3 Factors That Drive The U.S. Dollar

Posted by admin on November 7th, 2010

When it comes to the decision of whether you should buy or sell dollars, it all boils down to how the economy is performing. A strong economy will attract investment from all over the world due to the perceived safety and the ability to achieve an acceptable rate of return on investment. Investors always seek out the highest yield that is predictable or “safe.” Investment from abroad creates a strong capital account and a resulting high demand for dollars. (Learn about the basics of technical analysis in currency trading with our Forex Walkthrough.)

On the other hand, American consumption that results in the importing of goods and services from other countries causes dollars to flow out of the country. If our imports are greater than our exports, we will have a deficit in our current account. With a strong economy, a country can attract foreign capital to offset the trade deficit. The U.S. can continue as the consumption engine that fuels all the world economies even though it’s a debtor nation that borrows this money to consume. This also allows other countries to export to the U.S. and thus keep their economies growing. This explanation is simplistic, but it illustrates a point. (Learn more about how a country’s current account reflects the country’s economic health in Understanding The Current Account In The Balance Of Payments.)

Factors Affecting Dollar Value

The point is that when it comes to taking a position in the dollar, the currency trader needs to assess the different factors that affect the value of the dollar to try to determine a direction or trend. The methodology can be divided into three groups as follows:

  • Supply and demand factors
  • Sentiment and market psychology
  • Technical factors

Let’s take each group individually.

Supply Versus Demand for Dollars

When we export products or services, we create a demand for dollars because our customers need to pay for our goods and services in dollars and, therefore they will have to convert their local currency into dollars. Hence they sell their currency to buy dollars so that they can make the payment.

In addition, when the U.S. government or large American corporations issue bonds to raise capital, and if these bonds are bought by foreigners then again the bonds have to be paid for in dollars and the customer will have to sell their local currency to buy dollars so they can effect payment. Also, if there is strong growth in the U.S. and companies are expanding their earnings then the desire by foreigners to own corporate stocks in the U.S. also requires that they sell their currency to buy dollars to pay for the purchase of stocks.

Sentiment and Market Psychology

But what if the U.S. economy weakens and consumption slows due to increasing unemployment? Then the U.S. is confronted with the possibility that foreigners may sell their bonds or stocks and return the cash from the sale in order to return to their local currency. Hence they sell the dollars and buy back their local currency.

Technical Factors

As traders, we have to gauge whether the supply of dollars will be greater or less than the demand for dollars. To help us determine this, we need to pay attention to various news and event items, such as the release by the government of various statistics, such as payroll data, GDP data, and other market and economy measuring information that can help us to determine what is happening in the economy and to estimate whether the economy is strengthening or weakening. (For a comprehensive overview of 24 major indicators, take a look at our Economic Indicators Tutorial.)

In addition, we need to determine the general sentiment regarding what the players in the market think the outcome of events is likely to be. Very often, sentiment will drive the market rather than the fundamentals of supply and demand. To add to this mix of prognostication, besides the measurement of supply and demand factors and sentiment, we also have the historical patterns generated by seasonal factors, support and resistance levels, technical indicators and so on. Many traders believe that these patterns are repetitive and therefore can be used to predict future movements. (Learn about the basics of technical analysis in our Technical Analysis Tutorial.)

Bringing Them All Together

Since trading relies on the ability of a trader to take a risk and manage it accordingly, traders usually adopt some combination of the three above methods to make their buy or sell decisions. The art of trading exists in stacking the odds in your favor and building an edge. If the probability of being correct is high enough the trader will enter the market and manage his hypothesis accordingly. To stack the odds in our favor we therefore need to take into account each one of the three methodologies and hopefully find them to be congruent, meaning that they all point in the same direction.

An Example

The economic conditions during the recession that began in 2007 forced the U.S. government to play an unprecedented role in the economy. Since economic growth was receding as a result of the large deleveraging of financial assets taking place, the government had to take up the slack by increasing government spending to keep the economy going. The purpose of their spending was to create jobs so that the consumer could earn money and increase consumption thereby fueling the growth needed to support economic growth. (For a review of the recession during this time period, refer to The 2007-08 Financial Crisis In Review.)

The government took this position at the expense of an increasing deficit and national debt. It financed this increase by essentially printing money and by selling government bonds to foreign governments and investors – resulting in an increase in the supply of dollars. Hence the dollar depreciated as a result. Another concern for countries that rapidly issue debt is that the interest burden will increase and, therefore, more tax dollars will be allocated just to cover the interest rate.

One of the roles of the government is to create the conditions necessary to allow the markets to grow so that is the economy is as close to full employment as possible, but with controlled inflation. Thus when the economy deflates the government will try to do all it can to re-inflate it in a controlled manner.

The International Monetary Market (IMM)

Posted by admin on November 7th, 2010

The International Monetary Market (IMM) was introduced in December 1971 and formally implemented in May 1972, although its roots can be traced to the end of Bretton Woods through the 1971 Smithsonian Agreement and Nixon’s suspension of U.S. dollar’s convertibility to gold.

The IMM Exchange was formed as a separate division of the Chicago Mercantile Exchange, and as of 2009, was the second largest futures exchange in the world. The primary purpose of the IMM is to trade currency futures, a relatively new product previously studied by academics as a way to open a freely traded exchange market to facilitate trade among nations.

The first futures experimental contracts included trades against the U.S. dollar such as the British pound, Swiss franc, German deutschmark, Canadian dollar, Japanese yen and in September 1974, the French franc. This list would later expand to include the Australian dollar, the euro, emerging market currencies such as the Russian ruble, Brazilian real, Turkish lira, Hungarian forint, Polish zloty, Mexican peso and South African rand. In 1992, the German deutschmark/Japanese yen pair was introduced as the first futures cross rate currency. But these early successes didn’t come without a price. (Learn how to trade currencies, read Getting Started in Foreign Exchange Futures.)

The Drawbacks of Currency Futures

The challenging aspects were how to connect values of IMM foreign exchange contracts to the interbank market – the dominant means of currency trading in the 1970s - and how to allow the IMM to be the free-floating exchange envisioned by academics. Clearing member firms were incorporated to act as arbitrageurs between banks and the IMM to facilitate orderly markets between bid and ask spreads. The Continental Bank of Chicago was later hired as a delivery agent for contracts. These successes bred an unforeseen level of competition for new futures products.

The Chicago Board Options Exchange competed and received the right to trade U.S. 30-year bond futures while the IMM secured the right to trade eurodollar contracts, a 90 day interest rate contract settled in cash rather than physical delivery. Eurodollars came to be known as the “eurocurrency market,” which is used mainly by the Organization for Petroleum Exporting Countries (OPEC), which always required payment for oil in U.S. dollars. This cash settlement aspect would later pave the way for index futures such as world stock market indexes and the IMM Index. Cash settlement would also allow the IMM to later become known as a “cash market” because of its trade in short-term, interest rate sensitive instruments.

A System for Transactions

With new competition, a transaction system was desperately needed. The CME and Reuters Holdings created the Post Market Trade (PMT) to allow a global electronic automated transaction system to act as a single clearing entity and link the world’s financial centers like Tokyo and London. Today, PMT is known as Globex, which facilitates not only clearing but electronic trading for traders around the world. In 1975, U.S. T-bills were born and began trading on the IMM in January 1976. T-bill futures began trading in April 1986 with approval from the Commodities Futures Trading Commission.

The Rise of the Forex Market

The real success would come in the mid 1980s when options began trading on currency futures. By 2003, foreign exchange trading had hit a notional value of $347.5 billion. (Be aware of forex risks, check out Foreign-Exchange Risk.)

The 1990s were a period of explosive growth for the IMM due to three world events:

  1. Basel I in July 1988
    The 12 nation European Central Bank governors agreed to standardize guidelines for banks. Bank capital had to be equal to 4% of assets. (For background reading, see Does The Basel Accord Strengthen Banks?)
  2. 1992 Single European Act
    This not only allowed capital to flow freely throughout national borders but also allowed all banks to incorporate in any EU nation.
  3. Basel II
    This is geared to control risk by preventing losses, the realization of which is still a work in progress. (To learn more, read Basel II Accord To Guard Against Financial Shocks.)

A bank’s role is to channel funds from depositors to borrowers. With these news acts, depositors could be governments, governmental agencies and multinational corporations. The role for banks in this new international arena exploded in order to meet the demands of financing capital requirements, new loan structures and new interest rate structures such as overnight lending rates; increasingly, IMM was used for all finance needs.

Plus, a whole host of new trading instruments was introduced such as money market swaps to lock in or reduce borrowing costs, and swaps for arbitrage against futures or hedge risk. Currency swaps would not be introduced until the the 2000s. (Find out how tools magnify your gains and losses, read Forex Leverage: A Double-Edged Sword.)

Financial Crises and Liquidity

In financial crisis situations, central bankers must provide liquidity to stabilize markets because risk may trade at premiums to a bank’s target rates, called money rates, that central bankers can’t control. Central bankers then provide liquidity to banks that trade and control rates. These are called repo rates, and they are traded through the IMM. Repo markets allow participants to undertake rapid refinancing in the interbank market independent of credit limits to stabilize the system. A borrower pledges securitized assets such as stocks in exchange for cash to allow its operations to continue.

Asian Money Markets and the IMM

Asian money markets linked up with the IMM because Asian governments, banks and businesses needed to facilitate business and trade in a faster way rather than borrowing U.S. dollar deposits from European banks. Asian banks, like European banks, were saddled with dollar-denominated deposits because all trades were dollar-denominated as a result of the U.S. dollar’s dominance. So, extra trades were needed to facilitate trade in other currencies, particularly euros. Asia and the E.U. would go on to share not only an explosion of trade but also two of the most widely traded world currencies on the IMM. For this reason, the Japanese yen is quoted in U.S. dollars, while eurodollar futures are quoted based on the IMM Index, a function of the three-month LIBOR.

The IMM Index base of 100 is subtracted from the three-month LIBOR to ensure that bid prices are  below the ask price. These are normal procedures used in other widely traded instruments on the IMM to insure market stabilization.

The Fundamentals Of Forex Fundamentals

Posted by admin on November 7th, 2010

Since fundamental analysis is about looking at the intrinsic value of an investment, its application in forex entails looking at the economic conditions that affect the valuation of a nation’s currency. Here we look at some of the major fundamental factors that play a role in the movement of a currency.

Economic Indicators

Economic indicators are reports released by the government or a private organization that detail a country’s economic performance. Economic reports are the means by which a country’s economic health is directly measured, but do remember that a great deal of factors and policies will affect a nation’s economic performance.

These reports are released at scheduled times, providing the market with an indication of whether a nation’s economy has improved or declined. The effects of these reports are comparable to how earnings reports, SEC filings and other releases may affect securities. In forex, as in the stock market, any deviation from the norm can cause large price and volume movements.

You may recognize some of these economic reports, such as the unemployment numbers, which are well publicized. Others, like housing stats, receive little coverage. However, each indicator serves a particular purpose, and can be useful. Here we outline four major reports, some of which are comparable to particular fundamental indicators used by equity investors:

The Gross Domestic Product (GDP)
The GDP is considered the broadest measure of a country’s economy, and it represents the total market value of all goods and services produced in a country during a given year. Since the GDP figure itself is often considered a lagging indicator, most traders focus on the two reports that are issued in the months before the final GDP figures: the advance report and the preliminary report. Significant revisions between these reports can cause considerable volatility. The GDP is somewhat analogous to the gross profit margin of a publicly traded company in that they are both measures of internal growth. (Learn more about this important number in High GDP Means Economic Prosperity, Or Does It?)

Retail Sales
The retail-sales report measures the total receipts of all retail stores in a given country. This measurement is derived from a diverse sample of retail stores throughout a nation. The report is particularly useful because it is a timely indicator of broad consumer spending patterns that is adjusted for seasonal variables. It can be used to predict the performance of more important lagging indicators, and to assess the immediate direction of an economy. Revisions to advanced reports of retail sales can cause significant volatility. The retail sales report can be compared to the sales activity of a publicly traded company. (Read more in Using Consumer Spending As A Market Indicator.)

Industrial Production
This report shows the change in the production of factories, mines and utilities within a nation. It also reports their ‘capacity utilizations‘, the degree to which the capacity of each of these factories is being used. It is ideal for a nation to see an increase of production while being at its maximum or near maximum capacity utilization.

Traders using this indicator are usually concerned with utility production, which can be extremely volatile since the utilities industry, and in turn the trading of and demand for energy, is heavily affected by changes in weather. Significant revisions between reports can be caused by weather changes, which in turn, can cause volatility in the nation’s currency.

Consumer Price Index (CPI)
The CPI is a measure of the change in the prices of consumer goods across over 200 different categories. This report, when compared to a nation’s exports, can be used to see if a country is making or losing money on its products and services. Be careful, however, to monitor the exports – it is a focus that is popular with many traders because the prices of exports often change relative to a currency’s strength or weakness. (For further reading, check out The Consumer Price Index: A Friend To Investors.)

Some of the other major indicators include the purchasing managers index (PMI), producer price index (PPI), durable goods report, employment cost index (ECI), and housing starts. And don’t forget the many privately issued reports, the most famous of which is the Michigan Consumer Confidence Survey. All of these provide a valuable resource to traders, if used properly.

So, How Are These Used?

Since economic indicators gauge a country’s economic state, changes in the conditions reported will therefore directly affect the price and volume of a country’s currency. It is important to keep in mind, however, that the indicators discussed above are not the only things that affect a currency’s price. There are third-party reports, technical factors, and many other things that also can drastically affect a currency’s valuation. Here are a few useful tips that may help you when conducting fundamental analysis in the foreign exchange market:

  • Keep an economic calendar on hand that lists the indicators and when they are due to be released. Also, keep an eye on the future; often markets will move in anticipation of a certain indicator or report due to be released at a later time. (You’ll find more information in Trading On News Releases.)
  • Be informed about the economic indicators that are capturing most of the market’s attention at any given time. Such indicators are catalysts for the largest price and volume movements. For example, when the U.S. dollar is weak, inflation is often one of the most watched indicators.
  • Know the market expectations for the data, and then pay attention to whether or not the expectations are met. That is far more important than the data itself. Occasionally, there is a drastic difference between the expectations and actual results and, if there is, be aware of the possible justifications for this difference.
  • Don’t react too quickly to the news. Oftentimes, numbers are released and then revised, and things can change quickly. Pay attention to these revisions, as they may be a useful tool for seeing the trends and reacting more accurately to future reports.
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