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“In finance you are playing against God’s creatures, whose feelings are ephemeral, at best unstable, and the news on which they are based keeps streaming in.”

Taken from Why Markets Crash, Didier Sornette

Commentary & Analysis

Euro Morphing Into the Old Yen—the Equation Says So

What if the euro is morphing into the old Japanese yen? The Japanese yen which continued to rally for years against other major currencies despite Japan remaining tightly in the bear-hug of deflation for over a decade and nominal rates at zero (ZIRP) for many years?

There is growing concern the Eurozone is falling into a Japanese-style deflationary trap as the headline inflation rate across the zone continues to decline. Many expect the European Central Bank will be forced to cut interest rates.

I’m not sure declining headline inflation should be a big surprise given the unleashed domestic deflationary powers of austerity in an effort to save the single currency regime. But one interesting aspect of this is the surprising strength of the euro even though the Eurozone is losing the yield and growth game to the United States.

I want to share with you an equation I took from George Soros’s book, The Alchemy of Finance, when I read it back in 1987; which is doing a pretty job of justifying the path of the euro.

↑ T + ↑ N + ↑ S → ↑e

↑ T – Trade Surplus

↑ N – Non-speculative Capital

↑ S – Speculative Capital

↑ e – Exchange Rate

1. The Eurozone is still sporting a nice trade surplus.

2. Non-speculative capital flow seems to be increasing as banks in Europe delever outside of Europe in order to bolster domestic capital.

3. Speculative capital flow into periphery bonds, turnaround assets, and buying bad debt (vulture funds) has been brisk, as international fund managers find opportunity across Europe.

4. Therefore, the exchange rate is rising despite what from the outside appears to a relatively bad economy.

Is it that easy? No.

Markets are full of rational and irrational beings; and those beings can quickly move through various stages of rationality when it comes to money decisions. So, if we consider a situation whereby irrational beings are participating and impacting on the outcome they are also attempting to forecast (Soros’ Theory of Reflexivity), you can see the difficulty in using equations to determine outcomes. It’s highly unlikely any Holy Grail-type equation will emerge until Chaos theory and computing power are much further advanced. (That’s a story for another day.)

Despite their limitation in predictive power, I do think equations play an important role as a framework for scenario analysis (I create my own homegrown equations to try to better understand money flow; all are flawed to one degree or another). In the case of the equation I shared above, even if it breaks down as a rationale for the euro, i.e. the euro tanks, I do think it is helpful for thinking about how much flow impacts a currency and can run contradictory to the usual consensus regarding headline GDP or levels of interest rates.

In retrospect, Soros’ equation was an excellent framework for understanding why the Japanese yen remained strong despite Japan’s dismal economic woes. At the moment, it seems to be doing a pretty good job of defining rationales for euro strength. But Mr. Draghi is back behind the microphone on Thursday; so stay tuned.