The recent G20 meeting highlighted the need for international agreement to avert a so called currency war in international markets. Without wanting to get too much into the politics of the matter here, I will instead review a few possible fundamentals that might have been, and perhaps will continue, to shape the FX market.
The FX market is one of the most volatile environments out there. Technically, this volatility should not actually scare off international trade as it is only supposed to be a result of an efficient price discovery mechanism that is constantly seeking to rebalance relative performance across global capital markets.
However, it remains an unfortunate fact that certain parts of the market are not being allowed to “float”. In other words, price manipulation is taking place.
But where there’s manipulation, there’s usually inefficiencies, and where there’s inefficiencies, there are always arbitrage opportunities.
Let’s Keep It Super Simple
Again, let’s keep things ultra simple here and try and identify what is actually happening with, to take but one example (the elephant in the room) for this market: the Chinese FX reserves and their own currency setting policy.
China is currently heavily invested in the US currency to the extent that their currency, until very recently, moved in lock-step with the US rate. However, they have expressed a desire to loosen this peg, in part due to international pressure, but also due to personal interest. China itself understands the danger of too fixed an FX rate and, as it seeks to rebalance its reserves, then it will naturally move its peg away from the US floating rate.
This being said, peg it once was, and peg it shall still be. In other words, China is not seeking a market set floating rate, but is merely moving its emphasis on the lock step of the US dollar over to other FX crosses. All of this in layman’s terms: the Chinese Yuan’s move becomes predictable.
How Predictable is Predictable?
Well, unsurprisingly in this instance, China is not really being very open and transparent over what this rebalancing actually entails. But let me propose the following two basic ‘rules-of-thumb’:
- 1. The USD/CNY rate will lower as China allows revaluation over its currency over the US dollar. This is natural, to a certain extent, as China’s strong exports and ongoing economic performance should offer a relative gainer compared to the US dollar.
- 2. China, however, has substantial FX reserves in USD, so in order to still maintain control over its currency, it would then need to re-peg elsewhere unless it is willing to reduce its currency reserves (which is reasonably unlikely).
Therefore, the revaluation against the USD should increase Chinese reserves rebalances into other crosses. This, in turn, should increase the relative value of other currencies that were not, previously, subject to as much currency intervention. Basically, as China moves its interest away from USD assets: it reduces the scarcity in USD and increases the scarcity in other crosses.
So we have the following effect coming across: USD devalues versus CNY, CNY devalues against basket of foreign crosses excluding USD. In effect, instead of China’s export gains coming through internally into China and into their market, the inflationary effect is being passed along: first from the USA and now to the rest of the market.
This therefore brings us to the FX moves, assuming all other prices are perfectly floating (big assumption – I know), then we are left with only two variables USD/CNY and CNY/(everybody else except USA). Okay, so we now have a move, that isn’t being priced by the market and that isn’t necessarily linked to efficiency considerations. The next big assumption: if there is an inefficiency restricted to a subset of a broader efficient market then there must be arbitrage.
The Trade: Arbitrage Goes Round and Round, Round and Round…
Assuming an efficient market then a USD, travelling across the world, should, once brought back over to the US be equal to as much as it was when it first left. We can therefore try to model this fairly simply: take the USD, change it across other crosses, then bring it back to the USD once more. 1 for 1 right?
Okay, now let’s apply this to the USD/CNY cross, we know its pegged to a certain extent, but then we would expect the return to also be pegged right? Trade into pegged Yuan and back out of pegged Yuan should give us the same amount gross of any brokerage.
However, as we mentioned above, we also know that this peg is now trying to move back to a market equilibrium of sorts but only through its own loosening of FX sterilisation measures. So the move out should be reflected over to the other crosses.
If this move were properly efficient then USD to CNY, CNY to Basket, Basket to USD should still give us a 1 to 1. But, as noted above, this can not be an efficient move given that the FX peg sterilisation across to other currency rates is accompanied by reserve rebalancing. And so…
What does this give us over the course of the 2010 year? Well, my quick-and-dirty and no-guarantees-attached analysis comes to roughly 0.32% average return per day (st. dev. 0.08%) over this trade assuming an equal weighting across the basket. One quick improvement, just as a quick example, would be to match the weights over to the actual trade value of each component of the basket.
Again, this isn’t a real analysis, and I provide no guarantees what-so-ever as to the reliability of my FX source data (which is pretty much the big thing to check here). Oh and by the way, 0.32% per day is a lot, simply rerun the trade every day and you get…
The CSV with the results are attached below (again, please check these results for yourself), oh, and, happy trading…
- Background Links
Collated FX results 2010
Recent Bloomberg article regarding UniCredit opinion on USD