March 27, 2010

Market Insights - 27 March 2010

Here is the latest issue of Market Insights. As always, please email any questions to: . 

In This Week's Issue
• Weekly Snapshot
• Chart Of The Week
• Weekly Barometers 
• Taking on Krugman
• Katrina Quality Rescue Skills
• The Euro Weakness In A Different Light

Weekly Snapshot
• China will introduce its long-awaited stock-index futures on April 16 (WSJ)
• US Michigan Consumer Sentiment Index Held at 73.6 in March (Bloomberg)
• US GDP increased 5.6% in Q4 of 2009, 0.3% less than the second estimate (ESA)
• Mortgage delinquencies in the US rise to nearly 14% (Washington Post)
• US Government unveils $14bn plan to help troubled homeowners (AP)
• Euro-zone member countries agree to Greek rescue deal (FT)
• Fitch cut its rating on Portugal by one notch to AA- (AP)
• Industrial new orders down by 2.0% in Euro area, down by 0.2% in EU27 (Eurostat)
• New orders for manufactured durable goods in February increased 0.5% to $178.1 billion (NBER)
• Germany's IFO business climate index climbed in March to its highest since mid-2008 (
• Sales of new single-family homes in the US fell 2.2% to a 308,000 unit annual rate (Reuters)
• China likely to see a "record trade deficit" in March thanks to surging imports (China Daily)

Chart Of The Week
Our colleague from Political Calculations came up with a wonderful chart indicating the doubling rates of US Imports from China.  We will examine the relationship of international trade and currency exchange rates in great detail further down.

Weekly Barometers  (click on chart for larger image)

Stock-2010-0326   FX-2010-0326

Taking on Krugman
China has been the favored target of some politicians and an increasing number of high profile economists in recent months.  Talk of Chinese currency manipulation has become more widespread in the main-stream media too.  Ask someone about the name of the Norwegian currency for instance and you might get a blank stare. But the Chinese Renminbi a.k.a. Yuan has been part of the talk on the street these days.  And so is the common perception that it is the “artificially” low exchange rate which is to blame for the massive trade deficit between the US and China; better yet, blame China for every other challenge facing the US and global economy these days.

In his recent NY Times article Taking On China, Paul Krugman does some of that finger-pointing towards the East.  Call it a fool’s privilege, but I would like to “take on” the Nobel Laureate in Economics by reviewing the actual impact of currency exchange rates on international trade.  But first, let me clarify that I have the utmost respect for Mr. Krugman and that I am not out here to join the increasingly popular crowd bashing Keynesian economics, however convenient that may be at this time.  Keeping within the length restrictions of this short article, we have to simplify a few things. Realizing the limitations of a brief analysis, we cannot get into the complex historic circumstances that ended the Bretton Woods agreement which then lead to the current system of freely floating exchange rates among the major global currencies.  I simply question whether Mr. Krugman’s suggestion of a 25% tariff on Chinese Goods would convince the Chinese government to revalue their currency and I like to demonstrate that a stronger Chinese Yuan may not lead to an improvement of the US trade deficit with China.

To help us out here, let us examine some historic charts.  The two charts below show how the US Dollar traded against the Japanese Yen and the Deutsche Mark since 1971 (Ed. Note: The Deutsche Mark has been the legal tender of Germany until it was abandoned in favor of the Euro in 2002.   From Jan-2002 onward, we used the official conversion rate of  DM 1.95583 = 1 Euro to establish a hypothetical Deutsche Mark value for the purpose of charting this currency trend).

USD-JPY-Historic   USD-DEM-Historic

Although we did not have access to trade data of 1971, we were able to chart the US imports from Japan and Germany since 1985 and super-imposed those with the currency exchange rates.  To illustrate the fallacy in Mr. Krugman’s proposition, we can point to numerous periods when the US Dollar weakened and conversely the foreign currency appreciated while imports to the US had grown rather than decreased.


Take for instance the period between 1985 and 1995 when the US Dollar depreciated from ¥254 = $1 to about ¥100 = $1, that’s a 60% decrease in the value of the US$.  Meanwhile imports from Japan grew over 54% in the same time period.  A similar case could be made for the data from Germany.


In the same time period between 1985 and 1995, German imports to the US grew 46% while the US$ lost over 50% against the German Mark.  From 2000 until summer 2008, German imports to the US grew by nearly 120% while the greenback lost another 35% in value.  Having examined the actual data side by side, there is simply no correlation between these two sets of data (send me an email if you like a copy of our spreadsheet and data analysis). 

I realize that by not examining the other side of the trade equation (we shall examine that in a future article), we might run short of a more substantial proof that Mr. Krugman’s suggestion is flawed. However, it is commonly understood that the US has not been a leading exporter for several decades now and irrespective of where the US Dollar may have traded.  Moreover, it is often forgotten that that the demand for high quality products (i.e. Japanese consumer electronics, cars or German machinery/cars), even at a higher price, may still lead to higher sales figures through increased profit margins.  In simplified terms, I only need to sell half as many goods at double the price to achieve the same revenues.  Granted that the suggested taxes might take the biggest chunk out of the price increases temporarily but they would also create a new price benchmark and once repealed, the new price levels would be an immediate windfall for the exporters – overall, not a good solution.

When Japan entered the US market, initially gaining market share by supplying the cheapest products available and when the Japan bashing and calls for import duties entered the popular press, Japan countered with better products eventually selling at higher prices. Japanese car makers also responded by adding substantial manufacturing capacity directly inside the US.  They effectively circumvented trade or import duties that may have been in place. 

China is a slightly different animal but they have come very far in a short period of time and they will not forego the biggest global consumer market that easily.  Import Duties of 25% may put a damper on the massive US trade deficit with China, but it is unlikely that it will be an effective way to stop imports from China or from any other country for that matter. It is also questionable whether China would revalue its currency in response to trade barriers.  It is rather more likely that China will revalue its currency only when it serves its own economic and political purpose.  More probable still, China will increasingly focus on producing higher quality products which will be less sensitive to potential price changes i.e. via a stronger or eventually floating currency.  Finally, let’s not forget that a stronger Chinese Yuan has numerous positive effects on producers in China as well.  The price of commodities and raw materials which China has an increasing appetite for, would also fall for the Chinese manufacturers, offsetting at least some of the losses from Chinese exports via stronger currency.


When the Chinese Yuan might appreciate is anyone’s guess.  However, it is widely accepted that China will have to revalue its currency at some point anyway, making Mr. Krugman’s call for a 25% import tax seem rather desperate.  As history has shown time and again, prices can only be manipulated for so long, eventually the economic imbalances will become so great that price adjustments will have to be made, either through gradual and manipulated adjustments or via the natural forces of supply and demand.   Instead of blaming China for the economic misery of the world, one should consider what can be done to steer consumer demand away from cheap consumption goods to high quality and durable products that add value to society. Sometimes less is more.

Katrina Quality Rescue Skills  
Gerald Celente of the Trends Research Institute is known for making rather gloomy but often quite accurate and certainly entertaining predictions by following major global trends.  As you might have guessed, he is not exactly bullish on the economy and predicts another crash looming upon us. 

His confidence in the US government to have any positive effect on the long-term economy is obviously not the highest when he says:

“Everything they touch, they turn into a disaster.  They have Katrina Quality Rescue Skills...”

But instead of chiming in with the blame game, I would like to refer to the second part of the interview where he talks about the US-China financial relations and makes some interesting remarks about the exchange rates which are not dissimilar from our commentary above.  Enjoy!

The Euro Weakness In A Different Light
On the back of continued wrangling over a possible Greek bailout by Germany (or the IMF), currency players have been shorting the Euro with renewed rigor throughout the week.  When the 16 member countries of the Euro-zone put aside their differences and agreed on a pledge of financial support for Greece, the single currency reversed some of the losses and ended the week on a slightly less pessimistic note.
Throughout the week, European equities appeared relatively insulated from the Greek struggles; the German DAX was trading higher throughout the week and closed only 0.3% below its 52-week high.  Traders favored quality and safety over risk which was evident by the over 3 point spread of Greek treasury yields over German 10-year Bonds.  That same need for quality and safety has recently not been associated with the single European currency which was all to apparent in the decline of the Euro versus the US Dollar in recent weeks.

A little less publicized but much more vehement was the decline of the Euro versus other major currencies.  Topping the list are the cross-currency trades Euro versus Australian Dollar and Euro versus Swiss Franc, both of which may have emanated from a different rationale.

Let's examine the Euro versus Australian Dollar first.  The Euro hit a 13 year low of 1.4605 versus the Australian Dollar on Thursday. The single currency has now lost over 26% in the past 12 months and the speed and intensity of the decline has been rather troubling. 


Australia still enjoys a healthy 3% spread over European deposit rates making it a preferred target for a carry trade against the Euro as a funding currency.   But the Australian Dollar has now gained so much against the Euro that one might hesitate to put on a trade that may have already run most of its course.  There has been no significant technical correction to speak of since this dramatic currency slide began last February, which posed the question as to when the major net sellers of the Euro would cover their short positions.  Some short covering happened on Friday when, on the back of positive news about Greece, the Euro retraced upwards by over 200 points and closed the week at 1.4827. 


Any renewed doubts about the fiscal conditions in Greece or other countries such as Portugal, which saw its triple A rating reduced this week, will turn the pressure on the Euro again.  Political wrangling and fundamental factors aside, the technical elements continue to favor the downside so far.  Possible targets are a retest of the technical support at 1.4605 (previous low of September ‘97 and Thursday this week) as well as the all-time low of 1.4025.

Turning our attention to the Swiss cross trade now, the Euro fell to a 25 year low of 1.4232 on Wednesday. In the absence of previous reference points (our charts only go back to 1984), we are entering somewhat new territory here.


The Euro’s slide against the Swiss Franc by contrast to the Aussie, has not been quite as fast or as drastic and the rationale for favoring the Swissie over the Euro is slightly different from that of the Aussie $.  For starters, the Swiss currency has even lower deposit rates (0.25%) than the Euro (1%), so the carry trade is out.  Further, the Swissie is not exactly a commodity type currency and it is not nearly as important in terms of international trade.  However, it has historically been considered a safe-haven currency, perhaps a bit tainted after some heavy arm twisting by the US government that led to a partial lift of the Swiss banking secrecy laws, but nevertheless, it is a “neutral” country.  That neutrality would play well and as long as the Euro member countries are trying to sort out their sovereign debt issues.

Although the Euro gained back some of the losses on the positive Greek rescue deal, a true reversal of these two cross trades has not happened just yet.   In the absence of a deterioration of the Greek debt crisis and a possible spill over towards other Southern European member nations, fundamental reasons should outweigh neutrality.  As time passes, the Aussie Dollar might be the better fundamental trade via its favorable deposit rates over a much more neutral stance via the Swissie.  Much of the Euro-woes may have already been priced in by now, bearing in mind the severity of the decline thus far.  A pull-back from recent lows could happen fast and lift the Euro back to levels seen earlier this year. But as long as serious doubts about the continued existence of the Euro remain, one should consider expressing that opinion via the cross currency trade rather than the more commonly known Euro versus US Dollar trade.
Good luck and good investing!

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1 comment:

J. B. Loewen said...

"better yet, blame China for every other challenge facing the US and global economy these days."

So much easier to do than change our own behaviour.