Let’s talk about currencies. The different types of currencies and the various roles they play in the global financial system.
Because this topic is complex and I don’t want to get lost in the weeds, I’ll be making broad sweeping generalizations while focusing on the key points that matter. My plan is to do this while trying not to bore you to death.
Hopefully I’ll be able to tie all this together and show you why understanding these things will have a significant impact on your P&L in the year to come.
Here we go…
Money (cash + credit) is the foundation of the global financial system. It’s the oil that flows through the economic machine, greasing the gears of commerce and allowing markets to turn.
Money serves three primary functions: a store of value, a medium of exchange, and a unit of account.
All currencies are now fiat. Meaning, they have no intrinsic value. They are not backed by anything tangible.
Money is a system based on trust. This trust is complex and I’m not sure many people consciously think about it.
It’s predicated not only on our opinions and expectations surrounding the currency issuers stewardship of its value, but the opinions and expectations of others as well.
A fiat currency is ultimately worthless if it’s not fungible and others won’t accept it as: a unit of account, store of value, or medium of exchange.
Since all currencies are fiat and not pegged to something fixed (there are pegged currencies but those are pegged to other floating currencies), their values, referred to as exchange rates, fluctuate relative to one another over time.
Like all market prices, exchange rates are driven by supply and demand. Currency supply and demand can be separated into two broad categories: fundamental and speculative.
Fundamentals are things like the trade and balance sheet of the currency issuer and its fiscal and monetary policies, such as its budget deficits and its control of the money supply.
Speculative demand is centered around expectations of the relative and future value of the currency. Think exchange rate trends, interest rate differentials, and relative local market opportunities.
To simplify even further. Currency supply and demand is comprised of three things:
- Non-speculative capital transactions
- Speculative capital flows
Trade affects exchange rates through the balance of trade. Countries sell goods in their home currency. For other countries to buy those goods, they have to exchange their currency for the seller’s (exporter’s) currency. And vice-versa for when the country wants to import goods. This differential is referred to as the balance of trade. A trade surplus is an appreciating force on a currency and a deficit is a depreciating one.
Speculative capital flows are the buying and selling of currencies with no attached underlying asset.
Speculative capital moves in search of the highest total return. Total return is made up of: exchange rate differentials, interest rate differentials, and the local currency capital appreciation.
Of the three, exchange rates are the most important because they tend to fluctuate more than interest rates or market returns. It does not take much of an exchange rate decline/increase to completely overshadow the return on interest rates or capital appreciation.
Non-speculative capital transactions refer to all other cross border capital transactions.
In the short-term (months to a few years) exchange rates are driven by speculative flows. In the long-term, economic fundamentals (trade + non-speculative capital transactions) dominate exchange rate movements. It’s the dynamic tension between these two that comprise the trends and fluctuations of currency markets.
Here’s one of the key points of the bigger picture I’m getting at, via George Soros’ Alchemy of Finance:
Expectations about exchange rates play the same role in currency markets as expectations about stock prices do in the stock market: they constitute the paramount consideration for those who are motivated by the total rate of return.
To the extent that exchange rates are dominated by speculative capital transfers, they are purely reflexive: expectations relate to expectations and the prevailing bias can validate itself almost indefinitely… Reflexive processes tend to follow a certain pattern. In the early stages, the trend has to be self-reinforcing, otherwise the process aborts. As the trend extends, it becomes increasingly vulnerable because the fundamentals such as trade and interest payments move against the trend, in accordance with the precepts of classical analysis, and the trend becomes increasingly dependent on the prevailing bias. Eventually a turning point is reached and, in a full-fledged sequence, a self-reinforcing process starts operating in the opposite direction.
The point is that currencies are inherently reflexive.
Their tendency for large fluctuations make exchange rates the most important input in the total return equation. This means that as an exchange rate moves, it brings in speculators betting that it’ll continue to move. And the longer the trend endures, the more reinforced this behavior becomes. Until of course, the exchange rate diverges too far from fundamentals and the trend following bias weakens. Then the process aborts and and works in reverse.
This is why some of the best trends (opportunities for profit) happen in the currency markets. It has a strong reflexive nature.
And this brings us to my second point. The dollar.
The US dollar is at 14-year highs after recently breaking out of its nearly 2-year consolidation.
For the last three months it has gone vertical without taking much of a breather.
This trend is the most important trend in global markets right now. Its effects will be wide-ranging. Those of you who’ve been with us for a while know we often refer to the US dollar as the lynchpin of global markets. It’s the main grease lubricating the global economic machine.
This is true when the dollar is in equilibrium. It’s doubly true when it’s trending.
And this is because in macro there’s something called the core-periphery paradigm, put forth by Javier Gonzalez, in his book How to Make Money with Global Macro.
In this paradigm, global currencies can be divided into three subsets:
- The reserve currency which is currently the US dollar.
- Hard currencies, that come from countries that can lend to themselves at competitive rates. These tend to be net-importers of commodities. Hard currencies generally act as safe-havens during periods of risk-off.
- And soft currencies. Soft currencies tend to be commodity producers. They are countries that have to borrow in other currencies at higher rates. These currencies depreciate during periods of risk aversion.
Since the dollar is the reserve currency it’s the preferred medium of exchange for global trade. It’s also why commodities are priced in dollars.
Global capital sloshes around the world in search of the highest total return. So when the dollar appreciates due to the sum of exchange rate differentials, interest rate differentials, and local currency capital appreciation, it attracts more capital (both speculative and to a lesser extent non-speculative). This creates the feedback loop.
But that money is coming from somewhere… that somewhere is the periphery.
A higher trending dollar is a depreciating force on commodities and commodity producers (soft currency countries). And a weaker dollar is an appreciating force on commodities and its producing countries.
Here’s the following, again from Gonzalez, “Commodities rise for two reasons: investor flight to avoid a depreciating reserve currency and producers increasing their price to compensate for the depreciating unit of account.”
By that same logic, commodities fall due to capital flight back into the reserve currency