currency markets. Many in the currency industry refer to this as “capital flow,”
the phenomenon of money flowing out of one country and into another. This flow
of capital leaves a trail, and traders who want to gain clues as to which currencies will
take off next—and which ones are set to sink—will simply “follow the money.”
Capital flow is simply another way of looking at supply and demand. If many people
want one item, the price of that item rises, but in the currency world this concept goes
much deeper. Since there are two currencies involved in every Forex transaction, we are
searching for situations where investors will sell one currency and purchase another in
order to obtain something specific.
That specific item could be shares of a hot stock, or a quantity of precious metal, or
a prized parcel of real estate, or even a government bond. We’re searching for anything
that has a strong enough attraction to capital that it can create a flow of money out of one
country and into another. If the money is merely being redistributed within the borders
of one country, this will not be sufficient to move the currency markets.
HOT STOCKS
Here’s an example. Back in the late 1990s, the U.S. stock markets were on fire—especially
tech stocks. In fact, for the year 1999, the NASDAQ composite index gained more than
85 percent! According to the New York Times, in the year 1999 the NASDAQ experienced
the largest calendar year gain ever for any broad U.S. equity index.
Other equity indexes around the world scaled new heights as well, and many believed
the rise of U.S. technology companies like Cisco Systems, Intel, Microsoft, and
others heralded the dawning of a new age. Something special was happening in the
United States, and investors around the world wanted a piece of the action. But how
would overseas traders participate in the great U.S. tech bull? What would they have to
do in order to own a piece of the hottest stock market in the world?
SMALL SCALE
To understand the “hot market” phenomenon, let’s look at an example. Suppose a person
lives in Switzerland and wants to buy hypothetical tech stock ABCD that trades only on
the NASDAQ in the United States. Since ABCD is priced in U.S. dollars, he is going to
need greenbacks to purchase the shares. So, he withdraws some Swiss francs from the
bank, exchanges the francs for U.S. dollars, and then opens his U.S. stock trading account
and purchases the shares.
In order to facilitate the stock transaction, the trader sold CHF and purchased USD.
His actions alone will not move either currency, but what if traders all over Switzerland
have the same idea at about the same time? The result would be a stream of capital
pouring out of Switzerland and into the United States to purchase stock ABCD.
The “hot market” phenomenon was in full effect in 1999 as capital flowed into the
United States from around the world to participate in the tech rally. Although there were
many other factors at work that year, the U.S. dollar did have a very good year vs. the
Swiss franc in 1999.
LARGE SCALE
Now consider that investors all around the world want to participate in the tech rally
and own stock ABCD; those traders are going to pull money out of various countries,
exchange their currencies for U.S. dollars, and purchase shares of stock. Imagine that
you are a hedge fund manager investing in various markets around the world; if you
believe there is a superior opportunity out there, you are going to sell shares from one
market and move that money to another market.
So, if I believe that Latin American stocks represent the greatest opportunity in the
equities markets, and at the same time I am less enamored with my holdings in, say,
Europe, I might sell my European stocks. In return for those shares, I will receive euros,
and then perhaps I’ll exchange those euros for another currency. Perhaps I’ll exchange
my euros for Brazilian real so that I can invest in the Bovespa—the largest equity market
in Latin America.
If just one fund manager is taking this action, the results will be inconsequential,
but if many fund managers start taking the same trade simultaneously (as they often
do), the result is going to be a flow of capital out of Europe and into Brazil. Under such
circumstances, one would not be surprised to see the Brazilian real begin to climb against
the euro.
HOT COMMODITIES
We can see how a hot stock market can influence exchange rates, and the same can be
said about a variety of markets. For example, if commodities prices are rising, countries
that produce these commodities could experience an inflow of capital.
For example, Canada and Australia are big commodities producers; Australia is the
world’s fourth biggest producer of gold, while Canada is the seventh biggest (Canada also
exports a significant amount of oil, while Australia does not). If the price of gold suddenly
takes off, people around the world will need to send more capital to these countries to
purchase the same amount of gold. The rising price of gold (and rising metals prices in
general) creates buying pressure for the Australian dollar and the Canadian dollar.
Because many commodities are priced in USD, there is a magnified effect at work
here; gold and the USD move in opposite directions most of the time, so the effect of
rising metals prices on commodity currencies is magnified when we measure those currencies
vs. the U.S. dollar.
HOT REAL ESTATE
We’ve examined the effect of rising stock prices and of rising commodities prices on
currencies, but the cause of a capital flow can be something less obvious. For example,
what if real estate investors in Great Britain determined that they just had to own
Japanese real estate?
Perhaps they felt that those Japanese properties were undervalued and due for a
big rise in value. They might sell shopping malls in Great Britain and exchange those
British pounds for Japanese yen, so that they could purchase apartment buildings in
Tokyo. If this occurred on a large scale, the result would be a flow of capital out of Great
Britain and into Japan, and the effect of this could influence the exchange rate of the
GBP/JPY pair.
Source:The Ed Ponsi Forex Playbook: Strategies and Trade Set-Ups
