by Jim Rickards, Daily Reckoning:
One of the crucial insights in currency trading that many investors fail to grasp is that currencies don’t go to zero, and they don’t go through the roof. That’s a generalization, but an important one. Here are the qualifications:
This observation applies to major currencies only — not to currencies of corrupt or incompetent countries like Venezuela or Zimbabwe. Those currencies do go to zero through hyperinflation.
The observation also applies only in the short-to-intermediate run. In the long run, all fiat currencies also go to zero.
Yet over a multiyear horizon, major currencies such as the dollar (USD), euro (EUR), yen (JPY), sterling (GBP) and the Swiss franc (CHF) retain value and do not go to extremes. Instead, they trade in ranges against each other. That’s the key to successful foreign exchange trading. Trading profits are the result of catching the turning points.
Your correspondent in Zurich, Switzerland, during a recent visit. In analyzing the complex dynamics of foreign exchange markets, it is essential to visit the countries whose currencies are being studied. Foreign visits offer the opportunity to meet with government officials, bankers, business executives and everyday citizens of the affected countries to gain insights that are not available through digital and media sources.
Stocks can go to zero when a company goes bankrupt. Enron, WorldCom and a host of dot-com stocks in the early 2000s are all good examples. Bonds can go to zero when a borrower defaults. That happened to Lehman Bros. and Bear Stearns.
But major currencies do not go to zero. They move back and forth against each other like two kids on a seesaw moving up and down and not going anywhere in relation to the seesaw.
The EUR/USD cross-rate is a good example. In the past 20 years, the value of the euro has been as low as $0.80 and as high as $1.60. There have been seven separate instances of moves of 20% or more in EUR/USD in that time period. But EUR/USD never goes to zero or to $100. The exchange rate stays in the range.
Turning points in foreign exchange rates are driven by a combination of central bank interventions, interest rate policies and capital flows. The old theories about “purchasing power parity” and trade deficits are obsolete.
Foreign exchange trading today is all about capital flows driven by policy intervention, sentiment and interest rate differentials.
Another good example is the Swiss franc (CHF). If you look at its exchange rate with the dollar, an exchange rate of 0.80 francs per dollar indicates a strong franc. An exchange rate of 1.05 francs per dollar indicates a weak franc. Right now the exchange rate is 0.97, which leans towards a weak franc relative to the dollar.
CHF has traded in a range of 0.87–1.03 for the past six years. One move that stands out is the spike on Jan. 15, 2015, when CHF surged from 1.02 to 0.86, a nearly 20% move in a matter of hours. CHF then backed off that high of 0.86 and declined to its more recent trading range of 0.91–1.03.
The spike on Jan. 15, 2015, was caused entirely by the decision of the Swiss National Bank (SNB) to remove a cap on the Swiss franc relative to the euro intended to protect Swiss exports.
The Swiss economy is heavily dependent on exports of precision equipment, luxury goods such as Swiss watches and food including cheeses and chocolates. The Swiss economy also depends on tourism, which is akin to a service export sold to foreigners. All of these exports suffer when the Swiss franc is too strong.
The SNB has been enforcing the cap by printing francs and buying euros to put downward pressure on the franc. The problem with this policy is that the world wants francs as a safe haven.
That was especially true during the European sovereign debt crisis of 2010–2015. The SNB balance sheet was becoming top-heavy with European debt purchased with printed francs at a time when the European debt itself was in distress.
Eventually, SNB threw in the towel and allowed market forces to determine the value of CHF. This produced an immediate spike in CHF against the euro and the dollar, which has since moderated into a trading range.
But the franc is currently at the 1.09 level versus the euro, on expectations of monetary easing in both the euro zone and the United States have set in.