Know currency trade strategy and forex investment fundamentals

When we are formulating currency and forex investment strategies, we are in fact looking at the fund flow of the currency in a global context and in relative terms. Currency trade and forex investment requires us to understand real demand and supply. As a start we look at the demand side of currency first.

Distinguish between real demand and speculating demand, the speculating demand will reverse sooner or later

• Transaction demand for money is highly correlated to the countries level of import and export activity, production and gross domestic product (GDP), and employment levels. In general the higher the unemployment, the less the public as a whole will produce goods and services for export, the less wealthy the society will consume domestic or imported productions.
• China had hard-earned surplus balance of trade (sum of the money gain by selling exports exceed money spent on buying import). People also have high saving rate and hence domestic consumption market has not been fully explored.
• Investment demand for money is related to the net inflow of money for investing in companies, equities, bonds, factories etc. The money inflow is looking for value buys from countries with competitive advantage, that is, countries with relatively lower costs of production (labor, land, capital and technology). China is known to have lower costs of production and hence to have positive inflow of money for investment demand.
• Speculative demand for money is that the currency exchanged is not for investment or transaction purposes. Therefore the currency trade will reverse sooner or later. For example, many people purchased Euro dollars speculating for US dollars losing it value. The Euro dollars are not consumed to buy Europe equities, spend for travel or children's tuition fee. Rather, the Euro dollars just put in banks for saving purpose. The money will eventually turn back in domestic currencies for consumption. The more speculating demand is in a market, the more volatility is the currency trade. For example, Warren Buffett brought billions of Euro dollars and British pounds, we do not see him spend these currencies, for instance, to buy a single European or British company. These currency trades will reverse someday, that is, to buy back US dollars and sell EUR / GBP sooner or later.

Central banks can easily devalue its own currency but can be difficult to appreciate or defend its currency value

• Central banks typically have little difficulty to increase the money supply to accommodate changes in the demand for money due to business transactions. If the banks increase money more than the demand, the currency will face devaluation in value and inflationary pressure. Central bank will try to accommodate inflationary pressure by adjusting interest rates. Therefore it is easy to devalue its currency by increasing money supply. But this is a relative concept. During 2001 to 2004, USD money supply was much faster than EUR, GBP and YEN...
• Central banks can be difficult to appreciate or defend its currency value. A currency needs demand (transaction, investment and speculating demand) to appreciate its value. A positive inflow of money cannot be controlled by Central banks. If the money supply is not backed by enough currency exchange reserve, speculator can come in to borrow domestic currency, dump in market and ask for foreign currency. The Central bank without enough foreign currency reserve will have tremendous devaluation pressure on its unmatched currency supply just like Thailand in 1997.
• Most people will not be interested in a currency if they expect it to devalue. Expectation / loss of confidence will suppress demand. A currency will tend to lose value, relative to other currencies, if the countries level of inflation is relatively higher, if the country's level of output is expected to decline, or if a country is troubled by political uncertainty.

Bear in mind that currency fluctuation is an incremental and relative concept

• Currencies trade in pairs. Every trade involves the selling of one currency and the buying of another. Therefore it is incremental and relative concept. When there is an incremental demand, for instance, for Canadian dollars to buy gold and oil companies, by a US company, the company needs to sell its US dollars in exchange for Canadian dollars. Although the size of an acquisition compared to the size of foreign exchange market is no comparison, the exchange rate fluctuation just act like a balance. The impact of incremental demand toggles the whole balance of equilibrium.
• Foreign exchange market is volatile in short term speculation. Yet the nature of the market is trendy, that is, the trend is likely to sustain for years once it is built up. The Canadian dollars took more than 10 years to recover its value. A wrong decision costs lots of our money.
• If there is a currency that is very likely to appreciate in the future, what is your action? This perfectly leads to our next hot topic - How we can benefit from investing China currency, Renminbi.

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