Saturday, August 11, 2007

Credit Market Fall-Out #20 – Effect on Currencies

The article below from the WSJ is a good summary of how the currency markets could change in response to changes in interest rates. The point is not so much the specifics behind each currency, but it should be apparent at this point that the mortgage problems in the US are effecting the credit markets, which effects interest rates, which in turn effects the currency and stock markets. The effects of the mortgage problems in the US are very far reaching.

Currency markets have merely wobbled in the earthquake shaking the credit and stock markets. But they could soon suffer their own tectonic shifts.

For the past few years, currency traders have led pretty simple lives. They just borrowed in low-interest-rate currencies -- particularly the yen and Swiss franc -- and lent in currencies that offer higher rates, such as those of New Zealand, Australia and the U.K. This is the yen carry-trade or carry-trade that was in the news so much about 6 - 8 weeks ago.

This easy way of making money may end if global liquidity really tightens, or even if traders begin to think it might. They would become unwilling to bet against interest-rate rises in, say, Japan, which could cause the yen to appreciate and wipe out their carry-trade gains.

How likely is it that the financial turmoil will reshape the foreign-exchange markets? Well, the border between economic reality and financial speculation isn't always clear. For example, Australia's terms of trade -- the price of exports relative to the price of imports -- has improved by 70% in the past decade. That provides economic support for the Aussie dollar. But the improvement largely comes from high commodity prices. Those have been helped out by easy credit, which may be at an end.

But a few predictions are possible. First, the pound could be a loser. Sterling is at a 25-year high against the dollar. But the U.K. has a big trade deficit and looks unlikely to raise interest rates. That could undermine the pound.

Emerging-market currencies such as the Mexican peso and Turkish lira could come under pressure as investors pull away from riskier assets.

Meanwhile, the yen should strengthen. Japan has ceased to flood its domestic market with cash and has raised interest rates slightly. The Swiss franc could rise, especially against the euro. Switzerland's low inflation and low interest rates have made it a popular borrowing currency for traders. But the market turmoil may force its neighbors to lower their own rates.

The dollar could be a beneficiary, at least for a while. True, the U.S. has the mother of all trade deficits, which depresses the value of the dollar. But the greenback has also suffered from the belief that credit market troubles are restricted to the U.S. That's now clearly not the case.

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