Who cares about trade flows in predicting FX trends?

Back in the 1980s when the FX market used to jump around with the release of US trade data. It may be hard to believe now but it was the equivalent of today’s US CPI release or payroll data in terms of market sensitivity. In fact, it used to produce far more FX reaction than we see today from either the CPI or payroll report. Dollar/yen, for instance, would habitually surge or slump by two or three yens immediately after US trade data broke. Those days have long gone, and probably won’t come back.

In addition, the FX market seems to have lost sensitivity in a more general sense to trade trends. This is perfectly understandable; for while trade flows have risen slowly and steadily since the 1980s, transactions in financial assets, including currencies have surged dramatically. So today it seems impossible believe that the tail (trade flows) can wag the dog (the FX market), which means that predicting future currency trends on the basis of trade flows looks foolhardy at best. But should we totally ignore trade developments, especially if we also include trade in securities as captured in the balance of payments, and particularly if the trends in these flows are changing so much?

Steve Barrow, Head of Standard Bank G10 Strategy doesn’t think so, for there might still be some residual use in the balance of payments data. Right now, there are some truly huge changes going on between balance of payments trends in the US and those of the euro zone. The latter saw the release of June current account data yesterday. The EUR50.5bn surplus was the biggest on record and contrasts markedly from the record monthly deficit of near-EUR34bn two years ago. But it is not just the current account that has improved significantly; so too have financial flows.

For instance, the sum of foreign direct investment and portfolio flows in the year to June 2024 was around the zero mark. That’s up from a deficit of EUR150bn in the previous year. Add this to the annual current account figure, to construct a crude measure of the so-called basic balance, and the euro zone swung from a deficit of EUR120bn in the year to June 2023 to a surplus of EUR238bn in the year to June 2024. That’s a massive EUR358bn improvement in the euro zone basic balance. Importantly it contrasts starkly with the basic balance in the US where the deficit has increased dramatically in recent years; it was USD223bn in Q1. The divergence between the US and the euro zone has been mammoth and yet euro/dollar have gone nowhere. Why?

Steve Barrow said it would be for the reasons mentioned above; that balance of payments factors just don’t float the FX markets boat. Another explanation is that this improvement in the euro zone has largely come about via a position of economic weakness, not strength. For instance, both annual exports and imports have fallen over the past year, with imports falling by more. Euro zone firms have disinvested from abroad at a faster rate than foreign firms have disinvested from the euro zone, probably reflecting just how cash-strapped euro zone companies have been.

In short, this huge balance of payments improvement in the euro zone relative to the US has come with a narrative of relative euro zone economic weakness (and US strength) and that’s usually not a good story when it comes to euro strength. So, what now; should we continue to ignore these trends? Steve Barrow doesn’t think so. He thinks they add to the narrative that the US could be stretching the elastic on just how far it can use its economic might and ‘exorbitant privilege’ as it is called (of having the world’s dominant currency) to get the rest of the world to hold these huge and rising claims on the country. If that’s right, the US dollar is vulnerable even if it has defied gravity against the euro, and many other currencies, up to now.