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Lesson 3

Factors Affecting Major Currencies

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Federal Reserve Bank (Fed): The US central bank has full independence in setting monetary policy to achieve maximum non-inflationary growth. The Fed’s chief policy signals are: open market operations, the Discount Rate and the Fed Funds rate.

Federal Open Market Committee (FOMC): The FOMC is responsible for making decisions on US monetary policy, including the crucial interest rate announcements made eight times a year. The 12-member committee consists of a 7-member of the Board of Governors, the president of the Federal Reserve Bank of New York, with the remaining four seats carrying a one-year term each, in a rotating selection of the presidents of the remaining 11 Federal Reserve Banks.

Interest Rates: The Fed Funds Rate is clearly the most important interest rate. It is the rate that depositary institutions charge each other for overnight loans. The Fed announces changes in the Fed Funds Rate when it wishes to send clear monetary policy signals. These announcements normally have a large impact on all stock, bond and currency markets.

Discount Rate: The interest rate at which the Fed charges commercial banks for emergency liquidity purposes. Although this is more of a symbolic rate, changes in it imply clear policy signals. The Discount Rate is almost always lower than the Fed Funds Rate.

30-year Treasury Bond: The 30-year US Treasury Bond is also known as the long bond, or bellwether treasury. It is the most important indicator of markets’ expectations on inflation. Investors most often use the yield (rather than the price) when investing in this bond. As with all bonds, the yield on the 30-year Treasury Bond is inversely related to its price. There is no clear-cut relationship between the long bond and the US dollar; but the following usually holds true: A fall in the value of the bond (a rise in the yield) due to inflationary concerns may put pressure on the dollar. These concerns could arise from strong economic data.

Nevertheless, as the supply of 30-year bonds began to shrink following the US Treasury’s refunding operations (buying back its debt), the 30-year bond’s role as a benchmark had gradually given way to its 10-year counterpart. Depending on the stage of the economic cycle, strong economic data could have varying impacts on the dollar. In an environment where inflation is not a threat, strong economic data may boost the dollar. But at times when the threat of inflation (higher interest rates) is most urgent, strong data normally hurts the dollar because of the resulting sell-off in bonds.

Being a benchmark asset-class, the long bond is normally impacted by the shifting capital flows which are triggered by global considerations. Financial/political turmoil in emerging markets could be a possible booster for US Treasuries due to their safe character, thereby helping the dollar too.

3-month Eurodollar Deposits: USD-denominated deposits at banks outside the US are called Eurodollar deposits. The interest rate on 3-month dollar-denominated deposits held in banks outside the US is known as Eurodollar rate. It serves as a valuable benchmark when there are interest rate differentials and also they help determine exchange rates. To illustrate the USD/JPY as a theoretical example: the greater the interest rate differential in favour of the Eurodollar versus the Euroyen deposit, the more likely the USD/JPY is to receive a boost. Sometimes this relation does not hold true due to the influence of other factors.

10-year Treasury Note: The FX market usually refers to the 10-year note when comparing its yield with that of similar bonds: German 10-year bund), Japan’s 10-year JGB and the UK’s 10-year Gilt. The spread differential (the difference in yields) between the yield on 10-year US Treasury Notes and that on non-US bonds impacts the exchange rate. A higher US yield usually benefits the US dollar against foreign currencies.

US Treasury: The US Treasury is responsible for issuing government debt and making decisions on the fiscal budget. The US Treasury has no impact on monetary policy, but its statements regarding the dollar have a major influence on the currency.

Economic Data: The most important economic data items in the US are: Labor reports (payrolls, unemployment rate, and average hourly earnings), CPI, PPI, GDP, international trade, ECI, NAPM, productivity, industrial production, housing starts, housing permits, and consumer confidence.

Stock Market: The three major stock indices are the Dow Jones Industrials Average (Dow), S&P 500, and NASDAQ. The Dow is the index that is most likely to influence the dollar. Since the mid-1990s, the index has shown a strong positive correlation with the greenback, as foreign investors start purchasing US equities. Three major forces affect the Dow: 1) Corporate earnings, forecast and actual; 2) Interest rate expectations; and 3) Global considerations. Consequently, these factors affect the dollar.

Cross Rate Effect: The dollar’s value against another currency is sometimes influenced by another currency pair (exchange rate) that does not include the dollar. For instance, a sharp rise in the yen against the euro (falling EUR/JPY) could cause a decline in the еuro, including a fall in the EUR/USD.

Fed Funds Rate Futures Contract: This futures contract gives investors the ability to speculate on what the Fed’s interest rate might be. The contract’s value shows what the Fed Funds Interest Rate (overnight rate) is expected to be in the future, depending on the contract maturity. Hence, the contract is a valuable indicator of market expectations and the Fed’s policy. The rate is determined by subtracting the contract’s value from 100.

3-month Eurodollar Futures Contract: Similar to the Fed Funds Rate futures contract, the 3-month Eurodollar futures contract reflects the Eurodollar rate. For instance, the difference between the futures contracts on the 3-month Eurodollar and Euroyen deposits is an essential variable in determining USD/JPY expectations.


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