International Currencies Made EZ #7

by | Dec 17, 2004 | Archives

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 Seven. This report is dated but do not let the dates and numbers get in the way. The fundamentals remain the same.

Technical vs. Fundamental Currency Analysis

No one knows totally why the value of a currency moves. However, there are many factors that have a definite influence on the value of currencies. We will learn these factors in this lesson and Lesson Eight.

We will also learn how to analyze these factors, so we can form our own view about which currencies will rise and which will fall.

There are two types of currency analysis: technical and fundamental. Technical analysis is based on the actual movement of a currency. A technical trader buys a currency just because it is going up. He doesn't care why it is going up — he just buys because it is going up. Similarly, a technical trader sells a currency when it is going down.

Thus, if someone says that the “technical position” of a currency is strong, it means that the currency's value is rising. If the technical position is weak, it means the currency's value is falling. This school of thought does not care what the underlying fundamental reason for a currency's moves are. A technical trader believes that there are too many diverse factors that affect currencies and that one can never truly know why currencies move. This “technical school of thought” believes that the movements of the market are a true reflection of all these forces and thus currency movement is the only factor worth studying.

There also is another school of currency traders which prefers to make judgements on more basic, fundamental factors about each currency. “Fundamental” refers to the underlying reasons that a currency rises or falls. A fundamental trader invests in a currency because he believes the underlying fundamental factors indicate that the currency is strong and will rise in value. These underlying factors can be divided into short and long term factors as below:

Long Term Factors

1) Productivity 2) Trade Balance (Surplus or Deficit) 3) Government Debt and Government Deficit 4) Nature of Government Spending 5) Tax Rate

Short Term Factors

1) Interest Rates 2) Inflation 3) Real Return on Investment 4) Velocity 5) Money Supply

Knowing how to examine fundamentals of a currency's strengths and weaknesses is invaluable. When charting an investment course, it is important to have an overall currency plan based on these underlying factors and fundamentals. For this reason, we will examine in detail each of the fundamental and short term underlying factors that determine currency strength and weakness.

Long Term Factors

The global investor today has several long term trends staring him in the face. First, the U.S. dollar seems weak in the long term. Every possible indication is present that the dollar will continue to fall long term, especially against more disciplined currencies like the German mark, Swiss franc, and Japanese yen. Does that mean the dollar will fall next month vs. these currencies? Or throughout the coming year? Certainly not. Even in long term falls or rises, there are peaks and valleys that can unpredictably extend over long periods. But indications are present that the dollar will lose value in the long-term.

A Game Plan Gives Emotional Strength

Even when an investor studies the long and short term fundamentals of currencies, there will be times when the currencies do not move as predicted. However, the inevitable rises and falls of marketplaces can be more easily tolerated emotionally, if you understand the forces that make them move. Also by understanding underlying currency fundamentals and making investment decisions based on such knowledge, the chance for success is increased.

The Instantaneous Movers of Currency Value: Fear and Greed

The reasons that currencies do not always move as expected can be many. First, one may incorrectly understand fundamentals. Second, the statistics (normally government provided) that reflect currency fundamentals may be slanted or incorrect. Third, there may be factors that are unseen and unknown.

However, the greatest reason why currencies do not move exactly based on short and long fundamentals is because the ultimate value of a currency is determined by the currency markets. These markets are driven not only by the fundamentals, but by the traders' opinions.

Important Point to Remember: A currency's future value can never be totally known because it is affected by all of the opinions of the market. All these opinions can never be known and they are volatile because they are in turn driven by two underlying motives-to make a monetary gain and to avoid a loss. We could call these forces-fear and greed.

Although foreign exchange is ultimately based upon foreign trade (as payment for trade between countries), the day-to-day and moment-to-moment price of a currency is driven by currency traders, many of whom do not look at the underlying fundamentals of a currency's value.

These traders represent buyers and sellers around the world, all of whom are driven by the two most prominent motives when it comes to any type of investment: fear and greed. Currency traders, buyers and sellers, are continually afraid that they are holding currency that is about to fall in value — even if the currency is going up in value. But of course at the same time, they do not want to miss out on any appreciation they might receive. Which of these two motivators is the strongest? The answer is, by far, fear of loss.

Benjamin Franklin once said that a tired man would never get out of bed and go downstairs to earn a dollar. But the same man would jump out of bed and dash downstairs to save the loss of a dollar he had already earned.

Important Point to Remember: Many investment psychologists believe that the motive of fear outweighs the motive of profit by about two to one. A look at most bull and bear markets will show that a strong bear will normally fall at a rate that is twice as fast as a strong bull market will rise.

And so it is with currency traders. The price of currencies rise and fall in relationship with each other, based ultimately on the fundamentals we shall discuss. But underlying the movement are investors' fears of loss and potential gain.

Contrarian Trading Tactic

There is another school of thought that thinks most investors (in the long run) are always wrong. Most investors are captured by greed and buy at the top of a currency's strength and then panic and sell in fear at the bottom of its weakness. Contrarian investing philosophy suggests that we should always invest in currencies that are relatively very weak and avoid those that are relatively very strong.

One must understand fundamentals to understand when a currency is really relatively weak and when it's relatively strong. So for the rest of this lesson we will concentrate on the long term fundamentals.

Long-Term Factors of Currency Movement

* Long-Term Factor #1: Production and Consumption. The ultimate mover of a currency's value is the age old give and take between production and consumption.

It follows the natural law that governs all work and economic productivity: a person cannot consume what he does not produce. If a person does consume more than he produces, he has two choices and two choices only: One, he must increase income to meet or exceed consumption, or two, he must borrow to meet the discrepancy.

Ultimately, of course, the choice comes down to #1, because for an individual, borrowing can go on only so long before reckoning takes place. Governments, however, sometimes think they can borrow indefinitely, bolstered by their ability to create money from thin air and by their power to tax (and raise taxes) on citizens.

What is production? It's the creation of goods and services, the creation of new ideas that improve goods and services, and the distribution of these goods and services. Production involves the entire range of a country's economic activity: from the development and distribution of raw materials, to the formation of these raw materials into desirable, useful products, to the development of stable banking and insurance networks that finance and protect investors' capital outlay.

When a country has little actual growth in production, theoretically it should not increase its money supply. Unfortunately, this is the very time governments need money the most. Few can resist the impulse to print a little extra to tide them over.

If a government does not impose discipline to assure that no money is produced unless some production takes place, that currency will eventually fall in value compared with currencies that are based on more productive, stable values.

This is especially so of governments that use fiat currency. If a currency is based on gold, silver, or another hard asset, it is not possible to simply print whenever more is needed. The gold or other hard asset represents productivity, because no person or government is going to give away gold unless some productive value is exchanged. Fiat currencies have no base of hard assets, and the printing presses can churn it out unencumbered by small details. There is no worry such as is the currency really worth anything.

Fiat currencies are very sensitive to the emotions of fear and greed in the foreign exchange markets, because the only real value these currencies have is confidence. If an investor is confident that a Fiat currency will rise, he will buy it. If the investor fears that the currency will fall, then he will sell.

If all currencies were tied to a hard asset, there would not be so much fear that a country is creating more currency than productivity warrants. Nor would there be as much desire to speculate for profit on a currency's parity motion. Value would always remain steady.

What would this do for the world? It would ensure that governments would be more honest with its citizenry. Governments would not be able to expand beyond their citizens' desires to pay for governmental services. Governments would issue money based only on production. Certainly they could still borrow, and certainly they could adjust taxes from time to time. But overall, basing currency on hard assets would force governments to maintain fiscal discipline.

However, such discipline is something that few governments in history have maintained for any reasonable length of time. We must assume that the U.S. government will not suddenly gain this discipline and that growing U.S. debt will eventually destroy the remnants of the world's currency system as we now know it.

Important Point to Remember: Most governments today are accustomed to a system of borrowing far more then they can ever repay. This is a trend that has been promoted since the 1940s. Politicians have become hooked on budget deficit spending. Until this trend reverses itself, currency turmoil is almost certain because all the governments are spending more then they produce.

*Long-Term Factor #2: Government Debt. The fundamental basis for international currency movement may be trade and the resulting surplus or deficit in a country's balance of payments. However, the real world involves real governments, run by real people with real needs, short and long term. For this reason, the most fundamental basis of currency movement is government discipline (or lack of).

Governments today produce money out of thin air to fund their activities (as seen in the previous section on the U.S. Federal Reserve and fractional reserve banking). If governments produce money that is not backed by precious metal or by the productivity of their own people, the money created will eventually become weaker versus money issued by governments that produce money backed by precious metal or productive work.

The most fundamental law of money is that something cannot be consumed unless it is first produced. This simple, common sense law seems so obvious that it hardly needs stating. Yet ignoring this law has led (and will continue to lead) currency after currency to destruction!

Money, above all, is a form of discipline. In its most pure form, this discipline is aimed at stopping members of a community from taking more than they have produced.

For example, any government can add a new department and staff it, paying for the expenditure by simply printing (or creating) new money. But when a currency is tied to gold or silver, the government cannot simply manufacture it out of thin air. The government must first produce or earn the gold, then print the money. This keeps a government honest. It disciplines a government not to consume until it has produced. Gold or silver, in themselves, are merely representative of production accomplished.

If a government does not impose discipline on itself to assure that no money is produced unless some production occurs, that currency will lose its purchasing power versus currencies whose governments do maintain discipline. Some governments impose less discipline than others. The less discipline there is, the weaker the currency will be and the faster it will fall versus other currencies.

There are numerous ways to spot future weakness in a currency.

First, look for deficits in a government's annual budget. If a country has a deficit, it is producing money without discipline. As a rule, the larger the percentage of the debt compared with the country's gross national product, the more likely the country's currency will fall vs. other currencies.

Second, spot potential weak currencies by looking at a country's accumulated debt. If a country has a debt it must start running a budget surplus before it can pay down the debt. This can only be accomplished by either a slow down in spending or by an increased income. In either case, such discipline balances the budget. If a government does not balance its budget, it has to borrow to meet payments.

Third, look out for a government with both an accumulated debt and a deficit in its annual budget. This country is already in debt and the debt is increasing!

Unfortunately your task of finding such governments will be all too easy. Government deficit financing is now a normal part of most economies. Huge debts are being created by governments all over the world.

These debts create all kinds of economic problems. They interfere with private industry. This was one factor that seriously hurt bond prices in 1994. The huge demand by governments for financing of their debt attracted funds that once went to private bond issues. When governments borrow more and more money, this pushs up the yield on treasury issues, competing with bond issues and making them less attractive.

Government debt affects currency values in many ways. Some countries, especially developing countries, create so much debt that they cannot produce enough goods to service their debt (principal or interest). In these cases, the currencies of the countries are seriously affected. Even major nations are affected.

The amount of debt in relation to gross domestic product is an important factor to help us determine the value of a currency. “

Until next message, good investing!