Why Currencies Move Up, Down and Sideways

Today's comment is by Sean Hyman, our new Currency Director and editor of Money Trader.

Dear A-Letter Reader,

Most investors know that a company's earnings move a stock. But what moves a country's currency?

Actually, there are many factors that affect currencies every single day. But for now, let's take a look at the three most important factors that move currencies.

Interest rates are the first major factor that moves currencies. Each country's currency has an interest rate attached to it, which is determined by that country's central bank. So when you hold a certain currency, you've paid that country's rate of interest.

Money is attracted, most importantly, to rising interest rates. When rates are high and going higher, money moves away from lower yielding currencies and into higher yielding instruments.

After all, you would rather earn more on your money, right? Many currency investors do. That's why they invest in high-yielding currencies. This influx of buying drives up the demand for the currency and forces it higher. So that's what makes the currency go up.

How to Read a Central Banker's Mind

So the next question is: How do I read a central banker's mind to find out if he's going to raise or cut his country's interest rates? If I can figure that out, then I know if the currency will go higher and I'll actually earn more interest too.

Answer: You watch the inflation numbers.

A country's CPI (Consumer Price Index) is the second major factor that drives currencies. It's the "cost of living" index. CPI measures a basket of goods to determine if the costs of those goods are rising or falling. This basket of goods includes basic necessities like transportation, food, medical care, etc.

The central bank closely monitors these price levels. If prices continue to rise, then they know inflation is rearing its ugly head. A country can't continue to grow at a healthy clip if inflation gets too high.

So how do central bankers combat inflation? They raise interest rates. Raising rates increases borrowing costs. Higher rates make it more costly for businesses to expand and grow. When businesses slow, it tends to "cool" the demand for consumer goods. This means the CPI falls back down to levels that the central bank is comfortable with.

On the other hand, cutting interest rates tends to give an economy a "shot in the arm" and help jumpstart it again. (This is what the Federal Reserve just did last month in the U.S.).

However, investment assets tend to run away from falling interest rates. So by cutting rates, central bankers are effectively encouraging traders to sell their country's currency and push the currency's value down lower.

Money Runs Away from Risky Assets

The last major factor is called "risk aversion." The former two factors are associated with "risk seeking." However, the alternative is risk aversion. Risk aversion happens in the market when traders suddenly don't want to assume the risk to seek higher yielding currencies. This happens when markets get volatile and shaky.

For instance, when stock markets plummet, investors generally try to shield themselves from risk. So investors take their money and run towards assets that are beaten down (oversold) over the last 1-3 years. They're investing in assets they believe won't fall much more or at all. This is what "risk aversion" is.

Recently, we've seen this happening with the Japanese yen. Even though the yen's fundamentals are stable, Japan's currency has continued to drop over the last few years as investors sold the low-yielding yen to "seek" higher returns on their money through higher yields.

However, when financial markets get shaky or overly volatile, money runs from these higher yielding instruments. As economies start to "cool" and slow down, an investor loses the incentive to invest in that currency. It's just like when a stock investor chooses to dump a stock because the company's earnings momentum is slowing.

So you should ask yourself: Is the market in risk-seeking (stable) mode or is it in risk aversion (volatile, shaky) mode?

Also, watch the CPI levels. Watch to see if levels are increasing, flattening out or falling. If CPI levels are rising and they continue to rise above a central bank's comfort level, then look for rate hikes ahead.

If consumer prices have flattened, then central bankers will probably view inflation as under control. They may hold rates steady. If consumer prices are falling, then the central bank may cut interest rates to encourage business expansion.

If the market is in risk aversion mode, then the overall market sentiment is scared. When money gets scared, it looks for safe havens.

So then ask yourself: What's been largely sold over the past 1-3 years and could be due for a bounce back?

If you know that, you know where the money is headed next - and the big currency profits.

SEAN HYMAN, Currency Director

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Air Andorra Finally Can Spread its Wings

The Principality of Andorra lies in a secluded valley between France and Spain. This tiny haven is tucked away high in the Pyrenees - one of Europe's most impressive mountain ranges.

Since 1993, Andorra has been an independent parliamentary democracy. But before that, this little-known tax haven was a medieval principality. The president of France and a Spanish Catholic bishop jointly ruled this small land. For a few in the know, this picturesque country, almost forgotten by the world, offers affordable, crime free and tax-free living.

Andorra is a great ski attraction for the most of the year. But unfortunately, that also means the roads there could be covered in snow for much of the year.

Until now, Andorra has been hours away by car from the nearest airports in Barcelona, Spain or Toulouse, France.

But last week the Andorran government announced plans for a new airport just 15 minutes from the Spanish border. This should boost the number of ski enthusiasts and other tourists. It also may very well increase the number of resident foreigners seeking tax freedom and financial privacy.

Andorra's lone airport will be located in Seu d'Urgell, with first flights anticipated in 2010 or 2011. With a runway of 4,500 feet, it won't be long enough for some medium range aircraft. Most commercial air planes using the airport will be 60 to 80 seaters. There will also be plenty of room for the private jets favored by the wealthy who now consider Andorra a viable and more accessible tax haven.

In the past 40 years, Andorra has been transformed from a poor European country with no real economy to a vibrant independent state. The wealthy now seek out this little city-state for her tax haven status. Skiers come to Andorra for the ski runs, facilities and ski holidays infrastructure that rival the best in Europe.

Andorra and the more famous Principality of Monaco are Europe's leading tax havens, with residents enjoying the benefit of no income tax.

Property prices in Andorra are less than a third of Monaco's prices. Indeed, Andorra is a tax haven - no income, capital gains or inheritance taxes. No sales taxes or customs duties. There is a small local residence tax charged in most "parishes," as the local government unit is called.

And perhaps soon, we may be seeing the logo of "Air Andorra."

BOB BAUMAN, Legal Counsel

EDITOR'S NOTE: Click here to learn more about Andorra, in the newly released edition of The Sovereign Individual.

Wealth & Investments

The Next Market Shock Meltdown on Wall Street:
A Tale of M-LECs and SIVs Part II

As I said yesterday, SIVs are structured investment vehicles that some masterminds on Wall Street dreamed up years ago. But now these shell-company vehicles are coming under fire in the wake of the sub-prime induced credit crunch.

SIVs come in handy for big banks and financial firms that would like to "hide" mountains of risky debt off their own balance sheets. SIVs are typically set up by these bigger institutions, and given some seed-capital to get started, and then issue short-term commercial paper to raise even more capital.

Then they turn around and leverage up the cash - typically 10-15 times. Sometimes they leverage as high as 20 times! With this highly leveraged capital base, the SIV can buy even more mortgages and other debt.

Citigroup is the King of SIVs. They have no less than US$100 billion in assets outstanding as of July. At the peak, the total market size for SIVs was about US$425 billion as of mid-July. But according to data from Moody's, the industry has shrunk rapidly by more than 10% since the credit crunch shock began to roil markets.

The reason is that SIV funding depends upon constant issuance (or rolling over) of short-term commercial paper at favorable interest rates.

But when the credit crunch struck this summer, investors soon discovered that too much defaulting sub-prime debt was lurking in these portfolios. They quickly backed away from buying commercial paper issued by SIVs.

Interest rates on commercial paper soared as a result. They reached a peak of nearly one-full percentage point above the fed funds rate in August.

Since then, rates have come back down, but are still quite a bit higher than normal. So now the US$300 billion SIV market - leveraged up as much as 10- to 20-times that amount in asset-backed securities - is teetering on the brink of collapse. Needless to say, it's no longer able to access cheap financing.

Mass liquidation would create a downward spiral in asset values that would end in the outright collapse of many SIVs. This type of scenario is Wall Street's worst nightmare, because the big banks and brokers would then be forced to take these troubled securities back onto their own books. That would result in potential losses in hundreds of billions of dollars.

It's no wonder that Wall Street's biggest firms are busy lobbying the Treasury Department to create this super (bailout) fund. They are desperate to avoid a fire-sale of US$320 billion is troubled assets. If they don't dump these funds, these troubled assets will end up coming home to roost on their balance sheets.

It's no coincidence that investors in the Treasury bailout fund so far include Citigroup, Bank of America, and JP Morgan. These three financial powerhouses have all collectively agreed to kick-in as much as US$80 billion to rescue the SIVs. These three firms reported multi-billion dollar losses and charge-offs in recent weeks (see table above). Now they're staring down the gun-barrel of a much bigger hit if they don't do something fast to bail out these SIVs.

Desperate times call for desperate measures, and the Treasury sponsored super-fund is just such a measure

There are already plenty of skeptics to the super-fund idea. According to a story in Bloomberg, former Fed Chairman Alan Greenspan indicated last week that the fund could do more harm than good, saying: "It's not clear to me that the benefits exceed the risks."

The asset-backed commercial paper market - the life-blood of cheap SIV financing - declined again last week for the 10th straight week. It's officially the worst slump in seven years that caused the total value of the outstanding commercial paper market to contract 25% since July.

Imagine investors' reaction to a stock market crash of 25%! It happened on Wall Street 20 years ago. It's not that farfetched. Imagine that, and you have an idea of what SIVs are now facing. But in the aftermath of this crash, it may not be so easy to clean up the mess.

The credit crunch correction is far from over...and the next market shock to hit Wall Street looks even nastier!

MIKE BURNICK, Senior Editor & Global Markets Analyst

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