Escaping The Next Data Point…
May 16, 2010
May 22, 2010

My Currency Epiphany

I’m in Gundagai New South Wales at a charming café having buttered toast with canned spaghetti on top. I’m told it’s an Aussie delicacy. I’ve driven nearly 500 km from Sydney and have already had my first epiphany. It is said that generals always prepare to fight the last war. This cannot be truer when it comes to investing.

For decades, currencies have fluctuated in multi-year cycles. Once a currency begins to appreciate, that trend usually continues for years—before it reverses. Over time, most currencies do very little. Look at a multi-decade chart of most major currencies. It is a giant sine curve. Some currencies have an overlying trend to them. The Yen has slowly appreciated for years.  Our dollar has slowly devalued. However, the underlying trend is barely noticeable compared to the shorter term swings.  It is those swings that we all try to capture.

25 Year Chart Of The Dollar Index On Top Of A 25 Year Chart Of The British Pound

Over the years, I have made a good deal of money on these multi-year swings. In the shortest time frames, the direction of a currency is very closely tied to the direction of its interest rates. I’m not about to risk a few percent on a currency move to make a quarter of a percent more in interest rates. I want to capture those bigger moves.  I want to play the sine curve. Currency traders like to point to lots of statistics when analyzing a currency. Current account deficits, fiscal deficits, the price of a key commodity, these all matter. However, over the years, I’ve found the most reliable metric to simply be the cost of living in a country.

Devise a mental matrix based on what you think things should cost. This is naturally subjective. A nice dinner in London should cost more than in Reykjavík, Iceland. A sandwich in Sydney, Australia should cost more than one in Lima, Peru. A condo in New Orleans should cost more than one in Merida, Mexico. I don’t know why I believe that—but I intuitively believe that should be the case. These relative values should be static. Base your matrix upon the wealth of a nation, the size of the city and the hidden factors like the cachet of a place. This is a very subjective method—but you likely understand what I mean.

Over time, market forces should normalize these prices so that things cost what you would think they should in relation to other places. However, from time to time, prices in a country seem horribly out of synch. That’s called opportunity. I travel a lot. I notice these trends all the time. They almost always correct. It’s almost embarrassing to say it, but over the years, I’ve made millions of dollars buying and selling currencies based on little more than the relative price of a few beers and a plate of nachos.

Why does this happen? Look at the Euro. For years now, Europe has been expensive. It’s been horribly expensive. Is it any surprise that the currency is now dropping? Sure, the proximate cause is a debt crisis in Greece. However, the expensive currency likely had a lot to do with the deficits that Greece has run. Tourism has been weak and that’s because of the strong Euro.  As the Euro gets cheaper, people are more willing to visit, tax revenue increases and the deficits decrease. It’s self correcting, with giant lags at times. Where will the Euro drop to? Let’s just say that it’s not cheap yet in Europe. I’m not trying to buy it when it’s fairly valued. I’m trying to buy it when it’s cheap compared to other currencies. I don’t know if it will ever get there. I may never own Euros. That’s fine with me.

At the same time, you do not want to have a washout. The Mexican Peso has been cheap for years. Mexico is cheap to live in. I like it there. However, they do not respect their currency. Every so often, there’s a currency crisis and you get hurt bad. The currency is cheap almost in anticipation of that. So look for cheap currencies, but look only amongst those that will respect you as an investor. That leaves you with about two dozen currencies that are safe enough to own. That’s plenty of options.

20 Year Mexican Peso Chart. MXN has always been cheap for a reason

Picking up a bit of extra yield sure is attractive, but you should be buying cheap currencies, not the ones that pay the best. Look at the Icelandic Krona. For years, Iceland had interest rates in the mid-teens. It was seductive—until the music stopped and those holding the currency lost a third. If the investors had been there, they would have known it was expensive. I was there in the spring of 2009, AFTER the crisis. It was unfathomably expensive. It made London appear cheap. The Krona has a long way to drop from here.

Remember, currencies are not like stocks. There are no earnings or catalysts that force the currencies to do anything. You aren’t looking to make spectacular profits either. I don’t use leverage. I barely even think of it like I’m investing in currencies. Rather, I am merely changing the percentage of the various currencies that I denominate my fund’s equity in. I want it to always be in the cheapest currencies and always in a few of them for diversity’s sake. If I can add 5% a year by swapping amongst the cheapest currencies, I’m a happy hedgie.

For a decade, these have been my rules. They have worked well for me. For the last five years, I’ve mainly owned Australian (AUD) and Canadian Dollars (CAD). I was even short some British Pounds (it’s so expensive in London). I sold some of my AUD and CAD in early 2008 as they were getting very expensive on a living standards basis. The US dollar seemed cheapest, and I owned that (hesitantly). By early 2009, I was again a big owner of Canadian, Aussie after they collapsed. I also picked up some New Zealand Dollars (NZD) for the first time around 51c. A few months back, I sold some of my non US Dollar (USD) currencies as they again got expensive. I have owned quite a bit of USD for the past few months. Look at the charts. I am not saying I nailed the tops or bottoms (I didn’t), but I bought as they got cheap, sold as they got expensive and picked up some nice currency appreciation along the way.

5 Year Australian Dollar Chart On Top Of A 5 Year Canadian Dollar Chart

As I travel around Australia, I realize just how expensive it really is. The lady serving me my spaghetti sandwich says that she’s heading to the US next month to buy stuff. She says that even after spending on airfare and hotel, she will still save money when it comes to electronics and luxury goods. That’s how these processes correct themselves. I now own the most Dollars that I have owned in over a year. Normally, I would be copacetic. The USD is cheap. I always want to own the cheapest currency. Except, I’ve had this epiphany over toast and spaghetti. The rules of currencies are in flux. I need to adjust my rules in tandem.

For a long time, you bought the cheapest one and didn’t think much of it. Sure, often the currency was cheap for a reason. But it was rarely a serious problem. Maybe there was an election, or it was a bad balance of trade, or some politician mouthing off about something he didn’t understand. Sometimes, a currency was just out of vogue for whatever reason. Usually a cheap currency helped local businesses and was responsible for slowly alleviating whatever problem was supposed to exist. Now I think the rules are different. You buy a currency that will exist in a few years. You no longer buy the cheapest—just the sturdiest. There are too many fiscal problems in the world. I do not want to have a currency that will collapse in the next decade.

This is very problematic for me. It’s dangerous to throw out rules that have been so lucrative and there are rarely new paradigms. However, I grudgingly am coming around to accepting facts. I have known this for some time actually. It’s the reason why I have continued to own AUD and CAD even as they got expensive. Australia and Canada have problems. They have deficits and unfunded liabilities, but they are in much better shape than most countries. Maybe I need to be a bit more forgiving—I also need to look further abroad. Only in Asia are currencies both cheap in terms of living costs AND not likely to depreciate too badly over the next few years.

Besides, the Japanese Yen, I have never owned any of these currencies. I have always felt that they were too tied to the USD. Some of them are directly pegged to the Dollar actually. However, I don’t think the local elites will allow their net worth to disappear just because the US wants to print itself out of liabilities. It is time that I learn more about Asian currencies. I need to travel there and get a feel for the financial culture.

Right now the USD is appreciating. It will likely appreciate a bit further. However, I will need to choose something to swap into soon. The USD is no longer a store of value—neither is the Euro. These two will be depreciating for years to come. I don’t know what I want to own—but I want one that will survive—not just be cheap. The USD has become the New Peso. It reminds me of the time in Peru when I got change and the coins had Nuevo Sol printed on them. So I asked what happened to El Viejo Sol? No one wanted to talk about it.

Categories: Investment Strategy
Positions Mentioned: none

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