Wednesday, November 25, 2009

A Clarification

Dear Readers,

In my last posts I've mentioned US Dollar and its correlation with equities and commodities and the ongoing price action. Today, I received a phone call from a friend who did not want to put this issue in the coments section and so chose to directly ask me. Here is the conversation we had:

He: Do you really think dollar plays actual role in dollar based asset prices?
I : I did not write it anywhere, did I?
He: Your posts suggest as if US Dollar is driving the prices of assets like equities and commodities?
I : Well, it does, but, this correlation is not suggested in my posts.
He : So you mean it 'does exist' but not 'shown' in your posts?
I : Yes it does exist. But, we can not calculate or even guess the future direction of assets prices based solely on looking at US Dollar index.
Well, we need to understnad the US Dollar index first. before that, we need to look at currencies and how they are traded. A currency of nation A does not have a price unless it is put against that of some other nation, say B. So US Dollar in itself can be evaluated on comparing it with the currency of some other nation like UK. This doesn't give us complete information about USD as it may be strong there but week against Japanese Yen. So, there is the US Dollar index, which is actually an index of USD against a BASKET of currencies. Its actually five currencies against which it is meassured. These are following:
  1. Euro (EUR)
  2. Yen (JPY
  3. Cable (GBP)
  4. Loonie (CAD)
  5. Kronas (SEK)
  6. Francs (CHF)
What it means is we have an index which is meassured against only five currencies of the world. So, the US Dollar index can not give us actual data for this reason:

We may have all these six currencies going down and USD index may show stability. It may happen in times like today when every central banker wants a lower valued currency so that their country can stay afloat in crisis.

Then, we have also to take into account one important feature - carry trade. In currency trading, its not only the outlook of economy that matters. In fact, traders often find out a currency that has low interest rate and 'carry trade' with it with a currency that has high interest rate. For example, Japanese Yen (JPY) had been used as currency of carry trade because of Japanese Central Bank keeping interest rates near zero. What happens when traders chose a particular currency for carry trade is that currency keeps low against other currencies (against which it is traded, e.g., GBP/JPY). One of the reasons why US Dollar is for a good time losing its value is that most probably it has been started as a currency of carry trade, perhaps mostly for EURUSD pair (Euro / US Dollar). What is more important here is that traders use a heavy leverage in trading currencies - near 1:100. Some brokers offer even 1:400 leverage! So, the thing to consider here is the importance of any change in tide - a trader is subject to high risk if his position goes beyond the interest differential paid by the currncy pair. This can lead to overnight turnover in the direction of currency pair price. This all means one thing - US Dollar index can turn any side swiftly if there is a good enough catalyst.

This might be the reason why Gold is rising and making all time highs despite USD at 'only' 15 month lows. Otherwise, US Dollar index should also be at all time low if the correlation was that simple.

This should explain why the value of US Dollar index alone can't tell real picture and so, we must keep in mind that falling value of USD does mean bad for assets but we should not be limited to US Dollar Index. However, as we don't have better indicators, its better to use US Dollar index for our important decisions but only after we take into account many other things.

The other things we talked were not important to post here. I know many readers are well aware of the fundas behind US Dollar and currency trade in general, but I felt compelled to post these details for those dear readers who may be new to currency trading and might have been thinking like how this friend did.

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