I am reading this post Currency Strategy The Practitioner’s Guide to Currency Investing, Hedging and Forecasting by Callum Henderson. Callum Henderson is the head of fx strategy at a leading international bank in Singapore. The second edition of this book was published in 2006 and has got rating of 4.6/5 on Amazon. The main purpose of writing this book according to Callum was to help the read practitioners who work in the big banks, hedge funds and other financial institutions dealing with foreign exchange rates. In the Introduction Callum writes that he has written this book for not ordinary men and women but for those currency market practitioners like the corporate Treasurers, CEOs, hedge fund managers, mutual fund managers and other institutional investors whose flows move the currency market daily. This book is meant to help them make better decisions when it comes to currency markets. Callum claims that there is a gaping hole in the existing literature on exchange rates and this book is meant to cover it.According to him few books are aimed at those people who actually execute the currency market transactions.
You can see in the above image, Dow Jones Index falling like a stone. Callum claims that currency market is his passion and interest and he started covering it as a journalist in 1991 and can still vividly remember the Black Wednesday in 1992 when the Bank of England got defeated by the currency market and Britain had to abandon the ERM. His memory is vivid with currency dealers screaming on their phones and waves after waves of sterling buy orders by the Bank of England in an effort to maintain its value within the band stipulated by the ERM. Today currency markets have become so huge that it is impossible for any central bank to control it for a long time. In the short run, they might succeed for a few days but in the long run it will fail. Did you read the post, How to do Trend Trading with MACD.
Callum job was head of fx strategy at a leading international bank was to forecast the exchange rates. He calls it a humbling job and his reputation was always on the line whenever he made the forecasts. A factor that might be considered crucial market driver in forecasting exchange rates may become irrelevant in the new few minutes. Equilibrium based models like the Purchasing Power Parity, Real Interest Rate Differentials and the Real Effective Exchange Rate might work in the long run, in the short run these models are a total failure. For example economists can say that real effective exchange rate appreciation is most likely going to effect the external balance and cause the exports to become more expensive and hence less competitive in the international market. To restore export competitiveness we need REEF (Real Effective Exchange Rate) depreciation which is achieved by the depreciation of the nominal exchange rate. But there is no timeframe when this is supposed to happen. Most of the currency market practitioners like us traders are only concerned about what can happen in the next 1 day to 3 months. As traders we are only concerned about the next few days if we are swing traders and if we are position traders we might be looking at the next 3 months. Economists dismiss the short run of a few days as speculative and difficult to predict. Callum says this response is not adequate when we can use technical analysis and capital flow analysis to make the predictions for the next few days even if these are not perfect but work most of the time on average.
Currency Exchange Equilibrium Models
Economists love their equilibrium models. These models assume that market will reach a steady state equilibrium in the long run. When? These models cannot predict that. When the markets reach the equilibrium, they stay there and if the equilibrium is disturbed arbitrage forces the market to regain equilibrium shortly. The truth is markets are never in equilibrium and are always volatile and in flux meaning moving. So reaching a steady state equilibrium is out of question. Practically the equilibrium exchange rate is always moving when the economic reality underlying the exchange rate changes. Another myth perpetrated by economists is that market participants are rational and objective. This is far from the truth. Market participants are whimsical and emotional beings who are being effected by the changing market and the market is being effected by their decisions. So they are both the cause and the effect. Market participants base their decisions on their past experiences and past successes and failures. Supply and demand are both effecting each other in reality. If supply and demand were independent we would not see any trends in the market. Why? If supply and demand match each other then the market should be in equilibrium and we shouldn’t see prices moving up or down. Did you read the post, Bayesian Sequential Monte Carlo Methods for Traders.
Another myth perpetrated by economists is that markets are efficient. Efficiency means all market moving information is available to all the market participants at almost the same time. As said above economists assume that market participants are rational and always try to maximize their profits in the market. It is true information becomes public but its timing varies. Some market participants are more efficient and get the information earlier as compared to other market participants. It might be these market participants are big hedge funds who have big research departments who market unearth market inefficiencies. Information is what gives the market participant the advantage in the competition. Always keep this in mind that markets are a zero sum game. If you buy, then someone else is selling. If you win a trade, someone is losing. If you lose someone else is winning. When the Long Term Capital Market (LTCM) was imploding and losing billions of dollars in its bets, there were other market participants who were pocketing these billions of dollars. Economics is all about information and how market participants aggregate tiny bits of information. Not all market participants are maximizing profits. Speculators are seeking profits. But the corporate treasure is more interested in hedging and reducing the risk of currency exposure. Central banks are big players in the currency market now a days. Central banks have no profit motive when they intervene in the currency market which they do now a days on a frequent basis. Currency markets are very different and we cannot use one size fit all approach. Did you read the post, Bayesian Sequential Monte Carlo Methods for Traders.
We will often hear the talk about market psychology. Market psychology is a vague term that is precisely what Behavior Finance tries to explain precisely. How is that political events that have no relation with the economic fundamentals effect the currency market on regular and long term basis. Take the case of US Treasury Secretary in 1993 making the statement that Japanese Yen is undervalued. Whatever the reality, market participants interpret this as US is trying to devalue US Dollar against the Japanese Yen in an attempt to reduce the US Japan current account deficit. This led Japanese Yen to start appreciating against the US Dollar for something like two years. There were economic fundamentals behind it like the Japan having a huge trade and capital account surpluses with the US. In order to keep USDJPY stable, Japan needed to export capital to US in the form of buying real estate and other assets in the US market. When it did not happen, USDJPY would go up.
Let’s come to the subject of technical analysis. Many consider technical analysis to be vague just like market psychology. I use technical analysis in my daily trading. So does many other traders spread all over the world. Economists consider technical analysis as a sort of voodoo. Initially economists simply dismissed technical analysis with their random walk theory. Market was a random walk so we cannot predict the next move. But in early 2000, some books got written that showed that technical analysis chart patterns do have predictive power. Today we use technical analysis to time the market and predict the start of trends in the market. Under the Bretton Woods System, there was no currency risk. With the collapse of the Bretton Woods System, we enter the age of flexible exchange rates. In the beginning there was a lot of volatility in the currency market as free exchange rate regime was a new experiment. But in the coming decades, free exchange rate regime became well established and a main pillar of the modern financial system.
In the last few decades, the global economy has seen unprecedented globalization and expansion of trade and capital flows. Flexible exchange rates change according to the underlying economic fundamentals. Fixed exchange rates cannot change when the underlying economic realities change. Central banks are forced to intervene to keep the exchange rate fixed which is not required under free exchange rate regime. Exporters are keenly aware of the exchange rate importance. Even if your company does not export any product or service you can face a nasty surprise when an exchange rate depreciation can make things expensive by changing the domestic price level.Exchange rates are very important when it comes to investing in foreign markets. Did you read the post, How to download Tick data from MT5.
Fundamental Analysis Strengths and Weaknesses
Fundamental analysis depends on exchange rate equilibrium models. Collapse of Bretton Woods System ushered in a new era for the exchange rates volatility. Economists have worked hard over the last three decades to develop models that can forecast exchange rates. Most exchange rate models use some form of an equilibrium which is based on the relative pricing of some commodity. Exchange rate is just the price of one currency relative to another. The following exchange rate models have been developed: 1) Exchange rate as the relative price of two prices which is better known as Purchasing Power Parity. 2) Exchange rates as the relative price money which is known as the Monetary Policy Approach.3) Exchange rates as the relative price of interest also known as the Interest Rate Approach. 4) Exchange rates as relative price of current and capital account flows also known as the Balance of Payment Approach. 5) Exchange rate as the relative price of assets also known as the Portfolio Balance Approach.
Purchasing Power Parity
Purchasing Power Parity is also known as the Law of One Price. In an ideal world where there are no barriers to trade the price of a commodity should be the same everywhere overtime. The exchange rate must move in the direction which ensures that the price of a good is the same in both the countries. This is the basis of the Law of One Price or the Purchasing Power Parity (PPP). The price of the Mercedes sports car should be the same in Germany and Russia. Say we have the price of Mercedes sports car as 50K EUR and 100K RUB. The exchange rate should be 1EUR=2RUB. Suppose right now the exchange rate is 1EUR=4RUB meaning the Mercedes sports car is costing 50K EUR and 200K RUB. So we can say that right now RUB is undervalued and in the long run it should appreciate to 1EUR=2RUB. A Russian should go to Germany and buy the car and drive back to Moscow. He will find it cheaper. It may not be realistic scenario. He will most probably get stopped by the custom authorities on the border. This is what happens. Cheap currency attracts buyers who push up the demand and drive the price of that currency higher. This is how PPP works.
Now we don’t talk of price of one good when we talk about PPP. We talk about the general price level in one country relative to the general price level in the second country when we calculate the long term equilibrium exchange rate using PPP. Exchange rates that do not conform to the PPP are known as misaligned. A rational profit seeking market should be able to eliminate the misalignment. But in reality misalignment can persist for years. So in the short run PPP is a very poor predictor of exchange rates. Moreover how come a misalignment can last for years when arbitrage should make sure that the prices in the cheaper country should rise and equate with the expensive country.
Now this does not happen in reality because we don’t have zero import tariffs, zero export subsidies and there are still significant costs attached in trading. The exchange rate adjustment mechanism is not immediate. PPP main assumption is that relative prices of goods in the two countries are the main driver of exchange rates which may not be true with the liberalization of capital flows. The basket of goods may not be the same in the two countries. Base year effects may also distort PPP. Another fact that makes PPP not work in real world is the difference between tradable goods and non tradable good. Haircut in Moscow maybe cheaper than taking a haircut in Paris. But you wont buy an airline ticket and fly to Moscow to just get a haircut. Services like haircut are not easily tradable. Even for homogeneous products like McDonald burger there can be price differential due to the local differences in supply and demand and over short periods of time we might find McDonald burger cheaper in one country than the other.
The law of one price assumes that over a longer timeframe the price of the same goods will become equal in two countries. This can happen with exchange rate appreciating or depreciating. A multinational corporation maynot follow this policy and keep the prices of exactly the same product different in two countries taking in consideration difference in supply/demand, cultural tastes, market share considerations, prices of other competitor products. A few decades back when the US politicians were accusing Japan of price dumping, Japanese car companies were selling cars in the US market at a lower price as compared to the Japan home market. In the short run, PPP fails as there can be many factors that distort the law of one price on which it is based.
Economists magazine developed the Big Mac Index which sounds clunky? Maybe not. The law of one price requires that the price of the McDonald burger be the same in different countries. So we can construct a Big Mac Index which is after all what the PPP stipulates. We can look at the index and tell whether the exchange is undervalued, overvalued or alright. This is precisely what the Economist magazine did which is in circulation since 1820s. WHen the EURO came into being, many forecasted that it will appreciate as a lot of capital flow was anticipated and it was being thought that EURO was undervalued. But the exact opposite happened. EURO appreciated a little to 1.18 and then fell real hard disappointing many especially the ECB policy makers. But the Economist magazine got it right when it looked at the McDonald burger price in Europe and in US and in its January 1999 issue said that EURO was overvalued 13% instead of being undervalued. In the next two years, EURO depreciated and you could have made a lot of money. So after all Big Mac Index is not clunky.
Let’s talk about PPP and the real exchange rate. We can only directly observe the nominal exchange rate. Real exchange rate is a hidden variable if you know a little about Hidden Markov Chains. Real exchange rate is the nominal exchange rate adjusted for the price differential. This price differential is just the inflation differential between the two countries. If a country is having high inflation, the exchange rate should appreciate overtime. Just keep this in your mind, if PPP was to hold, exchange rates would be stable for long periods of time. But this is not trade. We see a lot of short term volatility in exchange rates. PPP can be used for making long term forecast with a time horizon of a few years.
Monetary Approach
Now let’s discuss Monetary Approach. If PPP is true then we know change in the price levels in the two countries effect the exchange rate. We also know that the price level in the country gets effected by the money supply. Rise in the money supply means too many currency notes chasing few goods so it leads to a rise in the price level. Money supply is controllable by the central bank. When the money supply rises, interest rates tend to fall. Money demand is not easy to determine as it is dependent on interest rates, real income and prices. Determining the money demand is a complex things.
Change in the money supply will change the money demand and the change continues til money supply becomes equal to money demand which is the equilibrium point. Equilibrium point is a moving target and is seldom achieved and even if achieved it is for a few moments before it changes. Monetary approach uses this concept of money supply and money demand to find the equilibrium point and the exchange rate. Monetary approach assumes that the transmission between the money supply impulse and the exchange rate should be very fast and quick but in reality this is not like that and there can be significant lag between the monetary impulse and the exchange rate. Exchange rate forecast made by the monetary approach are far from good but we cannot outhand reject the monetary approach model as this model has been derived from the economic theory.