Editor-in-Chief of Commodity Traders Consumer Reports
President and Chief Investment Officer of Pinnacle Capital Strategies,
As with all
futures, the key to predicting the future price of a currency
is the supply and demand. How can we determine the supply and
demand for currencies?
supply is actually relatively easy to figure out. We can simply
look at the money supply.
is some complication because we have so many different forms of
money. Should we look at narrow money or broad money? I tend to
look at both. Broad money supply is well correlated with the strength
of the economy. Iıll talk later why this is important.
the critical supply-side consideration is the relative monetary
policies of the two central banks. For example, if the Bank of
Japan is running a tighter monetary policy than the Federal Reserve
Bank of the US then, all other things equal, the yen should rally
against the US dollar. This means that we need to figure out how
to determine the relative monetary policies.
indicator is the difference in growth in narrow money supply.
Narrow money supply is under virtual control by central banks
while broad money is only influenced by the central banks. If
narrow money supply is growing slower in Japan than in the US,
that suggests that monetary policy is tighter in Japan than in
the US and that the yen should rally.
strong indicator of monetary policy is the shape of the yield
curve. Short term interest rates are controlled by central banks
but long term rates are not. I look at the relationship between
short term interest rates and long term interest rates, called
the yield curve, to give me a clue as to the tightness of monetary
the higher the level of short term rates are to long term rates,
the tighter the monetary policy. At the extreme, monetary policy
is very tight if short term interest rates are higher than long
term rates. Once again, the key is to look at the relative shapes
to determine bullishness. For example, the US may have short term
interest rates higher than long term rates, called a negative
yield curve, but the European Central Bank may have an even steeper
negative yield curve and we should therefore expect that the euro
will gain on the dollar.
demand is little trickier and we have to resort to more subtle
popular misconception is that a large trade deficit is a sign
that a currency is going to decline. The concept is that if a
country is bringing in goods in exchange for its currency then
there is a rising supply of that currency in the world and that
increased supply will cause the currency to decline.
may have been true in a world that took months to ship goods across
a sea but it is no longer true today. In fact, the opposite is
true. Take a look at the chart to see how a widening of the trade
deficit has actually been associated with a strong US dollar and
vice versa. Let me explain why.
World War II and particularly in the last 30 years, the movement
of capital has completely overwhelmed the effect of trade in the
setting of currency values. We now have capital movements every
day that are greater than the total value of global trade for
a whole year! Frankly, who cares about trade?
key question to analyze trade flows is: where can I make the most
money in the world today? As an investor I will look at the potential
returns from investing in the countryıs stock market, bond market,
and direct investments. In addition, I will factor in my outlook
for the currency.
key to understanding the demand for a currency is to understand
the investment environment for that country relative to the other
country. In other words, is it better to invest in the US stock
market or the Japanese stock market? Is the bond market in the
US more attractive than the Japanese bond market? Should I make
a direct investment in the US or Japan?
way to analyze this is to look at the difference in the economic
strength between the two countries. I tend to look at industrial
production rather than gross domestic product because it is more
sensitive to international considerations and monetary policy.
The broader measures of economic strength include services that
are not strongly affected by changes in the currency.
a strong investment environment will attract capital to a country
and cause its currency to appreciate. I look at the relative trends
of the stock and bond markets to give me an idea of which country
has the better investment prospects.
consideration of the demand is the relative inflation rates between
the two countries. Over the long run, the country with the higher
inflation rate will have the weakest currency. If the inflation
rate of Japan is 1% and it is 4% in the US, then we should expect
to see the US dollar depreciate at a 3% rate, over the long run.
Please note that I said the long run. In the short run, capital
flows dominate the change in the price of a currency.
I like to monitor the change in the inflation differential. Iıve
found that it is the change in the differential that has the most
impact on the intermediate term direction of a currency. For example,
if the differential between Japan and the US is 3% but moves to
2%, then that is bullish for the US dollar because the differential
is less bearish. In effect, the market does not look at the absolute
difference between inflation rates but to the changes in the pressure.
of the problems with analyzing currency fundamentals is that the
market can focus on just one or two o f the various factors I
have been outlining at one time. The psychology of the market
often gets fixated on one factor to the apparent exclusion of
others. This means that you must be listening to the "talk" in
the market to see what it is focusing on so you donıt waste time
on extraneous factors.
currencies from a fundamental point of view can be subtle but
the advantage is that currencies are like battleships, it takes
a long time to change the fundamentals. As with all trading, the
trend is your friend and, fortunately, the fundamental trends
are long and strong.
1999 by CTCR, Inc.
Smith is Editor-in-Chief of Commodity Traders Consumer Report
and President and Chief Investment Officer of Pinnacle Capital
Strategies and can be reached at (800) 832-6065, Box 7603 New
York NY 10150-7603, firstname.lastname@example.org, and ctcr.investors.net.