Lessons in FX

What have the past 12 months taught us about the global economy and FX markets that might help us maintain profitability in 2003? The following four lessons are those we think are important -- though the list is far from exhaustive.

1. If monetary policy didn’t cause it, it won’t necessarily fix it

A recession that has little to do with excessively tight monetary policy (but a lot to do with over-investment) will not respond well, even to aggressive monetary easing. Specifically in the US, we could add: ‘If in doubt, the Fed will act aggressively.’ Even though aggressive monetary easing is a doubtful remedy for what ails the US (massive overcapacity, and falling profits) -- and could even cause further economic imbalances -- the Federal Reserve does not like to see the economy suffer long before riding to the rescue. And when it does, it nearly always delivers a double dose of medicine.

2. What goes down, need not necessarily bounce back up, at least not quickly

This suggests we should not keep looking for a rebound in economic activity simply because the last period was poor. Economies only appear to work on a mean-reversion principle after the fact. For the same reasons, it does not make sense to assume that Fed funds must rise this year. For the dollar, current unattractive yields are likely to stay that way for a considerable time, and could even go lower. Just because the break-even hurdle of returns for firms has been lowered, it does not follow that firms must start investing, restocking or hiring again -- not when returns on real assets are little better than those on financial ones anyway. The relative unattractiveness of US assets is likely to remain a feature of asset allocation. Valuation and current account fundamentals are likely to gain in importance relative to capital flows, and on both counts, the dollar does badly.

3. If in doubt, the Japanese government will not restructure/reform

It is laughable to believe that Japan’s bad loan problems will be any different (except perhaps worse) two years from now. Though an improvement is exactly what we have been promised by the government. In fact, with the economy on course to head back into cyclical oblivion this year, bad loan growth will probably pick up again. Meanwhile, structural reform has effectively been scrubbed off the menu by an unreconstructed LDP party, leaving Prime Minister Junichiro Koizumi to look for other alternatives to placate the electorate. The departure of Bank of Japan governor, Masaru Hayami this March could offer him a solution. The next governor Koizumi appoints is likely to be amenable to the twin goals of an inflation target and a weak yen policy. The latter, being the means to achieve the former.

This sounds like a clear recipe for a weaker yen. The problem is that the yen is simply not overvalued -- at least, not according to the confederation of Japanese business -- and they should know. So though a weaker yen seems a good bet, as currencies do eventually tend to gravitate back towards fair value, this should not be taken for granted.

4. If in doubt, the ECB will do nothing

This has been one of the most frustrating lessons to learn. While the Fed has been throwing its weight behind the US economy, the European Central Bank (ECB) has been worrying about inflation and keeping rates steady. One could easily argue that the ECB’s recent conversion to lower rates could have been reached six or more months ago. The only thing that has changed is that eurozone growth has continued to weaken. This might have been avoided with a more forward-looking monetary policy.

However, the ECB should, eventually, cut rates again this year. It might even manage to close some of the interest rate differential with the US. Moreover, unlike the US, European interest rates are still a constraint on growth (at least for Germany), and monetary easing ought to encourage growth and even euro-asset ownership. The eurozone current account and valuation arguments are also helpful in contrast to the US, though this does not mean the euro is headed for the moon. It still carries considerable baggage, and EU expansion is likely to bring further problems. However, the euro should manage to stay above parity this year, and could even make some further gains in the short term.

5. Past history may not be a reliable guide to future performance

The final lesson is probably the most important. Recognising and riding trends is certainly one way to make money in foreign exchange. But knowing when the trend has changed, and knowing when there is no trend, are equally important. Last year’s winning formula may be this year’s turkey, and there are, as always, no easy FX bets to make this year.

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