Define market (in)efficiency: the Euro

Euro/USD prices: An anomalous move? Source: thinkorswim by TDAmeritrade

The Efficient Market Hypothesis is a well-known, well-respected theory.  It’s frequently cited by folks in the economic & financial space to justify very conventional, buy-and-hold investment products.  Particularly in the stronger forms of EMH, all publicly available information is immediately reflected in asset prices.

I’ve written before about the impact of ‘known unknowns’ versus ‘unknown unknowns’ in financial markets.  The recent crash in the Euro strikes me as an interesting case study:

• Why is the Euro crashing?  In a term, policy divergence.  The European Central Bank is providing quantitative easing to the Euro-area, which means (all other things equal) higher money supply and a cheaper currency.  In contrast, the Federal Reserve is gradually pulling back from their quantitative easing (i.e. letting their purchased bonds run-off), and thinking about raising interest rates this summer.  Both these actions should mean a stronger US Dollar.
• Why such a prolonged slide?  This is where I think the markets are interesting.  In an informationally-efficient world, I would have expected a big move at the onset of European QE, with not much happening thereafter (perhaps some oscillation around a new equilibrium level).  Instead, we’re being treated to a managed futures manager’s dream scenario: a fairly steady downward trend, without many pull-backs.
• Perhaps behaviour economics can answer?  An explanation could be found in the inefficiencies considered by behavioural economics.  Among the possibilities:
  • Discrete decision points: perhaps each business/investor considers the QE announcement at different intervals, and thus make moves in sequence.
  • Loss aversion/disposition effect: folks long Euros have been holding on, while losses pile up.  Over time, they accept their painful losses at different points based upon relative aversion.

In sum: efficient markets shouldn’t really show these kind of smooth trends.  But the trends exist all the same.  Hence it’s worthwhile considering momentum as a viable investment strategy.

A dire situation…or why it’s very fortunate to live in a reserve currency country

So Russia’s currency fell quite a bit yesterday, but today’s intervention by their finance ministry is stabilising things (so far, -ish) at around 70 RUB to the USD.  For those keeping track, that’s about a 50% devaluation since the beginning of the year.

Care for some RUB? Nyet. Source: Google Finance

OK, 50% seems like a crazy number.  What does it actually mean?  For most of us living in places like the US or UK, the idea of a currency depreciation doesn’t come naturally; unless we travel a bunch or have an export/import business on the side, FX rates aren’t an everyday concern.  But when your country imports 40% of food, for example, the situation isn’t pretty.  The lady quoted in the article is already paying 20% extra, a week into this depreciation.  People are worried what their salaries will buy.  This is sounding like the early stages of hyperinflation, where loss in the faith of a currency as a store of value can get bad, fast.

This is perhaps a concrete reminder of what gold bugs and Tea Partiers and such have been saying is the inevitable fallout from the Fed’s quantitative easing: namely, a dollar worth nothing.  They advocate buying real assets (such as gold, though I’ve already expressed my reservations there) to protect against a big dollar crash.

To be clear, however: the US and UK are very unlike Russia and other emerging countries.  The main difference, in this context, is having wide and deep financial markets denominated in domestic currency.  Let me explain:

• Who really has the power?  Lenders.  As much as we like to define power as military strength, in these days of relative peace the marginal power lay with the lenders.  Pretty much all governments rely on borrowed money to function; even the US government went through a completely idiotic own-goal by refusing to allow itself to borrow (NB: Tea Party, I blame you).
• What do lenders need?  Trust in borrower.  Remember that a lender’s best-case scenario is to receive back his principal + interest.  He can lose all of his principal.  In the case of US or UK, lenders are just fine receiving an IOU; they have faith they’ll be fully repaid.  With Russia and other emerging economies, lenders frequently require collateral; this frequently comes in the form of foreign exchange reserves, so lenders can seize ‘hard currency’ if needed.
• The key difference: domestic versus foreign currency borrowing.  Keep in mind that countries like the US and UK (and Russia) have fiat money, which means the USD and GBP (and RUB) are worth whatever the government and users say it’s worth.  Furthermore, all these governments have printing presses, allowing them to repay domestic currency debt with newly-printed money.  As a lender, then, the question becomes how likely you will be repaid with domestic currency worth anything.  If there’s doubt, the lender will only lend using (a more stable) foreign currency; for example, many emerging countries borrow in USD.  Once the borrower goes the route of foreign currency, the government has lost control of his debt burden; if his local currency devalues, it’s bad news bears.
• An interesting contrast, then.  Even with explicit repayment of government borrowings with newly-printed money (i.e. quantitative easing), the US and UK have rarely seen lower costs to borrow.  In contrast, Russia can’t get enough faith in their currency to keep the ruble alive: they need to intervene in foreign exchange markets to convince lenders that the ruble can and will stabilise in order to obtain debt financing for their government.  This is crucial, as with a low oil price Russia’s government has no hope of funding itself.  The US and UK have adopted almost the exact opposite (indeed, Switzerland adopted the exact opposite) approach: trying very hard to convince folks all the newly-printed money should cheapen their currencies, thereby stimulating demand.

In sum: the life of everyday Russians is getting worse and worse as their currency goes down the toilet.  Though the same problem could happen in the US or UK, in theory, the latter governments’ reliance on domestic-currency borrowings suggest nothing like the Russia situation in the foreseeable future.

A cold winter lies ahead for Russia

Anybody got a bid? Ruble versus USD. Source: thinkorswim by TDAmeritrade.

Remarkable move in the Ruble… Low of 78 to the USD today, which is about a 40% depreciation (is it fair to use the world ‘devaluation’ here?) in the past week.  The relevant quote from Bloomberg:

“Our traders are informing me that we see no bids to buy rubles,” Per Hammarlund, chief emerging-markets strategist at Skandinaviska Enskilda Banken AB, said by e-mail from Stockholm. “I thought 17 percent would give them at least a month of breathing space. We next have to look at the experience in 1998-1999. We are also one big step closer to capital controls.”

Yikes.  What impact will this have on the powers that be in Russia?? I presume most of the aristocracy are very much USD-liquid, so this crash in rubles will likely be a bigger problem for the masses.  Not good.