Wednesday, October 26, 2005

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How long can the fundamentalists be wrong?

When it comes to predicting exchange rates, there are chartists and fundamentalists. The former focus on short-term price trends and try to win the "predict everyone else's expectations" game. The latter look at underlying economic fundamentals to figure out where the exchange rate will inevitably head.

When it comes to the dollar's performance in 2005, chartists are beating fundamentalists. The Economist's Buttonwood column tries to explain why:

The currency has gained more than 10% this year, hitting a two-year high against the yen last week and a three-month peak against the euro. This is despite an American current-account deficit even wider than last year’s and apparently reduced enthusiasm among Asian central banks for dollar-denominated assets. Buttonwood was among those early in the year who expected the dollar to go every which way but up. How wrong can a columnista be? Why didn’t the currency behave as she told it to? Don’t deficits matter?

The answer seems to be that they do, but only when relative returns are not compelling and other news looks likely to be gloomy too....

Those who feared that Asian central banks would get tired of buying depreciating dollars, causing the currency to collapse and long bond yields to shoot up, have also had to think again. Though official statistics capture only a fraction of what the banks do with their fast-growing foreign-exchange reserves ($2 trillion higher since 2000), central banks are certainly a shadow of their former selves at Treasury auctions these days. The dollar has strengthened nonetheless, and ten-year bond yields are only a little higher than a year ago. Now that dollar bonds look a plausible investment, the central banks that used to buy them to foster their own export-led development have been able to retire, while private investors have stepped up to the plate.

So too, intriguingly, have the oil-exporting countries, whose current-account surpluses—far larger than China’s—cast a long shadow over financial markets these days. The impact of petrodollars on the ordinary sort is hard to pin down. Economists at Credit Suisse First Boston, for example, have calculated that for every increase of $10 a barrel in oil prices, the daily demand for dollars just to carry out transactions increases by $300m (though other transactions may be crowded out because energy-consumers don’t have money for both).

More important is where the petrodollars end up invested. Though credible figures are elusive, a fair whack has certainly found a home in dollar-denominated assets, some in corporate bonds and some in short-term paper. In the longer term, much of it will flow to Europe and Asia—to Germany, for example, which exports the kind of capital equipment the Gulf states need to develop their infrastructure. For the moment, however, the sharp rise in oil prices this year may well have helped the dollar.

The question is how long the chartists will stay bullish on the dollar. Speaking for the fundamentalists, New York Fed President Timothy Geithner is not optimistic (link via Brad Setser):

The fact that we are using a substantial part of the savings we are borrowing from the rest of the world to finance an unsustainable level of public borrowing leaves us more vulnerable than if those savings were being used for productive private investment. Large structural fiscal deficits limit the size of the sustainable external imbalance for any country, even the United States, and they necessarily increase concern about the terms on which we are likely to finance the present imbalance.

It should concern us because of how the imbalance has been financed. A substantial portion of the capital inflows that finance our current account deficit has come from foreign central banks—which have been accumulating dollar reserves to preserve exchange rate arrangements that are unlikely to be sustainable and are already in the process of change. The impact of a reduction in the scale of official accumulation of dollar assets could be fully offset by increases in purchases by private investors. But even in the context of a continued high degree of confidence in the relative return on claims on the United States, it is hard to know with confidence how the preferences of private savers might respond to the process of gradual evolution in their nation’s exchange rate regimes now underway.

And most importantly, perhaps, these imbalances matter because at some point they will have to reverse. Market forces will at some point induce an adjustment. And that inevitable process of adjustment will bring with it the risk of large movements in relative prices, greater volatility in asset prices and slower growth in the United States and in the rest of the world.

Geithner also touches on one of the big questions that I can't answer -- why the United States has such a comparative advantage in consuming goods and services:

The adjustment process is also complicated by the fact that the rest of the world does not appear likely, even over the medium term, to be in a position to provide a sufficiently strong offsetting source of demand growth to compensate for the necessary slowing in U.S. domestic demand. Policy actions to promote structural reform in the labor, product and financial markets could potentially change this, but the policy changes required are politically difficult, and their effects on net savings over time might be offset by demographic and other forces working the other direction.

it's not even clear that policy reforms of the sort Geithner is talking about will be sufficient in the Pacific Rim -- past crises have made that region loath to consume. Click here for more on the puzzle of Asia's lack of domestic consumption.

posted by Dan on 10.26.05 at 11:37 AM


For an engaging description of the inability of fundamentals to exchange fluctuations over a time horizon of less than about 2 years, see "The Microstructure Approach to Exchange Rates", by Richard Lyons, 2001.

posted by: Robert Bell on 10.26.05 at 11:37 AM [permalink]

I am a fundamentalist but bullish on the dollar. We should treat human capital, and demographics, and economic policy, as part of the relevant fundamentals. The bears look too much at just the current flows.

posted by: Tyler Cowen on 10.26.05 at 11:37 AM [permalink]

It seems to me the pattern has been pretty straightforward since I've been watching it -- the last 25-30 years. The Fed tightens, the dollar rises. The Fed loosens, the dollar falls. There are probably good fundamental reasons, the comparison with other investments being the main one. And if the Fed tightens, the expectation among investors that the dollar will rise and thus increase the value of dollar denominated investments is self-fulfilling, which may be a chartist reason.

posted by: John Bruce on 10.26.05 at 11:37 AM [permalink]

Tyler -- if you want to go long the dollar v. the renminbi on "fundamental" grounds, i am happy to take the opposite side of that trade. The US does have some fundamental strengths, but I don't see much evidence that we currently are investing in either the kind of physical or human capital needed to allow the US to easily increase our exports sufficient to keep the current account deficit from widening at current levels of the dollar. But tis entirely possible that my threshholds for debt/ GDP and debt to exports (external debt) are off, and the US net ext. debt will rise to say australian levels before the markets (or the Chinese central bank) demands adjustment.

Dan -- i was too slow to put my reactions to buttonwood; you beat me to it.

posted by: brad setser on 10.26.05 at 11:37 AM [permalink]

The recent strength of the dollar is tied to the implosion of the Euro, if you ask me. Western Europeans had their world shattered a couple months ago, when it became obvious that the Euro governments would never work together as had long been envisioned, dooming that currency in the long run...

posted by: L. B. Hughes on 10.26.05 at 11:37 AM [permalink]

People and investors put the money where there are more trust and dynamism. If you want dynamism go to India, China, and markets that can grow easely. If you want safety and "standart" grow put money in USA or some good European firm. Since Europe (Germany France , UK is going down too) isnt growing much and futur perspectives doesnt seem good either even for buying cheap yet.The Dollars assets are here to stay for now.

posted by: lucklucky on 10.26.05 at 11:37 AM [permalink]

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