Yen versus Dollar

The yen is at around 107 versus the dollar today; about 4% up month to date. There has been little sign of intervention by the BoJ. I think one factor that is pretty clear is that quite a few traders who had borrowed yen to sell it have reversed that trade in the course of closing out other market positions due to the credit crisis in the US.

The BoJ may not feel a need to intervene since Japanese automakers are rapidly gaining ground against the Detroit automakers and US auto sales are going to continue to decline across the board without regard to brand due to the credit crunch and overextended US consumer.

US dollar now upside down vs Canadian dollar

Take a look at these two charts borrowed from Yahoo Finance:

This is noteworthy as Canada is one of the USA's largest trading partners and this exchange rate reversal is a first for the USD versus the Canadian dollar. The strength of the Canadian dollar has likely driven up US exports to Canada in the third quarter GDP number that was just reported.

I see the Fed's cuts as making sense primarily in terms of helping banks' cash margins by widening the spread on loans they have outstanding that aren't in default. Banks that might be on the edge of solvency could be pulled back from the brink of receivership depending on their size.

Even though the Fed Funds rate has been lowered, there's still the issue in the interbank market of counterparty risk. I don't recall if it was the Fed Funds rate or LIBOR but recently one day's intraday data showed a high of 15%. So there are still confidence issues.

I could see the Fed raising by a quarter point by the end of the year depending on what happens with GDP. I think Trichet of the EU still needs to raise given the data that Claus Vistesen points out over at Alpha Sources.

Yen carry trade and New Zealand's economic prospects

Claus Vistesen at Alpha Sources notes today that the most recent inflation numbers for New Zealand

"beat the central bank's expectations. It is of course still too late to say anything but with today's inflation data the markets are gearing up for the RBNZ to raise the refi rate to an unprecedented 8.25% next week. In doing so the bank will clearly be playing into the hands of all those savvy retail investors and indeed institutional players playing the carry trade which is driven by very high global capital mobility and high interest rate differentials between central banks."

It seems to me that the prospect of the currency of one of the world's largest and most populous economies(Japan) being dumped for the currency of one of the world's smaller and more isolated economies is somewhat Kafka-esque.

A quick review of the Wikipedia entry on New Zealand shows NZ to be "a country heavily dependent on trade, particularly in agricultural products, and exports almost 28% of its output." Thus, the current carry trade situation looks to be particularly damaging to NZ's economic prospects.

As far as long term solutions for New Zealand go, the Wikipedia authors state that "the current government's economic objectives are centred on pursuing free-trade agreements and building a "knowledge economy". In 2004, the government began discussing a free trade agreement with the People's Republic of China, one of the first countries to do so. Ongoing economic challenges for New Zealand include a current account deficit of 9% of GDP[19], slow development of non-commodity exports and tepid growth of labour productivity. New Zealand has experienced a series of "brain drains" since the 1970s[20] as well educated youth left permanently for Australia, Britain or the United States." With a population of only 4.2 million and a below-replacement total fertility rate of 1.79, it seems to me that New Zealand likely lacks the human capital to generate sustained economic growth. Given the country's geographic remoteness, it seems unlikely to attract skilled immigrants in any meaningful numbers.

It seems that New Zealand's situation today is analogous to the Eastern European countries being discussed over at Demography Matters.

Counter-intuitive fact regarding US net international investment position

Brad Setser says:

A paper that Dr. Roubini and I wrote in 2004 – a paper that incidentally is still by far the most popular thing I have ever helped to write – made this argument. We recognized even then that US had one big advantage than most emerging economies lacked: its liabilities are denominated in dollars, while many of its assets are denominated in foreign currencies (mostly the euro and loonie). That means that falls in the dollar improve the United States external position. The falling dollar increases the value of many US external assets without changing the value of (most) US external liabilities.

In the linked article Setser expands considerably on the subject of the US's net international investment position, but the main point of the post is that, contrary to Setser's predictions, "the US net international investment position has actually improved since the end of 2004." The prime reasons for that being due to the decrease in the dollar's value, and also due to the fact that

"Foreign equity markets – in terms of their own currency -- dramatically outperformed US equity markets – in dollar terms -- in both 2005 and 2006...

The implied return (in local currency terms) on US holdings of foreign stocks (portfolio equity) was 22.1% in 2005 and 18.4% in 2006. Throw in currency moves, which cut a bit over 7% off US returns in 2005 but added about 5.5% in 2006, and the gain -- in dollar terms -- on US holdings of foreign stocks in dollar terms was around 15% in 2005 and 24% in 2006.

That tops the 3.1% return foreigners got (in dollar terms) on US stocks in 2006, and their 13.2% return in 2006.

US equity investors abroad did about 12% better than foreign equity investors in the US in 2005 and about 11% better in 2006. They make it hard to argue (credibly) that the US can finance large deficits because the US is such a good place for investment ..."

The question of why foreign investment in the US has performed relatively poorly compared to the reverse is a complex one...perhaps US investment managers are more sophisticated than their foreign counterparts. Two examples of investment trends in the US that drew a lot of foreign capital in recent years are the dot-com boom and the recent residential housing boom. In both instances, I believe a significant amount of capital that drove over-investment in these sectors came from foreign sources who likely failed to perform enough investigation of their investments before forking over their cash.

Dollar weakness and oil producing countries

Stephen Roach of Morgan Stanley says:

"Oil producers in the Gulf not only price their one commodity (oil) in dollars, but their currencies for the most part are dollar-pegged and, largely as a result, their foreign exchange reserves are massively overweight dollars. In a high oil price environment, the more the United States relies on external lenders to fund its saving-short economy, the more the Gulf region fills the void – and increases its dollar-concentration risk accordingly. This outcome does not sit well with asset allocators in the Middle East. In fact, in my two most recent visits to the region in early 2007, I detected a growing unease with these concerns. The region worries increasingly about excessive exposure to a chronically weak dollar scenario as an unavoidable outgrowth of a prolonged US current account adjustment. Nor is this situation stable. The longer the US suppresses its domestic saving, the greater the risks the Gulf region may face as a levered play on the dollar. Kuwait’s just announced decision to end its dollar-pegged currency regime may well be the first step in a regional diversification strategy that attempts to temper such risks."

Moving some portion of oil revenues out of dollar-based investments and into other countries is a logical move at this point for oil exporters. However, the types of investments that are made with these funds is a key variable. Just putting the money into sovereign debt wouldn't be that productive. Finding projects in emerging markets that can generate decent rates of return is the core issue...

Update: Well, I have to back up and say that if the US yield curve returns to a meaningful upward slope as it might be on its way towards based on today's market activity, all of the above becomes somewhat less relevant. If long-dated Treasury yields jump up quite a bit, that will goose the value of the dollar upward as well, obviously. Then the oil producers' problem is solved. Recent Treasury auctions have been weak anyway...