The Impact of Interest Rates on Currency Rates

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People usually carry credit cards or prepaid cards but still there is a dire need to stack up some cash in the wallet. In case the ATM is not working or In case there are some technical problems in accessing the respective card and so on, there are many unplanned things which may jeopardize the comforts and luxuries of your travel .

While exchanging the currency you may be lured by the signs like "Commission free exchange" which in many cases is nothing but a sweetener . You may well be manipulated in ways that may provide you with not so good rate. You can do two things, either you do not go to these agencies or if you go then ensure that you are well aware of the existing value of your currency in the concerned country which can help in negotiating. It is feasible to look for those companies that charge any commission as they may give you a rate that provide best value for the cash .

Many fundamental factors determine the supply and demand for a particular currency and its value against other currencies . Among these factors are interest rates. Central banks are the institutions that set the base rates in a country and change their levels to streamline the development of the local economy. Increasing the interest rate will result will in raising value of the nation’s currency while lowering interest rates should have the opposite effect, respectively .

Financial dictionaries describe currency depreciation as a process when a currency loses its value against another currency or basket of currencies. In such cases, more units of a local currency are needed to purchase the foreign currency i.e. if one British pound was able to purchase two U.S. dollars on a few years ago and now you receive 1.6 U.S. dollars for one British pound, then the pound has depreciated. Depreciation is a process driven by market forces and all fluctuations of currency rates reflect the present market conditions, forming the market value of a particular currency pair .

The currency depreciation can effect positively the overall economic development, though. It boosts competitiveness through lower export costs and secures more income from exported goods in a similar way devaluation does . On the contrary, depreciation makes imports more expensive and discourages purchases of imported goods stimulating demand for domestically manufactured goods. The governments worldwide influence appreciation and depreciation utilising the powerful tool of the base interest rates, which are usually set by the country's central bank and this tool is often used to intentionally depreciate the currency rates to encourage exports .

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Swiss franc (CHF) overvaluation

As of today's entry, it now takes a $1.05 USD to buy one Swiss franc, an amazing trajectory skyward for the Swiss franc where it was only back in year 2005 where it traded as low as 77 US cents for one CHF. If one looks at purchasing power parity, the charts show the Swiss franc as the world's most overvalued currency in the industrialized world now at 70 percent overvaluation to the US-dollar (USD). Beautiful Swiss scenery, the lure of Swiss chocolates, clocks and private banking may not be enough to prevent the CHF experience a modest currency correction in 2011.
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Currency Valuations as Suggested by Purchasing Power Parity

The concept of purchasing power parity (PPP) suggests that a country's exchange rate in relation to other countries' currency exchange valuations are in equilibrium when their actual purchasing power are the same in each of the two compared countries. Hence, the exchange rate between two countries in theory should equal the ratio of the two countries' price level for a fixed basket of products / goods & services.The Economist magazine (UK based) publishes a well known Burger Index comparing the price of a McDonald's Big Mac in various countries using the price of a United States made Big Mac as the base value. Recently, purchasing power parity has made some candid observations about currency valuations:

Switzerland's franc (CHF) is heavily overvalued in relation to the US dollar

The Chinese yuan renminbi is undervalued. If you happen to find yourself in China and hungry, a Chinese made Big Mac will be very affordable especially if you are traveling from Europe.

Currencies that appear to be significantly overvalued to the USD are Denmark, Norway, Sweden, Canada by upwards of 15 to 20% and Japan.

Undervalued currencies include Russia, many Asian countries such as the Philippines, South Korea, Hong Kong / China, Malaysia, etc. Surprisingly, countries like Poland, Mexico, Hungry and Turkey are other countries that PPP suggests that their currencies undervalued.

Commodity currencies such as Brazil, Australia, New Zealand, Canada appear to be headed for a correction. Our forecasts at BankIntroductions.com calls for a short term reversal in valuation for the USD as it has had a difficult three months with expected QE2 on the horizon this November 2010. In our view, it seems the market has already priced this in the USD currency valuation and the market may rally the USD on the actual day of event of quantitative easing round number two. It is the reverse to what logic suggests.

Sort of like buy on mystery, sell on the news!

The Euroland euro (EUR) at this time also looks a little frothy as they have significant economic challenges of their own including member countries Greece, Portugal and Spain experiencing economic headwinds. France is in the midst of labor revolt. This euro overvaluation is confirmed by PPP with a 20% overvaluation rating for EUR in relation to the USD.

Interesting times in the world of currencies. Our short term bet is to hold USD; gold bullion may have a correction of upwards of $200 USD an ounce over the next few months.

Happy speculating this Halloween season!

Euro Currency Zone to Downsize?

The Euroland euro common currency zone is experiencing growing pains. The value of the Euro currency (EUR) has declined from the 1.50 USD to 1 EUR level one year ago to hitting the 1.27 USD level last week. Why the decline?

Greece and its weak country sisters of Spain and Portugal are in the midst of a debt economic crisis. Spain itself remains in a depression with 20 percent unemployment.

And of course, the natural level of purchasing power parity suggesting a 1.20 USD to 1 EUR is the current natural trading level.

The idea of Germany bailing out and subsidizing the Greeks does not sit to well with many Germans. Many in Greece particularly in the public sector have generous benifits and lofty wages. A bail out is a short term band aid solution but it will not solve the problem. Greece's total debt load is exploding as its fiscal shortfall estimated at 14 percent of GDP. If a proposed bailout from Germany takes hold, Greece's total debt to GDP will rise upwards to 150 percent of GDP which is unsustainable.

The concept of the euro and a common currency makes sense if trade between one or more countries is extensive and if they have similar living standards and GDP per captia output. With Greece, they should never have been permitted entry into the euro zone in the first place. At least not now, perhaps in 20 years? Their economy is inefficient and not productive.

The choice for Greece is simple. Either roll back wages for public servants as they did in Latvia. That is, devalue the cost structure if they wish to remain in euro wage purchasing power parity while promoting tax and trade policies to boost foreign direct investment. The goal would be to increase national wealth via private sector investment. Or, the other option is to leave the euro zone and return the Greek drachma as national currency. The drachma will accordingly devalue in relation to the euro and public servants can be paid in local currency without a nominal pay cut.

Tough choices are ahead for Greece, Spain and Portugal. In our view, the euro will survive but not before growing pains are addressed. The EUR currency zone grew to quickly, too many countries too fast. The zone should downsize, stabilize and then gradually propel forward in the years ahead as new prospective member countries be in a stronger economic position for potential membership from the outset.

US BOND YIELDS RISING - USD TO APPRECIATE?

The market is finally catching up to reality with all this new US debt to be financed. As the Obama administration runs massive deficits in excess of 1.4 trillion USD, this shortfall has to be financed. During this 2nd week of April, the US Treasury has $168 billion of notes at auction, the bidders are likely going to wish for higher yields to compensate with the excess supply. As of April 5, 2010, the 10 year US Treasury note breached 4 percent, a first in 18 months. Yields on the 10 year are likely to hit 4.5 percent in the next few months.

How will this impact USD valuation? Rising yields even with excess money creation via debt (inflationary pressures) may see a repeat of the late 1970's where high inflation and high interest rates actually resulted in a USD bull market. Our currency consulting firm has forecasted a higher USD over the last few months and this has played out correctly. Our view is for continuing USD appreciation in the months ahead as US interest rates rise.

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Turbulent Times in the world of currencies

From South America to Asia to Europe, these are indeed turbulent times in the world of currencies. Venezuelan authorities revalued their currency to reflect the depreciating value of the bolivar. High inflation, lower oil prices, increased centralized state control of the economy along with continued high spending is maintaining downard pressure on Venezuela's currency.

In Asia, Vietnam recently devalued reflecting high domestic inflation.

During December 2009, North Korea crushes its citizens with a 100 to 1 revaluation of the brown won.

In Europe, yields for Greece sovereign bonds are rising. The collapsing bond market is now spreading to Spain and Portugal.

Will the bond market contagion spread globally?

Rising yields on America's massive fiscal shortfall are inevitable. But will happen to the USD?
Currencies at times trade illogical and this may happen again with the USD. Similar to the late 1970's at a time of high inflation and high interest rates, the USD was trading during a phase of a strong USD.

Moving ahead during 2010 - 2012, the USD may surpise many and enter a bull market with rising bond yields.

One must remember that the USD value must be compared to another asset for valuation. If other currencies find themselves in trouble in the next year or so such as pound sterling and the euro, the USD maybe the least ugly currency of the bunch.

Our call is for a stonger USD going forward even with gigantic fiscal shortfalls. The market will correct the deficits with higher interest rates and force the politicians to balance. It seems perfectly logical that if a government body can borrow at just under 4% for 30 year Treasury notes. It is like giving candy to a kid, of course the politicians will rack up massive deficits.

Expect higher interest rates, lower fiscal US shortfalls and a stronger USD going forward.

A US-dollar (USD) rebound around the corner?

The business media and pundits have all but declared the USD dead in the water. The question is, dead against what? When looking at currency valuations, a currency has to compared to another currency, usually in pairs.

Lets take a look at the USD and the Eurloand euro (EUR). In July 2008, it took 1.588 USD on average to buy one EUR. Today, it takes slightly less at 1.49 USD. The EUR itself may see significant short term headwinds in currency valuations as Greece, a signficant member within the Euro common currency zone is in serious economic difficulty. Greece's budget deficit is off the map, the economy is imploding and there is now talk of even Greece defaulting on its national debt. If Greece defaults, it will forced to leave the EUR and quite possibly return the drachma back to circulation within Greece as their new national currency. This currency event would be an economic earthquake in EUR trading valuations for several months. Accordingly, capital outflows out ot the Eurozone may see the USD benefit to a stronger exchange valuation. At present, the USD as measured by purchasing power parity is undervalued to the EUR by 20 percent, a valuation of 1.3 USD to 1 EUR is quite feasible by mid 2010.

The Japanese Yen has steadily increased in value to the USD since July 2008 from a valuation of 106 JPY to the USD to its current 89 JPY level. Much of the media talks about the US total debt ceiling approaching 90 to 100 percent of GDP depending on what figures you look at. But that is the general figure for the US debt at this time. Japan on the other hand has a national debt over twice as large as America's as measured as percentage of GDP. True, the majority of Japan's debt is held by domestic investors unlike the U.S., but Japan finds itself in a precarious position with other issues of significant concern. Their population is declining in numbers unlike the United States where the population base is growing. Japan's economy is not as diversified as America's. Further, Japan lacks the abundance of natural resources that America holds. With deflation still taking hold in Japan, it is a fair bet that the U.S. will likely see higher nominal interest rates down road before Japan. Don't be surprised to see an exchange valuation reversal in the near term with the USD breaking the 100 JPY level within 6 months. As measured by purchasing power parity, the USD is currently 25 percent undervalued to the Japanese yen.

Finally, lets look at gold. Gold is a great measure against all fiat currencies. Gold is due for a pullback currently holding at the 1150 USD per ounce level - a tremendous rally over the last year in USD gold valuation. However, it should be noted that gold like fiat currencies can trade illogical at times as well. Usually, gold and the USD trade inversely. When the USD falls, gold rises and vice versa. In the short term, it would not surprise us if we see both the USD and gold rising in value at the same time with gold approaching 1300 USD per ounce in 2010.

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