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13 Unconventional Factors that Affect the Dollar

February 21st, 2008

By Adam Kritzer

The majority of forex traders, whether amateur or professional, can be expected to have some degree of familiarity with the fundamental factors which weigh on the Dollar. One can plainly understand, for example, how the threat of inflation and the twin deficits make the Dollar less valuable. In fact, currencytrading.net has already compiled a comprehensive list of such factors, entitled 50 Factors that Affect the Value of the US Dollar. However, many of these factors are common knowledge, and, thus, it can be difficult to gain a competitive advantage over other traders who have access to the same information. After all, when certain closely-watched economic indicators are released, the markets react almost instantaneously, making it difficult for the average retail investor to squeeze out a profit.

Thus, it is perhaps more valuable to temporarily ignore the most obvious factors (while maintaining a rolodex in the back of your mind), and instead focus on certain “unconventional factors.” In fact, there are many undercurrents flowing through forex markets, which only the savviest of traders are able to identify. Discerning these secondary factors represents the key to understanding forex, especially since many of these trends underlie the primary fundamental factors. For example, it is not enough to understand that the US twin deficits are rising or that interest rates are falling; rather, one must understand why they are moving in their respective directions. The following list is intended to provide the reader both with examples of such factors as well as with a framework for developing his own list of unconventional factors.

1. Institutional Investment Trends

Ultimately, what moves the forex market is supply and demand; in this regard forex is no different from any other securities market. In other words, while inflation and interest rates appear to drive the market, they are actually driving the decision-making processes of market participants, who, in turn, influence the supply and demand for specific currencies. In addition, the majority of the world’s currency is exchanged through the interbank market. This market consists of a few centralized exchanges located around the world, where financial institutions exchange large blocks of currency, usually in increments of $1 million or greater. Since retail investors exert little or no force on the $3 Trillion-per-day global forex market, it makes sense to focus our microscope on institutional investors, namely hedge funds. In fact, hedge funds have extended their tentacles into forex to such an extent that the Chicago Mercantile Exchange has decided to introduce a special electronic exchange, catering specifically to hedge funds.

The hedge funds which are most prominent in forex are so-called “Global Macro” funds and “Emerging Market” funds. Global macro funds scrutinize global economic fundamentals and allocate capital accordingly. In reality, most of these funds make predictions about the global interest rate climate: how interest rates will behave in relation to each other. Since currencies are often seen as proxies for interest rates, many global macro hedge funds are active participants in forex markets. Emerging market funds, in contrast, target the capital markets of developing economies. The stock markets of Thailand and Vietnam, for example, have surged over the last few years as hedge funds have piled in, driving their currencies higher as well. Sometimes, emerging market funds target currencies directly, in a play on inflation. For example, there are several countries which peg their currencies to the Dollar. These pegs are almost always inflationary, and hedge funds have taken notice, betting that these currencies will be forced into appreciating against the Dollar. Those who recall George Soros (via his eponymous hedge fund) famously “breaking the Bank of England” and forcing the Pound upward should appreciate this strategy.

2. Petrodollars

Due to recent geopolitical developments, it has become widely known that the buying and selling of petroleum around the world is conducted almost entirely in Dollars. Thus, every country must necessarily maintain a reserve of so-called “petrodollars” to be used for the purchase of petroleum. On the flip side, those countries that are net exporters of oil have found themselves with a surplus of Dollars, which they have piled into US assets. Estimates of combined Middle East foreign exchange reserves number as high as $1.6 Trillion. In fact, many analysts believe the Dollar’s status as the world’s reserve currency- despite its recent multi-year decline- can be largely attributed to the petrodollar phenomenon. By extension, the main threat to the Dollar is the possibility that oil contracts will one day be settled in another currency. Iran has already announced a plan to open up an oil bourse, in which oil will be sought and sold using Euros, although this plan has been hold for over one year.

3. Japanese Interest Rates

In addition to petrodollars, the ‘carry trade’ phenomenon should be extremely familiar to forex traders. The carry trade refers to the trading strategy in which one currency (the Japanese Yen) is borrowed at a low interest rate and sold in favor of a higher-yielding currency. Obviously, it is only because Japanese interest rates remain extremely low that the carry trade has been able to flourish. Countries with comparatively high interest rates, such as New Zealand and Australia, will continue to have trouble holding their currencies down for as long as Japanese interest rates remain low. Even the Dollar has remained steady against the Yen, despite the recent economic divergence between Japan and the United States.

Moreover, traders have speculated that it would require a rise of 200 basis points in Japanese interest rates for the carry trade to lose its appeal, an event which is extremely unlikely to occur by the end of 2007. Instead, a little bit of volatility in forex markets might go a long way in coaxing the currency upward. The Economist has drawn an analogy of the current situation to 1998, when Russia’s default on its sovereign debt made hedge funds nervous, and they quickly unwound carry positions they had been maintaining at the time. The result was a rapid appreciation in the Yen.

4. Chinese demand for raw materials

In another feature, we noted that China’s unending economic boom is one of the prime factors behind the global rise in commodity prices. From cement and steel to support construction projects, to oil and natural gas to power its cars and satisfy its hunger for energy, China’s raw material needs are massive. ‘What does this have to do with forex?’ you are probably wondering. The answer is simple: those countries with large reserves of natural resources have seen their economies boom and their currencies rise. The Canadian Dollar has already achieved parity against the US Dollar, and the Australian Dollar is not far behind. The Russian Rouble has also outperformed. Those who wish to understand the appreciation of these three currencies should look no further than record-high commodity prices, for which Chinese demand is largely responsible.

5. Investor/Consumer sentiment

The importance of investor and consumer sentiment in forex markets is connected with the notion that perception is reality. Amateur, investors often make the mistake of focusing all of their attention on coincident and lagging indicators , such as employment and GDP, when making investing decisions. Savvy investors, however, devote equal attention to leading indicators- of which market sentiment is one- which represent a proxy for future economic performance. For example, if investors/consumers indicate a pessimistic outlook, it is likely that future economic growth will be lower. As a result, investors will be more likely to shift capital away from the US, which would drag down the Dollar.

6. US Real Estate Prices

This factor is probably the most conventional on this list, especially given the current economic milieu, where business headlines are dominated by coverage of the US sub-prime mortgage crisis. The housing/construction sectors have historically only accounted for a modest portion of US economic growth. However, the period of easy money that followed the collapse of the tech bubble in the late 1990’s led to a rapid run-up in real estate prices. An exceptional tolerance for risk in the financial community enabled buyers that were barely credit worthy to take out mortgages at impossibly low interest rates. In addition, existing homeowners rushed to cash in on the rising value of their houses by refinancing their mortgages and taking out a home equity loan. As everyone knew, the party had to end at some point, and the collapse in confidence is now threatening to spread to other sectors of the economy, perhaps precipitating a recession.

7. IMF and World Bank

While the International Monetary Fund (IMF) and World Bank are certainly diminishing in importance, they continue to exert influence in the developing world. Both organizations can still potentially impact economic growth by lending money for development projects and helping in times of crisis. In some cases, they demand control over member countries’ economic policies in exchange for favorable loan terms. The IMF is now more visible in forex since it officially changed the way it monitors the foreign exchange policies of member nations. Previously, the IMF focused on the internal effects of exchange rate policies, by looking at how the country in question was either harmed or benefited from the policy. The IMF’s new mandate , in contrast, extends to the evaluation of these policies from an external standpoint: how these policies affect other countries. As a result, the IMF is now justified in advising against currency policies that engender global economic instability. Predictably, Iran, Egypt and China have all voiced disapproval of this policy change.

8. Fixed Exchange Rate Regimes

Wait, I thought we were only interested in currencies covered by floating exchange rate regimes? By definition, currencies that are pegged don’t fluctuate in accordance with market principles (if they fluctuate at all), so they’re probably not worth paying attention to, right? While there is certainly some validity to this mindset, these currencies areworth following because at the very least, they impact the currencies to which they are linked. The Chinese Yuan, for example, remains pegged to a basket of currencies, consisting predominantly of Dollars. In order to maintain this peg, China’s Central Bank has been forced to stockpile over $1 Trillion in foreign exchange reserves, also predominated in Dollar-denominated assets. Thus, China’s fixed exchange rate regime, via the buying of US assets, directly supports the Dollar. And of course there are dozens of other examples around the world.

9. Central Bank Intervention

This factor is counter-intuitively included on the list precisely because it does not influence forex. Many policymakers have accused Japan and Korea, for example, of holding down their currencies in pursuit of policies of export promotion. In fact, Korea has recently intervened in forex markets, while Japan has not. Yet, the Won has soared while the Japanese Yen has remained frozen in place. The point illustrated by this example is that Central Banks are rarely able to influence forex valuations despite concerted efforts to the contrary. Even the US is a veteran of forex intervention, having intervened on behalf of the Dollar twice during the Clinton administration. Both times, however, the Dollar was virtually unaffected. In short, when you hear currency traders or policymakers griping about Central Bank intervention, feel free to shake your head and chuckle a bit.

10. US Treasury Secretary

The list of the most influential people in forex would probably be a “who’s who” of politicians, central bankers, and hedge fund managers. However, would you believe that the US Treasury Secretary is just as important, if not moreso, when it comes to forex? The reason is that the Treasury Secretary represents the US in matters of currency, regardless of whether the currency in question is the Dollar or a foreign currency. Despite having only recently been appointed, the current Treasury Secretary, Hank Paulson, has been quite vocal about currency issues. He has criticized China and Japan for their weak currencies while maintaining that it is in the best interest of the US to have a strong Dollar.

11. Financial Derivatives

A derivative is a financial security which has no inherent value and instead derives its value from an underlying asset. Financial derivatives, which include forwards, futures, options, and swaps, have proliferated in every branch of global capital markets. In fact, many analysts insist that long term interest rates are now based more on swaps valuations than on government bonds. With regard to forex, derivatives reflect market expectations for future exchange rates. Previously the bastion of professional investors, these securities are now available to amateur investors, who can quote a 12-month RMB/USD futures contract to see what exchange rate investors are willing to accept for delivery of RMB (Chinese Yuan) 12 months from now. With regard to options, traders can look at implied volatility , which can be induced from the price of the option based on the strike price, current exchange rate and time to maturity. Implied volatility offers an instant snapshot of how much investors believe a currency will fluctuate over the term of the option.

12. Composition of the EU

The composition of the European Union (“EU”) certainly has a bearing on the value of the Euro. As of October 2007, the EU had 27 members, and is currently in talks to add 3 more. When a new country adopts the Euro, its effect on the collective EU economy can be labeled either “accretive” or “dilutive.” When a country’s economic growth is higher than the EU average and/or its rate of inflation is lower, its effect on the EU average is said to be accretive. The opposite set of circumstances will have a dilutive effect. You may be familiar with this concept in the context of public company mergers, where analysts use similar language to evaluate the effect of the acquired company’s relative profitability on the acquiring company’s stock price.

13. Rating Agencies

You are probably wondering how rating agencies (S&P, Moody’s, Fitch) can influence forex, since after all, they don’t issue ratings on specific currencies. They do however, issue ratings for government bonds and a mix of other public/private securities. In theory, these ratings should merely serve to reinforce investor opinion since both investors and rating agencies have access to the same information. In practice, however, a great deal of stock is placed on a security’s credit rating, and securities with the same ratings tend to trade at similar valuations. When Iceland’s sovereign debt was downgraded last year, its currency instantly dropped over 10%. In addition, it was not until collateralized debt obligations tied to US subprime mortgages were downgraded that economists and investors really began to take scope of the US real estate crisis, which now threatens to spread to the rest of the economy and drag down the Dollar.

In conclusion, there are numerous factors in forex that escape the attention of the mainstream business media. Even when such factors do receive coverage, the link to forex isn’t clear. This list is in no way exhaustive; while its stated purpose was to bring to the surface a few unconventional forex factors, its broader purpose was to provide insight into a new framework for looking at what drives currencies. Ultimately, the main point is to encourage you to shift your attention to secondary and tertiary factors, which underlie the primary factors of inflation and interest rates, which in turn, drive currencies.

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