Crosscurrents

In these turbulent currency markets, a speculator could have made money by being simultaneously long the dollar and short the dollar. Does that sound strange? One of the more common misunderstandings about the foreign exchange market is that the dollar moves up or down in some sort of uniform pattern against all the other major currencies. Quite uniquely, on the contrary, it can move one way against one currency and another way against a different currency.

Case in point is the current pound/yen relationship. On Sept. 14, 1992, £1 was worth 235 yen; almost a 17% loss in value. Over the same period, the pound lost over 25 cents versus the dollar, so the dollar was strong, right? Wrong. In fact, the dollar/yen rate moved from above 125 yen per dollar to 120 per dollar in the same five-week period—a 4% loss in value.

The best strategy for capitalizing on this huge move would have been to ignore the dollar and simply sell pounds in exchange for yen. Many traders and investors are focusing increasingly on these nondollar or “cross-currency” relationships, which compose a growing proportion of daily global trading volumes.

What’s behind these cross-currency transactions? As with more traditional dollar flows, cross-currency transactions reflect the shifting of funds for either trade, investment, or speculative purposes. Looking at Japan as an example, one can easily discern a tremendous natural flow of money from Europe and the U.S. to Japan because of Japan’s swelling trade surplus. Japanese companies are yen-based, so they naturally translate (through foreign exchange transactions) their sales in currencies such as marks and dollars into yen. On the other hand, there are other currencies that reflect the Japanese investor’s appetite for global asset diversification.

Let’s focus for a moment on the translation of pounds into yen. This cross transaction creates a demand for yen (which must be bought) and a supply of sterling (which might be sold). The transaction is independent of any specific dollar impact. If there is sufficient nondollar-based demand for a currency, such as the yen, then at some point that demand will dominate an otherwise offsetting supply of that currency versus the dollar. All of these crosscurrents can be confusing at times, but that’s hardly surprising, since the currency market is where the global demand and supply for all currencies converge in a massive pool of commercial, investment, and speculative interests. These cross plays also provide wonderful trading opportunities once a specific currency relationship becomes obviously mispriced.

The recent strength of the yen versus the European currencies since September makes good sense from a variety of standpoints, and the European currencies should continue this weakening for some time. In particular, the recent surge in currency volatility caused a lot of Japanese investors to dump foreign securities and flee to the relative safety of domestic holdings. This repatriation process generated tremendous demand for the yen, which was further supported by the deteriorating economic conditions spreading through Europe as even Germany, the prior engine of very strong demand for the whole European economy, continues a seemingly inexorable march towards recession.

Germany’s economic picture is sufficiently bleak that it is only a matter of time before the Bundesbank’s priorities shift from anti-inflationary considerations to the implementation of pro-growth measures. This anticipated lowering of interest rates will be followed by the rest of Europe, with the exception of the U.K., which has already initiated an aggressive, simulative monetary policy.

This broad-based lowering of interest rates in Europe will contrast sharply with economic policies in Japan, which is very near the completion of its monetary easing cycle, and in fact has already shifted to fiscally expansive programs to boost its domestic economy. This fiscal expansion eventually will put upward pressure on Japanese interest rates. The net result of these policy shifts will be a gradual convergence of interest rates differentials (in favor of Japan), which will be very yen-supportive, as Japanese returns become relatively more attractive.

From a trade standpoint, the appreciation of the yen will be encouraged by the European authorities, since a stronger yen will make Japanese exports more expensive, thereby helping to redress the enormous Euro-Japanese trade imbalances.

To play this, I recommend buying one Philadelphia Stock Exchange March 73 deutsche mark/yen put at a price of 38 ticks, to capture an expected mark decline against the yen.

For those readers who followed the trade strategy of buying an Australian dollar put 23 ticks recommended in my Oct. 26 column, I suggest taking profits on one half of the position at the current price of 63 ticks.

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