For this installment of the macroeconomics group, Stockhouse members discussed some of the finer points of currency valuations. (Beware the Amero.)
Please add your comments at the bottom of the page, and enjoy!
[Editor’s note: Posts have been edited for punctuation, spelling, grammar and length.]
SH_Arber: Anyone else want to get into projections for currency valuations going forward? China's likelihood to revalue? The UAE has been tickling the notion of abandoning the petro-dollar standard and of unpegging Mid-East currencies - what other currency pitfalls are out there, and what does it mean for the economy? Standard of living? The price of a kilo of rice?
arnoldj: Rob, as you know, currencies are something I follow closely, given the inter-relationship with gold, which I also view as money. The difficulty with making targeted currency predictions is due to the inter-connectivity of the variables that impact them as major currencies today are in a state of competitive de-valuation.
Take a look at the loonie. David Dodge, before his retirement, on a number of occasions was extremely vocal in his concerns about a rising CAD dollar, as well as has been, and still is, Jim Flaherty. All money outside of gold and silver is valued by decree. They're FIAT currencies. Ultimately their worth, defined by confidence to hold your assets denominated in that currency, is backed up by the willingness and the capacity of the government to ensure re-payment upon demand, or upon agreed terms.
Money flow into currencies is as much a reflection of investment psychology, investment perception of the safety of money and its ability to retain purchasing power as it is a pure academic assessment of economic fundamentals of the country. They are absolutely connected but there are timing differences.
Political instability can overtake economic fundamentals or vice versa, driving away investment or attracting investment. Here's a hard rule: The larger the deficits that are run up (fiscal and trade), the greater the need to attract foreign investment... ergo the greater the capacity to manage perception of foreign investors to attract that capital. This explains the spin we see today from Paulson and Bernanke as well as Mervyn King or Jean-Claude Trichet or even comments from our own Bank of Canada.
Currencies are actively manipulated as well. Japan, China, India all routinely intervene in currency markets directly. Periodically over the decades members of the OECD have also done so. Again, all examples of competitive debasement.
Moreover, it is paradoxical (to say the least) for the U.S. to promote a strong dollar policy while pushing hard for China to upwardly re-value its currency. The Chinese must shake their heads in dismay as they ponder, upwardly re-value against who? The U.S. dollar... ergo they're then also calling for the U.S. dollar to fall against the Yuan... so fit that in with a strong dollar policy.
A supportive investment climate will attract capital or deter capital, reflected in that currency’s value. What made the Canadian currency climb then stop around parity after a brief material breach? Foreign investment demand into Canada no doubt related to energy. Money market funds seeking diversification out of the U.S. dollar, allocating some to Canada. Offsetting this has been efforts of late of the Canadian Pension Plan diversifying its own holdings, selling Canadian assets to purchasing foreign assets.
Short term interest rates drive short term money into currencies by hedge funds seeking yield. The carry trade is one such example. Most people think of the Japanese Yen as the principle source of funds into the U.S. dollar. The Swiss Franc is also one. This is what gave the greenback a boost last week as short term rates rose and attracted those seeking higher yields. This is usually temporary as those higher rates then hurt economic fundamentals, and that sours investor sentiment for U.S. assets driving away investment. It balances out. It's a matter of timing.
The point of the above is predicting currency direction is the toughest market of all. Valuations of any particular currency are a confluence of politics, economics, manipulation of not just the host country, but any other country open for foreign investment. I come back to the golden rule (pun not intended) alluded to above. Their worth is a function of faith – confidence that your investment is safe. I think we are now into an era where “safe” is defined by relative safety. Is the dollar safer than the Euro? Is the Yen safer than the dollar?
The US dollar benefits as the reserve currency because of political safety and vast liquid markets relative to other markets, made so by Bretton Woods when it was chosen as the reserve currency. Note it was backed by gold when it was first chosen as the reserve currency. Now it's backed by... the capacity of the U.S. taxpayer to fund government expenditures.
My view, and unless they dispense with the unfunded entitlement programs, is that the fiscal budget will break the Treasury's ability to obtain financing, destroying confidence in that all-important detail, confidence that my money is safe. If default is not opted for, but rather money is printed to fund this debt, the ‘ole "inflate your way out of it" strategy, the dollar is diluted. Either way, this is why I am a huge dollar bear. The outcome is inevitable.
The only question outstanding is, How long can the deficit funding come from abroad, as is currently the case. Paulson this week is on another roadshow trying to drum up sovereign wealth fund capital investment into the U.S. - given the inflationary repercussions to the foreign economies providing the funding. In the meantime, we're just witnessing the weekly gyrations in currencies, including gold, as worldwide investor psychology about relative safety and relative confidence ebb back and forth on news releases, officials jawboning, and a little ESF helping hand (at times), etc.
Another point that explains much of what we observe through the media today…
Management of the message is more vital than ever. Management of investment sentiment is more critical than ever when you are more dependent upon it more than ever before. This is why, almost as if they feel they have an aura of impunity under some universal safe harbor clause, officials, commercial and governments jawbone deliberate falsehoods intended on moving market perceptions. Irrespective of any deliberate jawboning, such as Ben Bernanke today, ultimately government debt levels break currencies, such as the U.S. dollar (to come) or the British Pound (end of WWII), and when they do expect another Bretton Woods, Plaza Accord type of cooperative counsel and an establishment of a new currency standard, at least for OECD countries as the pressures on upward appreciation on other currencies such as the Euro or the Yen will be intolerable, prompting push-back and perhaps direct intervention from their central banks.
Again, no one wants an expensive currency, especially when you're export dependent. Jim Sinclair's site (www.jsmineset.com) has proposed a gold certificate ratio evolving from this as a probable solution and Jim has written a great deal on this. A lot of this has merit, and naturally I'm attracted to it as it involves a heavy involvement of gold as an implicit source of value and preservation of purchasing power confidence. The key will be at what point the U.S. dollar starts to be abandoned as a reserve currency and (at this point the UAE and GCC rumblings fit in here) a more global currency takes its place. Think 2011 timeframe. Not far away.
P.S. The Amero is a dead issue as there's no way Canadians will voluntarily outsource control over their monetary policy to Washington. Canadians are more inclined to accept a more globally used currency. This could go on and on as the impact on central bank's interest rate policies, inflation is enormous... just late enough to call it a night.
frontline_jason: FX predictions! My favorite! My bets may sound "matter-of-facty" so apologies in advance. I'm tired and cranky but wanted to tackle this because I love currencies.
I'll start with the obvious: USD is toast. I just hope that the Amero doesn't come to fruition. I would leave Canada in that case. FX strategy for the next cycle (against a backdrop of rising prices) should be fairly straightforward for freely-floating currencies.
1) Favor those countries with strong external balance sheets and high savings rates (JPY, SGD, KRW, CHF, TWD). Note that these are the anti-carry trade currencies from this cycle.
2) Favor those countries that have/make stuff that the world wants (kind of an offshoot of point 1, but more geared to commodity producers that will continue to experience favorable terms-of-trade shocks). This means CAD, NOK, AUD, and maybe NZD. I am less hot on AUD and NZD because of their massive current account deficits.
3) Stay away from the big borrowers (USD, GBP).
4) Buy gold - it's the only real currency.
I don't see much upside for MXN (except maybe vs. USD) because of its tight linkage to the U.S. and ongoing problems in the resource sector. ZAR will remain under fire because of political risk, inflation, and a large current account deficit (7% of GDP last I checked).
The future of the Euro is a mystery. As I noted earlier, France and Germany are trying to get their act together. Ireland has blown the lights out, and although the housing market is faltering now their convergence was the best thus far. Spanish housing is in jeopardy, but bankers there may have hedged their exposure a bit better, and Italy is just a mess. Also, with reduced access to leverage, the fragility of the accession countries would undermine the overall strength of the Eurozone and increase risk to the entire Continent.
The pegged currencies are another animal altogether. Russia has already started to diversify out of dollars and into euros, and China has declared its intent to pursue a similar strategy. The Chinese will likely let RMB appreciate at a slower pace than RUB because of China's closer trade linkages to America.
As a sidebar, it is worth noting that as a percentage of total reserves, both Russia and China are holding record low amounts of precious metals. The Saudis have recently announced that they will remain pegged to the greenback, and I would expect that for the entire Middle East to drop their pegs, the Saudis would have to perform an about-face on this front. My only comment for this region is that price increases are at risk of getting out of hand, which could undermine growth. If growth falters but oil maintains its course of geometric increases, I would bet on THAT event being the inflection point for a change in a stance on the peg.
This group discussion was conducted with members of the Stockhouse community.
Next: Members get political (for a change) as the macroeconomics group discussion winds down.
Archive
Investor groups launch with macroeconomics discussion
Inflation and money supply, part I: Treasuries crowd bonds
Inflation and money supply, part II: Buyer’s remorse
Inflation and money supply, part III: Indeflationists unite
Inflation and money supply, part IV: Measuring money
Inflation and money supply, part V: Derivative “Death Star”
Oil supply, oil demand: Is oil in a bubble?
Housing crisis redux: Where do we go from here?
Spin-offs
Inflation debate stirs investors
Oil speculation theory taken to the woodshed
Oil prices: A critique