It's the Capital Account, Stupid

"Currencies should reflect fundamentals" and "I love Mom and apple pie": Who can disagree with such platitudes?

And yet officials appear to think that are saying something substantive when they say foreign-exchange prices should reflect fundamentals. Of course they should. Can they do anything but reflect fundamentals? The real issue is not fundamentals vs. something else but which set of fundamental factors is the key consideration for investment and speculative decisions.

The Capital Issue

When G7 or International Monetary Fund officials say that currencies should reflect fundamentals, it seems like they are referencing external imbalances. This underlies the call for Asian currencies to appreciate and the general belief that the U.S. dollar has to decline.

Yet we know that the money that is turned over in the currency market far overwhelms the flow of goods and services. Private estimates of daily volume in the foreign-exchange market are in excess of $2.5 trillion a day. That means one week's turnover in the foreign-exchange market is sufficient to cover a year of the world's trade. It seems unreasonable then to attribute a privileged place to the trade of goods and services in explaining or forecasting changes in foreign-exchange prices.

Rather than place undue emphasis on the trade account, investors and policymakers are better served focusing on the capital account. The fundamental considerations there seem to explain a greater part of market developments and foreign-exchange prices than trade balances.

The Yen and the Yield Curve

French and German officials have most recently expressed concern about the weakness of the yen. But the yen's weakness reflects a fundamental judgment of market participants.

That judgment isn't based on the fact that Japan's trade surplus is growing or that Japan is experiencing the longest economic recovery in its modern history. Rather, the key fundamental that market has been focused on is the low interest rate, the prospect that compared with Europe and the U.S., Japan's rates will remain relatively low. The steepness of the Japanese yield curve is likely to hold.

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Marc Chandler has been covering the global capital markets in one fashion or another for nearly 20 years, working at economic consulting firms and global investment banks. Currently, he is the chief foreign exchange strategist at Brown Brothers Harriman. Recently, Chandler was the chief currency strategist for HSBC Bank USA. He is a prolific writer and speaker and appears regularly on CNBC. In addition to being quoted in the financial press, Chandler is often a guest writer for the Financial Times. He also teaches at New York University, where he is an associate professor in the School of Continuing and Professional Studies. While Chandler cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.