Analyzing Currencies

By Courtney Smith
Editor-in-Chief of Commodity Traders Consumer Reports
President and Chief Investment Officer of Pinnacle Capital Strategies, Inc.

As with all futures, the key to predicting the future price of a currency is the supply and demand. How can we determine the supply and demand for currencies?
The supply is actually relatively easy to figure out. We can simply look at the money supply.
There is some complication because we have so many different forms of money. Should we look at narrow money or broad money? I tend to look at both. Broad money supply is well correlated with the strength of the economy. I¹ll talk later why this is important.
To me, the critical supply-side consideration is the relative monetary policies of the two central banks. For example, if the Bank of Japan is running a tighter monetary policy than the Federal Reserve Bank of the US then, all other things equal, the yen should rally against the US dollar. This means that we need to figure out how to determine the relative monetary policies.
One indicator is the difference in growth in narrow money supply. Narrow money supply is under virtual control by central banks while broad money is only influenced by the central banks. If narrow money supply is growing slower in Japan than in the US, that suggests that monetary policy is tighter in Japan than in the US and that the yen should rally.
Another strong indicator of monetary policy is the shape of the yield curve. Short term interest rates are controlled by central banks but long term rates are not. I look at the relationship between short term interest rates and long term interest rates, called the yield curve, to give me a clue as to the tightness of monetary policy.
Generally, the higher the level of short term rates are to long term rates, the tighter the monetary policy. At the extreme, monetary policy is very tight if short term interest rates are higher than long term rates. Once again, the key is to look at the relative shapes to determine bullishness. For example, the US may have short term interest rates higher than long term rates, called a negative yield curve, but the European Central Bank may have an even steeper negative yield curve and we should therefore expect that the euro will gain on the dollar.
Measuring demand is little trickier and we have to resort to more subtle measures.
One popular misconception is that a large trade deficit is a sign that a currency is going to decline. The concept is that if a country is bringing in goods in exchange for its currency then there is a rising supply of that currency in the world and that increased supply will cause the currency to decline.
That may have been true in a world that took months to ship goods across a sea but it is no longer true today. In fact, the opposite is true. Take a look at the chart to see how a widening of the trade deficit has actually been associated with a strong US dollar and vice versa. Let me explain why.
Since World War II and particularly in the last 30 years, the movement of capital has completely overwhelmed the effect of trade in the setting of currency values. We now have capital movements every day that are greater than the total value of global trade for a whole year! Frankly, who cares about trade?
The key question to analyze trade flows is: where can I make the most money in the world today? As an investor I will look at the potential returns from investing in the country¹s stock market, bond market, and direct investments. In addition, I will factor in my outlook for the currency.
So the key to understanding the demand for a currency is to understand the investment environment for that country relative to the other country. In other words, is it better to invest in the US stock market or the Japanese stock market? Is the bond market in the US more attractive than the Japanese bond market? Should I make a direct investment in the US or Japan?
Another way to analyze this is to look at the difference in the economic strength between the two countries. I tend to look at industrial production rather than gross domestic product because it is more sensitive to international considerations and monetary policy. The broader measures of economic strength include services that are not strongly affected by changes in the currency.
In general, a strong investment environment will attract capital to a country and cause its currency to appreciate. I look at the relative trends of the stock and bond markets to give me an idea of which country has the better investment prospects.
Another consideration of the demand is the relative inflation rates between the two countries. Over the long run, the country with the higher inflation rate will have the weakest currency. If the inflation rate of Japan is 1% and it is 4% in the US, then we should expect to see the US dollar depreciate at a 3% rate, over the long run. Please note that I said the long run. In the short run, capital flows dominate the change in the price of a currency.
Still, I like to monitor the change in the inflation differential. I¹ve found that it is the change in the differential that has the most impact on the intermediate term direction of a currency. For example, if the differential between Japan and the US is 3% but moves to 2%, then that is bullish for the US dollar because the differential is less bearish. In effect, the market does not look at the absolute difference between inflation rates but to the changes in the pressure.
One of the problems with analyzing currency fundamentals is that the market can focus on just one or two o f the various factors I have been outlining at one time. The psychology of the market often gets fixated on one factor to the apparent exclusion of others. This means that you must be listening to the "talk" in the market to see what it is focusing on so you don¹t waste time on extraneous factors.
Analyzing currencies from a fundamental point of view can be subtle but the advantage is that currencies are like battleships, it takes a long time to change the fundamentals. As with all trading, the trend is your friend and, fortunately, the fundamental trends are long and strong.

Copyright 1999 by CTCR, Inc.
Courtney Smith is Editor-in-Chief of Commodity Traders Consumer Report and President and Chief Investment Officer of Pinnacle Capital Strategies and can be reached at (800) 832-6065, Box 7603 New York NY 10150-7603, courtney@investors.net, and ctcr.investors.net.