The Nucleus of the Forex Market: Trade and Capital Flows

Talking Points:

• The core of the foreign exchange market is trading and capital flow
  This article illustrates why trade and capital flows driven by spot foreign exchange rates can have such a profound impact on an economy and the companies operating in that economy.
  Below we consider a hypothetical example using real prices and real scenarios affecting the Japanese economy.

  At the heart of the foreign exchange market, interest rates are often seen as the main driver. If an investor can earn daily interest simply by going long or short a pair of currencies, then there is an incentive to drive capital into that currency. When it comes to a rate hike scenario, where economies keep raising interest rates to keep inflation in check, this could lead to an ongoing tendency for the currency to be bullied by market players trying to take advantage of this new higher exchange rate. Interest rates conquer, always higher returns.

• But currencies differ from stocks in that they are not isolated asset classes: there is impact. Too much of a good thing can end up being really bad, as the Japanese nation saw it, and how Japan’s “Japanese economic miracle” after World War II turned into a “lost decades” for the Japanese economy.

  While the Japanese economy experienced strong growth over a 45-year period, a stronger yen, aided by the Plaza Accord in 1985, led to severe economic erosion as the economy slowed over 30 years of growth, in some cases deflationary. influences. Below we look at an example of how this can be done with very reasonable effort.

  Why do economic market cycles matter?

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USD/JPY Monthly Chart: 1977-2004

Created by James Stanley

Setting the Stage with the Japanese Yen

To fully tell this story, we need to go through a brief history lesson on the USD/JPY currency pair, a story whose roots actually go back to the 70s and stagflation.

To get out of stagflation, Paul Volcker had to raise U.S. interest rates to very high levels to stop the rampant inflation at the time. These extremely high interest rates create huge demand for the U.S. dollar due to carry trades and interest rate differentials between the two currency pairs in the listing.

From the 1978 low to the 1982 high, the dollar rose more than 56% against the yen. After Volcker’s U.S. policy came into effect, the pair began to cool, but by March 1984-February 1985, the bulls were back in control, with USD/JPY hitting a 1985 high of 262.80. That was when the Plaza Accord, which was essentially a G5 pact to manipulate the exchange rate to devalue the dollar, came into force.

This is when the strength of the yen really starts to show.

Check out our research on the history of trade wars and their impact on the market!

In the example below, we consider a hypothetical model with prices from 1998 to 2008, when the USD/JPY exchange rate depreciated significantly. But the problem persisted until Japan in 1998.

A Real-World (but Hypothetical Example) of Exchange Rates in Action

Let’s say that a Japanese auto-maker designed a car in 1998; and calculated that it cost them roughly ¥2,800,000 to produce it ($20,000). But, no problem at all – they were going to sell the car for $30,000 – which would allow a very handsome profit of $10,000 on every car sold.

The USD/JPY exchange rate in 1995 was approximately 140.00 yen. So we can see the total cost and sales of one of the cars below:

So keep in mind – 1 dollar was worth about 140.00 yen in 1998 – so this car cost 2,800,000 yen to build. But that’s okay – because they sold it for $30,000 or JPY 4,200,000. That netted the automaker a handsome profit of 1,400,000 yen or $10,000.

If it could stay that way forever, our automakers would definitely be happy with a 50% profit margin on every car sold.

But it didn’t stop. The world has changed dramatically since 1998.

Only 13 years later, that exchange rate on USDJPY had moved below 80.

Created by James Stanley

Let’s look at how our auto-manufacturer would fare in that environment.

It still costs 2,800,000 yen to make a car because they pay workers in Japan and buy goods in Japan (and probably pay higher wages to keep up with inflation, but for our simple example, let’s assume the same labor cost). So changes in exchange rates are not necessarily related to their cost structure.

However, it had a huge impact on their sales revenue. Remember how they sold in the US for $30,000. Well, now they only get back 2,400,000 yen ($30,000 X 80.00 yen = 2,400,000).

They don’t even pay their fees anymore! 50% of profits have just evaporated, and that’s just because the ¥ has strengthened.

Our car manufacturers are now losing 400,000 yen per car sold. How long do you think this will last? Not many companies can continue to operate at a loss so quickly.

So what will our automakers do? Well, they will answer that none of their options are great. They can raise prices in the US…but they won’t sell as many cars now. Customers will find that our Japanese automakers have raised prices over German, American or Chinese automakers; so this is not an off-the-shelf option.

They often respond to cost reductions. That means layoffs or at least fewer hires. They will focus on the “efficiency” of the business and try to find any way to save a few cents so they can at least cover their costs.

Any cost-cutting measures our automakers take will have a negative impact on the wider economy: fewer employees (higher unemployment), less or no wage growth (lower inflation), and a lack of future economic security. General panic because our automakers didn’t or even necessarily did anything wrong…they were just unknowingly attracted to stronger currencies.

It is for this reason that Japan has plunged into a decade-long recession and faced deflationary pressures across the economy.

The Response:

So what is Japan doing? They work hard to devalue their currency; for if they succeed, they can make the opposite effect work for them.

Suppose our car manufacturers find a way to survive in this expensive yen environment; they cut the cost to 2,300,000 yen per car.

This is certainly not an ideal situation as their profit margins are low (only 100,000 yen per car). But – they found a way to survive.

But — if the BOJ ends up devaluing the yen, our automakers stand to benefit a lot.

Suppose the Bank of Japan did something similar at the end of 2012, pushing the yen lower (USDJPY higher) to 100.00.

Well, our automaker has kept improving in tough times and still produces cars for 2,300,000 yen. But now USDJPY is 100.00 and they get 3,000,000 back for every car they sell…700,000 profit.

That means quite a bit…because now the profits can be reinvested back into the company’s equipment. These equipment purchases will be profitable for Japanese manufacturers who will then have to hire more workers. Our automakers can now become more price competitive because they now have a margin to lower their selling prices, and they can even outperform their German or American counterparts by offering lower prices.

Ultimately, our automakers will need to hire more workers, and as demand for workers increases (as both equipment and automakers are looking for labor), wages must increase.

This starts the whole synergy of economic growth in an economy, and all that really happens is a change in the exchange rate.

Weaker currency prices make exports more attractive; for export-oriented economies, cheaper currencies can bring significant economic growth.

This is the nucleus of the forex market: Trade and Capital flows. And this is a driver that’s often hidden in plain sight as a globalized economy has seen countries so aligned that it’s difficult to imagine one major economy sneezing without the other(s) catching cold.

— Written by James Stanley, Senior Strategist for DailyFX.com

Contact and follow James on Twitter: @JStanleyFX