Evaluating Global Economic and Financial Concerns – Choose Viewpoints Carefully

Monday, May 24, 2010

Last year, when rising cocoa prices were hot news, I described the problem with using only US dollar values to make an evaluation of a global product (see “Cocoa Prices and Currency Measurement” – October 23, 2009).

Today, with Europe, the Euro and “contagion” in the news, it’s time to revisit the need to choose our measurements carefully before making our evaluations.

News reports are ripe with domino theories:

  • Economies: Greece -> Spain/Portugal/Ireland -> Europe and UK -> second global recession
  • Finance/banking: Greece -> European bailout and bad debts -> second global banking collapse
  • Currencies: Greece/Europe financial problems -> Euro plummet -> possible breakeup of EU and abandonment of Euro currency -> Exacerbate European and global economies and finance/banking problems

Whew! Let’s pause a moment and look at some data.

Currency exchange rates offer a good window into what’s happening right now in a country relative to other countries. They also serve as excellent relative measuring sticks.

For example, “The Euro hits a four-year low!” in the US means that in Europe the headline reads, “The US dollar hits a four-year high!” Hmmm… So, are both these headlines “bad”, meaning opposite statements would be “good”? If so, why was there negative news a few months ago, when the US dollar was down versus all currencies and there was talk about it losing its global reserve status?

The best approach is not to be myopic – that is, not to think about currencies only from the US dollar perspective. Rather, look at how all relate to one another, then try to understand the dynamics behind the moves.

Note: Currency exchange rates are based on the “now”. This means today’s short-term interest rates, potential short-term changes in the rates, economic/political stability, trade deficits/surpluses and the “foreign” asset buys and sales (i.e., the supply/demand for currencies to consummate transactions). Long-term forecasts, such as for inflation, find their way in through the items above.

This graph is an example of how we can look at the Euro and where it is affecting others – and where it is not. I have chosen the period beginning with the financial market bottom of March 9, 2009. (Many economic and financial measures turned up after that day, including currencies, so it is a good period for evaluating how the recovery is doing.)

Note that only the UK pound has accompanied the Euro’s downtrend, relative to the US dollar. All other currencies are holding their same relative position to the US dollar. Thus, the Europeans and British are seeing rising currencies everywhere. The good news for them is that any foreign holdings they own are performing better for them. (For example, US Treasury bonds are appreciating nicely and even US stock market values, while down, are being cushioned by the US dollar’s strength.)

Now let’s think about investors and corporations around the world outside of Europe and the UK. As a US, Canadian, Chinese, Australian, Japanese, etc. investor or company, European and UK assets have suddenly gotten more attractive. Consumers, too, get into the mix, from buying a European product to taking a European holiday at lower prices. Importantly, these purchases require a currency exchange – sell home currency, buy Euro or UK pound. And that’s how a seemingly endless currency downslide ends.

So… Whenever we wish to evaluate an economic or financial measure that has a foreign component to it, we need to choose our measurements carefully. Currencies, in particular, can provide different, and even opposite, views that contain the seeds of trend reversals.

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John Tobey on Seeking Alpha

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May 2010