We often ask what sign would indicate that market conditions are normalising. One necessary pre-condition is that the macro-economic environment must matter again on a daily basis.
There have been occasions in 2008 when currencies were not unexpectedly responding to macroeconomic releases. The most obvious example is how the US dollar (USD) has moved counter-intuitively to US growth data. The dollar was very weak when US data turned surprisingly strong in the second quarter but then the dollar was surprisingly strong when US growth data was surprisingly weak.
Although the relationship between US data surprises and the dollar may have weakened, it does not mean that US activity surprises do not matter. There are, however, other factors that have been more powerful in dominating the dollar's direction. So, the fundamental expression for exchange rates was more evident from non-US growth data.
A key theme was how the euro-dollar was more sensitive to Eurozone activity than to US activity. More recently, however, there is a notable breakdown where exchange rates are responding much less to fundamental data. Instead, other factors, such as the fallout from the financial crisis and the deleveraging process, have become more important.
As the crisis has intensified, there is a strong belief that currencies are less responsive to fundamental data. This should not be surprising as fear and the deleveraging process could have crowded out exchange rates' response to macroeconomic data. Despite this, we assess whether some exchange rates are still responding to macroeconomic data.
Using the data from HSBC's Surprise Indices, we analysed the correlation between the daily change in various economies' activity surprise index and the daily change in its currency's closing price versus the dollar. The sample includes euro, sterling, yen, and Canadian dollar versus the dollar.
We found that euro-dollar was not very sensitive to US growth surprises and sterling-dollar is a similar story. However, even exchange rates that used to be very sensitive to US growth surprises such as dollar-Canadian dollar and dollar-yen are now less reactive.
Previously, the dollar-yen was the only exchange rate from the sample that was very sensitive to US activity data, but not the other way round. In other words, dollar-yen was reacting to US activity data only and not Japanese activity data. More recently, this relationship has changed. The dollar-yen has now also become less sensitive to US activity surprises - it is no longer following US growth data. Its changing nature reflects the idea that macroeconomics has been pushed into the shadow as fear and the deleveraging process has dominated.
Like the waning influence of US growth data, the sample as a whole appears less sensitive to other activity data. Dollar-yen is not sensitive to Japan activity surprises, while euro-dollar is less sensitive to UK activity surprises than a couple of months ago.
However, the most dramatic change since the financial market crisis gathered speed in the past few months is dollar-Canadian dollar.
It went from being very sensitive to US and Canadian activity surprises to no longer being sensitive to either. Euro-dollar has also succumbed to other influences. It is no longer very sensitive to Eurozone activity surprises.
A reduction in financial market stress will become evident when currencies start to react to the data meaningfully, particularly daily. Also, a sign of less financial stress would likely coincide with lower currency volatility, which would be important for the macroeconomic data to be seen as having a greater impact on currencies.
The dislocation in financial markets has meant that on a daily basis the foreign exchange market has been overlooking the economic data. It is pricing in a more broad based recession with the yen outperforming the Australian dollar and the New Zealand dollar.
However, these are broad brush moves and are not based on the day-to-day economic data.
Looking at signs that the markets are returning to a more normal trading environment, we believe an early warning sign will appear when the data matters again. For example, when market participants suddenly care about an economic release such as the next durable goods number, it would be an important clue. So far there are few signs of this taking place.
This report was compiled by the marketing department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.