Currencies are the largest trading market in the world, markets are open 24 hours a day, and there is estimated to be more than $5 trillion of trading volume per day.46 Currency markets are often where you see the quickest reaction to macroeconomic and political news. Exchange rates influence inflation, the ability for companies to sell products internationally and drive the cost of production materials. Analyzing all the potential interactions that currency valuations have in the economy can feel a bit like having to peel off all the layers of an onion with tweezers, especially as both can bring tears to your eyes.
Even if you are an experienced investor the foreign exchange markets (Forex) can be tricky to understand; it is not that it is difficult, it is just different. You typically see a stock or a bond quoted in a price. For example, perhaps the Pelham Pallet Company stock can be bought at $25 per share. You do not typically quote it in the price of another stock. For example, if Sunshine Casino Corp. stock was trading at $100 per share you would not say Pelham Pallets can be bought for 0.25 Sunshine Casino shares or a Sunshine Casinos share is worth 4 Pelham Pallet shares (i.e., $25/$100=0.25 or $100/$25=4, respectively). However, in currencies that is how it is done.
Currencies are typically quoted in pairs. As an example, EUR|USD is telling you how many U.S. dollars can be bought with one Euro. So when someone says, “The U.S. dollar is up today” what does that mean? First, the person may not know what they are talking about, or perhaps they are just not clearly explaining what they are saying. Is the U.S. dollar up against all currencies or just one currency in particular? While trades in currency are usually done in pairs, like the EUR|USD, there are indexes that can be traded that compare a single currency to a basket of other currencies. So that person that told you the U.S. dollar was up, may be quoting the price movement relative to a basket of other currencies. This is quite common. These baskets are usually done using just the largest liquid currencies—and each country’s currency is typically weighted in the index based on how much they trade with the base country—in this case the base currency is the U.S dollar so the weighting of each major currency in the basket would be based on the volume of trade with the United States. The other thing to note in how currencies trade is that what seems like small percentage movements can be big factors in profits and losses because the trades are usually very large in size and often are leveraged.
Corporations, investors, and individuals that have significant overseas operations or investments often use hedges on currencies. This allows them to lock in an exchange rate for a period using futures or forward contracts for delivery of a currency. These simple option markets are enormous, too. Investors and speculators will often just trade in these futures and forwards markets and that will effectively add to the volume in trades related to Forex and speculation has had some distorting effects on exchange rates at times, technology has made it possible for all of this trading to happen almost instantly around the world.
Currencies are not just trading vehicles they impact the economy broadly. If an exporting economy sees a decline in the value of their home currency relative to their trading partners, that makes their products cheaper to those countries where they sell. That might lead their economy to grow dramatically and lead to inflation as more money is coming into the economy and imported goods are more expensive. That may cause the central bank to raise interest rates, which could cause the currency of the exporting country to increase in value as more capital moves into that country to take advantage of the higher rates, hurting the country’s exports. You can see how this cycle can go and how many aspects in an economy get involved. This description assumes that the exchange rates are operating in a free-floating regime. Do not think that these regimes are truly free floating because governments get involved too. In addition to the natural flow of trade and speculation by investors impacting currency levels, central banks and treasury departments get involved in trading currencies all the time for various reasons. Sometimes they do this to manipulate the exchange rate to benefit their policies and sometimes to build up or wind down reserve currencies they are holding as a safety buffer.
Do not believe that the current floating exchange rate mechanisms and environment are a forever thing. For many years the major countries managed their exchange rates on a gold standard. There have been many periods where exchange rate mechanisms have been very different and there are many regions where exchange rates are fixed, or pegged. There are also partial fixes where a range is set and a currency only floats in that range. There have also been regional currency groups that manage their exchange rates in unison. There, of course, is also the great ongoing monetary union experiment known as the Euro. This has several countries sharing one currency and has only been in place since 1999. Currency arrangements change and currency regimes change. The current interaction of exchange rates is unlikely to be in place forever.
It is worth reviewing some of the traditional theories on why currency pairs trade as they do. Currencies do not trade directly in line with these theories, as many factors play into the actual value of a currency, including speculation and future expectations, but they are valuable to understand.
Since money is generally used to purchase things, one theory focuses on purchasing power parity (PPP). This implies that if you built a basket of goods in the United States and it cost you $5,000 if that same basket cost you CHF6,000 Swiss francs the exchange rate between the USD|CHF should be 1.20 (USD|CHF = 6,000/5,000). This of course does not factor in taxes, import, restrictions on goods, etc. This relationship does not appear to hold true over many cycles, but many economists have believed that the relationship holds well over a very long period.
Interest rate parity is another theory of how currency trades over time. If one country has a higher interest rate than another the exchange rate compensates for this, otherwise there would be an arbitrage. Meaning if a United States citizen could get 5% annual interest rates but saw that in Mexico they could get 7.5% in annual interest, they would want to do that for a year. However, if the exchange rate right now is USD|MXN = 10 at the time you want to do this transaction, it will take you a year to get the interest and by that time the exchange rate should have adjusted 10(1.075/1.05) = 9.77. Therefore, the United States citizen will get back fewer pesos than they got in the original exchange and this will wipe out the gain on the higher interest rate. The rationale is that the difference in the exchange rates is due to differences in the countries’ inflation rates, and the related monetary policy. Therefore, the country with the higher inflation is creating more supply and its money is worth less. Forex forwards do trade at levels based on anticipated future interest rates.
The level of confidence in a strong economy and political stability can drive currency exchange rates as can demand and supply of that currency. International trade is a huge market and technology and globalization have increased international supply chains and the volume of transactions. Trade balances can greatly influence currency exchange rates. The demand for a country’s goods often leads to demand for that countries currency as others need to pay for those goods. However, this theory does get impacted by the fact that not all international transactions take place in local currencies. Many types of transactions are contracted to take place in the largest most stable currencies in the world, most commonly the U.S. dollar. About 64% of global central bank reserves are also held in the U.S. dollar and about 39% of all debt is issued in U.S. dollars.47 This position of the U.S. dollar led, Francois Mitterrand, former president of France, to declare that the dollar had exorbitant privilege.48
The scenarios of what drives currency exchange rates can get very convoluted and one must play through numerous actions and reactions to try to track where the valuations might move to in various scenarios. Think about some reactions in the market. If the U.S. Federal Reserve Bank announces a rate hike and the European Central Bank (ECB) does not, the U.S. dollar should rise in value, unless the expectation is that the ECB will raise rates soon. If the economic results in Europe are much stronger than the trends in the United States, this might counterbalance the move upward in the U.S. dollar. However, if oil prices rise, that usually increases expenses in Europe more than in the United States, which could put downward pressure on the Euro. These iterations can go on and on. Other factors can include the level of trade, speculative actions, and currency purchases by central banks. Additionally, keep in mind in the example above that there was only one currency pair being examined, in reality traders are comparing a multitude of exchange rates.
Watching how currencies move in response to an economic news item or a change in the language of a central bank commentary can quickly give you some color on how the markets are viewing the news. However, you must remember that there is a plethora of items that can move currencies around in value. When using currency movements as a gauge for market reactions there must be an awareness of all the day’s economic headlines. It is always helpful to also try to get a sense of what the perception is outside of your home market. One tool to do this can be online subscriptions to the Wall Street Journal and the Financial Times that allow you to pull up United States, Asian and European versions of their papers, as well as some other regional versions. It is a healthy exercise to periodically review what the differences are in the top stories in various markets to get a better view on what the rest of the globe outside your home market is focused on.
If you are looking to monitor market reactions in currency on a global scale, sometimes following individual currencies may give you too narrow a picture. One tool is to build thematic currency baskets to monitor. For example, you could build a basket of “safe-haven” currencies that might include the United States dollar, the Japanese Yen, and the Swiss Franc. You could pair them all against another currency like the Euro or use their trade weighted baskets. When this basket goes up it could imply that global capital flows are looking for safer markets and de-risking, or just heavily favoring developed countries. Another theme could be commodities. Many large economies are heavily dependent on commodity prices. For a commodity currency basket you could include both developed and emerging currencies and include the Canadian and Australian dollar, the Brazilian real, and perhaps the Russian ruble. You can build out other themes such as monitoring the view on global trade by building currency baskets of major exporters or importers or countries dependent on supply chains. These baskets can be an interesting tool in developing investment themes or if you are monitoring currency for a global business.
The increased flows in international trade are increasingly causing factors other than just interest rates and inflation expectations to drive exchange rates. Short-term moves in currency markets are interesting gauges of market reactions, while longer-term moves in currencies can be a sign of a trend. Just because currency markets are a bit different, they should not be relegated in importance when undertaking economic and specifically investment analysis; they influence everything and at the same time are influenced by everything.
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