Notes from Abroad

#6: On language, foreign exchange, and the end of negative rates.

This week, The Last Bear Standing is in Europe for a wedding and a quick vacation (or should I say, holiday). Hello to all the European readers! This week’s post covers three separate topics inspired by the trip abroad.

Ignorant American

I speak English.

If pressed, I’d tell you that I speak some Spanish as well, with a tiny hint of self-satisfaction. More accurately, I know some Spanish words - I certainly do not speak it.

Traveling abroad makes me hyper aware of my linguistic shortcomings. I greet people in my native tongue, and they respond to me in their second or third language. They don’t just know English words, they speak English¹.

Let there be no mistake - this is incredibly convenient. It also makes me feel pretty embarrassed. It’s one thing if being bilingual is a professional requirement - an airline attendant or international hotel employee - but seemingly everyone I interact with, taxi drivers, waiters, retail workers, or strangers at the bar, speaks English pretty darn well. Even those with relatively limited proficiency can still run laps around my “Spanish”, which is really only Spanish in the most abstract sense.

Determined, in the moment, not to be an Ignorant American² and still deeply delusional about my own linguistic abilities, the scene plays out like this:

[TLBS approaches the counter at the café]

Barista: ¡Hola!

TLBS: ¡Hola!

In my better moments, I vomit verbs and nouns, free of decorum or basic conjugation, much like a toddler. Sometimes, whatever scraps of vocabulary that I prepared for the moment vanish from my head.

I stare back at her, slack jawed, for two or three endless seconds. We blink.

After a sufficiently awkward period has passed, she throws me the rope.

Barista: Hello sir, may I help you?

TLBS: Hi, yes, I’m so sorry, may I please have a double espresso and chocolate croissant?

As she grabs my drink, I feel blood rush into my face. Of all the ways to fail at communication, staring like a moon-faced moron is probably the worst. If you aren’t going to bother to learn the basic phrases necessary to order an espresso like an adult, you should instead have the courtesy to first ask them in their language or yours whether they might speak English³.

But I don’t. I’m determined not to be an Ignorant American, just not determined enough to do something about it.

Wanting to do something (or be something) is equally effortless and useless. I want to be bilingual, a craftsman, and a pool shark, but since I have spent no time learning these skills, I am not. Recognizing what you know and what you don’t know helps you avoid being a moon-faced moron.

Much of my financial and economic analysis has focused on the United States because that is the language I speak. Beyond living there, I’ve spent a lot of time studying the U.S. stock market, economy, and monetary policy.

I know things about other economies around the world, but more similar to the way I speak Spanish. I have written about the Federal Reserve repeatedly and at length but not the European Central Bank, Bank of Japan or Bank of England, because I know there’s a decent chance of embarrassment if I do.

I’ve worried that this U.S. centric content may alienate some international readers⁴, but ultimately it is better than providing bad information on things I only pretend to know.

Conveniently for me - like the ubiquity of the English language - the U.S. is the largest economy in the world, the Dollar is the most important currency, and the U.S. financial market dwarfs all others. American financial commentators lucked out.

Of course, it’s possible to learn new languages. For example - Chinese Real Estate. I’ve never stepped foot in mainland China and have no firsthand knowledge of any of the specific companies I’ve analyzed. But I did go down an obsessive rabbit hole of research and assessed that I was fluent enough to be dangerous.

While my Spanish is unlikely to improve, I promise to keep trying to learn more financial languages and share them with you.

Foreign Exchange

The Euro has weakened about ten percent compared to the Dollar since the last time I was in Europe about a year ago. That movement in EUR/USD foreign exchange (“FX”) rate benefits the Americans in Europe, and hurts the Europeans in America. But most of the time Americans are in America, and Europeans are in Europe.

Most of the time FX rates don’t really impact the average person because his or her income and expenses are in the same currency⁵. Unless you are a financial market junkie, there probably isn’t a good reason to even know what these rates are on a regular basis. USD:USD is always 1.00. You don’t take FX risk when you are at home.

But consider if you could.

What if your employer offered you (an American in this example) the opportunity to convert your ongoing salary from Dollars to Euros based on today’s exchange rate? Would you do it?

Since your food and rent are still due in Dollars, your personal revenue and costs would be mismatched. If the Euro depreciates 10% in a year, you would lose 10% of your salary without a change in expenses. The average person only saves about 6-7% of their paycheck. Of course, the Euro might move in your favor but why introduce FX volatility when you don’t need to? If you want to take a directional view on EUR/USD, you can do that on your own terms, in the size and timeframe you wish.

Now, what if the Euro-conversion also came with a big one-time raise? A 50% raise would certainly tilt the risk/reward math in favor of the conversion. You’d have a big buffer for Euro depreciation before you’d earn less than your prior Dollar salary. FX risk, like all risks, can be palatable for the right premium.

The same considerations and calculus apply to investing. Today, it is easier than ever to invest across boarders, which is great. Globalized capital markets offer a wider array of opportunities to investors while also providing capital to regions that have been historically underserved.

But the ease of cross-border investing also hides one of the key risks - currency. Investing in dollarized products such as ETFs and ADRs obscures the fact that if you are buying a company or index that earns revenue and profits in a foreign currency, you are taking FX risk. This is true even if your investment is quoted in Dollar terms.

Hedging FX risk in equity investments is also more challenging than it may seem.

You could buy an FX swap matched to the size of your investment, but then you introduce the new risk of a duration mismatch between the term of the swap and the length of your hold. As an equity investor, you want to be able to sell opportunistically and won’t know exactly how long you will want to hold the security when you make the initial investment.

Further, a swap costs money. You will pay a spread to the spot rate, and more importantly you will need to dedicate capital (through credit or cash collateral) to backstop your side of the swap, which may go against you during the hold period. This capital drag could significantly degrade your return on the investment.

For emerging markets with less liquid currencies, the ability to put in multi-year hedges is prohibitively expensive or non-existent.

And let’s be honest, these hedging challenges are moot, because the majority of investors aren’t even attempting them. When you make foreign investments you must accept foreign exchange risk, but that doesn’t mean that you should never take the risk. Just like the hypothetical salary conversion - you should require a premium return to compensate.

Applying a “country risk premium” is a fairly common way to adjust your cost of capital for foreign investments, but this usually is meant to account for political or legal risks associated with a less developed country.

A similar “FX risk premium” needs to be considered as well. The size of the premium should increase greatly with more volatile currencies but should also exist for Sterling, Euro, or Yen. This premium is not based on a directional view of your domestic currency, but rather because a currency-matched portfolio is preferable to one with FX volatility.

Positive Rates

Over the past week, some dismal economic data has come out of Germany. Real retail sales fell 5.4% in April, while year-over-year inflation ticked up to 7.9% - a nasty combination. Most agree that the Eurozone economic outlook is much worse than the U.S.

With limited local production, Europe has been slammed by an energy shortage and food price hikes. Energy and food prices were already screaming higher prior to Russia’s invasion of Ukraine, but the war dumped petrol on the fire. This disruption in commodity markets is likely the biggest challenge facing the continent, one that is not nearly as acute stateside.

A secondary headwind, though, is the end of negative interest rates - an extreme policy prescription of the European Central Bank over the last decade⁶. Yields on German 10-year government bonds have increased from -70bps during the pandemic to 124bps today, the highest level in eight years. British government 10-year yields avoided going negative, but nonetheless are now at eight year highs. Comparatively, 10-year U.S. Treasuries, while higher in absolute terms than European counterparts, have not yet breached 2018 levels.

Negative interest rates are a financial perversion made possible by monetary authorities bidding government bonds higher than their theoretical maximum value. This perversion, of course, flows through to things like housing prices, implying that they too may be higher than their theoretical maximum value. The unwind of the bond bubble created by the endless bid of central banks over the past decade will be painful globally. But Europe will have the unique experience of unwinding a negative-interest-rate-policy (NIRP) bubble.

Europe has little choice in the matter. With the Federal Reserve intent on hiking aggressively with a stronger consumer and secure supply of wheat and oil, the European Central Bank must follow suit or risk further devaluation of its currency, already under significant pressure over the past year.

A return to rationality in finance, after a decade of irrationality would be hard under any economic backdrop. Unfortunately, the backdrop is inflation, shortages and war.

1. Anecdotally, the ubiquity of the English language has increased over the years. There is a network effect to language, and English seems to be way ahead in that race. Of course, English is the default for international business, but it goes beyond that. I regularly hear Europeans who don’t speak the same first language using a third language (English) as the go-between. I’d be curious if anyone has data or perspective on this. Is it driven by an increasing globally connectivity in entertainment and culture? Is it a de-facto requirement for certain jobs? Is it a begrudged obligation, or something people strive to learn? This is not an area I know much about so please add your perspective in the comments!

2. I am singling out Americans because I am one, but as far as I can tell this is an English language problem. British tourists (from what I’ve seen) seem to be as deficient as Americans in language and decorum, but of course I’m biased. Nevertheless, the cross-Atlantic rivalry is interesting. Americans in Europe are self-conscious because they think Europeans dislike them (maybe true?) and because there is a undeniable style, sophistication, and history in the continent that America lacks. In turn, perhaps Europeans dislike America because it upended a centuries-long run of European economic and cultural dominance, and our stuff is generally newer, bigger, and better. To avoid the predicament, I tell people I’m from New York which invariably gets an enthusiastic, positive response.

3. After dusting off the cobwebs in the first day or two, I am happy to report that I have stopped going moon-face, and instead have fully graduated to toddler.

4. One of the coolest things to me is seeing all of the different languages that people have used while quote-tweeting some of my posts on Twitter. When this happens, I get very excited and yell across the apartment, “Babe! Some dude quote-tweeted me in HEBREW!”

5. Obviously, FX rates do matter at a higher level, as they impact international trade and capital markets, and in turn, prices paid by everyday people.

6. Didn’t I just say that I don’t know anything about the ECB? Yes - but you don’t need to know a whole lot to understand how negative rates come about (policy), and what happens when they reverse.