What’s the Story with Currency Markets and is the US all that different from China?

Matt and money

Matt loves to learn about money

Straight off, this article is about the markets and a big question I’ve been thinking about lately on the macroeconomic topic of currency rates. I am by no means an expert or any sort of whiz with finance or economics but it is something of a hobby to me and since we’ve been on the east coast, I’ve been faithfully reading Marketminder, a website run by my previous employer, Fisher Investments daily. (A small plug for the website: the website contains excellent editorial columns, research pieces, book reviews, and a daily review of worthwhile stories from third party sources.) I generally spend a half hour a day getting caught up on what’s going on in the world as it impacts financial markets and really enjoy it.

With the background and introductions aside, my current question has to do with what drives currency exchange rates on a macroeconomic level? The reason I’m puzzled by this is that my basic understanding is that it is, like stocks and bonds, driven by supply and demand. If there is a limited supply of a currency and people want to own one currency over another, this will drive the price up. We can play this out as we would with anything that can be traded looking at supply and demand.

The problem comes in for me as I’ve continued reading about the troubles with the Euro, sovereign debt issues, and the general lack of confidence in the European economy. There is a great deal to read about this topic and I’ve enjoyed it but what strikes me is that as of Friday’s close, the Euro is still considerably more valuable than the US Dollar (1 Euro=$1.34 USD). Why would this be? We could argue that the market views the US as more of a risk than the EU and the currency disparity stems from low demand for dollars. However, when the world markets were plummeting in 2008 and 2009, US bond prices soared as global investors sought the perceived safety of the US Government. If the US is the flight to security then, I find it hard to believe that the disparity is due to a lack of confidence in the US relative to the EU now.

It could be a supply issue. With all the quantitative easing done by the Federal Reserve, maybe there is a glut of supply of dollars while the Euro has lower supply pushing the price higher. If this is the case, it seems to me there must be a very small supply of Euros to have a 34% premium on the USD. In talking with a friend in the business, he said central bank interest rates play a big part. This makes sense to me as it impacts the supply and demand of a currency. If one country has a higher interest rate on borrowing money, it will deter people from borrowing that currency when they could borrow at a cheaper rate elsewhere. They could even borrow the cheap money and invest it in the currency or bond market of the higher yielding interest rate (I think this is the essence of the carry trade). Either way, if interest rates are playing a leading role in currency markets, why all the talk about China pegging their currency to the US dollar?

Typically, the Chinese are bashed for manipulating their currency by pegging it to the dollar. There is often political prattle about trying to force the Chinese to let it appreciate. There are some that think the pegging of the yuan to the dollar is actually beneficial to the US. However, most agree that it’s being done. If this is the case though and China is in fact manipulating their currency exchange rate, essentially to control supply and impact their imports vs. export markets, aren’t other countries – the US included, doing this as well?

I question this because in the case of China, the issue is them impacting the exchange rate of their currency by governmental actions. If the dollar is cheaper than the Euro because of the low rates from the Federal Reserve leading to a glut of supply, the Fed is clearly impacting the exchange rate of the USD. How is that different than what China is doing? We could say the same about the European Central Bank (ECB). They largely know the impact they’ll have on the currency based on what the set interest rate is for borrowing money.

In conclusion, are there really free currency markets? I recognize we can freely trade currencies, but are we essentially betting on government and central bank decisions or is there something else at play here that I’m missing? If it is in fact true that currency markets largely move on interest rates, than how is China really any different from any other country in this regard? The Fed knows the dollar will stay low if they set their target rate at under .25% for lending money, and that to me seems like currency manipulation.

I would love it if someone reading this had some insight and would be willing to shed some light on this subject. Feel free to email, call, or post a comment (contact info in About Us).

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