Forex Investment and Currency Trading

Currency Board or Peg

The popularity of currency boards comes and goes like a fashion fad. A peg can be very attractive because it can allow a nation to control inflation and develop a credible monetary policy by fixing its currency to a larger, more stable single currency or to a basket of currencies. Time after time, however, pegs prove unstable in the long run and are easy targets for foreign exchange speculators. A currency board or peg must have three elements: an exchange rate that is anchored to a single currency or a basket of currencies, convertibility, and long-term commitment to the monetary policy. This mechanism gives financial markets and the public the assurance that each unit of domestic currency is equally backed by an anchor currency of foreign reserves. A current example of an active peg is Argentina’s one-to-one peg to the U.S. dollar. A peg can offer economic credibility, control inflation, and reduce financial costs. In addition, it can give the government the flexibility to lower interest rates and spur economic growth. But there are some significant downsides, especially in countries that try to cure their weak banking system and volatile economy with a peg. With a peg in place, a nation has limited use of fiscal and monetary policy. In addition, as the world learned the hard way in the Asian crisis, nations can become slaves to their foreign exchange policy.

One of the key lessons of currency pegs is that traders should respect a government’s fiscal and monetary policy without overestimating how much control it truly has. In the U.S., for example, many economists agree that the president has very little, or no, power to effectively steer the economy. For example, the Republican Party has a reputation for being “business-friendly”, while the Democratic Party supposedly is not. The idea that presidents can wave a magic wand and conjure up economic growth is certainly false, but it is decidedly true that the economy and investors react to the actions of the president and other world leasers. Markets, after all, are the result of millions of decisions made by individuals, and individuals can get nervous or even panic.

Even during the economic boom times of the late 1990s, the markets reacted negatively when the lurid details of Bill Clinton’s affair with intern Monica Lewinsky came to light. More serious was the August 1991 rumor that Mikhail Gorbachev had been kidnapped. The dollar spiked upward because the entire project of European integration would be threatened if Russia were to fall under the rule of a hostile dictator. The rumor proved false, and the dollar fell back to its previous trading levels.

Subjectivity

It would be a costly mistake to view fundamental trading as predictable – as if currency movements were a mechanical response to an action. This is simply not the case in Forex. Just because Great Britain’s GDB increases and the U.S. GDP decreases doesn’t mean that the GBP/USD will increase in value.

After all, the importance of information is subjective, depending on who is receiving and interpreting it. Since fundamentals are factual and transparent, all participants have an equal opportunity to analyze information. It’s various interpretations of the same information that creates market volatility. Market psychology and behavior, predictions of fundamental changes, perceptions, and what data has already been discounted all become factors in fundamental trading. It is this complexity that throws off new Forex traders and drives them to become technical traders.