International Finance

The Reasons on Recently Change in Various Currency

a) Use this Web page to determine how exchange rates of various currencies have changed in recent months. Note that most of these currencies are quoted in units per dollar. In general, have most currencies strengthened or weakened against the dollar over the last three months? Offer one or more reasons to explain the recent general movements in currency values against the dollar.

The value of the dollar can be figured by the exchange rates, Treasury notes and the amount of dollars that are in custody by foreign countries. These three measurements usually run in sync with each other (Amadeo, 2010). But no matter how you measure it, the dollar is losing value over the long-term (Summary Measures of the Foreign Exchange Value of the Dollar, 2010).

The world still sees the dollar as the security currency in the globe as was recently seen by its recent strength against the Euro and Yen. European leaders’ are struggling to forge a plan to bail out Greece and the yen fell against all 16 of its most-traded counterparts this week as Japanese consumer prices dropped for a 12th month, increasing the chances the nation’s central bank will lag behind its peers in raising interest rates. Relatively, the U.S. economy is still showing signs of growth, improving corporate profits and a slowdown in unemployment. Company earnings went up 8% in the fourth quarter, topping the biggest year over year gain in 25 years. The U.S. economy expanded at a 5.6% annual rate (U.S. Dollar Outlook for 2010-2011: Euro, Yen, Aussie and Loonie Fall in Flight to Greenback Safety, n.d.).

News coming from the European and Japanese economies is often clouded and uncertain. With growth much slower than in the U.S., investors are uncertain and so they buy dollars. The dollar appreciated 0.9% to $1.3410 versus the euro, from $1.3530 a week earlier. It was starting for a gain of 6.8% for the quarter, the largest since it advanced 11.8% in the three months ending September 2008. Even the strong resource driven currencies like the Australian and Canadian dollars went down in comparison to the greenback recently amid speculation gains vs. The U.S. dollar and the euro couldn’t be sustained. Australia’s currency dropped 1.2% to 90.41 U.S. cents, from 91.54 cents on March 19. The Loonie, as Canada’s currency is nicknamed, dropped 0.9% to C$1.0266 per U.S. dollar (U.S. Dollar Outlook for 2010-2011: Euro, Yen, Aussie and Loonie Fall in Flight to Greenback Safety, n.d.).

Mexico’s peso was the only major currency that gained against the dollar this week, as an economic recovery in the U.S. fueled demand for the Latin American nation’s exports.

Over the long haul the U.S. dollar is still projected to weaken due to the overhanging federal deficit. However, with a stronger economy and the prospect of rising inflation/interest rates the U.S. dollar may finish 2010 much stronger against other world currencies (U.S. Dollar Outlook for 2010-2011: Euro, Yen, Aussie and Loonie Fall in Flight to Greenback Safety, n.d.).

The U.S. dollar is most easily considered by its exchange rate, which compares its value to other currencies around the world. Currency exchange rates allow for the determination of how much of one currency you can exchange for another. Exchange rates change every day because currencies are traded on the foreign exchange market, known as forex. A currency’s forex value depends on a lot of issues, including Central Bank interest rates, the country’s debt levels, and the strength of its economy. Most countries allow their currencies to be calculated by the forex market. This is known as a flexible exchange rate (Amadeo, 2010).

The dollar’s value is usually in line with demand for U.S. Treasury notes. The Treasury Department sells notes for a set interest rate and face value. Investors bid at a Treasury auction for more or less than the face value and then resell them on a secondary market. High demand means that investors pay more than face value, and accept a lower yield. Low demand means investors pay less than face value and receive a higher yield. That’s why a high yield means low dollar demand until the yield goes high enough to activate renewed dollar demand (Amadeo, 2010).

On the whole, the value of the dollar is weakening as measured by both exchange rates and by Treasuries. The world is in a recession, investors want a secure investment, and the dollar is looking less secure thanks to the $12 trillion U.S. debt. The higher the debt, the less secure the dollar seems. In order to fund the debt, the Treasury auctions more notes than there is demand, causing yields to go up. The dollar is owned by foreign governments who have an excess of cash, held in foreign currency reserves. This surplus happens when countries, such as Japan and China, export more than they import. Because these countries are concerned about the declining dollar, there is a decline in the percentage of reserves held in dollars (Amadeo, 2010).

The recent sharp fall in the Euro recently due to debt crisis in member nations seems a bit overdone. With the euro on the rise again against the dollar, and in the middle of speculation, traders who bet on its decline amid Europe’s independent debt crisis had to buy back the currency as it strengthened to a one-week high. It had dropped to $1.2144 against the U.S. dollar on May 19, the lowest level since April 2006, before rebounding above $1.26 (U.S. Dollar Outlook for 2010-2011: Euro, Yen, Aussie and Loonie Fall in Flight to Greenback Safety, n.d.).

As of the fourth quarter in 2009, there was $2.8 trillion in foreign government reserves held in dollars. This symbolizes 62% of total measurable reserves, down from Q3 2008, when dollars comprised 67% of reserves. Due to the fact that the percentage of dollar is slowly going down, foreign governments are slowly shifting their currency reserves out of dollars. The value of Euros held in reserves increased from $393 billion to $1.25 trillion during this same time period. Even though it is rising rapidly, it is still less than half the amount held in dollars (Amadeo, 2010).

The money that will do best against the U.S. dollar is those with central banks that are not keen to follow in the footsteps of the Federal Reserve, Bank of England and the Bank of Japan. These consist of the European Central Bank, Reserve Bank of Australia and the Reserve Bank of New Zealand. All 3 of these central banks have interest rates above 1.00% and have been slow to cut interest rates, let alone embark on quantitative easing (Lien, 2010).

As the most vigorously transacted currency in the world, the fluctuations in the U.S. dollar have broad consequences for the global economy. The weakness of the greenback drives other currencies such as the Euro, British pound and Japanese Yen higher. A major rally in their currency has a similar affect on the economy as rate hike. Many commodities are also priced in dollars which makes clear why oil and gold prices are radically higher. Oil prices peaked in July 2008. This was at the exact same time that the U.S. dollar bottomed. Since July 2008, the price of oil has had a 90% negative association with the dollar index. This means that when the dollar rises, oil prices fall most of the time. It is thought that the higher commodity prices and a weaker dollar will drive inflation higher. Currently, this is not a concern for the Fed because weak demand will prevent vendors from raising prices. Finally, the weaker dollar will help U.S. companies selling goods abroad by either increasing the competitiveness of U.S. exports or increasing the value of foreign earnings when converted by into U.S. dollars (Lien, 2010).

One of the more puzzled proposals in the area of currencies and exchange rates is the belief that the value of a currency is calculated or determined by the exchange rate. The dollar has recently gone down by about 13% against the euro and has lost about a third of its value against the euro since mid-2001 (Johnson, 2003).

It is the value, or purchasing authority, of a currency that basically decides the exchange rate to other currencies. The purchasing power equality theory of foreign exchange is merely the submission of the general theorems concerning the purpose of prices to the special case of the coexistence of various kinds of money (Johnson, 2003).

The most common metric measuring this accumulated stock of foreign borrowing by the United States is known as its net international investment position (NIIP). This measure has gone up from zero to over 20% of total GDP over the past 10 years. The increase has been particularly rapid in the past five years because the NIIP has gone up from 5% to 20% of GDP during this time. This increase in debt increase cannot be sustained. Ultimately investors will doubt the capability of the United States to pay back these loans and will withdraw their capital to look for safer investments in other places. This process of investors selling U.S. assets may have already begun, as the dollar’s value has declined significantly in the past year (Bivens, 2003).

b) Does it appear that the Asian currencies move in the same direction relative to the dollar? Explain.

A new study released from the Peterson Institute for International Economics concluded that the dollar is still considerably overvalued against a number of Asian currencies, most significantly the Chinese renminbi and the Japanese yen. It is thought that the renminbi needs to go up by about 30% against the dollar and the yen should strengthen by about 20%. A number of other Asian currencies also need to appreciate substantially so the desired increases amount to much less on a trade-weighted average basis which is under 20% for the renminbi and only about 5% for the yen (Lien, 2009).

This study also found that the euro and the pound are now overrated on average. They have not gone over the dollar a lot and the depreciation in their effective exchange rates should come largely from the appreciations of a number of Asian currencies. Generally, the dollar is now overvalued by less than 10%. It has gone down by almost 25% since early 2002. The U.S. current account deficit has improved by about $80 billion, falling from about 6% of GDP to about 5%. This gain would have been larger if it had not been for the sharp rise in the price of oil imports, and the reduction in the real deficit as incorporated in the GDP accounts (Lien, 2009).

The Asian currencies that should appreciate most are the Singapore dollar, the Chinese renminbi, the Malaysian ringgit, the New Taiwan dollar, and the Japanese yen. The Korean won is the only Asian currency estimated to be overvalued, despite which it would need to appreciate against the dollar (but not on a trade-weighted average basis) as part of the needed multilateral realignment (Lien, 2009).

Dollar depreciation will have different effects on economies with floating exchange rates and those with currencies pegged to the dollar. Most DMCs maintain floating exchange rates, under which authorities normally do not intervene in the foreign exchange market and the currency is left to react to market signals. Currencies with floating exchange rates will appreciate in response to dollar depreciation. A few DMCs peg their currencies to the U.S. dollar. Hong Kong, China formally pegs the Hong Kong dollar to the U.S. dollar. The People’s Republic of China (PRC) maintains a de facto peg to the U.S. dollar. The Malaysian currency is also kept within a very narrow range of exchange rate with the dollar. The pegged exchange rate arrangement requires authorities to intervene in the foreign exchange market to maintain the fixed exchange rate. They will have to buy domestic currency when it is in excess supply and sell it when it is in excess demand to avoid a currency depreciation or appreciation. When the dollar depreciates, currencies pegged to the dollar will also depreciate against other currencies.

Different policy regimes mean DMC currency changes will vary relative to the dollar. The effect of dollar depreciation will be different for economies with floating and pegged exchange rates (Lien, 2009).

Much has been written about the suitability of technical analysis for trading in the currency markets. While this is undoubtedly true, it can leave traders, particularly those new to the currency markets, with the impression that all technical tools are equally applicable to all major currency pairs. Perhaps most dangerous from the standpoint of profitability, it can also seduce traders into searching for the proverbial silver bullet: that magic technical tool or study that works for all currency pairs, all the time. However, anyone who has traded forex for any length of time will recognize that, for example, dollar/Yen (USD/JPY) and dollar/Swiss (USD/CHF) trade in distinctly different fashions. Why, then, should a one-size-fits-all technical approach be expected to produce steady trading results? Instead, traders are more likely to experience improved results if they recognize the differences between the major currency pairs and employ different technical strategies to them. This article will explore some of the differences between the major currency pairs and suggest technical approaches that are best suited to each pair’s behavioral tendencies (Dolan, 2010).

By far the most actively traded currency pair is euro/dollar (EUR/USD), accounting for 28% of daily global volume in the most recent Bank for International Settlements (BIS) survey of currency market activity. EUR/USD receives further interest from volume generated by the Euro-crosses and this interest tends to be contrary to the underlying U.S. dollar direction. For example, in a U.S. dollar-negative environment, the Euro will have an underlying bid stemming from overall U.S. dollar selling. However, less liquid dollar pairs will be sold through the more liquid Euro crosses, in this case resulting in EUR/CHF selling, which introduces a Euro offer into the EUR/USD market (Dolan, 2010).

This two-way interest tends to slow Euro movements relative to other major dollar pairs and makes it an attractive market for short-term traders, who can exploit “backing and filling.” On the other hand, this depth of liquidity also means EUR/USD tends to experience prolonged, seemingly inconclusive tests of technical levels, whether generated by trendline analysis or Fibonacci/Elliott wave calculations. This suggests breakout traders need to allow for a greater margin of error: 20-30 pips. A pip is the smallest increment in which a foreign currency can trade with respect to identifying breaks of technical levels (Dolan, 2010).

The next most actively traded currency pair is USD/JPY, which accounted for 17% of daily global volume in the 2004 BIS survey of currency market turnover. USD/JPY has traditionally been the most politically sensitive currency pair, with successive U.S. governments using the exchange rate as a lever in trade negotiations with Japan. While China has recently replaced Japan as the Asian market evoking U.S. trade tensions, USD/JPY still acts as a regional currency proxy for China and other less-liquid, highly regulated Asian currencies. In this sense, USD/JPY is frequently prone to extended trending periods as trade or regional political themes play out (Dolan, 2010).

For day-to-day trading, however, the most significant feature of USD/JPY is the heavy influence exerted by Japanese institutional investors and asset managers. Due to a culture of intra-Japanese collegiality, including extensive position and strategy information-sharing, Japanese asset managers frequently act in the same direction on the yen in the currency market. In concrete terms, this frequently manifests itself in clusters of orders at similar price or technical levels, which then reinforce those levels as points of support or resistance. Once these levels are breached, similar clusters of stop loss orders are frequently just behind, which in turn fuel the breakout. Also, as the Japanese investment community moves en masse into a particular trade, they tend to drive the market away from themselves for periods of time, all the while adjusting their orders to the new price levels, for instance raising limit buy orders as the price rises.

An alternate tactic frequently employed by Japanese asset managers is to stagger orders to take advantage of any short-term reversals in the direction of the larger trend. If USD/JPY is at 115.00 and trending higher, USD/JPY buying orders would be placed at random price points, such as 114.75, 114.50, 114.25 and 114.00, in order to take advantage of any pullback in the broader trend. This also helps explain why USD/JPY frequently encounters support or resistance at numerically round levels, even though there may be no other matching technical significance (Dolan, 2010).

China’s emergence as an economic superpower will escalate the demand for the Asian giant’s currency, which is also known as the people’s money. Beijing will eventually permit the Yuan to trade freely on foreign-exchange markets, discarding the current system under which the government controls the currency’s value. As China moves in this direction, other large emerging economies will presumably gradually move in the same direction and the end result will be something approximating to today’s Western monetary system. Under such a system, the renminbi, dollar and euro would all form the linchpin of the world’s currency markets (Patalon, 2010).

Of the four BRIC countries, China is thought to be likely to have the biggest impact in the near-term. Sometime this year, in fact, the Asian giant is likely to leap over Japan to become the world’s No. 2 economy behind the United States. In the next 10 years, China is likely to approach the U.S. economy is size. The Chatham House report stated that the dollar-based monetary system is no longer sufficient for a larger and more integrated world economy. Well-known developing economies are increasingly demanding to be included in any multilateral dialogue that aims to shape the new economic order (Patalon, 2010).

References

Amadeo, Kimberly. (2010). Value of the U.S. Dollar. Retrieved May 30, 2010, from About Web

site: http://useconomy.about.com/od/tradepolicy/p/Dollar_Value.htm

Biven, Josh. (2003). The benefits of the dollar’s decline. Retrieved May 30, 2010, from Economic Policy Institute Web site:

http://www.epi.org/publications/entry/briefingpapers_bp140/

Dolan, Brian. (2010). Currency Pairs. Retrieved May 30, 2010, from Forex Web site:

http://www.forex.com/forex_currency_pairs.html

Johnson, Richard C.B. (2003). The Fundamentals of a Falling Dollar. Retrieved May 30, 2010,

from Ludwig van Mises Institute Web site: http://mises.org/daily/1394

Lien, Kathy. (2009). Which Currencies Will Do Best Against the U.S. Dollar? Retrieved May 30,

2010, from GFT Web site: http://www.gftforex.com/analysis/864/which-currencies-will-

do-best-against-the-u-s-dollar#headline01

Patalon, William. (2010). Goldman Backs Money Morning Prediction That China’s Yuan Will

Dethrone the Dollar. Retreived May 30, 2010, from Money Morning Web site:

Goldman Backs Money Morning Prediction That China’s Yuan Will Dethrone the Dollar

Summary Measures of the Foreign Exchange Value of the Dollar. (2010). Retrieved May 30,

2010, from Federal Reserve Bank Web site:

http://www.federalreserve.gov/releases/h10/Summary/

US Dollar Outlook for 2010-2011: Euro, Yen, Aussie and Loonie Fall in Flight to Greenback

Safety. (n.d.). Retrieved May from Saving to Invest Web site:

http://www.savingtoinvest.com/2008/05/us-dollar-outlook-2008-2009-and-beyond.html