The Currency Value Exports Myth…


"Since the economy is extremely sensitive to changes in conditions, even a precise knowledge of a majority of the relevant dimensions of the economy will not necessarily lead to an accurate prediction."

-F.J Chu, from his brilliant book, The Mind of the Market: Spiritual Lessons For The Active Investor

Commentary & Analysis

The Currency value exports myth…

I think market lore (folk lore/wisdom/knowledge) falls into three different categories: 1) right, 2) sometimes right, or 3) total nonsense. For example:

Category #1: "A market can remain irrational longer than you can remain solvent."

Category #2: "Never sell a dull market."

Category #3: "The market hates uncertainty."

Every time I hear that last one, "The market hates uncertainty," I cringe in disbelief that anyone in this game can repeat this nonsensical phrase. It begs the question: When have we ever had certainty?

Answer: Never!

To take this one step further, consider this statement:

If we had certainty there would be no such thing as a market.

Do you agree with that? It’s true. Why buy or sell anything for speculative gain or loss if everyone knows the future with certainty? It’s under this flawed acceptance of certainty from which another huge nonsensical construct grows, i.e. "equilibrium." There is no such thing. At best there may be a tendency toward equilibrium, at worst we can’t even define the shape of those theoretical supply and demand curves…arrrgggggg….

Another piece of lore you may be familiar with is a bit more specific as it applies to a country’s currency value. You tend to here this often (usually from people who actually have no need to trade currencies for a living):

A country’s exports will suffer when the relative value of its currency strengthens; therefore a country’s exports will grow when the relative value of its currency weakens.

There’s only one problem with this line of reasoning–it doesn’t seem to hold water in the real world.

I place into evidence for your consideration four charts (below) which include two different price series:

1) The actual trade balance (gold); and 2) the value of the local currency (red). I have included the US, Japan, Germany, and China. The time frame is from early 1992 through the most current month of trade balance recorded for each country. This period encompasses two full cycles of the dollar index, i.e. bull market from early 90s to 2002, bear market to 2008, and what I believe is a bull market lasting until a yetto-be-determined date (let’s just say I lack certainty).

United States Trade Balance in Goods (yellow) versus the US dollar index (red):

Japan Trade Balance versus USD/JPY:

Germany Trade Balance versus EUR/USD:

China Trade Balance versus USD/CNY:

Some key points from the charts above that run counter to the standard wisdom:

  • Germany’s trade surplus continues to grow despite the huge appreciation in the euro that began in 2002
  • Japan’s currency is finally weakening and so is its trade balance
  • The US dollar bottomed in 2008 and is now appreciating in line with an improvement in the US trade balance
  • China is a simple dirty peg to the dollar here, so I have trouble fabricating a conclusion. But at least I can say there has been no dramatic increase in China’s currency value, yet its trade surplus is shrinking.

In the real world, such things as productivity, type of goods manufactured, supply chain, energy costs, transportation costs, local monetary policy, trade preferences, and foreign direct investment, just to name a few, have a lot to do with a country’s ability to export. It’s not just the currency.

But, the currency can at times play a leading role. Because economists don’t seem to talk about feedback loops the powerful role a currency can play is often overlooked.

For example, if a currency is appreciating and there are reasons why it makes sense to invest in a country with an appreciating currency (such as the foreign direct investment now flowing to the US because of the wide energy cost advantages to manufacture here and the shrinking labor cost advantage for China), this appreciation begets more funds flow (leading to greater appreciation) and the additional foreign direct investment can enhance the ability of a country to maintain its trade advantage in the face of a rising currency. I think Germany’s performance on exports in the face of a rising currency value is good real world example of this.

The reason I am sharing these thoughts today is because of an article that appeared in this morning’s Wall

Street Journal, US Manufacturers Gain Ground: Narrow Trade Deficit on Factory Goods Is a Sign of New Competitive Edge:

"After more than a decade of losing ground to China and other export powerhouses, U.S. manufacturers are finally showing signs of regaining their competitive edge.

"The U.S. deficit on trade of manufactured goods in this year’s first half shrank to $225 billion from $227 billion a year earlier, according to data compiled by Ernest Preeg, an economist and trade expert at the Manufacturers Alliance for Productivity and Innovation, an industry-funded research group in Arlington, Va. The improvement, while slight, came after years of ballooning deficits as the U.S. lost manufacturing business to China, South Korea and other nations.

"…His [Ernest Preeg] findings come as Boston Consulting Group–a leading proponent of the idea that U.S. manufacturing will come roaring back–predicts a surge in U.S. exports, partly helped by lower energy costs and stagnating wages. In a report for release Tuesday, BCG says rising exports and ‘reshoring’ of production to the U.S. from China ‘could create 2.5 million to five million American factory and service jobs associated with increased manufacturing’ by 2020. That, BCG says, could reduce the unemployment rate, currently 7.4%, by as much as two to three percentage points."

This is a similar story we fabricated a while back as a rationale for our longer-term expectation of a US dollar bull market (at least cyclically). It seems to be playing out. And if it does, guess what: The US dollar will be rallying while the US trade deficit is improving. Go figure?