Timing is Everything in Forex, Especially in this Environment

Timing is Everything in Forex, Especially in this Environment: "

I just finished reading a Wall Street Journal piece (Central Banks Rattle Markets), which laid out, in fairly broad terms, how the activities of Central Banks have become the main fodder for forex traders, and how this trend will continue as the global economy looks to move beyond the credit crisis. The piece got me thinking about the importance of timing, when it comes to forex.

Let’s face it, timing is important when trading any security. Buying a stock one month earlier and/or selling one month later (as compared to the actual trade dates) could yield drastically different results. This is especially the case in forex, for a couple reasons. The first is that the majority of forex traders have a shorter-time horizon than investors in bread-and-butter securities. We’re talking weeks or months here, compared to years and decades. The second reason is that while long-term trends certainly exist in forex, the average return for all currencies (over a long enough time period) should converge to 0%, since forex is a zero-sum game. In other words, buy $1,000 worth of stock today, and you might be a millionaire by 2050. Buy a $1,000 worth of Euros today, however, and you will probably have about the same, give or take, 40 years later.

This notion has taken on an added significance in the current environment because of its transitional character. As I said, there are certainly long-term trends in forex, but these tend to be anything but smooth. In the short-term, then, it’s conceivable that a currency will move with little correlation to its long-term “destiny.”

We have entered a period of extreme uncertainty, specifically surrounding the actions of Central Banks. Without exception, all of these Central Banks eased monetary policy to aid their respective economies through the credit crisis. This easing varied widely from bank to bank, and ranged from interest rate cuts to “liquidity injections” to wholesale money printing. Just as the performance of many currencies has been guided by the degree of easing exacted by their respective monetary authorities, so will such currencies be guided by the degree and speed of tightening, going forward.

For example, currencies such as the Australian Dollar and Norwegian Krone (as the WSJ article pointed out) have exploded since their respective Central Banks became the world’s first two to raise interest rates. Currencies such as the Dollar and Pound, meanwhile, remain in the doldrums, as it is forecast that the Fed and the Bank of England will be among the last to reverse the spigots of easy money that they unleashed last year.

And this brings me back to the issue of timing. There will be great rewards that inure to those who correctly anticipate interest rate hikes, “liquidity withdrawals,” etc. In this age of instantaneous fund transfers, predicting a move a day before it happens could mean thousands of PIPS in profits, maybe more, if you take leverage into account. Those that think the Fed will raise rates before the ECB but after the BOE can bet on currency crosses accordingly. Moreover, it is not enough to predict who/when will hike rates, but to what extent and how fast. Maybe the Fed will beat the EU out of the starting gate, but the EU will hike faster once it gets going, mirroring what happened (in reverse) when the credit crisis began. This possibility makes you wonder if slow and steady really wins the race…

In short, the next year or two could prove to be extremely choppy (gainful for some, bitter for others) as currencies spike and dive in accordance with the Fisher Effect (the empirical idea that money moves from low-yielding currencies into higher-yielding currencies, as investors chase higher interest rates). For those that think the Dollar is doomed in the long-run, then, be careful about betting all of your marbles in the short-run. That’s not to say that the carry trade will disappear; on the contrary, it could accelerate if interest rate discrepancies widen before they shrink. Instead, consider yourself warned that if the Fed beats other Central Banks to the punch of raising rates, there could be a dramatic pause in the Dollar’s downward slide.

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Pound’s Demise Will not be Hard to Time

Pound’s Demise Will not be Hard to Time: "

I’d like to follow up on my last post (Timing is Everything in Forex, Especially in this Environment) by looking at how to time one specific currency: the Pound. As I noted tongue-in-cheek with the title of this post, timing the Pound will not be difficult, since it is likely headed downward in both the short term and long term.

In the short-term, the Pound will be crippled by the UK’s economic woes: “Britain is the last of the big G20 countries still to be mired in recession. Its GDP has shrunk by 4.75% this year, far more than the 3.5% reckoned likely in April.” There’s no reason to pore through the economic indicators, since all signs suggest that it won’t be until 2010 that Britain returns to positive growth.

Of primary concern to forex markets, however, is not economic growth (or lack thereof, in this case), but rather how this will effect the decision-making of the Bank of England (BOE). To no surprise, the BOE announced yesterday that it would maintain its benchmark interest rate at .5%, and its liquidity program at current levels. It didn’t give any indication, meanwhile, that monetary policy on either of these fronts would change anytime soon.

Thus, Britain could conceivably replace the Dollar as one of the preferred funding currencies for the carry trade. While the Fed is also in no hurry to hike rates, the US economy has already emerged from the recession, which means that regardless of when it tightens, it will almost certainly be before the Bank of England. Unless the BOE pulls an audible then, timing the Pound will be fairly straightforward; the currency should begin to slip as soon as its peers begin to raise rates. Some analysts expect that the Pound will decline to $1.50 per Dollar within the next six months.

Over the long-term, the narrative governing the Pound is naturally more uncertain, but still straightforward. To try to dig itself out of recession, the government has spent itself well into the red, to the extent that this year’s budget deficit is forecast to be a whopping 12.6%, Next year could be even worse. The government has implemented a couple of half-baked measures designed to curb the deficit, but most of these are aimed at increasing tax revenue (which is futile during a recession), rather than trimming spending. While ratings on its sovereign debt were recently affirmed at AAA, Moody’s has warned that a downgrade in the next few years is not inconceivable.

So there you have it. As far as I’m concerned, the only question of timing, vis-a-vis the British Pound, is when the decline will begin. My guess is sometime in the beginning of 2010, when investors start getting serious about projecting near-term interest rate differentials, and pricing them into exchange rates. While most forex traders aren’t thinking this far down the road, it’s also comforting (for bears, not bulls, obviously) that the long-term fundamentals point to a sustained decline in the Pound. Whereas the Dollar could jump up before heading back down – making timing a crucial skill – the Pound will probably just head down.

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Euro: It’s Still Mostly About the Dollar

Euro: It’s Still Mostly About the Dollar: "

It’s been a while since I last wrote about the Euro (October 26: Euro Optimism (And not just Dollar Pessimism)). That’s because my perspective recently has been mainly Dollar-centric; I continue to believe that much of the recent movement in forex markets (with the exception of certain cross rates) can best be explained by the Dollar. Nowhere is this more evident than the Euro, whose rise should really be thought of in terms of the depreciation of the Dollar. It’s no surprise then that yesterday’s Euro decline – the steepest in months – was the result not of internal European developments, but rather of the US jobs report.

One analyst summarized the Euro’s ascent by noting, “The bias for risk-seeking is still in vogue.” This has nothing to do with the Euro, but rather is a roundabout way of speaking about the Dollar carry trade, which is responsible for an exodus of capital from the US, some of have which has no doubt found its way into Europe. In some ways, then, it’s almost pointless to scrutinize EU economic indicators too closely.

That being said, there are a few meaningful observations that can be made. The first is that the EU economy is tentatively in recovery mode. Some of the most closely-watched indicators such as the German IFO index, capacity utilization, and Economic Sentiment Indicator, have all ticked up in the last month, while the unemployment rate is holding steady. For better or worse, this improvement can attributed entirely to export growth, due to the recovery in world trade. GDP rose by .4% in the most recent quarter, which means that the Euro Zone has officially exited the recession.

The second observation is that many expect this exit to be short-lived. Due to the relative rigidity of the EU economy, specifically regarding the labor market, it may take additional time to get back on really solid footing. Thus, the European Commission “thinks that euro-area unemployment will continue to rise next year, reaching 10.9% in 2011. That will dampen consumer spending. Another worry is investment, which the commission thinks will fall by 17.9% this year. Businesses are unlikely to waste scarce cash on new equipment and offices when they have spare capacity. Firms confident enough to splash out may find it hard to secure the necessary financing from fragile and risk-averse banks.” The Commission also expects public finances to continue to deteriorate, perhaps bottoming at some point next year. There is even an outside concern that one of the fringe members of the EU could default on its debt, requiring a bailout in the same vein as the lifeline grudgingly being thrown to Dubai by the UAE.

Finally, there is the European Central Bank. Much like the Fed – and every other Central Bank in the industrialized world, except for Australia – the ECB is nowhere near ready to hike rates. “The overall economic context doesn’t suggest that they would want to tighten anytime soon. There is a feeling that, yes, things have improved, but that nonetheless, the outlook is still quite fragile,” summarized one economist. Sure, the ECB is winding down its liquidity programs, but so is the Fed. Based on long-term bond yields, investors believe that US rates could even eclipse EU rates at some point in the future.

In short, there isn’t really much to be optimistic about, when it comes to the Euro. The nascent recovery is hardly remarkable, and probably not even sustainable. While the Euro might continue to perform the Euro in the short-term for technical reasons, I would expect this edge to evaporate in the medium-term.

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Debunking the Myth: The Dollar and the Deficit

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.

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.

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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