The Three Factors that Influence the Currency Markets Right Now
by Rob Booker
As fear grips the financial markets and investors panic worldwide, what are consequences for the US Dollar? How do turmoil in the credit markets, the failure of major US investment banks and insurance companies, and sharp declines in stock market indexes affect the value of the world's major currencies?
Despite the fact that discussion of the currency markets has taken a back seat to the rest of the issues surrounding the current credit crunch, the value of the US Dollar and other major currencies have been, and will continue to be, heavily influenced by what is happening in the world of investment banking, the stock market, and especially the bond market.
The first major influence on the currency markets is uncertainty about the quality of US and European investments - primarly the stock market. The second influence is speculation about what the US Federal Reserve and the European Central Bank will do next. The third influence is all about whether the world begins to look at the Euro as the world's reserve currency.
by Rob Booker
As fear grips the financial markets and investors panic worldwide, what are consequences for the US Dollar? How do turmoil in the credit markets, the failure of major US investment banks and insurance companies, and sharp declines in stock market indexes affect the value of the world's major currencies?
Despite the fact that discussion of the currency markets has taken a back seat to the rest of the issues surrounding the current credit crunch, the value of the US Dollar and other major currencies have been, and will continue to be, heavily influenced by what is happening in the world of investment banking, the stock market, and especially the bond market.
The first major influence on the currency markets is uncertainty about the quality of US and European investments - primarly the stock market. The second influence is speculation about what the US Federal Reserve and the European Central Bank will do next. The third influence is all about whether the world begins to look at the Euro as the world's reserve currency.
US Dollar Scenario Number One: US Dollar Gains
Here's the bottom line: when investor confidence crumbles, they start buying US government debt. The dollar benefits because what do investors need in order to buy US Treasurys? They need dollars.
The world financial markets are complex but they depend on one major characteristic: investor confidence. At present, major banks, central bankers, hedge funds, and home-based investors share one common emotion: uncertainty. Generally, when traders worldwide feel unsure about market direction, they sell off their riskier assets -- like real estate, stocks, corporate bonds, and complex financial instruments called derivatives -- and they buy safer investments. This is why you've been hearing about a "flight to safety" on television, radio, and financial press.
What this means is that global investors are buying US Treasurys, which are viewed as safe investments (because they are backed by the US Government, which can tax its population or print money in order to pay back its debt; don't you wish you could print money or tax the government to pay off your own debts?).
Here is a chart that shows the price on the 2-year Treasury note and the US Dollar Index. You'll notice that as the price of the Treasury increased in the last 60 days, the value of the dollar increased.
Note: Past performance is not indicative of future results
The demand for "safe" US Government debt is so high that the Wall Street Journal reported on Thursday, September 17:
"The desperation was especially striking in the market for U.S. government debt, long considered the safest of investments. At one point during the day, investors were willing to pay more for one-month Treasurys than they could expect to get back when the bonds matured. Some investors, in essence, had decided that a small but known loss was better than the uncertainty connected to any other type of investment."
Summary of Scenario One: As global investors sell stocks, bonds, and anything else (denominated in their local currency), they can force up the value of the US Dollar as they buy US government debt. If this continues to happen, the greenback could continue to rise against the Euro, the Pound, and other currencies.
What to Watch: Watch for news about the US Treasury market. Remember that Treasury prices increase as their interest rate decreases -- if you hear that Treasury prices are decreasing, or that Treasury yields are decreasing, that is a sign that investors are actually buying more Treasurys.
US Dollar Scenario Number Two: The US Dollar Neutral
The bottom line: The European Central Bank and the US Federal Reserve could make moves which essentially cancel each other's effect on the US Dollar.
First, let's get a basic principle out of the way. Generally speaking, a nation with a higher interest rate will attract more investment into its currency than a nation with a lower interest rate. The currency of the nation with the increased investment can rise in value as the demand for that currency increases.
Central banks generally have two competing purposes: to fight inflation and to maintain stable economic growth. Although some central banks favor one mission over the other, it is unusual for a central bank to ignore rampant inflation or an exploding economy in order to focus on some other purpose.
Right now, the European Central Bank is wildly regarded as focusing much more on inflation than on the economy. In the midst of a world economic slowdown, the ECB has repeatedly stood firm and refused to lower its base interest rate. But what if the ECB buckles under the pressure to lower interest rates and provide some relief to its economy? Such a move would include statements (as we have heard recently from the Bank of England) about weakness in the European economy; such statements plus any rate cuts tend to drive down the value of a nation's currency.
We've already seen this effect recently as the Euro has fallen against the Dollar in the last 60 days. Essentially, the currency markets are betting that the ECB is going to have to eventually move to lower interest rates to spur economic activity. If the ECB actually does this, the Euro could fall significantly lower.
However, at the same time, the US Federal Reserve refused this week to lower the Fed Funds Rate -- which signaled to the marke that the Fed might be done lowering its rate.
Summary for US Dollar Scenario Two: If, as we discussed, the interest rates are correlated to the value of the Euro and the Dollar, then we could see a stalemate. A US Fed which refuses to lower rates (and may increase rates in the next 6-12 months) may cancel any move that the ECB makes to lower rates. In this scenario, the EUR/USD, for example, would not trend as much and would begin to trade in a range.
What to Watch: Be ready for the next European Central Bank interest rate decision, on October 2. Be aware that often the comments made by ECB President Jean-Claude Trichet are generally more influential than the actual decision itself. And then next decision of the US Federal Reserve, on October 29.
US Dollar Scenario Number Three: The US Dollar Losses
Does the US Government really have a "strong dollary policy?" The last scenario is that the US economy gets so bad, so fast, that the value of the US dollar declines regardless of any other news.
Quoting the Wall Street Journal from Thursday, Septemer 18 again:
"[a member of the US Congress] said recurring federal budget deficits already have raised alarms with foreign investors."
In the past two years there has been talk that eventually the Euro could replace the US dollar as the world's reserve currency. We have heard that oil producing countries might start asking for payment in Euros, or that central banks in Asia will begin to diversify their holdings to reduce exposure to the US dollar (remember that China and Japan combined hold over $1.5 trillion in US dollar-denominated securities and investments).
Summary for Scenario Number Three: If confidence in the US economy falters further, we could see another wave of dollar losses across the board, and in particular against the Euro, which is largely viewed to be the next most stable currency (whether it really is or not is a discussion for another time!).
What to Watch: Pay attention to news about central banks diversifying their holdings. You'll hear things about diversification into "currency baskets." Also, you might want to follow any news related to oil, US budget deficits, or statements by central banks about their holdings of US dollars.
Conclusion: Volatile Times Call for Responsible Traders
More importantly than any of the above, it's time to remember that valid arguments, reasoned analysis, or historically successful trading systems all fail miserably when combined with poor risk management.
If the recent failures of banks worldwide have proved anything, they have demonstrated that excessive risk leads eventually to excessive losses. If you trade currency, or anything else, realize that risk management isn't optional; it's critically important that you know how much you stand to lose on any given trade, and that you seek independent financial advice before you make your decisions.
The problems on Wall Street today are really problems of leverage. It's the Great Margin Call of 2008, if you think about it: Bear Stearns, Lehman Brothers, and AIG all suffered the consequences of trading on leverage and then betting big. When the markets tumbled, they didn't have the capital to ride out the losses. These types of losses are the great equalizers of traders: retail traders like you and me and seasoned Wall Street traders both realize that "worst case scenarios" sometimes do happen, that excessive leverage can lead to total loss, and most of all, the markets are bigger than all of us.
Here's the bottom line: when investor confidence crumbles, they start buying US government debt. The dollar benefits because what do investors need in order to buy US Treasurys? They need dollars.
The world financial markets are complex but they depend on one major characteristic: investor confidence. At present, major banks, central bankers, hedge funds, and home-based investors share one common emotion: uncertainty. Generally, when traders worldwide feel unsure about market direction, they sell off their riskier assets -- like real estate, stocks, corporate bonds, and complex financial instruments called derivatives -- and they buy safer investments. This is why you've been hearing about a "flight to safety" on television, radio, and financial press.
What this means is that global investors are buying US Treasurys, which are viewed as safe investments (because they are backed by the US Government, which can tax its population or print money in order to pay back its debt; don't you wish you could print money or tax the government to pay off your own debts?).
Here is a chart that shows the price on the 2-year Treasury note and the US Dollar Index. You'll notice that as the price of the Treasury increased in the last 60 days, the value of the dollar increased.
Note: Past performance is not indicative of future results
The demand for "safe" US Government debt is so high that the Wall Street Journal reported on Thursday, September 17:
"The desperation was especially striking in the market for U.S. government debt, long considered the safest of investments. At one point during the day, investors were willing to pay more for one-month Treasurys than they could expect to get back when the bonds matured. Some investors, in essence, had decided that a small but known loss was better than the uncertainty connected to any other type of investment."
Summary of Scenario One: As global investors sell stocks, bonds, and anything else (denominated in their local currency), they can force up the value of the US Dollar as they buy US government debt. If this continues to happen, the greenback could continue to rise against the Euro, the Pound, and other currencies.
What to Watch: Watch for news about the US Treasury market. Remember that Treasury prices increase as their interest rate decreases -- if you hear that Treasury prices are decreasing, or that Treasury yields are decreasing, that is a sign that investors are actually buying more Treasurys.
US Dollar Scenario Number Two: The US Dollar Neutral
The bottom line: The European Central Bank and the US Federal Reserve could make moves which essentially cancel each other's effect on the US Dollar.
First, let's get a basic principle out of the way. Generally speaking, a nation with a higher interest rate will attract more investment into its currency than a nation with a lower interest rate. The currency of the nation with the increased investment can rise in value as the demand for that currency increases.
Central banks generally have two competing purposes: to fight inflation and to maintain stable economic growth. Although some central banks favor one mission over the other, it is unusual for a central bank to ignore rampant inflation or an exploding economy in order to focus on some other purpose.
Right now, the European Central Bank is wildly regarded as focusing much more on inflation than on the economy. In the midst of a world economic slowdown, the ECB has repeatedly stood firm and refused to lower its base interest rate. But what if the ECB buckles under the pressure to lower interest rates and provide some relief to its economy? Such a move would include statements (as we have heard recently from the Bank of England) about weakness in the European economy; such statements plus any rate cuts tend to drive down the value of a nation's currency.
We've already seen this effect recently as the Euro has fallen against the Dollar in the last 60 days. Essentially, the currency markets are betting that the ECB is going to have to eventually move to lower interest rates to spur economic activity. If the ECB actually does this, the Euro could fall significantly lower.
However, at the same time, the US Federal Reserve refused this week to lower the Fed Funds Rate -- which signaled to the marke that the Fed might be done lowering its rate.
Summary for US Dollar Scenario Two: If, as we discussed, the interest rates are correlated to the value of the Euro and the Dollar, then we could see a stalemate. A US Fed which refuses to lower rates (and may increase rates in the next 6-12 months) may cancel any move that the ECB makes to lower rates. In this scenario, the EUR/USD, for example, would not trend as much and would begin to trade in a range.
What to Watch: Be ready for the next European Central Bank interest rate decision, on October 2. Be aware that often the comments made by ECB President Jean-Claude Trichet are generally more influential than the actual decision itself. And then next decision of the US Federal Reserve, on October 29.
US Dollar Scenario Number Three: The US Dollar Losses
Does the US Government really have a "strong dollary policy?" The last scenario is that the US economy gets so bad, so fast, that the value of the US dollar declines regardless of any other news.
Quoting the Wall Street Journal from Thursday, Septemer 18 again:
"[a member of the US Congress] said recurring federal budget deficits already have raised alarms with foreign investors."
In the past two years there has been talk that eventually the Euro could replace the US dollar as the world's reserve currency. We have heard that oil producing countries might start asking for payment in Euros, or that central banks in Asia will begin to diversify their holdings to reduce exposure to the US dollar (remember that China and Japan combined hold over $1.5 trillion in US dollar-denominated securities and investments).
Summary for Scenario Number Three: If confidence in the US economy falters further, we could see another wave of dollar losses across the board, and in particular against the Euro, which is largely viewed to be the next most stable currency (whether it really is or not is a discussion for another time!).
What to Watch: Pay attention to news about central banks diversifying their holdings. You'll hear things about diversification into "currency baskets." Also, you might want to follow any news related to oil, US budget deficits, or statements by central banks about their holdings of US dollars.
Conclusion: Volatile Times Call for Responsible Traders
More importantly than any of the above, it's time to remember that valid arguments, reasoned analysis, or historically successful trading systems all fail miserably when combined with poor risk management.
If the recent failures of banks worldwide have proved anything, they have demonstrated that excessive risk leads eventually to excessive losses. If you trade currency, or anything else, realize that risk management isn't optional; it's critically important that you know how much you stand to lose on any given trade, and that you seek independent financial advice before you make your decisions.
The problems on Wall Street today are really problems of leverage. It's the Great Margin Call of 2008, if you think about it: Bear Stearns, Lehman Brothers, and AIG all suffered the consequences of trading on leverage and then betting big. When the markets tumbled, they didn't have the capital to ride out the losses. These types of losses are the great equalizers of traders: retail traders like you and me and seasoned Wall Street traders both realize that "worst case scenarios" sometimes do happen, that excessive leverage can lead to total loss, and most of all, the markets are bigger than all of us.
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