For sophisticated traders in the currency markets who live 24/7 side-by-side with nano-information about the US dollar and other currencies, it’s not necessary for them to make an effort to think about the dollar, because they always do. For the rest of us – i.e., those of us who don’t trade currencies or who don’t possess the depth of knowledge about currencies that the traders and experts do – it’s still useful to look at the dollar and foreign currencies and what’s going on around them every so often. If you’re a stock trader or investor, the dollar and the forces that tug and pull on it have ultimately got a lot to do with what’s going on in the equity markets.
As someone focused on equities, you’ve probably watched the last few years as the value of the US dollar has fallen roughly fifty percent in relation to the Euro, and you may have noticed that the Canadian Dollar is nearly on par with the greenback (a recent foreign exchange rate had the one US Dollar equal to $1.01 Canadian). While these values fluctuate in the currency markets, where US dollars and other currencies are traded (via futures contracts), you may remember a decade or two ago where – if you traveled to Canada from the U.S. – a Canadian dollar was worth roughly only 65 to 70 US cents. So this is a marked change. The US dollar has gotten relatively weaker, the Canadian dollar relatively stronger. This is ultra-basic stuff for currency mavens, but stock traders and investors sometimes don’t pay enough attention to this.
The recent turbulence in the stock and credit markets caused the Fed to make dollars cheaper (driving the value of the currency down) by lowering interest rates and making more dollars available. Interest rates and money supply have historically been the Fed’s (and other central banks) tool to influence their respective economies. Heavily connected to this is the trade imbalance the U.S. has run for a number of years. Foreign goods, with foreign currencies growing in value, become more expensive, and we in the U.S. buy more and more of these goods with our dollars, while selling less of our own goods and services to our trading partners, causing our dollar’s continual decline in value. This continuing cycle, if unchecked, ultimately will produce inflation for the weaker currency, in this case the US dollar, as it takes ever more of the weakening currency to chase the same amount of goods, let alone even more goods.
There is, if not a kind of common sense to this intricate puzzle, a kind of interior or interwoven logic at work. Ultimately there are forces of supply and demand exerting themselves on each other, though in admittedly complex ways. This, by the way, is part of what the Fed sees as doing its mission when it attempts to keep orderly markets (particularly the credit market) to balance out market forces. The U.S. is not the only government which influences its markets this way; the Chinese have raised interest rates several times in the last year to slow their too-fast economic growth, and France wanted to enlist the aid of Great Britain to jawbone the U.S. into a coordinated action of holding the line on interest rates to keep European goods from becoming too expensive.
Markets, currencies, and interest rates all fight the same pressures: when they move for a long time in one direction, up or down, there are increased pressures to go the opposite direction. Thus you will read articles about a “bubble” in the decline of the dollar, though the metaphor of a burst bubble might be more appropriate.
Is it all good or bad? Well, like most economic things, it depends on where you are and if you are properly hedged. We are all consumers, of something—food, gasoline, healthcare, chocolate, mortgages, cars, ipods—and often of all these things. Venture capitalists with more money and more liquidity in the pipeline are more likely to fund a small start up or put a bundle of cash into a micro-cap as an investment. And potentially we are savers too, not just spenders. But why save as much with interest rates so low? So low interest rates and cheap dollars encourage spending, not saving, and while low interest rates are usually good for stocks, if the dollar becomes too radically cheap, it’s obviously not good.
Usually these forces, which work against each other, also balance each other out in at least a rough way over time. Stocks are cheap but only if the underlying values of the companies hold up. (See Bear Stearns or any losing investment or trade you might have had recently.) How to play this? Just watch how the major trends or forces of changing foreign exchange rates, or currency values, interest rates and liquidity exert their effects on the markets, and factor these in as another set of factors to be aware of when you trade or invest. Even long-term equity investors occasionally feel moved to do something with currencies, as in the case of Warren Buffett, who has been buying the Brazilian currency, the Real, and making a bundle.
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