Tag Archive | "Last Decade"

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Aussie is Breaking Away from Kiwi


The correlation between the Australian Dollar and New Zealand Dollar is among the strongest that exists between two currencies. Given their regional bond and similar dependence on commodities to drive economic growth, perhaps this is no wonder. Over the last year, however, the Aussie has slowly broken away from the Kiwi. While the correlation between the two remains strong, the emergence of distinct narratives has given rise to a clear chasm, which can be seen in the chart below. Given that the NZD is evidently among the most overvalued currencies in the world, does that mean the same can be said about the AUD?

Alas, geographic proximity aside, the two economies have very little in common. Australia is rich in coal, precious metals and other natural resources , while New Zealand produces and export primarily agricultural products. Granted, the prices for both types of commodities have exploded over the last decade (and especially the last year), but let’s be clear about the distinction. This has enabled both economies to achieve trade surpluses, but oddly current account deficits. Australia’s economy is projected to grow by more than 4% in 2011, compared to 2% in New Zealand. Australia’s benchmark interest rate is also higher, its capital markets are deeper, and the supply of its currency necessarily exceeds that of New Zealand.

Taken at face value, then, it would seem commonsensical that the Aussie should rise both against the Kiwi and the US Dollar. Indeed, it recently touched an all-time high against the latter, and is now firmly entrenched above parity. On a trade-weighted basis, it has been among the world’s best performers over the last two years.

In fact, some are wondering (myself included), whether the Australian Dollar might have risen too much for its own good. According to OECD valuations based on purchasing power parity (ppp), the Aussie is now 38% overvalued against the dollar, behind only the Swiss Franc and Norwegian Krone. In fact, exporters of non-commodity products (i.e. those whose customers are actually price-sensitive) have warned of mounting competitive pressures, declining sales, and inevitable price cuts. In other words, the portion of the Australian economy that doesn’t deal in commodities is actually in quite fragile shape. Given that China’s economy is projected to slow over the next two years and that booming investment in Australia’s mining sector should boost output, the commodity sector of the economy might soon face similar pressures.

For that reason, the Reserve Bank of Australia (RBA) has avoided raising its benchmark interest rate is fast as some analysts had expected, and inflation hawks had hoped. There is a chance for a 25 basis point hike as soon as June – bring the base rate to an even 5% – but the RBA’s own statements indicate that it probably won’t be until June and July. Regardless of when the RBA tightens, Australian interest rate differentials will remain strong for the foreseeable future, and likely continue to attract speculative inflows for as long as risk appetite remains strong.

So why does the Australian dollar continue to rise? It might have something to do with gold. As you can see from the chart above, the correlation between the Aussie and gold prices is almost just as strong as the relationship between the Aussie and the Kiwi. Given that Australia is the world’s second largest gold exporter, it is perhaps unsurprising that investors would see rising gold prices as a reason for buying the Australian dollar. However, it seems equally possible that demand for both is being driven by the pickup in risk appetite. While some gold buyers might counter that gold is best suited for those who are averse to risk (i.e. afraid that the financial system will collapse), the performance of gold over the last five years suggests that in fact the opposite is true. When risk appetite is high, speculators have bought gold and the Australian dollar (among other assets).

It’s unclear whether this will remain the case going forward. The Wall Street Journal recently reported that gold is increasing attracting risk-averse investment, as buyers fret about the eurozone sovereign debt crisis and other threats to the system. However, the same cannot be said about the Australian Dollar. For as long as risk is “on,” demand for the Aussie will remain intact. And if the Aussie Dollar Barometer survey – which found that “exporters expect the Australian dollar to reach a post-float record of $US1.16 by September and to remain above parity well into next year” – is any indication, risk appetite will indeed remain strong for the foreseeable future.

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G7 Leads Shift in Forex Reserves


As you can see from the chart below, the world’s foreign exchange reserves (held by central banks) have undergone a veritable explosion over the last decade. While emerging markets (especially China!) have accounted for the majority of this growth, there are indications that this could soon change. China’s reserve accumulation is set to slow, while advanced economies’ reserves are set to increase.


In the past, central banks from advanced economies have accumulated reserves only sparingly, and in fact, much of this growth can be claimed by Japan. This is no mystery. While held by emerging economy central banks, most of the reserves are denominated in advanced economy currencies. This has ensured a plentiful supply of cheap capital, to support both economic expansion and perennial current account deficits (namely in the US!). In addition, advanced economy central bankers tend to hew towards economic orthodoxy, which precludes them from intervening in forex markets, and obviates the need to accumulate forex reserves. Emerging economies, on the other hand, depend principally on exports to drive growth. As a result, many are driven towards holding down their currencies in order to maintain competitiveness. China has taken this to an extreme, by exercising rigid control over the value of the Yuan, and necessitating the accumulation of $3 trillion in foreign exchange reserves.

This trend accelerated in 2010 with the inception of the so-called currency wars (which have not yet abated). Competing primarily with each other, emerging economies bought vast sums of foreign currency in order to promote economic recovery. Many countries from South America and Asia which don’t normally intervene were also drawn in. The result was a tremendous accumulation of foreign exchange reserves, which is reflected in the chart above.

There is already evidence that this phenomenon is starting to reverse itself. Consider first that advanced economies have participated in the currency wars as well. Japan’s reserves have swelled to more than $1.1 Trillion. Switzerland spent $200 Billion defending the Franc, and South Korea has spent more than $300 Billion over the last five years trying to hold down the Won. The Bank of England (BOE) recently announced plans to rebuild its reserves (the majority of which were redeployed towards gilt purchases). The European Central Bank (ECB) has announced similar plans, and may be joined by the Bank of Canada and US Federal Reserve Bank.

Advanced economies need currency reserves for a couple reasons. First of all, they can no longer rely on monetary easing to reduce their exchange rates because of the inflationary side-effects. Second, the recent coordinated intervention on Japan’s behalf showed that the G7 will move to protect its members when need be. Finally, political forces are compelling advanced economies to slow the outflow of jobs and production, and this requires more competitive exchange rates.

Emerging economies, meanwhile, are starting to recognize that unchecked reserve accumulation is neither sustainable nor desirable. First of all, managing those reserves can be tricky. Intervention is not free, and exchange rate and investment losses must be accounted for somewhere. Second, continued intervention has several detrimental byproducts, namely inflation and the handicapping of domestic industry. Finally, emerging economy currency appreciation is inevitable. Constant intervention merely forestalls the inevitable and invites unending speculation and inflows of hot-money.

There are a few of ways that currency investors can position themselves for this change. As emerging market economies stop the accumulation of (or worse, sell off) their reserves, a major source of demand for advanced economy currency will be curtailed. This will accelerate the broad-based appreciation of emerging market currencies against their advanced economy counterparts. At the same time, I’m not sure how much reshuffling we will say in the composition of reserves. The euro is plagued by existential uncertainty, while the yen and pound have serious fiscal problems. In the short-term, the Chinese Yuan is prevented by several factors from becoming a legitimate reserve currency, namely that it is too difficult to obtain. (As soon as this changes, you can bet that emerging economy central banks will begin accumulating it. After all, they are competing with China – not with the US). The dollar is certainly also an “ugly” currency, but given the size of the US economy, the depth of its capital markets, and the liquidity with which the dollar can be traded, it will remain the go-to choice for the immediate future.

In the short-term, traders that wish to short advanced economy currencies (namely the Japanese yen) can do so in the secure knowledge that they are backstopped by the G7 central banks. It’s like you have an automatic put option that limits downside losses. If the Yen falls, you win! If the yen rises, the BOJ & G7 should step in, and at least you won’t lose!

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Retail Forex: Lower Corporate Profits = Lower Spreads for Traders?


In December 2010, both GAIN Capital and FXCM became public companies. This was thought both to signal the maturing of an industry and to herald the start of a period of explosive growth. Since then, the share prices for both companies have fallen dramatically, even while the S&P 500 has continued to rise. Trading volume has remained flat, and revenues have declined. As a result, analysts (myself included) are starting to question not only the operations of these two firms, but also of the entire industry.

Before we jump to conclusions, it’s important to understand the basis for this sudden aura of uncertainty . First of all, both firms – as well as the broader forex industry – have found themselves the subject of increased regulatory scrutiny, and consequent disciplinary action. Second, trading volume has been impacted by an uptick in volatility. Third, an increase in institutional trading volume has not translated into a proportional increase in revenues/profits. Fourth, the recent tightening of leverage rules has eroded a large profit center. Finally, high account turnover suggests that the brokers will eventually run out of customers.

I don’t want to dwell on the industry’s regulatory travails (since I have blogged about it before), except to say that I think it’s a good thing. It will bring greater transparency, and generally make trading safer and cheaper. For more information on the specific allegations and (potential) regulatory response, the WSJ recently published an excellent overview.


As for the temporary decline in retail trading volume, this is probably temporary. Overall forex volume has tripled over the last decade, and it is forecast to triple again over the coming decade. In addition, the mainstreaming of currency trading will spur millions of investors to at least dabble on forex. Unfortunately, this will probably be offset by a decline in trading activity by existing customers, as the majority come to terms with the difficulty of profiting through high-volume/high-leverage trading.

Furthermore, increased volume will combine with increased competition to facilitate lower spreads. According to a recent report by LeapRate, GAIN Capital now earns an average of only 1.7 pips per trade, a stunning drop for the 2.7 pips that it averaged during most of 2010. Basically, the same thing is now happening to forex that decimalization and computerization brought to bear on stocks. If hedge funds and other institutional traders continue to enter the market en masse, spreads will be arbitraged away to the point that 1-2 pips (or even smaller!) should become the norm for all major currency pairs.


In short, retail forex traders should applaud the decline in stock prices. After all, what’s good for traders is probably going to be bad for business. Liquidity is increasing, and spreads are falling. Enhanced regulation is eliminating shadowy sources of profit and will make trading more secure. The only thing left to hope for is that all forex brokers go public, and open up their books to the same level of scrutiny as GAIN Capital and FXCM.

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Aussie May Have Peaked in 2010


When offering forecasts for 2011, I feel like I can just take the stock phrase “______ is due for a correction” and apply it to one of any number of currencies. But let’s face it: 2009 – 2010 were banner years for commodity currencies and emerging market currencies, as investors shook off the credit crisis and piled back into risky assets. As a result, a widespread correction might be just what the doctor ordered, starting with the Australian Dollar.

By any measure, the Aussie was a standout in the forex markets in 2010. After getting off to a slow start, it rose a whopping 25% against the US Dollar, and breached parity (1:1) for the first time since it was launched in 1983. Just like with every currency, there is a narrative that can be used to explain the Aussie’s rise. High interest rates. Strong economic growth. In the end, though, it comes down to commodities.

If you chart the recent performance of the Australian Dollar, you will notice that it almost perfectly tracks the movement of commodities prices. (In fact, if not for the fact that commodities are more volatile than currencies, the two charts might line up perfectly!) By no coincidence, the structure of Australia’s economy is increasingly tilted towards the extraction, processing, and export of raw materials. As prices for these commodities have risen (tripling over the last decade), so, too, has demand for Australian currency.

To take this line of reasoning one step further, China represents the primary market for Australian commodities. “China, according to the Reserve Bank of Australia, accounts for around two-thirds of world iron ore demand, about one-third of aluminium ore demand and more than 45 per cent of global demand for coal.” In other words, saying that the Australian Dollar closely mirrors commodities prices is really an indirect way of saying that the Australian Dollar is simply a function of Chinese economic growth.

Going forward, there are many analysts who are trying to forecast the Aussie based on interest rates and risk appetite and the impact of this fall’s catastrophic floods. (For the record, the former will gradually rise from the current level of 4.75%, and the latter will shave .5% or so from Australian GDP, while it’s unclear to what extent the EU sovereign debt crisis will curtail risk appetite…but this is all beside the point.) What we should be focusing on is commodity prices, and more importantly, the Chinese economy.

Chinese GDP probably grew 10% in 2010, exceeding both economists’ forecasts and the goals of Chinese policymakers. The concern, however, is that the Chinese economic steamer is now powering forward at an uncontrollable speed, leaving asset bubbles and inflation in its wake. The People’s Bank of China has begun to cautiously lift interest rates, raise reserve ratios, and tighten the supply of credit. This should gradually trickle down in the form of price stability and more sustainable growth.

Some analysts don’t expect the Chinese economic juggernaut to slow down: “While there is always a chance of a slowdown in China, the authorities there have proved remarkably adept at getting that economy going again should it falter.” But remember- the issue is not whether its economy will suddenly falter, but whether those same “authorities” will deliberately engineer a slowdown, in order to prevent consumer prices and asset prices from rising inexorably.

The impact on the Aussie would be devastating. “A recent study by Fitch concluded that if China’s growth falls to 5pc this year rather than the expected 10pc, global commodity prices would plunge by as much as 20pc.” [According to that same article, the number of hedge funds that is betting on a Chinese economic slowdown is increasing dramatically]. If the Aussie maintains its close correlation with commodity prices, then we can expect it to decline proportionately if/when China’s economy finally slows down.

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Fed Paper: Power of Technical Analysis in Forex is Declining


Being a practitioner of fundamental analysis, you could say that I’m always on the lookout for hard evidence that fundamental analysis is superior to technical analysis. Thus, I was delighted to discover a working paper (“Technical Analysis in the Foreign Exchange Market“) by the St. Louis Branch of the Federal Reserve Bank, released just this month. Alas, the paper barely touched upon fundamental analysis, but its conclusions on technical analysis in the currency markets were startling. In short, the effectiveness of technical analysis in the currency markets has declined steadily since the 1970s, such that only the most sophisticated/complicated strategies are currently profitable.

Rather than conduct original research, the report’s authors – Christopher J. Neely, an assistant vice president and economist at the Federal Reserve Bank of St. Louis, and Paul A. Weller, the John F. Murray Professor of Finance at the University of Iowa – performed a meta analysis of the existing research. They cited a litany of studies, covered a variety of topics, sometimes with contradictory conclusions. In order to ensure comprehensiveness, they looked at the profitability of numerous types of technical analysis indicators, across numerous currency pairs, over time, in different types of trading environments, and adjusted for risk.

All of the earlier studies, dating back to the 1960s, established the profitability of technical analysis, even when it was simplistic. Since then, however, most studies have shown steadily declining effectiveness: “TTRs [Technical Trading Rules] ere able to earn genuine risk-adjusted excess returns in foreign exchange markets at least from the mid-1970s until about 1990…and that rule profitability has been declining since the late 1980s.” The same trend has unfolded in the last decade, as traders have relied increasingly on computerized trading strategies: “Kozhan and Salmon (2010), using high frequency data, find that trading rules derived from a genetic algorithm were profitable in 2003 but that this was no longer true in 2008.”

Given that the two authors also concede that the financial markets are undoubtedly inefficient and that currency markets in particular are filled with observable trends, how should we understand this decline in the effectiveness of technical analysis? In one word, the answer is competition. “Profit opportunities will generally exist in financial markets but…learning and competition will gradually erode [“arbitrage away”] these opportunities as they become known.” In addition, there has been a “dramatic rise in the volume of algorithmic trading,” which has given rise to a so-called financial arms race to develop ever-more sophisticated trading strategies.

Indeed, the research shows that “more complex strategies will persist longer than simple ones. And as some strategies decline as they become less profitable, there will be a tendency for other strategies to appear in response to the changing market environment.” In addition, technical analysis that is used to trade exotic (i.e. less liquid) currencies is more likely to be profitable than major currencies, especially the US Dollar.

The report opens the door to further research, by indicating that “Technical trading can be consistently profitable in certain circumstances.” As if it wasn’t already clear, though, the vast majority of technical traders (perhaps all traders for that matter) are destined to be outmaneuvered and will ultimately lose money trading forex. Another way of looking at this, however, is that the the savviest traders – those that can spot complex trends and execute trading strategies quickly – still have a chance at earning consistent profits.

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War = Good News for South Korea?


South Korea was in the midst of figuring out what to do with its appreciating Won when disaster struck, in the form of an unprovoked attack from North Korea. Combined with a worsening of the sovereign debt crisis in Europe, the news was enough to send the Won down 5% over the course of a couple weeks. From the standpoint of managing its currency, it looks like the (distant) prospect of war is actually a blessing in disguise.

Over the last decade, South Korea has been one of the world’s largest serial interveners in currency markets. Over the last two years alone, as evidenced by the growth in its foreign exchange reserves, it has spent more than $100 Billion defending the Won. As the so-called currency war has intensified, so, too has the Bank of Korea intensified its efforts to hold down the Won, having spent more than $20 Billion since July towards this effort.

South Korea Forex Reserves 2005-2010
You could say then that South Korea’s hosting of the G20 Summit on November 15 put it in a slightly awkward position. Still, it was determined to make clear that it would continue to take steps to combat the rise in the Won. According to Shin Hyun-song, the special economic advisor to President Lee Myung-bak, “This means that countries can intervene in the currency market when the market is in disorder and when there is a gap between the market rate and underlying economic fundamentals.” Of course, fundamentals is hardly an objective notion in this case.

While the G20 predictably called on participants to “move toward a market-driven exchange rate system and to refrain from competitive devaluations,” it nonetheless also guided them towards “implementing policy tools for bringing excessive external imbalances down to sustainable levels.” The underlying message is that certain countries should curtail their reliance on exports and try to achieve more balanced growth.

Naturally, South Korea’s interpretation was that while direct intervention is now taboo, taxes and other capital controls are sanctioned. Thus, it has been reported that “the Korean government has been gauging its timing to launch further measures to tighten the financial market and protect it from volatile global capital movement..bank levies on non-deposit liabilities and taxes on foreign purchases of government bonds are both possible options.”

As I said, though, the South Korea now has some breathing room. Its Won depreciated rapidly in the minutes after the shelling of Yeonpyeong island, which killed four and wounded 20, was first reported. The fact that the US government immediately pledged its support and solidarity (by sending over an aircraft carrier) is not instilling confidence. One analyst indicated, “We see a strong chance of further Korean won weakness in the days ahead as more details emerge, particularly if public opinion in South Korea puts pressure on the government there to take a stronger stance.”

Korean Won / US Dollar Chart

Even before this episode, the EU sovereign debt crisis had spread to Ireland, and put Spain and Portugal at risk, too. As a result, the Dollar-as-safe-haven mindset re-emerged, and spurred some capital movement back to the US. In this context, the drama with North Korea only exacerbated the climate of risk aversion.

Ultimately, both the EU fiscal crisis and the tensions with North Korea will subside, which should cause the Won to resume its rise. (In fact, Korean exporters have come to view this as inevitable, and have taken advantage of the relatively favorable exchange rate to repatriate overseas earnings). At this point, you can expect the Bank of Korea to begin implementing capital controls and continue the face-off with currency markets.

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Chinese Yuan Will Not Be Reserve Currency?


In a recent editorial reprinted in The Business Insider (Here’s Why The Yuan Will Never Be The World’s Reserve Currency), China expert Michael Pettis argued forcefully against the notion that the Chinese Yuan will be ever be a global reserve currency on par with the US Dollar. By his own admission, Pettis seeks to counter the claim that China’s rise is inevitable.

The core of Pettis’s argument is that it is arithmetically unlikely – if not impossible – that the Chinese Yuan will become a reserve currency in the next few decades. He explains that in order for this to happen, China would have to either run a large and continuous current account deficit, or foreign capital inflows into China would have to be matched by Chinese capital outflows.” Why is this the case? Simply, a reserve currency must necessarily offer (foreign) institutions ample opportunity to accumulate it.

China Trade Surplus 2009 - 2010
However, as Pettis points out, the structure of China’s economy is such that foreigners don’t have such an opportunity. Basically, China has run a current account/trade surplus, which has grown continuously over the last decade. During that time, its Central Bank has accumulated more than $2.5 Trillion in foreign exchange reserves in order to prevent the RMB from appreciating. Foreign Direct Investment, on the other hand, averages 2% of GDP and is declining, not to mention that “a significant share of those inflows may actually be mainland money round-tripped to take advantage of capital and tax regulations.”

For this to change, foreigners would need to have both a reason and the opportunity to hold RMB assets. The reason would come from a reversal in China’s balance of trade, and the use of RMB to pay for the excess of imports over exports, which would naturally imply a willingness of foreign entities to accept RMB. The opportunity would come in the form of deeper capital markets, a complete liberalization of the exchange rate regime (full-convertibility of the RMB), and the elimination of laws which dictate how foreigners can invest/lend in China. This would likewise an imply a Chinese government desire for greater foreign ownership.

China FDI 2009-2010

How likely is this to happen? According to Pettis, not very. China’s financial/economic policy are designed both to favor the export sector and to promote access to cheap capital. In practice, this means that interest rates must remain low, and that there is little impetus behind the expansion of domestic consumption. Given that this has been the case for almost 30 years now, this could prove almost impossible to change. For the sake of comparison, consider that despite two “lost decades,” Japan nonetheless continues to promote its export sector and maintains interest rates near 0%.

Even if the Chinese economy continues to expand and re-balances itself in the process (a dubious possibility), Pettis estimates that it would still need to increase the rate of foreign capital inflows to almost 10% of GDP. If economic growth slows to a more sustainable level and/or it continues to run a sizable trade surplus, this figure would rise to perhaps 20%. In this case, Pettis concedes, “we are also positing…a radical change in the nature of ownership and governance in China, as well as a radical redrawing of the role of the central and local governments in the local economy.”

So there you have it. The political/economic/financial structure of China is such that it would be arithmetically very difficult to increase foreign accumulation of RMB assets to the extent that the RMB would be a contender for THE global reserve currency. For this to change, China would have to embrace the kind of reforms that go way beyond allowing the RMB to fluctuate, and strike at the very core of the CCP’s stranglehold on power in China.

If that’s what it will take for the RMB to become a fully international currency, well, then it’s probably too early to be having this conversation. Perhaps that’s why the Asian Development Bank, in a recent paper, argued in favor of modest RMB growth: “sharing from about 3% to 12% of international reserves by 2035.” This is certainly a far cry from the “10 years” declared by Russia’s finance minister and tacitly supported by Chinese economic policymakers.

The implications for the US Dollar are clear. While it’s possible that a handful of emerging currencies (Brazilian Real, Indian Rupee, Russian Ruble, etc.) will join the ranks of the international currencies, none will have enough force to significantly disrupt the status quo. When you also take into account the economic stagnation in Japan and the UK, as well as the political/fiscal problems in the EU, it’s more clear than ever that the Dollar’s share of global reserves in one (or two or three) decades will probably be only slightly diminished from its current share.

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Why is the Japanese Yen Still Rising?


Most of today’s headlines regarding the Japanese Yen focus on one thing: Central Bank intervention. Basically, reporters have become focused on the likelihood of additional intervention in the currency markets by the Bank of Japan. However, this obsession has caused them to overlook the larger issue: Why is the Yen still rising?

JPY Versus USD Chart 1970 - 2010

I was prompted to ask this question after coming across the above chart, which tracks the historical performance of the Japanese Yen against the US Dollar. You can see that since 1970, the Yen has risen by a whopping 350% against the Dollar. It has doubled in value since 1990 and risen 14% since the start of the year, en route to a 15-year high. Over the same period (actually since 1980; I couldn’t find data from the 1970), Japan’s economy has expanded by an average annualized growth rate of 2.2%. Over the last 10 years, the average is a paltry .9%. The contradiction between fundamentals and reality could not be more stark!

In addition, investor risk appetite has been reinvigorated. During most of the last decade, carry trading caused the Yen to decline to 120 USD/JPY as investors borrowed Yen in bulk in order to purchase high-yielding assets. The credit crisis spurred a short squeeze (i.e. rapid unwinding of carry trade positions) in early 2007, and caused the Yen to rocket upward. If anything, we would expect the Yen to mirror its performance of a few years ago, as investors take advantage of low Japanese interest rates and rebuild carry trade positions in the Yen.

The recent run-up in emerging market currencies, global equities, commodities, and other risky assets would certainly seem to support a carry trade strategy. For its part, the Bank of Japan is also doing its best to create a healthy environment for carry trading by printing currency, easing monetary policy, and fighting to keep the Yen from rising. And yet, if indeed there are still carry traders (and there certainly are!), the current trend in forex markets suggests that they are very much outnumbered by those betting on the Yen’s rise.

It’s difficult to understand this phenomenon. Those that hold Yen earn a nominal return of near 0%. Long-term interest rates (proxied by 10-year government bonds) are only slightly higher – at 1% – and certainly too low to attract any foreign institutional interest. Besides, it’s well-known that 90% of Japanese government debt is held by domestic savers. Meanwhile, the Japanese stock market has stagnated for more than 2 decades, and the Nikkei average is lower than at any point since 1985 (except for a brief period following the dot-com bust. Japanese real estate is equally unattractive.

As a result, there are only two conceivable reasons for the Yen’s continued upward push. The first is fundamental/structural and is connected to Japan’s trade surplus. In spite of an appreciating currency, the Japanese export sector continues to be the lone bright spot in an economy with otherwise limited sources of growth. Compared to 2009, the trade surplus is up 83%, helped by a rise of 50% in September. It is on pace to top $100 Billion for the year. In this regard, foreigners that buy Japanese Yen do so because they must- for purposes of trade.

Japan inflation rate chart 1970 - 2010

The second source of demand for Japanese Yen is so-called safe haven flows. While the Japanese Yen is not a high-yielding currency, it is actually an excellent store of value. [This is one of the three primary functions that a currency should fulfill. The other two are medium of exchange and unit of account]. That’s because inflation in Japan is the lowest in the world, often to the point of being nil. Since 1970, the inflation rate has averaged only 3%, compared to 4.5% in the US. Over the last 15 years, inflation has been 0%. In other words, even if they are invested in low-yielding savings accounts, Japanese savers can ensure that 1 Yen today will probably still be worth 1 Yen 5 years from now. Foreign investors can take advantage of the same phenomenon, when they bet that the exchange value of the Yen will be equally stable.

On the one hand, it is somewhat surprising that the Yen has been able to thrive in the current “risk-on” investing climate. On the other hand, there is a parallel thread of risk-aversion that will always exist and gravitate towards safe-haven currencies, such as the Yen. In fact, it can be argued that this contingent of investors is as large as the risk-taking contingent, as evidenced by the inexorable appreciation of gold (if not also by the Yen). Insofar as inflation in Japan remains nil and the Japanese export sector proves it can be competitive regardless of exchange rates, demand for Yen will continue to confound the gloomy forecasts and rebuff the best efforts of the Bank of Japan.

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Debunking the Myth: The Dollar and the Deficit


Last week, I opined on the official US forex policy (“Strong Dollar” Policy is a Joke). Most of my analysis was directed towards the lackluster efforts of US policymakers in failing to execute this policy, and I paid short shrift to the policy itself. With this post, then, I would like to address whether a Strong Dollar is, on balance, actually good for the US economy, specifically as it bears on the balance of trade.

Dean Baker, of the American Prospect, in a post germane to this discussion, wrote that “Folks who took econ 101 know that currency fluctuations are the mechanism through which trade imbalances adjust.” Unfortunately, as anyone who follows the forex markets no doubt understands, reality is much more complicated. As the WSJ reported, US exports skyrocketed during the last decade when the Dollar was falling. Case closed, right? However, exports also rose during the 1990’s, when the Dollar was in fact rising. This contradiction should make make anyone think twice before assuming a cut-and-dried relationship between the Dollar and exports think twice.

Dollar and US exports 1990-2009
While exchange rates certainly correlate with export volume, there are a few confounding variables. Fist is the lag time between fluctuations in exchange rates and corresponding changes in exports. That’s because the majority of international trade is conducted by large companies and because global supply chains are not completely fluid. In other words, if the Dollar collapses tomorrow, it will take years before companies can fully modify their sourcing arrangements accordingly.

In addition, it is mainly on non-durable goods that companies have relative flexibility on choosing sourcing locations. In this age of ODM and OEM, it’s not difficult for Nike to shift production to Vietnam if the Chinese Yuan is suddenly revalued. On the other hand, it is significantly more complicated to move an automobile manufacturing plant or oil refinery. Investments in production facilities for durable goods are made on a long-term basis, then, and aren’t responsive to short-term changes in exchange rates. If you look at the breakdown of US exports, it is heavily concentrated in services and high-tech products, many of which it’s not (yet) practical to outsource.

For goods and services that are low-skilled labor-intensive, it’s obviously cost-effective to produce them overseas, because wages are lower. This is not a product of exchange rates, but rather to disparities in standards of living and levels of development. In China (where I am based), factory wages rarely exceed 8RMB per Dollar (about $1.25 at current exchange rates). Conservatively, that’s probably less than 1/20th of US counterpart wages, when you look at salary and benefits. That’s why the weak Dollar hasn’t done much to dent US demand for imports. Personally, I don’t expect to see the RMB rise 1500% in the next few years to erase this discrepancy, which means that’s unrealistic to ever expect the US Dollar to depreciate enough to ever make the US competitive enough in certain export categories.

Obviously, the inverse is true for imports. From the perspective of the US, the shifting of non-durable goods production outside the US represents a permanent structural changes in the US economy. Regardless of how low the Dollar sinks, it’s not reasonable to assume that the US will once again become the hotbed of low-tech manufacturing activity that it once was.

Overall, exports have actually risen steadily over the last decade (and the last 50 years, on average); the problem is that imports have risen even faster. In fact, ebbs and flows in the trade deficit can be better explained by global economic cycle than by short-term fluctuations in exchange rates. Despite the weak Dollar, the US trade deficit has exploded over the last decade because of a comparable explosion in US consumption, which was made possible by cheap credit. When that cycle came to an abrupt end in 2008, the trade deficit narrowed dramatically, despite the rise in the Dollar that took place simultaneously.

US trade deficit 1945-2009

Given that the US has basically committed itself to importing certain goods, a Strong Dollar is actually beneficial, because it reduces the cost of those imports. In the short-run, then, a 20% decline in the Dollar might be expected to correlate with a 20% rise in the trade deficit. The hope is that this can be offset over the long-term, with the relocation of production facilities (yes, foreign companies also outsource to the US; it’s a not a one-way exodus) to the US and the creation of new products/services that can fill the void of those that have already been outsourced.

In short, it’s not clear that a weak Dollar will dramatically improve the US trade imbalance. This can best be accomplished not through a weak exchange rate, but through incentives that stimulate innovation and discourage consumption of low-quality, non-durable goods, the majority of which are produced overseas. When you consider the inflation (Strong Dollar keeps prices in check) and financing (Strong Dollar increases the willingness of foreigners to invest in and lend to US entities) perks, the Strong Dollar probably provides a net benefit to the US economy. If Bernanke and Geithner actually believe this, it would be nice if they conducted policy accordingly.

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Kiwi and Aussie Diverge, then Re-Unite


Over the last few months, the New Zealand Dollar and Australian Dollar have largely moved in tandem (see chart below). When the Reserve Bank of Australia raised its benchmark interest rate earlier this month, it shocked the markets and the Aussie shot up, while the Kiwi remained fixed in place. Many observers predicted that such was the beginning of a divergence in the two currencies. Less than one week later, however, the New Zealand Dollar hitched itself back to the Australian Dollar, and the two currencies have since traded in lockstep.

Aussie - Kiwi comparison November 2009
Investors have long tended to view the currencies (and economies) of New Zealand and Australia as one. Both economies boast large export sectors, and for much of the last decade, high interest rates. Given that the carry trade has been (and continues to be) one of the largest forces in forex markets, it makes sense that the Kiwi and Aussie would be grouped together.

Both these superfical similarities mask substantive differences, which have only become more accentuated as a result of the global economic crisis. Alan Bollard, Governor of the Bank of New Zealand summarized this disparity as follows: “Australia has avoided negative growth, and its prospects are driven by strong terms of trade, vast mineral deposits, the Chinese market, and rapid population growth. New Zealand has had a recession, and the pick-up is slower and more vulnerable – a difference financial markets do not appear to appreciate.”

While both economies are currently experiencing negative trade imbalances, New Zealand’s deficit was 5.9% at last count, while Australia’s is closer to 2%. Given that Australia’s (energy and commodity) exports have surged by nearly 30% in the last few months, while New Zealand exports are stagnating, this discrepancy could widen in the coming months. Investment is also surging in Australia, as “The value of advanced resource projects — those that are either committed or under construction — jumped 41% to a record 112.46 billion Australian dollars (US$104.03 billion) in the six months to the end of October.” And of course, the most obvious point of differentiation is between the two economies’ respective benchmark interest rates. Thanks to the aforementioned rate hike, Australian rates stand at 3.5%, exactly 1% higher than comparable New Zealand rates.

Australia Balance of Trade 2009

Many analysts point to Australia’s improving fundamentals (higher rates, positive GDP growth, booming investment in the energy sector, increasing exports) as the basis for the strong appreciation in the Australian Dollar. Given that the New Zealand Dollar has kept pace with the Australian Dollar (it is in fact the world’s best performing “major currency” over the last six months), this kind of analysis seems dubious, if not completely irrelevant.

It should be clear to most observers that the carry trade is dominating activity in the forex markets. Carry traders, relatively speaking, are undiscriminating, with the main factor of importance being interest rate differentials. Despite the fact that New Zealand interest rates are only 2.5% higher than US rates (and actually less than Australian rates) – hardly enough to compensate investors for volatility risk – the markets are awash in liquidity, and investors are once again chasing yield wherever they can find it.

One analyst offered a frank summary of this phenomenon: “It’s all about the carry trade. The Fed can’t do anything; certainly they can’t raise rates and the market knows that, and is exploiting it for the carry trade, borrowing in U.S. dollars, and the Kiwi is a beneficiary of that…That’s the only game in town. You can forget most economic data, it’s all about…the Fed.” Given that Australian rates are projected to rise faster and higher than New Zealand rates (beginning as soon as December 1), it’s conceivable that the Aussie will outpace the Kiwi. At the same time, the fact that US interest rates will likely remain low for a while means that both currencies will continue to benefit in the short term.

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