I was reading the book Making Sense of Dollar by Marc Chandler. I thought I should discuss what he has said in his book and relate it to what is happening now and how we can use this knowledge in our trading. Forex trading is a challenging mental game. You are pitted against a totally unpredictable market. As technical traders, I trade what we see on the charts and disregard financial news which can be confusing most of the time. Last week, GBPUSD shot up 400 pips on the news the Brexit Deal between UK and EU is on the cards. Now this is fundamental financial news that simply turned the charts upside down. For the last many months GBPUSD was showing bearish sentiment All of a sudden it woke up and became bullish. I just look at the charts. I don’t care what is happening behind the scene that is making the patterns at the charts. I just look at the patterns. In the end my emotions are my worst enemies. When I lose I lose focus. Did you read the post on how psychology drives the currency market?
Understanding how the currency market works is going to help you become a better trader. You will understand how the market thinks and will be able to better interpret it. Marc Chandler currency market expert who also happens to be a prolific writer. He writes for the number of well reputed financial websites like the Financial Times and he also regularly appears on CNBC and Bloomberg. He is an active trader. Since all the seven pairs EURUSD, GBPUSD, NZDUSD, AUDUSD, USDJPY, USDCAD and USDCHF that I trade have USD either on the quote or the base side, it is always a good idea to understand the US Dollar. If you can understand US Dollar and how is operates and reacts to world events, you will be a better trader. FOMC Meeting is an important Economic News Event plus the NFP Report is also an important Economic News Event that happens to move almost all the pairs that I trade plus Gold, Silver, Crude OIl and the stock market and the commodity market. So it is a good idea to know what is the strengths and weaknesses of US Dollar and how we can use that knowledge in making better trading decisions. Cryptocurrencies are a new thing in town and many forex traders are now profiting from ICOs.
Making Sense of Dollar was written by Marc Chandler just after the financial crisis of 2008 when everyone was questioning the strength of US economy. There were many people who were doubtful about the continuing of US Dollar as a global reserve currency. Making Sense of Dollar tries to answer the US Dollar critics and forecasts that US Dollar is going to continue for a long time as a global reserve currency. Keeping this fact in view.British Pound is still very popular and one of the heavy traded currency in the global currency market despite the emergence of EURO. London is still ranked as the biggest currency market center. New York comes after London. London still accounts for around 40% of the daily currency trading volume while NY accounts for around 20% of the daily global currency trading volume. British Empire that gave birth to the British Pound as a global currency backed by the gold standard has long passed away. Gold standard also died many decades ago. But we still see British Pound as a heavily traded currency and London as the biggest currency trading center in the world. So when Marc Chandler asserts that US Dollar is going to be popular for a very long time. He seems to be making a right assertion. A few years back British Pound had a sudden flash crash. Can you predict a flash crash?
As long as US economy is competitive, US Dollar is going to rule the world. This is as simple as that. How do we know US economy is competitive when critics point out huge US Trade Deficits years in and years out running for many decades now. Marc Chandler addresses this fact in the beginning of his book by saying that US Trade Deficit is a sign of US competitiveness. Sounds strange? Well Marc Chandler argues this in the first chapter. Just keep this in mind, US Dollar is interlinked with US economy just like the stock of a company. If the US economy is competitive and strong, US Dollar will be strong and investors around the world will like to hold US Dollar as a hedge against uncertainty. According to Marc Chandler, half of the trade deficit run by US is caused by US corporations, sending parts to foreign countries, getting them assembled and importing the finished products. He gives the example of General Motors that sends parts to its Canada factory where the parts get assembled into a Chevy Impalas that get imported to US. Since the cost of parts is lower than the price of the car, when you import it, there is a trade deficit. Download a free copy of FX Trader Magazine.
In 2008, US ran a trade deficit of $58 Billion monthly. Everyone blamed China for it. Manufacturing jobs are being relocated to China.US is consuming more and producing less. Conventional wisdom tells that trade deficit is wrong. According to Marc, people blame the deficits but don’t look what’s happening behind the numbers. Americans are famous for producing ideas that have generated billions of dollars. Take the example of Bill Gates. Bill Gates started a software business and developed the Windows Operating System. We cannot touch this software but it has changed the lives of billions of people around the world who use Windows OS on their computers. Apple is another company that developed a number of innovative products like the iPod, iPad, iPhone that has revolutionized the global consumer market. According to Marc, software, drug patents, aircraft designs and designs of other products as well as brand names make a lot of money for the US companies.Most of the US companies have offices in different parts of the world. When those companies move product and services across borders, this gets reflected as trade deficit. Central banks are the main players in the currency market. If you trade USDJPY always watch what BOJ is doing.
In nutshell, the present system of trading accounting was designed for a world that no longer exists. Today, good, services and ideas are constantly moving from one border to another and don’t forget the investment capital. People own properties in different countries. Countries sell their passports if you invest a certain amount into their economies. So a large US trade deficit means nothing to Marc Chandler. He thinks US corporations are still the envy of the world. Trade deficit is simply the exports minus imports. But there is a problem here. Many companies are developing and designing their products in their US offices and then getting them manufactured overseas on other countries where the labor is cheap or we have other cost advantages. Fundamentals drive the currencies in the long term. Read why Japanese Yen can weaken.
The Bureau of Economic Analysis, a division of US Commerce Department is responsible for maintaining the Balance of Payment (BOP) accounts. Imports get more attention as there is often a tax or quota imposed on the imports. Exports don’t get that attention. There are three accounts. The Goods and Services Trade account only records the exports and imports. The Current Account includes the Goods and Services Trade Account plus remittances from abroad, tourism and transfer payments. The Capital and Financial Account includes investment made by individuals, firms and government. So a country that exports more and imports less will have a Trade Surplus while a country like US that imports more and exports less will have Trade Deficit. US has been running a trade deficit for the past three decades.
Accounting for goods in the current account is straightforward. Goods go through customs and easily get tallied. But services are not that easy to tally. A tourist family coming to US may be exporting tourist services from US but it is difficult to tally how much the tourist family spend during their hotel stay. So the services exports are basically estimates. Current account also includes the profits that US companies earn overseas and then repatriate that profit. Capital account on the other hand includes net non financial assets transactions. Capital can be exported as well as imported. When a Japanese company is building a car factory in US, it is importing capital. When a US company builds a plant overseas, it is exporting capital. Balance of Payments account is an identity. The current account should equal the capital account plus financial account services. By definition the balance of payment identity should balance. But it never does as it contains so many estimates that we never get zero. FOMC Meeting is a very important monthly meeting for US Dollar.
In gist, this is what Marc is saying. Balance of Payment accounting is not accurate when it comes to accounting for services plus many American corporations now have their manufacturing plants in foreign countries like China and when they import the finished products these products get credited to a foreign country and show a deficit in the current account balance. In theory Balance of Payment account should show zero balance but in practice the statistical discrepancy is always a significant number. According to Marc, Balance of Payment accounting methods were developed when the exchange rates were fixed, currencies didn’t float freely and capital mobility was limited. Balance of Payment accounting in its present form cannot account for the global economy that has developed in the last few decades. Balance of Payment accounts are maintained on flow basis and not stock basis. This is also one major problem. Old fashioned trading accounting is based on the notion that trade involves only raw material and finished products. Watch this video on what makes a successful trader despite losing a lot.
In the last two decades most retail businesses have started selling online. Most of the buying and selling is now being done electronically online. Balance of Payment (BOP) accounting system was developed when manufacturing was the backbone of US economy; Today US is known for its information economy and high technology that includes designing the high tech stuff. These things don’t get reflected in BOP accounting. Traditional BOP accounting cannot cope with the Multinational Corporations (MNC). MNCs today are selling all over the world and in not just one economy taking advantage of the global economy where capital can flow freely. Manufacturing can be done anywhere now a days. Designing can also be done anywhere. These changes are not accounted for in BOP system. Outsourcing and offshoring is an integral part of any MNC business model. The BOP accounting system in its present form puts more weight on costs and less weight on profits. This was the week when the market survived the flash crash.
According to Marc, we should not view the US trade deficit as a sign of economic weakness. Productivity figures and GDP per capita figures still favor the US as compared to other industrialized countries. If we calculate the BOP accounts based on Ownership Based Framework, US trade deficit is almost halved. So it shows that US trade deficit depends on the accounting method that you use. Americans enjoy a high standard of living as compared to the rest of the world. So naturally they look for jobs that pay well so that they can afford a high standard of living. Manufacturing used to be a good paying job. But now a days most of the manufacturing is being in automatic factories and manufacturing is not paying much.US now exports more steel than before but a lot less workers produce steel as compared to the past. It is better to become an engineer who designs new products than to be a factory worker. Free trade does not take away jobs. It’s the new technology that takes away job. We are hearing a lot about autonomous driving. Just imagine how many truck drivers will lose their jobs when autonomous driving trucks take over. Hawks sitting in BOE can raise the rates.
Where have most of the secretaries in the offices gone? We can’t blame China because Bill Gate’s Microsoft Office suite has replaced them. In the same manner the ATM machines have replaced most of the bank tellers. We can’t blame China or Mexico for that. In the last two decades when US was showing a big trade deficit, Microsoft Windows became the most popular OS. American entrepreneurs developed apps for the internet that made messaging and communication free. I am talking about Whatsapp. Facebook became the world’s most popular social media site. American entrepreneurs developed eCommerce and made is a trillion dollar business. But these things don’t get reflected in the BOP accounting system according to Marc. FED by mistake published USD rate hike forecast for the year.
Myth–Current Account Deficit Drives The US Dollar
This is the second assertion made by Marc in his book, Making Sense of Dollar. Price of a currency is determined by its supply and demand. This must be known to you as a student of Econ 101. Supply and demand for the US Dollar determines its pr-ice relative to other currencies in the world. When we talk of supply and demand we need to take into account capital flows in addition to the current account balance. Capital flow is infact much larger than the trade which is measured by the current account. Forecasting the current account does not help you forecasting the direction of US Dollar. The value of US Dollar has no relationship with the current account. In the 19th century and the first half of the 20th century, international monetary system was based on the gold standard. If a currency is tied to an underlying asset like gold,then the economy is also tied to that underlying asset meaning the economy is dependent on how much it has got that underlying asset in reserve. Crisis in EURO means you should buy EURO.
Now when the currency is tied to another underlying asset, people think that it is better to hoard that underlying asset instead of hoarding that currency. This is one of the reasons why people love gold and silver as they consider these metals to be a hedge against political uncertainty. A currency that is not tied to any underlying asset is known as Fiat currency. We now live in the age of fiat currencies. In nutshell, currency has value as long as people have confidence in it. When states fail their currencies also fail along with them. Trade in goods and services is important but it is not the main driver of US Dollar value. Daily more than $5 trillion get traded on the currency markets. This dwarfs the total stock trading that takes place in the different stock markets in the world by a factor of many times. Day traders have shifted to currency markets in the hope of making a quick buck.
Some people try to confuse trade deficit and the budget deficit by linking them. Some economists even call it Twin Deficits. Trade deficit and budget deficit are two different beasts and have not link whatsoever according to Marc. Trade primarily depends on comparative advantage. Comparative advantage means we should focus on doing things that we do best especially those things that make the most money for us. Exchange rate is simply the price of one currency expressed in terms of another currency. If one US Dollar buys more Pesos as compared to last year, it is worth more now. The basic thing that determines the price of a currency is supply and demand just like any other product or commodity. The supply and demand depends on broad economic factors which are hard to forecast and predict. There are many influences that can have an effect on the exchange rate but it is hard to quantify. US economy has one unique advantage. All US exports and imports are priced in US Dollars. This is not the case with the rest of the world. Oil is being traded in US Dollars. Countries importing oil need US Dollars. This is just one factor that shows that the supply and demand of US Dollar in the global market is not tied to US current account deficit.
What we need to do is keep an account on the Capital Account instead of the Current Account. Companies over the years have been building offshore plants with the intention to hedge the exchange rate risk. Japan has done by building car manufacturing plants in US to hedge weakening Yen and US companies have done to hedge against exchange rate risk. Over the years US has played the role of a safety value when it comes to excess population, excess production and excess saving. In the 19th and the first part of 20th century, immigration to US was open to anyone. Later US allowed Europe and Japan to export their excess production to US and now US is absorbing the excess savings from the rest of the world according to Marc Chandler.
Foreigners are investing their savings in US assets like stocks and bonds. Foreign governments also invest in US bonds considering them to be a safe long term investment. This inflow of foreign capital funds US consumption. Interestingly IRAs, 401Ks are considered consumption in BOP accounting. Money plays an important role in any economy. Banks serve as intermediaries between savers and borrowers. But sometimes the return of your money is more important than the return on your money. This was especially true in the credit crisis that developed after 2008. According to Marc, Federal Reserve is a banker to the world. FED has the unlimited amount of US Dollar swap facility with a few important central banks that includes European Central Bank, Bank of England and the Bank of Japan.
More than $2 trillion are being held by foreign governments in US Treasuries. An important question arises what will happen when foreign governments like China decide to sell the US treasury bonds that it is holding. But the problem is that there is no other place big enough to hold this much of investment. US bond market is the most liquid bond market that makes it ideal to hold surplus capital. The velocity of money supply is more important than the money supply in the economy. Higher the money velocity, less the amount of money needed to support the economy. Money velocity is just the money turnover in the economy meaning how fast the people spend the money instead of hoarding it. According to Marc, the problem of modern economies is production of too much surplus goods. In modern economies people are forced to consume in order to sustain production in the economy. Low US household saving are not a problem according to Marc. Accumulating capital is not a challenge for a modern economy. The challenge is to find a productive use of the capital where the return is greatest. According to Marc, US has become a manager of world’s surplus capital.
US labor force is highly skilled with comparatively less unionization and a relatively small basket of goods provided by the state in the form of health care. In the past US has been a major importer of labor that fueled industrial development. Take the example of a computer programmer who moves from India to US. His labor will be part of US GDP. Now suppose the computer programmer stays in India and emails his code to a software house in Silicon Valley. This time his work will count as part of India GDP. US will be importing his software services. Now a days intrafirm trade is playing an important role in the running of a modern MNC. Intrafirm trading is a reality of a modern economy that cannot be overlooked. Intrafirm trading accounted for $300 Billion of the $600 Billion US trade deficit in year 2005. Intrafirm trading between US companies and their affiliates across the globe explains why US Dollar and the US trade deficit are uncorrelated.
In economics, we have this identity that savings nation’s saving minus the nation’s investments is equal to the current account deficit. In US, a major investment that people make in their lives is getting higher education. Higher education in USA is tough and requires a lot of hard work. State universities are funded by the federal government and subsidize higher education whereas ivy league universities like Harvard, MIT, Stanford are expensive and very picky in selecting their students. Higher education is open to majority of Americans. Getting into a university is a major investment. This is interesting. College expenses are not shown as investment in GDP figures. Rather college education is shown as consumption. In the same manner, research and development expenditures are booked under consumption just like college education these are savings and investments. These are investments in new ideas that are the major drivers of innovation and wealth creation for the US economy.
Capitalism does not mean complete private ownership of all the resources in the society. Different countries have different forms of capitalism. Capitalism evolved differently in different countries based on that country’s social structure, culture and unique needs. Broadly capitalism developed into three broad categories. The first is Liberal Market Capitalism that evolved in Anglo American countries. Then there is Corporate Market Capitalism that evolved in Asian countries and lastly we have Coordinated Market Capitalism that evolved in European countries like Germany. The basic idea is the same. Market is the most efficient mechanism for the production and distribution of good and services. Market mechanism encourages ideas, innovation and entrepreneurship. Government role is limited to establishing the rules of competitions and then enforcing them and provide those services which are not being provided by the markets like education, health care, infrastructure and defense. Korean and Japanese model of capitalism is based on corporations which replace the government.
Whatever capitalism can evolve differently in different countries. The basics are the same: private ownership of land, labor and capital. American companies tend to use the capital market for their financing needs much more instead of taking loans from banks.European and Japanese companies tend to get financing by issuing bonds. It is easy to get out of equities. Investors can easily get out of equities by selling the company stocks. This will hurt the companies future plans so the management always will focus on the company performance in order to keep the share holders happy with the company. There can be difference in perceptions in different type of investors for example individual investors may think differently than the institutional investors. European and Asian companies come to US for venture capital financing.
Central Banks have been tasked with the job of managing inflation and unemployment in the capitalist countries. Central banks have a few monetary policy tools that they use to achieve their inflation and unemployment targets. In US , Federal Open Market Committee (FOMC) meets eight times a year to decide whether to increase/decrease interest rates or keep it unchanged. Intellectual property drives innovation, entrepreneurship and ultimately the capitalist system. Patents, trademarks and copyright have been developed to protect intellectual property and provide an incentive for innovation and entrepreneurship. In nutshell capitalism is not a singular doctrine that is same for everyone. As said above there are different shades of capitalism. Anglo American form of capitalism is strongly driven by profit motives. But governments role will always be there in a capitalist economy as markets tend to fail if not properly regulated. The important question is how much.
Myth-US Dollar has lost its privileged position
Much ink is being spilled over the internet discussing how countries are diversifying their reserves away from US Dollar. US Dollar is still the invoicing currency for many commodities that includes the crude oil. Actual reality is US Dollar is as important as ever. This is something important. When the financial crisis started in 2008, Bear Sterns fell. Then Lehman Brothers went belly up. US Dollar appreciated despite the fact the Wall Street was at the epicenter of the global financial crisis. US housing market had tanked which had brought down the mortgage market and with it the big banks were falling down. Despite all this US Dollar appreciated.When the global economy was looking shaky, US Dollar looked like a safe haven to the global investors. They rushed to buy it despite the fact that US economy was in a severe crisis.