Posts filed under ‘Currency – Foreign Exchange’
While the financial market party has been gaining momentum in the U.S., Europe has been busy attending an economic funeral. Mario Draghi, the European Central Bank President is trying to reverse the somber deflationary mood, and therefore has sent out $1.1 trillion euros worth of quantitative easing (QE) invitations to investors with the hope of getting the eurozone party started.
Draghi and the stubborn party-poopers sitting on the sidelines have continually been skeptical of the creative monetary punch-spiking policies initially implemented by U.S. Federal Reserve Chairman Ben Bernanke (and continued by his fellow dovish successor Janet Yellen). With the sluggish deflationary European pity party (see FT chart below) persisting for the last six years, investors are in dire need for a new tool to lighten up the dead party and Draghi has obliged with the solution…“QE beer goggles.” For those not familiar with the term “beer goggles,” these are the vision devices that people put on to make a party more enjoyable with the help of excessive consumption of beer, alcohol, or in this case, QE.
Although here in the U.S. “QE beer goggles” have been removed via QE expiration last year, nevertheless the party has endured for six consecutive years. Even an economy posting such figures as an 11-year high in GDP growth (+5.0%); declining unemployment (5.6% from a cycle peak of 10.0%); and stimulative effects from declining oil/commodity prices have not resulted in the cops coming to break up the party. It’s difficult for a U.S. investor to admit an accelerating economy; improving job additions; recovering housing market; with stronger consumer balance sheet would cause U.S. 10-Year Treasury Note yields to plummet from 3.04% at the beginning of 2014 to 1.82% today. But in reality, this is exactly what happened.
To confound views on traditional modern economics, we are seeing negative 10-year rates on Swiss Treasury Bonds (see chart below). In other words, investors are paying -1% to the Swiss government to park their money. A similar strategy could be replicated with $100 by simply burning a $1 bill and putting the remaining $99 under a mattress. Better yet, why not just pay me to hold your money, I will place your money under my guarded mattress and only charge you half price!
Does QE Work?
Debate will likely persist forever as it relates to the effectiveness of QE in the U.S. On the half glass empty side of the ledger, GDP growth has only averaged 2-3% during the recovery; the improvement in the jobs upturn is arguably the slowest since World War II; and real wages have declined significantly. On the half glass full side, however, the economy has improved substantially (e.g., GDP, unemployment, consumer balance sheets, housing, etc.), and stocks have more than doubled in value since the start of QE1 at the end of 2008. Is it possible that the series of QE policies added no value, or we could have had a stronger recovery without QE? Sure, anyone can make that case, but the fact remains, the QE training wheels have officially come off the economy and Armageddon has still yet to materialize.
I expect the same results from the implementation of QE in Europe. QE is by no means an elixir or panacea. I anticipate minimal direct and tangible economic benefits from Draghi’s $1+ trillion euro QE bazooka, however the psychological confidence building impacts and currency depreciating effects are likely to have a modest indirect value to the eurozone and global financial markets overall. The downside for these unsustainable ultra-low rates is potential excessive leverage from easy credit, asset bubbles, and long-term inflation. Certainly, there may be small pockets of these excesses, however the scars and regulations associated with the 2008-2009 financial crisis have delayed the “hangover” arrival of these risk possibilities on a broader basis. Therefore, until the party ends or the cops come to break up the fun, you may want to enjoy the gift provided by Mario Draghi to global investors…and strap on the “QE beer goggles.”
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own a range of positions, including positions in certain exchange traded funds positions , but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
This article is an excerpt from a previously released Sidoxia Capital Management complementary newsletter (February 3, 2014). Subscribe on the right side of the page for the complete text.
The porridge for stock market investors was hot in 2013, with the S&P 500 index skyrocketing +30%, while the porridge for bond investors was too cold, losing -4% last year (AGG). Like Goldilocks, investors are waiting to get more aggressive with their investment portfolios once everything feels “just right.” Dragging one’s feet too long is not the right strategy. Counterintuitively, and as I pointed out in “Here Comes the Dumb Money,” the investing masses have been very bashful in committing large sums of money out of cash/bonds into stocks, despite the Herculean returns experienced in the stock market over the last five years.
Once the party begins to get crowded is the period you should plan your exit. As experienced investors know, when the porridge, chair, and bed feel just right, is usually around the time the unhappy bears arrive. The same principle applies to the investing. In the late 1990s (i.e., technology bubble) and in the mid-2000s (i.e., housing bubble) everyone binged on tech stocks and McMansions with the help of loose credit. Well, we all know how those stories ended…the bears eventually arrived and left a bunch of carnage after tearing apart investors.
Fragile 5 Bed Too Hard
After enjoying some nice porridge at a perfect temperature in 2013, Goldilocks and investors are now searching for a comfortable bed. The recent volatility in the emerging markets has caused some lost sleep for investors. At the center of this sleeplessness are the financially stressed countries of Argentina and the so-called “Fragile Five” (Brazil, India, Indonesia, Turkey and South Africa) – still not sure why they don’t combine to call the “Sick Six” (see chart below).
|Source: Financial Times|
Why are these countries faced with the dilemma of watching their currencies plummet in value? One cannot overly generalize for each country, but these dysfunctional countries share a combination of factors, including excessive external debt (loans denominated in U.S. dollars), large current account deficits (trade deficits), and small or shrinking foreign currency reserves. This explanation may sound like a bunch of economic mumbo-jumbo, but at a basic level, all this means is these deadbeat countries are having difficulty paying their lenders and trading partners back with weaker currencies and depleted foreign currency reserves.
Many pundits, TV commentators, and bloggers like to paint a simplistic picture of the current situation by solely blaming the Federal Reserve’s tapering (reduction) of monetary stimulus as the main reason for the recent emerging markets sell-off. It’s true that yield chasing investors hunted for higher returns in in emerging market bonds, since U.S. interest rates have bounced around near record lows. But the fact of the matter is that many of these debt-laden countries were already financially irresponsible basket cases. What’s more, these emerging market currencies were dropping in value even before the Federal Reserve implemented their stimulative zero interest rate and quantitative easing policies. Slowing growth in China and other developed countries has made the situation more abysmal because weaker commodity prices negatively impact the core economic engines of these countries.
In reviewing the struggles of some emerging markets, let’s take a closer look at Argentina, which has seen its currency (peso) decline for years due to imprudent and inflationary actions taken by their government and central bank. More specifically, Argentina tried to maintain a synchronized peg of their peso with the U.S. dollar by manipulating its foreign currency rate (i.e., Argentina propped up their currency by selling U.S. dollars and buying Argentinean pesos). That worked for a little while, but now that their foreign currency reserves are down -45% from their 2011 peak (Source: Scott Grannis), Argentina can no longer realistically and sustainably purchase pesos. Investors and hedge funds have figured this out and as a result put a bulls-eye on the South American country’s currency by selling aggressively.
Furthermore, Argentina’s central bank has made a bad situation worse by launching the money printing presses. Artificially printing additional money may help in paying off excessive debts, but the consequence of this policy is a rampant case of inflation, which now appears to be running at a crippling 25-30% annual pace. Since the beginning of last year, pesos in the black market are worth about -50% less relative to the U.S. dollar. This is a scary developing trend, but Argentina is no stranger to currency problems. In fact, during 2002 the value of the Argentina peso declined by -75% almost overnight compared to the dollar.
Each country has unique nuances regarding their specific financial currency pickles, but at the core, each of these countries share a mixture of these debt, deficit, and currency reserve problems. As I have stated numerous times in the past, money ultimately moves to the place(s) it is treated best, and right now that includes the United States. In the short-run, this state of affairs has strengthened the value of the U.S. dollar and increased the appetite for U.S. Treasury bonds, thereby pushing up our bond prices and lowering our longer-term interest rates.
Their Cold is Our Warm
Overall, besides the benefits of lower U.S. interest rates, weaker foreign currencies lead to a stronger dollar, and a stronger U.S. currency means greater purchasing power for Americans. A stronger dollar may not support our exports of goods and services (i.e., exports become more expensive) to our trading partners, however a healthy dollar also means individuals can buy imported goods at cheaper prices. In other words, a strong dollar should help control inflation on imported goods like oil, gasoline, food, cars, technology, etc.
While emerging markets have cooled off fairly quickly, the temperature of our economic porridge in the U.S. has been quite nice. Most recently, the broadest barometer of economic growth (Real GDP) showed a healthy +3.2% acceleration in the 4th quarter to a record of approximately $16 trillion (see chart below).
|Source: Crossing Wall Street|
Moreover, corporate profits continue to come in at decent, record-setting levels and employment trends remain healthy as well. Although job numbers have been volatile in recent weeks and discouraged workers have shrunk the overall labor pool, nevertheless the unemployment rate hit a respectable 6.7% level last month and the positive initial jobless claims trend remains at a healthy level (see chart below).
Skeptics of the economy and stock market assert the Fed’s continued retrenchment from quantitative easing will only exacerbate the recent volatility experienced in emerging market currencies and ultimately lead to a crash. If history is any guide, the growl from this emerging market bear may be worse than the bite. The last broad-based, major currency crisis occurred in Asia during 1997-1998, yet the S&P 500 was up +31% in 1997 and +27% in 1998. If history serves as a guide, the past may prove to be a profitable prologue. So rather than running and screaming in panic from the three bears, investors still have some time to enjoy the nice warm porridge and take a nap. The Goldilocks economy and stock market won’t last forever though, so once the masses are dying to jump in the comfy investment bed, then that will be the time to run for the hills and leave the latecomers to deal with the bears.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in AGG, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
With the first phase of the post-financial crisis global economic bounce largely behind us, growth is becoming scarcer and countries are becoming more desperate – especially in developed countries with challenged exports and high unemployment. The United States, like other expansion challenged countries, fits this bill and is doing everything in its power to stem the tide by blasting foreigners’ currency policies in hopes of stimulating exports.
Political Hot Potato
The global race to devalue currencies in many ways is like a drug addict doing whatever it can to gain a short-term high. Sadly, the euphoric short-term benefit form lower exchange rates will be fleeting. Regardless, Ben Bernanke, the Chairman of the Federal Reserve, has openly indicated his willingness to become the economy’s drug dealer and “provide additional accommodation” in the form of quantitative easing part two (QE2).
Unfortunately, there is no long-term free lunch in global economics. The consequences of manipulating (depressing) exchange rates can lead to short-term artificial export growth, but eventually results convert to unwanted inflation. China too is like a crack dealer selling cheap imports as a drug to addicted buyers all over the world – ourselves included. We all love the $2.99 t-shirts and $5.99 toys made in China that we purchase at Wal-Mart (WMT), but don’t consciously realize the indirect cost of these cheap goods – primarily the export of manufacturing jobs overseas.
Global Political Pressure Cooker
Congressional mid-term elections are a mere few weeks away, but a sluggish global economic recovery is creating a global political pressure cooker. While domestic politicians worry about whining voters screaming about unemployment and lack of job availability, politicians in China still worry about social unrest developing from a billion job-starved rural farmers and citizens. The Tiananmen Square protests of 1989 are still fresh in the minds of Chinese officials and the government is doing everything in its power to keep the restless natives content. In fact, Premier Wen Jiabao believes a free-floating U.S.-China currency exchange rate would “bring disaster to China and the world.”
While China continues to enjoy near double-digit percentage economic growth, other global players are not sitting idly. Like every country, others would also like to crank out exports and fill their factories with workers as well.
The latest high profile devaluation effort has come from Japan. The Japanese Prime Minister post has become a non-stop revolving door and their central bank has become desperate, like ours, by nudging its target interest rate to zero. In addition, the Japanese have been aggressively selling currency in the open market in hopes of lowering the value of the Yen. Japan hasn’t stopped there. The Bank of Japan recently announced a plan to pump the equivalent of approximately $60 billion into the economy by buying not only government bonds but also short-term debt and securitized loans from banks and corporations.
Europe is not sitting around sucking its thumb either. The ECB (European Central Bank) is scooping up some of the toxic bonds from its most debt-laden member countries. Stay tuned for future initiatives if European growth doesn’t progress as optimistically planned.
Dealing with Angry Parents
When it comes to the United States, the Obama administration campaigned on “change,” and the near 10% unemployment rate wasn’t the type of change many voters were hoping for. The Federal Reserve is supposed to be “independent,” but the institution does not live in a vacuum. The Fed in many ways is like a grown adult living away from home, but regrettably Bernanke and the Fed periodically get called by into Congress (the parents) to receive a verbal scolding for not following a policy loose enough to create jobs. Technically the Fed is supposed to be living on its own, able to maintain its independence, but sadly a constant barrage of political criticism has leaked into the Fed’s decision making process and Bernanke appears to be willing to entertain any extreme monetary measure regardless of the potential negative impact on long-term price stability.
Just over the last four months, as the dollar index has weakened over 10%, we have witnessed the CRB Index (commodities proxy) increase over 10% and crude oil increase about 10% too.
In the end, artificially manipulating currencies in hopes of raising economic activity may result in a short-term adrenaline boost in export orders, but lasting benefits will not be felt because printing money will not ultimately create jobs. Any successful devaluation in currency rates will eventually be offset by price changes (inflation). Finance ministers and central bankers from 187 countries all over the world are now meeting in Washington at the annual International Monetary Fund (IMF) meeting. We all want to witness a sustained, coordinated global economic recovery, but a never-ending, unanimous quest for devaluation nirvana will only lead to export addicts ruining the party for everyone.
See also Arbitrage Vigilantes
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and WMT, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
What do you think of the Euro? How about the Japanese yen? Are you expecting the Thai baht to depreciate in value versus the Brazilian real? Speculators, central banks, corporations, governments, financial institutions, and other constituencies ask similar types of questions every day. The largely over-the-counter global foreign exchange markets (no central exchange) are ubiquitous, measuring in the trillions – the BIS (Bank for International Settlements) computed the value of traditional foreign exchange markets at $3.2 trillion in April 2007. Thanks to globalization, these numbers are poised to expand even further. Like other futures markets (think oil, gold, or pork bellies), traders can speculate on the direction of one currency versus another. Alternatively, investors and businesses around the world can use currency futures to hedge (protect) or facilitate international trade.
Without getting lost in the minutiae of foreign exchange currency trading, I think it’s helpful to step back and realize regardless of strategy, currency, interest rate, inflation, peg-ratio, deficits, sovereign debt, or other factor, money will eventually migrate to where it is treated best in the long-run. When it comes to currencies, it’s my fundamental belief that economies control their currency destinies based on the collective monetary, fiscal, and political decisions made by each country. If those decisions are determined imprudent by financial market participants, countries open themselves up to speculators and investors exploiting those decisions for profits.
Currency Trading Ice Cream Style
As mentioned previously, currency trading is predominantly conducted over-the-counter, outside an exchange, but there are almost more trading flavors than ice cream choices at Baskin-Robbins. For instance, one can trade currencies by using futures, options, swaps, exchange traded funds (ETFs), or trading on the spot or forward contract markets. Each flavor has its own unique trading aspects, including the all-important amount of leverage employed.
The Carry Trade
Similar to other investment strategies (for example real estate), if profit can be made by betting on the direction of currencies, then why not enhance those returns by adding leverage (debt). A simple example of a carry trade can illustrate how debt is capable of boosting returns. Suppose hedge fund XYZ wants to borrow (sell U.S. dollars) at 0.25% and buy the Swedish krona currency so they can invest that currency in 5.00% Swedish government bonds. Presumably, the hedge fund will eventually realize the spread of +4.75% (5.00% – 0.25%) and with 10x leverage (borrowings) the amplified return could reach +47.5%, assuming the relationship between the U.S. dollar and krona does not change (a significant assumption).
Positive absolute returns can draw large pools of capital and can amplify volatility when a specific trade is unwound. For example, in recent years, the carry trade from borrowing Japanese yen and investing in the Icelandic krona eventually led to a sharp unwinding in the krona currency positions when the Icelandic economy collapsed in 2008. High currency values make exports less competitive and more expensive, thereby dampening GDP (Gross Domestic Product) growth. On the flip side, higher currency values make imported goods and services that much more affordable – a positive factor for consumers. Adding complexity to foreign exchange markets are the countries, like China, that artificially inflate or depress currencies by “pegging” their currency value to a foreign currency (like the U.S. dollar).
Soros & Arbitrage Vigilantes
Hedge funds, proprietary trading desks, speculators and other foreign exchange participants continually comb the globe for dislocations and discrepancies to take advantage of. Traders are constantly on the look out for arbitraging opportunities (simultaneously selling the weakest and buying the strongest). Famous Quantum hedge fund manager, George Soros, took advantage of weak U.K. economy in 1992 when he spent $10 billion in bet against the British pound (see other Soros article). The Bank of England fought hard to defend the value of the pound in an attempt to maintain a pegged value against a basket of European currencies, but in the end, because of the weak financial condition of the British economy, Soros came out victorious with an estimated $1 billion in profits from his bold bet.
I’m not sure whether the debate over speculator involvement in currency collapses can be resolved? What I do know is the healthier economies making prudent monetary, fiscal, and political decisions will be more resilient in protecting themselves from arbitrage vigilantes.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at time of publishing had no direct position on any security referenced. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Treasury Secretary Timothy Geithner recently stated after a meeting of G-7 financial officials that “it is very important to the United States that we continue to have a strong dollar.”
With comments like this, why does Timothy Geithner remind me so much of Eddie Haskell (played by Ken Osmond) from the 1950s suburban sitcom Leave It to Beaver? Eddie Haskell plays the scheming trouble maker who is extremely polite on the exterior around adults, but reverts to a crafty conniver once the grown-ups leave the room.
I can just picture the conversations between Treasury Secretary Geithner and President Obama before a high powered meeting with Chinese administration officials:
Geithner: “Barack, the skyrocketing debt will be no problem, we can we shovel plenty of this paper on these Chinese.”
Barack: “Uh, oh…Hu is here for our meeting.”
Geithner: “Oh hello Mr. President Jintao – what a lovely trade surplus you have. We look forward to keeping a very fiscally responsible agenda here in the United States, so you can keep buying our valuable debt.”
Where did Timothy Haskell get his crafty dollar oration skills?
According to David Malpass, president of the research firm Encima Global and deputy assistant Treasury Secretary, Geithner training came from “using a code phrase, a carryover from the Bush administration. It means that the U.S. approves of a constantly weakening dollar but doesn’t want a disruptive collapse.”
These tactics and rhetoric can only work for so long. Exploding deficits and skyrocketing debt levels will eventually lead to a dumping of our debt, rising interest rates, crowding-out of private investments, and a damaging decline in the dollar. Sure, the weakening dollar helps us in the short-run with exports but eventually major U.S. debtholders will no longer buy our sweet talking.
With all the “U.S. dollar is going to collapse” talk, one would think a shift to an SDR (Special Drawing Rights) global currency structure is an inevitable outcome. Just six months ago the governor of China’s central bank argued the U.S. dollar’s role as the world’s reserve currency should be restructured. The SDR model has already been implemented by the IMF (International Monetary Fund), so if the Chinese wanted to create an SDR proxy, they could easily purchase euros, sterling, and yen in proper proportions. Would the Chinese want to make any sudden changes? Certainly not, because any quick adjustments would destroy the value of the Chinese’s existing dollar denominated portfolio. The logistics surrounding a legitimate SDR program would require the IMF or some other international agency to act as a global central bank, which would not only need to determine the appropriate mix of currencies in the SDR, but also decide future global liquidity actions. In order to legitimately run a new SDR program, countries like China would need to give up sovereignty – not a likely scenario.
Until a new SDR regime is agreed upon, dollar-reliant countries will continue to have barks bigger than their bites and Timothy Geithner Haskell will continue to sweet talk U.S. dollar owners.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
Hear Eddie (or Treasury Secretary) Speak Here:
I love it! Jimmy Rogers, chairman of Rogers Holdings is really going out on limb this time. Well, not really. It’s more like he is on a fence, and ready to fall over to whichever side the wind blows. Let me explain this claim in more detail. With the Dow Jones Industrials Average currently trading at about 8,800, Rogers sees the market climbing higher by +240% to 30,000 or perhaps collapsing another -43% (after the worse bear market in decades) to 5,000.
“I’m afraid they’re printing so much money that stocks could go to 20,000 or 30,000,” Rogers said. “Of course it would be in worthless money, but it could happen and you could lose a lot of money being short,” he adds.
Why stop there – why not a more outrageous range of guesses between 100,000 and 1,000? If inflation is his worry, then maybe Mr. Rogers should be concerned about declining PE (Price/Earnings) multiples, which reached single digits in the late-1970s and early-1980s when we were experiencing double-digit inflation.
Thanks Jimmy, those meticulously defined predictions will make many fellow astrologists proud. These prophetic claims remind me of my prescient call this year that I would either gain 100 pounds or lose 100 pounds. So far my forecast has turned out to be spot on, however I won’t confess which direction my weight has swung.
Although Jimmy’s tone is notably pessimistic, he reminds us that this is the last time he has had NO short positions since after the “Crash of 1987.” If lightning strikes twice, maybe his actions demonstrate that now is not such a bad time to buy.
However, be wary because Rogers is not only frightened by inflation. He goes onto say that some country is going to suffer a currency crisis, but he does not know which one yet. “I expect there to be a currency crisis later this year or maybe next year,” he states. Let us hope that “Zimbabwean-esque” inflation does not take hold, otherwise we will be in line with Rogers at the grocery store buying millions of dollars in the vegetable aisle.
Jimmy Rogers is obviously a bright investor (not to mention the Wall Street bow-tie king) who has achieved great success over his career. Nonetheless, I believe he could go into a little more detail in explaining his outrageous, sensationalized claims. For some reason I don’t think this trend will change, but at a minimum, he will continue to provide food for thought and fantastic entertainment.