The key risk-on and off drivers today are the same – U.S. politics, global growth, other centr...
10 Easy Currency Lessons
09/04/2013 12:00 pm EST
To a greater extent than usual, the movement of currencies are driving the prices of global stocks and bonds, and shaping monetary policies in key emerging markets, writes MoneyShow's Jim Jubak, also of Jubak's Picks.
Do you know the facts of life of the global currency market right now?
Is the US dollar headed up or down over the next few weeks? How about the Japanese yen? Is the Indian rupee and the Turkish lira and the South African rand headed into a crisis? How about the Brazilian real?
I'm asking because, right now, global cash flows-into some developed markets and out or most emerging markets-are driving the prices of global stocks and bonds. The effects of those cash flows are being expressed in the prices of currencies, such as the dollar and the real.
The movements of those currencies are both, the vehicle for those cash flows-the way that they're being turned into rallies and corrections in the financial markets-and, increasingly, the fundamental driver for price movements in those markets as the ups and downs of currencies cause changes in monetary policies in countries such as Brazil and India.
And finally, if you're trying to figure out where the bottom is for Asia's emerging markets, which entered official bear-market territory last week when the iShares MSCI Southeast Asia Index fell to a 21% drop from the peak on May 8, I think understanding the likely currency moves over the next quarter or two is a key.
So here's my take on what you need to know about global currencies in ten easy trends.
1. In the short run, the US dollar is likely to get stronger against most global currencies. That's because the gradual end of the Federal Reserve's program to purchase $85 billion a month in Treasury and mortgage-backed assets, possibly as early as the Federal Open Market Committee's September 18 meeting, will push US interest rates at least slightly higher. With the rest of the developed world's central banks still in stimulus mode (Japan), or near-stimulus mode (Europe), that means traders and investors, looking for higher yields, will turn to buying dollar-denominated assets.
2. We really don't know how long the short run might be. It's clear that Japan isn't about to reverse its weak-yen policy anytime soon, and the European Central Bank has revised its historic tendency to privilege low inflation above economic growth, to the extent of keeping interest rates at historic lows for a long period of time, as the eurozone struggles to escape recession or near-recession. But a sufficiently chaotic US political season-one that saw a budget impasse, and a credible threat of default, resulting from a failure to raise the debt ceiling-could make the dollar seem decidedly less attractive as early as October.
3. A strong dollar is a negative for commodities priced in dollars, such as oil, and for precious metals. Extreme fear and turmoil, such as that set off by the threat of US-led military intervention in Syria, can overwhelm the effects of a strong dollar in the short run. Gold was up 19% from its June low, as of August 29, to $1,409.80, but I think gold, along with other physical commodities, will have a hard time building a sustained rally, as long as the US dollar keeps moving up, and as long as global growth remains slow enough to remove all fears of inflation. The pressure that a strong dollar puts on commodity prices, plus weak commodity prices, due to slow demand from China and other developing economies, has hit commodity currencies hard. For example, the Australia dollar traded near 89 cents on August 28. That's down from $1.05 in April.
4. A strong dollar isn't good for emerging market financial assets. In 2012 as the Federal Reserve expanded its balance sheet, $1.2 billion flowed into emerging financial markets. In 2013 that cash flow has reversed.|pagebreak|
5. The countries, currencies, and financial markets hardest hit by the strong dollar are those running the biggest current accounts deficits. Economies such as India, Indonesia, and Turkey need to attract overseas cash in order to balance those deficits. Turkey, for example, needs to attract $5 billion a month.
6. A falling currency can set off a vicious cycle in a current account deficit country. A falling currency makes it harder to attract the cash needed to balance a current account deficit. And worries over a country's inability to cover its deficit, can lead to a further retreat in the currency, as investors and traders pull money out of assets that are worth less in dollar terms day by day.
7. A stronger dollar and weaker local currencies works to make trade deficits higher in developing economies. For example, India imports about 80% of its fuel. A climb in the dollar price of benchmark Brent crude makes it more expensive to pay India's fuel bill in rupees. India's oil imports averaged $14.2 billion a month in the first seven months of 2013, up from $13.9 billion a month in the same period a year earlier. The same dynamic savages companies in emerging economies that collect revenues in local currencies but that have to pay costs in dollars. About 56% of the costs at Brazil's airlines, for example, are denominated in dollars, mostly for jet fuel.
8. The potential responses, by central banks to falling currencies, all have nasty side effects. Central banks can intervene by spending down foreign exchange reserves to buy local currencies. That can actually weaken a local currency if the markets believe that the central bank doesn't have the foreign exchange reserves or the policy will to spend enough to reverse the market trend. That's the market's take to date on interventions by India, Indonesia, and Turkey. Another potential response is to defend a currency by raising domestic benchmark interest rates. That has a potential toxic side effect: Higher interest rates slow rates of economic growth. That seems to be happening now in Brazil.
9. All this has made emerging-market stocks and bonds cheaper, but also has led investors and traders to question if these markets are cheap enough yet. For example, the Indian rupee is down 20.1% in 2013, on its way to its worst loss since the 1991 balance-of-payments crisis forced the government to sell gold to pay for imports. But even at 68.845 rupees to the US dollar on August 28, that may not be a bottom. Speculation now is that the currency will have to sink to, at least, 70 rupees to the dollar, before this crisis is over. No one, right now though, is willing to bet very heavily that 70 rupees to the dollar will make a bottom.
10. Putting in a bottom will probably start with putting in a bottom in individual economies with larger foreign-exchange reserves, and that look closer to seeing economic growth move from slowing to expanding. Brazil is a strong candidate for an early turn on sufficient foreign-exchange reserves, and a central bank that has been early to raise interest rates. But growth in Brazil is still anemic. Mexico is another early recovery candidate, especially if the government's efforts to increase foreign investment in the country's oil industry look like they will result in a significant increase in production at Pemex, the national oil company. An overall recovery in emerging markets, however, is probably a 2014 event, and will depend on data showing a believable recovery in China's rate of economic growth. Or at least confidence that growth in China isn't about to fall much further.
Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of any stock mentioned in this post as of the end of June. You can find a complete list of the fund's holdings as of the end of June here.
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