Chapter 5

Looking at the Big Picture

In This Chapter

Getting to know the main drivers of currency rates

Monitoring monetary policy and interest rates

Understanding official currency policies and intervention

Gauging risk sentiment and financial stability

The forex market is inherently a big-picture market. FX traders focus on

• Interest rates and monetary policy developments.
• Economic growth and inflation data.
• Political elections and economic policies in major economies.
• Geopolitical risks, trade conflicts, and terror attacks.
• Major movements in other financial markets.

On a daily basis, currency traders have to sort through myriad economic reports, interpret the comments of political and financial officials from around the world, take stock of geopolitical developments, and assess movements in other financial markets. They do all this to help them determine what direction major currencies are likely to move.

Unfortunately, there is no set recipe for absorbing the daily flow of data and news to produce a clear-cut answer. Even if there were, many different market actors are pursuing their own interests, which may not be profit maximizing (see Chapter 3). Throw in market sentiment and future expectations, and you’re looking at market participants interpreting the same data and reaching different conclusions, or maybe reaching the same conclusions but at different times. In this chapter, we lay the foundation for building the framework to make sense of the many policy, data, and news inputs that affect the forex markets every day.

The first step in laying the foundation is to get a handle on interest rates and monetary policy, because they’re the final product of most of the other inputs. Unless you’re an economist or banker, following monetary policy developments probably is not one of your favorite hobbies. But if you’re going to actively trade in the forex market, you need to get a handle on monetary policy and interest rates. We’re not trying to turn you into an economist or an interest-rate analyst — we just want to give you the lowdown on how interest rates affect currencies.

In this chapter, we lay it all out so you can make sense of how it works, what goes into it, and how it’s communicated to the market. Later in the chapter, we get into the key elements of official currency policies and what happens when governments intervene in forex markets. Lastly, we take a look at the Great Financial Crisis of 2008–2009 (GFC) to see what lessons it holds for currency traders.

Currencies and Interest Rates

If the guiding principle in real estate is “location, location, location,” in currency trading it’s “interest rates, interest rates, interest rates.” The most significant overall determinant of a currency’s value relative to other currencies is the nature and direction of monetary policy set by a country’s central bank.

When we say “monetary policy,” we mean policy changes by a country’s central bank, such as changing interest rates and introducing quantitative easing, among other things.

Perhaps the most important thing that a central bank does in relation to the forex market is set domestic interest rates, which also influence overall economic activity. Lower interest rates typically stimulate borrowing, investment, and consumption, while higher interest rates tend to reduce borrowing and increase saving over consumption.

Interest rates are important to currencies because they influence the direction of global capital flows and serve as benchmarks for what investors expect to earn investing in a particular country. This situation applies most directly to fixed income investing (bonds), which comprise the lion’s share of investments, but it also influences equity and other investment flows. All other things being equal, if you could invest in a government-backed bond that yields 6 percent or one that yields 2 percent, which would you choose? The one with the higher yield, of course. And that’s exactly what happens with currencies. Currencies with higher yields (higher interest rates) tend to go up, and currencies with lower yields (lower interest rates) tend to weaken.

Although we stress interest rates as one of the primary drivers of currency rates, interest rates are not the only determinant of currency values. Plenty of other elements come into play, affecting currency rates both in short-term trading and in long-term trends. To use an analogy, think of the stage in a theater. Now think of interest rates as being the backdrop and the lighting on that stage. Various actors come and go; sets and props are changed between acts; but all the action on the stage takes place against the backdrop and under the lights. Interest rates provide the backdrop and set the lighting for most major currency movements, even if they’re not always the center of attention.

The future is now: Interest rate expectations

It’s not just the current level of interest rates that matter. Markets are always adjusting to changing circumstances and anticipating future developments. When it comes to currencies and interest rates, forex markets are focused more on the direction of future interest rate moves (higher or lower) than they are on the current levels because they’re already priced in by the market. So even though a currency may have a low interest rate, market expectations of higher interest rates in the future frequently will cause the currency to appreciate.

And what drives interest rate expectations? The evolving economic outlook based on incoming data (we look at understanding and interpreting economic data in Chapters 6 and 7), economic assessments and guidance by monetary policymakers (see “Watching the central bankers” section later in this chapter), and a host of other economic, fiscal, and political developments (some of which we look at later in this chapter).

Keep an eye on various interest rate futures markets, such as the Fed Funds futures contract for U.S. rates, to see what expectations markets are pricing in. These can be found on financial websites like Bloomberg.com, Reuters.com, and Marketwatch.com. The commentary will usually note that markets have priced in, say, 18 bps of tightening by the next FOMC meeting, meaning the market is expecting a 72 percent chance of a 25 bp rate hike (18 bps/25 bps= 72 percent).

The outlook period, or the time frame in which markets are expecting interest rates to change, can span several months or quarters into the future. Depending on the economic circumstances and the outlook, markets may price-in interest rate changes a full year in advance, driving short term yields and currency levels in the process. Subsequent currency and yield fluctuations are based on incoming data and official guidance relative to the expectations markets have priced-in.

Relative interest rates

It’s important to remember that currencies always come in pairs. Rather than focusing solely on a particular currency’s interest rate level or outlook, forex markets tend to focus on the potential difference between two currencies’ prospective interest rate changes. If two major currencies’ central banks are both expected to be raising rates by the same amount in the future, there’s little reason for one to outperform the other. But if one is expected to raise rates higher or faster, there are grounds for one currency to strengthen relative to the other.

Forex market volatility sunk to record lows in 2014 after the major global central banks all kept interest rates at close to record low levels. At the time of writing, the market was waiting for some divergence in interest rate policies to trigger a bout of volatility in the forex market. This is a good reminder of the fact that interest rates are one of the key drivers of the forex market.

Interest-rate differentials

The difference between the interest rates of the two currencies, known as the interest-rate differential or spread, is the key rate to watch. An increasing or widening interest-rate differential will generally favor the higher-yielding currency, whereas a falling or narrowing interest-rate differential will tend to favor the lower-yielding currency.

Some of the largest currency swings occur when two countries’ interest rate cycles are moving, or are thought to be set to move, in opposite directions. And they don’t necessarily have to both be moving — one currency could see expectations of higher/lower rates, whereas the other’s rates are set to stay on hold. By focusing on the interest-rate differential, you can detect such changes more readily than by focusing on the rates of any individual currency.

Traders should monitor the interest-rate differentials among the major currencies by looking at the spreads between short-term government debt yields to spot shifts that may not otherwise be evident. Worth noting: The government bond market tends to price-in expected changes to interest rates, so it can give a more up-to-date view of what the market is thinking about rates compared to, say, the actual level of interest rates announced by a central bank. For example, U.S. 2-year yields may decline by 5 bps (basis points, or a hundredth of 1 percent) — not an unusual daily development. Around the same time, Australian 2-year yields may move 5 bps higher — again, nothing earth shattering there viewed on its own. But add the two together, and you’re looking at a 10 bps move between the two, and that’s something to pay attention to. If the same thing happens again the following day, now you’re looking at a 20 bps change in the differential, which is nearly equivalent to a typical 25 bps interest rate change from a central bank. You can be sure that if the Reserve Bank of Australia (RBA) unexpectedly raised interest rates by ¼ percent, or the Fed surprised everyone by cutting rates by ¼ percent, there would be some sharp swings in AUD/USD. The same holds true for changes in the interest-rate differentials, and they occur on a daily basis rather than the monthly meetings of most central banks.

Nominal and real interest rates

The interest rate to focus on is not always just the nominal interest rate (the base interest rates you see, such as the yield on a bond). Markets focus on real interest rates (inflation-adjusted rates, which is the nominal interest rate minus the rate of inflation [usually consumer price index]). So even though a bond may carry a nominal yield of, say, 8.5 percent, if the annual rate of inflation in the country is 4.5 percent, the real yield on the bond is closer to 4 percent.

This phenomenon is most evident in emerging market economies facing hyperinflation. Even though nominal interest rates may be 20 percent, if the annual rate of inflation is 25 percent, the real yield is −5 percent. Hyperinflation and negative yields lead to capital flight. The result is extreme weakness in the domestic currency, even though nominal interest rates may be extremely high.

The same can be true with very low interest rates and deflation (negative inflation), such as what happened in Japan from 2000 to 2013. With interest rates at very low levels, eventually zero, and facing deflation, real Japanese yields were significantly higher than the nominal zero rates on offer. (Remember: If you subtract a negative number, it’s the same as adding that positive number.) As a result, the JPY experienced overall appreciation in this period despite very low nominal rates and abysmal economic prospects.

In the following sections, we introduce the key objectives of monetary policy, take you through the tool kits of monetary policymakers, and show you how to stay on top of the evolving interest rate picture.

Monetary Policy 101

Monetary policy is the set of policy actions that central banks use to achieve their legal mandates. Most central banks function under legislative mandates that focus on two basic objectives:

• Promoting price stability (a.k.a. restraining inflation)
• Promoting sustainable economic growth, sometimes with an explicit goal of promoting maximum employment

Although it’s a no-brainer that promoting economic growth is more important to those of us who work for a living, central bankers like to focus primarily on inflation. Low inflation fosters stable business and investment environments, so central bankers see it as the best way to promote long-run economic growth. Low inflation is also an end in itself because high inflation erodes asset values and undermines capital accumulation. Some central banks, like the U.S. Federal Reserve, have a joint mandate of price stability and promoting maximum employment. Other central banks, such as the European Central Bank (ECB), have only one mandate — to ensure price stability — with other policy objectives (growth and employment) explicitly relegated to secondary status. Still other central banks — the Swiss National Bank, for example — have a mandate to ensure a stable currency, though most countries have delegated that responsibility to the national finance ministry/treasury department.

Looking at benchmark interest rates

The primary lever of monetary policy is changes to benchmark interest rates, such as the federal funds rate in the United States or the refinance rate in the Eurozone. Changes in interest rates effectively amount to changes in the cost of money, where higher interest rates increase the cost of borrowing and lower interest rates reduce the cost of borrowing. The benchmark rates set by central banks apply to the nation’s banking system and determine the cost of borrowing between banks. Banks in turn adjust the interest rates they charge to firms and individual borrowers based on these benchmark rates, affecting domestic retail borrowing costs. Other tools in the monetary policy toolkit used by central bankers are

• Quantitative easing (QE): An unconventional monetary policy used by central banks, where they buy financial assets from commercial banks and private institutions to raise the price of assets and lower their yields, while simultaneously increasing the monetary base. In the aftermath of the financial crisis, major central banks embarked on programs of QE to try to boost their economies. This included buying government and some corporate bonds to lower bond yields and try to boost lending.
• Reserve requirements: The amount of capital required to be set aside by the banking system; money that cannot be used for lending.

Easy money, tight money

The main thrust (or bias, as markets call it) of monetary policy generally falls into two categories: expansionary or restrictive. An expansionary monetary policy aims to expand or stimulate economic growth, while a restrictive bias aims to slow economic growth, usually to fight off inflation.

Expansionary monetary policy

Expansionary monetary policy (also known as accommodative or stimulative monetary policy) is typically achieved through lowering interest rates (that is, reducing the costs of borrowing in the hope of spurring investment and consumer spending). Cutting interest rates is also known as easing interest rates and is frequently summed up in the term easy monetary policy. Central banks can also increase the money supply — the overall quantity of money in the economy — which also works to lower borrowing costs. A reduction in the reserve requirement of banks frees up capital for lending, adding to the money supply and reducing borrowing costs as well.

An expansionary monetary policy is typically employed when economic growth is low, stagnant, or contracting, and unemployment is rising. Central banks of the major economies reacted to the fallout from the GFC and the global recession by slashing interest rates to historically low levels, near zero in the case of the United States, Switzerland, and Japan.

Restrictive monetary policy

Restrictive monetary policy (also known as contractionary or tighter monetary policy) is achieved by raising, or “tightening,” interest rates. Higher interest rates increase the cost of borrowing, and work to reduce spending and investment with the aim of slowing economic growth and lowering inflation.

Central banks typically employ a tighter monetary policy when an economy is believed to be expanding too rapidly. The fear from the central banker’s perspective is that heightened demand coupled with the low cost of borrowing may lead to inflation beyond levels considered acceptable to the long-run health of an economy. With too much money chasing the same or too few goods, prices begin to rise, and inflation rears its ugly head. Rapid wage gains, for example, may lead to increased personal consumption, driving up the cost of all manner of retail products.

Changing rates incrementally

Changes in monetary policy usually involve many small shifts in interest rates, because central bankers are generally reluctant to shock an economy by adjusting interest rates too drastically. Even the potential for large interest rate changes could contribute to uncertainty among investors and businesses, potentially disrupting or delaying well-laid business plans, thereby harming the overall economy in the process and potentially boosting unemployment. Typical interest rate changes among the major central banks center on ¼ percent or 25 basis points (a basis point is 1/100th of 1 percent, or 0.01 percent), with 50 bps (or ½ percent) as the next most frequent rate adjustment.

The GFC and the accompanying global recession caused key central banks to slash rates rapidly, with cuts of 75 to 100 bps coming in rapid succession in some cases. Having cut benchmark rates to near zero, several major central banks felt compelled to undertake additional unconventional easing measures, such as QE, to support their economies.

Unconventional easing

Central banks can only directly influence the level of short term interest rates. Longer-term interest rates, the ones used by markets to set business and consumer lending rates, are determined by bond investors and are based on their views of growth, inflation, and creditworthiness. For example, the 10-year U.S. Treasury rate is the benchmark for U.S. mortgage rates.

When central banks cut their benchmark rates to near-zero levels, they were faced with the zero-lower bound of interest rates. To further support their economies, they sought to drive down longer-term lending rates through unconventional means, typically large-scale asset purchase programs where the central bank buys longer-term government bonds. (Remember, bond prices move inversely to bond yields — it’s just bond math. Buying longer-maturity bonds theoretically pushes bond prices higher and yields lower, hopefully sending consumer and business lending rates down in the process.)

Such large-scale asset purchase programs are frequently referred to as QE because the central bank is increasing the money supply, the quantity, by creating money to buy the bonds. In the United States, the Federal Reserve initiated two rounds of quantitative easing, while in the UK and Japan, the Bank of England and the Bank of Japan also undertook large-scale asset purchase programs. (Japan had also pursued QE repeatedly in the prior decade, well before the GFC.)

Currencies of countries pursuing such unconventional easing typically tend to weaken because such measures may drive down interest rates relative to other countries’ rates, at least while the program is in place. Some investors also view an increasing money supply as a currency negative (the greater the supply, the lower the value). But that doesn’t always hold true, especially if the extra money seeps out of the economy and into other markets, as it did in the United States in 2009.

A good example of this is when the U.S. Federal Reserve indicated in August 2010 it was considering undertaking a second round of QE, known as QE2. Initially, the USD weakened as the Fed was seen to be trying to lower rates further. But when the actual program was announced, the USD began to strengthen and U.S. yields moved higher. It might look like a case of “sell the rumor, buy the fact,” but it was more in response to U.S. data and the immediate outlook: The Fed was looking at QE2 in response to a slowdown in the summer of 2010, but by the time QE2 started in November 2010, U.S. data and the outlook had rebounded. And all that money the Fed was supposedly printing? It mostly ended up back at the Fed in the form of excess reserves held by the banking system, meaning it never entered the real economy.

Watching the central bankers

If you’ve read this chapter from the beginning, you’ve probably gotten the impression that determining monetary policy is mostly an exercise in shades of gray rather than a simple black-and-white equation — and you’d be exactly right. But given the significance of monetary policy to currencies, currency traders devote a great deal of attention trying to divine the intentions of central bankers. This has not always been an easy task, but recent trends among central banks to improve the openness of communications with markets, frequently referred to as transparency, have made the process less of a guessing game.

Central bankers communicate with the markets in a number of ways, and their comments can provoke market reactions similar to major economic data releases — by that, we mean sharp initial price movements followed by continued volatility or a potential change in direction.

• Rate decisions: Interest-rate setting committees of central banks meet at regularly scheduled times. At the conclusion of a meeting, they issue a formal announcement of the policy decisions made at the meeting. They can raise, lower, or hold interest rates steady. They can also make changes to reserve requirements or liquidity operations.
• Policy statements or guidance: Along with the interest rate decision, central banks frequently issue an accompanying statement that explains the basis for their policy action. These statements are also used to provide guidance to markets on the future course of monetary policy. The statements are carefully parsed by markets intent on discovering what the central bank is thinking, which way it’s leaning, and what the timing may be for future changes. In recent years, rate announcements are often preceded by a press conference by the head of the central bank. The Federal Reserve and the European Central Bank both hold press conferences after some of their meetings. Rate announcements and accompanying policy statements are included on economic data/event calendars.
• Public speeches: Central bankers frequently appear before community and business groups, and address subjects ranging from trends in the financial industry (such as the rise of hedge funds or the use of derivatives) to relatively mundane governance issues (such as financial reporting requirements). But when a central banker gives a speech that assesses the economic outlook or the future course of monetary policy, forex markets are all ears.

Appearances by central bank officials typically are included on most economic event/data calendars, and you need to be aware of them to avoid being taken by surprise. Sometimes, the topic of the speech is given in advance; other times, it’s not. The most important speeches are those that focus on the economic outlook or the current monetary policy assessment.

In most cases, a prepared text is released by financial newswires at the scheduled start time of the speech. Accredited news agencies receive copies of speeches in advance to allow their reporters to prepare stories and headlines, but the release of the information is embargoed until the designated time. The remarks are then encapsulated into a series of headlines that capture the main points of the speech; this is the news that markets receive at the appointed time. When these headlines hit traders’ screens, market prices start to react. If a question-and-answer session follows, the central banker’s comments will be posted by the newswires as they’re delivered live. This setup can make for some exciting headline-driven trading.

Currency traders need to be aware of and constantly follow the current market thinking on the direction of interest rates because of the strong relationship between interest rates and currency values. The best way to do this is to follow market commentaries in print and online news media, always keeping in mind that such outlets (especially print) are usually one step behind the current market. This makes online news commentaries that much more relevant. Some of the best sites for timely insights and market reporting are Bloomberg.com, Reuters.com, and MarketWatch.com. Twitter is a great resource for getting the latest central bank headlines. Best of all, for now, most of these sites are free.

Look for currency brokers that offer real-time market analysis and news updates.

In the next section, we delve a bit deeper into how monetary policy is presented to financial markets by central bank officials. We also look at currency-specific policies and rhetoric. Sometimes, how a message is delivered or who delivers it is more important than the message itself. This is certainly true of monetary or currency policy comments from central bank or government finance officials.

Interpreting monetary policy communications

Earlier in this chapter, we cover the various ways in which central bankers communicate their thinking to market participants (see the preceding section). But the process is far more nuanced and evolved than relying simply on official policy statements or speeches before the Rotary Club of Indianapolis. Central bankers are keenly aware that their comments have the ability to move, and potentially disrupt, financial markets all over the world. So they choose their words very carefully, leaving traders to act as interpreters. Before you start interpreting monetary policy statements and commentary, it’ll help to know the following.

Not all central bankers are created equal

The interest rate setting committees of central banks, frequently known as Monetary Policy Committees (MPCs) — the Fed’s FOMC is one of these — typically operate under a one-member/one-vote rule. But when it comes to delivering a message to the markets, the chairman or president of the central bank and its deputies hold far more sway than any other individual member. This is partly in deference to the central bank chief’s role as first among equals, but also because that person is frequently viewed as expressing the thinking of the entire committee. Central bankers strive for consensus in reaching their decisions, and who better to represent and present this view than the chairman or president?

When the head of the central bank gives an update on the economy or the outlook for interest rates, listen up. A scheduled speech by the chair of the Fed, for instance, is likely to be preceded by market speculation similar to that of a major economic data report. And the reaction to his comments can be equally sharp.

In the case of the Fed, the FOMC is composed of 12 voting members consisting of the board of governors and a rotating slate of regional Federal Reserve Bank presidents each year. So when a Federal Reserve Bank president is set to speak, make sure you know whether she’s a voting member in the current year before acting on her comments.

Remarks by nonvoting FOMC members are frequently discounted or ignored by traders because the speaker is not going to be casting a vote at the next meeting. But this is a bit of an oversimplification and can be risky. Before downplaying a nonvoter’s comments, you need to consider her comments in the context of the FOMC consensus. Is she expressing her own views or elaborating on a shift in consensus thinking?

Birds of a feather: Hawks and doves

Central bank officials are frequently a known commodity to market analysts and traders, either from past policy statements or from their academic or policy writings prior to becoming central bankers. Markets typically refer to central bankers in terms of being hawks or doves. A hawk is someone who generally favors an aggressive approach to fighting inflation and is not averse to raising rates even if it will hurt economic growth. A dove, on the other hand, is a central banker who tends to favor pro-growth and employment monetary policy, and is generally reluctant to tighten rates if it will hurt the economy. In short, hawks tend to be fixated on fighting inflation, and doves tend to stress growth and employment.

Don’t get us wrong: There are plenty of central bankers in the middle who can wear both hats (or feathers, in this instance). In those cases, the middle-of-the-roaders tend to reveal their hawkish or dovish leanings only at the extremes of the policy cycles.

So if a hawk is slated to speak on the outlook for monetary policy, and he cites the risks from inflation or the need to prevent any increase in inflationary pressures, guess what? You’re not going to see much of a reaction from the markets because he’s a known quantity speaking true to form. You get a much sharper reaction when a hawk downplays the threats from inflation or suggests that inflationary pressures may be starting to recede. Markets will jump all over dovish comments coming from a hawk, and vice versa with hawkish comments made by a dove.

Official Currency Policies and Rhetoric

Another major influence on currency values is government policies or official stances regarding the value of individual currencies. Some of the largest changes in currency values in recent decades have been brought on by official policies and multilateral agreements among the major industrialized economies. For instance, the Plaza Accord of 1985 stands out as a watershed in forex market history, ultimately resulting in a roughly 50 percent devaluation of the U.S. dollar over the course of the next two years.

National governments have a great deal at stake when it comes to the value of their currencies. After all, in a sense, a nation’s currency is the front door to its economy and financial markets. If the currency is viewed as unstable or too volatile, it’s tantamount to slamming the front door shut. And no major economy can afford to do that today.

In this section, we look at the major objectives of national currency policies, who sets them, and how they’re implemented.

Currency policy or currency stance?

Referring to official government thinking on currencies as a currency policy may be a mischaracterization. Instead, you may do better to think of it as a stance on particular currency values at a particular point in time.

Daily trading volumes in the forex market dwarf most national central bank currency reserve holdings. (Currency reserves are the accumulated stocks of international currencies held by central banks for use in market interventions and overall central bank reserve management.) Japan and China together have more than $2 trillion in central bank currency reserves. That may seem like a lot, but average currency trading volume in the global forex market is over $4 trillion per day. This means that even if national governments wanted to routinely manage the value of their national currency, they would be hard-pressed to overcome market forces if they were at odds with the official policy.

To summarize why governments are generally reluctant to get involved in trying to influence currency values, it comes down to the following:

• They can’t because they’re too small. Forex markets are much bigger than any one nation’s foreign currency reserves.
• They can’t because of market structure. Forex markets operate outside national jurisdictions.
• They can’t agree on what to do. Currencies always have another country or countries on the other side of the pair. You may want your currency to weaken, but do others want their currencies to strengthen? Not everyone can have a weak currency.
• They don’t want to meddle in the free market. Tampering with international capital flows is a recipe for economic disaster and, in some cases, diplomatic discontent.

Generally speaking, then, governments prefer to refrain from getting involved in setting currency rates or trying to influence overall currency direction. They recognize that their power is extremely limited and that it must be used sparingly, usually only when extreme circumstances demand action from the national government or collective action from several governments. Moreover, the global economic superpowers are believers in the power of free markets to best allocate capital and maximize long-run economic potential. It simply would not do for them to openly reject free-market policies by regularly seeking to influence currency rates. You have to practice what you preach, or you start losing your following. For governments, that translates to credibility — and that’s a trait most governments seek to cultivate and protect.

But — and this is a big but — governments do seek to influence currency rates from time to time. And when they do, it’s usually a key long-term turning point in currency values.

In the next section, we look at the principal actors in each country or currency zone and what their recent actions on currencies suggest for their currency policy goals.

Calling the shots on currencies

In the “Currency policy or currency stance?” section, earlier in this chapter, we list a number of reasons why national governments are reluctant to get involved in trying to influence the value of their currencies. Chief among these are the size and extent of the global forex market and the need for nations to reach agreement on whether adjustments are even needed. The Group of Seven (G7) used to be the main body where currency issues would be handled, but globalization has brought more economies to the table in the form of the Group of Twenty (G20). (We list the membership of the G7 and G20 at the end of Chapter 3.) With an even larger collection of competing national interests in the bigger G20, collective action on currencies seems less likely.

If governments had their way, they would probably prefer to see fixed exchange rates replace floating rates and avoid the subject entirely, but that’s not a realistic option for the foreseeable future. Confronted with the realities of forex markets, most government currency officials go to great lengths to avoid discussing currency values out of fear that their comments will be misinterpreted and lead to sharp exchange rate shifts. That fear was born out of experience, and today’s top currency officials are much more discreet than their predecessors just a few decades ago.

Responsibility for currency matters typically falls to the finance ministry or the central bank in the nations of the most heavily traded currencies. In the following sections, we take a look at who has responsibility for setting and implementing currency policies in the five major currencies and what their major motivations are.

The United States

The Department of the Treasury has the legal mandate for all currency matters, from printing the notes and minting the coins to ensuring the soundness of the U.S. dollar in international markets. The secretary of the Treasury is the primary spokesman for the U.S. dollar. The deputy Treasury secretary for international affairs is the hands-on Treasury official responsible for day-to-day currency matters.

When the U.S. Treasury secretary speaks on the value of the dollar, or any other currency for that matter, FX markets listen.

The Eurozone

The European Central Bank (ECB) is responsible for both monetary policy and currency matters under the agreement that created the single-currency Euro in 1999. The ECB’s governing council is the primary decision-making body; it’s composed of the presidents of the central banks of the participating nations, with the ECB president as the group’s chief policy maker and spokesman.

When the ECB needs to intervene in the market, it can do so by itself, along with the central banks of the member states on its behalf. In the EUR’s early years, global central banks intervened to prop up the newly formed currency; however, in recent years, there has been no official intervention in the EUR.

However, individual European countries continue to exert influence over currency policy through their finance ministers, who had responsibility for currencies prior to the introduction of the euro and the creation of the ECB. The Eurozone finance ministers meet regularly as a group and frequently weigh in on forex market developments. There still appears to be great consideration given to the member states’ governments by markets with regard to currency values, with the two largest European economies — Germany and France — wielding the greatest influence. But consensus appears to be the key element in deciding if the euro is too strong or too weak, and a clear majority of member states needs to be on board in opposing market movements before the market will pay attention.

The ECB is primarily concerned with fighting inflation and seeks to achieve currency stability as a means of fostering long-term economic growth. Although Europe remains heavily export oriented, so extreme euro strength is a risk factor for the Eurozone economy, the ECB has been reluctant to intervene in the forex market so far.

Japan

The Ministry of Finance (MOF) is responsible for currency matters in Japan. The MOF is the most powerful government ministry in Japan and can wield more influence over economic affairs than even the Bank of Japan (BOJ), the central bank. The MOF devotes a great deal of attention to the value of the JPY. The primary day-to-day currency spokesman for the MOF is the vice minister for international affairs, but during periods of volatility the finance minister will frequently issue statements. It is not at all uncommon for the MOF to issue daily comments on the forex markets, particularly when JPY volatility increases. The MOF last ordered an intervention (see the next section) in September 2010 as the JPY was strengthening and USD/JPY was threatening to drop under the key 80.00 level as the Fed geared up for a second round of quantitative easing. The Japanese authorities, along with the major global central banks, also intervened in the JPY in the aftermath of the 2011 tsunami. The yen surged on the back of safe-haven flows, but the intervention was necessary to limit JPY strength and help rebuild the Japanese economy on the back of this tragic event.

Japan’s economy remains highly export oriented, so the value of the JPY is important to export competitiveness and corporate profitability. Excessive JPY strength, which makes exports more expensive abroad and lowers the profit from foreign sales, is usually the trigger point for the MOF to express concern and possibly take action in the market.

Great Britain

The Chancellor of the Exchequer (treasury secretary or finance minister) is the individual responsible for the British pound’s fate. The governor of the Bank of England (BOE) also shares responsibility for the pound in a bit of a holdover arrangement from when the BOE became independent from the government in 1997.

The chancellor/BOE generally stays out of currency matters and appears most concerned with the pound’s exchange rate versus the euro, because the bulk of UK trade is conducted with the Eurozone.

The United Kingdom is closely aligned with European economies and would be a candidate to join the Eurozone single currency, but nationalism runs deep when it comes to getting rid of the pound. The standing government line is that no decision on joining the euro would be made without conducting a national referendum.

Switzerland

The Swiss National Bank (SNB) is charged with responsibility for the Swiss franc along with setting monetary policy. The SNB is most concerned with the Swiss franc’s exchange rate versus the euro, because nearly 80 percent of Swiss trade is conducted with Eurozone nations. The SNB has been known to speak up in opposition to CHF strength or weakness whenever the EUR/CHF exchange rate approaches extreme levels. During the Eurozone debt crisis in late 2009–2010, EUR weakened sharply against the CHF and prompted the SNB to intervene repeatedly to stem CHF strength, but without any success.

However, in 2011, the SNB took the unusual step of imposing a 1.20 peg on the EUR/CHF rate. At the time of writing, the SNB remains fully committed to this peg. Whenever the EUR/CHF rate approaches 1.20, the SNB is ready to intervene to stop it from falling below this level and limiting CHF strength. The market has taken the SNB at its word, and there have been only a handful of occasions since 2011 when the EUR/CHF rate has fallen below 1.20. This is an unusual situation — usually, intervention occurs only for a temporary period or in response to an economic crisis or national disaster.

Taking a closer look at currency market intervention

In every big-bank currency trading room in major financial centers, there is a direct line to the open market trading desk of the central bank. When that line lights up, the whole dealing room erupts. That line is reserved for open market intervention by the central bank, and when it rings, it usually means only one thing: The central bank is intervening in the market.

Intervention refers to central banks buying or selling currencies in the open market to drive currency rates in a desired direction. Direct intervention in the market is usually taken only as a last resort. It also may be a stopgap measure to stabilize markets upset by extreme events, such as a stock market collapse or a natural disaster. When it’s not necessitated by emergency circumstances, markets are generally aware of the increasing risks of intervention.

Open market intervention is usually preceded by several less-blunt forms of official intervention. The idea from the government’s point of view is to get as much bang for the buck as possible before committing real money. Remember: Central banks have limited firepower in relation to the overall market, so they have to pick their spots well. Sometimes, the government’s objective is simply to slow a market move to restore financial market stability, and less drastic forms of intervention are not yet necessary. Some of the more subtle forms of intervention are

• Verbal intervention or jawboning: These are efforts by finance ministry or central bank officials to publicly suggest that current market directions are undesirable. Basically, it amounts to trying to talk up or talk down a particular currency’s value. For example, if the Japanese MOF is intent on preventing further JPY strength to protect its export sector, but the USD/JPY rate keeps moving lower, senior MOF officials may indicate that “excessive exchange rate movements are undesirable.” This message is a warning for currency traders to reduce their USD selling/JPY buying or risk the potential consequences. If the market ignores the warning, the MOF may take it up a notch and indicate that it is “closely monitoring exchange rates,” which is language typically used before actual open market intervention.
• Checking rates: This is the central bank’s open market desk ringing in on the direct line to major currency banks’ trading desks. The traders don’t know if it’s going to be a real intervention or not, but they still react instinctively based on previously indicated preferences. Even rumors of a central bank checking rates are enough to trigger a significant market reaction.

In terms of actual open market intervention, there are several different forms it can take, all depending on which and how many central banks are participating. The more the merrier; better still, there’s strength in numbers.

• Unilateral intervention: This is intervention by a single central bank to buy or sell its own currency, such as the SNB. Unilateral intervention is generally the least effective form of intervention, because the government is perceived (usually correctly) to be acting alone and without the support of other major governments. Markets will typically revert to the earlier direction after the intervention has run its course to test the central bank’s resolve and to see if it’s intent on stopping the move or simply slowing it. The MOF/BOJ intervention in fall 2010 was a unilateral intervention and had little success stemming the tide of JPY strength. However, as we mention earlier, the Swiss authorities have been successful at pegging the EUR/CHF rate at 1.20, even though it’s acting alone. There is always an exception to every rule.
• Joint intervention: This is when two central banks intervene together to shift the direction of their shared currency pair. For example, if the ECB and the Federal Reserve are concerned about EUR strength versus the USD, they may decide to intervene jointly to sell EUR/USD. This is a clear sign to markets that the two governments are prepared to work together to alter the direction of that pair’s exchange rate. Joint intervention is very rare, and this example is, so far, only hypothetical.
• Concerted or multilateral intervention: This is when multiple central banks join together to intervene in the market simultaneously, also referred to as coordinated intervention. This is the most powerful and effective type of intervention, because it suggests unity of purpose by multiple governments. Concerted intervention is not done lightly by major central banks — and markets don’t take it lightly either. It’s the equivalent of a sledgehammer to the head. Concerted intervention frequently results in major long-term trend changes. This is considered a last resort, and it’s typically used only in response to natural disasters such as the 2011 tsunami in Japan.

In terms of the impact of intervention, different governments are given different degrees of respect by the market. Due to the frequency of past interventions and constant threats of it, the Japanese tend to get the least respect. The BOE, the SNB, and the ECB are treated with considerably more respect by markets, with the ECB being the linchpin of credibility for the Eurozone. Finally, when the U.S. Treasury (via the Fed) formally intervenes, which is a rare occurrence, it’s considered a major event, and the market usually respects the intervention.

There is a difference between a central bank intervening for its own account and a central bank intervening on behalf of another foreign central bank. For example, during the MOF/BOJ intervention campaign in 2003 and 2004, there were several instances where the U.S. Fed bought USD/JPY during the New York trading day. The first reaction was that the U.S. Treasury was joining in and supporting the intervention by the MOF/BOJ, and this amplified the effect of the intervention. But the U.S. Treasury later denied that it had ordered the intervention. What happened was that the BOJ asked the New York Fed to intervene on its behalf during the New York trading session. Central banks have standing agreements to act as each other’s representatives in their local markets. So even though the New York Fed bought dollars, it bought them for the BOJ.

Does intervention work? That is a question that frequently comes up when central banks get involved. The simple answer is an unequivocal “Yes, but … . ” Intervention is most effective when it’s backed by monetary policy moving in the same direction, such as expected higher interest rates to support a weak currency or easier monetary policy to weaken a strong one. Even then, interest rate changes are no guarantee that the intervention will be successful.

In the short run, the intervention may seem fruitless and counterproductive. This is especially the case with unilateral intervention. The market typically rejects the unilateral intervention and reverts to pushing the market in the direction opposed by the intervention. This situation can go on for weeks and months or — in the SNB’s case in 2010 — years, which can lead central banks to take even more dramatic action, such as imposing a currency peg. When it’s a joint or concerted intervention, the results are usually more immediate and successful.

Financial stability

The Great Financial Crisis of 2008–2009 triggered a massive global recession, the likes of which not seen since the Great Depression of the 1930s. As a result, major governments’ finances were thrown into disarray, as tax revenues plunged and spending was maintained or increased through fiscal stimulus. Suddenly the creditworthiness and financial stability of major national governments were being questioned by global markets.

A currency’s perceived value is intrinsically linked to the faith investors have in the financial stability of the nation(s) standing behind it. If investors fear a sovereign debt default, meaning government bonds won’t be paid back, they’re likely to sell both those bonds and the country’s currency. The result can be a market frenzy in which government bond prices crash, sending yields soaring and increasing the government’s borrowing costs, effectively forcing the government out of global capital markets and leading to a default.

The Eurozone debt crisis of 2009–2012 is the most obvious recent example, where bond investors fled Greek, Irish, Portuguese, and Cypriot government debt, raising borrowing costs to unaffordable levels and forcing those governments to seek a bailout from wealthier Eurozone members. From the start of the Greek debt crisis in November 2009 until a temporary bailout mechanism was established in May 2010, the euro weakened against the USD by more than 20 percent, and fell even more against other currencies.

And the fallout from the GFC is not confined to government debt. Major global banks lost trillions in the crisis, and some didn’t survive. In the aftermath of the financial crisis and the Eurozone debt crisis, some global banks remain extremely fragile and on government life support. In the case of European banks in particular, they hold around half of outstanding Eurozone government debt, meaning sovereign defaults or restructurings (a euphemism meaning investors don’t get back the full amount or payments are delayed) have the potential to cause additional massive losses to the banking sector, imperiling the Eurozone economy even further.

Debts, deficits, and growth

In the aftermath of the GFC, highly indebted European countries are certainly not alone in having investors question their financial stability. Debt levels in the United Kingdom, United States, and Japan are routinely cited as potential negatives, weighing on sentiment for those currencies from time to time. For the USD, its standing as the global reserve currency of choice is increasingly being called into question. And then there are the outliers, like Hungary, Iceland, and Dubai, small economies overall, but credit fears over their financial stability have a way of reverberating throughout global markets and sending risk sentiment (which we discuss later in this chapter) into a tailspin.

As part of your analysis of individual currencies, you need to be aware of the financial stability of the key currency countries. The metrics to keep in mind are

• Debt to GDP ratio. A measure of the total amount of government debt relative to the size of the economy. Debt/GDP ratios over 90 percent of GDP tend to put countries under the credit-risk microscope.
• Deficits as a percent of GDP. Current and projected deficits add to the total amount of government debt, which can increase the debt/GDP ratio, potentially destabilizing a country’s credit outlook. As a general rule, anything over 6 percent is usually considered danger level, and a deficit in the region of 3 percent is considered stable.
• Growth rates (GDP). Low or negative growth can undermine a nation’s GDP relative to its debt service obligations, increasing the burdens of debt service and raising the risk of default. The imposition of austerity measures (budget cuts and tax increases) in the most beleaguered Eurozone countries during the sovereign debt crisis threatened to lock those countries into a cycle of underperformance, which weighed heavily on their debt loads.

For the economics novice, this may all seem overwhelming. Don’t worry if you couldn’t imagine finding out a debt-to-GDP level on your own. Read the business pages in the paper or on the web — they usually flag countries with debt problems well in advance.

Gauging credit risk

Just as with monetary policy and interest rate developments, financial stability evolves over a long time period. But there are day-to-day developments that impact the markets’ views of individual countries’ financial stability.

How can you monitor the current state of the markets’ views of a nation’s creditworthiness? Keep an eye on the following credit risk measures through markets’ news reports and economic commentaries:

• Credit ratings. Although often late to the game in the GFC, the sovereign debt ratings issued by Moody’s, Standard & Poor’s (S&P), and Fitch still carry a lot of weight. A ratings downgrade can make government debt issues ineligible for certain institutional investors, forcing them to sell those government bonds. Prior to a ratings change (they can be upgrades as well as downgrades), the credit rating agencies will typically issue an announcement that a country’s debt ratings are under review and offer a bias to that review, such as “Portugal sovereign debt placed on review; outlook negative.” Such announcements can have a significant impact on the currency involved.
• Yield spreads. These are the difference between the yields (interest rates) of one government’s bonds relative to an ostensibly safer country’s bonds. In the Eurozone debt crisis of 2009–2013, for example, markets fixated on the spread between yields of peripheral countries like Greece and Portugal and those of stalwart Germany. A widening spread indicates increasing credit concerns, as the bonds of the weak country are sold, sending yields higher, and bonds of the safe country are bought, sending those yields lower, widening the spread. Yield spreads fluctuate on a daily and intra-day basis, with widening spreads indicating deteriorating credit risk and narrowing spreads indicating greater relief.
• Credit default swaps (CDS). These derivatives are basically an insurance policy in the event of a default, where the buyer pays a premium and the seller is obligated to make good on the bond in the event of a default. CDS are an active speculative counterpart to the underlying bonds themselves, and may often lead bond market moves. Rising CDS indicate increasing credit risk and falling CDS rates, expressed in basis points (bps), signal lesser concern.
• Debt auction results. Governments borrow money through regularly scheduled auctions or issuances, where the government offers its debt for sale to global investors. The extent of demand and the price investors are willing pay (the yield) are the key measures here. Demand is gauged according to the bid/cover ratio, meaning how much is bid, or sought, relative to the amount being offered. The higher the bid/cover ratio, the greater the demand and supposed security. A failed auction, one where the government is not able to sell, or borrow, the full amount it seeks is “not a good thing,” as Martha Stewart might say. But some investors are usually willing to buy anything if the price is right, and that’s where the yield comes in. If investors demand a higher yield (bid a lower price) relative to current rates, it’s an indication of concern. For U.S. Treasury debt, there’s yet another indicator, supposedly attesting to the international appetite for U.S. debt, with implications for the value of the USD. The amount bought by indirect bidders is viewed as a proxy for foreign central bank and reserve managers’ demand. A low turnout by indirect bidders could be interpreted as a vote of no confidence for U.S. debt and/or the USD by other major governments. The bid/cover ratio, yield results, and amount of indirect bids measures are all interpreted relative to prior auction results for similar issuances.

Geopolitical Risks and Events

Geopolitics is nothing more than a fancy word used to describe what’s going on in the world at large. As it’s applied to the currency markets, geopolitics tends to focus on political, military/security, or natural disruptions to the global economy or individual regions or nations. Because currency markets are the conduits for international capital flows, they’re usually the first to react to international events, as global investors shift assets in response to geopolitical developments.

Currency markets have no national or patriotic allegiances when it comes to favoring one currency over another. The forex market simply calculates the likely economic fallout from an international event and its ultimate currency impact. A recent example is the popular uprisings in the Middle East and North Africa in early 2011. Egypt is a relatively small economy, meaning that the turmoil there did not threaten the global economic outlook, and forex and other financial markets were not seriously affected. But as the unrest spread to Libya, a major oil producer, oil prices spiked on supply disruptions, and concerns grew that other oil producers could be affected. Stock markets started to wobble, and the USD weakened as oil and gold soared. Likewise, geopolitical tensions between the Ukraine and Russia in 2014 had very little influence on markets because the Ukraine economy is fairly small and the market took the view that the tensions wouldn’t escalate or threaten European oil and gas supplies from Russia. You have to interpret each international event dispassionately, with an eye on the short- and long-term economic impact to determine its significance for individual currencies.

The United States tends to wield more influence on the world’s stage because it’s the largest national economy and the primary military superpower. In addition, the U.S. dollar is the largest global reserve currency and the de facto currency in many developing economies. Finally, with increasing globalization of trade and markets, the U.S. dollar frequently functions as a global risk barometer (see the next section for more on risk). For these reasons, the U.S. dollar tends to experience the greatest reaction in times of global turmoil or uncertainty, and the market tends to think in USD-positive and USD-negative terms, viewing all other currencies in contrast to the U.S. dollar. When geopolitical events are looking problematic, the USD tends to suffer, especially against safe havens like the yen. If the risks or tensions come down, the dollar may go up.

Elections in individual countries, including by-elections and legislative referenda, also fall under the geopolitical risk umbrella, especially when the outcome may lead to a change in government or economic policies. By-elections (ad hoc elections to fill individual legislative seats made vacant by death or resignation, for example) are typically seen as interim votes of confidence on the governing party. Depending on how near the next general election is, and on other economic factors, by-elections may have a greater effect on political sentiment.

As important as geopolitical issues are to the market’s overall assessment of a currency’s value, they tend to have relatively short-run implications and must be interpreted in light of other prevailing economic fundamentals. For instance, if the USD is weakening based on a weak economic outlook, for example, and there’s a disruption to oil supplies from political unrest or a natural disaster, sending oil prices higher, it’s just another reason to sell USD. In contrast, if the USD is strengthening based on a more positive economic trajectory and higher rate expectations, a spike in oil prices may see the usual inverse relationship break down, and both oil and the USD move higher.

Gauging risk sentiment

In recent years, the concept of risk sentiment has taken hold as a way of expressing overall conditions across financial markets, including forex. Risk sentiment refers to investor behavior and whether investors are actively seeking returns by embracing riskier assets (risk seeking or risk appetite), or whether they’re seeking the safety of supposed more secure assets (risk averse or risk aversion). These two behavioral modes are frequently referred to as risk-on and risk-off, or risk-positive and risk-negative.

For currency traders, the risk environment can be a critical factor in driving currency rate movements. Part of the reason has to do with the interest rates of various major currencies. Hedge funds, commodity trading advisors (CTAs), and other leveraged speculators (see Chapter 3 for more on these guys) borrow funds (the leverage) on a short-term basis at the lowest cost available, meaning currencies with the lowest interest rates are used as funding currencies. In a risk-on environment, they then sell those currencies and use the proceeds to buy risk assets with greater price appreciation potential. In a risk-off environment, they’re compelled to sell their risk assets and buy back those funding currencies that they previously sold.

Risk on or risk off?

So what determines whether risk is on or off? In a word, volatility. Volatility refers to the size and speed of price movements over a short time frame, meaning hours or days. But volatility is the symptom and not the cause of those price changes. News and events are what dictate market reactions. In the simplest sense, when news and economic data are positive and everyone’s feeling good about the outlook, risk is on and risk assets tend to appreciate (see the following section for what constitutes risk assets). When the news or data turns negative or outright catastrophic in the case of the GFC, investors turn more cautious and may exit risk trades, potentially triggering widespread selling that may force prices lower and force other investors to bail out as well, amplifying the sell-off.

We have little doubt that much of the increase in the risk-on/risk-off trading dynamic in recent years is the result of algorithmic, or model-based, trading, which has taken on increased prominence in all markets. If the computer is told that an X percent change in one asset or indicator means it should exit an existing position, it will literally not “think” twice about selling out.

Gauges of risk sentiment

To follow the evolution of risk sentiment, it helps to have a good handle on the current state of market affairs and expectations (see Chapter 10 for how to get up to speed on these). For more empirical indications of risk sentiment, pay attention to the following:

• VIX index: This is the options volatility on the S&P 500 U.S. stock index, frequently referred to as the fear index. A rising VIX indicates increased risk aversion (stocks are being sold), and a falling VIX signals the outlook is calming.
• Government bond yields: Major government bonds, such as U.S. Treasuries, German bunds, UK Gilts, or Japanese JGBs, are considered safe assets (for now at least). Rising yields typically mean those bonds are being sold and investors are embracing risk. But sometimes those bonds are being sold on credit concerns, which is risk-negative. Falling yields suggest risk aversion, as investors are fleeing risk assets and buying the safety of government bonds.
• Emerging-market stock performance: Investors have become increasingly international in their perspective and buying shares in Shanghai or Rio is no longer considered exotic. Such emerging market economies have led the way out of the GFC, and their stock markets can be the canary in the coal mine — prices down, risk-off; prices up, risk-on.

Risky versus safe assets

The low interest rate environment of recent years has forced investors and speculators alike to chase returns by investing in so-called risk assets that offer higher potential returns. The clearest example of risk assets are stocks and commodities: A more positive outlook (risk-on) may see stocks gain as corporate profits increase, and commodities may benefit on stronger demand for raw materials and natural resources, like oil. In forex, the risk-on currencies are those linked to commodities (AUD, CAD, and NZD, in particular) and major alternatives to the USD, like EUR and GBP. A risk-on environment may also see carry trades bought, where higher yielding currencies such as those just mentioned are bought and lower yielding currencies like the JPY, USD and CHF are sold (funding currencies). For example, a positive risk environment may see AUD/JPY move higher.

On the other side of the risk equation (risk-off) are the supposedly safe assets, such as U.S. Treasury bonds, the USD, CHF, and JPY. When bad news and events hit markets (think the Great Financial Crisis or Eurozone debt bailouts), investors typically flee risk assets, selling stocks and commodities and buying the safety of government bonds and safer currencies like CHF, JPY, and the USD. Price moves in a risk-off environment can be extremely volatile because it’s a one-two punch where traders exit (sell) risk-on positions and also buy safer, risk-off assets.

Pay attention to the news when potentially disruptive events threaten the economic outlook, and be aware of the risk-on/risk-off dynamic. Depending on the nature of events, especially whether they’re short-term like a natural disaster, or more enduring like a debt crisis in Europe, they can offer potential opportunities to reenter a longer-term trend from lower price levels.

Sometimes there is no such unifying theme such as risk on/risk off and individual currencies tend to walk to the beat of their own drums. As major global central banks take steps to unwind enormous stimulus programs and normalize monetary policy in the coming months and years, risk on/risk off could be replaced with a greater focus on the economic fundamentals (see Chapter 6).