Quality and Quantity: A powerful currency prediction framework

Currency forecasters usually talk about all sorts of issues except the right ones when it comes to predicting currency direction.  This is why nearly all currency predictions are wrong, and not just wrong, but badly wrong. 

Now, we don’t presume to know exactly where the rand is going next year, but we do want to give readers a more sound framework for determining currency direction in these crazy times.  And based on this framework, the rand is going stronger.  MUCH stronger. 

The first important point to make is that the rand is the currency everyone loves to hate.  The bearish rand view is always the most popular.  Look at most forecasts for next year or 2011 and you get the rand getting weaker not stronger.  When the rand gets to below R8.00/$ it’s unsustainable, when it gets to R12.00/$ it’s blowing out to R20.00/$. 

Listening to these perennial wrongnosticators you would think the rand is permanently on borrowed time, just waiting to fall into oblivion to where it’s justified by the ‘real’ fundamentals.  Just about every year these folks are proved wrong, and every year they’re back sprouting the same wisdom.  Insanity? 

Now, don’t get me wrong, the rand weakening from parity to the US dollar in the early ’80’s to R7/dollar now is no accident, and is an undoubtedly bearish trend.  Also, the rand did get smashed briefly late in 2008 as global investors panicked and fled to dollars during the worst of the banking crisis.  All this is deserved.  From the mid-80’s until now, the Reserve Bank has run massively inflationary policies at a time when in the US the Regan-Bush-Clinton era produced low inflation and dollar stability.  The rand didn’t have a chance vs the greenback.  The blowout last year was also somewhat deserved, and while much of it had to do with a clamour for dollar liquidity across the globe, a lot of it also had to do with rampantly excessive money supply growth in the preceding few years.  The rand, in a sense, was spring-loaded for weakness last year. 

So, where does the rand stand now, and what is its medium term future? 

Human Action proposes two key factors to consider in a proper currency framework:  Quality and Quantity. 

Analysts generally think the rand’s quality is forever worsening due to the current account deficit, political risk, weak manufacturing sector, unproductive labour, HIV/Aids etc etc.  This is an easy trap to fall into, but wrong nonetheless.  The real test of a currency’s quality is what backs it, and the real test of where that currency is heading relative to another currency (assuming quantity fixed for now) is how that currency’s quality, or backing, is changing relative to the other. 

The quality of all the major currencies has been worsening through this recession.  Major central banks have been printing new money and buying up very poor assets from ailing banks.  Where the US dollar was once backed by gold, it then became backed by US govt debt, and now it’s backed by unsustainable govt debt, and toxic mortgage backed assets.  This keeps getting worse.  This can be called qualitative easing. 

The rand is backed by a mix of gold, government bonds, foreign exchange and various other assets.  The rand’s backing is not particularly good and it shares similarly poor quality with most other fiat currency, but the big point is that through this recession, SA has not worsened the rand’s quality, and the govt debt that backs it is still at a manageable level, unlike most of the major economies.  Very importantly, as a major gold producer, the rise in gold demand and price means the rand is increasingly backed by appreciating underground money reserves. 

So, one can say at the very least that the rand’s quality is not getting worse, while the quality of the US dollar, pound sterling, euro and yen is declining rapidly. 

In terms of quantity, this is a far easier story to tell.  A quick look at money supply stats shows US, UK and European money supply growth is rampant, while SA’s money supply is stagnating if not falling slightly.

SA M1 money supply growth near 0%…

US M1 money supply growth around 15%…

With no new rand’s currently being printed out of thin air, and a vast wall of dollars being created and pumped into the system (quantitative easing), and with the rand’s quality not deteriorating while the dollar’s quality is being hammered, the rand is likely to not only stay strong, but keep getting stronger against the major currencies. 

Where can we go in 2010?  Below R7.00/$?  Definitely.  Below R6.00/$?  Probably.  Below R5.00/$?  Very Possible.