The Research HUB: FX

Why FX matters in this structural regime

I briefly touched on FX in yesterday’s article and how it fits into the macro picture but I want to expand on some more of the logic for FX.

When I first started this Substack, I wrote a series of educational primers on every macro asset and major macro idea. I did a 5 part series on how to quantify all the moving parts of FX and trade it correctly.

The main idea I want you to take away today is that there are a lot of changes taking place that will influence trades in the FX market. Since 2019 we have already seen a dramatic change in how central banks influence the bond market and FX market. This has been coupled with changes in supply-side dynamics which inherently connects to the balance of payments. Fundamentally, an FX pair is the expression of the net impact expressed in the balance of payments. Now clearly a lot of this comes from the capital account and how the fixed-income complex is moving. However, if you are trying to get an edge, you are mapping all the balance of payment inputs and connecting them with the growth, inflation, and liquidity of the respective country. From here, the fixed income complex has a seamless integration into how you think about the economy and BoP.

Again, like I said in the previous article about alpha (link), if someone finds a real edge in the FX market, they will be trading it with A TON of size until it disappears. Understanding the moving parts of any market and then connecting it to a changing regime is how you find these alphas.

Here are some papers you can read as an educational resource:

• https://www.bis.org/publ/qtrpdf/r_qt2212h.htm

• https://www.bis.org/publ/work1057.htm

• https://www.bis.org/publ/work983.htm

• https://www.bis.org/publ/work982.htm

• https://www.bis.org/publ/work864.htm

• https://www.bis.org/publ/qtrpdf/r_qt1709e.htm

• https://www.bis.org/publ/work602.htm

• https://www.bis.org/publ/work590.htm

• https://www.bis.org/publ/qtrpdf/r_qt1609e.htm

• https://www.bis.org/publ/bppdf/bispap40.htm

• https://www.bis.org/publ/bppdf/bispap38.htm

I want to focus on several specific things today though. Since the inclusion of China in the WTO, we have seen the supply of goods and services increase. This overlapped with a financial crisis in 2008 which caused deleveraging and disinflationary forces.

Why do these two events matter? Because we are seeing the opposite of them right now. The Fed is setting a floor under any systematic risk (think regional banking crisis) and deglobalization is occurring at an alarming rate.

Banks are making all-time highs which means defaults aren’t happening and disinflationary forces from deleveraging are DEFINITELY not happening.

You can find a helpful (and pretty cool) breakdown of the imports and exports for the US here: https://oec.world/en/profile/country/usa

But the bottom line is that we are still in a significant current account deficit which means the US has more demand than it has output:

It is in this changing world that policymakers are going to continually make mistakes. We have already seen how policymakers are using the theoretical R* instead of understanding that large portions of debt are locked in at low rates and there is only an impact on incomes once this debt rolls over.

The problem is that policymakers still don’t dynamically adjust their actions to BOTH the conditions and preconditions of ALL economic data.

The reason why people find all of the variables so difficult to nail down is because the transmission between them is always shifting. For example, the credit creation from commercial banks is inherently connected to economic activity. Credit puts more money in the system for spending. If this additional demand isn’t met with additional supply, prices are the release valve (aka inflation). However, this is different from the money base and reserves the Fed controls.

One of the reasons we have seen such an incredible rally in equities, BTC, and gold is because this liquidity valve is on. This liquidity can ONLY impact the valuation side of assets because there are more cash like assets in the system (see

Prometheus Research

’s work for more insight on liquidity).

This is why valuations have been rising on the index:

The credit side is what can change the underlying cash flows and actually increase earnings. As I noted in yesterday’s report (link), the credit spigot is being turned back on: SLOOS

Conclusion:

What does all of this mean for FX? It means the credit and liquidity measures impacting fixed income and asset markets are inherently tied to FX. Moreover, it will be the differential between these factors that will drive FX price action.

There are clearly a lot more “sneaky” ways that the Fed is trying to adjust liquidity but it’s clearly not stopping inflation the way that they want.

Moving forward, there will be a tension taking place between the deglobalization forces constraining supply and central bank’s actions (or inaction). It is an understanding of these variables and how they relate that will be KEY for taking larger positions in the FX market.