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 two key factors affecting a currency's value are central bank monetary policy and the trade balance. 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.
The other 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. 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. Futures on major currencies and on cross-currency rates are primarily traded at the Chicago Mercantile Exchange.
Dollar - The dollar index in 2007 sold off fairly steadily during the year and closed 2007 down -8.4%, adding to the -8.2% sell-off seen in 2006. The dollar index in 2007 posted a new record low for the series that has history going back to 1973 when the modern era of floating exchange rates began. The dollar index through the end of 2007 was down by a total of 36.6% from the 21-year high of 121.02 seen in July 2001.
The dollar in 2007 extended the decline that began in spring 2006 when the U.S. housing sector first started showing signs of cracking and when the U.S. Federal Reserve was on the verge of halting its series of interest rate hikes. The U.S. Federal Reserve from mid-2004 through mid-2006 raised the federal funds rate target by 425 basis points from 1.00% in mid-2004 to 5.25% in mid-2006.
The sell-off in the dollar accelerated in August 2007 when the U.S. subprime mortgage situation blew wide open. The Fed was forced into a sharp easing move that took the federal funds rate down by a total of 100 basis points (bp) from the 5.25% level in mid-2007 to the 4.25% by the end of 2007, and even lower in early 2008. During that time frame, the European Central Bank and the Bank of Japan left their key interest rates unchanged, meaning there was a sharp deterioration in U.S. interest rate differentials that undercut the dollar. The U.S. trade deficit in 2007 narrowed to the range of $57-62 billion from the record high of -$67.6 billion posted in August 2006, although the narrower U.S. trade deficit provided little support for the tumbling dollar.
Euro - The euro in 2007 rallied early in the year, traded sideways from May through July, and then rallied sharply in August 2007 when the U.S. subprime mortgage debacle began. The euro rallied by a total of 11.4% during 2007 to $1.4713 at the end of 2007. The euro received continued support in 2007 from the European Central Bank's overall 200 bp rate hike from 2.00% in late-2005 to 4.00% by June 2007. Moreover, the European Central Bank after the U.S. sub-prime mortgage debacle began in August 2007 did not cut interest rates, as opposed to the Fed which cut its funds target by 100 bp in the latter half of 2007.
Yen - The yen rallied by 4.0% against the dollar in 2007 but closed -7.0% lower against the euro. The yen rallied sharply against the dollar in the latter half of 2007 after the U.S. subprime mortgage debacle emerged because of (1) the decline in U.S. dollar interest rate differentials against the yen, and (2) a cut back in the yen carry trade as global stocks sold off and as various higher risk securities melted down. When yen carry trades are lifted, the yen tends to rally because traders need to pay back the yen loans they used to finance high-yield investments in other currencies. The yen was also boosted in early 2007 by the Bank of Japan's 25 bp rate hike to 0.50% in March 2007, which added to the 25 bp rate hike to 0.25% seen in mid-2006. Against the euro, the yen in 2007 showed weakness due to the yen's large 350 bp negative interest rate differential versus the euro in benchmark central bank interest rate targets.