FX Market: Multiple equilibria – Deutsche Bank

Sebastien Galy, Macro Strategist at Deutsche Bank points out that there is an ill-conceived notion that currency forecasts are set in stone.

Key Quotes

“What we can do is a reasonable test of our beliefs. Is the currency set to be range round, mean reverting to some long term fair value or moving away from it? Is it a temporary stable equilibrium or is it a global one? Once this is set it is a question of the intensity and duration of each move.”

“Mean reversion has been studied the most with a half-life of two to five years depending on the measure for advanced economies. Moving away from the mean is far less understood. It depends if it is a smooth trend as capital builds up or a structural break linked to explosive current account or fiscal dynamics. These are far less understood as the equilibrium becomes unstable with the currency ever more likely to become unanchored and vacillate from one unstable equilibrium to a more stable one. Experience with emerging markets suggests that there is an array of unstable equilibrium not just one. Sometimes it is defined by the ability to intervene or hike interest rates, sometimes it is the ability to control capital outflows by freezing them. Volatility then can drop rapidly and with it portfolio flows can come back reinforcing the stability of the local equilibria. However, if these inflows become more important letting the currency appreciate only accelerates the inflows and the problem of excessive unsterilized capital in the economy. Hence stability is defined by a concept of duration.”

“Each equilibria has for characteristics a two to three dimension area intuitively and a fourth through time. The more stable the equilibria the more it is reinforced by leverage until such time as the leverage creates hedging pressures that force too tight a range. As the leverage unwinds the ball zips out of the basin into another equilibria. The latest example was EURUSD that stayed compressed by “ECB repression” before exploding higher. It has for now not reached the mid 1.20s where most people presume many fair value concepts of equilibrium are. This leaves EURUSD in a temporary equilibrium without anchor except the increasing tendency of vol traders to bet on a range. The question is therefore where will the ball zipped to. The chances are that it is higher driven by corporate hedging demand while the Fed continues to be significantly behind the curve.”