PMC Market Commentary: March 21, 2014

A Macro View – Economic Demand vs. Financial Demand

Economics 101 states that price is determined by supply and demand. When supply of a particular good exceeds its demand, its price goes down; when demand exceeds supply, its price goes up. For most goods, supply is generally stable and it is the fluctuating demand side of the equation that most influences price. There are two kinds of demand, economic demand and financial demand. Economic demand is associated with actual consumption – for example, we demand food for nutrition and housing for shelter. Financial demand, however, is not for actual consumption, but rather aimed at achieving a financial reward.

For many goods, there are both economic and financial demands from various consumers. For example, regular consumers purchase gasoline to fuel their cars (economic demand). Commodity traders, however, buy gasoline contracts for hedging, speculation or market-making (financial demand). In most cases, price movements are determined by the dynamics of economic demand while financial demand is merely a reflection of economic demand.

However, for certain types of goods economic and financial demand can exert opposing forces on price movements and more often than not financial demand dictates the price direction. Gold is a quintessential example of this seemingly counterintuitive phenomenon. Gold is a luxury good whereby most of the economic demand is from its use in expensive jewelries. You would think that the price of gold would increase during prosperous times as more people can afford jewelries and thus bid up the price. Quite the contrary, gold prices generally rise during turbulent times while falling during booming times. During the 1970s, when the world was under the threat of nuclear war and energy shortage, the price of gold jumped more than ten-fold; however, during the 1990s, when the world witnessed the end of the Cold War and the birth of the Internet, gold tumbled nearly 30%. Why? The surge in financial demand for safety and stability during turbulent times and tumble of such demand during booming times far outweighs the dynamics of economic demand.

The currency market is another example where the financial dynamics far outweigh economic demand. The currency economic demand is derived from the import and export of goods or related to tourism/consumption in other countries. If this were the sole demand factor, foreign exchange rates should fluctuate only slightly within a short period as the purchasing powers among currencies generally do not shift significantly. However, as we all notice, it is not unusual even for major world currency exchange rates to swing a couple percentage points per day even though there is no way that economic demand can fluctuate that much on a daily basis. It can be only explained by the changes of financial demand that is heavily influenced by financial factors such as interest rate and monetary policy changes. For example, in 2013, due to Japan’s aggressive currency devaluation monetary policy, the Japanese Yen tumbled more than 20% against the dollar even though the Japan still ran a current account surplus and maintained its status as the second-largest foreign government holder of U.S. Treasuries in that year.

The takeaway is that we tend to underestimate the influence of financial demand and quickly dismiss it as noise or speculation, if not outright manipulation or fraud. Financial markets are not just a barometer of the real economy, but a very important and integral part of it. Due to their fast-moving and efficient nature, their impact can be more pronounced than the factors in real economy. Financial markets serve an important role in the economy for price discovery, enabling swift and efficient allocation of resources.

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