Today's comment is by Boris Schlossberg and Kathy Lien, top currency traders and editors of The Money Trader.
Dear A-Letter Reader:
Yesterday, we introduced you to into the spot currency market. This is the market that has greater daily volume ($1.9 trillion) than all the stock markets of the world combined, yet remains a mystery to most individual investors.
As we saw, this is a market that has generated hundred-million and even billion-dollar paydays for elite investors like Warren Buffett, George Soros and Bruce Kovner. Yet it's also a market where you can open an account for just $1,000 (even less).
You can also trade without commissions, get far higher interest rates than in the U.S. and you can turn the dollar's windfall into a profit windfall of 70% to 80% or more, even using relatively conservative trading strategies.
Today, we're going to go a step further and look at the fundamental reasons why any one currency is likely to rise of fall against another currency.
In short, there are three primary factors that determine the relative value of currencies. They are interest rates, political stability and macroeconomics. Let's take a look at them one by one.
A Higher Interest Rate Doesn't Necessarily Mean a Rising Currency
Interest rates are the first indicator of a currency's relative strength or weakness. But it isn't just about which currency sports the higher rate. The relative direction of the interest rates is actually more important.
For instance, the Federal Funds rate in the U.S. hovered just over 6% for most of 2000. That was almost double the average interest rate for the European Central Bank during 2000. Yet, over the next three years, the U.S. dollar fell 24% against the euro.
That's because the U.S. Fed embarked on a drastic easing campaign from September 2000 to September of 2003. During that time, it dropped the Fed Funds rate from 6.5% to 1%. The European Central Bank also eased during this period, but at a much more moderate pace-from about 3.5% to 1%.
So, even though the respective Central Bank rates were roughly the same by September of 2003-at around 1%--the U.S. dollar had fallen sharply against the euro. In good part, that was because the "spread"-or interest rate differential between them was steadily narrowing and then eventually disappeared.
Aggravating the disappearing spread was the fact that the U.S. economy had some major structural problems (and still does). And that brings us to another key factor affecting the relative value of currencies. That's its country's macroeconomic outlook.
Budget and Trade Balances Affect the Value of Currencies
When a country has a trade deficit, it essentially is borrowing money from abroad to sustain its consumption habits. When it has a fiscal deficit, the government is borrowing from the public to sustain its spending habits. When a country has both-a trade and government deficit-and when both those are at record levels, the country overall has a lot of debit it will have to pay back.
For fiscal and trade deficits, those repayments may come from increasing savings. That means slowing down consumption, which can be a drag on the economy. The money to pay the fiscal deficit can also be found by raising taxes, another drag on the economy. Or, the government can simply print more money to pay its debts. And printing money is simply a direct way of devaluing a currency.
In short, protracted and worsening trade deficits tend to be bearish for a currency. Ditto, protracted and worsening government deficits. When a country has twin deficits that are reaching record levels, their currency's outlook is extremely bearish.
Remind you of any currency you can think of?
The Political Situation Affects Currencies
Since government controls a nation's currency printing presses, the stability of that government is a big factor in the perceived worth of the currency.
A recent example was the uncertainty surrounding the European Union last year. When French and Dutch voters rejected the proposed EU Constitution within a week of each other in May, 2005, the euro tanked 7% in just over a month.
Using conservative leverage and strictly limiting your risk, you could have turned that drop into gains of 70% or more in about six weeks time.
But leverage is part of tomorrow's tutorial on the spot currency market. For now, keep in mind that the three top factors affecting a currency's relative worth are interest rates, macroeconomic fundamentals and political stability.
That's why, once the Fed stops raising rates, many veteran currency traders think the dollar will start to fall with a vengeance. It will then have neutral or falling interest rates in conjunction with poor macroeconomic fundamentals. At the same time, you have a new Fed chairman who has recently admitted to a "lapse of judgment" in recent remarks... that spells political uncertainty.
The dollar, in short, could be looking at three strikes.
Tomorrow we'll discuss conservative and a bit more risk-aggressive strategies for profiting from the dollar's fall.
KATHY LIEN & BORIS SCHLOSSBERG, Editors
of The Money Trader, on behalf of The Sovereign Society
EDITOR'S NOTE: Boris Schlossberg and Kathy Lien are senior currency strategists with a top currency trading firm in New York. They have been rated the #1 currency traders in separate quarters this year and last by FX Magazine, a leading institutional publication. Boris and Kathy are also co-authors of the report Secrets of the Spot Market: How to Make 18% to 58% on Your Safe Cash. The report is written to make the spot currency market completely transparent and accessible for individual investors. To reserve a copy, on a risk-free basis, click below.
LINK: http://www.isecureonline.com/reports/MTR/EMTRG654/