Ok so US economy is sluggish, Unemployment rate is high, but day before yesterday USD crushed Euro back to 1.28 range. I am confused. How could economy, shares and bonds goes down but Currency goes up ??. Sorry for asking noob Question.
:rolleyes::rolleyes:
Currencies trade relative to each other. How are things looking in the Eurozone these days?
When the panic button is hit, The dollar comes out the winner.
This is a common question and something that took a long time for me get. If you browse FX news sites, you will invariably hear mention of risk appetite and risk aversion. Okay, so then you look up the definition of those terms and you’re still confused? Risk appetite is merely a measure of an investor’s risk tolerance. This definition doesn’t really help your understanding.
Things got even worse because I had always understood fx fundamentals in terms of money flow. If the Dow Jones rose, considering that equities are a moderately risky investment vehicle, one would expect the demand for dollars to rise and for dollar pairs to rise. This is a still a valid model, but its not the whole story.
The way I’ve finally come to understand it is by imagining that US government securities (and foreign government securities) are considered the benchmark for low risk (for obvious reasons). Now imagine we have two pools of investors (foreign and domestic). Also imagine that there are two investment markets, the government securities field mentioned earlier, and a pool of higher risk markets that include equities and commodities (regardless of whether these markets are foreign or domestic).
Now to use these basic definitions in a meaningful fashion we need to understand that investors (again regardless of whether they are foreign or domestic) already have their investments allocated in fashions that reveal their current risk preferences. Since fx is a mostly speculative market, any news that changes investors perception of future risk trends will cause these investors to reallocate their investment portfolios. It is this reallocation that affects fx price action.
Okay, you might be thinking, how does this help? Well all the pieces are in place, when the dust settles the story will be told. Price action will move in the direction that investors believe it WILL go. If risk appetite rises and the dollar rises, thats one story, if risk appetite falls, and the dollar falls, thats another. If risk appetite rises and the dollar falls, we will then know that majority of investment reallocation was away the US. If risk appetite falls and dollar pairs rise then we will know that the majority of investment allocation was toward the US.
Key to understanding these flows is understanding that indices such as S & P and the Dow Jones are sometimes just proxies for a gauge of risk appetite. i.e. just because the Dow rises doesn’t mean it was the only equity market rising. Other equity markets may have risen more. This is frequently the case when earnings or growth estimates for other markets are higher than those in the US market.
The story is similar for commodities markets. If an investor believes a commodity is undervalued (or equivalently that a commodity’s current price will rise) then more investors will be willing to risk investing in those markets. Remember, there are many commodity markets abroad.
Okay, enough blathering. Lets get an example. Here is one that cost me thousands of dollars (early in my fx misadventures). Its July 2008, the dollar is getting trounced by the euro. All the talking heads are talking eur/usd at 1.65 or 1.70. Some people had been spooked by Bear Sterns Fed loan a few months earlier, but that only strengthened the case for the euro. In early August, the news of Lehman Brothers and the final crash of Bear Sterns revealed that global markets were in for a **** storm. I foolishly believed that this was the knell for the dollar and went heavily long euro.
What happened? Demand for Treasuries went crazy in September. On September 17, 2008 (or thereabouts, I can’t remember exactly) short-term US-notes actually had a NEGATIVE interest rate. That means investors were willing to take a small known loss instead of risking far larger losses abroad. This was driven by two factors, domestic investors dumping foreign investments and moving capital home, and foreign investors dumping their domestic investments and moving their domestic capital into the US. Again, domestic equities markets were a proxy for this sentiment. The Dow plummeted to nearly 6K (I predicted 6.5K as a bottom and was able to make quite a bit during that move back up to 10K, when I got out). Again, we see it was the type and location (country of origin) of the asset that was driving price action, not necessarily the economic prospects for the US at the time. Investors wanted safe assets, and while all government securities rose, the US was seen as the safest.
So lets keep in mind that as worries eased over the next couple of months (Oct and Nov) many of those investors who panicked, now began to move their funds OUT of US treasuries and into the recovering equity and commodities markets (remember oil at around $27 from a hight of $150 or so). This movement out of Treasuries both reduced demand for the dollar and increased demand for its respective currency pairs.
In summary, while it is true that a country’s fundamentals do drive demands for that currency pair, they are not the whole story. Ultimately, it is demand for a currency itself that will rule the day. While they two are usually paired, (check out the dollar from 1995 to 2001 during the dot.com boom), they can part ways for years. Markets wax and wane, and these movements will give a clearer picture.
Wow, Pablo . . . lots of great info there. Thanks for sharing.
Here is my cheat sheet for how things seem to go. When economic outlook is bad, investors want to reduce risk and the currencies at the top gain. When the outlook is good, they want risk, and the currencies at the bottom gain.
[U][B]RISK OFF[/B][/U] :mad:
1 JPY
2 USD
3 CHF
4 EUR
5 GBP
6 NZD
7 AUD
8 CAD
[U][B]RISK ON[/B][/U] 
Thank You Very much for this Kind Information, One more stupid question is How Reserve banks stabilizes its currency value ?
Now that is a perfect way of looking at all of the major currencies in relation to each other’s risk levels! I will peruse this “cheat sheet” in the future to better set up my trades according to expected risk appetite/aversion in the market. Thanks Lew!
I’d actually flip EUR and GBP right now, and probably put CAD above NZD, but it varies. It all varies. That’s what makes it all so interesting.