Currency Forecasting-what Bookworms And Economists Look At

For more avid students of foreign exchange who want to learn more about fundamental analysis and valuing currencies, this section examines the different models of currency forecasting employed by the analysts or the major investment banks. There are seven major models for forecasting currencies: the balance of payments (BOP) theory, purchasing power parity (PPP), interest rate parity, the monetary model, the real interest rate differential model, the asset market model, and the currency substitution model.

The balance of payments theory states that exchange rates should be at their equilibrium level, which is the rate that produces a stable current account balance. Countries with trade deficits experience a run on their foreign exchange reserves due to the fact that exporters to that nation must sell that nation's currency in order to receive payment. The cheaper currency makes the nation's exports less expensive abroad, which in turn fuels exports and brings the currency into balance.

What is the Balance of Payments? The balance of payments account is divided into two parts: the current account and the capital account. The current account measures trade in tangible, visible items such as cars and manufactured goods; the surplus or deficit between exports and imports is called the trade balance. The capital account measures flows of money, such as investments for stocks or bonds. Balance of payments data can be found on the web site of the Bureau of Economic Analysis (www.bea.gov).

Trade Flows. The trade balance of a country shows the net difference over a period of time between a nations exports and imports. When a country imports more then it exports the trade balance is negative or is in a deficit. If the country exports more than it imports the trade balance is positive or is in a surplus. The trade balance indicates the redistribution of wealth among countries and is a major channel through which the macro-economic policies of a country may affect another country.

In general, it is considered to be unfavorable for a country to have a trade deficit, in that it negatively impacts the value of the nations currency. For example, if U.S. trade figures show greater imports than exports, more dollars flow out of the United States and the value of the U.S. currency depreciates. A positive trade balance, in comparison, will affect the dollar by causing it to appreciate against the other currencies.

Capital Flows. In addition to trade flows, there are also capital flows that occur among countries. They record a nation's incoming and outgoing investment flows such as payments for entire (or for parts of) companies, stocks, bonds, bank accounts, real estate, and factories. The capital flows are influenced by many factors, including the financial and economic climate of other countries. Capital flows can be in the form of physical or portfolio investments. In general, in developing countries, the composition of capital flows tends to be skewed toward foreign direct investment (FDI) and bank loans. For developed countries, due to the strength of the equity and fixed income markets, stocks and bonds appear to be more important than bank loans and FDI.

Equity Markets Equity markets have a significant impact on exchange rate movements because they are a major place for high-volume currency movements. Their importance is considerable for the currencies of countries with developed capital markets where great amounts of capital inflows and outflows occur, and where foreign investors are major participants. The amount of the foreign investment flows in the equity markets is dependent on the general health and growth of the market, reflecting the well-being of companies and particular sectors. Movements of currencies occur when foreign investors move their money to a particular equity market. Thus they convert their capital in a domestic currency and push the demand for it higher, making the currency appreciate. When the equity markets are experiencing recessions, however, foreign investors tend to flee, thus converting back to their home currency and pushing the domestic currency down.

Fixed Income (Bond) Markets The effect the fixed income markets have on currencies is similar to that of the equity markets and is a result of capital movements. The investor's interest in the fixed income market depends on the company's specifics and credit rating, as well as on the general health of the economy and the country's interest rates. The movement of foreign capital into and out of fixed income markets leads to change in the demand and supply for currencies, hence impacting the currencies' exchange rates.

Summary of Trade and Capital Flows Determining and understanding a country's balance of payments is perhaps the most important and useful fool for those interested in fundamental analysis. Any international transaction gives rise to two offsetting entries, trade flow balance (current account) and capital flow balance (capital account). If the trade flow balance is a negative outflow, the country is buying more from foreigners than it sells (imports exceed exports). When it is a positive inflow, the country is selling more than it buys (exports exceed imports). The capital flow balance is positive when foreign inflows of physical or portfolio investments into a country exceed that country's outflows. A capital flow is negative when a country buys more physical or portfolio investments than are sold to foreign investors.

These two entries, trade and capital flow, when added together signify a country's balance of payments. In theory, the two entries should balance and add up to zero in order to provide for the maintenance of the status quo in a nation's economy and currency rail's.

In general, countries might experience positive or negative trade, as well as positive or negative capital flow balances. In order to minimize the net effect of the two on the exchange rates, a country should try to maintain a balance between the two. For example, in the United Slates there is a substantial trade deficit, as more is imported than is exported. When the trade balance is negative, the country is buying more from foreigners than it sells and therefore it needs to finance its deficit. This negative trade flow might be offset by a positive capital flow into the country, as foreigners buy either physical or portfolio investments. Therefore, the United States seeks to minimize its trade deficit and maximize, its capital inflows to the extent that the two balance out.

A change in this balance is extremely significant and carries ramifications that run deep into economic policy and currency exchange levels. The net result of the difference between the trade and capital flows, positive or negative, will impact the direction in which the nation's currency will move. If the overall trade and capital balance is negative it will result in a depreciation of the nation's currency, and if positive it will lead to an appreciation of the currency.

Clearly a change in the balance of payments carries a direct effort for currency levels. It is therefore possible for any investor to observe economic data relating to this balance and interpret the results that will occur. Data relating to capital and trade flows should be followed most closely. For instance, if an analyst observes an increase in the U.S. trade deficit and a decrease in the capital flows, a balance of payments deficit would occur and as a result an investor may anticipate a depreciation of the dollar.

Limitations of Balance or Payments Model The BOP model focuses on traded goods and services while ignoring international capital flows. Indeed, international capital flows often dwarfed trade flows in the currency markets toward the end of the 1990s, though, and this often balanced the current accounts of debtor nations like the United Slates.

For example, in 1999, 2000 and 2001 the United States maintained a large current account deficit while the Japanese ran a large current account surplus. However, during ibis same period the U.S. dollar rose against the yen even though trade flows were running against the dollar.

The reason was that capital flows balanced trade flows, thus defying the BOP's forecasting model for a period of time. Indeed, the increase in capital flows has given rise to the asset market model.

Note: It is probably a misnomer to call this approach the balance of payments theory since it takes into account only the current account balance, not the actual balance of payments. However, until the 1990s capital flows played a very small role in the world economy so the trade balance made up the bulk of the balance of payments for most nations.

The purchasing power parity theory is based on the belief that foreign exchange rates should be determined by the relative prices of a similar basket of goods between two countries. Any change in a nation's inflation rate should be balanced by an opposite change in that nation's exchange rate. Therefore, according to this theory, when a country's prices are rising due to inflation, that country's exchange rate should depreciate in order to return to parity.

PPP's Basket of Goods The basket of goods and services priced for the PPP exercise is a sample of all goods and services covered by gross domestic product (GDP). It includes consumer goods and services, government services, equipment goods, and construction projects. More specifically, consumer items include food, beverages, tobacco, clothing, footwear, rents, water supply, gas, electricity, medical goods and services, furniture and furnishings, household appliances, personal transport equipment, fuel, transport services, recreational equipment, recreational and cultural services, telephone services, education services, goods and services for personal care and household operation, and repair and maintenance services.

Big Mac Index One of the most famous examples of PPP is the Economist's Big Mac Index. The Big Mac PPP is the exchange rate that would leave hamburgers costing the same in the United States as elsewhere, comparing these with actual rates signals if a currency is under- or overvalued. For example, in April 2002 the exchange rate between the United States and Canada was 1.57. In the United States a Big Mac cost $2.49. In Canada , a Big Mac cost $3.33 in local Canadian dollars (CAD), which works out to only $2.12 in U.S. dollars. Therefore, the exchange rate for USD/CAD is overvalued by 15 percent using this theory and should be only 1.34.

OECD Purchasing Power Parity Index A more formal index is put out by the Organization for Economic Cooperation and Development. Under a joint OECD-Eurostat PPP program, the OECD and Eurostat share the responsibility for calculating PPP's. This latest information on which currencies are under- or overvalued against the U.S. dollar can be found on the OECD's web site at www.oecd.org. The OECD publishes a table that shows the price levels for the major industrialized countries. Each column states the number of specified monetary units needed in each of the countries listed to buy the same representative basket of consumer goods and services. In each case the representative basket costs 100 units in the country whose currency is specified. The chart that is then created compares the PPP of a currency with its actual exchange rate. The chart is updated weekly to reflect the current exchange rate. It is also updated about twice a year to reflect new estimates of PPP. The PPP estimates are taken from studies carried out by the OECD however, they should not be taken as definitive. Different methods of calculation will arrive at different PPP rates. According to the OECD information for September 2002, the exchange rate between the United States and Canada was 1.58 while the price level for the United States versus Canada was 122, which translates to an exchange rate of 1.22. Using this PPP model, the USD/CAD is once again greatly overvalued (by over 25 percent, not that far away from the Big Mac Index after all).

Limitation to using Purchasing Power Parity PPP theory should be used only for long-term fundamental analysis. The economic forces behind PPP will eventually equalize the purchasing power of currencies. However, this can take many years. A time horizon of 5 to 10 years is typical.

PPP's major weakness is that it assumes goods can be traded easily, without regard to such things as tariffs, quotas, or taxes. For example, when the United States announces new tariffs on imports the cost of domestic, manufactured goods goes up; but those increases will not be reflected in the U.S. PPP tables.

There are other factors that must also be considered when weighing PPP: inflation, interest rate differentials, economic releases/reports, asset markets, trade flows, and political developments. Indeed, PPP is just one of several theories traders should use when determining exchange rates.

The interest rate parity theory states that if two different currencies have different interest rates then that difference will be reflected in the premium or discount for the forward exchange rate in order to prevent riskless arbitrage.

For example, if U.S. interest rates are 3 percent and Japanese Interest rates are 1 percent, then the U.S. dollar should depreciate against the Japanese yen by 2 percent in order to prevent riskless arbitrage. This future exchange rate is reflected into the forward exchange rate stated today. In our example, the forward exchange rate of the dollar is said to be at discount because it buys fewer Japanese yen in the forward rate than it does in the spot rate. The yen is said to be at a premium.

Interest rate parity has shown very little proof of working in recent years. Often currencies with higher interest rates rise due to the determination of central bankers trying to slow down a booming economy by hiking rates and have nothing to do with riskless arbitrage.

The monetary model holds that exchange rates are determined by a nat ion's monetary policy. Countries that follow a stable monetary policy over time usually have appreciating currencies according to the monetary model. Countries that have erratic monetary policies or excessively expansionist policies should see the value of their currency depreciate.

How to use the Monetary Model There are several factors that influence exchange rates under this theory:

All of these factors are key to understanding and spoiling a monetary trend that may force a change in exchange rates. For example, the Japanese economy has been slipping in and out of recession for over a decade. Interest rates are near zero, and annual budget deficits prevent the Japanese from spending their way out of recession, which leaves only one tool left at the disposal of Japanese officials determined to revive their economy: printing more money. By buying stocks and bonds, the Bank of Japan is increasing the nation's money supply, which produces inflation, which forces a change in the exchange rate. The example in Figure 3.5 illustrates the effect of money supply changes using the monetary model.

Indeed, it is in the area of excessive expansionary monetary policy that the monetary model is most successful. One of the few ways a country can keep its currency from sharply devaluing is by pursuing a tight monetary policy. For example, during the Asian currency crisis the Hong Kong dollar came under attack from speculators. Hong Kong officials raised interest rates to 300 percent to halt the Hong Kong dollar from being dislodged from its peg to the U.S. dollar. The tactic worked perfectly as speculators were cleared out by such sky-high interest rates. The downside was the danger that, the Hong Kong economy would slide into recession. But in the end the peg held and the monetary model worked.

Limitations of Monetary Model Very few economists solely stand by this model anymore since it does not take into account trade flows and capital flows. For example, throughout 2002 the United Kingdom had higher interest rates, growth rates, and inflation rates than both the United States and the European Union, yet the pound appreciated in value against both the dollar and the euro. Indeed, the monetary model has greatly struggled since the dawn of freely floating currencies. The model holds that, high interest rates signal growing inflation, which they often do, followed by a depreciating currency. But this does not take into account the capital inflows that would take effect as a result of higher interest yields or of an equity market that may be thriving in a booming economy—thus causing the currency to possibly appreciate.

In any case, the monetary model is one of several useful fundamental tools that can be employed in tandem with other models to determine the direction an exchange rate is heading.

The real interest rate differential theory states that exchange rate movements are determined by a nation's interest rate level. Countries that have high interest rates should see their currencies appreciate in value, while countries with low interest rates should see their currencies depreciate in value.

Basics of the Model Once a nation raises its interest rates, international investors will discover that the yield for that nation's currency is more attractive and hence buy up that nation's currency. Figure 3.6 shows how well this theory held up in 2003 when interest rate spreads were near their widest levels in recent years.

The data from this graph shows a mixed result. The Australian dollar had the largest basis point spread and also had the highest return against the U.S. dollar, which seems to vindicate the model as investors bought up higher-yielding Aussie currency. The same can be said for the New Zealand dollar, which also had a higher yield than the U.S. dollar and gained 27 percent against USD. Yet the model becomes less convincing when comparing the euro, which gained 20 percent against the dollar (more than every currency except NZD) even though its basis point differential was only 100 points. The model then comes under serious question when comparing the British pound and the Japanese yen. The yen differential is -100 and yet it appreciates almost 12 percent against the dollar. Meanwhile, the British pound gained only 11 percent against the dollar even though it had a whopping 275-point interest rate differential.

Interest Rates vs. U.S.	Eurozone	Japan	U.K.	Canada	Australia	New Zealand
Central Bank Rate End of 2003	100	-100	275	175	425	400
% Change 2003 vs. USD	20%	12%	11%	21%	34%	27%

This model also stresses that one of the key factors in determining the severity of an exchange rate's response to a shift in interest rates is the exported persistence of that shift. Simply put, a rise in interest rates that is expected to last for five years will have a much larger impact on the exchange rate than if that rise were expected to last for only one year.

Limitations to Interest Rate Model There is a great deal of debate among international economists over whether there is a strong and statistically significant link between changes in a nation's interest rate and currency price. The main weakness of this model is dial it does not take into account a nation's current account balance, relying on capital flows instead. Indeed, the model tends to overemphasize capital flows al the expense of numerous other factors: political stability, inflation, economic growth, and so on. Absent these types of factors, the model can be very useful since it is quite logical to conclude that an investor will naturally gravitate toward the investment vehicle that pays a higher reward.

The basic premise of this theory is that the flow of funds into other financial assets of a country such as equities and bonds increases the demand for that country's currency (and vice versa). As proof, advocates point out dial the amount of funds that are placed in investment products such as stocks and bonds now dwarf the amount of funds that are exchanged as a result of the transactions in goods and services for import and export purposes. The asset market theory is basically the opposite of the balance of payments theory since it takes into account a nation's capital account instead of its current account.

A Dollar-Driven Theory Throughout 1999, many experts argued that the dollar would fall against the euro on the grounds of the expanding U.S. current account deficit and an overvalued Wall Street. That was based on the rationale that non-U.S. investors would begin withdrawing their funds from U.S. stocks and bonds into more economically sound markets, which would weigh significantly on the dollar. Yet such fears have lingered since the early I980s when the U.S. current account soared to a record high at the time of 3.5 percent of GDP.

Throughout the past two decades, the balance of payments approach in assessing the dollars behavior has given way to the asset market approach. This theory continues to hold the most sway over pundits due to the enormity of U.S. capital markets. In May and June of 2002 the dollar plummeted more titan a thousand points versus the yen at the same time equity investors fled U.S. equity markets due to the accounting scandals that were plaguing Wall Street. As the scandals subsided toward the end of 2002 the dollar rose 500 basis points from a low of 115.43 to close at 120.00 against the yen even though the current account, balance remained in massive deficit the entire time.

Limitations to Asset Market Theory The main limitation of the asset market theory is that it is untested and fairly new. It is frequently argued that over the long run there is no relationship between a nation's equity market performance and the performance of its currency. See Figure 3.7 for a comparison. Between 1986 and 2004, the S&P 500 index and the U.S. Dollar Index had a correlation of only 39 percent.

Also, what happens to a nation's currency when the stock market is trading sideways, stuck between bullish and bearish sentiments? That was the scenario in the United States for much of 2002, and currency traders found themselves going back to older moneymaking models, such as interest rate arbitrage, as a result. Only time will tell whether the asset market model will hold on or merely be a short-term blip on the currency forecasting radar.

This currency substitution model is a continuation of the monetary model since it takes into account a nation's investor flows. It posits that the shifting of private and public portfolios from one nation to another can have a significant effect on exchange rates. The ability of individuals to change their assets from domestic and foreign currencies is known as currency substitution. When this model is added to the monetary model, evidence shows that shifts in expectations of a nation's money supply can have a decided impact on that nation's exchange rates. Investors are looking at monetary model data and coming to the conclusion that a change in money flow is about to occur, thus changing the exchange rate, so they are investing accordingly, which turns the monetary model into a self-fulfilling prophecy. Investors who subscribe to this theory are merely jumping on the currency substitution model bandwagon on the way to the monetary model party.

Yen Example In the monetary model example we showed that by buying stocks and bonds in the market place the Japanese government was basically printing yen (increasing the money supply). Monetary model theorists would conclude this monetary growth would in fact spark inflation (more yen chasing fewer products), decrease demand for the yen, and finally cause the yen to depreciate across the board. A currency substitution theorist would agree with this scenario and look to take advantage of this by shorting the yen or, if long the yen, by promptly getting out of the position. By taking this action, our yen trader is helping to drive the market precisely in that direction thus making the monetary model theory a fait accompli. The step-by-step process is illustrated in Figure 3.8.

A. Japan announces now stock and bond buyback plan. Economists are now predicting Japan 's money supply will dramatically increase.

B. Economists are also predicting a rise in inflation with the introduction of this now policy. Speculators expert a change in the exchange rate as a result.

C. Economists expect interest rates to rise also as inflation takes hold in the economy. Speculators start shorting the yen in anticipation of a change in the exchange rate.

D. Demand for the yen plummets as money flows easily through the Japanese economy and speculators dump yen in the markets.

E. The exchange rate for Japanese yen changes dramatically as the yen falls in value to foreign currencies, especially those that are easily substituted by investors (read: liquid yen crosses).

Limitations of Currency Substitution Model Among the major, actively traded currencies this model has not yet shown itself to be a convincing, single determinant for exchange rate movements. While this theory can be used with more confidence in underdeveloped countries where hot money rushes in and out of emerging markets with enormous effect, there are still too many variables not accounted for by the currency substitution model. For example, using the earlier yen illustration, even though Japan may try to spark inflation with its securities buyback plan, it still has an enormous current account surplus that will continually prop up the yen. Also, Japan has numerous political land mines it must avoid in its own neighborhood, and should Japan make it clear it is trying to devalue its currency there will be enormous repercussions. These are just two of many factors the substitution model does not take into consideration. However, this model (like numerous other currency models) should be considered part of an overall balanced FX forecasting diet.