I highly recommend this audio presentation from Avinash D. Persaud at the CFA Mid East Conference. It can be found here with all of the other freely available CFA podcasts:
http://itunes.apple.com/us/podcast/cfa-institute-audio-podcasts/id200636111
The first 9 minutes or so of the presentation are a thoughtful diatribe on risk management and forecasting before he gets into currencies.
Persaud discusses what drives currency value and changes in exchange rates over various time periods. The key take aways:
- In the short term, risk appetite drives currency. In times of risk seeking, capital flows to higher inflation, higher yield currencies. In times of risk aversion, CAPITAL COMES HOME. It does not, according to Persaud go to the “safest” currencies, but it comes home.
I find this interesting because US Dollar strength during times of risk aversion has been a pretty consistent trade over the last few years. I venture to guess it is because there are so many damn dollars in existence and our financial system remains highly leveraged. All of those dollars that we’ve printed in the last 40 years and the leverage that has been applied to that monetary base is part of the sloshing pool of global capital.
Add to this the Dollar’s role as global trading currency and the fact that most of the world’s business needs are USD-based. In the short-term, periods of risk aversion will continue to be USD-positive and for this reason, the US Dollar remains an effective, though low volatility, hedge against risky assets.
- Over long-time periods, the value of a currency has little to do with a country’s growth prospects as is commonly thought. Many investors, according to Persaud, mistakenly think about currencies as a country’s equity– its stock price if you will. When in fact, currencies are much more like bonds. Their value is driven by the underlying inflation rate of the country. A currency’s value is tied to its ability to maintain purchasing power.
This is why, Persaud argues, that the strongest currencies over multi-decade time frames, like the Swiss Franc or even the Japanese Yen, are in slow growth, low inflation countries.
And inflation– is deeply political. Chris Whalen’s book, Inflated, does a good job of detailing this fact. Inflation transfers wealth from creditors to debtors. Countries end up with inflation rates that they implicit want– that the voters want. And this has a lot to do with demographics.
An aging nation living off of fixed income from coupon payments, such as Japan, does not want inflation. A relatively young, highly indebted nation, such as the U.S. WANTS inflation. Now if YOU are a relatively old, relatively debt-free saver or retiree– YOU may not want inflation, but the country as a whole– and the politicians who they elect–do. Certainly they have a willing participant in Helicopter Ben Bernake. We need to be aware of this fact.
This line of thinking leads Persaud to argue that the strength of the Yen and the Euro at the expense of the USD will persist, defying those investors that think of currencies as equities– that is driven by growth.
His presentation stops here, but I won’t. He logic is very, very solid. I agree that currencies should be thought of as the credit of a country and tied to its credit quality and ability to hold value or purchasing power. It is precisely for these reasons, that going forward, the Yen will ultimately weaken– its credit position is beyond weak (see Kyle Bass’ analysis here) and ultimately the Yen will be thrown under the bus over the next several years to avoid outright default. You can’t always get what you want.
The Euro is a much more complicated political situation. The PIIGS and other periphery countries want and need inflation. Their citizens will ultimately demand it. The core of Europe and the Nordic countries want low inflation and fiscal austerity. The Monetary Union does not provide for the necessary flexibility. Something has to give. If countries like Greece leave the European Monetary Union (seems unlikely), the Euro would likely strengthen. I’ve seen estimates that a Euro ex PIIGS is worth $2 and that the PIIGS collectively, need a Euro around $0.60 to become competitive. This is the political tug of war that will play out over the next several years. I have no idea how it will be resolved, but it seems it will be ugly
I also want to address countries that having varying levels of currency pegs (whether officially or through “dirty pegs” of market intervention) to the USD. These countries have been importing US monetary and inflation policy for years, leaving their currencies’ chronically undervalued. Work by JP Morgan suggests a market cap weighted aggregate of 22 Emerging Market currencies is 32.3% undervalued on a purchasing power parity basis. Witness the Chinese Yuan (40% undervalued) and the Indian Rupee (60% under on PPP) as well as host of other Asian currencies. These countries also tend to have a very strong credit position. See this excellent piece from Research Affiliates on the fundamentals of various Sovereign debt issuers. The natural secular tendency will be for these currencies to rise, not because of their growth, but because of their fiscal position and an eventual move away from USD pegs.
Understanding currencies today, including the ultimate store of value, Gold, must be an essential component to any investment strategy.
