Opportunities for Currency Investors Amid Market Turmoil

Investors in currencies are confronted with some uncomfortable realities.  Currency prices do not respond to the same events that drive equity and bond prices, so the investor must look for different signals.  World demand for a specific currency is influenced by an uncountable number of factors, and no academic study has ever pinpointed a single variable that is a reliable predictor of future currency prices.  The most important single variable is the interest rate spread between two currencies, but even so, interest rate discrepancies fail to accurately predict future currency prices.  There are too many factors that influence currency prices for one single thing to have a consistent effect. 

Also, currency investing, as opposed to currency trading, has almost no accepted wisdom to guide an investor.  For normal securities investing, there is a body of standardized advice to which many professionals in the industry subscribe. The majority of financial advisors, for example, will probably give an approving nod to a diversified portfolio of large and small cap stocks, mixed with international equities and short bond funds.  But, there is no similar agreement in currency investing 

Over a long time, investors will see opportunities in the currency markets that generally fall into one of three categories: momentum trades, which should be left to the professionals; value trades, which depend on the individual's perception that a particular currency is under or over-valued with respect to another; and the carry trade, which is an interest rate play between a high-yielding currency and a low-yielding one. 

The foreign exchange market today is not fertile for carry trade investing--things are too turbulent, and the highest interest rate currencies are falling fast.  There may be a play with these currencies (see below), but it is not in the carry trade.  So, having excluded momentum trading and the carry trade, all that is left to a prudent investor are value plays. 

Value plays are the same everywhere.  If you view a particular currency as being seriously undervalued, then you should buy the currency and hold it, looking to profit from its eventual revaluation.  This is the basis of value investing in any asset--bonds, equities, real estate or currencies.  The problem, of course, is how do you tell when something is undervalued?

Ignoring this last question for the time being, I view two currencies as presently undervalued:  the U.S. dollar and the Japanese yen.  I also believe the Chinese yuan is undervalued, but since the dollar is going up, I don't know that the yuan will rise faster than the dollar, so I am undecided on that currency for now.

My evidence, such as it is, is shown in the chart below.  I use the PowerShares Dollar Bullish ETF (UUP) as the chosen vehicle.  This ETF is long on the U.S. dollar and short against a basket of the Euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc.  It follows a Deutsche Bank proprietary index. Six months of price history is shown.

The chart also shows Rydex's Japanese yen ETF (FXY) and Barclays GEMS Index ETN (JEM), an emerging market currency bundle, to give some perspective to the dollar and the yen prices.

click to enlarge images

UUP began its rise in mid July of this year.  Recall that the dollar has fallen over the last seven years and reached extremely low valuations before turning around.  It fell so far that I now believe it to be seriously undervalued.  There are many comparative prices you can research that support this supposition.  In my view, it has turned the corner and will continue recovering for some time.  

My opinion on the dollar is not shared by all, however.  Many predict it will soon resume its fall.  Unanimity is not a common currency in this market.  I have explained my position in other publications, and I think it will continue its recovery.  I could be completely wrong, of course.  For those who think the dollar will go down, then the companion fund of PowerShares (UDN) is the dollar bearish fund.  It goes long on the currencies that UUP shorts, and it shorts the U.S. dollar. 

The Japanese yen is also rising against the dollar,and, again, I expect it to continue.  This currency is often manipulated by the Bank of Japan, and the entire currency trading community has been awash in rumors for months of its impending rise--many expect it to continue for some time.  Although there will be only nominal interest earnings from holding the yen, I expect it to rise at a fairly consistent rate over several years, with the Bank of Japan controlling the pace.  Of course, they can always decide to let the yen go its own way;  there is no way of knowing what they will do in advance.  But their history suggests a long, steady rise. 

A position in both these ETFs would, in my view, leave the investor with capital gains over the next couple of years.  But, since things change quickly in this market, it pays to keep a close eye on developments.  Currencies are not for buy and hold investing. 

Speaking of developments, the currency market over the weekend was instructive.  The U.S. dollar and Japanese yen took off, as the flight to quality for international investors reached new levels.  In the graph below, take a look at some of the equity share prices in emerging markets as compared with the Dow Jones Industrial Average. The last six months of three indexes are shown:  Dow Jones (DJI) and the iShares Emerging Markets ETF (EEM), and the South Korean ETF from iShares (EWY).  Many emerging markets' equity shares have fallen 60% or more over this period.

Their currencies have also taken a significant hit.   The chart below shows the U.S. dollar (UUP) as measured against developed market currencies over the same period, with EEM and JEM.  JEM is a basket of emerging market currencies in Asia, Latin America, Europe, the Middle East,  and Africa.  EEM and JEM are not identical, but their compositions are quite similar, with EEM following equity prices and JEM following currency levels.

A couple of forces explain the reaction of investors shown in the charts above:   The first is that everyone is concerned that the slowdown in America and European economies will disproportionately affect emerging markets, since the western nations buy much of all emerging market goods.  During a downturn, demand for many of the goodies the emerging market countries produce will fall, and their export trade, which largely drives their economies, will falter.

A second reason is an extension of this phenomenon into the Hedge fund domain.  Hedge funds have been particularly large investors in the emerging market economies over the last decade, often using highly leveraged buying.  Their investments have covered the complete range of securities: currency holdings, equities,  and debt.  Now that the party is over, the Hedge funds are having to pony up on margin calls.  This leads them to dump much, if not all, they bought in the past,  thus forcing the downturn into an even steeper slide.  Isn't that always how it goes?

The U.S. dollar and the Japanese yen, of course, were the safe havens during this time, and they have prospered.  The number one and two economies in the world, regardless of how bad they  look to us,  are still the safest places to put one's confidence--or at least that is what the financial markets around the world are telling us.

Given the serious decline in currency prices in the emerging markets, coupled with  the huge debt burdens these countries have issued to finance their production capacity--mostly with the developed nations--  the banks and Treasuries of the lending countries are concerned about being repaid. 

The problem of potential default is made much worse by the fact that the currencies of the emerging market world are falling at the same time that their economies are tanking.  And,  much of the debt they owe is denominated in dollars.  This gives them a double whammy to face.  Their revenues are falling because of their shrinking production, and their currencies are depreciating at the same time that the U.S. dollar and yen are increasing.  Now they have a much bigger problem in repaying their debt.

Lenders are quite upset.  But, the lenders (large banks and other financial institutions) have access to the ears of their respective governments, and no one in any government wants more bad news on  their financial pages.  They are already working as hard as they can to contain the carnage that is devastating markets now.  If defaults of some of the major emerging market countries are added to the list, it would set off a new round of tumbling confidence and falling stock prices--exceptionally destabilizing in today's market.  Therefore, there is a move afoot to help the emerging market countries by a coordinated effort of the developed nations to buy emerging market currencies.  This would help prop them up, at least until things settle down a bit.

This type of action is not as hard to arrange as a bailout, though, because the Treasury and Federal Reserve can do this without holding Congressional hearings or have their every move second-guessed.  If this rescue effort comes about,  then look for emerging market currencies to have a good bump.  ETNs such as JEM would benefit, as would individual currencies such as Brazil, Mexico, South Africa, Russia, etc..  This would be something of a momentum play,  so it is more risky than many investors will find comfortable.

It  is also far from a done deal;  it may come off and it may not.  It not, then the emerging market currencies could well continue falling.  If there is intervention, then I would take a short term view of the improvements in currency prices, and have a strong idea of when to get out.  For those with a strong risk appetite, this may be a good place to look for a dangerous liaison.

Even if you don't have a stomach for this risk level, you may still choose to go long on the dollar and/or yen.  These two currencies, in my view, will continue to prosper throughout the coming turmoil.  If they do, then your portfolio will have some built-in inoculation against the crash that is going on in most other markets.

Disclosure: Author holds a long position in UUP

Comments

[Joe1234987:]

What about Japan weakening the Yen as they did in the 2000's? Japan and China have been talking about not letting the dollar fall further (against their currencies).

2008 Oct 27 10:37 AM

[Ray Hendon:]

Joe: This is a very real possibility. As of today, not only Japan but the G7 finance ministers also, are talking about selling yen in order to keep it from getting too higy. I put some references in my latest blog about this development it you'd care to check it out.

Best wishes,

Ray

2008 Oct 27 11:44 AM

[User 287120:]

Ray, thanks for the article. Wouldn't you expect to see the USD weaken long term? The world is awash in them and the printing presses are running full speed to support all the bailouts. When something is over-produced doesn't the price usually go down?

2008 Oct 27 11:49 PM

[User 287120:]

Ray, thanks for the article. Wouldn't you expect to see the USD weaken long term? The world is awash in them and the printing presses are running full speed to support all the bailouts. When something is over-produced doesn't the price usually go down?

2008 Oct 27 11:49 PM

[Ray Hendon:]

I do not expect the dollar to weaken in a long-term sense. It has spent the last seven years doing that, and I believe it has weakened past the point where it was reasonably valued.

You seem to be taking a narrow point of view about the dollar, looking at it from your American perspective. But the demand for dollars is truely world wide, and all over the world, the dollar is still a sought after currency because it can be used to purchase what America sells or what other countries sell and will accept dollars for. America produces over 35% of the world's GDP, and people want what we sell, whether computers, software, airplances or stocks and bonds.

Nor is the bailout relevant to the dollar supply world wide. The bailout is a mere trading of assets. We sell debt and trade the proceeds of that debt for other debt. We may win or lose on the trade, but this is not the same as pumping raw money into the bankings system. We are buying assets that will, in the long run, be quite valuable. Even if there are mortgage defaults, the underlying property can be re-mortgaged to more qualified buyers.

Also, things may be bad here, but they are not as bad as elsewhere, at least for many places. Europe is further into a decline than we are, and all of developing Asia is hurting. With the decreasing supply of world dollars eminating from reduced foreign purchases by Americans, there is even more need for dollars to satisfy world liquidity needs. No other currency can take its place, at least for now. And, I don't think there will be a viable competitor for its place in world finance for some time to come.

In this sense, then, the dollar is not being over produced. It is now or will be soon, actually undersupplied as the world's clearing currency. I see the demand for it going up rather than falling, because all other currencies are now taking their turn being hammered.

You may be right. I confess I don't know what will happen. But I'm still long on the dollar and will be until the fundamental value gets out of line. It is still out of line on the down side for now. And it will probably take a long time for it to get into an overvalued position. At least that is my take on it.

Best wishes,

Ray

2008 Oct 28 01:01 AM