What You Need to Know About the Currency War | ASXnewbie.com

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What You Need to Know About the Currency War.

What You Need to Know About the Currency War

There’s a lot of talk about currency wars these days, but very little understanding about what that means for specific countries, economic growth, inflation, and your pocketbook.

Let’s fix that.

First of all, there has been no declaration of any currency war. And there likely won’t be. That’s because open currency warfare could quickly lead to a mushrooming global crisis.

But that doesn’t mean countries aren’t already engaged in currency battles; they are. They almost always are.

Here’s an over-simplified explanation about how currency wars affect you…

What You Need to Know About CurrenciesIf Japan exports cars to America and America exports grain to Japan, each has to pay the other. American grain exporters want to get paid in US dollars, so they can spend those dollars in the US. The Japanese want to get paid in yen so they can pay their workers in yen, pay their taxes in yen, and spend their money in Japan.

Americans can ‘buy’ yen with their dollars to pay the Japanese for their cars, or the Japanese can accept dollars as payment and then use those dollars to buy yen themselves.

Of course it works the other way around if you’re a grain farmer selling to Japan.

But the value of yen to dollars, or dollars to yen, isn’t constant. There is no set exchange rate. Exchange rates are set in open currency trading markets where currencies are bought and sold to the tune of several trillions of dollars a day, every day. One day a dollar might buy 100 yen and the next day it might buy only 98 yen, or it could buy 102 yen.

Lots of factors determine exchange rates, but the biggest, by far, is interest rates. I’ll get to that, and then you’ll understand the whole currency thing, and never forget it.

Currency wars, which are waged all the time, but not dramatically, are all about the value of your ‘home’ currency relative to other countries’ currencies. Our home currency in America is the US dollar, in Japan it’s the yen, in the 17-nation euro-currency bloc it’s the euro, in Great Britain it’s the pound, and so on.

Countries that export a lot of goods want their currency to be ‘cheap’ relative to other countries, especially those countries who are buying the home countries’ exported goods.

If the value of American dollars to Japanese yen is strong, meaning a dollar can buy a lot of yen, when you buy a Japanese car, for example, it will take fewer dollars to pay for it.

If the value of the yen goes up relative to the dollar, that car is going to cost more because your dollars don’t buy as many yen as they did before.

Currency exchange rates have nothing to do with what kind of car you are buying from Japan or what features it has; the currency ‘cost’ is a separate component of the cost of that car. That’s true for all products imported and exported around the world.

Because Japan exports a lot of cars, not just to America, but around the world, it wants its currency to be ‘cheaper’ than other currencies so it doesn’t take as many dollars, or euros, or pounds to buy a Japanese car, or any product exported from Japan.

Here’s the problem. America is a huge exporter of goods and services, too. So is Germany, and of course so is China. From a political perspective, all governments want to support their exporting industries. It’s about manufacturing and jobs, and revenue and profits, and economic growth and standards of living.

The easiest way to facilitate an export-driven economy, like Japan’s, like China’s, like Germany’s, and like America’s (especially lately as domestic demand in the US has softened as a result of the Great Recession) is to keep the home currency ‘cheap’ relative to other currencies.

If exporting countries, especially those that don’t have big domestic demand bases, meaning less-developed and ‘emerging-markets’ economies, are all trying to export their way to growth (as is the US) and they all want to have their currencies be ‘cheap’ on a relative basis, that can’t happen. Everyone’s currency can’t be cheap at the same time.

That’s what precipitates currency wars. Governments who want to stimulate growth through exports (and who doesn’t?) usually subtly, but sometimes overtly, take measures to lower the value of their currencies.

Japan’s new Prime Minister, Shinzo Abe, in an unusual exception to the pacifist approach to currency skirmishes, recently fired a shot heard round the world. To lower the value of the yen, Abe is demanding domestic monetary easing, aggressive stimulus, and more dangerously, has openly been talking down the yen.

While Abe’s bold-faced rhetoric is provocative, G20 finance ministers and Christine Lagarde, Managing Director of the IMF, have been calmly trying to defuse any mounting tensions that could trigger any country-specific retaliation and a global race to devalue currencies.

Is Japan to blame? No. America really started the latest round of currency battles.

In order to ‘stimulate’ our way out of the Great Recession, which included President Obama’s articulated policy of dramatically increasing America’s exports, the Federal Reserve, in conjunction with the Administration’s wishes and its own interest in re-capitalizing the nation’s big banks the Fed is beholden to, has kept interest rates low, as in very low.

One of the ways the Fed has done this is by ‘printing’ money. The Fed has the ability, beyond the reach of Congress or the President, to buy what it wants, which is most often US Treasury government bonds (that pay interest). It pays for what it buys by simply issuing ‘credits’ as payment.

Those credits are turned into money as they are spent by the government whose bonds the Fed buys, or by banks who sell the Fed (on a temporary basis, with the intention of buying them back in the future, usually) their underwater mortgage-backed securities. Thus, the banks supposedly have money to lend.

Here’s Where It All Comes TogetherBecause the Fed has kept interest rates so low in America, investors who want more interest income on their money than they get here are parking their money in other countries where interest rates are higher.

In order to put your money into a bank in another country that offers higher interest rates than banks offer in the US you have to first buy that country’s currency. And that bids up that country’s currency relative to the dollars that you are selling.

In addition to the dollar being weakened, on a relative value basis, by investors selling dollars to buy and invest in other countries currencies, the amount of money being printed by the Fed means that at some point in the future all that money in the system will cause prices to rise.

Inflation is the result of a lot of excess paper money chasing a set amount of goods and services.

Inflation, and just the prospect of inflation, causes the dollar to fall further. And if the dollar is falling relative to the Japanese yen or the euro, other countries who want to grow their exports are going to eventually do what they have to in order to lower the value of their own currencies.

That’s how we get into currency wars. The net result is inflation, which arrives in several different ways.

You’ll know when it’s starting to spread. Interest rates will start to rise; watch the yield on the US 10-year treasury. Commodity prices will rise; you’ll see it in your grocery bills. You may already be seeing the incipient signs.

Stocks will rise at first – then start to collapse. So, make sure you’re in the market but keep raising your protective stops as prices rise.

Buy commodities and gold, but take profits on your commodities as they skyrocket; they won’t stay high forever.

Shah Gilani
Contributing Editor, Money Morning

Publisher’s Note: This is an edited version of an article that originally appeared in Money Morning (USA)

This article is contributed by Money Morning. Click Here to Subscribe to their free newsletter.