High-yielding notes a good buy?

I read with interest an entire page of Sunday Times, invest on 4th May 2008, dedicated to foreign currency investment:

1. Is it time to buy into foreign currencies?
2. How to profit from the forex market
3. Which high-yielding notes are a good buy?

Forex Fundamentals

While tonnes of books are dedicated to deal with the topic in detail (similarly to the topic of investment), I'm more interested in seeing it from a practical, non-academic layman point of view.

It seems to me that the strength of a currency boils down to 2 factors:

1. Demand (and supply)
   
2. Confidence
   

1. Demand (and supply)

It follows from simple logic that demand pushes the price of any item highly sort after, while too much of it will drive prices down. The same holds true for currency. To drive up the demand, a central bank rate for the relevant currency can pay a high yielding interest (e.g Australian or New Zeland Dollars) or the currency can be a common currency used for most market transaction (e.g USD).

To drive it down, the market can simply be flooded with tonnes of the cash, i.e. the country can just keep printing money.

2. Confidence

Confidence here does not refers to blind faith about any accurency. I'm referring to the confidence in an economy. The stronger the economy, the stronger or more stable its currency. Strength about any economy can be estimated or projected from the leading economic indicators such as GDP, GDP growth, trade balance, current account balance, productivity etc.

Forex Investment Vehicles

Given my limited knowledge in forex, the only vehicle that make sense to me is foreign fixed-deposit. If I want to bet currency X will appreciate vs Singapore Dollars, all I need is to open a fixed deposit account for currency X with any bank that offers one. My returns will be the capital appreciation (or depreciation) plus interest. Trading cost is negligible too.

High yielding notes are a good buy?

Fundamental investment logic states that returns must be proportional to the risk involved. Let's see whether it applies here.

On the table (taken from link 3 above):

Australian dollars:
Interest Rate = 6.74%

New Zealand dollars:
Interest Rate = 7.75%

Wow, these are few times risk free CPF rates! If these currencies don't appreciate, the interest rate is already very attractive! However, the concern is whether they will actually depreciate?!

Under the table:

Recall that the strength of a currency is a function of demand and confidence, i.e.:

strength = f ( demand, confidence)


Demand?

High interest rate can at least sustain demand, else how does United States continue to sell its bond for so long until China and Japan got stuck with overwhelming USD foreign reserves.

Confidence?

How about the economic numbers for Australia and New Zealand? The following data is obtained from the wikipedia:

Australia:
GDP: 908.826B
Account account balance: -50,960B
As a % of GDP: 5.6%
GDP growth: 4% (2007 est)

New Zealand:
GDP: 128.141B
Account account balance: -9.973B
As a % of GDP: -7.78%
GDP growth: 3% (2007 est)

Comparing with US:
GDP: 13,843.825B
Account account balance: -747.100B
As a % of GDP: -5.39%
GDP growth: 2.2% (2007 est)

In terms of % of GDP, both Australia and New Zealand ran a current account deficit even larger than US! Unless they can continue to maintain their GDP growth rate, any slow down will just widen the deficit, cutting rates will just be a matter of time. The resultant rate cut will then result in a currency devaluation, similar to USD depreciation when FED cut interest rate from 5.25% to 2% within a short time.

Thus the risk with high yielding notes are the 'hidden' potential for currency devaluation. However, most fixed deposits are short term, 1 mth or 3mth. So depositors are implicitly betting against devaluation within these periods. Yet again, how many of such depositors think about current account deficit or other economic indicators when they put money into foreign fixed deposits?

USD, out of the woods yet?

In an earlier article, I wrote about boom bust theory and value investing. In short, market perception (or reaction) always lags fundamental changes. For USD vs SGD, I believe
the fundamentals have change, but the market is still one step behind.

Common market perception is the believe that USD will continue to depreciate against SGD. The main supporting factors are:

1. The continued SGD strengthening policy of Monetary Authority of Singapore, MAS to fight inflation
2. The continued rate cutting by FED in US to avoid a recession

I believe otherwise, i.e. while short term volatility or even slight depreciation in USD is possible, downside is very well limited while appreciation is pretty much in the pipeline.

1. MAS's SGD strengthening policy

Singapore's economy is obviously better diversified (away from electronics) now compared to a few years ago when we were badly hit during SARS crisis, Asian financial crisis etc. While MAS is trying to fight inflation by allowing SGD to float higher against a basket of currencies, the higher SGD float up, the less room they have for maneuver. The sole reason is we are still a export oriented and services driven economy. There's a financial limit to breach before it start to hurt foreign investment and our competitiveness.

As for current inflation, I do not believe it will last very long. Overheated inflation can persist as long as the economy powers on at breakneck pace, e.g. China, Russia, Middle Eastern countries and other fast emerging economies. Inflation coupled with recessive factors just dampen demand eventually. Inflation should wane. If so, there is less incentive for MAS to continue to boost SGD.

2. Continued Rate Cutting by FED

To avoid a recession, FED rapidly cut short term interbank lending interest rates from a high of 5.25% in mid 2006 to the present 2%. However, the rapid rate cut resulted in a rapid devaluation of USD ever since. This seemingly resulted (controversially) in an escalation of commodity prices (mostly traded in USD), especially oil. The latter also resulted in a spike in food commodities because transportation cost went up.

Traditionally, FED used interest rates to control liquidity of USD in the market, thereby controlling inflation or spur the economy, depending on circumstances. However, current 'recession' (greatly anticipated, greatly discussed, but not seen... yet) is spurred by a liquidity crisis. The massive write-offs by so many major banks in US and Europe that arose from the defaults in sub-prime mortages in US almost render the cutting rates useless. Nobody seems to be willing to lend anymore.

Hence, it seems to me that FED can no longer use short term interest rate to control the current financial crisis, it had to look for something else. It is not to their best interest to see the USD depreciates against major currencies any further. I came across a few articles suggesting the same. Further rate cutting could just devalue the USD further and spur the commodities, especially oil price to shoot through the roof.

What other measures they could try I do not know. But I do believe that USD vs SGD will just make a U-turn from here. The question is how long the trough of the 'U' is, this I had no answer.

How would a stronger USD affect my portfolio?

An appriecation in USD will have a bigger impact on 2 companies in my portfolio, namely First Ship Least Trust and Multi-Chem.


First Ship Lease Trust

Their revenue streams are in USD and hence their quarterly payout is in USD, converting to SGD. Thus my dividend would see an appreciation in quarters to come.

Multi-Chem

I already wrote in another article that because USD make up a substantial portion in Multi-Chem's debt and payables, Multi-Chem's debt used to be 'shrinking', resulting in a huge forex gain. This gain will be slowly eroded away. Anyway, its a bonus to have forex gain, not a business critical earnings component.

Conclusion

One has to be careful of the hidden risk in investing in 'low risk' foreign fixed deposits.When the yield is high, the alarm bell should ring and careful analysis should be be done. There's no free lunch.