sun is rising and the sun is falling depending on the time of the day, but we know that in the universe, the sun doesn't actually move at all, and everything moves around it.

And I've always sort of kind of thought of the dollar this way, like sometimes we talk about the dollar going up and down, but sometimes it seems like it might make sense to just talk about everything else that's priced relative to the dollar, and the conversation always kind of hurts my head. I would broadly agree with that.

And of course, the financial system revolves around the dollar, and the dollar holds that very special position in the financial system, which is that it is the world's reserve currency, which gives it an ster layer of complexity. Isn't that fun? Yeah, So both of us get our head hurt by currency conversations and trying to wrap our head about around the role of the dollar in the financial system. So I'm

very excited about the guest we have on today. We're going to talk about how to think about valuing currencies, how to think about valuing the dollar with a long time that a an expert in the world of currencies. He is Mark Chandler. He's a managing partner at Bannockburn Global forex and he is going to break it all down for us today. So Mark, thank you very much

for joining us. Thank you. I don't know about your headaches, but I can tell you this that there's two types of people I think in the world, people who give headaches and people who get headaches. And I'm a giver. You're gonna give us both headaches, both headaches, I think, and I thought, you're gonna be here to relieve our headaches.

The incredible thing is how complicated for and exchanges. And I think that you put two currency strategist and you'll get three different opinions, and think that that's the challenges. I think that you guys hit it in the sense that currencies are central, the dollar es central. But valuation. You know, when you think about stocks and bonds, there's a clear model of the valuation either an earning stream, free cash flow, breakup, value, replacement costs, all more or

less agreed upon models to evaluate equities. And you can do the same thing with fixed income NBAS. Economists can project the future value of the earning stream. But it comes to currencies and their pure form, they don't have an earning stream. You can turn them into a deposit and then they have yields, and then we can talk about interest rate differentials. But in their pure form, we live in an era of fiat currencies where money has

no value except the value we give it. It's not backed by gold or silver anymore, it's not backed by commodities. They're free floating for the most part of the major currencies, and so valuation becomes much more elusive. I think that's what a source of headaches are people, not only all the other problems with valuation on the head why both

Tracy and I get headaches talking about this topic? Okay, So on that note, I mean you just mentioned mark that, unlike a stock or a bond that generates some sort of cash flow, currencies aren't really doing that. So how do you go about valuing currencies? And does the value of a currency have to come from it moving up against something else. That's a good question. So how do we evaluate currencies? I think there's even the among economists, there's a few agreed upon tools that give one a

handle on valuation. I use w c RS on Bloomberg, and that'll give you thank you for the plugs they should that. They'll give you the uh the change in the day, but towards the bottom of it you get purchasing power parity p p P. I think of this sometimes as the famous one everybody's familiar with, probably the Big Mac, and the idea that the Big Mac should should sell very roughly the same amount in various countries, and and if they don't, it's because of a currency misalignment.

It's kind of a basic approach, and the idea is that currencies ought to equalize. The currency should move to equalize the basket of treatable goods. So whether you do with a iPad or you do with a Starbucks cappuccino, you do with the Big Mac, you get roughly the same general thing, and that is that the value of

currency is based on what it can buy. So let's talk about the famous Big Mac index and just really drill down, because I think you made an important point that I want to make sure people understand a big Mac. Pretty much everywhere, whether it's Tokyo, whether it's Zurich, Switzerland, whether it's New York City, whether it's somewhere in China,

it's roughly the same ingredients. Probably there are some tweaks here and there, but there's some flour or there's some wheat, and there's beef, and there's a certain amount of human labor that it takes to assemble a big mac and the pickles and the tomatoes, and so they are roughly the exact same product everywhere. And so what can you tell if a big mac is much more expensive and at a given moment in say Switzerland, than it is in China, what does that tell you about currency valuation?

So that are the the economists would argue that where the big mac is more expensive, it's where the currency is undervalued. And so you go around, You go around to find out where the big mac is cheap, and they'll tell you where the currencies are rich. And so I think that I had a colleague once who came to New York from London. It was amazed at how cheap the big macs were. That's all he ate while he was here. But no matter how many eight, it

didn't help bring the prices into alignment. He he himself wasn't able to close the arbitrage exactly, just shy. But I think that wait, wait, wait, okay, um, So I have a question on this, and sorry to be labor the big MAC point, But wouldn't some of the currency fluctuation come from differences and say labor costs between countries exactly? I think you hit Tracy on the key point here is that the that these kind of person power parity only measure the price of goods, so they might be

implicit in there. Some e commists will use instead of the big MAC, will use measures of inflation, and then you can use something such as like unit labor costs two, so you value you depreciate the couragcies by some kind of index based on unit labor costs, and that gets around that problem that I think you're right about if you think about the labor as a Chinese labor, Mexican labor compared to American labor, especially as we hype minimum wage.

And we've talked to say ten dollars or fifteen dollars an hour to make a big MAC compared to a few dollars in some other countries. But the other problem with the person power parity comments have tried to come up with new models who address this. It seems that in modern production the cost of capital is important, so in some ways then the cost of capital is not really picked up and I think gets to your point tracing not just about labor costs, but cost of capital rents.

In Hong Kong, maybe you have high rents. It's you know, like Manhattan's uson island, people have to build up, so maybe rents are elevated, and that will that will raise the cost of doing business, including selling Big Max or

Starbucks cappuccinos. So ultimately, although people do like models such as the Big Mac index, it only gets you so far because while there are certain baskets of tradeable goods like wheat or beef that really should equalize everywhere in any given location, there are enough local idiosyncratic things that that is just not enough to tell you whether our

currency is going to go up or down exactly. And and to your point, the you can look at the variance of Big MAXI on the world, or you can look at the Big Mac variance within the United States. And the variance in the United States also cannot be

accounted for by simply a currency misalignment, you'd imagine. So, but they kind of have come up with these and it's also available on the w c RS page for you is they call it, You've got real equilibrium exchange rates, which try to make sense of both the current account to trade balance as well as capital flows. The idea is here that currencies ought to equalize bring the capital account or the current account into balance, and so there

would be another measure. So you'd incorporate then not only the differential inflation, but the differential in the current account and the capital account to bring that into another model. And they more or less tend to all point the same direction. Currency that are overvalued, like the Swiss shrink, is still overvalued almost no matter how you want to look at it. What it really determined that the magnitude

of the overvaluation. So shall we talk about the dollar, because, as Joe mentioned in the intro, there has been a lot of attention focused on the dollar recently, maybe more so than usual. How special is the dollar? How special is the dollar? Can I say very? I mean, and by that I mean the foreign exchange market. This is

why I really like it. The average daily turnover five point three trillion dollars a day that comes from the Bank for International Settlements that does a survey every three years, five point three trillion dollars a day. That means in one week, does enough turnover in the foreign exchange market to cover world trade for a year, you know. And so it's it's a huge market and the dollar is on one side of roughly the trades. Why is it

so big? I mean, if you say the size of the trade and currencies dwarfs actual world trade, is it? Is it just speculative trading? Like what what drives these massive flows? Yeah? Share? So the one point is that trade is a big part of it, but it's relatively

a small part of it. Capital flows are much bigger than than trade flows and capital flows you think about the internationalization of portfolios buying foreign bonds and stocks compared to the trade I didn't think of between the U S And Canada, for example, among the two largest trading partners in the world. Capital flows are much bigger than the trade flows, and the capital flows require currency transactions, but also hedging. Also think about how the industry works.

So you are a bloomberg, you deciety getting some revenue in in Mexican pesos, and so what do you do with that Mexican pesos? Well, maybe would hedge them by selling pasos in the forward market or the futures market to protect you from a depreciation of the pace. So so, but then also you have an order, I say, a hundred million pasos, You give it to your favorite bank, and that that that bank might break it up into

smaller pieces give it to other banks. So in some ways foreign exchange trading is like um passing a hot potato around. Who's got the risk, who's managing the risk? And you get paid to manage the risk. That actually brings me to a question that I'm meant to ask earlier, but it's sort of a nice pause. You mentioned you get paid ultimately to manage the risk, to hold the hot potato of currency risk. Tell us a little bit

about your career. You've been analyzing this for a long time, and I assume you've talked to a lot of people in exactly that position who feel that they need to manage that risk. Just tell us a step back and sort of tell us about your experience in this market. Sure, So when I first got out of score, well, the only thing I do is right, I had to graduate degrees. I knew what unemployment was, but I wouldn't have a clue as what unemployment meant for interest rates or currencies.

And the first job I had was as a journalist on the floor the Chicago Markettil Exchange covering the currency markets, and I just read this book called The Dollar at its Rivals by an Italian economist, Para Bonni, and he sort of argued that the currency markets in the modern world is where nation states fight out national interest They wars are deadly and they're messy and the destructive, and we want to avoid those and so how can nation

states compete? And so from Pere Barney's views that I really took early in my career is that the currency markets is that arena in which the national companies, national corporates, national finance theres would fight out national interests. And from being a journalist, I found out that the markets reward people to have an opinion. And it's funny about the having an opinion. They don't have to be right. The idea is not so much being right, but sometimes it's

offering a Yeah. I think I think you had recently sent out a tweet or a note about how poor econoists are at forecast in the future, sort of like the old Yogi Bearras story about how difficult it is

to forecast, especially about the future. And I think it's true, but I think that the value added of strategies like myself and I don't claim to any great track record and forecasting the day to day moves, but I think that the value added comes from trying to explain the framework how these different variables are interacting, So providing a like a framework of which variables are important, which aren't important,

trying to help people navigate this mind field. And so from there, I just became from one analysts job to another banks hedge funds, and has oftentimes gotten to trade myself, whether that prop desks at a hedge funt of having a small fund myself. And I find that analyzing the market is one thing and trading it is a different It's a different set of skills. Like does it really matter fundamentally whether the YROs at one thirteen and want

their teen fifty five? Not really, but it could matter a lot to your daily PoDL or to your own position, And so knowing like stops technical analysis. What are short term movers like market positioning put call ratios versus long term fundamental drivers? And I think it's hard for especially early in my career, I thought it was very difficult to manage both having a short term view, I think the dollar is going to fall, but a long term view,

I think the dollar is going to go up. And how to manage those I think that's tricky as well as in taking positions with your views or having to take a position against your views. So that analogy of currencies being sort of um financial warfare is really interesting. Does that mean that the inevitable state of currencies is always one of aggression? And does that mean that someone is always out there trying to unseat the dollar as the sort of center of the global financial system. That's

a good question. I do think that. I think that's partly what bitcoin was about. I remember when the Euro was born that people thought the Euro was not going to replace the dollar. Every so often someone tells me that the Chinese R and B is going to replace the dollar. I started think that an important turning point took place in that was when Robert Rubin took over at the Treasury from Lloyd Benson, and that was the

beginning of the strong dollar policy. And I know there's a lot of confusion of what a strong dollar policy means. We had one Treasury secretary who suggested a strong dollar was one that was difficult to counterfeit. Now it's a good interesting but I think that the here's what I think it really means. I think that starting in the US said we will not weaponize the foreign exchange market.

Remember the crash in seven. A couple of months before that, James Baker threatened the Germans that if they didn't stimulate the economy, he let the dollar fall. Lloyd Benson early threatened the Japanese if they didn't reduce their tera. I think on cars uh, he would let the dollar fall. Against the end, the US had weaponized the foreign exchange market, or had had acted as a weapon as weaponized the dollar.

And after there's been an agreement not only for the US but through the G seven and then ratified by the G twenty not to use the currency market as a weapon. And that the way they say it is something like that the market the termine exchange rates. So it's not that the policy is to have an always strengthening dollar. It's that we won't use the dollar explicitly as a tool to sort of gain trade advantage, which of course raises the question is the era of the

strong dollar coming to an end? Trump clearly talks about the UH the currency market different than his predecessors. I think it's safe to say, yeah, I think that Trump various and trying to re weaponize the foreign exchange market. But I've noted that other policy makers haven't taken his bait yet. There's some stuff about the edges, but think that I would describe as really weaponizing the currency markets. Even some of Trump's comments, I'd say because they were ignored.

It takes two to tango. Because his comments were ignored, I think it helps mean that people are trying to like look beyond those kind of provocations. But I do think that it is possible they would go back into the sort of dog eat dog world and we weaponized a foreign exchange market. I think there's talk about that. That's why I'm so sensitive and I see people talking about currency wars because it's sort of like an arms

control agreement. We could blow each other up Russia at Charina, we can blow ourselves up many times over, but we've agreed not to use certain types of weapons. And I think that's the same thing that foreign exchange market. The arms control can break down with a different leader, with a different set of circumstances. I mean, there did seem

to be some confusion. Maybe there still is, but certainly in the first few months of Trump becoming president, it seemed like he himself was confused about whether or not he wanted a strong dollar or a week dollar. Do you think he's leaning towards one side now and what's the difference between the two or what does a strong dollar mean for the U. S economy versus a week dollar. Well, I think that I can't really speak to Trump's state of mind. Who can? But I tend to think that

he's just more opportunistic. Sometimes when a strong dollar it looks like it's as about a conference in America, he likes it. And when he sees it sees US corporates completing about a strong dollar and impact on earnings, he doesn't like it so much. But generally I think that what people, I think want is not a strong dollar or a week dollar, but they want a dollar that's like appropriate for where we are in the business cycle.

I mean, why do other countries accumulate treasuries. They typically accumulate treasuries because they're preventing their courtesies from strengthening, which is preventing the dollar from weakening, which is preventing, say, other macro economic adjustments, and so I would think that what we want now, I've just given that the US economy is still growing relatively quickly while Europe slowing down.

In fact, Germany had a contraction in Q three, Pan which is the world's third largest economy, contracted in Q three. China is slowing down. The FED is tightening. No other, no other major central bankers tightening as aggressively as the FED. And so I think in these circumstances, the dollar is going to go up. And one of these sort of uh methodological things that I look at, besides interest rate differentials, is the policy mix tight monetary policy or tighter monetary policy,

looser fiscal policy. I look for countries with that policy mix, that policy mixes associated with stronger currencies. That's what Reagan Volker had, That's what Germany had when the Berlin Wall felt that's that led to a super deutsch Mark, that led to the collapse of the exchange rate mechanism and then the birth of the Euro. And so I look for countries with this kind of policy mix, and to extent, the US pursues this policy mix. I still like the dollar.

But to Joe's point, that might be coming to an end. I see some reports that suggests that maybe after exploding the budget deficit in the US through these tax cuts and spending increases, now it looks like, uh, some political forces, including perhaps the White House, is not going to come back and try to cut some benefits to try to

help balance the budget. So if the US goes from tighter monetary looser fiscal to the opposite, Fed pauses maybe has to cut rates, government goes from fiscal expansion to fiscal tightening, that might be trouble for the dollar. So big picture, and you mentioned the Reagan Vulkar era. One of the things that you and I have talked about when you've come on TV a few times is this idea of like three recent big dollar ble runs. So Reagan had a really big dollarable run, Clinton had a

dollarable run. You talk. I think we first started talking about the current bull run really definitely under the Obama and it's continued through Trump. Big picture like how long could it go? And what drives sort of multi year sustained shifts in the price of the dollar. Yeah, that's why I one of the things that really like about

the phone exchange market. In some ways it's forgiving, and you have these long term trends, and unlike say currents, unlike interest rates, are bars which are much more tied to the business cycle. Currencies because as you were saying, curacy, they're partly relative value. How do we know it's the dollar moving not the euro, or how do we know it's the dollar not the Mexican pay So I think that's where the art of it comes in and try

to look at what the context of it matters. So in my view, I'm anticipating the dollar to continue to be relatively firm through the middle of next year. Around the middle of expect the Federal reserved to pause, and when we don't know what the when the Fed pauses, we don't know it's gonna pause in the sense that so they say they the June meeting and they don't high grades in June. Is that a pause or how

do we know they won't hip grades in July? So the Federal have to indicate to us that they're pausing, and sometimes in the past the Fed has done that by hiking grades fifty basis points a cutting rates fifty basis points to sort of sort of ended with an exclamation point. But I'm thinking this time the fedges pauses, lets us know they pause, and around that same time,

I think we'll see other countries. For example, the ECB is talking about raising interest rates, possibly at the end of summer, so around the time they FED pauses, theoretically the ECB could raise interest rates, and I think that there goes my big divergent story, and there goes what could be the tipping point at the end of the

big dollar supercycle. So if that were to happen, would those moves, the corresponding moves in the FX market, would those just be telling us something about where those respective economies are in the business cycle. Yeah, I think that not just the business cycle tracy, but I also would think about like monetary policy. You know, I think that sometimes that interest rates and currencies are both prices of money. So I think that in general, there's two explanatory models

that economists that strategies to use. One is the external balance. Countries with the trade deficit or current account deficit ought to have weaker currencies, so the ferry goes and countries they have strong have strong trade surpluses OC current account surpluses like China should have appreciating currencies. That's sort of one model that currencies ought to equalize, bring into equilibrium

trade counts, external accounts. The other model, which I tend to emphasize, focuses on interest rate differentials, yield curve shapes policy mixes, and right now the US premieres. You know, sometimes people talk about this exhorbited privilege the US has having the dollar as a reserve currency. But oftentimes the exorbited privilege was lower interest rates. But right now the US is having much higher interest rates, almost record high

interest rates against Germany. It's got near record high interest rates against Japan. There's no privilege here. The US is paying higher interesting because the markets demanding it, because it's strong growth, higher inflation, and lots of supply. And so with those change, I think we have to be sensitive to that, watch those changes, and change the view on

the currencies. Let's tackle one of the big questions that you've alluded to earlier, which is the perennial obsession with will the dollar one day be dethroned by another currency or or maybe in theory, when we live at a sort of multi reserve currency world, where there's no single uh, there's no single dominant currency. And of course right now, if there's one currency that people talk about as theoretically one day putting a challenge to the dollar, still obviously

the Chinese currency, although it's nowhere yet. What would it take for that to happen? For the whatever that means, I don't even know what it means for sure, but whatever that means for the dollar to be dethroned in some way, what would it take for that to happen? Yeah? Sure, I think I think about this a lot, because I mean, not only are we living in a time where the US power, where we've seen the rise of other countries, with the U S share of world GDP is not

what it was a twenty or forty years ago. So I know what conditions can the dollar be dethroned as the as a numera area, as a number one currency. I had two scenarios. One is if the US abdicates and in some ways that's what some people think, that's what Trump is doing, and we see this among some of the economists, to free trades not in US interest. Having the reserve currency of the world is not in US interests. It's expensive. There's more money dollars in circulation

outside the US and inside the US. How can you manage your economy like this? So it's possibly we advocate. We just say we don't longer want to do this, And one way we would do that is by making it more difficult to trade US treasuries, which is where the reserves are really held it. Another scenario would be if there was a compelling alternative. You know, we both use the same kind of keyboard, Q W E R T, right, and if you said to me, this is not really

a good keyboard. It's not ergonomically sound, you hurt your risk, you get cardinals, tunnel syndrome, all these bad things happen. You've got a better keyboard. It can't just be a little bit better. It's got to be a lot better for me to make this transition. And so having something that's just as good as the dollar is not good enough. It has to be superior, and right now I don't

really see anything superior. Superior might be a country that has less of an external deficit, has a lower you know, the U S has a debt to GDP of close to a pent. So he's find me a country that has less debt external surplus. He said, well, maybe this country could be a better curve sy for the long term store value. I don't see a compelling alternative. And I know some Americans they worry about China, but when I talked to Chinese officials, they know they're not even

in the game yet. If this is still early days. They think times on their side. But we're not going to see it. I mean, central banks move it like glacial speeds. And we're talking about the dollar being say roughly six or seven trillion dollars held in reserves in treasuries versus a couple of hundred billion held in Chinese currency. So we we if it takes a long time, and I think that we really need a clear alternative. And I thought maybe some people thought bitcoins was gonna be it.

Remember the europe people thought now that there was an alternative China. I just don't see something that's compelling enough to say that the depth and breath of the U. S. Treasury market can be replaced by anybody. Well, mark on that forward looking note, on that speculative note about the future currency, Thank you very much for joining us. And although I'd say you did sort of give us headaches.

I do think she clarified to really important topic. Thank you. So, Tracy, wait, do you have more of a headache now or less of a headache? I'm trying to think. I actually, I think Mark laid stuff out very very clearly. But I think it's impossible to fundamentally resolve the tensions of currencies,

which are that they are all relative. So even when we're talking, for instance, about big bull runs in the dollar, you know, he mentioned those three historic ones, one of which we're possibly and now it seems like the opposite side of that argument would be, well, maybe the rest of the world was just doing terribly during that time, right. I thought that was a really interesting point about currencies as a a asset class, so to speak, that's not

all that cyclical with the rest of the economy. So stocks sort of go up in a boom and down in a recession, and interest rates go up typically during growth periods, and down in a recession, and that currency has the have these long cycles that don't correspond neatly to to the data. I thought that was an interesting point.

I hadn't quite thought of it like that before. Yeah, and it's definitely interesting to just think more about what the dollar actually is and how we're assigning a value to it, given that eventually almost everything ends up being

converted into dollars in one way or another. And you know, people talk about all these different financial assets from bonds to stocks, to commodities going up or going down, and all of those have some sort of tie to the green back, and we often don't have the conversation about

what's happening to the green back itself. Yeah, and this whole idea, I actually thought that was very helpful, the definition of a strong dollar policy, because I don't think I'd ever quite hurt it like that, because and I do think that the way people typically talk about it is more that people want the dollar to appreciate, or that an appreciating dollar is somehow the key gauge of American economic strength or might. But that is not so much.

That is just that we're not going to play around with it as a policy tool to win or defeat our other countries in the realm of global trade. Yeah, that's definitely an interesting definition. Al Right, well, uh, strong dollar policy. Okay, This has been another episode of the Odd Lots podcast on Tracy Alloway. You can follow me on Twitter at Tracy Alloway and I'm Joe Wise though. You could follow me on Twitter at the Stalwart, and you should follow Mark on Twitter. He's got a great feed.

He's at Mark Making Sense and be sure to follow our producer to Hope for Foreheads he's at Foreheads te as well as the Bloomberg head of podcast, Francesca Levie at Francesca Today. Thanks for listening.