Sunday, May 19, 2013

How Capital Flows Impact Currency Movement

We live in a bizarro world today that differs greatly from the investment landscape of the 1970's and 1980's. Today, an increase in central bank printing (supply) can be met with a large rise in the currency strength (see Europe's recent movement). A large supply of new government debt can also be met with open arms (see the U.S. dollar's recent movement). In the long term, real fundamentals have the advantage, but in the short term, that is not always the case.

The currency of a country strengthens or weakens for one simple reason: there are more buyers of that currency than there are sellers. If more people are selling their yen in exchange for another form of currency such as the US dollar or the Euro (which has been occurring over the last 6 months), then you will see the value of the yen drop in the open market vs. the dollar.

This means that the dollar now buys more yen. It also means that the dollar now buys more goods that are manufactured in yen. Imagine that you make toy boats on the beaches of Japan. After you complete your toy boat you get on a real boat and travel across the sea to the United States to sell it to an American waiting to buy it on their shores.

If the Japanese yen is valued at par with the US dollar, meaning that 1 Japanese yen = 1 US dollar, then the boat costs $1 and the American can purchase 1 boat. What happens if the Japanese yen falls to 0.5 USD in the currency exchange market? The person in America converts their 1 American dollar into Japanese yen and they find that they now have 2 Japanese yen. They can now afford to purchase two boats when the seller arrives at the port.

This simple walk through is the foundation for what is taking place around the world today called "currency wars." Countries are in the process, in some cases completely open about it (see Japan), in devaluing their currency to boost their exports.

What causes a currency to be devalued?

The first and most simple to understand is an increase of the total units of that currency in existence  We know that if 10 people live on an island and there are 1,000 shells that they use as money and someone finds a secret location holding another 1,000 shells, the total value of each individual shell on the island will fall in value. Scarcity is a key component to value, not just in currencies, but in every good on the planet.

The second part is a bit more complex. When capital enters a country, it needs to find a home. As money pours in it will likely end up in the form of real estate, stocks, or bonds (looking for a "return" on the money). The largest liquid investment opportunity in a country is usually in government bonds. If an investor believes that the government is very likely to pay back the money they lend them and they are receiving a strong return (interest rate) then it becomes more attractive to buy bonds.

A Japanese citizen may take 100 yen and get back on a boat toward the shores of Australia. They arrive and go to the local Australian currency office to exchange their 100 yen for Australian dollars (the number of Australian dollars they receive is based on the exchange rate in the open market that day). They now take their Australian dollars and invest in Australian government bonds because they are a trust worthy government who provides a strong interest return.

This process lowers the value of the yen (yen is sold), raises the value of the Australian dollar (Aussie dollar is bought) and raises the price of Australian government bonds (bonds were bought).

This does not happen today with someone taking a boat to Australia. It occurs electronically, with trillions of dollars moving around the world at the speed of light.

So, what would reverse this process? If sentiment toward Australian government bonds were to fall, which could occur because investors lost faith in the government's ability to return their money in full or they expected the underlying currency that they purchased the bonds in to fall in value.

Then the process would reverse. Aussie government bonds would be sold, Australian dollars would be sold, and the yen would be purchased (or some other currency).

This is only a fraction of what is involved when looking at why a currency should fundamentally move up or down in value, but it is enough to provide a full discussion on how each currency's financial statement looks around the world.

Up Next: The Fundamentals Behind Currency Strength & Weakness

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