Here is a very informative article for those of you who are interested in the currency trading market (like moi). This article is brought to you by SEAN HYMAN, Currency Director of The Sovereign Society.
Most investors know that a company’s earnings move a stock. But what moves a country’s currency?
Actually, there are many factors that affect currencies every single day. But for now, let’s take a look at the three most important factors that move currencies.
Interest rates are the first major factor that moves currencies. Each country’s currency has an interest rate attached to it, which is determined by that country’s central bank. So when you hold a certain currency, you’ve paid that country’s rate of interest.
Money is attracted, most importantly, to rising interest rates. When rates are high and going higher, money moves away from lower yielding currencies and into higher yielding instruments.
After all, you would rather earn more on your money, right? Many currency investors do. That’s why they invest in high-yielding currencies. This influx of buying drives up the demand for the currency and forces it higher. So that’s what makes the currency go up.
How to Read a Central Banker’s Mind
So the next question is: How do I read a central banker’s mind to find out if he’s going to raise or cut his country’s interest rates? If I can figure that out, then I know if the currency will go higher and I’ll actually earn more interest too.
Answer: You watch the inflation numbers.
A country’s CPI (Consumer Price Index) is the second major factor that drives currencies. It’s the “cost of living” index. CPI measures a basket of goods to determine if the costs of those goods are rising or falling. This basket of goods includes basic necessities like transportation, food, medical care, etc.
The central bank closely monitors these price levels. If prices continue to rise, then they know inflation is rearing its ugly head. A country can’t continue to grow at a healthy clip if inflation gets too high.
So how do central bankers combat inflation? They raise interest rates. Raising rates increases borrowing costs. Higher rates make it more costly for businesses to expand and grow. When businesses slow, it tends to “cool” the demand for consumer goods. This means the CPI falls back down to levels that the central bank is comfortable with.
On the other hand, cutting interest rates tends to give an economy a “shot in the arm” and help jumpstart it again. (This is what the Federal Reserve just did last month in the U.S.).
However, investment assets tend to run away from falling interest rates. So by cutting rates, central bankers are effectively encouraging traders to sell their country’s currency and push the currency’s value down lower.
Money Runs Away from Risky Assets
The last major factor is called “risk aversion.” The former two factors are associated with “risk seeking.” However, the alternative is risk aversion. Risk aversion happens in the market when traders suddenly don’t want to assume the risk to seek higher yielding currencies. This happens when markets get volatile and shaky.
For instance, when stock markets plummet, investors generally try to shield themselves from risk. So investors take their money and run towards assets that are beaten down (oversold) over the last 1-3 years. They’re investing in assets they believe won’t fall much more or at all. This is what “risk aversion” is.
Recently, we’ve seen this happening with the Japanese yen. Even though the yen’s fundamentals are stable, Japan’s currency has continued to drop over the last few years as investors sold the low-yielding yen to “seek” higher returns on their money through higher yields.
However, when financial markets get shaky or overly volatile, money runs from these higher yielding instruments. As economies start to “cool” and slow down, an investor loses the incentive to invest in that currency. It’s just like when a stock investor chooses to dump a stock because the company’s earnings momentum is slowing.
So you should ask yourself: Is the market in risk-seeking (stable) mode or is it in risk aversion (volatile, shaky) mode?
Also, watch the CPI levels. Watch to see if levels are increasing, flattening out or falling. If CPI levels are rising and they continue to rise above a central bank’s comfort level, then look for rate hikes ahead.
If consumer prices have flattened, then central bankers will probably view inflation as under control. They may hold rates steady. If consumer prices are falling, then the central bank may cut interest rates to encourage business expansion.
If the market is in risk aversion mode, then the overall market sentiment is scared. When money gets scared, it looks for safe havens.
So then ask yourself: What’s been largely sold over the past 1-3 years and could be due for a bounce back?
If you know that, you know where the money is headed next – and the big currency profits.