Forex and Interest Rates

If you follow my trading very long, you will know what great stress I put on interest rates, and their fluctuations as set by central banks around the world. Please do not mistake that as a love for central banking. The truth is, the Fed, since its' inception nearly 100 years ago, has done more to destroy the American Economy than liberal, socialistic programs and taxes combined.

Since 1913, the dollar has lost 95% of its purchasing power. All of that has been single handedly engineered by the Fed. Destruction of purchasing power means that more American dollars need to be used in order to buy the same amount of foreign goods. It also results in the transfer of American wealth to foreign economies. Ever wonder how the Chinese economy came to own America? Just look at the history of the Fed.

But be that as it may, we have to trade within the parameters of what we are given. At the present point in history, central banks govern the interest rate cycles. It is important for us to know how they affect the value of a currency.

Running contrary to the well known equity cycle where the Fed lowers rates and the stock market takes off headed higher, an interest rate cut affects a currency in an adverse manner. Here's why.

If the US has an interest rate at 5.25%, but the Eurozone has an interest rate of 4.0%, the best place for investors to park their money would be in the US; because they would receive a higher rate of interest from the T-bills. But if the US cuts its rate to say 5%, this adversely affects the dollar because it now has intrinsically less attraction. True it is still a full point higher than the Euro, but as interest rates travel in cycles, and a cut seldom occurs alone, an interest rate cut may cause a severe dollar weakness as currency traders may well forecast that future meetings will actually produce an interest rate lower than the European counterpart. Additionally, if the Eurozone was in an expansion mode while the US was contracting, rate increases in the euro, combined with rate cuts in the USD, whole produce a real change in affection. Now all the big money would be flooding into the Euro in anticipation of getting a better rate of return there.

Therefore, the pricing mechanism for a currency (as regarding interest rates) is exactly the opposite of what it is for stocks.

This also helps explain why trading in the forex has been so challenging in recent years. As interest rates have fallen to historically low levels, and have held there, trying to find a good currency is like trying to judge first place in an ugly contest.

But also this has produced the anomaly called risk aversion/risk appetite. In the absence of real rate fluctuations, and a real fear of a double dip recession world wide, items of news that should be good for the dollar, end up crushing it. But items that should be bad news for the dollar end up causing it to appreciate. Confused yet? You should be! Such is the affect of a central bank on the money of a nation. Everything gets turned on its head.

Basically, the US has operated for generations as the funding currency for all the worldwide economies. They produced stuff, and we bought it. When we couldn't afford it, we refinanced our houses, paid off our credit cards, and started over. But with the Great Depression II of 2008, this cycle came to an end. Lenders wouldn't lend. Borrowers couldn't borrow. The US no longer supplied money to purchase all the world's widgets. So as our economy crashed, everyone else's followed. Until the US recovers, there won't be any real recovery anywhere else.

Thus, bad news for the dollar, meant bad news for the world, and scared money flowed into the only place it felt safe; US Treasuries. This demand for US dollars increased the value of the dollar, even while the economy was in a tailspin. Thus, the US wins first place in the ugly contest: round one.

We are slowly attempting to emerge from this scared money mentality, but it is not easy. Nor will it happen over night, if it happens at all.

Until next time...Happy Trading!

Bill