Mean reversion is “a concept of normality,” where extreme events can cause an asset to diverge from its long-term averages. For Deutsche Bank Foreign Exchange Macro Strategist Sebastien Galy, the theory of mean reversion works, so long as the underlying economic principles that exert the law of gravity on currency prices don’t change. Looking at currency markets, however, Galy notes that sometimes currency valuations and prices just don’t revert to their mean. This can be particularly when prudent government policies are not maintained.

Get The Timeless Reading eBook in PDF

Get the entire 10-part series on Timeless Reading in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

Currency valuations
RJA1988 / Pixabay

Currency valuations follow a formula

Currencies have traditionally been valued based on a formula, of sorts, with a variance being afforded to developed world nations over emerging market countries to various degrees. When Argentina lifted its peg to the US dollar and allowed the currency to free float, it was not luck that led former JPMorgan banker turned Argentine Finance Minister Alfonso Prat-Gay to predict the estimated value of the currency. The same was the case when the Swiss left the euro currency, as the value was immediately calculated by the market in a flash.

In many cases, central bank involvement in interest rates plays a key role in currency value, and this can be particularly noticeable in emerging markets. Central banks intervene in their currency to lower make exports more competitive, which is accomplished in part by lowering interest rates but also through market supply and demand adjustments.

“A country intervenes in its currency primarily as a form of insurance for its export sector,” Galy noted in an August 22 report titled “The fear of asset bubbles.”

“The result is an amplification of currency intervention much as an orchestra tumults to the aria," he wrote. "As this mechanism eventually fades lower so will the official demand for US Treasuries.”

 

Currency valuations  - mean revert, so long as core economic fundamentals remain intact

Currencies are often mean reverting assets, so long as their underlying economic anchors are not much changed on a relative basis. Trading gyrations that result in dislocations of currency valuations is normally correct. Normally, that is.

“Stopping time problems such as defaults or unstable dynamics of the debt and current account can lead a currency to not return towards the mean,” Galy observed, pointing to the Mexican Peso “which has been on a steady downtrend for decades irrespective of temporary bouts of reform.” When reforms fail or are essentially meaningless, a sustained currency downtrend can follow.

As the emerging markets come closer into focus, with numerous analysts pointing to investment themes giving them prominence, Galy notes the currency dilemma of a currency peg:

Many Emerging Market economies are geared towards export of low to mid level value added products and are very unlikely to change as this is where their comparative and to some extent absolute advantage is. Hence, they will continue to intervene till the point where they become advanced economies and some time beyond that as is evident with Korea, Japan and Singapore. Having said this they can choose business models that are more sustainable than they currently are.

But how does this translate into the developed market?

“As the Fed and others finally and belatedly tighten a bit, they are likely to be faced with an asset bubble that drags on present consumption,” Galy predicted. With most major developed world currencies near their current averages, what is the path forward?

We are now in a strange position where many G10 currencies are not so far off from long-term averages though this is very much conditional as to how we face deflating the bubble built during pre-crisis times. The Fed with a new chair nominated next year is likely to favor an asset bubble and repeat the mistake that Japan did in the 1990s. That overall suggests that long-term financing conditions are going to stay easy making it attractive for Corporates to tap the dollar market and swap into euro or other currencies.

With talk of asset bubbles in developed world economies rife, keeping an eye on mean divergence and core changes to economic fundamentals will keep currency traders on their toes.