James Tobin Primer On Currency War

by: Investment Biker

Of late, currencies have increasingly become part of the global monetary policy debate. The Japanese yen (JPY) would be the most obvious case and the sharp weakening of the JPY (NYSEARCA:FXY) could have broader global policy implications. In my first article "Is Japan Prompting A 1930s-Like Currency War?" I had written about the major outcomes and threats of a looming currency war.

Japan's Currency War: Much Discussed, But Hard To Find

Given zero bound interest rates, central banks have been using unconventional methods to stimulate growth. This problem is compounded by the large output gaps and anemic growth projected in most of the major economies. While this has had some adverse impact on the exchange rates, it is not the focus of any central bank. Reflecting the same, I had discussed as to why Japan's case is different from the 1930s scenario given its chronic deflation problem, no growth economy, ageing population and current monetary regime. Readers can refer to my previous article "Why G7 Countries Should Not Bother About Japan's Currency War", to know why Japanese yen looks overvalued when compared to other G4 countries based on its i) FX reserve, ii) Real effective rate iii) Foreign exchange rates at purchasing power parity and iv) Trade Dynamics (current account balance). Given these data, it would be preposterous for political leaders all over the world to openly attack Japan on the currency front.

Though interest rate and inflation differentials are the major reasons stated for currency depreciation, there are factors much bigger than these at play. Bond yields are one of the major reasons that drive exchange rate movements. We will now look into The Absolute return Letter of March 2012 to understand how bond yields affect exchange rates. Before getting into the details, the author Niels C. Jensen, tries to squash two popular misconceptions.

Misconceptions # 1: National income accounting principles guarantees that net foreign capital inflows into a country will always equal the account deficit (the flow identity). For precisely the same reason, the total stock of a country's assets held by foreigners must equal the sum of all past deficits (the stock identity). This implies that as long as a country runs a current account deficit, foreigners will accumulate claims on it whether they wish to do so or not. Likewise, counties that run a surplus will accumulate claims identical to the size of the surplus.

Misconceptions # 2: Bond market is not the only adjustment mechanism that reflects any asset preference. Whilst we all sit and wait for bond prices to fall out of bed, the currency may in fact take the brunt of the adjustment.

Now let us look into the economic theory developed by James Tobin (amongst others) back in the 1970s that explains the relationship between currency movement and bond yields.

Factor 1: Asset preferences - Let us assume a case where foreign investors wish to sell of domestic gilts (lower yields) and invest the proceeds in domestic equities. If the preferences of the domestic investors remain unchanged, the moment they observe falling bond prices and rising equity prices, they will move to take advantage of those price moves and reinstate what they consider to be the equilibrium between bond prices and equity prices. The currency bears the impact of any adjustment. If domestic and foreign investors become disenchanted at the same time, bond yields will rise whereas the currency will only be modestly affected.

Factor 2: Inflation expectations - If the inflation expectations change simultaneously for domestic and foreign investors, bond yields would rise. If foreign investors change their inflation expectations for the worse whilst domestic investors remain more sanguine, the currency will take most if not all of the impact.

Factor 3: Current account deficit - Weakening currency would favorably impact the level of competitiveness. More the trade deficit improves as a result of the weakening currency; the more bond yields may rise over time due to the law of supply and demand of funds. Because the improving trade deficit leaves fewer pounds in the hands of foreigners to be invested in domestic assets.

Factor 4: Savings rate - Assuming total domestic savings increase by an amount equal to the improvement in the trade deficit, supply/demand argument in the previous paragraph falls away, as the falling demand from foreign investors due to the improving trade deficit will be offset by increased demand from domestic investors due to the growth in savings. In this case, bond yields will be unaffected.

Investment Implications:

Current monetary policy largely synonymous with asset price manipulation: Since the onset of the crisis, the world's monetary authorities have been forced to ditch their inherent conservatism and embrace extreme measures on an unprecedented scale to stave off financial and economic collapse. Central banks have repeatedly been called on to step in, providing exceptional levels of support to the financial system, when governments have been unable or unwilling to act.

The monetary policy of the developed countries has been focused toward asset price manipulations with regular interventions in the bond market. As a result, foreign exchange rates would be subject to a period of extreme volatility from bond yields. The debt of major developed countries is huge and would be difficult to pay it off using economic growth alone. Inflation and financial repression are the other two major policy tools available in the hands of the central banker. As I have mentioned in my previous article, "Marc Faber: Get Ready For Decade-Long Low Interest Rates", though the end-game of central bank's intervention policies are not clear, the outcome of these ultra-loose monetary policies could be quite significant for the next decade:

  • Huge deficits with less scope for fiscal discipline
  • Negative interest rates for the next decade
  • Asset price inflation especially in emerging markets, commodities and other risk assets
  • Leveraged speculator benefit at the expense of savers

Now let us look on investment options.

Gold: Readers can refer to my previous article "How Gold Can Help Stabilize The Balance Sheets Of Central Banks" to understand how Gold could be the ultimate bet to play the Central Bank stabilization theme. Further I have also written on the reason as to why gold could gain importance as a reserve asset and a FX hedge against global currency war in "3 Reasons To Be Bullish On Gold". Investors can get exposure to gold using the following ETFs: SPDR Gold Shares (NYSEARCA:GLD), Market Vectors Gold Miners ETF (NYSEARCA:GDX) and Market Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ)

Emerging market: I have written about this in my previous article "Emerging Market Currencies: Best Way To Play QE3." The South African rand, Chinese renminbi (NYSEARCA:FXI) and the Indian rupee (NYSEARCA:ICN) offer real yield advantage and are undervalued. Investors can also look at companies with significant emerging market exposure that should also see simple translational benefits from appreciating emerging market currencies. Companies that get significant share of income from emerging markets include Vodafone (NASDAQ:VOD), Sanofi (NYSE:SNY), Philip Morris (NYSE:PM), Colgate-Palmolive (NYSE:CL), Novartis (NYSE:NVS), Yum Brands Inc (NYSE:YUM), Glaxosmithkline (NYSE:GSK) and Procter & Gamble Co (NYSE:PG)

Indirect Real Estate Plays: U.S housing looks set for a rebound as seen from the a) improvement in the NAHB index b) fall in excess inventory c) rising housing prices d) increase in mortgage demand and e) improvement in housing affordability. Investors could benefit from increasing volumes and prices by investing in the U.S. homebuilding companies. The home-builder universe of stocks include Beazer Homes (NYSE:BZH), DR Horton (NYSE:DHI), Hovnanian Enterprises (NYSE:HOV), KB Home , Lennar (NYSE:LEN), MDC (NYSE:MDC), Meritage Homes (NYSE:MTH), PulteGroup (NYSE:PHM), Ryland and Toll Brothers (NYSE:TOL).

Infrastructure and Utility companies with pricing linked to Inflation Index: National Grid (NYSE:NGG), Ferrovial (OTCPK:FRRVF) and Severn Trent (OTCPK:SVTRF)

Japan Reflation Game: The two major outcomes of Japan's (NYSEARCA:DXJ) reflation game are: Yen depreciation and growth in Japan's domestic demand. Countries like Indonesia (NYSEARCA:EIDO), Thailand (NYSEARCA:THD) and Malaysia (NYSEARCA:EWM) would be the major beneficiaries of Japan's robust demand growth and its complementary trade association. Korea (NYSEARCA:EWY) will be the biggest loser as it competes directly with Japan in the export market. Japanese companies like Toyota (NYSE:TM), Honda (NYSE:HMC), Toshiba and Mazda (OTCPK:MZDAY) would be the biggest winners at the expense of U.S. companies like Ford (NYSE:F), General Motors, Caterpillar (NYSE:CAT), General Electric (NYSE:GE) and Deere (NYSE:DE) from yen devaluation.

Southeast Asia: Southeast Asia is also home to an expanding middle class, creating investment opportunities in industries such as organized retail, consumer products, healthcare, education, transportation, and telecommunications. Investors can gain exposure to these regions using the following ETFs: iShares MSCI Malaysia Index Fund , iShares MSCI Indonesia Investable Market Index Fund , iShares MSCI Singapore Index Fund (NYSEARCA:EWS), Market Vectors Indonesia Index ETF (NYSEARCA:IDX), iShares MSCI Thailand Index Fund , Market Vectors Vietnam ETF (NYSEARCA:VNM), MSCI Philippines Investable Market Index Fund (NYSEARCA:EPHE) and Global X Debuts ASEAN ETF (ASEA).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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