You don’t need to be an Einstein to understand that everything is relative. Whether we are talking about being early vs. being late, or being cheap vs. being expensive, you need a point of reference to make meaningful qualitative or quantitative distinctions. The same is true for money.
FIXED AND FLOATING CURRENCIES
Without turning this into a history lesson, here's a little background. After the end of World War II and with their economies in ruin, the 44 Allied countries met in Bretton Woods, N.H. in July 1944 and fixed the value of the U.S. dollar relative to gold at the rate of $35 per ounce. The value of the non-U.S. currencies were then individually fixed to the value of the dollar, et voila, the gold standard was born. Each of the countries knew where they stood relative to the U.S. dollar, and where the dollar stood relative to an ounce of gold. Individual currencies were allowed to vary within a narrow band and if they floated out of that range, central banks adjusted monetary policy to bring them back in line.
That worked great for a while, but the United States had limited gold reserves and certainly not enough to cover all of the currency in circulation, a situation akin to check kiting, and the lack of gold and dollars put a damper on global economic activity.
To relieve the strain on the U.S. economy and to allow for global economic expansion, something had to give. Then President Richard M. Nixon unilaterally killed the gold standard in August 1971. In response to global economic instability that resulted, the G-10, a group of Western economic powers, entered the Smithsonian Agreement in December of that year. The agreement devalued the U.S. dollar to $38 per ounce of gold, eliminated the direct convertibility of dollars to gold and allowed the value of the U.S. dollar to float within a narrow range, and the fiat currency system was born. The United States was in the midst of the Vietnam War and continued deficit spending. The value of the dollar plummeted relative to other currencies based on supply and demand, the agreement fell apart, and within a few years all of the major industrialized countries eliminated their pegs to the U.S. dollar and floated freely, their value decided in the market place by supply and demand.
One current and notable exception is China, which values its currency, called the yuan or the renminbi, against a basket of Western currencies, much like an index, and allows the value to float within couple of percentage points.
MOVING THE FOREX MARKET
What can you buy for a dollar today? Less and less is the obvious answer, but the real question is “why?” Now that currency values float freely, they reflect more accurately the economic condition of their home country and, generally speaking, there are three factors that determine the health of an economy: productivity, a measure of how much stuff is produced; investment, reflecting a confidence in that productivity; and interest rates, which attach a time value to resources invested in that productivity.
Forex traders are very interested in productivity, and they track productivity at the macro level with the gross domestic product and employment statistics. When it comes to productivity, more is better, and countries with high levels of productivity and high employment levels tend to have strong economies. However, too much productivity and employment can result in inflation, which is a devaluation of the currency.
Forex traders also are interested in whether money is being invested in, or divested from, an economy. Money flowing into a country is good, reflecting confidence in future productivity. Capital flowing out means that the grass is greener elsewhere. The United States Treasury tracks international capital flow and publishes its findings on a quarterly basis in the Treasury International Capital System, commonly called TICS data (see “Checking for TICS,” below). The TICS data describes U.S. and non-U.S. government and private party investments in corporate and government securities, meaning stocks and bonds. Other productivity measures are trade and budget balances.
Interest rates are where everything comes together in contemporary economics and foreign exchange trading. Central banks, such as the Federal Reserve Bank in the United States, the European Central Bank and the Bank of England, among many others, stimulate growth and squash inflation by increasing or decreasing short-term interest rates. When economies are growing too quickly, central banks raise interest rates to temper inflation and lower them to stimulate borrowing and economic growth (see “Forex fundamentals: Moving the markets,” January 2007). Inflation is another important issue for forex traders, and to monitor inflation, they track the consumer price index (CPI), producer price index (PPI) and consumer spending (PCI), which are available from the Bureau of Labor Statistics.
FOREX AND REALPOLITIK
Managing monetary policy is the primary responsibility for the Federal Reserve, and interest rates are the heaviest hammer the Fed swings, but Forex fundamentals often rest on the whims of politicians, who can and do affect currency values to manage trade.
“Manipulation is a harsh word,” says Bob Kozak, currency trader at Alaron, “but there is moral suasion and intervention,” and two visible examples are Japan and China. After a huge economic expansion throughout the 1980s, Japan fell into a deflationary cycle when the economic boom went bust. Inflated property values plummeted, removing liquidity from the markets, and banks and companies failed.
To keep exports healthy and spur borrowing, the Bank of Japan (BoJ) cut interest rates to zero and kept them there for years. But they were only partially successful. Despite the U.S. government buying Japanese yen and shorting the U.S. dollar in 1990, the yen’s value dropped and the BoJ inadvertently created a prime opportunity for carry traders, who shorted the yen and bought appreciating currencies like the New Zealand or Australian dollars, exacerbating the liquidity crunch.
Until July 2005, the Chinese yuan was pegged to the U.S. dollar and undervalued by as much as 40%. By deliberately undervaluing the currency, the Chinese have been able to keep their goods for export very inexpensive relative to other Asian exporters, such as Japan, South Korea, Singapore and Indonesia, resulting in a huge trade surplus, according to Kozak.
Now the yuan is pegged to a basket of currencies, similar to an index, and the Chinese have expanded the floating range (see “Yuan gets breathing room,” below). “What they are doing is moving slowly towards the kind of currency management environment that we find in most countries,” says Michael Englund, chief economist for Action Economics, and the goal is to continue widening the range until there is no actual peg.
With growth comes inflation and with its major stock index, the China CSI 300, increasing by 120% in the past year, and 12% gross domestic product growth, the Chinese have too much money in the economy chasing too few goods and the result is a 4.4% rate of inflation, roughly twice that in the United States. And to cool off their economy, in addition to raising interest rates, the Chinese are reducing export and tax incentives.
China also has followed Japan’s example and now manages the value of the yuan by purchasing huge amounts of U.S. Treasury securities, which props up the value of the U.S. dollar and keeps Chinese exports cheap relative to U.S. domestic and other imported goods. And while there has been much fear of the massive trade imbalance that we have with these countries, and talk on Capital Hill about sanctioning China for manipulating its currency, Englund says that for now, this is a win-win situation.
“[China has] managed the exchange rate up till now, but [the United States has] maintained a low unemployment rate and a relatively healthy economy throughout,” Englund says, citing low unemployment and high productivity in the United States as proof.
“The United States is, on the margin, competitive with foreign countries at the current exchange rates. And this equilibrium is maintained with the requirement that [the Chinese] buy several hundred billion dollars of our debt every year, pretty much forever, if they want to maintain the regime.” Such efforts are felt throughout the markets, inciting other Pacific Rim countries to manage their own rates to compensate for the discrepancies between their currency and China’s.
That strategy funds the U.S. economy and keeps interest rates down; the alternative is to unwind the strategy, which would drive down the value of U.S. exports, which would provide the United States with a huge windfall gain, at least politically. “Our exports would start to shoot the lights out across Asia and Europe, relative to foreign countries,” he says.
While it is an uncomfortable realization for many, the United States has been losing ground against other economies, starting before George W. Bush took office. In the past seven years, our trade and budget deficits have expanded rapidly as we went to war in Afghanistan and Iraq and the U.S. dollar has declined roughly 30%.
On the upside, a weaker dollar is boon for corporations that do business overseas, as our exports are less expensive relative to other goods, which will help pay down the trade deficit, and prop up our employment numbers.
“Milton Freidman used to point out that if people treated trade statistics like they treated their own finances, they would have pretty much the opposite opinion on most things,” Englund says. “If your neighbor kept giving you lots and lots of his stuff, and you didn’t have to give him your stuff, you’d think that was pretty good,” he laughs.
It is important to remember when trading forex, particularly for the currencies of countries dependent on exports, that a cheaper currency relative the dollar is beneficial to trade, and some politicians will do whatever it takes to keep that edge.
