Chasing Currencies: Smart vs. Dumb Money

Currency watching seems to have become a big deal recently with the emergence of QE2 in the US and the increasing glitter of gold. More injection of money into the market by the US Federal Reserve effectively devalues the US dollar and, if truly a hedge instrument, the price of gold rises -- at least when measured in USD. Devaluation is however a relative sort of thing, so you do have to specify just what it is that the USD is being compared.

In addition to gold, US investors watch the currencies of other major economies, in particular the Euro, the British pound and the yen. The Canadian loonie is only of secondary interest to them. Despite the huge trade between our countries, our economy is relatively small and, like Australia, our currency is often seen as little better than a proxy for mineral commodities (which is largely true).

Aside from the high-stakes currency games in play across the globe, there are many people in Canada -- those that do not actively participate in the markets -- that see the CAD:USD exchange rate as a type of sports match; they cheer the home team (the loonie) when it is near par with the USD and are distressed when it declines. This is silly since par has no economic meaning, or at least no more than any other exchange rate. It can even infect those who ought to know better. I once had a CEO who one morning was all giddy about the strength of the currency. I quietly reminded him that our major market was the US and the currency appreciation was making our products more expensive for our customers and therefore less competitive. Worse, our parts costs were fixed in local currency even though many were imported from the US so we couldn't benefit on product costs on the other side of the ledger.

While we keep our laser focus on the linear threshold that represents the par value of the CAD:USD chart (adjacent), and the US compares their dollar to other currencies, there are still others who compare the USD to gold and even to stocks. That last one really puzzled me, as you can see in this October 15 article in the Wall Street Journal. Here we have someone not only comparing the USD to domestic stock indices but then saying that there is an investing opportunity when they diverge, as if there is some fundamental measure of fair value that proclaims they ought to be closer together. In other words, if the USD is declining when the market is rising there will soon come a revaluation of the market lower, in concert with the USD, as a type of reversion to the mean.

Even if we assume for the moment that there is a mean (fair value) to which the market will revert, there is no reason to assume that the market will move. We can get reversion by the USD rising, the USD and market both rising and both falling, or meeting somewhere in the middle. Yet we are to believe that the "smart money" -- by this the author means financial professionals, not you and me -- will bet on the market falling if the USD rises. That doesn't sound so smart to me. One fundamental reason is that as the USD declines, the competitive position of exporting US companies is improved which will be reflecting in their share price and therefore the market. There is perhaps a better argument to be made for the divergence to be a positive feedback loop that will (to a degree) drive the USD and market further apart. So who's dumb and who's smart?

This also impacts the loonie and Canada since there is tension between an increasing need for Canadian resources due to renewed economic expansion in the US and their higher cost of importing our resources. It's this sort of conundrums that keep the talking heads yapping in the media. It also reinforces the point that investing can be a perilous venture for the likes of us when major economies play power games with each other.