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Foreign Exchange-the Fastest-growing Market Of Our Time. Effects Of Currencies On Stocks And Bonds
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The foreign exchange market is the generic term for the worldwide institutions that exist to exchange or trade currencies. Foreign exchange is often referred to as “forex” or “FX.” The foreign exchange market is an over-the-counter (OTC) market, which means that there is no central exchange and clearinghouse where orders are matched. FX dealers and market makers around the world are linked to each other around the clock via telephone, computer, and fax, creating one cohesive market.

Over the past few years, currencies have become one of the most popular products to trade. No other market can claim a 57 percent surge in volume over a three-year time frame. According to the Triennial Central Bank Survey of the foreign exchange market conducted by the Bank for International Settlements and published in September 2004, daily trading volume hit a record of $1.9 trillion, up from $1.2 trillion (or $1.4 trillion at constant exchange rates) in 2001. This is estimated to be approximately 20 times larger than the daily trading volume of the New York Stock Exchange and the Nasdaq combined. Although there are many reasons that can be used to explain this surge in activity, one of the most interesting is that the timing of the surge in volume coincides fairly well with the emergence of online currency trading for the individual investor.

EFFECTS OF CURRENCIES ON STOCKS AND BONDS

It is not the advent of online currency trading alone that has helped to increase the overall market's volume. With the volatility in the currency markets over the past few years, many traders are also becoming more aware of the fact that currency movements also impact the stock and bond markets. Therefore, if stocks, bonds, and commodities traders want to make more educated trading decisions, it is important for them to follow the cur­rency markets as well. The following are some of the examples of how cur­rency movements impacted stock and bond market movements in the past.

EUR/USD and Corporate Profitability

For stock market traders, particularly those who invest in European cor­porations that export a tremendous amount of goods to the United States , monitoring exchange rates are essential to predicting earnings and corpo­rate profitability. Throughout 2003 and 2004, European manufacturers complained extensively about the rapid rise in the euro and the weakness in the U.S. dollar. The main culprit for the dollar's sell-off at the time was the country's rapidly growing trade and budget deficits. This caused the EUR/USD (euro-to-dollar) exchange rate to surge, which took a significant toll on the profitability of European corporations because a higher exchange rate makes the goods of European exporters more expensive to U.S. consumers. In 2003, inadequate hedging shaved approximately 1 billion euros from Volkswagen's profits, while Dutch State Mines (DSM), a chemicals group, warned that a 1 percent move in the EUR/USD rate would reduce profits by between 7 million and 11 million euros. Unfortu­nately, inadequate hedging is still a reality in Europe , which makes moni­toring the EUR/USD exchange rate even more important in forecasting the earnings and profitability of European exporters.

Nikkei and U.S. Dollar

Traders exposed to Japanese equities also need to be aware of the develop­ments that are occurring in the U.S. dollar and how they affect the Nikkei rally. Japan has recently come out of 10 years of stagnation. During this time, U.S. mutual funds and hedge funds were grossly underweight Japan­ese equities. When the economy began to rebound, these funds rushed in to make changes to their portfolios for fear of missing a great opportunity to take advantage of Japan 's recovery. Hedge funds borrowed a lot of dol­lars in order to pay for increased exposure, but the problem was that their borrowings are very sensitive to U.S. interest rates and the Federal Re-serve's monetary policy tightening cycle. Increased borrowing costs for the dollar could derail the Nikkei's rally because higher rates will raise the dollar's financing costs. Yet with the huge current account deficit, the Fed might need to continue raising rates to increase the attractiveness of dol­lar-denominated assets. Therefore, continual rate hikes coupled with slow­ing growth in Japan may make it less profitable for funds to be overlever­aged and overly exposed to Japanese stocks. As a result, how the U.S. dollar moves also plays a role in the future direction of the Nikkei.

George Soros

In terms of bonds, one of the most talked-about men in the history of the FX markets is George Soros. He is notorious for being “the man who broke the Bank of England.” This is covered in more detail in our history section (Chapter 2), but in a nutshell, in 1990 the U.K. decided to join the Exchange Rate Mechanism (ERM) of the European Monetary System in order to take part in the low-inflationary yet stable economy generated by the Germany's central bank, which is also known as the Bundesbank. This alliance tied the pound to the deutsche mark, which meant that the U.K. was subject to the monetary policies enforced by the Bundesbank. In the early 1990s, Germany aggressively increased interest rates to avoid the in­flationary effects related to German reunification. However, national pride and the commitment of fixing exchange rates within the ERM prevented the U.K. from devaluing the pound. On Wednesday, September 16, 1992 , also known as Black Wednesday, George Soros leveraged the entire value of his fund ($1 billion) and sold $10 billion worth of pounds to bet against the Exchange Rate Mechanism. This essentially “broke” the Bank of Eng­land and forced the devaluation of its currency. In a matter of 24 hours, the British pound fell approximately 5 percent or 5,000 pips. The Bank of England promised to raise rates in order to tempt speculators to buy pounds. As a result, the bond markets also experienced tremendous volatility, with the one-month U.K. London Interbank Offered Rate (LI­BOR) increasing 1 percent and then retracing the gain over the next 24 hours. If bond traders were completely oblivious to what was going on in the currency markets, they probably would have found themselves dumb­struck in the face of such a rapid gyration in yields.

Chinese Yuan Revaluation and Bonds

For U.S. government bond traders, there has also been a brewing issue that has made it imperative to learn to monitor the developments in the currency markets. Over the past few years, there has been a lot of speculation about the possible revaluation of the Chinese yuan. Despite strong economic growth and a trade surplus with many countries, China has artificially maintained its currency within a tight trading band in order to ensure the continuation of rapid growth and modernization. This has caused extreme opposition from manufacturers and government officials from countries around the world, including the United States and Japan . It is estimated that China 's fixed exchange rate regime has artificially kept the yuan 15 percent to 40 percent below its true value. In order to maintain a weak currency and keep the exchange rate within a tight band, the Chinese government has to sell the yuan and buy U.S. dollars each time its currency appreciates above the band's upper limit. China then uses these dollars to purchase U.S. Treasuries. This practice has earned China the status of being the world's second largest holder of U.S. Treasuries. Its demand has kept U.S. interest rates at historical lows. Even though China has made some changes to their currency regime, since then, the overall revaluation was modest, which means more is set to come. More revaluation spells trouble for the U.S. bond market, since it means that a big buyer may be pulling away. An announcement of this sort could send yields soaring and prices tumbling. Therefore, in order for bond traders to effectively manage risk, it is also important for them to follow the developments in the currency markets so that a shock of this type does not catch them by surprise.

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