The Revenge Of ‘Econ 101’

News flow slowed to something approximating a trickle ahead of Jackson Hole, a consequence of the summer doldrums and the proximity of a risk event.

The lull, in conjunction with an apocalyptic spiral in European gas and power prices, gave analysts and former traders an opportunity (read: excuse) to dust off economics textbooks in the service of explaining and forecasting FX moves. I mean “dust off” figuratively, but I’m reminded that I actually kept my physical textbooks for years, despite being in the (fortunate?) position to get advance copies of the new editions. Although difficult to imagine in 2022, it remained somewhat challenging to access quality information efficiently on the internet right up to the dawn of the smartphone era. I didn’t unburden myself of those textbooks until 2006.

Anyway, this week’s hot topic is terms of trade. Don’t raise this discussion at any cocktail parties, and certainly not hunched over any small mirrors on coffee tables in the Hamptons. It only works at micro breweries next to campus, and even there, you’ll need to look for forty- and fiftysomethings with Bernanke beards, awful goatees and plaid button-downs force-tucked into khakis.

It also works with macro investors, or at least in the polite world of Cameron Crise, who somehow managed to come away from a career on both the buy-side and sell-side believing the industry is a generally congenial place populated by sober, math-minded, hyper-rational professionals, as opposed to… well, as opposed to the exact opposite of that.

“One of the reasons that so many macro investors have a background in foreign exchange is that you need to know a little bit of everything to be a good currency trader,” Crise wrote Tuesday, in a column on the terminal. “Ultimately, trading FX is about anticipating the relative supply and demand for a given currency pair over a given time frame,” he added. “Forecasting those flows entails knowing something about the drivers of the capital and current accounts, thus requiring a familiarity with other assets, policy and economics.”

Ok, sure. Crise has considerable experience, so we’ll go with that, but I’d gently note that “ultimately,” trading FX also requires a lot of courage (I eschewed the temptation to use a “better” word) and luck, and also a knack for taking the temperature of local politics in real time, something no one can teach, and thereby nobody can “learn.” Take the Turkish lira, for example. You either “get” the reality of Recep Tayyip Erdogan, or you don’t. Most market participants and analysts (still) don’t.

For everyday investors (i.e., for people who aren’t managing other people’s money or, in the case of FX funds which nearly went extinct prior to 2022’s renaissance, mismanaging it), all you need to know about FX is that interest rate differentials matter a lot, that for commodity currencies, commodities matter a lot and that emerging markets are different from developed ones. If you understand those three things, and you’re at least vaguely familiar with the concept of carry, why capital flows are important for EMs and understand the difference between hard currency debt and local currency debt, you’re in good shape. Pretty simple really, again providing you’re not trying to actually (actively) trade.

The sheer scope and rapidity of this year’s energy price shock ushered in something of a sea change, though. As Crise wrote, “terms of trade [is] becoming a significant driver for developed-market energy importers like the euro zone, UK and Japan.” Crise hates overlay charts, which he habitually derides as “naive.” So adamant is Crise on that point, that one of his colleagues felt compelled to preemptively apologize for employing one earlier this month. This week, however, Crise found a use for a simplistic overlay — namely, to make the point that even a “dumb” chart (in this case eurodollar/euribor spreads versus EURUSD) shows rate diffs aren’t sufficient to explain the euro’s drop below parity.

The problem, of course, is the existential surge in European power prices and the implications of soaring energy costs for Europe’s trade account, something SocGen’s Kit Juckes described in stark terms on Monday, calling the situation potentially “devastating.”

The figure (above) is straightforward.

“Unless unhedged European financial assets have suddenly become a lot more appealing to global investors, the decline of the trade account into a significant deficit naturally represents a millstone around the neck of the single currency,” Crise wrote.

Juckes weighed in for the second time this week. He utilized a visual showing terms of trade for the US and Germany, rebased to the beginning of 1999 (figure below).

For two decades, “they were pretty well correlated, a pair of major economies seeing broadly similar trends in import and export prices,” Juckes wrote. “But the surge in energy prices (first) and natural gas prices (in Europe, especially) has changed everything,” he went on to say.

Juckes called the divergence shown above “dramatic,” and emphasized, as did Crise, that this “Econ 101 factor” is now “more important than what the Fed or the ECB are doing when it comes to the outlook” for the beleaguered single currency.

And it’s not just the euro. “I can’t see a significant rebound for any European currency until we get through the gas crisis,” Juckes remarked.