Sunday, May 19, 2013

The Fundamentals Behind Currency Strength & Weakness

The thought process that I move through when deciding when to purchase an asset is a relatively simple one. I spend time deciding on a "shopping list" within a specific asset class that I feel is attractive. The second part of the process is easy: wait for an asset on the shopping list to go on sale and sentiment to become low, then accumulate.

For this discussion, we are going to talk about currencies, or options for where/how to hold cash. There are three major components that I use to determine whether I believe a currency is a long term, fundamentally strong buy:

1. The current price and sentiment of the currency on the open exchange
2. The government debt to GDP within that country
3. Interest rates within that country

There are numerous other factors involved, but these three will provide us with a foundation for the scope of the discussion. Based on the insane nature of the currency wars taking place around the world, if you only use these three benchmarks to make your decision you will do better than almost all other investors in the long term.

We'll begin first with the currencies that are currently on my personal shopping list. I would suggest you do your own research to develop your own:

1. Canadian Dollar
2. Australian Dollar
3. New Zealand Dollar
4. South African Rand
5. Swedish Krona
6. Norwegian Krona
7. Malaysian Ringgit
8. Mexican Peso

After discussing the big three characteristics above for these 8 currencies, we will move on to the group of currencies I believe are fundamentally weak:

1. U.S. Dollar
2. Euro
3. British Pound
4. Japanese Yen

Over the next decade, I believe money will be moving from developed (bankrupt) to developing (healthy balance sheet) countries. This will not occur in a straight line process due to the fact that markets tend to act irrational for long periods then make major shifts to re-adjust. 

I like the eight currencies discussed above. I also like others. Do I recommend that someone move 100% of their cash position into those currencies today? NO! Again, this is just my shopping list, not the only currencies I own. Many of these currencies have performed well since they bottomed in 2009. This makes them less attractive at the moment. Others have not, making them stronger buys. We'll discuss the price movements for all of them.

I think the majority of a cash position today should be held in "safe cash," or pre-crisis cash, which I have discussed numerous times over the past few years. This represents ultra-short U.S. treasury T-bills. Why? The U.S. dollar, for all its flaws, is still the world's reserve currency and if there is a liquidation moment in markets there will be a scramble for liquid U.S. dollars.

This is the moment you can trade in your fundamentally flawed U.S. dollars for the items on your shopping list that are (hopefully) selling at a discount. 

I think we have one more "great" liquidation in front of us before you can feel comfortable moving 100% of your portfolio out of U.S. dollars. In the meantime the process is easy. You make your shopping list and raise safe cash. Then all you have to do is wait for the sale light to go on. We'll now review the markets discussed above and you can decide if they represent attractive assets for your personal list.

Up Next: The Canadian Dollar

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