Reflexivity in the Currency Market: Cause and effect are two horses from the same stable

Quotable

“There is no important idea that stupidity does not know how to make use of, for it can move in all directions and is able to wear all the garments of truth. Truth, on the other hand, has only one garment and one road and is always at a disadvantage.”

Taken from Robert Musil’s book, The man without qualities

Commentary & Analysis

Reflexivity in the Currency Market: Cause and effect are two horses from the same stable

From George Soros the brilliant macro trader (not the less than brilliant leftist activist) circa 1985:

“While reflexive interactions are intermittent in the stock market, they are continuous in the market for currencies.

“Changes in one [fundamentals versus exchange rate] may precede changes in the other, but it does not make sense to describe one as the cause and the other as the effect because they mutually reinforce each other. It is more appropriate to speak of a vicious circle in which the currency depreciates and inflation accelerates or of a benign circle where the opposite happens.”

Vicious and benign circles are a far cry from equilibrium. Nevertheless, they could produce a state of affairs akin to equilibrium if the reflexive, mutually self-reinforcing relationship could be sustained indefinitely. But that is not the case. The self-reinforcing process tends to become more vulnerable the longer it lasts and eventually is bound to reverse itself, setting in motion a self-reinforcing process in the opposite direction.”

Not long ago, people who write books and talk about currencies, where damning the US for creating a “currency war” by weakening the dollar. There were offshore conferences where real people spent money to understand a so-called war using a flawed methodology. It reminds me of the scene in the movie, Good Will Hunting, whereby Matt Damon tells the hubris-filled Harvard students if they would have just applied for a library card they could have saved their parents at least $50,000 a year in tuition.

If all those people excited about currency war and the dollar demise would check out George Soros’ book, Alchemy of Finance, from their local library they would save themselves a lot of money.

“The Federal Reserve is reluctant to tighten credit because of the many weaknesses in the financial structure. If dollar are being created faster than foreigners are willing to absorb them, the exchange rate ought to resume its decline—unless the economy is strong enough to induce the Federal Reserve to tighten. It always comes back to the same question: the strength of the economy.

So, the Fed created dollars faster than they could be absorbed, effectively, during those heady US-China symbiotic relationship years which engendered the Credit Crunch. Thus, we have this simple flow diagram to explain:

The dollar falls == U.S. exports become cheaper == foreign demand for U.S. goods grows == U.S. companies benefit == U.S. stock markets rise on higher corporate earnings == U.S. investors feel positive wealth effect from their 401K == Fed continues to ease == global liquidity is enhanced keeping growth intact and demand for US goods brisk …

Proof this worked as planned (though not perfect) can be seen not only in the rising stock market, but the improving current account deficit in the US:

So, you can see in the chart above the dollar bottomed after the current account already started to improve. And those so confident the US dollar was headed into the dustbin of history didn’t even consider something was amiss with their argument.

“The participants’ bias introduces an element of instability into the system. If the system has an innate tendency toward equilibrium the participants’ bias could not disrupt it; at worst, it could introduce some random, short-term fluctuations. But when the causal connections are reflexive, the participants bias may engender, sustain, or destroyed a vicious or benign circle.

In short, the crowd was dollar bearish on the old rationales even though the fundamentals suggested it was time for dollar bears to rein in their hubris. Of course, with the gift of hindsight, we were lurching deep into what is commonly called “overshoot” territory for the dollar at the time, i.e. it had fallen in value well beyond what the fundamentals suggested.

“International capital movements tend to follow a self-reinforcing/self-defeating pattern.”

But remember, this stuff is much harder to pinpoint for currencies than it is in the stock market (which is hard enough already) because “reflexive interaction is continuous” for currencies.

I think it is fair to say the US dollar is in a self-reinforcing rally at the moment. Can we establish some variables to highlight this more clearly? Maybe!

↑ T + ↑ N + ↑ S → ↑e

↑ T – Trade Surplus

↑ N – Non-speculative Capital (Foreign Direct Investment)

↑ S – Speculative Capital (Hot money for yield and punters on a trend)

↑ e – Exchange Rate

Source: The Alchemy of Finance

  1. The US trade surplus is improving.
  2. Non-speculative capital flow has/is being driven by international firms wanted access to US consumers (improving economy) by manufacturing here because of the rising US energy and technology advantages.
  3. Speculative capital flow the primary driver here has to be the growing relative yield differential favoring the US. Then add money being thrown at the profitable trend itself. [The category of rising hedged bets for portfolio managers buying European and Japanese equities falls in between category 2 (non-speculative) and 3 (speculative) because after all these managers are speculating the dollar rally will continue though they are making longer-term capital investments.]
  4. Therefore, the exchange rate is rising

Is the currency itself being driven higher by the improving fundamentals or is the currency itself sucking in more capital flow thus making the fundamentals better and better?

If you consider these various baskets of money flow, I think Soros is right on when he says determining cause and effect is a difficult process when it comes to currencies. It is the quintessential virtuous circle for the dollar; and the quintessential vicious circle for the euro.

But there is no need for book writers and seminar operators to run off half-cocked screaming about a currency war because the US dollar is too high now. Why do I say that? Because it will all reverse sooner or later, as it is the natural long-term ebb and flow which characterizes the currency market, i.e. the strong dollar now (or weak euro, or weak yen, or weak yuan) will likely trigger a self-reinforcing process in the opposite direction.

Of course the multi-trillion dollar question is: When?

Some recent chart analysis sent to our subscribers’ next page

Australian Dollar

New Zealand and Aussie sharply higher this morning; as NZ central bank held on rates and Australian employment numbers not bad. Daily these guys are quite oversold…so this move may have some legs.

AUD/USD Hourly: Likely a move to 0.7913 to shake out some shorts? An extension to 0.8132 would be even better….

AUD/USD Daily: Same chart, different day, showing that target at 0.7586-68…bottomed yesterday at 0.7558…fascinating how the Aussie has followed so perfectly within that channel lower since August 2014. Funny how this stuff works sometimes! Daily oscillators turning higher at key extension area, so long here makes some sense. If we only get a 38.2% retracement of the trend move lower from the 0.9507 high; that represents a rally back to 0.8302. It gives you an idea of how far this move has come without a decent correction.

10-year Benchmark Spread Aussie – United States versus AUD/USD: The pair continues to trade on the spread. If US growth disappoints, Aussie could run a lot higher….seems we already know a June hike from the Fed is baked in the cake [actually we don’t know, but that is the crystalized consensus at the moment]:

Update: USD/JPY Hourly View – Correcting lower

12 March 2015/6:47 a.m. ET

Trading Strategy: Looking to enter long on a pull-back to 120.46-119.72 level for eventual test of daily swing high at 124.16 minimum.

Update: EUR/USD Daily View – A bullish correction or more?

12 March 2015/9:30 a.m. ET

EUR/USD Daily View [last 1.0661]: What if? 1) The Eurozone economy is recovering much faster and better than we believe/expect? If that is true, and signs suggest it would not be a huge surprise, one would expect benchmark yields to start moving higher; though not enough to challenge US yields but an improving differential nonetheless. This maybe the fundamental rationale for a euro correction or rally, however one sees it, to travel much higher from here; especially since shoeshine boys and soccer moms are talking euro/dollar parity.

Interesting the extension level in this daily chart, bullish/corrective view, carried to 1.0460, not far from the low today at 1.0494. If we work from the premise that corrections often carry back to minor Wave iv of the prior impulse down, that would carry the euro all the way to 1.1388. Now that would do a job on euro bears for sure…

Thank you.

  • Rayfo

    Interesting insight; I always consider a balanced view vs the most (sometimes too) obvious trend. Since the whole global economy goes through cycles I think it can round the edges 🙂

    Thanks to share your analysis with us Jack!

    It’s detailed and well written as always with nice references.

    Thump up!