Why a Currency Isn't the Stock Price of a Country
This week's purchasing managers' indices (PMIs) from Europe and the U.S. were generally better than expected. It looks like the developed world may be growing again despite the slowdown in China. That should be beneficial for growth of the world economy as a whole. So how might stronger growth affect currencies?
Contrary to popular belief, a strong economy does not necessarily mean a strong currency. A currency isn't the stock price of a country, which goes up when the country's "results" beat expectations. Currencies go up and down for a lot of reasons, some of which may be affected counter-intuitively by growth.
There are of course many ways in which a strong economy would naturally translate into a strong currency. An economy that's growing faster than its neighbors would tend to attract inflows of capital into its stock and bond markets, as well as direct investment. It might have higher interest rates than other countries that were struggling. Its economy could be doing well because of robust exports, which might mean a trade surplus. All of these factors would tend to support a currency.
On the other hand, sometimes an economy speeds up because of monetary stimulus, which means low interest rates and a weak currency. Some countries tend to import more when they are doing well and struggle with balance-of-payment problems. And risk-seeking sentiment tends to improve when a country's economy is doing well, leading to more willingness to invest abroad.
It seems reasonable that a weak economy would have a weak currency, but that could be putting the cart before the horse. Sometimes an economy might be weak because its currency is too strong. Examples of that might be if the country has found oil or is seeing a large inflow of funds into its bond markets to take advantage of high interest rates. On the other hand, sometimes an undervalued currency can offer the country a competitive advantage that helps its economy to growth faster.
(Read More: Watch Out, Euro May Be About to Flex Its Muscle )
Finally, a collapse in the economy can actually cause the currency to rise, as happened in some countries in Asia after the 1997 crash. Imports slowed dramatically as residents slashed their spending, but exports kept up as usual since those countries' trade partners were unaffected. The resulting trade surpluses caused the currencies to recover (or at least allowed the countries involved to rebuild their foreign exchange reserves).
You can see the relationship between growth and currencies from this graph, which shows the change in the DXY index of the dollar's value compared to the U.S. economy's growth rate relative to that of the other countries whose currencies comprise the index - which is 57.6 percent euro, 13.6 percent yen, 11.9 percent pound sterling, 9.1 percent Canadian dollar, 4.2 percent Swedish Krona and 3.6 percent Swiss Franc.
The other economies' growth rates are weighted according to their weight in the DXY. The graph covers the last 10 years. The result, as you can see, is: no correlation. Sometimes the dollar rises when U.S. growth is stronger than in other countries, sometimes it falls.
I tried the same exercise with various lags, and also tried it using the change in the growth rate rather than the absolute level, in case markets are more concerned about which economy is accelerating or slowing. No dice. Nor does it work for the individual countries in the DXY, either.
Nowadays, changes in growth are likely to affect the developed countries' currencies through monetary policy. The stronger a country's growth is, the earlier that country can consider abandoning zero interest rates, quantitative easing, or any other extraordinary monetary policies it might have implemented.
That's one reason why when the manufacturing PMIs from peripheral Europe came out better than expected, it sent euro/U.S. dollar up more than when the U.S. Institute of Supply Managers (ISM) index beat expectations (although the fall in the U.S. ISM employment index to a four-year low of 48.7 may have been partly responsible as well).
The idea of the U.S. Federal Reserve "tapering off" its asset purchases will surprise no one in the market, but there is still a question about whether the European Central Bank (ECB) will need to implement further extraordinary policies. Stronger growth, particularly in the periphery, would lessen that need and therefore be bullish for the euro.
In any case though it's clear that neither the ECB nor the Fed is likely to change rates any time soon. ECB President Mario Draghi said recently that "our policy has been accommodative in the past, it is in the present and it will remain so for the foreseeable future," a sentiment that several of his ECB Council colleagues echoed.
The Fed has also been trying to play down expectations of an eventual rise in rates there too. Against that background, the first move in exiting from extraordinary measures will probably be up to the Fed, which is discussing only the "when," not the "whether," of tapering off its bond purchases.
That should make the dollar the main beneficiary of higher global growth, not the euro. Moreover, it's not so much the difference in expectations for short-term rates that drives euro/dollar as it is the difference in expectations for real short-term rates (i.e., after inflation), and that measure still favors the dollar.
The author is the head of global FX strategy at IronFX, an online trading firm specializing in forex, CFDs on U.S. and U.K. stocks, and commodities. He was previously head of the forex committee at Deutsche Bank Private Wealth Management.