NEWS / Foreign Exchange

Why You Need to Understand Forex

by Ed Ponsi

It's morning in Anytown, USA. People wake up and go to work, leaving behind a huge investment - a house, the value of which is measured in U.S. dollars. At the end of the week they receive a paycheck that is valued in U.S. dollars. They invest some of this capital in stocks and bonds, which are also valued in U.S. dollars. They study hard at school, they work hard at their jobs, and they save money - all in an effort to accumulate U.S. dollars. Yet despite all of this hard work, and despite all of the wealth accumulated, many of us don't 'feel' quite as wealthy as we had imagined. What is going on here?

You may have noticed that in the above scenario, every asset was measurable in terms of U.S. dollars. In the U.S., most of us are part of a single-currency culture, meaning that everything that we buy, sell, or own is valued in one currency. It is possible that a person who never leaves the U.S. could live their entire life without coming into contact with a currency other than the greenback. This is a very different situation from other parts of the world (such as Europe and Asia), where the use of multiple currencies is a part of everyday life. This was especially true in Europe prior to the emergence of a unified currency, the Euro.

Like it or not, the world is becoming a smaller place, and we all must live with the positive and negative ramifications of this. Advances in technology have improved the lives of millions - and also made all of us more vulnerable to terrorism. Political unrest in far away lands causes prices to rise at home. With increasing speed and escalating effect, events that occur abroad impact the quality of our lives at home. Those of us who choose to ignore this do so at our own peril.

Back to our friends in Anytown, USA; why are they still having trouble making ends meet? Their wealth is suffering because they have concentrated all of their assets in a single currency that is falling in value. They are struggling to accumulate assets that must rise in value just to offset the decline in the currency. Over the past five years, the U.S. dollar has fallen precipitously against most of the major currencies of the world (see Figure 1).

Figure 1: Since 2002, the U.S. dollar has fallen dramatically vs. the Canadian dollar. Source: Saxo Bank

On a recent trip to California, I spoke to John O'Donnell, OTA's Chief Knowledge Officer, who has a fascinating view of global economics. John explained that even if the U.S. stock markets were to reach a new high tomorrow, those markets are valued in a currency that has fallen dramatically, and therefore the so-called "new high" would be achieved in nominal terms only. If the true value of the indexes were measured in terms of "constant dollars", the numbers would prove to be much less impressive than they currently appear.

A friend of mine from Switzerland who trades the S&P futures recently asked me how he could protect himself from a decline in the U.S. currency. His main concern was that even if he traded profitably, his profits might erode because the S&P futures are valued in U.S. dollars. Since he holds most of his assets in Swiss Francs, weakness in the greenback would mean that the proceeds from his futures trades might seem impressive in terms of dollars, but would be negatively affected when he exchanges those dollars for Swiss Francs. These concerns are especially alarming when one considers the recent track record of the U.S. dollar vs. the Swiss Franc (see Figure 2).

Figure 2: The Swiss Franc has battered The U.S. dollar over the past five years. Source: Saxo Bank.

While we worked out a plan to protect my friend's capital, it occurred to me that other traders should protect themselves from weakness in the buck - especially traders who own real estate, a stock portfolio, and a retirement account that have 100% exposure to the USD. I'm not saying that the greenback is going to fall off of a cliff, but the currency does have some serious fundamental problems, and ignoring the danger will not make it go away. U.S. citizens can't disregard the possibility that a sharp decline in the greenback would affect the value of everything they have worked so hard to achieve.

How can the residents of Anytown, USA protect themselves from the dangers of a weak currency? The first step is to learn to understand Forex. The currency market is much more than just an alternative trading vehicle; it is a key to the accumulation and protection of wealth. A prudent investor wouldn't dream of keeping 100% of his retirement account in one stock. In a shrinking world where information is readily available and technology has made it easier to diversify one's holdings, why on earth would that same investor hold all of his wealth in one currency?

Question of the Week

Q) I have a sterling account at HSBC London from when I worked there. Is there any benefit in keeping a pound account open since, for Americans, they're not so easy to get?

Ed Ponsi) You could hedge against weakness in the U.S. dollar by holding some of your assets in British Pounds. First, check with your tax advisor to see if there are any negative ramifications. Most Americans are 100% long the USD, a currency that has serious fundamental issues and could fall sharply in the future. Why not hedge some of that risk by holding some of your wealth in currencies other than USD? The Pound has a solid recent track record, especially against the dollar (see Figure 3).

Figure 3: The British Pound flirts with multi-year highs vs. the U.S. dollar Source: Saxo Bank

More Thunder

Last week I wrote about the strong Australian Dollar (see "Thunder From Down Under"), as it continued its rampage against the greenback, the Japanese Yen (see Figure 4), and other world currencies.

Figure 4: Aussie bounces back to reach multi-year highs vs. Japanese Yen. Source: Saxo Bank

On April 2, 2007, a strong Retail Sales report catapulted the Aussie to new 10-year highs vs. the USD and JPY. This week will bring us a decision on interest rates from the Reserve Bank of Australia (RBA). Opinions are split on whether the RBA will raise interest rates to 6.50% or leave them at the current 6.25%. Traders will be focused on any comments coming from RBA officials immediately following the decision, as they look for clues to the central bank's next move. Australia has benefited from a run-up in commodities prices, because the country is a large producer and exporter of gold and other metals. Because of its strong relationship to commodities prices, the Aussie is referred to as a "commodity currency".

Have a question about Forex trading? Send an email to eponsi@tradingacademy.com and we'll use your question in an upcoming newsletter. Until next time, best of luck to you in trading.