Singapore Dollar Drops, Watch For The Rebound

I was outlining an article on why the Singapore dollar (NYSEARCA:FXSG) would drop in the near future... Then it did before I finished. Why did it drop? Could it go further? And when will it rebound?

The immediate trigger was clearly talk of Fed tapering. Expectations of tighter USD supply will obviously raise USD/SGD exchange. Similarly, the growth (slow as it may be) in the U.S. economy will support the currency. In particular, Singapore's relative strength over the last few years was well priced in. The U.S. outlook has been less certain. Couple this with Singapore's slight contraction last quarter (see my Singapore update), and the stage was clearly set for a Singapore dollar depreciation.

Beyond the qualitative reasoning, there is one exchange rate theory which supports the drop.

Purchasing power parity says that a currency with lower inflation should see an appreciating exchange rate. While many currencies show significant deviations from this theory, Singapore should be closer due to its highly open economy. Currency majors have such large domestic economies that price indexes are mostly influenced by non-tradable products (housing, restaurants, local barber, etc) rather than tradables (cost of steel). Singapore however imports and exports so much (over 100% of GDP) relative to the total economy that all prices are impacted by external prices.

In essence, everything in Singapore is imported or could be. Thus we expect Singapore dollars to deviate less from purchasing power parity. Singapore did not show significant deflation risk over the last few years, and a strong housing market has resulted in headline inflation rates of 3-4%. Even core inflation (which in Singapore removes housing) has been holding steady at 1.5-2.5%. So Singapore inflation has been above the FOMC's PEI for some time. For this reason, a drop in SGD value towards purchasing parity was expected. Over the last few years, SGD depreciations have been much sharper than appreciations. So again I'm not surprised by a sudden jump in a week.

(click to enlarge)

The second theory to consider is interest rate parity. It's been shown that covered interest rate parity holds on most currencies - currency futures prices are set such that one can't take a riskless arbitrage on the difference between interest rates by buying spot now and a future to convert back later. Uncovered interest rate parity - the theory that the spot price will move to the expected future price based on current interest rate spread - often does not hold. Country risk, but especially changes in interest rate and other monetary policy often take the spot prices away from expectation. There is an exception: Singapore. For Singapore, even uncovered interest rate policy tends to hold. My explanation is that interest rates are not set by the central bank, thus the interest rates are set based on global rates plus expectations for exchange rate changes. Below we can see that USD rates have recently dropped under SGD rates. Forward swap points in January through March were generally positive suggesting a rise in USD/SGD at some point.

However, MAS policy still calls for an appreciating Singapore dollar in order to fight that inflation. The yen is no longer crashing - though it still has some drop left - so that appreciation is likely to come from USD/SGD. Further, current forward swap points for 1, 3, and 12 month swaps have all turned consistently negative. What that says is that even though interest parity is calling for a weaker Singapore dollar, the market is expecting MAS to step in and reverse the trend. If the Fed does taper QE3, then U.S. rates are likely to rise slightly, which would then restore the interest rate relationship. All this can be summed up in a chart with my estimates of MAS bounds:

The blip down on Sunday might be the beginning of the turn down or it may be nothing. Overall, I see a reversal, and potentially a long one, starting in the near future. A rate in the vicinity of 1.26 for USD/SGD is likely a good entry; 1.27 is possible, 1.28 would be fabulous but unlikely. A drop back to the middle of the band - around 1.235 - is highly likely. A pick up in the Singapore economy could bring the rate down much further than that.

Disclosure: I am long EWS, EWSS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long Singapore Dollars