Beat the Market

by Kieran Healy on February 18, 2005

My friend “Pierre-Olivier Gourinchas”: has co-authored a “very interesting paper”: with “Hélène Rey”: called “International Financial Adjustment.” (Here’s the “PDF version”: You might think that’s not a title to set the world on fire, but don’t be fooled. A more appealing — though perhaps less responsible — alternative would be something like “Dude! We can predict exchange rates!” Here’s the abstract:

bq. The paper proposes a unified framework to study the dynamics of net foreign assets and exchange rate movements. We show that deteriorations in a country’s net exports or net foreign asset position have to be matched either by future net export growth (trade adjustment channel) or by future increases in the returns of the net foreign asset portfolio (hitherto unexplored financial adjustment channel). Using a newly constructed data set on US gross foreign positions, we find that stabilizing valuation effects contribute as much as 31% of the external adjustment. Our theory also has asset pricing implications. Deviations from trend of the ratio of net exports to net foreign assets predict net foreign asset portfolio returns one quarter to two years ahead and net exports at longer horizons. The exchange rate affects the trade balance and the valuation of net foreign assets. It is forecastable in and out of sample at one quarter and beyond. A one standard deviation decrease of the ratio of net exports to net foreign assets predicts an annualized 4% depreciation of the exchange rate over the next quarter.

Now, I am not a macroeconomist so I should leave further discussion to Daniel and John. The guts of the paper are really beyond my competence to evaluate. But this is a blog, so naturally I will carry on regardless and make three points anyway.

The first point is that the paper is interesting because their result is a real surprise — especially that bit about “forecastable in and out of sample at one quarter and beyond.” You shouldn’t be able to reliably predict rates better than a random walk, and certainly not over relatively long periods. How do Gourinchas and Rey do it? They begin with the observation that if a country’s current account balance is in deficit, it must eventually get readjusted through increased exports or by depreciation of the currency. They argue that the “sharp increase in gross cross-holdings of foreign assets and liabilities” between countries that we’ve seen over the past twenty years introduces a significant pathway by which rebalancing can happen without changes in trade: “Put simply, a fall in today’s net exports or in today’s net external asset position has to be matched either by future net export growth or by future increases in the returns of the net foreign asset portfolio … The budget constraint implies that today’s current external imbalances _must predict_, either future export growth or future movements in returns of the net foreign asset portfolio, or both.”

They go on to derive a quantity — “the deviation from trend of the ratio of net exports to net foreign assets” — that captures movements in the external asset position. They decompose it into the bit explained by trade and the bit explained by financial adjustment. Then they collect a longitudinal dataset for the U.S. case including a measurement of this quantity and show that the financial adjustment component accounts for about a third of total readjustment, mainly in the relatively short-term. An implication of the theory is that this quantity should predict future _returns_ on a country’s portfolio of foreign assets, and this turns out to true also.

Now, the rate of return on assets like this is determined partly what they earn abroad and partly by what the exchange rate is. The fact that the financial component of the rebalancing itself works through the mechanism of depreciation leads Gourinchas and Rey to “raise an obvious and tantalizing question: could it be that the predictability in the dollar return on gross assets arises from predictability in the exchange rate?” Again, the answer is yes:

bq. Overall, these results are striking. Traditional models of exchange rate determination fare particularly badly at the quarterly-yearly frequencies. Our approach … finds predictability at these horizons. … a large ratio of net exports to net foreign assets predicts a subsequent appreciation of the dollar, which generates a capital loss on foreign assets.

_Et voila_, a theoretically grounded, empirically applicable technique for predicting movements in exchange rates.

My second point is about what happens next, assuming that Gourinchas and Rey are right. As they say themselves in their conclusion,

bq. The challenge consists in constructing models with fully-fledged optimizing behavior compatible with the patterns we have uncovered in the data. A natural question arises as to why the rest of the world would finance the US current account deficit and hold US assets, knowing that those assets will under-perform. In the absence of such [a] model, one should be cautious about any policy seeking to exploit the valuation channel since to operate, it requires that foreigners be willing to accumulate further holdings of (depreciating) dollar denominated assets.

If rational agents knew about the relationship between external imbalances, foreign asset return and exchange rates that the paper describes, then we wouldn’t expect to find the patterns in the data that we do. If the rest of the world knew their assets were going to under-perform, they wouldn’t have made that particular investment. Now that this relationship has been uncovered, we might expect this gap to close as the knowledge is incorporated into investment decisions. It’s in the nature of economics to prove itself both true and false, in this way. True, because the specific bit of pricing technology uncovered by the paper is now grist for the decision models and pricing mechanisms used to make investment decisions (“Our theory also has asset pricing implications”, as the abstract says). So the rationality of market agents will more closely approximate the ideal state that theory says it ought to. But false, too, in the sense that the empirical relationship demonstrated in the paper might disappear as a result, and everything gravitate back to an efficient-market random walk again.

My last point follows naturally from the previous one: If Pierre is my friend, then why didn’t he let me know about all of this, oh, say, 18 months or so ago. Then I could have formed a CT investment consortium managed (for a small fee) by John and Daniel. This could have taken care of CT’s hosting bills for ever and ever, and I could be writing this from a private island in the Pacific ocean instead of a Starbucks in SeaTac airport.



Jeremy Osner 02.17.05 at 7:44 pm

If I read that last bit correctly, they are not confident of being able to use the strategy to get rich at this point, without further refinement.


Kieran 02.17.05 at 7:49 pm

Yeah. But what are economists for, if not to help us get rich?


Jeremy Osner 02.17.05 at 8:08 pm

To warn us of the folly of our ways?


Andrew McManama 02.17.05 at 8:20 pm

Well, I don’t think that the Japanese and Chinese central banks care as much about their assets underperforming as they do about their nations’ export economies. So in this case they don’t really qualify as “rational agents”.

Sea-Tac is really one of the worst isn’t it? Nothing even semi-editable for sale in the entire place.


lemuel pitkin 02.17.05 at 8:49 pm

Andrew McManama is right: the flaw here is the presumption that exchange rates are being set by returns-maximizing private investors, when in fact they’re being set by central banks, which have a different set of objectives — avoiding appreciation of their own currencies, maintaining exchange reserves, preventing instability in the inernational financial system, perhaps staying on the good side of the US.

I disagree with him on one point, tho: Kieran’s piece, at least, is fully editable, once you paste it into Word. Altho I guess strictly speaking it’s not for sale…


Andrew McManama-Smith 02.17.05 at 9:05 pm

Thanks LP, I meant “edible.” I really should be more careful with my spelling and grammar.


John Quiggin 02.17.05 at 9:15 pm

Whenever I’ve looked at exploiting relationships of this kind, the transactions costs of taking and maintaining short positions outweigh the profits, at least for the small scale on which I operate.

Of course, I’ve reduced my exposure to $US assets as far as possible. The puzzle is why other private investors, including US residents, haven’t followed suit.


Cryptic Ned 02.17.05 at 9:20 pm

Congratulations to Andrew on his marriage between 8:20 and 9:05 PM this evening.


Jeremy Osner 02.17.05 at 9:48 pm

Dr. Quiggin — I, a financial neophyte, would dearly love to read a book or article explaining how I can limit such exposure — my current stab at doing it is to buy a fair amount of mutual funds whose assets are foreign stocks or foreign bonds, but I don’t know how effective that is — after all the funds themselves are still denominated in dollars right? Can you recommend reading for me?


dsquared 02.17.05 at 10:11 pm

It’s a serious piece of work and fills in a gap that everyone knew was there about the importance of portfolio movements in equilibrating the various relations that ought to hold in foreign exchange.

But I’d be careful before trading based on these forecasts. Note that the forecast requires you to have access to the data on foreign positions contemporaneously. I’m not sure how practical it would be to do this in real-time. In other words, once you’ve got the historical dataset, you can establish that January’s portfolio data forecasts February’s returns, but that might not be all that much use if in real life you only get reliable figures for January half-way through March.

I’ll read it again tomorrow when I’ve sobered up. But Helene Rey has done lots of good stuff in the past, so I am certainly not inclined to be wholly sceptical.


John Quiggin 02.17.05 at 11:35 pm

Jeremy, it doesn’t matter particularly that the assets are denominated in $US in your accounting statements. If the underlying asset is a foreign (say euro or yen) bond, it will appreciate in ($US) value along with the currency. Similarly with equity in a foreign company.

I will look around for a good book.


Michael Wolfe 02.17.05 at 11:42 pm


Read your fund’s prospectus to determine whether it’s denominated in dollars or not, and if not, whether or not the fund hedges to reduce its exposure to currency risk (which hedging, in this case, would be undesirable to you). T. Rowe Price has several no-load funds that that I know of that are denominated in Euros and not hedged against currency risk, including PRESX, PRIDX, PIEQX, and RPIBX. You could also look at if you had 10k sitting around and were interested in opening a Euro-denominated CD.


Andrew McManama-Smith 02.18.05 at 12:03 am

Are Euro demoniated Assets such a safe bet? I’ve read that the by a number of measures the Euro is OVERvalued v the dollar, though whether this means the euro will rise or fall against the dollar is a different issue. I guess this all returns to Asian central banks, since the RMB is pegged to the dollar at a ludicriously low rate.
It may be nationalism, but I’ve invested a lot in AUS$ assets.


Jeremy Osner 02.18.05 at 1:38 am

Thanks all.


cdm 02.18.05 at 2:23 am

[d^2] As also has Pierre-Olivier…


Giles 02.18.05 at 4:41 am

I haven’t read this paper properly but doesnt it assume a competitive market. It seems to make sense for an economy like Lxembourg but at the end of the day the US accounts for about a quarter of world gpd and will continue to do so for the foreseable future. It therefore has market power and so, while interesting for most economies, has few relevant results for the big economies of the world ie US, china and EU that are actually setting prices as opposed to leaving the market to decide.


Darren 02.18.05 at 9:40 am

Jeremy, see – Goldmoney and “The Coming Collapse of the Dollar” you may find both sites interesting.


Jeremy Osner 02.18.05 at 12:36 pm

Hmm… but goldbuggery is not what I was looking for…


Jeremy Osner 02.18.05 at 1:15 pm

Hmm… but goldbuggery is not What I Was Looking For…


elliottg 02.18.05 at 6:41 pm

In holding a short position, short term momentum is much more important than being right in the long term. How many lost money on Internet stock shorts even if ultimately they would have been right? Did it serve McGovern to be right about Vietnam? Only Long Term Capital Management was able to weather the storm of short term irrationality (with a massive capital infusion and help by central bankers) only because the people in power were unwilling to let it fail.


Ken Houghton 02.18.05 at 7:54 pm

Which is why one should never bet against the central banks, unless they are clearly and unarguably wrong. (In that one case, the rule is to stay out of the market.)

A country’s assets include political influence bought by holding dollars. How much is it worth to China, for instance, to hold enough USD assets that the possibility of dumping them into the market would be a significant enough threat to change US foreign policy?


Ken Houghton 02.18.05 at 7:55 pm

Which is why one should never bet against the central banks, unless they are clearly and unarguably wrong. (In that one case, the rule is to stay out of the market.)

A country’s assets include political influence bought by holding dollars. How much is it worth to China, for instance, to hold enough USD assets that the possibility of dumping them into the market would be a significant enough threat to change US foreign policy?


Ken Houghton 02.18.05 at 7:57 pm

Sorry for the double-down. Not exactly anything profound enough to split.


Giles 02.18.05 at 9:44 pm

Significant – but not credible. Dunping their reserves means that they loose about 60% of GDP in one bung – as well as their largest export market.


Jack 02.20.05 at 10:37 am

Giles may be right about the result but the calculations are not as clear cut as he suggests. China wouldn’t lose 60% of GDP in one bung, maybe 30% if the effects were really extreme for starters.

Nor would it lose the whole market — where would the US buy all that stuff from if not China?

Over time the size of China’s influence will change in relation to the size of its economy, most likely in China’s favour.

In any event it will depend upon what is at stake and finally it will be a game of chicken and nooone should rely on simple economic rationalism to determine behaviour in all circumstances. For example Saddam could have reasoned – why would the US spend $300bn to get rid of me?

There are also many ways of wielding power. For example it would be fun, sort of, to see China do to the treasury market what Citigroup did to the Euro bond market.


Michael Mouse 02.23.05 at 4:34 pm

Ken Houghton> Which is why one should never bet against the central banks, unless they are clearly and unarguably wrong. (In that one case, the rule is to stay out of the market.)

Or unless the depth of your pockets is of the same or greater magnitude than the central bank(s) you’re betting against, in which you can put your money where your mouth is and reasonably hope it’ll pay off handsomely.

The small number of entitities who are in this position probably don’t get their trading tips from CT comments tho’ …

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