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February 2017 | Macro Insights

Quant Call: Terms of Trade as a Signal for Currency Markets


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A risk-premia focused approach incorporating trade data can help determine fair value in currency markets, writes Stephan Kessler, Head of Research for the Alternative Investment Strategies team in GSAM’s Quantitative Investment Strategies platform.

We believe the US dollar is overvalued against the majority of global currencies, though it still has potential to appreciate. Historically we have seen the dollar can sustain stretched valuations for a long time, so our analysis is focused on identifying markets where the dollar is most likely to weaken.

To this end, we have found currency valuation analysis that incorporates trade data is more useful than traditional measures such as purchasing power parity (PPP). We found that, on average, currencies of countries with a significant commodity export component have started to reduce their undervaluation versus the US dollar, due in part to recovering commodity prices. This leaves currencies of economies that don’t rely heavily on commodities exports on average with a greater potential to appreciate versus the dollar.

Currency valuation: where do the trade data fit?

PPP is a common approach to determining fair values in exchange rates. This methodology simply compares the price of a particular market basket of goods in two countries at any given time, taking the exchange rate into account and excluding other economic data.

Our team believes that incorporating economic data—particularly trade-related data—using tools such as behavioral equilibrium exchange rate (BEER) models, can provide better insight into currency valuations. The BEER model relies on empirical analysis to identify drivers of exchange rates. The model we use includes factors such as terms of trade (TOT), that is, the average price of exports divided by the average price of imports. If a country’s TOT is rising, its economy is more competitive, because the value of its exports is outpacing that of its imports, and vice versa. BEER models assume that currencies of countries with higher levels of competitiveness should have stronger valuation.

US Dollar: overvalued across the board

Not surprisingly given the US dollar’s five-year strengthening trend, many valuation models indicate that it is widely overvalued. Looking at BEER models going back to 2008, the US currency’s valuation averages in the 90th percentile, as of the end of January. This overvaluation is pervasive across both developed and emerging economies.

Historically, currencies that deviate from fair value tend to correct the extent of the misvaluation in the subsequent 12 months. Over the past 18 years, our analysis indicates that average over/undervaluations of the US dollar have tended to last 3.4 years before converging back to fair value, but divergence can also last for more than 10 years. The US dollar has been in overvaluation territory since November 2014.

Commodity exporters: potential to fare better versus the dollar?

The US dollar shows economically significant overvaluation across both developed and developing economies, with only a few exceptions, such as the Swiss franc and New Zealand dollar (see chart). The overvaluation is currently most pronounced at 35% versus the Turkish lira’s fair value. On average the dollar shows less overvaluation versus currency fair values from economies with a strong commodity export component than those with a broader base of exports (-4.4% versus -10.8%,respectively).

Exhibit 1: US dollar widely overvalued

Source: GSAM. We base this analysis on one of a range of possible BEER models - the Goldman Sachs Dynamic Equilibrium Exchange Rate Model.

Looking ahead: opportunities in the FX Value trade

From a valuation perspective, most currencies should have the potential to appreciate versus the US dollar. Currencies of economies with a small commodity component in their export mix appear to have on average the largest appreciation potential. However, uncertainty over the new US administration’s trade policies might pose larger risks to such currencies. This might be particularly true for countries with large trade surpluses versus the US and a deep integration in the US supply chain. Currencies of commodity exporters might be more resilient to volatility surrounding trade policies as their products do not compete with local industries of importer countries such as the US. Absent those considerable political risks, we think emerging market currencies such as the Chilean peso, South African rand and Indian rupee look attractive versus the US dollar and have the added benefit of positive momentum and attractive carry.

About the Author

Stephan Kessler

Stephan Kessler

Head of Research, Alternative Investment Strategies team, Goldman Sachs Asset Management

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