Currencies Should Reflect Fundamentals, I love Mom, and Apple Pie

Who can disagree with such platitudes? And yet officials appear to think they are saying something substantive when they say foreign exchange prices should reflect fundamentals. Of course they should. Can they do anything but reflect fundamentals? The issue is not fundamentals versus something else, but which set of fundamentals.

When G7 or IMF officials say that currencies should reflect fundamentals, it seems like they are referencing external imbalances. This lies behind the call for the desire for Asian currencies to appreciate and the general belief that the US dollar has to decline.

Yet we know that the money that is turned over in the currency market far and away overwhelms the flows of goods and services. Private estimates of daily volume in the foreign exchange market are in excess of $2.5 trillion a day. That means that the turnover in the foreign exchange market in a week is sufficient to cover the world’s trade for a year. It seems unreasonable then to attribute a privileged place to the trade of goods and services in explaining or forecasting changes in foreign exchange prices.

Rather than place (undue) emphasis on the trade account, investors and policy makers are better served focusing on the capital account. It seems like the fundamental considerations there are what explains a greater part of market developments and foreign exchange prices than trade balances.

French and German officials have most recently expressed concern about the weakness of the yen. But the weakness of the yen does reflect a fundamental judgment of market participants. That judgment is not based on the fact that Japan’s trade surplus is growing or that Japan is experiencing the longest economic recovery in its modern history. Rather the key fundamental that the market has focused on is the low interest rates, the prospect that compared with Europe and the U.S., their rates will remain relatively low and the steepness of the Japanese yield curve.

It is difficult to prove this thesis true, but consider how Copernicus proved that the earth went around the sun. The short answer is he didn’t. But by assuming that the earth went around the sun instead of the opposite, Copernicus was able to explain other “facts”, in this case observations. Similarly, if we assume that the foreign exchange market is being driven more by capital account considerations than trade factors, a number of other “facts” make sense. It helps explain why the Swiss franc is weak as well. After Japan, Switzerland offers the lowest interest rates in the world. The Swiss National Bank key rate stands at 2.0% (the midpoint of the 1.5-2.5% 3-month LIBOR band). Speculators at the IMM have not been net long Swiss francs since early June.

In addition to the price of money, the quantity of money is also an issue for the capital markets. The take away point is that global liquidity, measured by money supply, is ample. A contrarian indicator of the importance of money supply is the fact that the Federal Reserve stopped reporting the broad based measure called M3 almost a year ago. However, other measures suggest U.S. money supply is growing at a robust pace. Consider that when the Fed began raising interest rates in this cycle back in mid-2004, M2 was growing at an annualized rate of 4.6%. As of the end of December 2006, M2 was growing at a 5.3% clip. The growth rate accelerated in Q4 2006 and the Dec reading was the highest since February 2005.

A year after the European Central Bank began raising interest rates money supply is expanding at its fastest rate in nearly two decades. The ECB reported today that December 2006 money supply rose 9.7% above year ago levels. This is more than twice their 4.5% reference rate. In November 2005, the month before the ECB began entered its tightening cycle M3 was growing at a 7.5% pace.

In the UK, M4 grew at a 12.5% year-over-year pace in December. This represents a modest slowing from the 14.4% peak recorded in Sept, but is still well above nominal growth rates and the 12-month average is at its highest level in more than a decade.

In Japan, normalization of the central bank’s reserve provisions to the commercial banks slowed the growth of the monetary aggregates, but the measure of the broad definition of liquidity (M3+CDs) rose at a 2.7% pace in Dec. This compares with a 2.3% pace in the June, the month before the BOJ hiked rates 25 bp from zero. This matches the fastest pace since May 2005. Moreover, since early last year bank lending turned positive for the first time in years.

Although it is arguably still a developing economy, the fact that in purchasing power parity terms it is the world’s second largest economy and in nominal terms it is the world’s fourth largest economy (could surpass Germany next year to move into third place) we would be remiss if we did not include China in this brief survey of liquidity. Money supply, measured by M2 in China, is rising at almost a 17% year over year rate in December. By their own assessment this is excessive.

This survey illustrates another important feature of the fundamental landscape for investors and policy makers. Despite the rate hikes, money supply growth has accelerated, leaving the world flush with liquidity. Just as high tide hides the rocks below the surface, so too does the flood of liquidity encourage a move into higher yielding and riskier assets. This produces what bureaucrats and economists regard as the mis-pricing of risk. And of course this speaks to the carry-trades and the weakness of those currencies, like the Japanese yen and Swiss franc, which also have substantial current account surpluses, as well as some of the strength of emerging market currencies.

If the official claim is right, that the currency markets should reflect fundamentals and they aren’t now, what is the remedy? As the psychologist Abraham Maslow once observed, if all one has is a hammer, all problems look like nails. It is abundantly clear, that the G7 are not prepared to intervene materially in the foreign exchange market to put their tax payers’ money behind their assertion (not an argument) that currencies should reflect trade fundamentals. The “hammer” officials have are words. Verbal intervention and there are obvious limits on its efficacy.

Consider that ahead of the G7 meeting on February 9-10, German officials in recent days have verbally intervened to strengthen the yen. At the end of last week, January 19, the dollar finished near JPY121.24. It is modestly higher now at JPY121.50. The euro was trading near JPY157.10 and is now just below JPY157—essentially unchanged. Sterling is about 0.5% lower against the yen than it was a week ago, but this appears to reflect a correction in sterling, after dovish comments by BOE Governor King and fading speculation of another rate hike here in Q1.

If the thesis sketched here is accurate, that the currency market is reflecting fundamentals, but based on capital market considerations rather than trade positions, then the underlying trends may persist as long as the world’s liquidity remains abundant. Investors and speculators respond to incentives. If the incentive structure changes, investment patterns and speculative propensities will also change. It seems likely that the financial engineering and the further development of the capital markets allows for the extension of the credit cycle, but officials still can strongly influence, even if not dictate, the incentive structure. If policy makers want the market to price risk more according to their models and for the yen and Swiss franc to strengthen they have to do more to reduce liquidity and alter the interest rate outlook for Japan and Switzerland.