A Shocks & Surprises Approach to Currencies

Currency Conclusions

Strengthing Trends

• US Dollar: Since early January, the dollar has been on a strengthening trend vs the SDR, and that trend is not currently under threat. 
• Euro: The current strengthening trend has been in place since mid-September, and is not under threat.
• Rmb: The current strengthening trend has been in place since early October 2012, and is not under threat. 

Weakening Trends

• Yen: The weakening trend has been in place since mid-December and is not under threat. 
• Sterling: A new weakening trend emerged in mid-January, and is strongly in place. 
• Gold: Reflecting the dollar's strength, since early January gold has been on weakening trend, and that trend is not under threat.

On Watch

• Australian Dollar: The strengthening trend which was in place since the second week of January is now under threat. 

Argument & Methodology
Forecasting exchange range is for mugs. Despite it being a lucratively-rewarded profession, no-one knows how to forecast currencies with near-certainty or accuracy, and for good reasons. The first good reason is that the spot price will always reflect a fluctuating arbitrage between short-term cashflows and longer-term balance sheet necessities, and both sides of that arbitrage are fundamentally in the process  of new discovery, as is the appropriate arbitrage between them. For example, that current cashflows may support the Yen or the Euro can be a situation which can quite easily co-exist - for decades - with a situation in which balance sheet considerations look distinctly unappetising.

The second reason is simpler: for major currencies, fx markets are probably the nearest thing we have to perfect competition,  the logical extension of which is that your explanation is likely to be just as good, or bad, as mine, no matter how hard you (or I) work at it.  Competition, after all, exists to discover information which can be discovered in no other way.

But the itch, the desire to say something useful about currencies, remains. Even working day since Friday December 1st 1995, I have collected OANDAs' tick-averaged fx for all major Asian and European currencies, and consequently have a reasonable database from which to make observations. In practice I use them not to forecast, but rather construct from them rules-of-thumb about the state of individual currencies: are they stable, strengthening or weakening, and at what point to they look like breaking trend?    The rule for this is simple: I track moving averages and standard deviations measured from the point of inflection in 90-day trends. (Each day, the average and standard deviation will change as the trend is extended - typically as the trend lengthens, the average deviation from it will fall, whilst the standard deviation grows). Historically I find that when daily prices are more than two standard deviations away from that trend, a trend inflection usually follows.  

What I am attempting to do is simple and limited: I am trying to accurately identify current trends, and identify plausible threats to them.   I intend to publish my conclusions every Monday.

A Week In Quotes

I spend a lot of  my time sieving the world's data, but there are other ways to understand what's happening.  Here's another view of the week, constructed from the things people have said.

China
A move 'reflecting the noble character and sterling integrity and open-mindedness of a Communist'. Xinhua hails Jiang Zemin for asking for his name to be listed among those of  retired leaders, and below the current generation of leaders.

'That Gini coefficient is, to quote Zheng Yuanjie, even wilder than a fantasy'. Xu Xiaonian, former research head at Gao Hua Securities, on being told that the National Bureau of Statistics calculated the Gini coefficient of income inequality had narrowed to 0.474.

Japan and the Yen

'When a large country with its own currency reaches its fiscal limit, growth ends not with a bang but a whimper of declining vitality and diminishing resilience.' Adam Posen, Peterson Institute

'I think 100 yen is a good level for Japan, 110 is too weak but 95 or 100 is no problems. We need to bring the yen back to a level that works well for Japan's economy.' Koichi Hamada, advisor to PM Abe.

'The current level around 90 can be said to be a correction of the strong yen, but it isn't over yet.' Yasutoshi Nishimura, Deputy Economy Minister

Sino-Japanese Relations

"While Japan's high-profile move on the Diaoyu Islands is a direct confrontation against its neighbour, its actions in Myanmar are a secret detour against China."  The cancellation of Y500bn in Myanmar debt 'is not a healthy competition, but a vicious economic war which aims to drive out Chinese companies, control Myanmar's economy, and finally, cut off China's energy passageway to the Indian Ocean." China's Global Times sees Japan and the US trying to encircle China.

“America is the world’s greatest naval power and pre-eminent economic superpower; Japan is Asia’s largest maritime democracy and a liberal capitalist state second only to the United States. It stands to reason that our two nations should be partners.” What Japan PM Abe was to  have said in a cancelled speech in Jakarta. 

European Politics

'Judging from the latest opinion polls, the most likely election result is gridlock, perhaps in the form of a Bersani-Monti coalition of the centre-left, possibly with a centre-right majority in the Italian senate, where different voting rules apply. This would leave everyone, more or less, in charge. Nobody would have the power to implement a policy. Everybody would have the right to veto one.' The FT's Wolfgang Munchau thinks about Italy's forthcoming elections.

Britain, Sterling and the EU

'Substantial headwinds to recovery remained, including . . . the deterioration in UK competitiveness over the past couple of years. The sterling real exchange rate might be above the level compatible with the necessary rebalancing of the economy'. Notes from Jan 10 Bank of England policy meeting:

'If the UK left, France would find herself locked into a situation in which Germany's distinctive strategic culture and security policy would prevail. This would not be easy to accept for the French, who continue, like the British, to have their own views on international security and the use of force. France could then be tempted to balance the German centre through the systematic practice of countervailing coalitions with the other members of the EU. And, with that, the spirit of the Elysee treaty would be irrevocably lost'. Francois Heisbourg, special advisor to the President of the Foundation of Strategic Research. 

'Without trade regulations and the single market of the EU, Britain will be more open to China's huge market.' Ding Chun, Director of Europe Research Center at Fudan University.

Global Business

'Having held Eu790bn of goodwill at start of 2011, the companies surveyed by ESMA suffered Eu40bn of impairment losses during the course of the year.' That only 5% was written down was a 'clear indicator that there might be too much optimism in financial statements regarding goodwill'. European Securities and Markets Authority warns there's too much goodwill out there. 

'The inconsistencies between Solvency II and Basel III are a major issue. Who's going to provide capital to the banks'? Basel II means European banks may need to raise Eu2.3tr euros in l/t funding: but Solvency II dissuades insurers from buying l/t bonds. 'At a high level they want banks to have more capital and you know who owns the banks - It's us. Solvency II, which is our own solvency regime, says that we cannot invest in banks. I've made the point here to many regulators: How does that work?" CEO of Prudential plc ceo. 

Shocks & Surprises Weekly Espresso

Shocks & Surprises Espresso selects for closer inspection those bits of economic news which not only came in significantly stronger or weaker than expected, but also did so for what I think are interesting reasons.

This week I'm looking at:

• the blowout in November's US trade deficit (is all as it seems?) and 
• China's bank lending / aggregate financing numbers for December. 

If you would like to receive a copy, please drop me a line at michael.taylor@coldwatereconomics.com

Shocks & Surprises Among the Bunting

Economic data releases didn’t quite stop over the holiday period,  but there was less of it, and most of it in any case was fated to pass unnoticed and unlamented.  Here are three which I think are worth noticing:

•        Taiwan’s Exports Orders, which provided a dramatic surge in the export book/bill ratio
•        The Bank of England’s quarterly credit conditions report, which contained surprisingly robust news on both supply and demand conditions.  Have we Brits learned nothing from the financial crisis? Seems not. 
•        China’s Industrial Profits. Few economists seem to follow this data, which seems a pity since profits are, after all, the point of the business cycle. 

1. Taiwan's Exports Recovery On Dec 20^th, Taiwan reported that Nov’s export orders jumped 11.1% yoy, on a 6.1% mom rise which was 1.9SDs above seasonal trends. Given that Nov’s actual exports were dull (up just 0.9%) this dramatically improved the export book to bill ratio, producing the best one-month result since early 2010 and inflecting the 6m line up sharply to its strongest since Jan 2011. The stage was set for the export surprise which duly arrived in Dec’s data – exports rose 9% yoy, and the 4.9% mom jump was 0.95SDs above seasonal trends.

So far so normal, and the clear implication is that Taiwan’s economy is gradually feeling the warmth of China’s modest upswing.  Indeed, it would seem the most obvious truism that if Taiwan’s exports are in recovery, then exports to China, and electronics export in particular, must be in recovery.

But the details of Dec’s export strength confound such easy assumptions. First, Taiwan’s electronics sector is lagging the recovery, not leading it, rising only 1.3% mom in Dec, vs 4.9% for exports as a whole. Rather, what’s delivering the growth is intermediate goods and raw materials: basic metals rose 12% mom, plastics/rubber rose 10.1%, chemicals rose 8.3%, and precision instruments rose 8.3%.  Taiwan’s exporters seem to be piggybacking on a broader industrial re-inventorying rather than a consumer-led electronics recovery.

Industrial re-inventorying? That sounds like Mainland. But once again, the assumption isn’t right: exports to the Mainland rose only 4.4% mom – that’s lagging the monthly gain. Rather, Dec’s export strength reflected European demand: exports to Germany, UK and the Netherlands jumped 23.6% mom. Meanwhile, exports to the US were flat mom, and fell to most of the rest of Asia (except Hong Kong).

The message is clearly complicated, but the moral perhaps is that whilst we assume Taiwanese exports can only be about China and electronics, it seems actually what Taiwan is really selling is its extraordinary production flexibility.  

2. British Credit Conditions Sometimes important surprises arrive almost entirely unheralded (even by me). This happened with the quarterly Bank of England survey of credit conditions, which surfaced quietly on Jan 3^rd. It had two major findings: first, that the availability of credit for households and corporates is improving dramatically, and secondly, the demand for credit  from households, for both secured and unsecured lending, is also recovering sharply. Both are potentially extremely important.  

First, the new availability of credit for households and corporates is unprecedented since BoE’s survey began in 2007. It is almost certainly owing to the Funding for Lending Scheme initiated in July 2012, subsequently disappearing from commentary and due to expire in Jan 2014. Under the scheme the Bank of England will be prepared to swap Treasuries for bank loan collateral up to a maximum of 5% of the initial loan book, plus 100% of the marginal loans made to households and corporates, with no upper limit. More, the fee charges for the collateral swap will fall as the size of banks’ loan books grow. It has taken a little time for the size and power of these incentives to sink in, but the survey suggests the message is now finally getting through.

Just as important is that household credit demand is also undimmed: the survey shows not just robust demand for mortgage (and re-mortgage)borrowing, but also for credit card debt too.

Has the British consumer learned nothing from the financial bust (unlike his counterparts throughout the world from Japan to the US? Seemingly not. All of which is potentially good news for British domestic demand in 2013: over the last five years, domestic demand momentum has generally tended to mirror changes in demand for household secured credit.  

3. China Profits Recovery  China’s industrial profits survey isn’t widely followed at the best of times, so the Dec 27^th report that profits rose 3% yoy in November probably sank without trace. But it is worth salvaging because the trend-breaking recovery was the product both of stronger revenues, and wider margins, than trend. By my unadjusted calculations, revenues rose 11.4% yoy (vs 8.6% in Oct), and margins for the  month widened to 7.4% from 6.3% in Oct and 7% in Oct 2011. 

The recovery seems to have been shared by every major reporting sector except the auto industry.   If we take this profits recovery at face value, it provides solid underpinning for the  economy’s mild upswing. But there is a downside: accounts receivable also grew at the fastest rate since April, and by far more than in Nov 2011. What this suggests is that as non-bank lending is allowed to reliquefy the system,  China’s corporates are emerging from the downturn with their financial risk-appetite undimmed.  Good thing or bad thing?