No Flip-Flopping On Currencies

It took me a few days longer to do it than I had hoped, mainly due to technical difficulties with different computer programs, but now I am finally finished with the paper I mentioned a few days ago. That means I can finally resume blogging at a normal pace, or nearly normal pace.

The paper was about the phenomena known as carry trade. As I document with numbers in the paper, this strategy have over a longer period of time been a very profitable one for those who have pursued it. Although it has not always been profitable, and so is not a risk free strategy for someone with a short to medium term perspective, the fact remains that in defiance of the theory of uncovered interest parity, the expected value of such a strategy is positive and will be positive for people with a longer term perspective.

I explain this deviation from uncovered interest parity with a number of factors, most important of which are the fact that given the existence of differences in real interest rates and the mechanism supporting purchasing power parity in the goods markets, prevent the kind of massive initial real depreciation assumed by the uncovered interest parity theory from being fully realized. This theory is something which as far as I know, no one has thought of before, so it will be interesting to hear the feedback.

Anyway, returning to the finding that high interest rate currencies provide better value for investors, a question some might ask is that given that I have frequently expressed a bullish position on the low interest currencies yen and Swiss francs, does that mean that I in light of this finding will change my outlook? Actually, no. This is because first of all, this was a long-term phenomenon, and in a shorter term perspective, these currencies will likely gain from the stock market weakness I expect. Moreover, it should be noted what my bullish stance on these currencies meant and what it didn't mean. I never said that return from interest bearing securities in Switzerland and Japan would be higher. All I said they would rise. And as I also found in the paper, these two currencies have actually been the strongest over a longer term perspective and because of their lower inflation, they can be expected to remain stronger. However, because interest rates is so much lower in these countries compared to for example Australia and New Zealand, return might still be lower over a longer term, even though their currencies rise.

Finally, it should also be noted that the link between interest rates and exchange rate adjusted return was found to be stronger if you adjust interest rates for inflation than if you don't. And Swiss and Japanese interest rates aren't fully as bad as they seem in nominal terms if you adjust for inflation. By contrast, American interest rates are even worse in relative terms after you adjust for inflation, meaning that these findings give support for the bearish outlook on American securities and the U.S. dollar that I have long held.

So, in conclusion, I still think the Swiss franc and the yen will rise in both the short term and the long term. However, for someone who wants to invest in interest bearing securities, Australia and New Zealand looks most attractive, at least in the long term.