Currency, Sovereign Debt, Aand Interest Rates Interplay Helping USD Gain

In the last few days, the interplay between sovereign debt ratings, interest rates, and exchange rate movements was in full display. First it was Dubai World that left lenders and stock financial market investors in a state of disbelief. This was followed by Greece earning the dubious distinction of first country in the European Union to earn a sovereign rating under A-. As if this didn't fill the investors' cup of woes, investors confidence was dented with Standard & Poor's putting Spain on a negative credit outlook.

Credit woes in Greece and Dubai damaged the euro and pound sterling but helped the U.S. dollar gain against these currencies. While the Bank of England's interest rate announcement was a non-event for the currency market, the pre-Budget report on Tuesday was not. The pound fell to its lowest level in almost two months against the U.S. dollar as the report focused attention on the health of the country's finances. In spite of heightened sensitivity to sovereign risk, Chancellor of the Exchequer Alistair Darling delivered a fiscally neutral package. The concerns over government debt have weighed on sterling, given the possibility that the UK may face a similar fate if it does not get its public finances in order. Analysts said the government had deemed it too early to begin an assault on the UK's budget deficit however, because of fears that deep spending cuts could choke off the anemic economic recovery.

Selected currencies — weekly results

Investors who follow the financial news will intermittently hear reference to the carry trade. This is a popular strategy where someone borrows money from a low interest-rate country and invests those funds in a high-interest rate country. Over a period, this should lead to adjustment in exchange rates. So, monitoring currency markets can give investors insight into investors' risk profile (aversion, neutral, and liking). Similarly, it can also show when investors want to reduce risk and are reversing this trade. More importantly, recent history suggests that when investors are willing to do the carry trade, they are also willing to take risk in equity markets not just interest rate markets. Therefore, monitoring the carry trade can provide helpful signals on equities too.

A look at the above table gives a display of these strategies being employed in currency markets. Year to date (YTD) Australia dollar (AUD) has gained over USD by 28.3% but over the December 11 ending week it registered a loss of 0.3%. Such currency play was also observed in AUD and Japanese yen (JPY). Japanese government has been pumping money into the markets through stimulus packages. An excess supply of liquidity because of these monetary stimulus gave an opportunity to traders to take money out of Japan and invest it in Australia. This caused the Australian dollar to strengthen against JPY. Another popular carry strategy this year has been to take money out of the United States and invest it in Brazil or in Europe. This has caused the Brazilian currency (the real) to increase in value and so has the euro. However, currency movements during the past few weeks suggest that investors may be turning more cautious and are reversing or lightening up on the carry trade. For example, the Australian dollar has recently declined in value relative to the Japanese yen. In addition, the Brazilian real has dipped slightly versus the U.S. dollar. On the other side of these trades, the U.S. dollar has turned up versus several currencies including the euro as well as the Brazilian real. A rally in the U.S. dollar is probably a signal that investors are turning more risk averse and are returning some funds to the safety of U.S. markets. The logic behind these trades is simple. When the global economy is getting stronger, the demand for resources that Australia produces tends to increase, boosting the Australian economy. This is bullish for global commodity prices, Australian equity prices and the value of the Australian currency. This has been a big factor boosting these markets much of this year. During the recession when investors turned negative on the global economy in 2008, commodity prices dropped sharply. This hurt the resource-based Australian economy, causing the Australian currency to decline in value along with many global stock markets. So was the case with USD. When global risk appetite increases USD weakens against currencies of those countries where risk appetite increases. When global risk appetite decreases USD strengthens against currencies of those countries where risk appetite decreases.