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Strong vs. Weak CurrenciesSubmitted by Townsend Asset Management Corp. on March 8th, 2016
What is the largest financial market in the world – stocks or bonds? Neither one. Billions of dollars change hands each day in the global equities market, but trillions of dollars are exchanged daily in currencies.
Recently, several European central banks, along with Japan, moved their interest rates into negative territory, while the U.S. took a baby step in the other direction, with the Federal Reserve increasing the target federal funds rate by 0.25%.
Negative interest rates? That is something we never studied in Economics 101. Commercial banks normally park their excess reserves with central banks, earning some interest on the money. But, with negative interest rates, central banks effectively are charging commercial banks a storage fee to hold their excess reserves. The intent of these negative policies is to spur commercial banks to lend the money and hopefully stimulate sluggish global economies.
One of the consequences of negative interest rate policies is a weakening of a currency. While there are other factors at work, the currency of a country with low or negative interest rates often falls, relative to a country with higher interest rates.
And, it seems that is exactly the consequence many countries desire – a cheapening of their currencies.
Why would a country want its currency to be less valuable?
- Export Growth – If the Japanese Yen falls in value vs. the U.S. Dollar, it makes Japanese exports to the U.S. less expensive, potentially boosting sales, economic growth and jobs in Japan.
- Inflation – After many years of battling inflation worries, central bankers are now preoccupied with poor global growth and deflation concerns. If you cheapen your currency it makes imported goods more expensive, which should result in more inflation.
- Debt Relief – While a weaker currency may help boost a country’s income and inflation rate, if their debt is issued in their local currency, it also makes this debt less expensive, making it easier to be paid back.
Does It Work?
Countries with weaker currencies may see some short-term benefits, but there are negative impacts as well. Currency exchange rates are relative – if one goes up, another must go down. Ultimately, this is a zero-sum game. If too many countries seek to increase their share of global exports by trashing their currencies, then no country really achieves their goal. In that case, they may erect trade barriers or other measures designed to protect domestic industries and stimulate inflation. Tactics such as these may also help in the short-term, but eventually by limiting free trade they make economic activity less efficient and global growth suffers.
With other countries pursuing negative interest rate policies and weak currencies, the U.S. Dollar may remain strong due to the small, but positive, interest rate policy of the Federal Reserve. This implies that the sales and profits of companies with weaker currencies may benefit, which could boost their stock prices in their own currency, but weaken their stock price when translated back to U.S. Dollars.
One way to participate in foreign markets in climates such as these is to hedge your currency exposure. For most investors the most practical way to do this is to utilize mutual funds or exchange-traded funds that actively employ currency hedging techniques.
Gerald A. Townsend, CPA/PFS/ABV, CFP®, CFA®, CMT is president of Townsend Asset Management Corp., a registered investment advisory firm offering comprehensive wealth management expertise to its clients. Email Gerald@AssetMgr.com for more information. For the latest news and updates, follow Townsend's growing platforms on Linked In, Facebook and Twitter.