Foreign Exchange Market Often Defies Logic Longer Than You Think

Includes: JYN
by: Lok Sang Ho

In the wake of the global financial tsunami I predicted that Japan's export machine will be affected and that it will have to import most of the stuff needed for rebuilding what had been destroyed. The data bears out my predictions.

Because of the disruptions to the economy and the damage to the infrastructure incoming FDI declined, while outward FDI jumped.

(Click to enlarge)

All of this should depress the yen. I wrote that any strength of the yen should be temporary, and that it should weaken rather than strengthen over the medium term.

At the time (March 17, 2011) the exchange rate was 79 yen to the dollar. Rather than weakening, it gradually gained strength until by late 2011, it was trading at about 75-76 yen to the dollar.

While Japan might need to repatriate its overseas assets for the rebuilding effort, the repatriated funds would still have to be spent on imports, thus should not lend much net strength to the yen. The only explanation for the strength, given the trade and capital flow data, is speculation. The strength invited multiple interventions by the Bank of Japan. Still the yen resumed its strength each time after a little while. One had to wait until mid February before the yen fell back to 79 yen to the dollar, and now it has broken through 83 yen to the dollar, and with a first yearly trade deficit in 30 years is expected to continue to decline against a basket of currencies in the coming year.

This shows how logical reasoning may be shortchanged by speculation, which could be more stubborn and longer lasting than you think. In 2008 Citic Pacific lost a fortune speculating on foreign exchange derivatives that the Australian dollar would appreciate. The derivatives had a weighted strike price of 87 cents to the USD. Citic Pacific would have made a fortune if the contracts could be rolled over till now. But it cost the company a loss of $2 billion because the Australian dollar fell all the way through $1 to less than 70 Australian cents, before it went back on course to strength. The lesson from all this is that speculators based on logical reasoning, granted that the logic is valid, must be prepared to hang on longer than they would like, implying that they must guard against excessive leveraging. Often times, short-term capital flows that defy logic and fundamentals will get the upper hand.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.