During my time as a teacher before joining the financial industry, I always had one rule: “There is no such a thing as a dumb question.” Questions point toward flaws and caveats in a logical chain of explanations and hence contribute to enhancing both knowledge and pedagogical skills.
As an economist, I had to make an exception to this rule, which is explained by the following story: Albert Einstein dies and meets three people in his afterlife. He asks the first person: “What was your job before you died?” Answer: “I used to be a physicist.” Einstein is cheered by this and replies: “Marvelous, we will have all of eternity ahead of us to reconcile quantum physics with relativity!” Einstein then asks the second person what their job was. Answer: “I used to be a philosopher.” Again, Einstein is happy and says: “Great, we will have all of eternity ahead of us to figure out whether God plays with dice or not!” Then he asks the third person: “And what was your job?” Answer: “I used to be an economist.” Einstein looks somewhat disappointed and then asks: “And where do you see the dollar next year?”
Compared to physics and even philosophy, economics – and currency forecasting in particular – does not afford many definitive answers. First, one needs to acknowledge that the currency markets come the closest to what economists would define as a “perfect” market: a large number of market participants who are too small to influence prices, completely homogeneous objects to exchange with each other, and information transparency; that is, new information is available to all participants at the same time.
Intuitively, one would expect that forecasts for such a market should be easy to arrive at, but the opposite is actually the case. Efficient market theory comes to the conclusion that perfect markets behave like a random walk: the best forecast for an exchange rate tomorrow is to take the exchange rate today.
As Einstein's disappointment showed, this is not very satisfactory. What else can economic theory offer? Actually, there are plenty of models that attempt to explain the behavior of currencies based on “fundamentals”. However, not all fundamentals point in the same direction. Moreover, market participants will prefer some fundamentals to others and those preferences might shift over time. There are times when market participants are concerned about trade deficits and times when they are not; there are times when they focus on carry trades and times when they do not; there are times when relative productivity takes center stage and times when it does not.
The art of successful currency investing demands, among other things, an ability to recognize when fundamentals that matter to the market start to shift. Hence, the question shouldn’t be where the dollar will be in a year from now but what are the current fundamentals the market is focusing on when assessing currencies.
Obviously, Greece has been a main concern for investors in recent weeks. But Greece is only the tip of a huge iceberg of ballooning government debt. If market participants look beyond this tip and start to focus on the trillions of dollars in US debt, then the mini rally in the dollar might end more quickly than many are forecasting.
No comments:
Post a Comment