results of extensive professionally designed surveys that are conducted on a regular basis in many countries.When these survey results are released, they provide important information on expectations regarding the economy of a country. This information is seriously assessed by central banks in determining their next moves in controlling inflation. Growth in business orconsumer confidence has inflationary potential, while a decline in business or consumerconfidence portends economic slowdown. When these releases come out, they move themarket, especially if the results are surprising.Beyond having an impact upon their release, confidence indicators can also providea leading indicator for the forex trader. If business confidence is at its highest in years,the market will interpret it as positive for the currency because greater confidence indicates expansion and growth of an economy. Where there is expectation of expansionand growth, there is the concomitant expectation of interest rates not going lower andpossibly going higher. These confidence surveys are not perfect predictors of resultingcurrency moves. They are one of the most important ingredients in the mix of fundamental forex factors.Some of the important confidence indicators are listed on page 42 and should be followed. Their release times are tracked in the numerous economic calendars available,and strategies for trading these economic data releases should be learned by traders.It is interesting to note that every major country has its version of investor and business confidence indicators. These form in effect a leading indicator about currencydirections.
A
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Investor/Business Confidence Indicators
r Zew Economic Sentiment Indicator (www.zew.de)r IFO Business Climate Survey (www.cesifo-group.de)r Institute of Supply Managers (www.ism.ws/)r Tankan Report (www.boj.or.jp/en/)r National Australian Bank Business Survey (www.nabmarkets.com/research/flagshippublications/nationalmonthlybusinesssurvey.aspx)U.S. Sentiment Indicators
r Consumer Confidence (www.conference-board.org)r University of Michigan Sentiment (http://about.reuters.com/productinfo/universitymichigan)
r ABC Consumer Comfort Index (www.washingtonpost.com/wp-srv/business/articles/consumerindexdata.htm)
r Fed Beige Book (released two weeks prior to Federal Open Market Committee meetings, eight times a year)
r ISM Nonmanufacturing (www.ism.ws/ISMReport/index.cfm)r Empire State Manufacturing Survey (monthly report, www.ny.frb.org/research/regional economy/empiresurvey overview.html)
r Chicago PMI ISM Nonmanufacturing (released on the third business day of themonth, can be found at www.ism.ws/)
r Richmond Fed Manufacturing Survey (www.richmondfed.org/research/regionalconditions/manufacturing conditions/index.cfm)
r Philadelphia Business Outlook Survey (monthly, www.phil.frb.org/econ/bos/index.html)
ASSIGNMENTGo to an Economic Calendar (www.econoday.com) and Find the Next Businessor Consumer Conﬁdence Report Release TimeWatch what happens upon the release to the currency pairs.
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CHAPTER 7
FundamentalPersonalities ofCurrencies
f each currency’s value is a reflection of the underlying economy of its country orregion, we can begin to think of them as having a fundamental personality that canguide our strategies for trading. This chapter focuses on how a trader can gain anunderstanding about the strength and weakness of a currency. The concept of a tradeweighted currency basket is introduced as well as how to obtain the latest trade-weightedinformation and data that can be directly used in trading.
I
TRACKING CURRENCY STRENGTH: HOW STRONGIS A CURRENCY?In reviewing the “big” fundamental picture for a currency, we have reviewed what movesforex prices from an economic point of view. We can be convinced that currencies reflectworld opinion about how well an economy is doing or expected to do. The next step infundamental analysis is to be able to make a judgment about a particular currency itself.Ultimately, the question arises for the trade: How strong is the currency? In spot forextrading, the trade itself is always a paired event of one currency against another. Butwhen a trader makes a judgment about the strength or weakness of a currency by onlycomparing one currency against another (usually the U.S. dollar), the conclusion can bemisleading as to the global strength or weakness of the currency. When trading majorswhere the U.S. dollar is part of the pair, the comparative question becomes: How strongis the U.S. dollar against that currency? It’s important to get an insight on how stronga currency is with respect to its total global trade position. To enable an answer to the43
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question of how strong a particular currency is on its own terms without reference toanother pair, the trade-weighted index (TWI) is used by economists and should also beused by currency traders.The TWI represents how well the currency of a country is doing against a basketof other currencies. The currencies included in the TWI are those that reflect the majortrading relationships with the index currency. Each currency receives a weight in theindex that reflects its importance. For example, in Table 7.1, we can see that Japan isAustralia’s major trading partner and has the greatest weight in the Australian TWI. Wecan also see that Canada and many other nations have a very small percentage component of the TWI.Each year the central bank and economists adjust the weights to reflect changingrealities of international trade. As China increases its trading relationships around theworld, it will receive more weight in TWIs. The point is that the TWI represents a way
TABLE 7.1
Weights in the Australian TWI (2002 versus 2005)Trade Weight (%)
Currency
2002
2005
Japanese yenU.S. dollarEuropean euroChinese renminbiSourth Korean wonNew Zealand dollarU.K. pound sterlingSingapore dollarNew Taiwan dollarIndonesian rupiahMalaysian ringgitHong Kong dollarThai bahtSaudi Arabian riyalCanadian dollarIndian rupeeVietnamese dongSouth African randPapau New Guinea kinaUAE dirhamPhillippine pesoSwedish kronaSwiss franc
17.205815.068112.39818.57546.55885.56895.13654.00903.58773.23992.87332.43602.33561.63151.57431.52801.05830.99710.95880.89400.84540.83100.6875
16.359611.938813.081912.74915.71785.63814.17854.12993.30412.61593.30571.52373.15091.25391.47862.82631.47941.15871.13960.81460.60890.87370.6723
Source: Reserve Bank of Australia.
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of gauging the change in value of a currency in terms of its global trading position. Byknowing the TWIs of each currency, the forex trader can detect a strengthening andweakening of a currency and also get a sense of how a currency can be impacted byevents in countries of their trading partners.Many traders often ask the question: What do you think of the U.S. dollar (or yen,pound, or euro)? One important way of answering is from the perspective of the TWI.Each currency gains a trading personality, and knowing the TWI for each currency isvery useful, because it will reflect the big picture much more accurately.Most recently, the International Index Company issued a new product line callediBoxxFX® , which are indices that are, in fact, trade weighted. They allow an averageforex trader to take a snapshot of the strength of a currency without the noise of the forexmarket. Table 7.2 shows the iBoxxFX® currency baskets for each currency. Notice howeach currency index reflects the varying importance of its different trading partners. Wewill see shortly that these trade weights are a clue to defining the fundamental personalityof a currency.
AUSTRALIAN DOLLAR (AUSSIE)The Australian dollar, also known as the “aussie,” as a floating currency started in 1983.Before that time, it was pegged to the dollar, and before that it was pegged to the Britishpound. By floating its currency, the market sets the value of the currency and the central bank can avoid the necessity of intervening by buying and selling dollars to keep thecurrency value. But a floating currency also permits capital to float out of a country. Thefear of floating is great among totalitarian regimes and emerging countries that want tomaintain control of their economy. By looking at the aussie TWI (see Table 7.2b), wecan see that the aussie is affected by economic growth in all parts of the world and hasits trading relationships almost evenly distributed among Asia, Europe, and North America. The role of Australia as a global trading country makes it an attractive currency totrade.The recent years of economic expansion have created strength in this currency. Thecurrency in 2006 had a strong upward trend, which, from a world trade perspective, remains intact. The Australian dollar is almost as equally sensitive to the Japanese economyas it is to the euro or the U.S. economy. We can even see that its neighbor New Zealandcan impact the value of the aussie because it generates 11 percent of Australia’s tradingvolume (see Figure 7.1).Important also to consider are commodity-related events such as movements in copper and gold. Australia is a major producer of both of these commodities and is affectedby price patterns. Figure 7.2 shows the Australian dollar–U.S. dollar (AUDUSD) pair
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TABLE 7.2
Trade-Weighted Indexes of Eight Currencies
(A) Iboxx® Trade-Weighted Basket For European Euro
Weights (%)
U.S. dollarBritish poundJapanese yenSwiss francSwedish krona
38.7428.3716.849.336.62
(B) Iboxx® Trade-Weighted Basket for Australian Dollar
Weights (%)
Japanese yenEuropean euroU.S. dollarNew Zealand dollarBritish pound
31.9525.5523.3211.018.17
(C) Iboxx® Trade-Weighted Basket for British Pound
Weights (%)
European euroU.S. dollarJapanese yenSwiss francSwedish krona
66.5921.475.913.142.89
(D) Iboxx® Trade-Weighted Basket for Canadian Dollar
Weights (%)
U.S. dollarEuropean euroJapanese yenBritish poundSwiss franc
86.145.965.292.180.43
(E) Iboxx® Trade-Weighted Basket for New Zealand Dollar
Weights (%)
U.S. dollarEuropean euroAustralian dollarJapanese yenBritish pound
30.9426.0218.7417.307.00
(F) Iboxx® Trade-Weighted Basket for U.S. Dollar
Weights (%)
European euroCanadian dollarJapanese yenBritish poundSwiss franc
35.7032.1719.829.522.79(continues)
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Fundamental Personalities of Currencies
TABLE 7.2
(Continued)
(G) Iboxx® Trade-Weighted Basket for Swiss Franc
Weights (%)
European euroU.S. dollarBritish poundJapanese yenAustralian dollar
70.4315.047.405.151.98
(H) Iboxx® Trade-Weighted Basket for Japanese Yen
Weights (%)
U.S. dollarEuropean euroBritish poundAustralian dollarCanadian dollar
60.9125.896.333.673.20
versus using the Goldman Sachs Commodity Index. We can see how the movements arein sync, visualizing a strong correlation between commodity moves and the aussie-dollarpair.Figure 7.3 takes a closer look at how the aussie-dollar pair calibrated against copper. It shows that in 2006, these commodities began to diverge down while the aussie
FIGURE 7.1 Trade-Weighted Australian Dollar.iBoxx® is a registered trademark of International Index Company Limited.
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FIGURE 7.2 Australian Dollar versus Goldman Sachs Commodity Index.
continued strengthening. When a trader sees divergence from the traditional relationship, questions arise. Why would the aussie continue to be strong if copper is weak? Theanswer was that there was great strength in other sectors of the Australian economy,making copper less important.The fundamental personality of the aussie is that of a commodity- and tradedependent currency. The aussie will be affected by global economic growth and, inparticular, Chinese growth. China is now the second largest buyer of Australian exports,making the aussie more sensitive then ever before to the direction of the Chineseeconomy.A special feature of the aussie is that it has a multiple fundamental personality. Itcan be considered an Asian currency, reflecting Asian growth, and it can be considered a currency that also is impacted by the United States and Europe. This means thatthe forex trader should seriously look to trade the aussie pairs such as the Australiandollar–Japanese yen (AUDJPY) and Australian dollar–euro (AUDEUR), as well as thetraditional Australian dollar–U.S. dollar (AUDUSD) pair. The Organisation for Economic
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FIGURE 7.3 Copper Futures versus Australian Dollar.
Co-operation and Development’s (OECD’s) Economic Outlook report summarized thefundamental Australian picture as:A pick-up in export volumes is likely to bring output growth gradually back upabove the trend rate of over 3% by 2008, despite a decline in the terms of trade anda cooling of the business investment boom. Growth will, however, be held back in2007 by the effect of a drought on the agricultural sector.The cycle of growth that the aussie is in will be certainly tested. Events in Chinaand the commodity markets will be important factors to watch. Also, perhaps more
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%
%
60
60Exchange rate change
40
40
20
20
0
0
–20
–2090-day interest ratespread
–40
–402003
2004
2005
2006
FIGURE 7.4 Australian Dollar–Japanese Yen Carry Trade.Source: Guy Debelle, head of the International Department, Australian Foreign Exchange Market,November 2006.
significant over the coming year are events in Japan. If Japan raises its interest rates, theaussie will suffer because the conditions for the carry trade will decline. The Japaneserate of 0.50 percent and the aussie rate of 6.25 percent has encouraged a great deal ofinvestment flow out of Japan and into Australia. If this spread changes, so will the conditions encouraging a stronger aussie.Figure 7.4 shows why the carry trade has been persuasive. In recent years, it hasbeen very rare for the aussie to depreciate against the yen. This made the risks of anunhedged carry trade very low. But the risk of carry trades providing a big declineremains very real.Domestically, the Australian economy entered 2007 with 30-year lows in unemployment at 4.6 percent. The Reserve Bank of Australia increased rates to 6.25 percent tohelp slow down the economy. At the end of 2006, inflation rates were at 3.9 percent, stillhigh for global standards and above the central bank’s target rate of between 2 percentand 3 percent. The combination of domestic growth and global growth makes trading theaussie in the coming years a lot of action.
CANADIAN DOLLAR (LOONIE)Canada has experienced significant economic growth, surpassing $1 trillion of gross domestic product (GDP). Its robust expansion led the Central Bank of Canada to increase
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interest rates to 4.50 percent as of July 2007. This currency’s fundamental personalityreflects its big sister, the United States. The United States is Canada’s major trading partner, reflecting the fact that the U.S. dollar receives a weight of 86 percent in the tradeweighted basket. Refer to Table 7.2d.Therefore, when the U.S. economy slows, the Canadian economy also suffers. Theother major factor influencing the direction of the Canadian dollar, also known as the“loonie,” is crude oil. Canada’s tar sands are an important magnet for capital, and Canadais a net exporter of oil. When oil prices increase, the Canadian currency benefits. Figure7.5 demonstrates the strong relationship between crude oil and the Canadian dollar.
FIGURE 7.5 Crude Oil and the Loonie.
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FIGURE 7.6 Trade-Weighted Canadian Dollar.iBoxx® is a registered trademark of International Index Company Limited.
The Canadian currency’s performance against a trade-weighted basket in 2006shows a broader range than most currencies due to the decline in the price of oil (seeFigure 7.6).From a fundamental point of view, trading the Canadian dollar against the U.S. pair isthe most effective way to play this currency. A useful web site for tracking the Canadianeconomy is www.canadianeconomy.gc.ca/.
NEW ZEALAND DOLLAR (KIWI)The New Zealand dollar, also known as the “kiwi,” should get more of the attention offorex traders. New Zealand is almost a classic example of how fundamentals can drivecurrency movements. The New Zealand economy is small. It exports about $2.8 billion
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and imports $3.4 billion. Since its consumer economy is small, the fundamental characteristic that affects its economy is whether its exports can grow. Therefore, interestrates and the resulting currency valuation are key to its future economic vitality. Thefact is that 151 companies generate 78 percent of New Zealand’s exports. Data show only4 percent of the New Zealand firms do any exporting.New Zealand’s interest rates are now at 8.0 percent and, as a result, the currency hasrisen substantially in strength. New Zealand’s unemployment rate has been at a low levelof 4.6 percent; however, its inflation rate is high, at 3.6 percent. New Zealand’s centralbank is in a difficult position. At current interest rate levels, New Zealand’s rates are thehighest of all the major currency pairs. But this level was recognized as having risks ofslowing the New Zealand economy. In fact, the New Zealand Central bank intervenedfor the first time since 1990 and sold the New Zealand dollar on June 11. If it tries toraise rates further to slow down inflation, it can choke off exports and cause a majorcontraction. If it doesn’t, inflation may rise to unacceptable levels. The fundamentalspoint to a mixed situation that can go either way. As a result of this uncertainty, thekiwi offers potentially very many trading strategies, as the currency will be extremelysensitive to central bank actions as well as surprises in economic data.New Zealand’s major trading partners are balanced between the United States, Europe, and its neighbors Australia and Japan (refer back to Table 7.2e). China’s influenceis also growing and will soon be reflected in its official trade-weighted indexes (seeFigure 7.7).The forex trader looking to trade the kiwi can explore trading the dollar pair U.S.dollar–New Zealand dollar (USDNZD), as well as the kiwi against the aussie (NZDAUD),the yen (NZDJPY), or the euro (NZDEUR).
MEXICAN PESOThe peso is a currency that offers potential for trading more than ever. Mexico’s economic profile reflects a growing potential. Its GDP is now nearly $900 billion, and Mexicomay overtake Canada in GDP. Mexico is the world’s fifth largest oil producer and ninthlargest oil exporter. Pemex, Mexico’s monopolistic oil company, generates an estimated35 percent of federal government revenues. The OECD projects a GDP growth in Mexicoof 3.5 percent in 2007 and 4 percent in 2008. Importantly, inflation is projected to be justabove 3 percent (www.oecd.com).Also important in understanding the dynamics of Mexico’s economic growth is theimpact of China. China is a competitive threat to Mexico, and as it grows, Mexico’s manufacturing and export business have suffered because of China’s advantage in its low costof manufacturing and assembly due to the lack of a float of its currency.
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FIGURE 7.7 Trade-Weighted New Zealand Dollar.iBoxx® is a registered trademark of International Index Company Limited.
The peso’s value will also tend to be supported by its relatively high interest rates,which are now at a level of 7.2 percent, but lower than previous highs of 8 percent.Additionally, the peso is strengthened by its ability to attract capital flows. It is useful tonote that those traders who sell the U.S. dollar and buy the Mexican new peso (MXN)in the USDMXN pair, receive interest rate payments. So the peso can be used as a carrytrade currency pair. The second major factor is the U.S. economy. Mexican exports areat a level of over 80 percent to the United States, and there is a high inflow of capitalcoming from Mexicans living in the United States.Oil also needs to be considered. Like Canada, Mexico is a net exporter of oil andattracts petrodollars. A major negative factor is business confidence. The Mexican business climate is often marred by inefficiencies, and the political economy generates a greatdeal of negative sentiment. Another factor emerging is Asian competitiveness. As countries such as Vietnam and others in East Asia are emerging as low cost manufacturers,Mexico’s comparative advantages in world trade suffer.
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FIGURE 7.8 Mexican Peso Monthly Chart.iBoxx® is a registered trademark of International Index Company Limited.
From a fundamental point of view, there are many risk factors impacting the peso’sdirection. If Mexican interest rates fall, the peso could weaken substantially; if the U.S.economy slows, Mexican growth will suffer. Based on this fundamental picture, tradingthe Mexican peso should be considered mainly against the dollar, and trading this pairusing longer-duration charts is more advisable (see Figure 7.8).
JAPANESE YENJapan is the second largest developed economy in the world. Yet its size doesn’t guarantee a successful economy. To understand Japan today, one has to have a sense of wherethe Japanese economy has come from.In 1989, the Nikkei 225 Index, which is a price-weighted index of the top 225 stockson the Tokyo exchange, peaked around 39,000. In 1990, the Nikkei Index fell by 39 percent, and in March 2007, it was at the 17,400 mark, still quite a way from the highs of theprevious era. The “bubble” (1987–1991) in Japan had broken. The “bubble” was characterized by extremes in consumption of luxury cars, expensive food, outlandish art
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auction prices, and surges in sales of luxury brand bags and jewelry. The Nikkei hadtripled in price in the 45 months prior to its peak. Also, metropolitan land prices tripledbetween 1985 and 1989. Finally, there was a significant increase in borrowing to financehome purchases (Atsushi Maki, “Changes in Japanese Household Consumption and Saving Behavior before, during, and after the Bubble Era: Empirical Analysis Using NSFIEMicro-data Sets,” Japan and the World Economy, January 2006).Then Japan experienced what has been called “The Lost Decade.” Between 1995 and2002, the average annual GDP growth rate was an anemic 1.2 percent. Compare this tothe same period growth rate of other nations, shown in Table 7.3.The Japanese stagnation had many causes, but a major contributor was the Japaneseconsumer. Studies (e.g., Charles Horioka, “The Causes of Japan’s Lost Decade: TheRole of Household Consumption, Japan and the World Economy, Vol. 18, 2006) haveshown that in Japan, what could go wrong in consumption did. Household disposableincome declined, household wealth declined, and, coupled with uncertainty about thefuture, the result was low confidence in prospects of strong growth. Once the forextrader appreciates what the era of stagnation was like in Japan, he or she will havea greater understanding of why Japan today is still not on firm footing of renewedgrowth.For example, household disposable income had a growth rate of only 0.98 percentfor 1991 through 2003 compared to 3.32 percent for 1980 through 1991. Household wealthdeclined by an average 0.39 percent. Interestingly enough, there is data showing that theproportion of people saving for old age rose from 50.5 percent in 1991 to 60.4 percent in1995, demonstrating great fear of the future and lack of confidence in the economy. Thedata from Japan underscores the importance of consumer confidence. When confidenceis low regarding one’s country, consumers tend to save much more. This makes it difficult to stimulate growth through traditional monetary measures such as lowering interest rates. Another important characteristic was that prices were actually in deflationarymode, and when prices keep falling there is little incentive for consumers to purchasesince they expect cheaper prices.
TABLE 7.3
Growth Rates, 1995–2002
Country
GDP Growth Rate
CanadaUnited StatesUnited KingdomEurozoneAustraliaMexicoJapan
3.43.22.72.23.82.61.2
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Few of today’s forex traders remember this period of time in Japan, even thoughit was less than a decade ago. It was before the emergence of the retail forex market.But the era of stagnation also holds clues as to whether Japan will experience robust,uncertain growth or retreat again into stagnation. Much will depend on the interest ratedecisions of the Bank of Japan and business and consumer confidence surveys becausethe core cause of stagnation was lack of consumer confidence and spending. Therefore,the core of recovery will be a recovery in consumer spending.But it is not easy to stimulate the Japanese consumer. This means that the forextrader should carefully watch consumer confidence and inflation data coming out ofJapan for clues as to whether Japan is overcoming deflationary fears. One such clue occurred in March 2007 when, for the first time in 16 years, Japanese land prices showed anincrease. Other clues will be necessary before the Japanese inflation rate moves beyondits current 0.0 percent rate. Also important is export data on Japan. Stimulating exportsbecomes a critical factor in determining the ability of the Japanese economy to grow.Any significant strengthening of the Japanese yen, particularly against the dollar or theeuro, could threaten Japan’s export growth. However, any extreme level of weakeningof the yen would help exports. But remember that too weak a yen against, for example,the euro may help Japanese exports but would undermine European exports. The forextrader should note that where there are beneficiaries to a currency direction, there arealso losers. The Japanese finally increased interest rates to 0.50 percent as part of itscentral bank’s policy of encouraging inflation. But the interest rate differential betweenJapan and other nations is still quite steep. Even if the Bank of Japan increases rates to0.75, if other central banks also increase their rates (the central bank of New Zealand increased rates to 8.0 in June 2007), the effect of this differential may encourage continuedoutflows of capital from borrowing