International Currencies Made EZ #9


Few economic events can have as much impact on your life as the falling U.S. dollar. I am learning this right now while on a trip to London. If one converts what things cost here in dollars…well its just better not to.

While I am away, the Gary Scott messages each day contain a review from the course International currencies Made EZ. This information can help you understand why and how currency parities move. Here is a section from Chapter Nine. This report is dated but do not let the dates and numbers get in the way. The fundamentals remain the same.

Short-Term Factors of Currency Movement

If we look at the value of the U.S. dollar versus the German mark, we can see that in long term fundamentals are causing the dollar to fall. The fundamental direction of the dollar versus the German mark is down.

We can see this long term downward move in the chart below. However we can also see that at times the dollar has risen, such as from 1980 to 1986.

These temporary moves against the fundamental trend are caused by short term currency factors which include:

Interest Rate Differences

Inflation

Real Returns

Velocity & Technical Trading Factors

Money Supply

Here we look at these short term factors in more detail.

* Short-Term Factor #1: Interest rate differences. A country can borrow only if its treasury issues are attractive on a global scale. Take, for example, a German investor in 1985 who bought a $10,000 U.S. dollar Treasury bond that would mature ten years later in 1985. We can see from the chart above that in 1985 it took about 2.8 German marks to buy one U.S. dollar. That German investor had to spend 28,000 German marks to get the $10,000 for the bond. When the bond matured in 1995, the dollar bought only 1.4 German marks. This means that the $10,000 now pays back only 14,000 German marks. The German investor lost 50% of his investment in the capital value of the bond!

Having seen this example and having seen in the chart the real loss in value of the dollar, we must ask, why would the German investor ever want to buy a U.S. dollar bond?

The answer is that the investor will have to be tempted to take the currency risk by a sufficient interest rate. Assuming that U.S. dollar bonds paid 7% per annum when the investor decided to buy and at that time the German mark bonds only paid 4%. Then the 3% interest differential was the main reason why the German investor decided to buy the bond. The other reasons would be the desire for diversification and a chance for a currency profit because at the time the bond was purchased the investor obviously did not know that the dollar would fall so far.

To make bond issues, in any currency, attractive, interest rates need to be competitively high versus interest rates in other currencies. Generally raising interest rates increases the strength of a currency because it attracts foreign investment and thereby causes a greater demand for the currency on international exchange markets. Also, raising interest rates slows the internal economy, tending to reduce industrial production and slow the rise of prices and reduce inflation.

A government uses interest rates to attract foreign investment to debt offerings and to establish industrial activity and price levels internally. Therefore, generally speaking, when the interest rate on a country's new debt offerings is high, the currency is quite often weak. The high interest rates are offered to attract foreign investment, which needs incentive in order to be interested in a fundamentally weak currency.

For instance, why would an Swiss investor, whose currency (the Swiss franc) is fundamentally much stronger than the U.S. dollar, be interested in purchasing U.S. treasury certificates? The investor has to realize that over time it is quite likely that the dollar will fall in relationship with the Swiss franc and that a forex loss will be sustained. In the last year alone, the dollar has fallen 7.5% against the franc. The only incentive the U.S. government can give is to offer a higher rate of interest than could be obtained by investing in the Swiss franc. The 30 Year U.S. Treasury Bond offers just over 8% yield, while Swiss long- term bonds are at just over 5.5%.

* Short-Term Factor #2: Inflation. Perhaps the best way to spot weakness in a currency is to look at a country's internal inflation trends. We learned in earlier lessons that a currency that is inflating will tend to fall in value versus a currency that is not inflating. These days most currencies have some rate of inflation. If the inflation rate of a currency is higher than the inflation rate of another currency, the currency with the higher inflation will tend to lose value versus the other.

In regard to spotting future inflation trends, let's review some fundamentals we've already discussed.

First, we described in previous lessons how the U.S. Federal Reserve attempts to control inflation by adjusting interest rates. As you'll recall, when the Fed fears that inflation is rising, it raises interest rates, thereby making the cost of loans higher and slowing borrowing by businesses and private individuals. When borrowing is slowed, businesses cut back on production and private individuals cut back on spending (purchasing via credit cards, mortgages, car loans, etc.) As a result, the price of goods is held in check, and inflation is held under control.

What does this show? That in general, rising industrial production in a country is a sign that prices (inflation) will rise. Dropping industrial production is a sign that prices will drop. As an aside, it should be noted that in many countries the population is growing extremely rapidly. Growth in the United States and industrial European countries is less than 3% per annum, but in many developing countries growth is over 10% per annum. This rapid growth causes consumer demand from this growing population to outstrip production potential. The result? Increased demand for a smaller number of goods, rising prices, and rising inflation. Take into account also that many developing countries have inefficient systems of production and distribution. Thus, as the population grows, production growth is spotty, further stimulating inflation.”

I am back from London and my regular messages resume tomorrow. You can study the complete International Currencies Made EZ course free at http://www.garyascott.com/news/currez/index.html

Until tomorrow, Good investing!

Gary


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