What Moves a Currency

We have been bombarded with spam emails claiming that the dollar is falling and that we must purchase their strategy to save our portfolios. I would certainly never subscribe to these services, as their radical approaches to investing makes about as much sense as their scare tactics to sell them. However, I always seem to agree with their bullet points of issues that we are facing in the US economy right now. I would love to say that we sit around our conference table with infinite wisdom as to where the dollar, gold and the stock market in general are headed. Rather than try to predict short term dollar or market movements, we focus on core long term healthy asset classes and build portfolios that can adapt to bull and bear markets. Nevertheless, we certainly cannot ignore the effect of the declining dollar on our lives. Instead of subscribing to someone’s scare mail about the dollar to learn more about the situation, we look to some of the best financiers in the business for guidance.

My first stop is with my friends at Index Universe. www.IndexUniverse.com is a great resource on ETFs and their quarterly newsletter “Journal of Indexes” is a free publication to financial advisors. This quarterly publication is treated like gold in our office. Each quarter, some of the best talents in the world of finance write articles about indexing. The cover of the current edition reads “death of the dollar?”

In the first article, “Currency the Overlooked Asset,” authors Dave Nadig, Matt Hougan and Lara Crigger describe what moves currency. This will help you understand the basics of what makes the dollar move.

You have to understand that the dollar does not have a value alone on the market like Coke or GE stock, but we must compare the dollar to other currencies to get a relative value. The world’s major currencies are the US dollar (USD), the euro (EUR), the British sterling pound (GBP), the Japanese yen (JPY), the Swiss frank (CHF), the Australian dollar (AUD) and the Canadian dollar (CAD). We can now take a look at what moves these currencies. I quote the article directly.

“Interest rates: Every currency lives in the context of the interest rates being paid by a country’s central bank for purchases of government bonds. Comparatively high interest rates tend to attract investor to a currency. Lower interest rates, on the other hand, tend to depress a currency’s value.

Inflation/Deflation: Countries with low inflation will see their currency appreciate, as their purchasing power rises relative to other countries. High inflation, on the other hand, usually depreciates currency values.

Economic Indicators: Employment data, retail sales data, GDP growth and other economic health indicators can influence the value of a country’s currency, but these signals are often highly contextual. For example, strong employment data after a market crisis might support a currency, as it suggests economic recovery. But in a healthy economy, it could signal inflation which would depreciate a currency.

International Trade: Countries that import more than they export (e.g. Japan) must sell their own currency in order to purchase the currency of their export partners and thus will see their own currency value depreciate as a result. Thus, shifts in macroeconomic international trade metrics such as current account, capital account and financial account data can all influence exchange rates.

Geopolitical or Global Economic Events/Default Risk: Wars, coups, civil unrest, elections, fiscal policy decisions and local or worldwide financial crises can all change a country’s underlying economic health, and even increase its default risk, thus affecting its currency.

Commodity Prices: If natural resources drive the bulk of a country’s economy, then the country’s currency is also move with value of the commodity.”

So now that we see the basics of what makes a currency move, my second stop is Bill Gross of Pimco. Mr. Gross is probably the best bond fund manager in the world and has the track record to prove it. He recently appeared on CNBC to discuss king Dollar. My summary of the discussion is as follows: (Full article here)

Bill Gross believes that the dollar will continue to decline. He believes that the dollar is “over owned” in that the government has increased borrowing and this will make the dollar “more and more owned and less and less desirable” but this is necessary for balancing the world economy, as it may result in higher production in the US and lower production in China.

He also adds that the US Government talks that it wants a strong dollar but its actions are the opposite and maybe for a good reason. “Let’s face it, a lower dollar is basically a protectionist barrier,” he said. “The Federal Reserve is likely to keep rates at the same level for a while, because the economy would need to grow by nominal rates of 4 percent or 5 percent to prevent debt from destroying growth,” he said. “They [the Fed] have to stay low because the embedded cost of debt in the economy is 67 percent,” said Gross.

Gross also talks about a “new normal,” where companies will be de-leveraging and where home buyers are just going to have to put 20% down as opposed to 0%.

The US workforce is currently at a high level of unemployment, the Feds are keeping interest rates low and the government is borrowing money at record rates. This is a very simple explanation as to the decline in the US dollar. There are certainly more complicated issues, but the point here is that we need an economic recovery to regain the value of our currency.

Additional Note: As I write this, the US Government is debating entering into the health care business for which it currently does not have the funds. Certainly, curbing government lending would help the dollar. After all, as Bill Gross mentioned, China and other foreign countries will only lend so much. At some point, we have to stop borrowing. Maybe a health care bill should wait until we have money to spend, or we better hope China will be offering no payment and 0% interest for 100 years!

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