The Key drivers
Whenever exchange rates move rapidly or consistently we hear a few standard culprits named as the reason(s) why. This includes interest rate differentials, relative economic strength and demand for exports – largely commodity prices.
There has been considerable academic work on this topic as a quick google search will confirm, however like most “money making” theories no one has really been able to show much more than correlation, ie two measures moved together at the same time.
Correlation – the great deceiver
I know I’ve banged on about this before but its importance cannot be overstated – correlation is quite possibly the most misunderstood statistical concept of all and from what we see is responsible for the vast majority of poor, otherwise avoidable investment decisions. I cannot stress enough the importance of understanding the possibly subtle but tremendous difference between the seemingly important “correlation” – i.e. things moving at the same time; and the actually important “causality” – or actual cause and effect.
All too often we observe correlation and assume it must be causality without stopping to consider whether it actually is. This is particularly difficult when two things seem like they would be linked – in fact a surprising number of people (including apparent experts) tend to be blissfully unaware of the difference.
The investment community is rife with such misguided misinformation, so much so that virtually every investment manager will provide countless graphs and analysis to show their performance correlation against the market or competitors. Whilst promoted as relevant statistical research, this is no more than clever marketing spin designed to paint the purveyor in a more flattering light.
Unfortunately many so-called investment specialists do not understand the basic inputs to this data, let alone the real conclusions that can be reliably drawn – i.e. none! If you can’t clearly articulate why one thing causes another, then assume it’s correlation until you can.
AC-DC and the Economy
I doubt few people would link the highs of Australia’s most successful rock bank with economic doom but consider the following correlations
1973 – Band forms in Sydney – Oil crisis begins which results in a quadrupling of the Oil price
1980 – Band releases its breakthrough album “Back in Black” – inflation in the UK reaches 20% and unemployment reaches 2 million.
1990 – Band launches comeback with “Razor’s Edge”, again No 1 around the world as the UK heads to recession.
2008 – Again the band tops the UK charts as a global recession looms as a result of the GFC.
Now (I hope!) most people would consider this pure coincidence and whilst many have called for the banning or restriction of their music over the years, I’m yet to see the economy quoted as their justification. Given there’s no obvious link between the two we readily accept the coincidence, however this gets harder when we know less about the topic and the relationship seems closer, such as the economy and sharemarket returns or export prices and exchange rates.
What doesn’t drive exchange rates
Before we propose an answer let’s consider what doesn’t. Commodity\export prices and exchanges rates clearly must be linked as to buy Australian products (eg Coal) you need Australian dollars. Therefore China must surely be buying up Australian dollars by the bucket load so they can purchase all that coal, iron ore and LNG?
Well, yes, but not really. You see whilst we are exporting more “value” than ever before we also need to consider the value of what we import as we need to sell Aussie dollars to buy the things we bring in. Therefore a more accurate measure of the weight of money is the net figure, or the balance of payments, i.e. what we are selling minus what we are buying.
This is essentially the “net” dollars exchanged and is the most reasonable indication of demand. For example, according to the ABS, in 12 months to August 2010, Australia’s exports totalled $265.6 billion. Over that same time though, imports were $264.1 billion, leaving a net boost of a measly $1.5 billion. Ok so that’s not small change in most circumstances by but how does that compare to the total foreign exchange market?
According to the Bank for International Settlements in April 2010, the average daily turnover is estimated to be USD$3.98 trillion, with the humble Aussie dollar accounting for around 7.6% of turnover, or roughly USD$302 billion. That’s in one day! In one single day, more than a whole year’s worth of exports value is traded. What about the other 250 odd trading days? Even more stark, remember the net number was only $1.5 billion for the whole year!
Come in Spinner
So what about the balance of transactions? Pure speculation! The foreign exchange market is the world’s biggest casino where speculators can not only gamble to their hearts content, the leverage they can access is astounding. All up this creates a massive power of money driven purely by the whims of speculators.
So the 35%+ rise in the Aussie dollar is only driven by the demand for exports and interest rate differentials to the point where the speculators believe the weight of money will be a net positive. When this position reverses (as it did in May 2010 where it dropped 13%), no amount of iron ore or anything else, will be enough to counter the tidal wave of money flowing out of our little currency. When that time arrives, our humble Aussie dollar will come flying back to a very different level.
So when will this happen? The only honest answer is I have no idea. What I do know is there’s no fundamental reason for the exchange rate to move this high this fast and that suggests it shouldn’t stay there. . Therefore like all things we can’t control, we simply try to manage the risk of one event negatively impacting wealth accumulation I.e. we use competent investment managers who actively hedge some or all of the currency risk out of the portfolios. This provides insurance against adverse currency movements, so just as I can’t ultimately control whether my house burns down, I use insurance to minimise the financial impact if it does.
So let’s take advantage of a high dollar (online shopping here we come!) continue to focus on managing risks and most importantly, continue to focus on the drivers of wealth we can control so that no matter what happens with exchange rates, investment markets and the like, you’ll be more financially secure in the future. In any case, now looks to be a great time to be invested Internationally.
CEO, Financial Adviser
Analysing what can seem to be like complex issues, Matt is effective in using analogies to better explain scenarios and truths to the rest of us. This is what Matt enjoys – educating clients on the truths and debunking the commonly held (wrong) view.