Currency Movements

Feb 5, 2014   //   by Profitly   //   Profitly  //  1 Comment

money-hand

There are so many people out there that want to learn to trade, but don’t want to take the time to do it. Learning to trade Forex is even more difficult, and the education behind it even more important. Currencies (aka Forex) typically see fast price movements, especially on days where economic data comes out such as the monthly jobs report. Here is a post first on Investopedia by Elvis Picardo about the risks of currency movements.

Devaluation and revaluation are official changes in the value of a nation’s currency in relation to other currencies. The terms are generally used to refer to officially sanctioned changes in a currency’s value under a fixed exchange rate regime. Thus, devaluation and revaluation are typically one-time events – although a series of such changes can occasionally occur – that are usually mandated by the government or central bank of a nation.

In contrast, changes in the levels of currencies that operate under a floating exchange rate system are known as currency depreciation and appreciation, and are triggered by market forces, such as the jobs report that I mentioned above. Puzzlingly, even though devaluation and revaluation are becoming less of an issue for the global economy since most major nations have adopted floating exchange rate systems, exchange rate moves continue to exert a very significant influence on the economic fortunes of most nations. Most notably, they have direct impacts on imports and exports. After reading this post, you’ll see why many argue that the head of the Federal Reserve Bank of the United States is the second most powerful person in the world, just behind the President.

This type of price movement was discussed frequently following the financial crises, as central banks around the world began programs to lower interest rates. An example of depreciation and appreciation of currencies would be the U.S. dollar going from a worth of 1.34 euros to 1.30 euros. In that case, the dollar saw depreciation while the euro saw appreciation.

But forget about deprecation and appreciation for a second, to begin understanding a fixed rate currency system, you first need to look at devaluation and revaluation. Devaluation refers to a downward adjustment in the official exchange rate of a currency, while revaluation refers to an upward adjustment in the exchange rate.

“In a fixed exchange rate system, a nation’s domestic currency is fixed to a single major currency such as the U.S. dollar or euro, or is pegged to a basket of currencies. The initial exchange rate is set at a certain level and may be allowed to fluctuate within a certain band, generally a fixed percentage either side of the base rate. The frequency of changes in the fixed exchange rate depends on the nation’s philosophy. Some nations hold the same rate for years, while others may adjust it occasionally to reflect economic fundamentals.”

If the actual exchange rate diverges significantly from the base rate and moves out of the permitted band, the central bank will interfere in order to bring it back in line with its targeted base rate.

“For example, assume a hypothetical currency called the Pseudo-dollar (PSD) is fixed to the U.S. dollar at a rate of 5 PSD per USD, with a permitted band of 2% on either side of the base rate, or 4.90 to 5.10. If the PSD appreciates (i.e. it trades below the bottom level of the permitted band) to say 4.88, the central bank will sell the domestic currency (PSD) and buy the foreign currency (USD) to which the domestic currency is fixed. Conversely, if the PSD depreciates and trades close to or above the 5.10 upper end of the permitted band, the central bank will buy the domestic currency (PSD) and sell the foreign currency (USD).”

So what are the causes of devaluation and revaluation? First, know that it is far more common to see a devaluation than a revaluation, but both occur because the exchange rate has been fixed at an artificially low or high level. This makes it increasingly difficult for the central bank to defend the fixed rate. A central bank must have sufficient foreign exchange reserves to be willing to buy all the offered amounts of its currency at the fixed exchange rate. If these Forex reserves are insufficient, the bank may have no option but to devalue the currency.

Examples are always helpful to me when trying to understand something, so take a look back at one of the most notable examples of currency devaluation: the British pound’s exit from the Exchange Rate Mechanism (ERM) in September 1992. The ERM was a predecessor to the creation of the euro, and was a system for tying the value of the pound and other currencies to that of the Deutsche mark, in order to get economic stability and low inflation. On September 16, 1992 – a day that was later dubbed “Black Wednesday” in the British press – the pound came under massive speculative attack as currency speculators deemed that the currency was trading at an artificially high level. In a bid to curb the speculative frenzy, the Bank of England took emergency measures such as authorizing the use of billions of pounds to defend the currency and raising interest rates from 10% to 12% to 15% during the day. These measures were to no avail, as the pound was forced out of the ERM, netting legendary hedge fund manager George Soros a $1-billion profit on his short pound position.

How does this impact the economy? Well, devaluation will often have an adverse effect on the economy initially, but it eventually should result in a substantial increase in exports and a associated shrinkage in the current account deficit. In the initial period after a devaluation, imports become much more expensive while exports stay stagnant, leading to a larger current account deficit.

In a number of cases, devaluation has also been accompanied by massive capital flight, as foreign investors pull their capital out of the country. This further exacerbates the economic impact of devaluation, as the closure of industries that were reliant on foreign capital increases unemployment and lowers economic growth, triggering a recession. The effects of the recession may be amplified by higher interest rates that were introduced to defend the domestic currency.

Revaluation does not have the same far-reaching effects as devaluation, since revaluation is generally precipitated by a rapid improvement – rather than deterioration – in economic fundamentals. Over time, a revaluation is likely to result in a nation’s current account surplus shrinking to some extent.

The potential portfolio impact: since currency devaluation is by far the more likely event, investors should be aware of the risks posed by devaluation.

Example: assume that you have 10% of your portfolio in bonds denominated in the Pseudo-dollars described earlier, with a current yield of 5%. Now if Pseudo-dollars undergo 20% devaluation, your net return from these bonds would be -15%, rather than +5%. As a result, the overall return on your portfolio would decrease by 1.5% (i.e. 10% portfolio weight X -15%).

But, let’s say that you have a total 40% of your portfolio in emerging market assets and these are afflicted by the contagion effect of the Pseudo-dollar devaluation. If these emerging market assets also decline 20%, your overall portfolio return would be down by a very substantial 8%. See how things can add up if you’re not paying attention to how you have your portfolio allocated?

So what should you watch for?

Make sure you stay informed about currency capers – one of the biggest currency issues confronting the global economy in recent years has been the artificial suppression of the Chinese yuan, which has helped China gain massive market share in global exports.

Limit your exposure to emerging markets that have deteriorating fundamentals – currency contagion is a real threat to your portfolio, so limit your exposure to emerging markets whose economic fundamentals are deteriorating. In particular, look out for nations with burgeoning current account deficits and high rates of inflation.

Consider the impact of currency moves on your overall portfolio returns – holding assets in a currency that is appreciating can boost your portfolio returns

Now you should understand more about the risks of currency devaluation, as it can be a hidden source of portfolio risk, especially if it results in a contagion effect.