What Really Moves Currency Prices?

10/12/2011 6:00 am EST

Focus: FOREX

Rick Wright

Instructor, Online Trading Academy

The introductory article in this multi-part series discusses how central bank and government-sponsored currency intervention impacts forex prices, citing recent action in the euro and US dollar.

In today’s MoneyShow.com article, I would like to address a couple of fundamental topics to help explain why the market is behaving like it is. There are many variables to some of the economic theories and possibilities out there, but before we get started, we do need to have an agreement in that the examples I will give are reflective of a basic Economics 101 explanation.

The first question we will discuss this week is, "Does a government want a strong or a weak currency?"

The answer is "It depends on who they are talking to." A government/central bank/Treasury department will tell the average voter that a strong currency is very desirable because it makes the uninformed stand up straighter with national pride, cheering on their government.

While in Economics 101, we learned that a stronger local currency also allows consumers to buy more goods at the local stores (specifically imported goods), thereby increasing potential tax revenues.

A negative byproduct is that our exported goods are more expensive overseas, which is actually bad for jobs here. Fewer exports means fewer workers here are needed, and hence, we get layoffs. But at least everything I buy that is imported from large export countries is really cheap. Get it?

Generally speaking, a country actually wants a weaker currency. The reasoning is just the opposite of the above: it actually helps with exports from the country with the weaker currency because their goods are cheap in other countries.

This potential increase in exports is good for jobs in the weak-currency country. Lots of jobs equals a lot of votes. Now, if it were just a matter of turning a dial to weaken a currency, anyone could do it.

In the spot foreign currency market, however, all of our trades are relationship trades: if one currency weakens, it is weakening versus another. One is getting stronger, like it or not!

What happens if both governments/central banks of the two currencies want their money to be weaker? Welcome to our current worldwide economic environment!

Many of the major economies of the world were/are in a race to see who could make their currency the weakest and who could do so the fastest. A race to the bottom of the toilet, if you will!

In the following chart, we see the EUR/USD pair over the past 16 months where the pair traded from approximately 1.1900 to a high near 1.4930 and back down to a recent low of 1.3747.

chart
Click to Enlarge

As the US dollar (USD) had been getting weaker over these months, the euro (EUR) was getting stronger. If you have not been paying close attention to recent news, allow me to inform you that the Euro currency/economic zone has been having some mildly terrifying structural and debt issues.

Put "Eurozone crisis" in a Google search and you will receive only about 13,400,000 results talking about the problems with this currency experiment. My prediction is the EUR will be gone, or some of the weaker participants kicked out (or stronger economies will flee) within 18 months, which makes it the slowest trainwreck in the history of the world.

We have known for many months that Greece, Italy, Spain, and Portugal are having serious debt crises, yet the EUR was still rapidly gaining versus the US dollar. How weak must the US dollar really be to have a currency on life support gaining on it so rapidly?

So, the question is: What tools can a government or central bank use to weaken its currency? There are a few available.

The easiest and most obvious is to lower interest rates. Every few weeks when the central bank representatives of the major economies meet, they discuss what to do with interest rates to influence the economy.

When these bankers want to weaken their currency, they will vote to lower interest rates to help spur on borrowing to "help" the economy. The theory is that the lower the interest rates are, the more entrepreneurs and businesses will borrow money to expand, and therefore, increase jobs.

Here is a table of the major economies and their bank rates; thanks to FXStreet.com for the info:

chart
Click to Enlarge

Apparently, these central banks have been pretty busy lowering their rates, although it is kind of hard to lower rates below zero! Yes, it is possible, but it’s rare.

So, what is a central bank to do when their rates are near or at zero? What else could they do to weaken their currency? Those questions and more will have to wait until Part 2 tomorrow.

By Rick Wright, instructor, Online Trading Academy

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