impact on the price of currencies. In fundamental terms, a
company is valued on the basis of its balance sheet and current
or future income as well as intangible factors that will
affect that future income, including business model and plan,
management and leadership, competitive advantage, and
adherence to laws and regulations. External factors that affect
a company’s value include the valuation of the industry in
which it competes, the company’s rank or market share in that
industry, interest rates, and current or pending legislation that
will affect regulation of the industry. If a company’s products
or services are selling at a profit and are expected to continue
doing that and if other market conditions are favorable, that
company’s value, or stock, should go up. It is said that the
company is fundamentally sound in those circumstances, and
the market reflects that value. If sales slow, expenses are
higher than expected, or external factors affecting profitability
change in a negative direction, the stock price should go
down. If sales are steady and the company makes no appreciable
gains, the stock may go sideways.
Similar concepts apply to countries and geographic unions. In
very simplified terms, if the companies and citizens in a country
are producing more than they spend and taxes are sufficient to
cover expenses, increased income in the form of tax receipts flows
into government coffers. Because most businesses continually
seek to improve, there is increased competition for money, or
funding, as individuals and businesses borrow money to expand.
An increased rate of borrowing money leads to increases in interest
rates, which will attract capital from investors seeking a
higher yield for their savings and investments and thus cause an
increase in tax receipts. Job growth is healthy when businesses
are spending money to stay competitive. In a healthy worldwide
environment, the stronger an individual country’s economy is,
the more demand there is for stocks and other investments
denominated in that currency, the more pressure there is for
higher interest rates, and the stronger the currency is. Conversely,
the slower the economy is, the more pressure it puts on stock
prices as investors exit investments in search of higher yields and
on central bankers to lower interest rates, further decreasing the
return on investments valued in that country’s currency; in that
case, the country’s currency becomes weaker.
To generalize about the impact of a positive global business
climate, it can be said that higher interest rates mean a stronger
currency and that a weaker currency leads to lower interest
rates. The most direct link between interest rates and currency
values is the level of business activity. If business activity is
growing, there is room for higher interest rates created by
demand for more money and thus a stronger currency. If business
activity is contracting, higher interest rates are a threat to
commerce and interest rates may have to be lowered, with the
effect being a weaker currency.
In times of global economic uncertainty and recession, however,
traders and investors favor lower-yielding currencies
because governments and businesses in those countries will be
relatively less handicapped by lower borrowing costs (interest
rates) in a slowing economic environment. In summer 2008 we
saw a good example of this as global stock markets turned lower,
erasing the gains of the previous two years. Investors around the
world went from thinking about the return on their investments
to being concerned about the return of their investments. With
governments, businesses, and individuals all trying to exit their
previously higher-yielding investments at the same time, currencies
with higher-yielding interest rates fell sharply as money
poured out of the British, European, Canadian, Australian, and
New Zealand currencies and into the lower-yielding U.S. dollar
and Japanese yen. The sharp reevaluation of currencies in the
third and fourth quarters of 2008 also pointed out the fact that
the currency market is a self-correcting mechanism. What
strengthens a currency initially also can weaken it as interest
rates become too high and currency valuations become too
inflated relative to those of competing countries and unions.
Although Canadian citizens felt proud as their currency rose
from 0.60 to 0.80 against that of their U.S. neighbors, Canadian
businesspeople felt concern and then fear as the looney kept
on strengthening from 0.80 to 1.00 against, or on par with, the
U.S. currency. This 40 percent increase in the looney made it
very easy for American farmers and manufacturers to take
business from their Canadian counterparts because the cost of
American feed and products was so much lower compared
with the Canadian than it had been just three or four years earlier.
As business shifted away from Canada, the looney turned
and was sold off, and the Canadian government cut interest
rates accordingly. Like a pendulum that has swung too far, it
can be said that the weight of a stronger currency can cause its
value to swing lower. It is this characteristic of a free enterprise
system with floating currency values that ideally ensures that
the best products and services at the most competitive prices
are what will set economic standards going forward, not political
or nationalistic considerations.
Source: Mastering the Currency Market: Forex Strategies for High and Low Volatility Markets
