Fundamentals Affecting the U.S. Dollar

by Martin Chandra - Date: 2006-12-08 - Word Count: 1052 Share This!

Fundamental analysis refers to the study of the core underlying elements that influence the economy of a particular entity. It is a method of study that attempts to predict price action and market trends by analyzing economic indicators, government policy and societal factors (to name just a few elements) within a business cycle framework.

If you think of the financial markets as a big clock, the fundamentals are the gears and springs that move the hands around the face. Anyone walking down the street can look at this clock and tell you what time it is now, but the fundamentalist can tell you how it came to be this time and more importantly, what time (or more precisely, what price) it will be in the future.

Interest Rates: Fed Funds Rate: Clearly the most important interest rate. It is the rate that depositary institutions charge each other for overnight loans. The Fed announces changes in the Fed Funds rate when it wishes to send clear monetary policy signals. These announcements normally have large impact on all stock, bond and currency markets.

Discount Rate: The interest rate at which the Fed charges commercial banks for emergency liquidity purposes. Although this is more of a symbolic rate, changes in it imply clear policy signals. The Discount Rate is almost always less than the Fed Funds Rate.

30-year Treasury Bond: The 30-year US Treasury Bond, also known as the long bond, or bellwether treasury. It is the most important indicator of markets' expectations on inflation. Markets most commonly use the yield (rather than price) when referring to the level of the bond. As in all bonds, the yield on the 30-year treasury is inversely related to the price. There is no clear-cut relation between the long bond and the US dollar. But the following relation usually holds: A fall in the value of the bond (rise in the yield) due to inflationary concerns may pressure the dollar. These concerns could arise from strong economic data.

Depending on the stage of the economic cycle, strong economic data could have varying impacts on the dollar. In an environment where inflation is not a threat, strong economic data may boost the dollar. But at times when the threat of inflation (higher interest rates) is most urgent, strong data normally hurt the dollar, by means of the resulting sell-off in bonds.

Nonetheless, as the supply of 30-year bonds began to shrink following the US Treasury's refunding operations (buy back its debt), the 30-year bond's role as a benchmark had gradually given way to its 10-year counterpart.

Being a benchmark asset-class, the long bond is normally impacted by shifting capital flows triggered by global considerations. Financial/political turmoil in emerging markets could be a possible booster for US treasuries due to their safe nature, thereby, helping the dollar.

3-month Eurodollar Deposits: The interest rate on 3-month dollar-denominated deposits held in banks outside the US. It serves as a valuable benchmark for determining interest rate differentials to help estimate exchange rates. To illustrate USD/JPY as a theoretical example, the greater the interest rate differential in favor of the eurodollar against the euroyen deposit, the more likely USD/JPY will receive a boost. Sometimes, this relation does not hold due to the confluence of other factors.

10-year Treasury Note: Forex markets usually refer to the 10-year note when comparing its yield with that on similar bonds overseas, namely the Euro (German 10-year bund), Japan (10-year JGB) and the UK (10-year gilt). The spread differential (difference in yields) between the yield on 10-year US Treasury note and that on non US bonds, impacts the exchange rate. A higher US yield usually benefits the US dollar against foreign currencies.

Federal Reserve Bank (Fed): The U.S Central Bank has full independence in setting monetary policy to achieve maximum non-inflationary growth. The Fed's chief policy signals are: open market operations, the Discount Rate and the Fed Funds rate.

Federal Open Market Committee (FOMC): The FOMC is responsible for making decisions on monetary policy, including the crucial interest rate announcements it makes 8 times a year. The 12-member committee is made up of 7 members of the Board of Governors; the president of the Federal Reserve Bank of New York; while the remaining four seats carry one-year term each, in a rotating selection of the presidents of the 11 other Reserve Banks.

Treasury: The US Treasury is responsible for issuing government debt and for making decisions on the fiscal budget. The Treasury has no say in monetary policy, but its statements on the dollar have an major influence on the currency.

Economic Data: The most important economic data items released in the US are: labor report (payrolls, unemployment rate and average hourly earnings), CPI, PPI, GDP, international trade, ECI, NAPM, productivity, industrial production, housing starts, housing permits and consumer confidence.

Stock Market: The three major stock indices are the Dow Jones Industrials Index (Dow), S&P 500, and NASDAQ. The Dow is the most influential index on the dollar. Since the mid-1990s, the index has shown a strong positive correlation with the greenback as foreign investors purchased US equities. Three major forces affect the Dow: 1) Corporate earnings, forecast and actual; 2) Interest rate expectations and; 3) Global considerations. Consequently, these factors channel their way through the dollar

Cross Rate Effect: The dollar's value against one currency is sometimes impacted by another currency pair (exchange rate) that may not involve the dollar. To illustrate, a sharp rise in the yen against the euro (falling EUR/JPY) could cause a general decline in the euro, including a fall in EUR/USD.

Fed Funds Rate Futures Contract: Interest rate expectations can be made through the Fed Funds rate in the futures market. The contract's value shows what the Fed Funds interest rate (overnight rate) is expected to be in the future, depending on the maturity of the contract.

Hence, the contract is a valuable barometer of market expectation vis-a-vis Federal Reserve policy. The rate is obtained by substracting the contract's value from 100, and comparing the result to the prevailing Fed Funds rate in the cash/spot market.

3-month Eurodollar Futures Contract: While the Fed Funds futures contract reflects Fed Funds rate expectations into the future, the 3-month Eurodollar contract does the same for the interest rate on 3-month eurodollar deposits.

To illustrate, the difference between futures contracts on the 3-month eurodollar and euroyen deposits is an essential variable in determining USD/JPY expectations.

Related Tags: money, invest, trading, forex, currency, foreign exchange, dollar, fundamental

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