A Fundamental Take, Trading Thoughts, and Questions (for you)

First thing is first, sorry for the length.

Most talk about Forex trading on here is focused on technical analysis on rightfully so. However, I am not a technical trader, or that is I understand technical trading however I am a much longer-term view (which in FX, isn't always saying much) and focus more around fundamentals or structural nature of the currency. In particular, focusing on the real supply and demand of a currency.

Before someone tries to give me lecture on how important technical analysis is in FX, let me assure you that I use such analysis however it is not my primary method of determining the direction I trade/invest but rather as a method of determining an entry point and when that position is fully valued, or an exit point.

Much like a company, the product or service that company sells can only be as good as the companies management in the long term. I don't think currencies veer too far off that path as monetary officials (and at times politicians) and their policies will determine the value of the currency primarily because they control the supply side of the equation however it will also affect the demand side of equation, e.g. interest rates. In the end, there are more outlaying factors that monetary officials do not control that will drive demand for a currency, e.g. business investment.

In any case, I am hoping others out there can both discuss and trade idea's off of said analysis. I do not have any breakthrough analysis but I have been looking at some data points that have me quite concerned with currencies like GBP and CHF that I'd like to share and get some thoughts and feedback on.

Starting with the Pound. The obvious fundamentals aren't pretty: recessionary environment with contracting GDP, low interest rate environment, monetary stimulus, high unemployment, high levels of debt to GDP, etc.

All of that said, the single most concerning thing on my radar for the pound is their monetary base and its rapid growth rate. Comparing the monetary base of the pound to the US dollar over the past 13 months (Sept 2011 - Sept 2012), we have seen an increase of 76% in the money supply while in the United States, believe it or not, the monetary base has decreased.

To make it clear, I look at the monetary base (M0 or narrow money) because it is the most liquid form of the money supply and a growth of the base will grow the other money supply measures due to the money multiplier effect.

That said, the difference in the GBP/USD exchange rate relative to the GBP/USD monetary base ratio was 9.4% in September of 2011, or to say that the GBP/USD exchange rate was 1.56 (rounding) in September 2011 while the monetary base ratio was at 1.42.

Today, the real exchange rate for the pair rests at 1.615 while the monetary base ratio is at a whopping low of 0.80. That is a difference of over 103% in one year. While many factors effect exchange rates, I am not sure why we would see such a variance in the real exchange rate compared to the monetary base ratio. I am not advocating that the monetary base ratio should per at par with the exchange rate, but the divergence is quite astonishing to say the least.

In comparison with the USD/JPY, we have seen the exchange rate move along with the monetary base ratio up until the last two months. Even when it has broken correlation in the past it seems to "catch up". Again, this is not a scenario where I am saying par is correct, however the pair seems to act (gain and lose) around supply.

Which leads me to my next point. If you deduced all other indicators and fundamentals factors for the pair, one could conclude that the monetary base differential has driven the direction of this pair. However, that same argument cannot be made for the GBP/USD.

So the questions begin:

 

1. If we look at real supply as the real money in the system defined by a countries monetary base, then we could concluded that all being equal, if one country's supply of money grows faster than another, then that currency should depreciate (again, all else equal). Is this a fair conclusion?
2. What would be the best way of defining demand? While we could broadly look at metrics like interest rates, current account balances, and growth metrics like GDP, are there more specific methods of determining real underlying demand outside of intraday price action?

More specific:

 

1. If we can say that real supply = monetary base, then has there been such a demand to offset the GBP/USD monetary ratio difference to keep it elevated at these levels? More specific, could the Olympics in London have held the pair this high even while the monetary base ratio between the UK and the US has collapsed to 0.80? Or, was the market so forward-looking that it priced in a full blown QE by the US that will reverse the monetary base ratio back to normalized levels?
   

If the USD/JPY is moving on supply more than demand, as can be said over the past year, and GBP/USD is not moving on supply whatsoever, than that would imply that the GBP/USD has a massive bid under the pair.

The next logical question then would be:

 

1. Assuming supply = monetary base then what components of the monetary base affect currency devaluation the most? I would assume the physical creation of notes and coins would do so, but there appears to be no "truthful" data on this.

I bring this point up because if one looks at the Swiss franc, the SNB has their monetary base driven up foreign exchange positions and the BoE has theirs in reserve balances, while the BoJ has most of its monetary base in notes and coins in circulation. That being said, the previous question would then be false right?



There are many factors that move a currency pair and this is only one variable, I understand that, however it is a variable to which I believe in a growth slowdown environment where monetary bases are not on their typical steady trend higher but rather going parabolic as Central Banks try to stave off deflation and spark economic growth, this variable has very high importance.


For hedge funds, a larger player in the FX world, the carry trade is almost nothing relative to 5 or 6 years ago, where they have to reach out to the AUD against USD, JPY, or CHF and yield very little. In short, it's becoming a very dangerous trade. This is how I would look at demand for a currency for the meantime, along with GDP per capita growth, unless we can define demand more substantially.


And on a final note, I have noticed recently that my broker is paying me above market rates in some cases to sell USD against other currencies or if buying the USD, is charging me above market rates for the carry. This tends to occur as they profit from the market rate to their rate and its differential however the spreads (interest rate spreads) between my broker and the market are widening out to points which I cannot remember them being this wide in the past two years. And it's all centered around the US dollar as the cross currencies seem to be the same as before.



The question: do you think my broker is experiencing some type of dollar shortage, is their a dollar shortage, or are they just trying to increase their business in this lower trading environment? And please answer if you actually have a good idea to why this is happening with some facts. By the way, I won't disclose my broker so please do not ask, but I do need to move.



Sorry for the length again. Looking to hear what some of you other fundamental traders have for thoughts on this plus other idea's.

I wanted to make follow up with my comment about which components of the monetary base effect the exchange rate the most (if at all). I asked the question would the physical creation of money devalue the currency the most, however I do not have evidence of this and in further thinking, because the creation of money is a one time event (while I can create much more of it, I cannot splice a $1 bill multiple ways), reserve balances would be the logical answer considering you can create more than $1 from $1 because of the money multiplier effect, correct?

However, this does not explain the non-correlation between the GBP/USD exchange rate and the pairs monetary base ratio, unless the belief is that the reserve balances will generate more money via bank money which can be used for loans, which helps improve economic activity, so forth and so on.

Thoughts?

If we look at what each citizen of a particular country is "responsible" for, we find quite a variance between the US, Japan, the UK, and Switzerland.

By simply taking the number of US citizens and dividing it by the country's total GDP, we find that each citizen is responsible for $48,441. If we do the same for the monetary base of the US (the supply of money), it equates to $8,340. And if we do the same for federal government debt, we find each citizens responsible for $49,894. Here are the comparisons for the other country's listed above:



And if we set GDP to $100, it looks as follows:




I look at this in three ways:

 

1. Since GDP is the easiest data point to measure total economic output, we can determine on a per citizen basis which country is more productive (theoretically).
2. A measure of the monetary base per citizen gets us an idea of the monetary policy, situation, and balance in the country. Too much of a monetary base per citizen and the threat of hyperinflation (or some form of faster-than-expected inflation) could be real. Too little of a monetary base and the threat of deflation can arise in times where liquidity is highly sought after.
3. The federal debt per citizen gives us an idea on what the fiscal policy of the country is.

In looking at all three, we can get a very easy view on policy. I relate GDP to the business and private sector side of the equation, while I look at monetary base as a reflection of monetary policy in the country and the federal debt as the government's fiscal policies. When you look at it on a per citizen basis, adjusted in US dollars, the picture becomes clear. Of course there is more research into each one of the three that must be done, but for the sake of simplicity, I think these three indicators tell you what you need to know about the structural nature of the currency in each country.


Every country appears to have a debt problem, with Japan, the US, and the UK well ahead of Switzerland. Switzerland also appears to be much more productive on a per citizen basis than the other three countries. From a monetary standpoint, the UK and Switzerland are both in interesting spots however the makeup of the monetary base is different between the two countries, which could factor into how inflation occurs, if at all.


On balance, the UK seems to be in the worst situation just looking at these three metrics. Low GDP per citizen, high levels of federal debt (85) per GDP, and a rapidly rising monetary base. Also, if I am understanding this correctly, because their monetary base is primarily in their reserve balances section of the base, the money multiplier is going to expand upon just $1 (or 1 GBP) into many, many more units of currency, versus let's say JPY in which their largest portion of their monetary base is in physical notes and coins (about 66% of their monetary base).


Any thoughts, suggestions, comments, or critiques?

I'd like to point out something out of the box.

 

1. The world is ripe with corruption (let's not debate this statement).

1. The US debt publicized by the media is false. The US debt vs US GDP is actually way higher than what you have shown in your graph. The actual US debt is around 3-5x or more than its GDP.

1. Japan's culture has its integrity (to somewhat some degree compared to the US) which actually represents its Debt vs GDP to a slightly more accurate representation. Nevertheless, it is still not the real figure.

1. Despite what Economists say (and represented by the media)... they are paid to say what they need to say.

1. Ladies and Gents, transparency is not that transparent... And it was designed that way.

At the end of the day, anyone can label these statements as conspiracies. Just remember... whether you label these as conspiracies or not, will determine your actions, your decisions, on how to approach and go about your business.

Documentary: Inside Job

Thanks for your thoughts and I do not believe they are conspiracy's as I am in most of the same camp you are (it seems).

Yes, off balance sheet liabilities and future liabilities are a threat to the stability of not only the currency, but the societal structure of a country.

When shocks come to market, then the currency and all other financial assets will take in that news and adjustments will be made. The question is, what does or has the market priced in and what it has not? For currencies, I do not think they are as far reaching out to the future like equities are, but that is debatable. This is why I posted the data about the GBP monetary base relative to the JPY or USD. Maybe this is a non-factor, this I do not know, or to your point, maybe there is something occurring that the public has no clue of. Many "what if's" if you will.

In thinking about real demand for a currency and trying to find the best sets of metrics to measure real demand, I believe the best two are foreign investment and the velocity of money.

Unlike technical analysis, in which we can picture a shorter-term demand on a chart, for fundamental purposes, or for a much longer-term outlook, foreign investment would/could indicate how much the currency is in a real demand state. I say this because foreign investment into a country requires the foreign investor to exchange "their" currency for the country's currency they wish to invest in, e.g. a US companies expanding their operations into Brazil could be considered bullish for the Brazilian real.

Velocity of money would be another metric that I would think we be a good indicator to determine the demand of a currency. As the velocity of money falls, a simplistic thought process would say that money "hoarding" is occurring and less spending (turnover of money) is present. However, when the velocity is high, the demand for the currency would be lower as people are buying goods, services, assets, etc. rather than holding onto the currency.

With the velocity of money, I would think supply of a currency would also be a major factor in terms of how much the velocity actually affects (if at all) the value of the currency. If a central bank is in a expansionary mode of the supply of money, then even if the velocity of money is slowing (relatively speaking), if the supply outweighs the "hoarding" of cash, the currency in question would be devalued.

Prices of goods and services would also be a major determinate as well. In general, I would believe if the VoM drops while the supply rises and inflation is increasing, with the cost of general goods and services rising, that trying to find a balance of the value of the currency may be hard. We see that now in the US where the Velocity of M2 is at an all time low along with near all time low interest rates, however the monetary base in the US has increased dramatically since 2008 and inflation is present, specifically in non-discretionary goods like food and energy.

Factors like higher interest rates would also spark a higher demand in a currency as we know, but I do not think this is, on a longer term, a major factor. This is because the central bank is increasing rates as a reactionary measure to rising inflationary pressures. In a short to medium term outlook, this would be a better metric for determining demand in a currency.

This is all me thinking out loud. Maybe I am wrong in my thinking or I am misunderstanding. If so, let me know (any economic buffs out there).

In terms of trading opportunities, there are a few positions I have on now. As I type, I am closing out my long USD/JPY I had on since the beginning of last week for a profit of 3% of my account value. The reason for this is that is hit my target, not from a technical perspective but from a fundamental standpoint.

This short-term trade was based off 13 months worth of data averaging from a supply side of the currency. For supply, I am focused on the monetary base of both currencies and how it has grown (contracted) relative to its exchange rate.

At the end of September, for USD/JPY, my target price was 78.72, which was 78 pips higher from its closing price. The target was reached today and was sufficient for a close for the mean time. Here is a simplistic view (graph) of the model I use. It won't tell you too much (for obvious reasons), but it shows a widening out in the exchange rate month-over-month compared to the monetary base ratio month-over-month:




Looking at both CHF and GBP, both currencies are away from their targets. USD/CHF has a target of 0.9663 while the GBPUSD has more room to move with a target of 1.5352. Attached are the model for both:






Again, I am only factoring in supply to these targets and not focusing on demand. I am not saying I am not paying attention to real demand (FDI, Velocity of Money, and Trade Balance as the largest 3), but I am of the belief that in a slow to no growth environment, minus any financial collapses, the demand for one currency over the other is less of a factor to the exchange rate than the real supply and the supply growth of a currency. For supply, the primary factor is the monetary base, as it leads to bank money or credit money which grows other money supply metrics due to the money multiplier.

I dont see a fundamental reason to close a Uj long at this time. Data out of US has been NOT bad in past 2-3 weeks, 2yr US bonds are trending higher and Japan is to announce more easing measures next week.

Maybe your view is on a very longer term and you do your analysis very deep but to me uj seems bullish from the both sides of the coin for next few weeks.
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great thread, keep it up.

I will be contributing here soon.

don't give up on your thread.

how do you think money flow will be affected as rates begin to rise?

This is my first post! And I have been looking for a thread like this for a very long time! Fundamentals are key to trading success and it cannot and should not be ignored. I dont have the fundamental skills like you to contribute to this thread but I hope to learn from you though.

If I post few questions regarding fundamentals do you mind answering them for me please?