GEOPOLITICAL EVENTS

GEOPOLITICAL EVENTS
Like all markets, the currency market is affected by what is going on in the
world. Key political events around the world can have a big impact on a
country’s economy and on the value of its respective currency. Turmoil,
caused by labor strikes and terrorist attacks, as we have witnessed in this
new millennium, can cause short-term price shocks in the currency markets.
Terrorist attacks seem to have played more havoc on the energy markets
than on the currency markets in 2006, but we need to be aware of any
lasting economic impact these heinous acts have before we react by forming
an opinion and placing a trade. We have heard the term flight to safety,
indicating that traders are moving money from one country to another,
thereby causing shifts in currency values. These events need to be monitored
by forex traders as well.
Monetary and Fiscal Policy
When central banks act, it is called monetary policy. Other factors controlled
by government decisions are referred to as fiscal policy changes,
which are controlled by political concerns. Such changes can be linked to
a change in specific laws, the changing of the guard, so to speak, such as
how a new leader can and certainly does influence currency values. If a
new leader is voted into office and does not have the confidence to run a
country effectively, then we can see money leaving a country, which causes
a decline in value of that currency. Therefore, these two points are major
concerns for which forex traders should watch.
1. Economic conditions, including outlook on interest rates and inflation.
2. Fiscal policy changes and political leadership.
These factors have a long-term impact, which makes forex attractive to
trade due to the long-term trending conditions established by central bank
decisions based on these factors. Forex also offers investors some diversification,
necessary as protection against adverse movements in the equity
and bond markets.
Let’s go over what you and I will see on a day-to-day basis through reports
and news events and apply what is otherwise known as fundamental
analysis—the study of tangible information in order to anticipate supply
and demand flows. Several events can directly affect the outcome of supply.
For example, changes in interest rates from country A would make its
currency less valuable compared to the currency of country B where one
would receive a higher rate of return on money invested. This would cer-
The Business of Trading Money 39
tainly reduce the demand for country A’s currency. That is a prime example
of a supply/demand–driven event.
How about trying to decide or to anticipate if there is a change in the
strength or the weakness of an economy? This is where we really need to
pay close attention to specific reports. For starters, a report showing a
country’s employment rate might reveal what the potential for future
household disposable income is. It would give analysts and economists
an idea of how much spending could occur due to the number of people
working. Another aspect of fundamental analysis may be the ability to follow
and understand the political scene on both an international and a domestic
level.
If the European Central Bank meets and announces that it will raise interest
rates in a surprise move, this will have an immediate impact on the
value of the euro and, inversely, the U.S. dollar. If values of these currencies
shift abruptly and severely, then products that are imported and exported
would be priced differently. Ultimately, this could cause a ripple effect on
the prices of goods and services. It is important to understand and to interpret
what the potential outcome might be in the markets you are trading
when these special reports are released. For a fundamental trader not to
know what day or time a report is released could be hazardous to his financial
health. At the very least, even if you are a veteran trader or a beginner,
it cannot hurt to be aware of the main fundamental factors that
might affect the markets you are trading. You should be aware of what
could happen before most reports are released. That is why news services
put out what time current events and special reports are coming out. Publications
like Barron’s Weekly, Investor’s Business Daily, or the Wall Street
Journal will most likely show you what you will need to know to stay in
tune with the markets. Most forex dealers also provide special calendars
that include the date and times that most major economic and agricultural
reports are released. A calendar of events is also available free of charge at
www.fxtriggers.com. Trading is not an easy venture, and there is one bit of
advice that I wish you would follow: Be aware of the day’s current events if
you are in the markets. Knowing about a major report before it is released
is sometimes better only because you have a chance to eliminate a surprising
adverse market move. You could always make an adjustment to your
position before a report is released.
Another reason you want to follow the developments on the economy
is because it usually dictates how various equity markets and financial
products will perform. The stock market likes to see healthy economic
growth because that equates to better or substantially larger corporate
profits. The bond market prefers a slower sustainable growth rate that will
not lead to inflationary pressures. By watching and tracking economic data,
analysts and investors will be better able to stay in tune with the markets
and their investments. Moreover, foreign capital flows may increase if U.S.
40 FOREX CONQUERED
The Business of Trading Money 41
instruments are higher-yielding than those abroad. We want to track the
value of these instruments because that can give us a clue that there will be
a shift in currency values.
Understanding what fundamental events dictate the markets at a given
time may give you better insight to trade a currency based on the price direction
of these financial products. The terms yield maturity, rates, and
prices are all relevant in forex trading.
Playing the Carry-Trade Game
Each foreign currency has a central bank that issues an overnight lending
rate. This is a prime gauge of a currency’s value. In recent history, low interest
rates have resulted in the devaluation of a currency. Many analysts
assume this is a function of the carry-trade strategy, employed by many
hedge funds. This is a trade where one buys and holds currencies in a highyielding
interest rate market, such as the United States, and sells or borrows
money from a foreign country where the currency is in a low-yielding
interest rate market, such as exists in Japan. There is a significant risk exposure
to this investment, which requires large capital, or a highly leveraged
position from an exchange-rate fluctuation.
Understanding Treasuries: Yield and Price
When I discussed the inverted yield curve and pointed out the discrepancy
between the 10- and 2-year notes as shown in Figure 1.6, I wanted to further
explain how these instruments work and the relationship to forex. Let’s
first define what a Treasury bond is and how it works and is priced out.
U.S. Treasury bonds (T-bonds) are by all definitions a loan. Taxpayers are
the lenders. The U.S. government is the borrower. The government needs
money to operate and to fund the federal deficit, so it borrows money from
the public by issuing bonds.
When a bond is issued, its price is known as its “face value.” Once you
buy it, the government promises to pay you back on a particular day that is
known as the “maturity date.” They issue that instrument at a predetermined
rate of interest called the “coupon.” For instance, you might buy a
bond with a $1,000 face value, a 6 percent coupon, and a 10-year maturity.
You would collect interest payments totaling $60 in each of those 10 years.
When the decade was up, you’d get back your $1,000. If you buy a U.S.
Treasury bond and hold it until maturity, you will know exactly how much
you’re going to get back. That’s why bonds are also known as “fixed-income”
investments; they guarantee you a continuous income and are
backed by the U.S. government. There are also the concepts of yield and
price. That is what confuses most investors. It is very simple: When yield
goes up, price goes down; and vice versa.
Treasury Bonds, Bills, and Notes
The U.S. government issues several different kinds of bonds through the
Bureau of the Public Debt, an agency of the U.S. Department of the Treasury.
Treasury debt securities are classified according to their maturities:
• Treasury bills have maturities of 1 year or less.
• Treasury notes have maturities of 2 to 10 years.
• Treasury bonds have maturities greater than 10 years.
Since there are more equity traders in the investment world than there
are forex traders, this investment area may attract more participants. If the
equity markets are forecast to generate normal to even subnormal returns
based on a historical standard for 2006 and beyond, then the appetite for
making money may attract the individual investor to trade in the Treasury
and forex markets.