Chapter 3
What Moves the Currency Market?

Now that we know a little bit about the history of the forex market, let's take a look at what moves currencies. There are two primary ways to analyze financial markets: fundamental analysis and technical analysis. Fundamental analysis is rooted in understanding underlying economic conditions, while technical analysis uses historical prices to predict future movements. For as long as technical analysis has been around, there has been an ongoing debate as to which methodology is more successful. Short-term traders prefer to use technical analysis, focusing their strategies primarily on price action, while medium-term traders tend to use fundamental analysis to determine a currency's current and future valuation.

Before implementing successful trading strategies, it is important to understand what drives the movements of currencies in the foreign exchange market. The best strategies tend to be the ones that combine both fundamental and technical analysis. Textbook perfect technical formations have failed too often because of major fundamental news and events like U.S. nonfarm payrolls. But trading on fundamentals alone can also be risky. There will oftentimes be sharp gyrations in the price of currency on a day when there are no news or economic reports. This suggests that the price action is driven by nothing more than flows, sentiment, and pattern formations. Therefore, it is very important for technical traders to be aware of the key economic data or events that are scheduled for release, and, in turn, for fundamental traders to be aware of important technical levels that the general market may be focusing on.

Fundamental Analysis

Fundamental analysis focuses on the economic, social, and political forces that drive supply and demand. Those using fundamental analysis as a trading tool look at various macroeconomic indicators such as growth rates, interest rates, inflation, and unemployment. We outlined some of the most important economic releases in the first chapter of this book. Fundamental analysts will combine all of this information to assess current and future performance. This requires a lot of work and thorough analysis, as there is no single set of beliefs that guides fundamental analysis. Traders employing fundamental analysis need to continually keep abreast of news and announcements, as they can indicate potential changes to the economic, social, and political environment. All traders should be aware of the broad economic conditions before placing trades. This is especially important for day traders who are trying to make trading decisions based on news events because even though Federal Reserve Monetary Policy decisions are always important, if the rate move is completely priced into the market, then the actual reaction in the EURUSD could be nominal.

Taking a step back, currencies move primarily based on supply and demand. That is, on the most fundamental level, a currency rallies because there is demand for that currency. Regardless of whether the demand is for hedging, speculative, or conversion purposes, true movements are based on the need for the currency. Currency values decrease when there is excess supply. Supply and demand should be the real determinants for predicting future movements. However, how to predict supply and demand is not as simple as many would think. There are many factors that contribute to the net supply and demand for a currency. This includes capital flows, trade flows, speculative, and hedging needs.

For example, the U.S. dollar was very strong (against the euro) between 1999 and the end of 2001. This rally was driven primarily by the dot-com boom and the desire by foreign investors to participate in these elevated returns. This demand for U.S. assets required foreign investors to sell their local currencies and purchase U.S. dollars. Since the end of 2001, geopolitical uncertainty arose, the United States started cutting interest rates, and foreign investors started to sell U.S. assets in search of higher yields elsewhere. This required foreign investors to sell U.S. dollars, increasing supply and lowering the dollar's value against other major currency pairs. The availability of funding or interest in buying a currency is a major factor that can impact the direction that a currency trades. It was one of the primary drivers of the U.S. dollar between 2002 and 2005, making foreign official purchases of U.S. assets (also known as the Treasury International Capital Flow, or TIC data) an important economic indicator.

Capital and Trade Flows

Capital flows and trade flows constitute a country's balance of payments, which quantifies the amount of demand for a currency over a given period of time. Theoretically, a balance of payments equal to zero is required for a currency to maintain its current valuation. A negative balance of payments number, on the other hand, indicates that capital is leaving the economy at a more rapid rate than it is entering, and hence, it should fall in value.

This is particularly important in current conditions (at the time of this book's publication), where the United States is running a consistently large trade deficit without sufficient foreign inflow to fund that deficit. As a result of this very problem, the trade-weighted dollar index fell 22% in value between 2003 and 2005. The Japanese yen is another good example. As one of the world's largest exporters, Japan runs a very high trade surplus. Therefore, despite a zero interest rate policy that prevents capital flows from increasing, the yen has a natural tendency to trade lower based on trade flows, which is the other side of the equation. To be more specific, following is a more detailed explanation of what capital and trade flows encompass.

Capital Flows

Capital flows measure the net amount of a currency that is being purchased or sold due to capital investments. A positive capital flow balance implies that foreign inflows of physical or portfolio investments into a country exceed outflows. A negative capital flow balance indicates that there are more physical or portfolio investments bought by domestic investors than foreign investors. There are generally two types of capital flows—physical flows and portfolio flows (which are further segmented into equity markets and fixed-income markets).

Physical Flows

Physical flows encompass actual foreign direct investments by corporations such as investments in real estate, manufacturing, and local acquisitions. All of these require that a foreign corporation sell its local currency and buy the foreign currency, which leads to movements in the FX market. This is particularly important for global mergers and corporate acquisitions that involve more cash than stock.

Physical flows are important to watch, as they represent the underlying changes in actual physical investment activity. These flows shift in response to changes in each country's financial health and growth opportunities. Changes in local laws that encourage foreign investment also serve to promote physical flows. For example, due to China's entry into the WTO, its foreign investment laws have been relaxed. As a result of China's cheap labor and attractive revenue opportunities (population of over 1 billion), corporations globally have flooded China with investments. From an FX perspective, in order to fund investments in China, foreign corporations need to sell their local currency and buy Chinese renminbi (RMB).

Portfolio Flows in Equity Markets

As technology has enabled greater ease with respect to transportation of capital, investing in global equity markets has become far more feasible. Accordingly, a rallying stock market in any part of the world serves as an ideal opportunity for all, regardless of geographic location. The result of this has become a strong correlation between a country's equity markets and its currency: If the equity market is rising, investment dollars generally come in to seize the opportunity. Alternatively, falling equity markets could prompt domestic investors to sell their shares of local publicly traded firms to take advantage of investment opportunities abroad.

The attraction of equity markets over fixed-income markets has increased across the years. Since the early 1990s, the ratio of foreign transactions in U.S. government bonds over U.S. equities has declined from 10 to 1 to 2 to 1. As indicated in Figure 3.1, it is evident that the Dow had a high correlation (of approximately 81%) with the U.S. dollar (against the EUR) between 1994 and 1999. In addition, from 1991–1999, the Dow increased 300%, while the USD index appreciated nearly 30% for the same time period. As a result, currency traders closely followed the global equity markets to predict short and intermediate term equity-based capital flows. However, this relationship shifted after the tech bubble burst in the United States as foreign investors remained relatively risk averse causing a lower correlation between the performance of the U.S. equity market and the U.S. dollar. Nevertheless, a relationship still exists, making it important for all traders to keep an eye on global market performances in search of intermarket opportunities.

Figure 3.1 Dow and USDEUR

Portfolio Flows in Fixed-Income Markets

Just as the equity market is correlated to exchange rate movement, so too is the fixed-income market. In times of global uncertainty, fixed-income investments can become particularly appealing, due to the inherent safety they possess. As a result, economies boasting the most valuable fixed-income opportunities will be capable of attracting foreign investment—which will naturally first require the purchasing of the country's respective currency.

A good gauge of fixed-income capital flows are the short- and long-term yields of international government bonds. It is important to monitor the spread differential between the 10-year U.S. Treasury yield and the yield on foreign bonds because international investors tend to move money from one country to another in search of the highest yielding assets. When U.S. assets have one of the highest yields, this encourages more investments in U.S. financial instruments, hence benefiting the U.S. dollar. When the United States has the lowest yields, this discourages investments. Investors can also use short-term yields, such as the spreads on 2-year government bonds, to gauge the short-term flow of international funds. Aside from government bond yields, Fed fund futures can also be used to estimate movement of U.S. funds, as they price in the expectation of future Fed interest rate policy. Euribor futures are a barometer for the Euro region's expected future interest rates and can give an indication of EU future policy movements. We will discuss how to use fixed-income products to trade FX further in our strategy section.

Trade Flows: Measuring Exports versus Imports

Trade flows are the basis of all international transactions. Just as the investment environment of a given economy is a key driver of its currency valuation, trade flows represent a country's net trade balance. Countries that are net exporters—meaning they sell more goods abroad than they buy—will experience a net trade surplus. Countries that are net exporters are more likely to have their currency rise in value because from the perspective of international trade, their currency is being bought more than it is sold. This impacts currency flows because international clients buying the exported product/service must first buy the currency of the exporting nation.

Countries who are net importers purchase more goods abroad than they sell, creating a trade deficit. These nations will generally see more downward than upward pressure on their currencies because in order to purchase these foreign goods, importers must sell their own currency and purchase the currency of the country from which they are buying the good or service. This accordingly drives down the value of the currency when all else is equal. This concept is important because it is one of primary reasons why many economists say that certain currencies need to fall to reverse burgeoning trade deficits.

To understand this further, let's imagine that the UK economy is booming, and its stock market is performing well. Meanwhile, in the United States, a lackluster economy is creating a shortage of investment opportunities. In this type of environment U.S. investors will feel more inclined to sell their U.S. dollars and buy British pounds to participate in the outperformance of the UK economy. When they elect to do so, it results in the outflow of capital from the United States and the inflow of capital into the United Kingdom. From an exchange rate perspective, this would induce a fall in the USD coupled with a rise in the GBP, as demand for USD declines and the demand for GBP increases, translating into strength for the GBP/USD currency pair.

Even day and swing traders will find it valuable to keep up with incoming economic reports from the major economies.

Trading Tip: Charting Economic Surprises

One way for traders to stay on top of economic trends is to chart economic data surprises against price action. Figure 3.2 illustrates how this can be done. The chart graphs how much an economic indicator has deviated from its consensus forecast, or the “surprise,” and stacks them on the same side and graphs price (blue line) action when the data was release against the surprise, with a simple regression line (white line). This can be done for all of the major currency pairs and provides a visual guide to understanding whether price action has been in line with economic fundamentals and can be used as a guide to future price action. Economic data can be found on the calendars of any major forex website, and price action can generally be downloaded from your trading platforms.

Figure 3.2 Charting Economic Surprises

According to Figure 3.2, in November of 2004, there were 14 out of 15 positive economic surprises and yet the dollar sold off against the euro during the month of December, which was the month in which the economic data were released. Although this methodology is not exact, the analysis is simple and past charts have yielded some extremely useful clues to future price action. Figure 3.3 shows how the EURUSD moved the following month. As you can see, the EURUSD quickly corrected itself during the month of January, indicating that the fundamental divergence from price action that occurred in December proved to be quite useful to dollar longs, which harvested almost 600 pips as the euro quickly retracted a large part of its gains in January. This method of analysis, called variant perception, was first invented by the legendary hedge fund manager Michael Steinhardt, who produced 24% average rates return for 30 consecutive years.

Figure 3.3 EURUSD Chart

Source: eSignal

Although these charts will rarely offer such clear-cut signals, their analytical value may also lie in spotting and interpreting the outlier data. Large positive and negative surprises in economic data can often yield clues to future price action. If you go back and look at the EURUSD charts, you will see that the record current account deficits in October 2004 were the catalyst that sent the dollar plunging over the next two months. In many ways, economic fundamentals matter more in the foreign exchange market than in any other market, and charts such as these could provide valuable clues to price direction. Generally, the 15 most important economic indices are chosen from each region, and then a price regression line is superimposed over the past 20 days of price data.

Technical Analysis

Prior to the mid-1980s, fundamental traders dominated the FX market. However, with the rising popularity of technical analysis and the advent of new technologies, the influence of technical trading on the FX market has increased significantly. The availability of high leverage also led to an increased number of high frequency and momentum. They have become active participants in the FX market, with the acute ability to influence currency prices.

Unlike fundamental analysis, technical analysis focuses on the study of price movements. Technical analysts use historical currency data to forecast the direction of future prices. The underlying belief behind technical analysis is that all current market information is already reflected in the price of that currency; therefore, studying price action is all that is required to make informed trading decisions. In a nutshell, technical analysis assumes that history will repeat itself.

Technical analysis is an extremely popular tool used by short- and medium-term traders for analyzing the forex market. It works especially well in the currency markets because short-term currency price fluctuations are primarily driven by human emotions or market perceptions. The primary tool in technical analysis is price and charts. Traders will look for trends and patterns to identify trading opportunities. The most basic concept of technical analysis is that markets have a tendency to trend. Being able to identify trends in their earliest stage of development is the key to technical analysis. Range trading is also very popular, and similar tools can be used to identify these setups. Technical analysis integrates price action and momentum to construct a pictorial representation of past currency price action and to use this information to predict future performance. Technical analysis tools such as Fibonacci retracement levels, moving averages, oscillators, candlestick charts, and Bollinger bands provide further information on the value of the emotional extremes of buyers and sellers. It also helps to gauge when greed and fear are the strongest. There are basically two types of markets, trending or range bound, and in the trade parameters section, we outline some rules that can help traders determine the type of market they trading in right now and the sort of trading opportunities they should be looking for.

Is Technical Analysis or Fundamental Analysis Better?

No one will ever win the age-long battle between technical and fundamental analysis. However, most individual traders will start trading with technical analysis because it is easier to understand and does not require hours of study. Technical analysts can also follow many currencies and markets at one time, whereas fundamental analysts tend to focus on a few pairs due to the overwhelming amount of data in the market. Nonetheless, technical analysis works well because the currency market tends to develop strong trends. Once technical analysis is mastered, it can be applied with equal ease to any time frame or currency traded.

However, it is important to take both strategies into consideration, as fundamental analysis can trigger technical movements such as breakouts or reversal in trends. Technical analysis, on the other hand, can also explain moves that fundamentals cannot, especially in quiet markets, causing resistance in trends or unexplainable movements. For example, as shown in Figure 3.4, in the days leading up to September 11, USDJPY had just broken out of a triangle formation and looked poised to head higher. However, as the chart indicates, instead of breaking higher as technicians may have anticipated, USDJPY broke down following the September 11, 2001, terrorist attacks and ended up hitting a low of 115.81 from a high of 121.88 on September 10.

Figure 3.4 USDJPY September 11th Chart

Source: eSignal

Currency Forecasting—What Bookworms and Economists Look At

For more avid students of foreign exchange who want to learn more about fundamental analysis and valuing currencies, this section examines the different models of currency forecasting used by analysts of the major investment banks. There are seven major models for forecasting currencies, which include the balance of payments theory, purchasing power parity, interest rate parity, the monetary model, the real interest rate differential model, the asset market model, and the currency substitution model.

Balance of Payments Theory

The balance of payments theory states that exchange rates should be at their equilibrium level, which is the rate that produces a stable current account balance. Countries with trade deficits experience a run on their foreign exchange reserves due to the fact that exporters to that nation must sell that nation's currency in order to receive payment. The cheaper currency makes the nation's exports less expensive abroad, which in turn fuels exports and brings the currency into balance.

What Is the Balance of Payments (BOP)?

The balance of payments account is divided into two parts: the current account and the capital account. The current account measures trade in tangible, visible items such as cars and manufactured goods; the trade balance is the surplus or deficit between exports and imports. The capital account measures flows of money, such as investments for stocks or bonds. Balance of payments data can be found on the website of the Bureau of Economic Analysis.

Trade Flows

The trade balance of a country shows the net difference over a period of time between a nation's exports and imports. When a country imports more than it exports, the trade balance is negative or is in a deficit. If the country exports more than it imports, the trade balance is positive or is in a surplus. The trade balance reflects the redistribution of wealth among countries and is a major channel through which the macroeconomic policies of a country may affect another.

In general, if a country has a trade deficit, it is considered to be unfavorable, since it negatively impacts the value of the nation's currency. For example, if U.S. trade figures show greater imports than exports, more dollars flow out of the United States and the value of the U.S. currency depreciates. A positive trade balance, in comparison, will affect the dollar by causing it to appreciate against the other currencies.

Capital Flows

In addition to trade flows, there are also capital flows that occur among countries. They record a nation's incoming and outgoing investment flows, such as payments for entire or parts of companies, stocks, bonds, bank accounts, real estate, and factories. Capital flows are influenced by many factors, including the financial and economic climate of other countries, and can be in the form of physical or portfolio investments. In general, in developing countries, the composition of capital flows tends to be skewed toward foreign direct investment (FDI) and bank loans. For developed countries, due to the strength of the equity and fixed-income markets, stocks and bonds appear to be more important than bank loans and FDI.

Equity Markets

Equity markets have a significant impact on exchange rate movements because they are a major place for high-volume currency movements. Their importance is considerable for the currencies of countries with developed capital markets, where a great amount of capital inflows and outflows occur, and where foreign investors are major participants. The amount of the foreign investment flows in the equity markets is dependent on the general health and growth of the market, reflecting the well-being of companies and particular sectors. Movements of currencies occur when foreign investors move their money to a particular equity market. Thus, they convert their capital in a domestic currency and push the demand for it higher, making the currency appreciate. When the equity markets are experiencing recessions, however, foreign investors tend to flee, thus converting back to their home currency and pushing the domestic currency down.

Fixed-Income (Bond) Markets

The effect that fixed-income markets have on currencies is similar to that of the equity markets and is a result of capital movements. An investor's interest in the fixed-income market depends on the company's specifics and credit rating, as well as on the general health of the economy and the country's interest rates. The movement of foreign capital into and out of fixed-income markets leads to change in the demand and supply for currencies, hence impacting the currencies' exchange rates.

Summary of Trade and Capital Flows

Determining and understanding a country's balance of payments is perhaps the most important and useful tool for those interested in fundamental analysis. Any international transaction gives rise to two offsetting entries: trade flow balance (current account) and capital flow balance (capital account). If the trade flow balance is a negative outflow, the country is buying more from foreigners than it sells (imports exceed exports). When it is a positive inflow, the country is selling more than it buys (exports exceed imports). The capital flow balance is positive when foreign inflows of physical or portfolio investments into a country exceed that country's outflows. A capital flow is negative when a country buys more physical or portfolio investments than are sold to foreign investors.

These two entries, trade and capital flow, when added together signify a country's balance of payments. In theory, the two entries should balance and add up to zero in order to provide for the maintenance of the status quo in a nation's economy and currency rates.

In general, countries might experience positive or negative trade, as well as positive or negative capital flow balances. In order to minimize the net effect of the two on the exchange rates, a country should try to maintain a balance between the two. For example, in the United States, there is a substantial trade deficit, as more is imported than is exported. When the trade balance is negative, the country is buying more from foreigners than it sells, and therefore it needs to finance its deficit. This negative trade flow might be offset by a positive capital flow into the country, as foreigners buy either physical or portfolio investments. Therefore, the United States seeks to minimize its trade deficit and maximize its capital inflows, with hopes that the two will balance out.

A change in this balance is extremely significant and carries ramifications that run deep into economic policy and currency exchange levels. The net result of the difference between the trade and capital flows, positive or negative, will impact the direction in which the nation's currency will move. If the overall trade and capital balance is negative, it will result in a depreciation of the nation's currency, and if positive, it will lead to an appreciation of the currency.

Clearly, a change in the balance of payments carries a direct effect for currency levels. It is therefore possible for any investor to observe economic data relating to this balance and interpret the results that will occur. Data relating to capital and trade flows should be followed most closely. For instance, if an analyst observes an increase in the U.S. trade deficit and a decrease in the capital flows, a balance of payments deficit would occur, and as a result, an investor may anticipate a depreciation of the dollar.

Limitations of BOP Model

The BOP model mainly focuses on traded goods and services, while ignoring international capital flows. Indeed, international capital flows often dwarfed trade flows in the currency markets toward the end of the 1990s, and this oftentimes balanced out the current account of debtor nations like the United States.

For example, in 1999, 2000, and 2001, the United States maintained a large current account deficit while the Japanese ran a large current account surplus. However, during this same period in time the U.S. dollar rose against the yen even though trade flows were running against the dollar. The reason was that capital flows balanced out trade flows, thus defying the BOP's forecasting model for a period of time. Indeed, the increase in capital flows has given rise to the asset market model.

Note: It is probably a misnomer to call this theory the balance of payments theory since it only takes into account the current account balance, not the actual balance of payments. However, until the 1990s capital flows played a very small role in the world economy, so the main statistic viewed was the trade balance, which made up the bulk of the balance of payments for most nations.

Purchasing Power Parity

The purchasing power parity (PPP) theory is based on the belief that foreign exchange rates should be determined by the relative prices of a similar basket of goods between two countries. Any change in a nation's inflation rate should be balanced by an opposite change in that nation's exchange rate. Therefore, according to this theory, when a country's prices are rising due to inflation, that country's exchange rate should depreciate in order to return to parity.

PPP's Basket of Goods

The basket of goods and services priced for the PPP exercise is a sample of all goods and services covered by GDP. It includes consumer goods and services, government services, equipment goods, and construction projects. More specifically, consumer items include food, beverages, tobacco, clothing, footwear, rents, water supply, gas, electricity, medical goods and services, furniture and furnishings, household appliances, personal transport equipment, fuel, transport services, recreational equipment, recreational and cultural services, telephone services, education services, goods and services for personal care and household operation, and repair and maintenance services.

Big Mac Index

One of the most well-known examples of PPP is The Economist's Big Mac Index. The Big Mac PPP calculates the exchange rate that would leave hamburgers costing the same in America as elsewhere. Comparing these with actual rates helps to signal if a currency is under- or overvalued. As described by The Economist, the index is a lightheartedly guide to currency valuation. It was never intended as a precise gauge of currency misalignment, but merely a tool to make exchange-rate theory more digestible.

For example, in January 2015, the exchange rate between the U.S. dollar and Chinese yuan was approximately 6.20. At the time, a Big Mac cost $4.79 in the United States. In China, the same burger cost 17.15 yuan, or approximately $2.77 at market exchange. This means that based on the comparison between the two burger prices, the Chinese yuan was undervalued by 42%.

OECD Purchasing Power Parity Index

The Organization of Economic Cooperation and Development (OECD) releases a more formal index. Under a joint OECD-Eurostat PPP Program, the OECD and Eurostat share the responsibility for calculating PPPs. Their latest information on which currencies are under- or overvalued against the U.S. dollar can be found on the OECD website at www.oecd.org. The OECD publishes a table that shows the price levels for the major industrialized countries. Each column shows the number of specified monetary units needed in each of the countries listed to buy the same representative basket of consumer goods and services. In each case, the representative basket costs a hundred units in the country whose currency is specified. The chart that is then created compares the PPP of a currency with its actual exchange rate. The chart is updated weekly to reflect the current exchange rate. It is also updated about twice a year to reflect new estimates of PPP. The PPP estimates are taken from studies carried out by the OECD; however, it should not be taken as definitive. Different methods of calculation will arrive at different PPP rates.

According to the OECD's data as of April 17, 2015, the PPP value of the Australian dollar versus the U.S. dollar based on GDP is 0.6712. At the time, the AUD/USD exchange rate was 0.7812. Using this model of valuation, this indicates that the Australian dollar was 14% overvalued.

Limitations to Using Purchasing Power Parity

PPP theory should only be used for long-term fundamental analysis. While the economic forces behind PPP will eventually equalize the purchasing power of currencies, this can take many years. A time horizon of 5–10 years is typical.

PPP's major weakness is that it assumes goods can be traded easily, without regard to such things as tariffs, quotas, or taxes. For example, when the U.S. government announces new tariffs on imported steel, the cost of domestic manufactured goods goes up; but those increases will not be reflected in the U.S. PPP tables.

There are other factors that must also be considered when weighing PPP: inflation, interest rate differentials, economic releases/reports, asset markets, trade flows, and political developments. Indeed, PPP is just one of several theories traders should use when determining exchange rates.

Interest Rate Parity

The interest rate parity theory states that if two different currencies have different interest rates, then that difference should be reflected in the premium or discount for the forward exchange rate to prevent riskless arbitrage.

For example, if U.S. interest rates are 3% and Japanese interest rates are 1%, then the U.S. dollar should depreciate against the Japanese yen by 2% in order to prevent riskless arbitrage. This future exchange rate is reflected in the forward exchange rate stated today. In our example, the forward exchange rate of the dollar is said to be at discount because it buys fewer Japanese yen in the forward rate than it does in the spot rate. The yen is said to be at a premium.

Interest rate parity has shown very little proof of effectiveness in recent years. Oftentimes, currencies with higher interest rates rise and attract incoming investment, while currencies with low and falling interest rates decline as outflows slow.

The Monetary Model

According to the monetary model, exchange rates are determined by a nation's monetary policy. The premise is that countries that follow a stable monetary policy over time should have appreciating currencies. Countries that have erratic monetary policies or excessively expansionist policies should see the value of their currency depreciate.

How to Use the Monetary Model

Three factors influence exchange rates under this theory:

1. A nation's money supply
2. Expected future levels of a nation's money supply
3. The growth rate of a nation's money supply

All of these factors are key to understanding and spotting a monetary trend that may force a change in exchange rates. For example, let's assume that the Japanese economy has been slipping in and out of recession for over a decade. Interest rates are near zero and annual budget deficits prevent the Japanese from spending their way out of recession, which leaves only one tool left at the disposal of Japanese officials determined to revive Japan's economy: printing more money. By buying stocks and bonds, the Bank of Japan (BoJ) is increasing the nation's money supply, which produces inflation, and this forces a change in the exchange rate. The example in Figure 3.5 illustrates the effect of money supply changes to the Japanese yen using the monetary model.

Figure 3.5 Monetary Model

Indeed, it is in the area of excessive expansionary monetary policy that the monetary model is most successful. One of the only ways a country can keep its currency from sharply devaluing is by pursuing a tight monetary policy. For example, during the Asian Currency Crisis, the Hong Kong dollar came under attack from speculators. Hong Kong officials raised interest rates to 300% to halt the Hong Kong dollar from being dislodged from its peg to the U.S. dollar. The tactic worked perfectly, as speculators were cleared out by such sky-high interest rates. The downside was that the Hong Kong economy would slide into recession. But in the end, the peg held and the monetary model worked.

Limitations of the Monetary Model

Very few economists rely solely on this model because it does not take into account trade flows and capital flows. For example, throughout 2014 Australia had higher interest rates, growth rates, and inflation rates than both the United States and the European Union, yet, the AUD appreciated in value against both the dollar and the euro. Indeed, the monetary model has greatly struggled since the dawn of freely floating currencies. The model holds that high interest rates signal growing inflation, which it often does, followed by a depreciating currency. But this does not take into account the capital inflows that would take effect as a result of higher interest yields or of an equity market that may be thriving in a booming economy—thus causing the currency to possibly appreciate.

In any case, the monetary model is one of several valuation tools that can be employed in tandem with other models to determine the direction an exchange rate is heading.

Real Interest Rate Differential Model

According to the real interest rate differential theory, exchange rate movements are determined by a country's interest rate. The idea is that countries with high interest rates should see their currency appreciate in value, while countries with low interest rates should see their currency depreciate in value.

Basics of the Model

The basic premise of the model is that when a country raises its interest rates, international investors will buy that currency because they find its yield more attractive. When a country lowers interest rates, they sell the currency. Figure 3.6 shows how well this theory held up in 2003, when interest spreads were near their widest levels in years.

Figure 3.6 Real Interest Rate Model

The data from this graph show a mixed result. The Australian dollar had the largest basis point spread and also had the highest return against the U.S. dollar, which seems to vindicate the model, as investors bought up higher-yielding Aussie. The same can be said for the New Zealand dollar, which also had a higher yield than the U.S. dollar and gained 27% against USD. Yet the model becomes less convincing when comparing the euro, which gained 20% against the dollar (more than every currency except NZD), even though its basis point differential was only 100 points. The model then comes under serious question when comparing the British pound and the Japanese yen. The yen differential is –100, and yet it appreciated almost 12% against the dollar. Meanwhile, the British pound gained only 11% against the dollar even though it had a whopping 275 point interest rate differential.

This model also stresses that one of the key factors in determining the severity of an exchange rate's response to a shift in interest rates is the expected persistence of that shift. Simply put, a rise in interest rates that is expected to last for five years will have a much larger impact on the exchange rate than if that rise were expected to last for only one year.

Limitations to the Interest Rate Model

There is a great deal of debate among international economists over whether there is a strong and statistically significant link between changes in a nation's interest rate and currency price. The main weakness of this model is that it does not take into account a nation's current account balance, relying on capital flows instead. Indeed, the model tends to overemphasize capital flows at the expense of numerous other factors, such as political stability, inflation, and poor economic growth. Absent these types of factors, the model can be very useful, since it is quite logical to conclude that an investor will naturally gravitate toward the investment vehicle that pays a higher reward.

The Asset Market Model

The basic premise of the asset market model theory is that the flow of funds into the financial assets of a country such as equities and bonds increases the demand for that country's currency (and vice versa). As proof, advocates point out that the amount of funds that are placed in investment products such as stocks and bonds now dwarf the amount of funds that is exchanged as a result of the transactions in goods and services for import and export purposes. The asset market theory is basically the opposite of the balance of payments theory since it takes into account a nation's capital account instead of its current account.

A Dollar-Driven Theory

Throughout 1999, many experts argued that the dollar would fall against the euro on the grounds of the expanding U.S. current account deficit and an overvalued Wall Street. That was based on the rationale that non-U.S. investors would begin withdrawing their funds from U.S. stocks and bonds into more economically sound markets, which would weigh significantly on the dollar. Yet, such fears have lingered since the early 1980s when the U.S. current account soared to a record high 3.5% of GDP.

In the two decades that followed, the balance of payments approach in assessing the dollar's behavior has given way to the asset market approach. This theory continues to hold the most sway over pundits due to the enormity of U.S. capital markets. In May and June of 2002, the dollar plummeted over 1000 points versus the yen at the same time equity investors fled U.S. equity markets due to the accounting scandals that were plaguing Wall Street. As the scandals subsided toward the end of 2002, the dollar rose 500 points from a low of 115.43 to close at 120.00 against the yen, even though the current account balance remained in massive deficit the entire time.

Limitations to the Asset Market Theory

It is frequently argued that over the long run, there is no relationship between a nation's equity market performance and the performance of its currency. See Figure 3.7 for a comparison. Between April 2014 and April 2015, the German DAX and EURUSD have a very weak correlation.

Figure 3.7 The DAX Index and the EURUSD

Also, what happens to a nation's currency when the stock market is trading sideways—stuck between bullish and bearish sentiments? That was the scenario in Germany for much of 2014, and currency traders found themselves going back to older money making models, such as interest rate arbitrage, as a result. Only time will tell whether the asset market model will hold up or merely be a short-term blip on the currency forecasting radar.

The Currency Substitution Model

The currency substitution model is an enhanced version of the monetary model because it takes into account investor flows. It posits that the shifting of private and public portfolios from one nation to another can have a significant effect on exchange rates. The ability of individuals to change their assets from domestic and foreign currencies is known as currency substitution. When this model is added to the monetary model, evidence shows that shifts in expectations of a nation's money supply can have a decided impact on that nation's exchange rates. Simply put, investors are looking at monetary model data and coming to the conclusion that a change in money flow is about to occur, thus affecting the exchange rate, so they are investing accordingly, which turns the monetary model into a self-fulfilling prophecy. Investors who subscribe to this theory are merely jumping on the currency substitution model bandwagon on the way to the monetary model party.

The Yen Example

In the monetary model we talked about how the Japanese government was basically printing yen and increasing the money supply when it bought stocks and bonds. Monetary model theorists would say that this monetary growth would spark inflation (more yen chasing fewer products), decrease demand for the yen, and finally cause the yen to depreciate. A currency substitution theorist would agree with this scenario and look to take advantage of this view by shorting the yen, or if they were long the yen promptly getting out of the position. By taking this action, our yen trader is helping to drive the market precisely in that direction, thus making the monetary model theory a fate accompli. The step-by-step process is illustrated in Figure 3.8.

1. Japan announces new stock and bond buyback plan. Economists are now predicting Japan's money supply will dramatically increase.
2. Economists are also predicting a rise in inflation with the introduction of this new policy. Speculators expect a change in the exchange rate as a result.
3. Economists expect interest rates to rise and inflation takes hold in the economy. Speculators start selling short the yen in anticipation of a change in the exchange rate.
4. Demand for the yen plummets as money flows easily through the Japanese economy and speculators dump yen in the markets.
5. The exchange rate for the Japanese yen changes dramatically as the yen falls in value to foreign currencies, especially those that are easily substituted by investors (read: liquid yen crosses).

Figure 3.8 Currency Substitution Model

Limitations of the Currency Substitution Model

Among the major, actively traded currencies, this model has not yet shown itself to be a convincing, single determinant for exchange rate movements. While this theory can be used with more confidence in underdeveloped countries where “hot money” rushes in and out of emerging markets with enormous effect, there are still too many variables not accounted for by the currency substitution model. For example, using the yen illustration in Figure 3.8, even though Japan may try to spark inflation with its securities' buyback plan, it still has an enormous current account surplus that will continually prop up the yen. Also, Japan has numerous political landmines it must avoid in its own neighborhood, and should Japan make it clear that it is trying to devalue its currency, there will be enormous repercussions. These are just two of many factors the substitution model does not take into consideration. However, this model (like numerous other currency models) should be considered part of an overall, balanced, FX forecasting diet.