Saudi Arabia Faces Challenges in the New Year

By Michael Nayebi-Oskoui

January 6, 2015 | 09:00 GMT

The Middle East is one of the most volatile regions in the world — it is no stranger to upheaval.

The 2009 uprisings in Iran and the brinksmanship of Mahmoud Ahmadinejad's government were followed by the chaos of the Arab Spring, the spillover of the Syrian conflict into Iraq and a potential realignment of the U.S.-Iranian relationship. Unlike recent years, however, 2015 is likely to see regional Sunni Arab interests realign toward a broader acceptance of moderate political Islam. The region is emerging from the uncertainty of the past half-decade, and the foundations of its future are taking shape. This process will not be neat or orderly, but changes are clearly taking place surrounding the Syrian and Libyan conflicts, as well as the region's anticipation of a strengthened Iran.

The Middle East enters 2015 facing several crises. Libyan instability remains a threat to North African security, and the Levant and Persian Gulf must figure out how to adjust course in the wake of the U.S.-Iranian negotiations, the Sunni-Shiite proxy war in Syria and Iraq, and the power vacuum created by a Turkish state bogged down by internal concerns that prevent it from assuming a larger role throughout the region. Further undermining the region is the sharp decline in global oil prices. While Saudi Arabia, Kuwait and the United Arab Emirates will be able to use considerable cash reserves to ride out the slump, the rest of the Middle East's oil-exporting economies face dire consequences.

For decades, long-ruling autocratic leaders in countries such as Algeria and Yemen helped keep militancy in check, loosely following the model of military-backed Arab nationalism championed by Gamal Abdel Nasser in Egypt. Arab monarchs were able to limit domestic dissent or calls for democracy through a combination of social spending and repression. The United States not only partnered with many of these nations to fight terrorism — especially after September 2001 — but also saw the Gulf states as a reliable bulwark against Iranian expansion and a dangerous Iraq led by Saddam Hussein. Levantine instability was largely contained to Lebanon and the Palestinian territories, while Israel's other neighbors largely abided by a tacit agreement to limit threats emanating from their territories.

Today, Saddam's iron grip on Iraq has been broken, replaced by a fractious democracy that is as threatened by the Islamic State as it is by its own political processes. Gone are the long-time leaders of states like Tunisia, Libya and Egypt. Meanwhile, Algeria, Saudi Arabia and Oman are facing uncertain transitions that could well take place by year's end. The United States' serious dialogue with Iran over the latter's nuclear program, once a nearly unthinkable scenario for many in the Gulf, has precipitated some of the biggest shifts in regional dynamics, especially as Saudi Arabia and its allies work to lessen their reliance on Washington's protection.

The Push for Sunni Hegemony

Riyadh begins this year under considerably more duress than it faced 12 months ago. Not only is King Abdullah gravely ill (a bout of pneumonia forced the 90-year-old ruler to ring in the new year in the hospital and on a ventilator), but the world's largest oil-producing country has also entered into a price war with American shale producers. Because Saudi Arabia and its principal regional allies, Kuwait and the United Arab Emirates, boast more than a trillion dollars in cash reserves between them, they will be able to keep production levels constant for the foreseeable future.

However, other OPEC producers have not been able to weather the storm as easily. The resulting 40 percent plunge in oil prices is placing greater financial pressure on Iran and the Shiite-dominated government in Iraq, Saudi Arabia's largest sectarian and energy rivals.

Riyadh's careful planning and building of reserves means the Saudi kingdom's economic security is unlikely to come under threat in the next one to three years. The country will instead continue to focus on not only countering Iran but also rebuilding relationships with regional Sunni actors weakened in previous years.

Riyadh's regional strategy has traditionally been to support primarily Sunni Arab groups with a conservative, Salafist religious ideology. Salafist groups traditionally kept out of politics, and their conservative Sunni ideology was useful in Saudi Arabia's competition against Iran and its own Shiite proxies. Promoting Salafism also served as a tool to limit the reach of more ideologically moderate Sunni political Islamists like the Muslim Brotherhood and its affiliates, groups Riyadh sees as a threat because of their success in organizing grassroots support and fighting for democratic reforms.

With rise of external regional pressures, however, Gulf monarchies such as Saudi Arabia are re-evaluating their relationships with the Muslim Brotherhood. Internal threats posed by Salafist jihadists and a desire to limit future gains by regional opponents are pushing countries such as Saudi Arabia and the United Arab Emirates to try to forge a relationship with the Muslim Brotherhood to limit the risks posed by rival groups in the region.

Restoring relations with the Muslim Brotherhood will also have effects on diplomatic relations.

Qatar has long been a supporter of the Muslim Brotherhood, a fact that has strained its relations with other countries — Saudi Arabia, Bahrain and the United Arab Emirates even went so far as to close their embassies in Qatar. However, the continuation of the United States' rapprochement with Iran and Riyadh's own discomfort with the rise of Salafist jihadist groups has made it reconsider its stance on political Islamism. Riyadh, Bahrain and Abu Dhabi's agreement to resume diplomatic ties with Doha, and the latter's consideration of changing its relationships with Egypt and Libya, points to a shift in how the bloc's engagement with the Muslim Brotherhood has the potential to streamline the Gulf Cooperation Council's (GCC) efforts in the region.

The Gulf monarchies' attempt at reconciling with political Islamists can potentially benefit the GCC. For its part, Qatar has engaged with the staunchly anti-Islamist Libyan government in Tobruk, and it appears tensions with President Abdel Fattah al-Sisi's government in Egypt have calmed. Both scenarios point to the likelihood of the GCC moving closer to adopting a more unified regional stance beginning in 2015, one more in line with Riyadh's wishes to preserve the framework of the council.

This improvement in relations comes at a critical moment. With the United States and Iran undergoing a rapprochement of their own, the Gulf monarchies will try to secure their own interests by becoming directly involved in Libya, Syria and potentially Yemen. This military action will also aim to project strength to Iran while also filling the strategic void left by the absence of Turkish leadership in the region, especially in the Levant.

However, Qatar has been opposed to this course of action in the past. Despite its small size, the country has used its wealth and domestic stability to back a wide array of Islamist groups, including the Muslim Brotherhood in Egypt, Ennahda in Tunisia and rebel groups in Syria. Tensions between Qatar and regional allies came to a head in 2014 in the aftermath of Saudi and Emirati support for the July 2013 uprising that ousted the Doha-backed Muslim Brotherhood government in Egypt. The tension threatened the stability of the GCC and caused rebel infighting in Syria. This disconnect in Gulf policy has had wide regional repercussions, including the success of Islamic State militants against Gulf-backed rebel groups in Syria and the Islamic States' expansion into Iraq.

Without foreign military intervention on behalf of the rebels, no faction participating in the Syrian civil war will be able to declare a decisive military victory. As the prospects of a clear-cut outcome become less realistic, Bashar al Assad's Russian and Iranian backers are increasing diplomatic efforts to negotiate a settlement in Syria, especially as both are eager to refocus on domestic woes exacerbated by the current drop in global energy prices. Kuwait's recent decision to allow the Syrian regime to reopen its embassy to assist Syrian expats living within its borders points to a likelihood that the Gulf states are coming to terms with the reality that al Assad is unlikely to be ousted by force, and Sunni Arab stakeholders in the Syrian conflict are gradually giving in to the prospect of a negotiated settlement. A resolution to the Syrian crisis will not come in 2015, but regional actors will continue looking for a solution to the crisis outside of the battlefield.

Any negotiated settlement will see the Sunni principals in the region — led by the GCC and Turkey — work to implement a competent Sunni political organization that limits the authority of a remnant Alawite government in Damascus and future inroads by traditional backers in Tehran. Muslim Brotherhood-style political Islam represents one of the potential Sunni solutions within this framework, and with Saudi opposition to the group potentially fading, it remains a possible alternative to the variety of Salafist options that could exist — to include jihadists. Such a solution ultimately relies on a broader democratic framework to be implemented, a scenario that will likely remain elusive in Syria for years to come.

North Africa's Long Road to Stability

North African affairs have traditionally followed a trajectory distinct from that of the Levant and Persian Gulf, a reality shaped as much by geography as by political differences between the Nasser-inspired secular governments and the monarchies of the Gulf. Egypt, Saudi Arabia's traditional rival for leadership of the Sunni Arab world, has become cripplingly dependent on the financial backing of its former Gulf rivals. The GCC was able to use its relative stability and oil wealth to take advantage of opportunities to secure its members' interests in North Africa following the Arab Spring. As a result, Cairo has become a launching pad for Gulf intentions, particularly UAE airstrikes against Islamist militants in Libya and joint Egyptian-Gulf backing of renegade Gen. Khalifa Hifter's Operation Dignity campaign.

Like Syria, Libya represents a battleground for competing regional Sunni ambitions. Qatar, and to a lesser extent Turkey, backed Libya's powerful Islamist political and militia groups led by the re-instated General National Congress in Tripoli after the international community recognized the arguably anti-Islamist House of Representatives in Tobruk. Islamist-aligned political and militia forces control Libya's three largest cities, and Egyptian- and Gulf-backed proxies are making little headway against opponents in battles to gain control of Tripoli and Benghazi, prompting more direct action by Cairo and Abu Dhabi.

Saudi Arabia, Egypt and the United Arab Emirates are primarily concerned with the possibility of Libya, an oil-rich state bordering Egypt, becoming a wealthy backer of political Islam. Coastal-based infighting has left much of Libya's vast desert territories available for regional jihadists as well as a host of smuggling and trafficking activities, posing a significant security risk not just for regional states but Western interests as well. Egyptian and Gulf attempts to shape outcomes on the ground in Libya have proved largely ineffective, and Western plans for reconciliation talks favor regional powers such as Algeria — a traditional rival to Egyptian and Gulf interests in North Africa — that are more comfortable working with political actors across a wide spectrum of political ideologies to include Muslim Brotherhood-style Islamism.

Libya will likely find itself as the proving ground for the quid pro quo happening between the participants of the intra-Sunni rift over political Islam. In exchange for Saudi Arabia and its partners reducing their pressure on Muslim Brotherhood-style groups in Egypt and Syria, Qatar and Turkey are likely to work more visibly with Tobruk in 2015 in addition to pushing Islamist proxies into a Western-backed national dialogue. Libya's overall security situation will not be settled through mediation, but Libyan Islamists are more likely to re-enter a coalition with the political rivals now that both sides' Gulf backers are working toward settling differences themselves.

Regional Impact

Dysfunction and infighting have marred attempts by the region's Sunni actors to formulate a cohesive strategy in Syria. This has enabled Iran to remain entrenched in the Levant — albeit while facing pressure — and to continue expending resources competing in arenas such as Libya and Egypt. The next year will likely see an evolving framework where Saudi Arabia and Qatar, and to a lesser extent Turkey, will reach a delicate understanding on the role of political Islam in the region. 2014 saw a serious reversal in the fortunes of Muslim Brotherhood-style groups, which inadvertently favored even more far-right and extremist groups such as the Islamic State as the Gulf's various Sunni proxies were focused on competing with one another.

Iran's slow but steady push toward a successful negotiation with the United States, as well as the threats posed by militant Islam throughout the Levant, Iraq and North Africa, is necessitating a realignment of relationships within the Middle East's diverse Sunni interests. Less divisive Sunni leadership will be instrumental in coordinating efforts to resolve the conflicts in both Libya and Syria, although resolution in both conflicts will remain out of reach in 2015 and some time beyond.

A more robust Sunni Arab position, especially in Syria and the Levant, will likely put more pressure on Iran to reach a negotiated settlement with the United States by the end of the year. While a settlement may seem harmful to Gulf interests, the GCC is shifting toward a pragmatic acceptance of an agreement, similar to Riyadh's begrudging accommodation of a future role for the Muslim Brotherhood in the Middle East. The GCC's new goal is to limit Tehran's opportunities for success rather than outright denying it. Part of this will be achieved through an ongoing, aggressive energy strategy. The rest will come from internal negotiations between Saudi Arabia, Egypt, Qatar and Turkey.

The next year will see the Sunni presence in Syria attempt to coalesce behind rebels acceptable to Western governments that are eager to see negotiations begin and greater local pushback against the Islamic State. More cohesive Gulf leadership will also present a more effective bulwark against Iranian and Alawite interests in the Levant. Most important, however, is the opportunity for regional Sunnis, led by Saudi Arabia, to present a more mature and capable response to mounting pressures.

Whether through more assertive military moves in the region or by working with states such as Qatar to steer the Muslim Brotherhood rather than embolden the Islamist opposition, 2015 will likely see a shift in Sunni Arab strategies that have long shaped the región.

01/06/2015 12:22 PM

Operation Helicopter

Could Free Money Help the Euro Zone?

By Anne Seith

The European Central Bank has run out of ammunition to defend itself from deflation.

 The European Central Bank has run out of ammunition to defend itself from deflation.

Fears that the euro zone is heading for deflation refuse to abate. Now, many economists are demanding that the European Central Bank hand out money to consumers to stimulate the economy. But would it work?

It sounds at first like a crazy thought experiment: One morning, every resident of the euro zone comes home to find a check in their mailbox worth over €500 euros ($597) and possibly as much as €3,000. A gift, just like that, sent by the European Central Bank (ECB) in Frankfurt.

The scenario is less absurd than it may sound. Indeed, many serious academics and financial experts are demanding exactly that. They want ECB chief Mario Draghi to fire up the printing presses and hand out money directly to the people.

The logic behind the idea is that recipients of the money will head to the shops, helping to turn around a paralyzed economy in the common currency area. In response, companies would have to increase production and hire more workers, leading to both economic growth and a needed increase in prices because of the surge in demand.

ECB Has Lost Control

Currently, the inflation rate is barely above zero and fears of a horror deflation scenario of the kind seen during the Great Depression in the United States are haunting the euro zone. The ECB, whose main task is euro stability, has lost control.

In this desperate situation, an increasing number of economists and finance professionals are promoting the concept of "helicopter money," tantamount to dispersing cash across the country by way of helicopter. The idea, which even Nobel Prize-winning economist Milton Friedman once found attractive, has triggered ferocious debates between central bank officials in Europe and academics.

For backers, there's more to this than just a new instrument. They are questioning cast-iron doctrines of monetary policy.

One thing, after all, is becoming increasingly clear: Draghi and his fellow central bank leaders have exhausted all traditional means for combatting deflation.

The failure of these efforts can be easily explained. Thus far, central banks have primarily provided funding to financial institutions. The ECB provided banks with loans at low interest rates or purchased risky securities from them in the hope that they would in turn issue more loans to companies and consumers. The problem is that many households and firms are so far in debt already that they are eschewing any new credit, meaning the money isn't ultimately making its way to the real economy as hoped.

In response to this development, Sylvain Broyer, the chief European economist for French investment bank Natixis, says, "It would make much more sense to take the money the ECB wants to deploy in the fight against deflation and distribute it directly to the people." Draghi has calculated expenditures of a trillion euros for his emergency program, funds that would be sufficient to provide each euro zone citizen with a gift of around €3,000.

'It Has To Be Massive'

Daniel Stelter, founder of the Berlin-based think tank Beyond the Obvious and a former corporate consultant at Boston Consulting, has even called for giving €5,000 to €10,000 to each citizen. "It has to be massive if it is going to have any effect," he says. Stelter freely admits that such figures are estimates. After all, not a single central bank has ever tried such a daring experiment.

Many academics have based their calculations on experiences in the United States, where the government has in the past provided cash gifts to taxpayers in the form of rebates in order to shore up the economy.

Oxford economist John Muellbauer, for one, looks back to 2001. After the crash, the US gave all taxpayers a $300 rebate. On the basis of the experience at the time, Muellbauer calculates that €500 per capita would be sufficient to spur the euro zone. "It (the helicopter money) would even be much cheaper for the ECB than the current programs," the academic says.

And yet European central bankers and conservative economists still shudder when asked about the concept. "It would be the ultimate sin," warns Jörg Krämer, the chief economist at Commerzbank, Germany's second largest private bank. "If the central bank gives away money one time, there's no way it will remain an isolated case. Politicians will demand even more the next time around."

Muellbauer counters such fears by noting that central banks have a clear target: inflation of close to 2 percent. Once that target is achieved, the money handouts would cease. But the problem is that monetary policy often cannot be adjusted to that degree of precision. Many experts say that inflation is like a bottle of ketchup: when you whack on the bottom, nothing happens at first -- but then it all comes out in a gush.

The fundamental factor which determines the value of money is the trust of those who spend it -- the belief that a €10 or €20 bill will be enough to buy lunch for the foreseeable future and that a medium-sized car won't cost €100,000 five years from now. Should this trust evaporate, the entire monetary system begins to crumble.

Vast Uncertainties

It is an experience Germany became familiar with in the 1920s. The trigger for hyperinflation at the time was, of course, the fact that the German Reich paid for its wartime expenses by printing money. But the situation got out of control when the state's creditors along with its citizens lost faith in the mark. Investors refused to make more money available to the state and doctors began demanding barter in exchange for services rendered. Prices exploded, to the point that a loaf of bread ultimately cost 140 billion marks.

"Once people have experienced money raining down from the heavens, it will create vast uncertainties about future inflation," warns Commerzbank economist Krämer. "How often might it happen and how quickly will prices climb? What kind of shape must the euro be in if the ECB has resorted to giving out money?"

And even if people head to the shops with the money they have been given, it is still far from certain that companies would ramp up production. "It is possible that people would merely be competing for the same supply of goods. Prices would climb, but there would be no lasting stimulus for the economy," warns economist Thomas Mayer, formerly the chief economist for Deutsche Bank. The phenomenon is known among economists as stagflation.

Willem Buiter, the well-respected chief economist of the US financial giant Citigroup, has thus modified the idea of helicopter money. His version calls for policymakers and central bankers to act in concert. The state would improve economic competitiveness by way of reforms in addition to investing money in infrastructure projects or handing it out to taxpayers in order to trigger consumption. The central bank would finance the move via the purchase of sovereign bonds.

Buiter is unconcerned about EU regulations preventing the ECB from the kind of direct state financing such a plan would entail. He considers Article 123 of the Lisbon Treaty, which addresses the issue, to be a "disaster" anyway. He also doesn't believe the plan would endanger the ECB's independence. "Independence does not mean that you don't answer the phone when the minister of finance is calling," he says. "Independence means the right to say no." Cooperation and coordination of monetary and fiscal policy is thus "perfectly consistent."

Japanese Prime Minister Shinzo Abe apparently saw things similarly when he entered office at the end of 2012. His country had been suffering under deflation and economic stagnation for decades. In response, Abe announced structural reforms along with a gigantic investment program -- and pushed the central bank to finance it. Since then, the Bank of Japan has spent trillions, but the country nonetheless finds itself stuck in recession once again today.

The odd thing is that the Japanese example provides evidence to both supporters and detractors of the helicopter money plan. Does it reveal the absurdity of central bankers seeking to combat structural problems with money? Or is it merely proof that mass liquidity only works if politicians lay the necessary groundwork?

Nobody knows for sure because the Abe administration failed to pass a majority of the promised reforms. Monetary policy alone, however, "is not getting you out of the secular stagnation," as even helicopter fan Buiter admits. It is a sentence that could have come from his most adamant detractors.

Heard on the Street

Low Wages Work Against a Fed Move

December Jobs Data Show Drop in Unemployment, Payroll Gains

By Justin Lahart

Jan. 9, 2015 3:02 p.m. ET

Even as unemployment keeps falling, wages just aren’t picking up. With nobody confidently able to explain why, the Federal Reserve should have the confidence to take it slow on raising rates.

The U.S. added 252,000 jobs in December, the Labor Department reported Friday, with revisions to the previous two months raising the country’s total payrolls count by another 50,000. The unemployment rate fell to 5.6% from 5.8% in November, and 6.7% a year earlier.

Yet average hourly earnings fell by 0.2% from November, and November’s gain was revised to 0.2% from 0.4%. That put hourly earnings just 1.7% above where they were a year earlier, one of the weakest readings on record.

When unemployment falls, employers, facing stiffer competition for workers, are supposed to pay higher wages. That is something that held in the past but isn’t now, and it is unclear why.

One explanation is that wage growth is low because there is more slack in the labor market than the unemployment rate shows. But this view no longer really cuts it. The labor force participation rate, or the share of the working-age population that’s either employed or looking for employment, hasn’t risen even as hiring has picked up. And with the employed as a share of the population rising to 59.2% from 58.6% over the past year, there’s clearly less slack now, which ought to accelerate wage gains.

Economists at UBS have advanced another idea. They point out that the average age of U.S. workers has stopped increasing in recent years—perhaps because baby boomers are beginning to retire—so a rising premium for more-experienced workers is no longer embedded in wages.

But they add that this theory isn’t quite satisfying.

Federal Reserve Bank of San Francisco economists, meanwhile, have pushed a view that the labor market is experiencing a phenomenon called pent-up wage deflation. This works as follows: Because companies were unable or unwilling to cut wages during the downturn despite an extremely weak labor market, they haven’t had to raise wages so much since. Indeed, this week, those economists presented evidence that industries that were able to adjust wages lower in the recession have since raised them by more. The implication is that once this pent-up deflation passes through the system, wages could start climbing rapidly.

But wage growth is currently so low the Fed can afford to wait to see it actually pick up. Indeed, to be consistent with the Fed’s 2% inflation target, wages would need to be increasing by 3% to 4%.

The view of most Wall Street economists that the central bank will begin raising rates in June is looking a little tenuous, especially with falling energy prices cued to push overall price measures into outright deflation. Yet if hiring strength continues, unemployment could easily fall to 5% by the time Fed policy makers gather in June.

It could be a very interesting meeting.

The dubious relationship between yields and exchange rates

Matthew C Klein

Jan 06 18:23

Professor Krugman has a new post that tries to explain why nominal US sovereign interest rates are higher than nominal euro area bond yields. Much of the piece is useful, especially since he is right that credit risk has nothing to do with the differential between German and American borrowing costs.

Higher US rates are instead the result of differences in real rates and inflation expectations between the two countries. But we part ways with Krugman when he makes this argument in the context of expected changes in the exchange rate between euros and dollars:
The crucial point here is that German bonds are denominated in euros, while U.S. bonds are denominated in dollars. And what that means in turn is that higher U.S. rates don’t reflect fear of default; they reflect the expectation that the dollar will fall against the euro over the decade ahead.
The really questionable bit comes later:
The relative strength of the US economy has led to a perception that the Fed will raise rates much sooner than the ECB, which makes dollar assets attractive — and as Rudi Dornbusch explained long ago, what that does is cause your currency to rise until people expect it to fall in the future. The dollar is strong right now because the U.S. economy is doing better than the euro area, and this very strength means that investors expect the dollar to fall in the future.
We don’t understand this logic. If people think the dollar will depreciate against the euro in the future they should sell dollars and buy euros today, which would cause the dollar to fall against the euro. Yet the dollar has been rising as the yield gap has widened.

In fact, there has been a reasonably strong relationship between the difference in German and American sovereign borrowing costs and the EURUSD exchange rate, where an increase in relative UST yields goes hand in hand with an increase in the relative value of the dollar:

(Source: Bloomberg, author’s calculations)

It’s possible that the confusion comes from the fact that the exchange rate quotes you will hear when you call up your friendly neighborhood currency dealer will vary depending on when you want to actually exchange dollars for euros. If you want to swap currencies today, you will get the rate that pops up in the news (about $1.19 per euro as of pixel time). If you want lock in a rate today but wait for ten years to actually hand over your dollars for euros, you will get a different rate where the euro is worth relatively more than it is now, precisely because interest rates in the US are higher than they are in most of the euro area.

And, in fact, a thing you sometimes hear in FX is that a currency is “priced to depreciate” or “priced to appreciate” by a certain amount based on short-term yield differentials. In particular, lower-yielding currencies are “priced to appreciate” against higher-yielding currencies, while high-yielding currencies are “priced to depreciate” against low-yielding ones.

This doesn’t mean, however, that people who trade currencies go around betting that low-yielding currencies will rise in value relative to high-yielding ones, as Krugman implies. If anything, traders tend to prefer selling low-yield currencies while buying high yield-currencies.

Interest rate differentials have basically no predictive power for exchange rates. People like Eugene Fama were writing about this years before we were born, and even he wasn’t new to the subject.

Economists have long had a hard time explaining movements in currencies. Here is a 1982 paper by Ken Rogoff on the failure of academic models, h/t Tony Yates. Strategies that aren’t “supposed” to work (selling low-yielding currencies in exchange for high-yielding currencies and momentum) have proven to be remarkably profitable. No one seems to have a great explanation as to why.

For what it’s worth, one convincing argument we have heard is that many of the biggest players — tourists (not macro tourists), nonfinancial companies engaging in cross-border M&A, and central banks that intervene in the markets to improve the competitiveness of their exports, for example — aren’t trying to maximise trading profits but have other agendas that are difficult to capture with models. The good news for traders is that if you can identify what these players are going to do and fade them, you can make money. But knowledge of economic fundamentals alone won’t get you very far.

So what explains the FX jargon?

It’s easiest to think about this with a simple example. Imagine a world where the 1-year risk free interest rate in the USA is 5 per cent and 0 per cent in Japan, and that the current exchange rate is 100 yen per US dollar. If I start with $1 and 100 yen currency and invest my money into risk-free accounts in each country, then after one year I will have $1.05 and 100 yen. Put another way, today’s market pricing implies that my 100 yen will buy more dollars in the future than they do now.

Now, none of this tells us anything about what the actual dollar/yen exchange rate will be after a year. However, it does tell us that anyone who trades currency forwards should account for the differences in interest rates that you can lock in today to avoid handing free money to your counterparty.

To use the example above, the 1-year forward exchange rate should be about 95.3 yen per dollar (100/1.05). If you call up your friendly neighborhood FX dealer and he says that he will agree to buy your future dollars at the rate of 100 yen then you should take the deal in a big way. Specifically: borrow a lot of yen for a year at basically no interest, find another currency dealer to immediately convert those yen into dollars at the rate of 100 yen to the dollar, lock in a 5 per cent return on your dollars, and then wait for a year.

After a year, you would ring up your friendly neighborhood currency dealer, give him the dollars you agreed on, get back enough yen to repay your debt, and then have fun with the leftover dollars you made by doing nothing. Those leftover dollars effectively came from your friendly neighborhood currency dealer, unless he found a chump to take the other side of your trade and offload his earlier misquote. To avoid this outcome, FX desks give quotes for future exchange rates that are different from spot exchange rates.

The important point here is that none of the participants needs to have a view about what the future dollar/yen exchange rate will be. Rather, they are simply using today’s yield curves to calculate today’s forward curve for the exchange rate. (Incidentally, the same logic applies to futures prices of commodities and financial assets. The difference between the current price of crude and the prices implied by futures tells you basically nothing about what will actually happen to the oil price, although it can tell you interesting things about the cost of physical storage.)

Just as the difference between German and American sovereign borrowing costs tell us nothing about default risk, neither do they tell us anything meaningful about future exchange rates, much less market expectations of future exchange rates.