Global Interest Rates and Foreign Currencies

Almost every month, there are news of some central banks in some corner of the earth slashing their interest rates to fight the ongoing credit and financial crisis. These came along with aggressively generous economic stimulus packages by various governments, drawn from reserves or borrowed from future generations. Theoretically, the potential amount of money flooding the market is sufficient to create a tsunami, devaluing their currencies and loosening credit. But I see no sign of any minute rise in tide across the horizon.

Global Interest Rate Trend


The above chart shows the Interest Rates of some key central banks. The aggressive slashing of the interest rates can be seen quite clearly and if extrapolating the trend make any sense, all are headings towards 0%, following the lead of Bank of Japan (BOJ) and US Federal Reserve (FED).

Signs of bottoming?

It seems to me that various currencies (against SGD) have more or less bottom out not because things had gotten better. Some governments are still borrowing, some are still printing money quite aggressively. But because most of what can be done are already done. Doing more actually does not have much impact now (other than potentially creating new bubbles for the future). What's left to do really, is to let the market consolidate, weed out the excesses and patiently wait for the dust to settle, i.e. clear the debris and start afresh.

Potential Actions

Without taking into account whether MAS will change its stance on SGD policy in the next deliberation in April, I am considering the number of options I had to take advantage of bottoming currencies.

Foreign Currency Fixed Deposits

A check on UOB foreign currency fixed deposit rates show some expectedly disappointing rates (mirroring the recent aggressive rates cuts above). USD, for example, had no interest on 3 months fixed deposits and NZD only offer 1.83%, a far cry from a year ago. Thus, unless my intention is capital preservation, these fixed deposits are still not appealing at all.

Equities quoted in foreign currencies

A check with SGX shows up a list of equities trading in foregin currencies, e.g. USD, HKD and AUD. Most of these equities are quoted in USD, a number in HKD and AUD. HKD is still pegged to USD and the equities quoted in AUD are mostly (unappealing to me) property developers. Thus what remained interesting are those quoted in USD.

A few interesting ones are Chemoil Energy Limited, Lyxor Commodity CRB Fund and Pacific Shipping Trust. Chemoil Energy is an integrated supplier of marine fuel products. It is currently trading slightly below book value and about 5.2 times rolling P/E. It could bounce back when the marine sector recovers. However, at about 4.3 times debt-to-equity ratio, it remains to be seen whether it can survive the ongoing credit crunch.

Lyxor Commodity CRB Fund tracks a basket of future contract on commodities, especially energy, metals and agricultural products. Assuming demand on commodities will eventually recover, there should be sufficient upside if one is willing to take a long term view on this.

The most interesting one is none other than Pacific Shipping Trust. Without any short term refinancing risk and no asset-to-loan covenant to worry about, Pacific Shipping Trust should be able to ride out the current storm quite comfortably. Perhaps the only treat to its dividend distribution is one or more of its charterers going bust. Its relatively high dividend payout per quarter of about 0.9 cents USD (about 24% yield) should be quite sustainable despite having to pay off an amortizing loan due to its long term leases.


Conclusion

Most major economic power houses in the developed west are in recession and the export-oriented emerging economies are beginning to struggle despite building up massive reserves after the Asia Financial Crisis. The aggressive interest rate cut by so many central banks almost all at the same time and seemingly racing toward zero simply meant a collective weakening of their currencies. But currencies are relative in nature. Thus, I believe their value vs SGD have neared or reach a bottom. Other than riding on severely battered equities for the huge potential upside when the business cycle eventually recovers along with the general economy, why not give it a an additional boost of forex leverage.

Singapore Dollar to weaken against the US dollar?

I read with interest the recent prediction by Morgan Stanley that Singapore Dollars will depreciate against the US dollar to $1.80 by next year. I decided to explore this prediction further, fundamentally.

Monetary Authority of Singapore Policy (MAS) on Singapore Dollar (SGD)

A check with policy statement of MAS's website shows that MAS manages SGD exchange rate. The following is quoted from the website:

... The objective of Singapore's exchange rate policy has always been to promote sustained and non-inflationary growth for the Singapore economy. Since 1981, monetary policy in Singapore has been centered on the management of the exchange rate. MAS manages the Singapore dollar against a basket of currencies of Singapore's main trading partners and competitors.

The trade-weighted exchange rate is allowed to fluctuate within a policy band, and where necessary, MAS conducts direct interventions in the foreign exchange market to maintain the exchange rate within this band. The exchange rate policy path and the band are regularly reviewed to ensure that they remain consistent with underlying economic conditions. ...

In order words, MAS manages SGD exchange rate directly and regularly review the strength of SGD against major trading partners for sustained non-inflationary economic growth for Singapore.

In fact, MAS reviews the exchange rate policy twice a year and publish them on its website.

Trade-weighted Exchange Rate

It is explicitly mentioned in the policy that the exchange rate is trade weighted. MAS neither reveal the exact currencies in its basket of currencies nor their weightage, thus I decided to compile a list of major trading partners of Singapore and estimate how the various currencies' will affect SGD.


A few points to note on compiling the above table:

1. Other than the interest rate which is current, the rest of the data are full year results for 2007.
2. Estimated trading volume are estimated by totaling import and export to these economies. These data are taken from Statistics Singapore.
   
3. Due to the difficulty (or rather, my laziness) in compiling data for the entire European Union (EU), I estimated EU's data with France and Germany, two large entities in EU that are somewhat representative.

Major Conclusions that can be drawn from the table above

1. Simplistic trade weighted equation?

In the simplest case:

SGD = 0.18 x MYR + 0.15 x RENMINBI + 0.145 x USD + ...

If SGD exchange rate is derived simplistically as above, SGD's strength (or weakness) against any single currency will just depend on that currency against all others in the basket. In other words, SGD should not fluctuate much against major currencies. If so, the recent USD devaluation is less about the strengthening of SGD, but more of a weakening of USD against all other currencies.

2. Strengths of currencies in the basket

Assuming most (if not all) of the currencies in the table are found in the basket and my simplistic trade weighted formula approximates the SGD exchange rate, then the strength (or weakness) of SGD will very much depend on how well these currencies perform.

While many factors affect the strength of a currency, important ones include economic growth, trade balance, current current balance, central bank rates etc. Prolonged current account deficit can be sustained so long as influx of capital continues, either due to high central bank interest rates (high yield attracts capital) or high demand of goods and services (including commodities).

Australia is a case in point. Its account balance is highly negative (even higher than United States in terms of percentage of GDP) but it has sustained so for a relatively long time due to its high interest rate and huge demand for its resources. With the onslaught of global financial crisis (sparking a cut in its interest rate) and ensuing drop in demand of its raw resources, Australian dollars plunge against major currencies.

Looking at the current central bank interest rate and their current account balance of these economies, those with huge account deficit, high interest rate or both are most prone to weaken. These include, United States, Australia and United Kingdom. Together, these accounted for 21.3% of 'my' estimated basket. If these were to weaken against the rest of the 78.7% of the basket, then it is more probable that SGD will strengthen against them.

Conclusion

Though being a major and important trading partner, Singapore don't just trade with United States alone. The basket of currencies is meant to price SGD to sustain Singapore's economic growth. Since US borrow in USD (selling US dominated bonds), they can and are already printing USD as much as they need, it will be quite surprising if USD does not depreciate against major currencies and consequenty against SGD. Unless MAS intervened (directly or indirectly with a policy change) for the sake of Singapore export oriented economy, it is more likely SGD will appreciate against USD.

Analyst's analysis --- to be taken with a tonne of salt?

I read with amusement the morning news about the effect of quitting of Japanese PM on NIKKEI, on Channel NewsAsia on 2nd September 2008:

0846 hrs: Japanese shares open lower after PM's resignation
0917 hrs: Japanese stocks turn higher after PM resigned

How do these analysts know the stocks went up or down due to his resignation? Apparently they didn't, reversing their views just around an hour. This brought me to recall what I heard when I attended the analyst briefing of Surface Mount Technology sometime this year when its CEO commented:

... there are two professions who does not need to take responsibility for what they say, one is the weather forecasters, the other is stock analysts...

As a whole, their hits and misses are seemingly so evenly distributed that it became common sense to take them with a huge tonne of salt. Thus it is rather surprising (at least to me) that people still believe them (else why ask them for opinion) and even more surprising why they are still employed and so highly paid.

Reasons behind salty analysis

I read somewhere, in one of the books on the left column (can't recall which) that it is human nature to attribute cause and effect, e.g. trying to find a pattern when there is none. It works pretty well during hunting, i.e. aiming and throwing a spear ahead of a speeding deer instead of directly at its body when one can almost predict (correctly) that it will run straight.

But it is altogether a different story making forecast in a stock market, especially on a short term basis. It's as good as trying to predict the next roulette spin. The reason is that the sheer number of participants and events affecting a short term outlook in the market make the next price movement almost a perfectly random event.

I do not believe these highly educated professionals, with their training and experience could not understand the fundamentals causes behind macroeconomic events unfolding before them. But many seemingly like to make straight line forecasts. If that is so easy, anybody can become an analyst.

Lastly, being an accredited analyst, market expect them to give an answer, a projection. They have to call a number (any number is better than no number). "oil will hit 400 usd per barrel" sounds much better than "I don't know, probably the oil price will be very volatile".

Layman's view

I do not need to call a number if I don't know and I am under no pressure to kid myself. So it is great to look back at my past comments to see how I fare in my own macroeconomic views.

SGD vs USD (and other foreign currencies)


When USD was fast depreciating in 2007 and most of 2008, many analysts are calling ever lower targets with each record high achieved by Sing dollar against the USD. The lowest target I recall is 1.32. Might as well say parity. But the fundamental events clearly pointed otherwise as I wrote the article on 10th May 2008:

10th May 2008: High-yielding notes a good buy?

In it, I pointed out the limitations on how far US can allow its currency to drop and how badly it will hurt Singapore if MAS continue to strengthen SGD endlessly. Ironically, after being so bullish before the August decline in Sing dollar, many analysts now forecast a steeper decline in Sing dollar. Given MAS's policy of using SGD as an inflation fighting tool and mounting US debt, I doubt there will be a clear trend in SGD vs USD. It will most probably be volatile exchange rates until the dust settle down in the next few years.

On a separate note, my post was actually targeted at the prevailing interest then to buy high yielding fixed foreign currency deposits but I cautioned against the risk involved. There must be a reason for the high interest attached, and it is definitely not risk free.

Since that post, New Zealand dollar, NZD had depreciated about 7% against SGD:

and Australian dollar, AUD by about 7.5%:

Thus offsetting the 'high' interest rate on these fixed deposits (about 6 to 7% then). I'm not the first to see these fundamental changes, I read them somewhere, so can these 'analysts'.

Oil prices --- aiming for the moon?


When crude oil crosses USD 140 a barrel in June this year, analyst again extrapolated crude oil to shoot for the moon. Supporters of peak oil (oil supply had peaked but growing demand will ensure rising prices without conservation or alternative sources) are right to point out that growing global demand (esp. due to rising demand from China and India) will drive up prices.

However the run up in prices are seemingly more of a speculative adventure then a shift in fundamentals. I wrote another article on this back then on the unsustainable crude rise:

1st June 2008: Oil bubble or trouble?

When it hit above 140 a barrel, some predicted a 200 a barrel by year end. Now, when crude collapse below 110, some predicted it to retreat back to 80. In the long run, I do not doubt crude demand will definitely outpace supply unless more economically exploitable fields are discovered or more serious adventure in alternative fuels takes off. The following figures put the key consumers in perspective:

Crude oil consumption per capita per year:

US: 68.81
China: 4.96
India: 2.18

GDP to Crude oil consumption ratio:

US: 1.65
China: 0.94
India: 0.86

Crude oil consumption in absolute terms (1,000 barrels per day):

US: 20.59
China: 7.27
India: 2.53

Crude oil consumption if China & India's consumption per capita matches US:

US: 20.59
China: 100.86
India: 79.86

Even if China & India become as efficient as US in terms of consumption per GDP:


US: 20.59
China: 12.76
India: 4.85

(But this assumes China and India's economy remains unchanged. At the rate they are growing, both economies will match, if not surpass, that of US within the next decade. Thus at the same efficiency, both consumption will exceed US by a significant margin)

However, in the short term, it is somewhat incredible for oil to double in just 2 years. Similar to SGD vs USD, going forward, crude oil price could just be as volatile in the near future before it settles down to a price dictated by fundamental supply and demand.

Conclusion

It is sometimes amusing to read analyst reports on stock valuations. Many like to use P/E ratios. It is a convenient tool because it allows practically any number to be called for a stock valuation. In a bull run, for a forward or historical earnings, just pluck a high P/E ratio and you get a huge target price. Conversely in a bear market, with the same earnings, pick a low P/E ratio and you get a much lower target price. It is as good as a doctor trying to diagnose you with a wheel of fortune.

It is no wonder they are so handsomely paid. Not because their job are difficult to do, but its difficult to keep because any Tom, Dick or Harry can become one. Fortunately I do not depend on analyst reports for my stock picks.

Disclaimer

I am not saying all analyst are not up to mark, but the significant number of black sheep amongst the good ones are indeed bringing a bad name to the collective lot. It is those that can and dare to give better quality comments and reports that will capture the trust and confidence of rational investors.

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.