• Present and future government
• Economy and outlook
• Inflation and inflation target
• Current interest rates, anticipated changes
• Trade balance - is it a problem
• Current account - enough money flowing into the country
• Present and future government

How good a job the incumbent government is doing and how the people view the performance of its present government have a direct bearing on the exchange rate. Future changes in government, especially party changes are equally important. In the U.S. for example, the Democrats are generally viewed as a U.S. dollar negative because they tend to favor a weaker exchange rate; the idea is U.S. manufacturers will be more competitive and that will directly help the blue collar workers (Democrat’s voter base and election engine).

Economy and outlook (fall 2003)
The present state of the economy and perceived future outlook for the economy have a direct bearing on the exchange rate. The positive ramifications of a strong economy cannot be underestimated. There is clearly a domino effect. People are working and view the future optimistically. So they spend money. The companies are making money so they spend money. Tax revenues are good so the government is spending money. All this spending tends to make the economy stronger still, and so on. When the economy is weak and the outlook is negative the opposite reaction occurs.

Inflation and inflation target
Inflation has not been an issue this decade for any of the major countries. Deflation has been a problem for Japan and presently the United States is more concerned with deflation than inflation. Inflation outlook has changed because economies like the United States produce far less goods (prone to inflation) and much more services (practically no inflation risk). In fact better ways of servicing can lower costs and serve as a buffer.

Current interest rates, anticipated changes
The currencies of Australia, Canada and Great Britain have considerably higher interest rates than the United States, Japan, Switzerland and the Euro. The high interest rate currencies have what is known as a positive cost of carry when paired up against a low interest rate currency and that makes them especially attractive to investors. Positive cost of carry simply means the investor earns more interest on the currency bought than is paid on the currency sold. What oftentimes happens is that the high interest currencies are bought when the currencies are stable.

Trade Balance – is it a problem
A country has a positive trade balance when it exports more goods and services than it imports. When a country imports more than it exports it has a trade balance deficit. The United States has a huge trade deficit problem; each month it imports $40 billion more than it exports.

Most of the net U.S. trade deficit is with China and Japan. To correct this glaring imbalance the United States is pressuring China and to a lesser extent Japan to allow their currency to appreciate against the USD; this would make their goods less appealing to U.S. importers. A weaker USD would also help U.S. exporters sell their goods and services abroad.

Japan on the other hand has a trade surplus but that hasn’t stopped the Japanese government from officially intervening in the currency markets and buying 80 billion USDJPY this year. The U.S. up until recently has turned a blind eye on these perverse USD purchases. However, recent comments by Fed officials, the tone of the G7 communiqué, and comments from the International Monetary Fund (IMF), suggest a change in tactic on the part of the U.S. Specifically, it appears the U.S. wants a lower dollar.

Current account – enough money flowing into the country
The current account is simply net trade surplus or deficit. When foreigners were buying U.S. stocks with reckless abandon, the U.S. dollars leaving the country in net trade were working their way back through foreign purchases of U.S. stocks. That’s not happening anymore; in fact foreigners have been net sellers of U.S. for a long time now. What is happening is that China and Japan are taking all those trade dollars and buying U.S. government bonds. Problem with that is they have about 25% of all outstanding U.S. government debt; what it means is they could cause on a run on the dollar and or skyrocket U.S. interest rates if they sold a chunk over a short period of time.

Summary U.S. Fundamentals
Economy doing relatively well but the trade deficit, current account deficit, and budget deficit are all huge and getting worse. The U.S. dollar will end in tears unless something is done to correct these imbalances. U.S. dollar devaluation would help and is in the cards. Short USD is the only trade to be in these days.


Note:

Jimmy Young is a seasoned institutional forex trader having 20 years of experience with different banks. He headed up bank FX dealing rooms. He is FX profitability consultant to major European private bank. He manages funds and also trades personal money. Between 1981 and 2004 he was a foreign exchange trader at following banks: Societe Generale, Julius Baer, Fuji Bank, Indosuez, Erste, Hill Samuel, Manufactures  Hanover, Paribas, European American. www.EurUsdTrader.com