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Currency Matters

 By Marc Amateis

When China recently announced a quarter-point hike in its one-year lending rate, the effect on global stock and currency markets was immediate.  The U.S. dollar strengthened and stocks fell 1.5%. Financial headlines warned of “currency wars.”

In today’s global economy, the worldwide currency markets have a significant impact on the stock and bond markets.  It’s fair to say that few investors pay attention to currency issues, and even fewer understand them.

Currency Basics

Currencies are traded 24 hours a day, five days a week.  Like stocks, their value can change minute-to-minute.  And like anything else in economics, supply and demand determine value.  The more demand there is for U.S. dollars, for example, the more the price of the dollar will rise.

But here is where currency trading differs from stock trading.  Because one currency is used to buy another, currencies are always traded in pairs, and when one currency rises in value, the other currency must fall.  This is very different from the stock market, where all stocks can go up or down in value together.

 

In addition, a currency can rise in value vs. one currency, and at the same time fall in value vs. another.  For example, if the market determines there is more demand for U.S. dollars from traders exchanging Japanese yen, it will take more yen to buy a dollar.  At the same time, the market may determine there is less demand for U.S. dollars from traders exchanging euros, and so it will require fewer euros to buy a dollar.

Currencies trade in pairs. When one rises in value, the other falls.

In the very short term, currencies, much like stocks, move up and down in response to breaking news.  Initial reaction to China’s Oct. 19 quarter-point rate hike was that it would slow global economic growth.  As a result, investors cut risk by selling stocks, purchasing the U.S. dollar (thereby driving its value up) and selling many other currencies (driving their value down).

The very next day, however, investors decided their fears were over-blown.  Stocks regained almost all they had lost, and the dollar declined.

Over the long term, the value of a currency, like a stock, is determined by fundamentals.  In the case of a stock, it’s a company’s earnings.  In the case of a currency, it’s the economic strength of the issuing country.  Those countries with higher interest rates to lure investment, strong economic growth, low national debt, low deficits, and a secure legal and political environment will see their currency appreciate relative to weaker countries.

Currency Wars

Recent fears of “currency wars” refer to the attempts by many developed nations to actually devalue or debase their currency.  Lowering interest rates and printing money to flood the market with a currency are two ways to accomplish that.

Long term, no country wants to see its currency lose value.  But as we emerge from the global recession, countries that export goods try to make those goods more price-competitive in the global marketplace.

A country’s exports become more affordable to overseas buyers when its currency weakens.  Remember though, if one currency weakens another must strengthen, and therein lies the problem.

It creates a race to the bottom where each country fights to devalue its currency more quickly and deeply than the next, hoping to get a bigger piece of a pie that isn’t growing.  In the end everyone loses, as happened during the global depression of the 1930s.

Implications for investors

Currency movement can have a profound impact on some investments, so it is important that investors and their advisors consider currency issues when constructing a portfolio.

If you own stock in a foreign company, or a domestic company with overseas earnings, those earnings will be expressed in your home currency.  If your home currency is the U.S. dollar and it weakens vs. the foreign currency, those earnings will buy you more dollars and give you a greater dollar-denominated return.

Unfortunately, while a weakening dollar boosts your return on foreign investments, the dollars themselves aren’t worth as much in the global economy.  It’s going to take more of those devalued dollars to buy something imported from a country with a stronger currency.

If, as a U.S. investor, you own a foreign bond or foreign bond fund, the interest payments on those bonds must be converted into dollars.  Again, if the dollar weakens against the bond’s home currency, those interest payments will buy you more dollars and you will realize a return that is greater than the bond’s yield.  However, if the dollar strengthens, the opposite effect will occur and your return will be diminished.

For further reading:

International Investing, from the U.S. Securities and Exchange Commission

Most commodities (oil, gold, etc.) are priced in U.S. dollars.  As a result, when the dollar weakens, it takes more dollars to buy a unit of a commodity (a barrel of oil, for example) and the price rises in the U.S.  But the commodity becomes cheaper in terms of the strengthening currency, and so its price falls in that country.

Some mutual funds reduce or eliminate currency effects through complicated hedging strategies that include buying and selling currency futures contracts. So it is important that you know what you own.

Today, a well balanced and diversified portfolio will contain foreign investments, as well as domestic securities with foreign currency exposure.  It is therefore extremely important that investors and advisors pay attention to currency issues and their impact on the value of stock, bond, and commodity holdings.

Marc Amateis is a vice president at Landaas & Company.

initially posted Oct. 27, 2010

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