Wayne McDonell provides analysis of the currency market: supply and demand.

To be a truly successful currency trader one must understand global money flow well. Healthy economies tend to attract investment. As a result, their currencies are in high demand. In such situations, the classic supply and demand equation dictates that the value of the currency rises.

The goal of a currency trader is to conduct analysis on economies around the world to identify healthy and weak currencies in order to trade them against each other. Therefore it is useful to look at global money flow and to break it down, using both macroeconomics and microeconomics.

Macroeconomics
Why is a currency in high demand? Let’s use Australia as an example. One of the country’s great strengths is its natural resources. Australia produces gold, diamonds, wheat, beef, iron ore, coal, and fabulous wines, all of which are in high demand by expanding economies such as China. In fact, China purchased 21 per cent of all Australia’s exports in 2009. However, the Chinese cannot spend their currency within Australia. They must first buy the Australian dollar. The more goods and services foreign economies purchase from Australia, the higher the demand for the local currency (AUD) becomes.

This is true for long-term investments as well. An international corporation might wish to build a factory; or a foreign institution might wish to buy a government bond; or perhaps a billionaire in Malaysia would like to invest in the Australian Stock Exchange. These three examples, like a plethora of other possibilities, would all create demand for the Aussie dollar.

Let’s not forget central banking policy. All this demand for Australian resources creates a flow of money from around the world into the local economy. Farmers, ranchers, miners, and bankers all benefit financially. They, in turn, spend their money within the local economy: bigger houses, faster cars, and fancier watches. Suddenly a 30-foot boat doesn’t seem adequate, so hordes of successful Aussies begin to buy 42-foot yachts, which drives up prices for the yachts. This is classic inflation, the evil nemesis of the Reserve Bank of Australia.

How does a central banker deal with the threat of inflation? Central bankers have many tools available to them, of which the most visible is the interest rate. In an effort to curb spending, a central banker often increases the cost of borrowing money. If you don’t have the cash or can’t afford the higher borrowing cost, you will have no boat to float and thus demand for yachts dwindles. Central bankers increase the cost of borrowing money by raising interest rates and raising the yield curve. This strategy also encourages saving, further reducing spending and alleviating inflationary pressures.

Raising the cost of money and enticing a higher savings rate is effective only within the local economy. A 10 per cent mortgage rate could indeed slow the housing boom and a 7 per cent savings account interest rate may be effective in changing the spending habits of Australian citizens. But the unintended consequence of the higher interest rate is foreign investment.

Global money flow is also affected greatly by interest rates. It’s not just China’s desperate need for clean coal, but the world’s desperate need for a high rate of return for a low-risk investment. Higher interest rates, relative to the interest rates of other mature economies, will create a carry trade.

Savvy investors, such as hedge funds, seek to borrow cheap money and invest it in a safe asset that offers a higher return. The higher the differential of low cost and high return, the greater the flow of money from around the world: the greater the flow of money into Australia, the higher the demand for the Australian dollar. The likely outcome of this scenario is a higher valuation for the currency. As a currency trader, you would want to be in a long position versus a weaker economy’s currency.

Microeconomics
This is all fine and dandy after the fact, but how does a trader enter at the beginning of this global money-flow trend? It comes down to fundamental analysis.

On a global scale, microeconomics is the study of a particular economy through trends in its economic reports. For example, when studying the United States and discerning the future value of the greenback, one should review reports that outline inflation, employment, housing, output, and so on. Within these economic reports, you should find trends and, more importantly, changes in trends.

For example, fundamental analysis shows there is no inflation in the American economy. As long as this stays true, central banking policy is not likely to change at the Federal Reserve Bank. However, the economic fundamentals will change in time and thus central banking policy will eventually change as well. The only question is when. If you get the timing correct, you will likely be rewarded for a great macroeconomic trade based on sound microeconomics.

In the United States the most important economic reports to watch are:

Manufacturing
• ISM
• Industrial production
• Capacity utilisation
• Durable goods
• Gross domestic product

Employment
• Weekly jobless claims
• Nonfarm payrolls
• Unemployment rate

Housing
• Building permits
• Housing starts
• New home sales
• Existing home sales
• Pending home sales
• Case Shiller index

Inflation
• Consumer price index
• Producer price index
• Personal consumption expenditures

Consumer
• Consumer confidence
• Personal income
• Personal spending
• Retail sales

An economist or quantitative analyst would study each report. The analyst would look for a trend or a change in trend in each. They would also look for a trend or change in trend in each subcategory, and attempt to combine each report to come to a general conclusion as to the health of the economy.

There are many questions one can ask. Do people have jobs? Do people feel confident in retaining their job? Are people spending money? Are factories in full production? Are inventories high or low? Is there inflation for factory owners? Will inflation be passed to consumers? Are consumers confident of the future? Will consumers make long-term investments, such as buying houses, vehicles, or stainless-steel refrigerators?

Much as a composer uses musical notation to create harmony and rhythm from various combinations of notes, an economist must make sense of the large sets of data to piece together the story of a local economy. A person who has a steady job is confident enough to make day-today and even frivolous purchases, thereby stimulating the economy.

Factories and businesses will work to fulfill and replenish the needed inventories. This in turn keeps the employees of these businesses confident in the future of their jobs. They too spend their money and a positive cycle is created. Over time, inflation is created and interest rates are raised to try to contain the inflation at sustainable levels.

It is a currency trader’s job to understand the cycle, to understand where in the cycle each economy around the world is, and to anticipate changes in the cycle. The economy is either expanding, contracting, or in a peak or valley between expansion and contraction. Expanding economies are often associated with appreciating currency values.

Contracting economies are often associated with depreciating currency values. The exceptions to these rules are safe-haven economies such as the United States, Japan, and Switzerland.

Safe-haven currencies
It’s important to understand these exceptions. When the world is facing a global financial meltdown and fear is the defining factor for investing, parking money in a safe place is highly attractive. Safe havens often offer little or no return on investment beyond peace of mind. However a calm mind is often better than a messy portfolio.

Safe havens include the treasuries of the first and second largest economies in the world. Traditionally they also include gold and the safety of Swiss bank accounts. Therefore gold, the US dollar, the Japanese yen, and the Swiss franc often appreciate, even in times when the economies of those countries are less than stable. It is important to note that this is true only when the rest of the world’s economies are in similar trouble.

For example, at the beginning of 2009 the nonfarm payrolls report showed terrible employment statistics in the United States. At that time the US economy was losing 600,000 jobs each month, but the US dollar was extremely solid. This paradox was created by the fact that foreign investors, facing similar dire straits, sought the safety of government-backed treasuries. To purchase these treasuries a foreigner first had to purchase the US dollar; thus its value appreciated, based on high global demand.

A few months later, the nonfarm payrolls employment report showed ‘less bad’ figures. This was the first sign that the worst was over and it was possibly an opportunity for foreign investors to cash out of their safe haven and return money to higher-return assets. This was evident as stock indices around the world began to recover and the value of the US dollar began to decline.

Even at the worst part of the global financial meltdown the USD was at its strongest. Then, as the US nonfarm payrolls report because ‘less bad’, the US dollar began to weaken against the Australian dollar. This clearly shows how investors were no longer seeking the safety of US Treasuries after the economic crisis had hit bottom, but preferred the expanding economy Down Under for its opportunities to make money… and later to provide a higher yield.

As you can see, even if safe-haven currencies offer a paradox, a sound understanding of global money flow gives investors insight into how currency valuations change based on demand for those currencies. Demand for a currency may be high during a flight to safety, as in the case of the Swiss franc, while the global economy is contracting. However, during an expanding global economy, the Australian dollar may be in high demand for its higher relative interest rates.

A savvy currency trader always has something to be bullish about.

Be it greed or fear, there is always an opportunity to make money if you understand global money flow. Study the microeconomic data for each major economy around the world and develop a global macroeconomic map for strong and weak economies. You will likely be able to plot the path of money… this is your opportunity to make money from foreign currency arbitrage.

Click here to watch a companion video about this topic.

Wayne McDonell is the Chief Currency Coach of FxBootcamp.com, a live forex training organisation. He is a member of the US National Futures Association and registered as a Commodities Trading Advisor. His book ‘Strategic and Tactical Forex Trading’ (Wiley Publishing) is a bestseller in the Foreign Exchange category of Amazon.com. To watch a companion video for this strategy, please visit www.fxbootcamp.com/yte/buylowsellhigh.

This article was originally published in the Nov/Dec 2010 issue of YourTradingEdge magazine. All rights reserved. © Copyright 2011, Your Media Edge Pty Ltd. 
To subscribe to YourTradingEdge magazine click here, or to purchase this issue as a single back issue, click here.