This is not what I normally do here…

In my first post every year, I stress that I focus on empirical observations and data rather than theoretical predictions. Yet, today, I will do exactly that, argue based on theory without having empirical proof that this is likely to happen. Furthermore, I will touch on something that I rarely talk about, namely currencies. No, I have not lost my mind, it is just something that I have been pondering for a while and I can’t really find an answer, so I wanted to reach out to my readers who know so much more about FX than I do. Maybe you can chime in. I promise, this post is one of the rare exceptions to my rule and normal service will resume tomorrow.

I openly admit being bad at forecasting currencies. On the other hand, I am also an excellent FX investor. After all, I have never lost money with currencies. But that is like me claiming that I am an excellent tennis player because I have never lost a match against Novak Djokovic. If you don’t play, you won’t lose.

But for what it’s worth, my simple rules for currencies are that over ten or twenty years, purchasing power parity will determine where currencies go. Countries with higher inflation rates will see their currencies depreciate vs. currencies with lower inflation rates. And for an investment horizon of one year or so, carry tends to work, meaning that currencies with higher interest rates tend to appreciate against currencies with lower interest rates.

You can see the driving force of interest rate differentials in place for the Sterling/Dollar exchange rate in the chart below.

Sterling/Dollar exchange rate and real rate differential

Source: Liberum, Bloomberg

The carry trade helps you when central banks change interest rates. As the Fed hiked rates sooner and more aggressively than the Bank of England or ECB, the US Dollar strengthened against Sterling and Euro. However once the Bank and ECB caught up, the advantage shifted towards these currencies as interest rate hikes became relatively more aggressive compared to the Fed.

In 2024, central banks will embark on the opposite path and try to cut rates. At the moment, however, it looks like the Fed is likely to start only a little bit earlier than the Bank or the ECB. But for most of 2024, they seem to be going in lockstep. Which makes it difficult to play the carry trade. If rates are cut at the same speed in the Eurozone, the UK, and the US, there is no change in interest rate differentials and no direction for exchange rates.

Which made me think about what else could drive exchange rates in 2024. One factor that came to mind after reading a theoretical paper by the IMF was fiscal policy. If monetary policy doesn’t make a difference, fiscal policy, which is normally a minor influence on exchange rates, can start to be the deciding factor. If a country reduces its fiscal deficit more aggressively that implies that its credit improves, and the currency should strengthen relative to the currencies of countries with larger or widening deficits.

Looking at the projected path in government deficits that would speak very much in favour of the Euro and Sterling rather than the US Dollar. The chart below shows that the US is one of only two countries where the budget deficit is projected to increase between 2023 and 2025. Meanwhile, the European stability mechanism forces most Eurozone countries to cut their deficits in 2024 and 2025. In the UK, we may not have a stability mechanism, but the experience of the near collapse of our government finances under Liz Truss means that today, both major parties are committed to reducing the deficit significantly to keep our fiscal credibility.

Projected change in deficits 2023-2025

Source: Liberum, Bloomberg

For what it’s worth, these arguments speak in favour of a strong Sterling and Euro and a weaker US Dollar. But as I said at the start, these are theoretical considerations, and I would be glad to hear from FX specialists if this makes any sense or if I am just talking nonsense.