Currency forecasting is a useful exercise to complement investment decision making. Suppose as an investor, you are keen on gaining exposure to emerging or frontier markets for their growth potential. Financial and economic analysis will be the key inputs in the decision making. However, investors often forget that the final investment return will factor in the currency appreciation or depreciation of the investment asset as well.
If you are keen on making currency trades, timing the cycle of the currency and knowing its future direction will be important. Part 2 to this post will more directly address this question.
With these questions in mind, this article is a primer on using simple economic variables to forecast the direction of currency movement. I have provided data sources that are freely accessible, for your reference. By the end, you will have a good idea about how to approach currency forecasting without doing a PhD in economics!
1. Rising trade balance strengthens the currency
The trade balance measures the difference between the value of exports and imports of goods and services of a country. A positive trade balance reflects exports exceeding imports. When Singapore's exports are booming, there is rising global demand for its products. Higher demand pushes up the price of Singapore's goods and strengthens the Singapore Dollar (SGD) in the process.
When Singapore's imports exceed its exports, domestic participants are demanding foreign products, driving up the prices of foreign goods and weakening the SGD relative to foreign currencies.
Relevant example: In 2020, during the COVID-19 pandemic, Taiwan and Korea’s currencies outperformed peers (against the USD) in the region. Despite weak global demand, Taiwan and Korea offered products that were highly demanded at the time—work from home electronics. This boosted Taiwanese and Korean exports while their imports lagged due to weak domestic spending.
Data source: Trade statistics are published by trade ministries or national statistics offices.
2. Rising capital account balance strengthens the currency
A country’s capital account reflects the difference between capital inflow (in the form of inward investment by foreigners) and capital outflow (investment by domestic players abroad). The capital account is in surplus when a country receives more foreign capital investment than what it invests abroad. Capital account surplus strengthens a currency by augmenting investor appetite for domestic assets.
Relevant example: Walmart opening a factory in India is direct investment whereas Walmart’s investment team buying Indian stocks or bonds is portfolio investment. Either type of investment in Indian assets strengthens the Indian Rupee (INR).
Domestic asset managers’ investment strategy is a useful leading indicator of capital account dynamics. For example, Korea’s National Pension Service (NPS, Korea’s largest investor) announced its intention to enhance foreign asset allocation to boost investment returns. This would imply capital outflow from Korea and Korean Won (KRW) weakness.
Data source: Central banks publish data on portfolio and direct investment inflows. The International Monetary Fund (IMF) publishes capital flow data by country here.
3. Higher domestic inflation weakens the currency
Inflation refers to the rise in the price of goods and services in the local economy, over a period of time. When inflation increases, 1 unit of local currency can purchase fewer goods and services. This weakens the purchasing power of the local currency.
Relevant example: Emerging market economies such as Argentina, Brazil, India and the Philippines have seen their currencies weaken against the US Dollar (USD) over time, given that their inflation is higher than the US.
Data source: The national statistics agencies and central banks publish inflation data monthly or quarterly. The IMF’s World Economic Outlook database and the World Bank’s macro data pages contain a compendium of macroeconomic data by country.
4. Central bank policy rate hike causes currency appreciation
The central bank sets the country’s monetary policy. It decides the rate at which domestic banks borrow from it. As the central bank’s policy rate is the benchmark for other debt instruments in the economy (loans, bonds), domestic interest rates increase when the central bank hikes the policy rate. With domestic interest rates rising, foreign investors may take advantage of the higher policy rate by investing in the local debt instruments which now offer higher interest income. Foreign capital inflows seeking higher return in the domestic economy, lead to currency appreciation (as per point 2 above).
Relevant example: When the US Federal Reserve and European Central Bank (ECB) slashed policy rates during the global financial crisis in 2008, foreign investors seeking higher yield income, rushed to buy emerging market debt.
Data source: Central banks release their monetary policy statements on their websites. These statements provide useful economic snapshots and central bankers often comment on currency dynamics.
5. Higher money supply on a relative basis weakens the currency
Money is supplied into the economy through the government or central bank. When the government expands its expenditure plans, it pumps money into the economy. When the central bank lowers the policy rate at which banks borrow from it, banks lower lending rates and make it cheaper to borrow funds. This raises money in circulation. When supply of money exceeds demand, the purchasing power of currency in circulation weakens. In other words, too much money chases too few goods. There are several measures of money supply termed M1, M2, M3 and M4. The most practical term for our analysis is M2 which represents money in circulation (cash and coins), deposits made into savings accounts, money market securities and time deposits.
Relevant example: As a result of the COVID-19 pandemic and economic shock, the US Federal Reserve and government introduced significant stimulus into the economy. Both fiscal and monetary policy measures raised the currency in circulation. On a relative basis, the growth rate of M2 in the US (yearly or monthly basis) exceeded South Korea as the degree of stimulus in the US was far greater than in Korea. This implied that the USD should weaken again the Korean Won (KRW).
Data source: Data on M2 is available on central bank websites. Readers should compare M2 growth (y/y or m/m) rather than M2 levels. CEIC provides free data on M2 growth by country.
6. Central bank’s intervention to weaken the currency
Before we discuss central bank policies, we should link currency strength and weakness to imports and exports. In section 1, we observed that a rising trade balance strengthens the currency against its main trade partners. A stronger currency indicates that 1 unit of foreign currency will be able to purchase fewer goods from the exporting country, thereby reducing its exports. Central banks may be wary of sharp currency appreciation and its offsetting impact on exports.
Relevant example: In 2020, several Asian central banks implemented policies to prevent currency appreciation against the USD in order to maintain export competitiveness. The Indian central bank (RBI) prevented the rupee from appreciating by buying USD and shoring up its FX reserves. FX reserves build up is a good indicator of central bank intervention.
The central banks of China and Vietnam manage their currency within a band or by pegging the level. The Thai central bank eased policies to boost capital outflows in order to weaken the Baht. Sometimes governments may exert pressure on the domestic asset managers to allocate funds abroad in order to generate capital account outflows (see section 2 on capital account dynamics) and weaken the currency. Korea’s National Pension Service comes to mind.
The easiest way to understand central banks’ policy biases is by reading their commentaries, monetary policy statements and policy announcements.
Data source: FX reserves data is available on central bank websites as well as the IMF. The US Treasury’s semi-annual FX report provides useful analysis of the FX policies of US’ important trade partners.
7. Real effective exchange rate
The REER assesses a currency's value against the weighted average of other currencies of the country’s major trade partners. Rising REER indicates currency strengthening. This reduces export competitiveness.
Data source: The Bank for International Settlements (BIS) compiles REER indices for 60 countries, here. In the dataset, 2010 is considered to be the base year and BIS provides REER values for the past 5 years. You can compare the REER in the current month to its value over the past 5 years as well as against 2010. This exercise will indicate whether the currency is over or under- valued relative to its own history. REER indices help traders forecast the future movement of currencies towards their fair value.
Key takeaways from the article:
1. Currency forecasting can complement investment decision making, by helping investors identify regions or countries having good currency outlook. This can help investors narrow down their investment options.
2. Although currency performance is uncertain and dependent on various factors, simple economic concepts can be used to make judgements on the direction of currency movement.
3. The economic variables assessed in this article include trade balance, capital account balance and inflation among others. All variables are freely available on central bank websites and macroeconomic databases.
