Foreign Exchange Market Theories: The Asset Market Model
The Asset Market Model implies that a currency will be in higher demand and should appreciate in value, if the flow of funds into the financial markets of this country, such as equity and bond markets, increase. The bond markets, however, are far bigger than equity markets, therefore their importance is far higher for currency valuations.
As opposed to the Balance of Payments Model, that often concentrates on trade flows such as current accounts, the Asset Market Model emphasizes financial assets.
An example is the correlation between Japanese government bond (JGB) yields (but also US treasuries) and the Japanese yen. When government bonds rise in price (and inversely correlated yields fall), then the yen appreciates. Especially the huge number of Japanese private investors move out of riskier assets, e.g. American stocks, into safe bonds, consequently the yen gets stronger.
Another example is continuing immigration into Switzerland and Australia in recent years and resulting upwards pressure on real estate prices. Assets in these countries appreciate and therefore must the currencies.
The evaluation of stock returns in US$ terms that regularly appears in “The Economist” reflects a different perspective on the Asset Market Model. In its extreme, this variant of the Asset Market Model suggests that stock returns calculated in the main investor currency US$ for developed nations should be equal over the whole world.
An example was the low value of the DAX of 5000 in September 2011, as opposed to 7000 in August 2012, a difference of 30%. In September 2011 the S&P 500 was trading around 1200, in August 2012 around 1400, a difference of only 15%. With the 15% depreciation of the euro between 2011 and August 2012, the gain of the DAX is cut from 30% to 15% in dollar terms.
Exceptions to the rule that all stock returns of developed nations should trade at the same US$ price, apply to countries with structural problems (like currently the European periphery).
Another application of the Asset Market Model is when a central bank does quantitative easing or lowers interest rates: stocks of this country increase in value but the currency depreciates. By this measure inflation should increase and the currency and bonds lose in price (see “what drives government bond yields?“). (Often, as in the Japanese case, bond prices do not adjust directly, but only after inflation has really developed. Traders manage to adjust the FX rate far more quickly. The reasons are the higher liquidity of the currency market and that currencies often “overshoot”).
A weaker currency is advantageous for exporters and stock markets improve. The US$ price of the stocks, however, remains equal.
The latest example is the Japanese yen during the so-called “currency wars” . In August the Japanese Nikkei225 had only appreciated by 3% in local currency, but at the end of the year the gain went up to 18% in local currency.
The S&P500 gain improved from 11% to 16% between August and December, while the one for the Nikkei in US$ terms was up only from 3% to 8%. For foreign investors the huge Nikkei improvement was mostly eaten up by the weaker currency.
This tendency continued in 2013: the yen further depreciated and the Nikkei appreciated but its dollar return remained low.
We judge that the big gap between return in the local currency and in US$ can not remain forever. A weaker currency and higher stock prices help to increase exports and employment. Consequently the GDP, income and asset prices further improve with the consequence that one day higher inflation shows up.
If despite inflation growth continues, the currency must finally appreciate.
A quick introduction to the Asset Market Model is given here:Disclaimer: The opinions expressed above are not intended to be taken as investment advice. It is to be taken as opinion only and we encourage you to complete your own due diligence when making an investment decision. Even if we often write about Forex trading, our advices aren't written for day traders who follow technical channels, but rather for mid- and long-term investors. Our aim is to show discrepancies between fundamental data and current asset valuations, which can lead in mid-term to an inversion to technical channels.