Currencies

A currency rate involves the price of the base currency (e.g., the dollar) quoted in terms of another currency (e.g., the yen) or in terms of a basket of currencies (e.g., the dollar index). The world’s major currencies have traded in a floating-rate exchange rate regime ever since the Bretton-Woods international payments system broke down in 1971 when President Nixon broke the dollar’s peg to gold. The key factor affecting a currency’s value is central bank monetary policy. An easy monetary policy (low interest rates) is bearish for a currency because the central bank is aggressively pumping new currency reserves into the marketplace and because foreign investors are not attracted to the low interest rate returns available in the country. By contrast, a tight monetary policy (high interest rates) is bullish for a currency because of the tight supply of new currency reserves and attractive interest rate returns for foreign investors.

Currency values are also affected by economic growth and investment opportunities in the country. A country with a strong economy and lucrative investment opportunities will typically have a strong currency because global companies and investors want to buy into that country’s investment opportunities.

Another key factor driving currency values is the nation’s current account balance. A current account surplus is bullish for a currency due to the net inflow of the currency, while a current account deficit is bearish for a currency due to the net outflow of the currency. Futures on major currencies and on cross-currency rates are traded at the Chicago Mercantile Exchange and the FINEX exchange.

Dollar – The sharp sell-off in the dollar that began in early 2002 continued into 2003. The dollar index temporarily rebounded upward during summer of 2003 as the US economic rebound started, but then the dollar showed weakness again during autumn and the dollar index in December 2003 posted a new 7-year low. There were two major bearish factors for the dollar during 2003: (1) the Fed’s expansionary monetary policy, and (2) the massive US current account deficit. With its 1% federal funds target, the Fed aggressively pumped dollar reserves into the banking system, keeping interest rates low but also creating an oversupply of dollars that depressed the dollar’s value against other currencies as well as against real commodities.

At the same time, the US in 2003 ran a record US current account deficit near $550 billion, which is roughly equal to 5% of US GDP. That meant that the US had to import more than $1.5 billion of capital every calendar day in order to cover its trade and services deficit. Cyclical factors such as weak overseas demand for US exports were partly to blame for the US current account deficit. However, structural issues were the main cause of the current account deficit. Those issues were the heavy US demand for imported energy, the need for the US to import capital to cover the burgeoning US federal budget deficit, and the perennially weak US household savings rate. The OECD expects the massive US current account deficit to continue near 5.1% in 2004, meaning the dollar will remain under a cloud.

Euro – The euro rallied fairly steadily against the dollar starting in Q2-2002 and on through 2003. The euro in December 2003 posted a record high against the dollar of 1.1978 euros/USD. The euro’s rally was mainly driven by the fact that the European Central Bank (ECB) held to a tighter monetary policy than the US Fed by keeping its refinancing rate pegged at 2% through the second half of 2003, a full percentage point higher than the Fed’s 1.00% funds rate target. Higher European interest rates encouraged European investors to keep their investment capital at home in higher-yielding debt instruments. Still, Europe had its share of problems during 2003 with very weak economic growth, ongoing structural problems related to heavy business regulation, a sclerotic labor market, and fiscal problems where Germany and France couldn’t keep their budget deficits below the 3% Euro-zone ceiling in 2003.

Yen – The dollar/yen traded mostly sideways in early 2003 but then dropped sharply in late 2003 to post a new 3-year low of 107.50 yen/0 The Bank of Japan spent much of 2003 intervening in support of the dollar/yen because Japanese government policy was to prevent a significant appreciation in the yen so that the Japanese economy could benefit from increased exports. In spite of that effort, the dollar dropped against the yen due to the dollar’s weak fundamentals.

British Pound – The British pound rallied sharply against the dollar beginning in early 2002 and lasted through 2003. The British pound in December 2003 posted a 5-year high of $1.72, which was only about 1 cent below the 11-year high of $1.7325 posted in October 1998. The British pound was supported by the relative economic strength seen in Britain and by the fact that the Bank of England was the first of the major G7 central banks to raise interest rates, pushing the base rate up 0.25 percentage points to 3.75% on November 6, 2003.