Chapter 26
Currency Profiles and Outlook

In order to understand how to trade currencies effectively, it is important to have a firm grasp of the general economic characteristics of the most commonly traded currencies. This includes understanding which economic reports and factors have the most significant impact on a currency's movements. For example, some currencies are extremely sensitive to commodity price movements and others are not. Learning the characteristics or personalities of each currency will help traders understand what factors influence the exchange rate on a short- and long-term basis. We will look at the eight most actively traded currencies—the U.S. dollar, euro, British pound, Swiss franc, Japanese yen, and Australian, New Zealand, and Canadian dollars. Of course, the most important currency of them all is the U.S. dollar.

Currency Profile: U.S. Dollar (USD)

Broad Economic Overview

The United States is the world's leading economic power, with gross domestic product valued at over US$17 trillion as of 2014. This is the highest in the world, and based on the purchasing power parity model, it is four times the size of Japan's output, five times the size of Germany's, and seven times the size of the United Kingdom's. The United States is primarily a service-oriented country, with nearly 80% of its GDP coming from real estate, transportation, finance, health care, and business services. Yet, the sheer size of the U.S. manufacturing sector still makes the U.S. dollar particularly sensitive to developments in the manufacturing sector. With the United States having the largest and most liquid equity and fixed income markets in the world, foreign investors have consistently increased their purchases of U.S. assets. According to the IMF, foreign direct investments into the U.S. are equal to approximately 40% of total global net inflows for the United States. On a net basis, the United States absorbs 71% of total foreign savings. This means that if foreign investors are not satisfied with their returns in the U.S. asset markets and they decide to repatriate their funds, this would have a significant effect on U.S. asset values and the U.S. dollar. More specifically, if foreign investors sell their U.S. dollar denominated assets holdings in search of higher yielding assets elsewhere, this would typically result in a decline in the value of the U.S. asset, as well as the U.S. dollar.

The import and export volume of the United States also exceeds that of any other country. This is due to the country's sheer size, as true import and export volume represent a mere 12% of GDP. Despite this large activity, on a netted basis, the United States is running a very large current account deficit of over $113 billion as of Q4 2014. This is a major problem that the U.S. economy has been struggling with for decades, as the large current account deficit makes the U.S. dollar highly sensitive to changes in capital flows. In fact, in order to prevent a decline in the U.S. dollar as a result of trade, the United States needs to attract a significant amount of capital inflows per day. Thankfully, the U.S. bond market is the largest in the world, and Treasuries remain an attractive investment due to the lack of suitable alternatives.

Most major economies also count the United States as its largest trading partner, with U.S. trade representing 20% of total world trade. These rankings are very important because changes in the value of the dollar and its volatility will impact the U.S. trading activities with these respective countries. More specifically, a weaker dollar will encourage more U.S. exports, whereas a stronger dollar could curb foreign demand for American goods. However, since the United States is not a trade-dependent economy, the strength of a dollar is less troublesome. Here's a breakdown of the most important trading partners for the United States, in order of importance:

Leading Export Markets

1. Canada
2. Mexico
3. China
4. European Union
5. Japan

Leading Import Sources

1. China
2. Canada
3. Mexico
4. European Union
5. Japan

Source: US Trade.gov 2014

Monetary and Fiscal Policy Makers—The Federal Reserve

The Federal Reserve Board (Fed) is the monetary policy authority of the United States. The Fed is responsible for setting and implementing monetary policy. The board consists of a 12-member Federal Open Market Committee (FOMC). The voting members of the FOMC are the seven governors of the Federal Reserve Board, plus five presidents of the 12 district reserve banks. The FOMC holds eight meetings per year, which are widely watched for interest rate announcements or changes in growth expectations. After four of those meetings, the head of the Central Bank holds a press conference, and typically that is when major monetary policy changes are made.

The Fed has a high degree of independence to set monetary authority. They are less subject to political influences, as most members are accorded long terms that allow them to remain in office through periods of alternate party dominance in both the presidency and Congress.

The Federal Reserve issues a biannual Monetary Policy Report in February and July followed by the Humphrey–Hawkins testimony where the Federal Reserve chairman responds to questions from both the Congress and the Banking Committees in regards to this report. This report is important to watch, as it contains the FOMC forecasts for GDP growth, inflation, and unemployment.

The Fed, unlike most other central banks, has a mandate or “long-run objectives” of “price stability and sustainable economic growth.” In order to adhere to these goals, the Fed has to use monetary policy to limit inflation and unemployment and achieve balanced growth. The most popular tools that the Fed uses to control monetary policy include the following.

Open Market Operations

Open market operations involve Fed purchases of government securities, including Treasury bills, notes and bonds. This is one of the most popular methods for the Fed to signal and implement policy changes. Generally speaking, increases in Fed purchases of government securities decreases interest rates, while selling of government securities by the Fed boosts interest rates.

Fed Funds Target

The Fed Funds target rate is the key policy target of the Federal Reserve. It is the interest rate for borrowing that the Fed offers to its member banks. The Fed tends to increase this rate to curb inflation or decrease this rate to promote growth and consumption. Changes to this rate are closely watched by the market and tend to imply major changes in policy and will typically have large ramifications for global fixed income and equity markets. The market also pays particular attention to the statement released by the Federal Reserve as it can offer guidance for future monetary policy actions.

Fiscal policy is in the hands of the U.S. Treasury. Fiscal policy decisions include determining the appropriate level of taxes and government spending. In fact, although the markets pay more attention to the Federal Reserve, the U.S. Treasury is the actual government body that determines dollar policy. That is, if they feel that the USD rate on the foreign exchange market is under- or overvalued, the U.S. Treasury is the government body that gives the NY Federal Reserve Board the authority and instructions to intervene in the foreign exchange market by physically selling or buying USD. Therefore, the Treasury's view on dollar policy and changes to that view can be important to the currency market.

Over the past few decades, the Treasury and Fed officials have maintained a “strong dollar” bias. While a weak dollar helps to promote growth for political reasons, the government is unlikely to change their stance in support of a weak dollar policy.

Important Characteristics of the U.S. Dollar

• Over 80% of all currency deals involve the dollar. The most liquid currencies in the foreign exchange market are the EURUSD, USDJPY, GBPUSD, and USDCHF. These currencies represent the most commonly traded currencies in the world, and it is no coincidence that all of these currency pairs involve the U.S. dollar. In fact, 80% of all currency deals, which include currency conversion, hedging, and trade settlement, involve the U.S. dollar. This explains why U.S. data, the U.S. dollar, and U.S. fundamentals are so important to foreign exchange traders.
• Prior to the introduction of the euro and the growing utilization of the Chinese renminbi, the U.S. dollar was considered one the world's premier “safe-haven” reserve currencies. The U.S. dollar has long been one of the world's premier “safe-haven” currencies, with 76% of global currency reserves held in dollars. To this day, the dollar is still the preferred currency of choice, but in recent years its safe haven, reserve currency status has been challenged by the euro and Chinese renminbi. We are still a very long way from the dollar being usurped by either currency, but in the past decade, many central banks have slowly diversified their reserves by reducing their dollar holdings and increasing their euro and renminbi holdings. This trend will only accelerate in the years to come, but until European and Chinese bond markets are large and developed enough to handle the reserve diversification flows, the dollar and U.S. Treasuries will still be the investment of choice for reserve managers.

• The U.S. dollar moves in the opposite direction of gold prices. One of the unique characteristics of the U.S. dollar is that there is a strong inverse relationship between the price of gold and the value of the U.S. dollar as shown in Figure 26.1. These two instruments are near-perfect mirror images of each other, which means that when the value of the dollar declines, the price of gold rises; and when the dollar appreciates, the price of gold falls. There is, of course, a good reason—gold is priced in U.S. dollars. The correlation is not perfect—in times of geopolitical uncertainty, investors generally prefer hard versus fiat currencies or gold versus the dollar.
• Many emerging market countries “peg” their local currencies to the dollar. Pegging a currency to the dollar refers to the idea that a government agrees to maintain their currency at a specific rate or range to the U.S. dollar. As the value of the dollar changes, this requires the central bank to buy or sell their local currency and the U.S. dollar to maintain the peg. For example, let's imagine that Country A pledges to maintain a fixed currency peg of 7.5 versus the U.S. dollar. If the dollar weakens, causing downward pressure on the exchange rate, the central bank would have to buy U.S. dollars and sell their local currency to maintain the peg. After buying dollars, they would typically invest those funds into U.S. Treasuries. This process is exactly how China and other Asian economies became large holders of US Treasuries. Through the years, many countries have switched from a fixed to floating rate peg and in some cases a peg that references a basket of currencies, but in each case, the dollar is still the leading component. However, the movement from fixed U.S. dollar pegs to a basket reduces the amount of dollars that a country like China needs to buy, and as their currency regime and others in the region are loosened further, the impact on the dollar will grow.
• Interest rate differentials between U.S. Treasuries and foreign bonds strongly followed. The interest rate differentials between U.S. Treasuries and foreign bonds are a very important relationship that professional FX traders need to follow. It can be a strong indicator of potential currency movements because the U.S. market is one of the largest markets in the world, and investors are very sensitive to the yields that the offered by U.S. assets. Large investors are constantly looking for assets with the highest yields. As yields in the U.S. decrease or if yields abroad increase, this would induce investors to sell their U.S. assets and purchase foreign assets. Selling U.S. fixed income or equity assets would influence the currency market because that would require selling U.S. dollars and buying the foreign currency. If U.S. yields rise or foreign yields decrease, investors in general would be more inclined to purchase U.S. assets, therefore boosting the value of the dollar (USD).
• Keep an eye on the dollar index. Market participants closely follow the U.S. dollar index as a gauge of overall dollar strength or weakness. The USD index is a futures contract traded on the Intercontinental Exchange (ICE) that is calculated using the trade-weighted geometric average of six currencies. It is important to follow this index because when market participants are reporting general dollar weakness or a decline in the trade-weighted dollar, they are typically referring to this index. Unfortunately, the weighting does not accurately reflect U.S. trade activity. Nonetheless, the DXY is closely followed and actively traded. Also, even though the dollar may have moved significantly against a single currency, it may have not moved as significantly on a trade-weighted basis. This is important because some central bankers may choose to focus on the trade-weighted index instead of the individual currency pair's performance against the dollar.
• The dollar is impacted by equities and Treasuries. In earlier chapters, we have established that there is a strong correlation between a country's equity and fixed-income markets and its currency: If the equity market is rising, generally speaking, foreign investment dollars should be coming in to seize the opportunity. If equity markets are falling, domestic investors will be selling their shares of local companies and looking for opportunities abroad. With fixed-income markets, economies boasting the most valuable fixed income opportunities with the highest yields will be capable of attracting more foreign investment. Daily fluctuations and developments in any of these markets reflect movement of foreign portfolio investments, which would require foreign exchange transactions. Cross border merger and acquisition activities can also influence the price action of currencies. Large M&A deals, particularly those that involve a significant cash portion, will have a notable impact on the currency markets. The reason is that the acquirer will need to buy or sell dollars to fund their cross-border acquisition.

Figure 26.1 Dollar Index vs. Gold

Important Economic Indicators for the United States

Economic data is always important, but U.S. data tends to have the greatest impact on currencies because more than 80% of currency transactions involve the U.S. dollar. Here are some of the most important and market moving pieces of U.S. data:

Employment: Nonfarm Payrolls

The employment report is the most important and widely watched indicator on the economic calendar. Its importance is mostly due to political influences rather than pure economic reasons, as the Fed is under strict pressure to keep unemployment under control. As a result, interest rate policy is directly influenced by employment conditions. The monthly jobs report consists of data compiled from two different surveys: the establishment survey and the household survey. The establishment survey provides data on nonfarm payroll employment, average hourly workweek, and the aggregate hours index. The household survey provides information on the labor force, household employment, and the unemployment rate. When this report is released on the first Friday of every month, forex traders will immediately hone in on the nonfarm payrolls number, the unemployment rate, and average hourly earnings. However, any revisions or seasonal adjustments can also impact the dollar's reaction to the overall report.

Consumer Price Index

The Consumer Price Index is a key gauge of inflation. The index measures the prices on a fixed basket of consumer goods. Economists tend to focus more on the CPI-U or the core inflation rate, which excludes the volatile food and energy components. The indicator is widely watched by the FX markets as it drives a lot of activity because job growth and inflation is the key to monetary policy.

Retail Sales

The key to growth is consumer spending and for this reason, the retail sales report is also extremely market moving. The Retail Sales Index measures the total goods sold by a sampling of retail stores over the course of a month. This index is used as a gauge of consumer consumption and consumer confidence. The most important number to watch is retail sales less autos, as auto sales can vary month-to-month. While retail sales can be quite volatile due to seasonality, it is one of the most important indicators on the health of the economy along with a key input for GDP.

Nonmanufacturing and Manufacturing ISM

The monthly nonmanufacturing and manufacturing reports released by the Institute for Supply Management is also important because it generally provides the most current information on activity in the economy. ISM releases a monthly composite index based on surveys of 300 purchasing managers nationwide representing 20 different industries. An index value above 50 reflects expansion, while values below 50 are indicative of contraction. The ISM nonmanufacturing index is particularly important because the United States is a services economy, and typically this report is released ahead of nonfarm payrolls; and the employment subcomponent can provide early clues on the health of the labor market.

Consumer Confidence

The Consumer Confidence Survey measures how individuals feel about the economy. There are two popular reports—one released by the Conference Board and one by the University of Michigan. In the Conference Board survey, questionnaires are sent out to a nationwide representative sample of 5,000 households, of which approximately 3,500 respond. Households are asked five questions:

1. A rating of business conditions in the household's area
2. A rating of business conditions in six months
3. Job availability in the area
4. Job availability in six months
5. Family income in six months

Responses are seasonally adjusted and an index is constructed for each response, and then a composite index is fashioned based on the aggregate responses. The University of Michigan Survey, on the other hand, only polls 500 people, but since it is released before the Conference Board's report, it can have a larger impact on currencies. Rising consumer confidence is viewed as a precursor to stronger consumer spending and growth.

Producer Price Index

The Producer Price Index (PPI) is a family of indexes that measures average changes in selling prices received by domestic producers for their output. PPI tracks changes in prices for nearly every goods producing industry in the domestic economy, including agriculture, electricity and natural gas, forestry, fisheries, manufacturing, and mining. Foreign exchange markets tend to focus on seasonally adjusted finished goods PPI and how the index has reacted on a monthly, quarterly, and annualized basis.

Gross Domestic Product

Gross domestic product, or GDP, is a measure of the total production and consumption of goods and services. In the United States, the Bureau of Economic Analysis (BEA) constructs two complementary measures of GDP, one based on income and one based on expenditures. The advance release of GDP, which occurs the month after each quarter ends, contains some BEA estimates for data not yet released, inventories and trade balance, and is the most important release. Other releases of GDP, which are the revisions, are typically not very significant unless a major change is made.

International Trade

The balance of trade represents the difference between exports and imports of foreign trade in goods and services. Merchandise data are provided for U.S. total foreign trade with all countries and details for trade with specific countries and regions of the world, as well as for individual commodities. Traders tend to focus on seasonally adjusted trade numbers over a three-month period as single month trade periods are regarded as volatile and less reliable.

Employment Cost Index (ECI)

The employment cost index data is based on a survey of employer payrolls in the third month of the quarter for the pay period ending on the twelfth day of the month. This survey is a probability sample of approximately 3,600 private industry employers and 700 state and local governments, public schools, and public hospitals. The big advantage of ECI is that it includes nonwage costs, which adds as much as 30% to total labor costs. Reaction to the ECI, however, is often muted as it is generally very stable. It should be noted however that it is one of the Federal Reserve's favorite indicators.

Industrial Production

The Index of Industrial Production is a set of indexes that measures the monthly physical output of U.S. factories, mines, and utilities. The index is broken down by industry type and market type. Foreign exchange markets focus mostly on the seasonally adjusted monthly change in aggregate figure. Increases in the index are typically dollar positive.

Treasury International Capital Flow Data (TIC Data)

The Treasury International Capital flow data measures the amount of capital flow into the United States on a monthly basis. This economic release has become increasingly important over the past few years since the funding of the U.S. deficit is becoming more of an issue. Aside from the headline number itself, the market also pays close attention to the official flows, which represents the demand for U.S. government debt by foreign central banks.