Stocks, bonds, and commodities all have fundamentals underneath the speculation discount rate fluctuations. Academics have written papers and textbooks on how to value these assets, how to measure the risk premiums embedded in their prices, and why certain trading strategies appear to make money over time.
Currencies are different. With the exception of the big commodity exporters, there are no consistently dependable explanations — or even pseudo-explanations — for why exchange rates move the way they do. Anything and everything can affect their prices. Some might therefore conclude you have to be a renaissance man to trade currencies. Cynics might argue the complexity of the currency markets makes room for some…interesting analysis.
One reasonable-sounding theory is that prices of internationally-traded goods ought to be the same everywhere, after adjusting for taxes and tariffs. If a smartphone or a sports car trades at significantly different prices in different places then that could imply a currency mismatch. Yet “purchasing power parity” often fails to hold in the real world. The International Monetary Fund’s measure implies it “should” only take about 3.5 Chinese yuan to be worth one dollar, even though the market exchange rate is 6.33 yuan per dollar.
Another plausible approach is to focus on the purchasing power of money, rather than goods. By this argument, people will move their savings where they can earn the highest real return, adjusted for risk. While currency pairs sometimes move in tandem with changes in the spread between the two countries’ inflation-adjusted interest rates, they often do not. (See, for example, EURUSD in the past 15 months.)
The more sophisticated variant is the idea that relative growth prospects are what matter. While this makes intuitive sense — money should flow to the places with the best investment opportunities — it also fails to work in practice much of the time.
Abe Shinzo’s proposals for stimulus and reform during the 2012 elections was supposed to get Japan out of its post-2008 slump while also boosting the country’s longer-term growth rate. Traders seemed to believe it would work and aggressively bid up Japanese share prices as his victory appeared increasingly likely. Yet traders also sold yen, causing the currency to depreciate sharply.
While this could potentially be justified by changes in the inflation outlook, it’s far from the obvious consequence. After all, traders initially seemed to treat America’s plans for a military buildup, tax cuts, and deregulation as an excuse to bid the dollar up, before later revising that view.
Perhaps the most sophisticated approach is to look at who owns assets and owes liabilities in each currency and then track what motivates their behaviour. In the mid-1990s, it seemed “obvious” to many traders that Japan would benefit from a cheaper yen and that the government’s policies — low interest rates plus fiscal stimulus — would help push the currency lower. Yet these traders were blindsided by the impact of the Great Hanshin Earthquake of 1995. Japanese insurers and other savers that had spent the 1980s accumulating large hoards of foreign assets needed to sell them to pay for damages denominated in yen. The result was that the yen appreciated by about 25 per cent in the course of about two months.
That experience led to another popular narrative: some currencies are “havens” that do well when things go badly. The yen is the classic example, but so is the Swiss franc and, to a lesser extent, the US dollar. (The yen’s apparent soft peg to gold corroborates the idea that both are “havens” in the popular imagination.)
Thus we have a new note from Bilal Hafeez, who runs G10 FX strategy at Nomura. He implies that the recent news out of Facebook is a reason to buy yen. Yes, really.
Most of the note is sensible. Several of the world’s biggest companies are social media businesses that trade at absurd multiples of their physical assets because they own valuable intellectual property and networks that allow them to cheaply harvest consumer data. If they are too effective at using the data they collect to encourage engagement among their users they will be threatened by politicians and regulators. If they are incapable of directing advertising to the right audiences — despite their allegedly powerful algorithms — they will see their customer base disappear.
So what does this have to do with currencies?
Trade wars, populism, income inequality can be looked at in isolation, but together they all point to a reaction against the growth of fluid intangible-intensive industries such as the data/platform companies. This means that these markets will come under increasing pressure on how they value data/platforms as the year unfolds. While the direct fall-out of this could be seen in equity markets, the currency markets could also be affected. The most obvious currency to benefit from these dynamics would likely be the yen, which is not at the centre of the tri-polar data/platform world and typically performs well in a volatile world.
That’s the whole argument!
For what it’s worth, the yen has tended to stay flat in nominal terms and depreciate in real terms since the mid-1990s:
Hafeez may prove correct in his analysis and his predictions. But the link between the claims in his note and his trade recommendation is tenuous.
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