PROFILE AND UNIQUE CHARACTERISTICS OF MAJOR CURRENCY PAIRS

PROFILE AND UNIQUE CHARACTERISTICS OF MAJOR CURRENCY PAIRS

It is important for all traders to have a good grasp of the general economic characteristics of each of the most commonly traded currencies in order to gauge what economic data and factors in general may have the most significant impact on a currency’s movements. Some currencies tend to track commodity prices, while others may move in complete contrast. Traders also need to be aware of the difference between expected and actual data. That is, the most important aspect of interpreting news and its impact on the foreign exchange markets is the determination of whether the market is expecting a piece of news. This is known as the “market discount mechanism.” The correlation between the currency markets and news is very important. News or data that are in line with expectations have less of an impact on currency movements than unexpected news or data. Therefore, short-term traders need to closely monitor expectations of the market.

CURRENCY PROFILE: U.S. DOLLAR (USD)
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Broad Economic Overview

The United States is the world’s leading economic power, with gross domestic product (GDP) valued at over US$13 trillion in 2006. This is the highest in the world, and, based on the purchasing power parity model, it is three times the size of Japan’s output, five times the size of Germany’s, and seven times the size of the United Kingdom’s. The United States is primarily a service-oriented country with nearly 80 percent of its GDP coming from real estate, transportation, finance, health care, and business services. Yet the sheer size of the U.S. manufacturing sector still makes the U.S. dollar particularly sensitive to developments within the sector. With the United States having the most liquid equity and fixed income markets in the world, foreign investors have consistently increased their purchases of U.S. assets. According to the International Monetary Fund (IMF), foreign direct investments into the United States are equal to approximately 40 percent of total global net inflows for the United States. On a net basis, the United States absorbs 71 percent of total foreign savings. This means that if foreign investors are not satisfied with their returns in the U.S. asset markets and they decide to repatriate their funds, this would have a significant effect on U.S. asset values and the U.S. dollar. More specifically, if foreign investors sell their U.S. dollar-denominated asset holdings in search of higher-yielding assets elsewhere, this would typically result in a decline in the value of the U.S. asset, as well as the U.S. dollar.

The import and export volume of the United States also exceeds that of any other country. This is due to the country’s sheer size, as true import and export volume represent a mere 12 percent of GDP. Despite this large activity, on a netted basis, the United States is running a very large current account deficit of over $800 billion as of 2006. This is a major problem that the U.S. economy has been grappling with for more than 10 years. However, in the past five years, it has become an even larger problem since foreign funding of the deficit has been languishing as foreign central banks consider diversifying reserve assets out of dollars and into euros. The large current account deficit makes the U.S. dollar highly sensitive to changes in capital flows. In fact, in order to prevent a further decline in the U.S. dollar as a result of trade, the United States needs to attract a significant amount of capital inflows per day (in 2006, this number was over $2 billion per day).

The United States is also the largest trading partner for most other countries, representing 20 percent of total world trade. These rankings are very important because changes in the value of the dollar and its volatility will impact U.S. trading activities with these respective countries. More specifically, a weaker dollar could boost U.S. exports to its trade partners, whereas a stronger dollar could curb foreign demand for U.S. exports. Here are the breakdowns of the most important trading partners for the United States (in order of importance).

The list of export markets is important because it ranks the importance of growth and political stability of these countries for the United States. For example, should Canadian growth slow, its demand for U.S. exports would also fall, which would have a ripple effect on U.S. growth.

Leading Export Markets

1. Canada
2. Mexico
3. Japan
4. United Kingdom
5. European Union

Leading Import Sources

1. Canada
2. China
3. Mexico
4. Japan
5. European Union

Source: Bureau of Economic Analysis, “U.S. International Transactions,” 2006 Report. 

Monetary and Fiscal Policy Makers—The Federal Reserve

The Federal Reserve Board (Fed) is the monetary policy authority of the United States. The Fed is responsible for setting and implementing monetary policy through the Federal Open Market Committee (FOMC). The voting members of the FOMC are the seven governors of the Federal Reserve Board, plus five preidents of the 12 district reserve banks. The FOMC holds eight meetings per year, which are widely watched for interest rate announcements or changes in growth expectations.

The Fed has a high degree of independence to set monetary authority. It is less subject to political influences, as most members are accorded long terms that allow them to remain in office through periods of alternate party dominance in both the presidency and Congress. 

The Federal Reserve issues a biannual Monetary Policy Report in February and July followed by the Humphrey-Hawkins testimony where the Federal Reserve chairman responds to questions from both the Congress and the Banking Committees in regard to this report. This report is important to watch, as it contains the FOMC forecasts for GDP growth, inflation, and unemployment.

The Fed, unlike most other central banks, has a mandate or “long-run objectives” of “price stability and sustainable economic growth.” In order to adhere to these goals, the Fed has to use monetary policy to limit inflation and unemployment and to achieve balanced growth. The most popular tools that the Fed uses to control monetary policy are open market operations and the federal funds rate.

Open Market Operations Open market operations involve Fed purchases of government securities, including Treasury bills, notes, and bonds. This is one of the most popular methods for the Fed to signal and implement policy changes. Generally speaking, an increase in Fed purchases of government securities decreases interest rates, while selling of government securities by the Fed boosts interest rates.

Federal Funds Target The federal funds target rate is the key policy target of the Federal Reserve. It is the interest rate for borrowing that the Fed offers to its member banks. The Fed tends to increase this rate to curb inflation or decrease this rate to promote growth and consumption. Changes to this rate are closely watched by the market, tend to imply major changes in policy, and typically have large ramifications for global fixed income and equity markets. The market also pays particular attention to the statement released by the Federal Reserve, as it can offer signals for future monetary policy actions.

In terms of fiscal policy, that is in the hands of the U.S. Treasury. Fiscal policy decisions include determining the appropriate level of taxes and government spending. In fact, although the markets pay more attention to the Federal Reserve, the U.S. Treasury is the actual government body that determines dollar policy. That is, if the Treasury feels that the USD rate on the foreign exchange market is under- or overvalued, the U.S. Treasury is the government body that gives the New York Federal Reserve Board the authority and instructions to intervene in the foreign exchange market by physically selling or buying U.S. dollars. Therefore, the Treasury’s view on dollar policy and changes to that view is generally very important to the currency market.

Over the past few decades, the Treasury and Fed officials have maintained a “strong dollar” bias. This was particularly true under former Treasury Secretary Paul O’Neill, who was frequently very vocal in advocating a strong dollar. Under the Bush administration, Treasury Secretary Henry Paulson has reiterated this view and stated that he, too, favors a strong dollar. However, the Bush administration has done little to stem the dollar’s slide between 2003 and 2008, which has led the market to believe that the administration actually favors a behind-the-scenes weak dollar policy and uses it as a tool to spur growth. Yet, for political reasons, it is not likely that the government would vocally change its stance to supporting a weak dollar policy.

Important Characteristics of the U.S. Dollar 

• Over 90 percent of all currency deals involve the dollar.

     The most liquid currencies in the foreign exchange market are the EUR/USD, USD/JPY, GBP/USD, and USD/CHF. These currencies represent the most frequently traded currencies in the world, and all of these currency pairs involve the U.S. dollar. In fact, 90 percent of all currency deals involve the U.S. dollar. This explains the importance of the U.S. dollar to all foreign exchange traders. As a result, the most important economic data that usually move the market are dollar fundamentals.

• Prior to September 11, the U.S. dollar was considered one of the world’s premier safe haven currencies.

     The reason why the U.S. dollar was previously considered one of the world’s premier safe haven currencies was because prior to September 11, 2001, the risk of severe U.S. instability was very low. The United States was known to have one of the safest and most developed markets in the world. The safe haven status of the dollar allowed the United States to attract investment at a discounted rate of return, resulting in 76 percent of global currency reserves being held in dollars. Another reason why currency reserves are held in U.S. dollars is the fact that the dollar is the world’s dominant factoring currency. In choosing a reserve currency, the dollar’s safe haven status also played a major role for foreign central banks. However, post-9/11, foreign holders of U.S. assets, including central banks, have pared their dollar holdings as a result of increased U.S. uncertainty and decreased interest rates. The emergence of the euro has also threatened the U.S. dollar’s status as the world’s premier reserve currency. Many central banks have already begun to diversify their reserves by reducing their dollar holdings and increasing their euro holdings. This will continue to be a major trend that all traders should watch for in the years ahead.

• The U.S. dollar moves in the opposite direction from gold prices.

     Gold prices and the U.S. dollar have historically had a near perfect inverse relationship and are near perfect mirror images of each other; this means that when gold prices rise, the dollar falls, and vice versa. This inverse relationship stems from the fact that gold is measured in dollars. Dollar depreciation due to global uncertainty has been the primary reason for gold appreciation, as gold is commonly viewed as the ultimate form of money. Gold is also seen as the premier safe haven commodity; therefore, in times of geopolitical uncertainty investors tend to flock to gold, which in essence hurts the dollar.

FIGURE  Gold versus Dollar Chart

• Many emerging market countries peg their local currencies to the dollar.

     Pegging a currency to the dollar pertains to the basic idea that a government agrees to maintain the U.S. dollar as a reserve currency by offering to buy or sell any amount of domestic currency at the pegged rate for the reserve currency. These governments typically have to also promise to hold reserve currency at least equal to the amount of local currency in circulation. This is very important because these central banks have become large holders of U.S. dollars and take an active interest in managing their fixed or floating pegs. Countries with currencies pegged to the dollar include Hong Kong and, up until July 2005, China as well. China is a very active participant in the currency market because its maximum float per day is controlled within a narrow band based on the previous day’s closing rate against the USD. Any fluctuations beyond this band during the day will be subject to intervention by the central bank, which will include buying or selling of U.S. dollars. Prior to July 21, 2005, China had pegged its currency at a rate of 8.3 yuan to the U.S. dollar. After years of pressure to revalue its currency, China adjusted its exchange rate to 8.11 yuan and reset the rate to the closing price of the currency each day. Along with this, China is gradually moving to a managed float referencing a basket of currencies.

Over the past year or two, the market has paid particular attention to the purchasing habits of these central banks. Talk of reserve diversification or more currency flexibility in the exchange rates of these Asian countries means that these central banks may have less of a need to own U.S. dollars and dollar-denominated assets. If this is true, it could be very negative for the U.S. dollar over the long term.

• Interest rate differentials between U.S. Treasuries and foreign bonds are strongly followed. 

The interest rate differential between U.S. Treasuries and foreign bonds is a very important relationship that professional FX traders follow. It can be a strong indicator of potential currency movements because the U.S. market is one of the largest markets in the world and investors are very sensitive to the yields that are offered by U.S. assets. Large investors are constantly looking for assets with the highest yields. As yields in the U.S. decrease or if yields abroad increase, this would induce investors to sell their U.S. assets and purchase foreign assets. Selling U.S. fixed income or equity assets would influence the currency market because that would require selling U.S. dollars and buying the foreign currency. If U.S. yields increase or foreign yields decrease, investors in general would be more inclined to purchase U.S. assets, therefore boosting the USD.

• Keep an eye on the Dollar Index.

Market participants closely follow the U.S. Dollar Index (USDX) as a gauge of overall dollar strength or weakness. The USDX is a futures contract traded on the New York Board of Trade that is calculated using the trade-weighted geometric average of six currencies. It is important to follow this index because when market participants are reporting general dollar weakness or a decline in the trade-weighted dollar, they are typically referring to this index. Also, even though the dollar may have moved significantly against one single currency, it may not have moved as significantly on a trade-weighted basis. This is important because some central bankers may choose to focus on the trade-weighted index instead of the individual currency pair’s performance against the dollar.

• U.S. currency trading is impacted by stock and bond markets.

There is a strong correlation between a country’s equity and fixed income markets and its currency: If the equity market is rising, generally speaking, foreign investment dollars should be coming in to seize the opportunity. If equity markets are falling, domestic investors will be selling their shares of local publicly traded firms only to seize investment opportunities abroad. With fixed income markets, economies boasting the most valuable fixed income opportunities with the highest yields will be capable of attracting foreign investment. Daily fluctuations and developments in any of these markets reflect movement of foreign portfolio investments, which in the end would require foreign exchange transactions. Cross-border merger and acquisition activities are also very important for FX traders to watch. Large M&A deals, particularly those that involve a significant cash portion, will have a notable impact on the currency markets, the reason being that the acquirer will need to buy or sell dollars to fund its cross-border acquisition target.

Important Economic Indicators for the United States

All of the following economic indicators are important for the U.S. dollar. However, since the U.S. economy is service oriented, it is important to pay particular attention to numbers for the service sector.

Employment—Nonfarm Payrolls  The employment report is the most important and widely watched indicator on the economic calendar. Its importance is mostly due to political influences rather than pure economic reasons, as the Fed is under strict pressure to keep unemployment under control. As a result, interest rate policy is directly influenced by employment conditions. The monthly report consists of data from two different surveys, the Establishment Survey and the Household Survey. The Establishment Survey takes data from nonfarm payroll employment, average hourly workweek, and the aggregate hours index. The Household Survey gives information on the labor force, household employment, and the unemployment rate. Currency traders tend to focus on seasonally adjusted monthly unemployment rates and any meaningful changes in nonfarm payrolls.

Consumer Price Index  The consumer price index (CPI) is a key gauge of inflation. The index measures the prices on a fixed basket of consumer goods. Economists tend to focus more on the CPI-U or the core inflation rate, which excludes the volatile food and energy components. The indicator is widely watched by the FX markets as it drives a lot of activity. 

Producer Price Index  The producer price index (PPI) is a family of indexes that measures average changes in selling prices received by domestic producers for their output. The PPI tracks changes in prices for nearly every goods-producing industry in the domestic economy, including agriculture, electricity and natural gas, forestry, fisheries, manufacturing, and mining. Foreign exchange markets tend to focus on seasonally adjusted finished goods PPI and how the index has reacted on a monthly, quarterly, and annualized basis.

Gross Domestic Product  Gross domestic product (GDP) is a measure of the total production and consumption of goods and services in the United States. The Bureau of Economic Analysis (BEA) constructs two complementary measures of GDP, one based on income and one based on expenditures. The advance release of GDP, which occurs the month after each quarter ends, contains some BEA estimates for data not yet released, inventories, and trade balance, and is the most important release. Other releases of GDP are typically not very significant unless a major revision is made.

International Trade  The balance of trade represents the difference between exports and imports of foreign trade in goods and services. Merchandise data are provided for U.S. total foreign trade with all countries, detail for trade with specific countries and regions of the world, as well as for individual commodities. Traders tend to focus on seasonally adjusted trade numbers over three-month periods as single-month trade periods are regarded as unreliable.

Employment Cost Index  The employment cost index (ECI) data is based on a survey of employer payrolls in the third month of the quarter for the pay period ending on the 12th day of the month. The survey is a probability sample of approximately 3,600 private industry employers and 700 state and local governments, public schools, and public hospitals. The big advantage of the ECI is that it includes nonwage costs, which add as much as 30 percent to total labor costs. Reaction to the ECI is often muted as it is generally very stable. It should be noted, however, that it is a favorite indicator of the Fed.

Institute for Supply Management (Formerly NAPM) The Institute for Supply Management (ISM) releases a monthly composite index based on surveys of 300 purchasing managers nationwide representing 20 different industries regarding manufacturing activity. Index values above 50 indicate an expanding economy, while values below 50 are indicative of contraction. The number is widely watched, as former Fed Chairman Alan Greenspan once stated it is one of his favorite indicators.

Industrial Production The Index of Industrial Production is a set of indexes that measures the monthly physical output of U.S. factories, mines, and utilities. The index is broken down by industry type and market type. Foreign exchange markets focus mostly on the seasonally adjusted monthly change in aggregate figure. Increases in the index are typically dollar positive.

Consumer Confidence The Consumer Confidence Survey measures the level of confidence individual households have in the performance of the economy. Survey questionnaires are sent out to a nationwide representative sample of 5,000 households, of which approximately 3,500 respond. Households are asked five questions: (1) a rating of business conditions in the household’s area, (2) a rating of business conditions in six months, (3) job availability in the area, (4) job availability in six months, and (5) family income in six months. Responses are seasonally adjusted and an index is constructed for each response; then a composite index is fashioned based on the aggregate responses. Market participants perceive rising consumer confidence as a precursor to higher consumer spending. Higher consumer spending is often seen as a spark that accelerates inflation.

Retail Sales  The Retail Sales Index measures the total goods sold by a sampling of retail stores over the course of a month. This index is used as a gauge of consumer consumption and consumer confidence. The most important number is typically ex-autos, as auto sales can vary from month to month. Retail sales can be quite volatile due to seasonality; however, the index is an important indicator of the general health of the economy.

Treasury International Capital Flow Data (TIC Data) The Treasury international capital flow data measures the amount of capital inflow into the United States on a monthly basis. This economic release has become increasingly important over the past few years since the funding of the U.S. deficit is becoming more of an issue. Aside from the headline number itself, the market also pays close attention to the official flows, which represent the demand for U.S. government debt by foreign central banks.

CURRENCY PROFILE: EURO (EUR)
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Broad Economic Overview

The European Union (EU) was developed as an institutional framework for the construction of a united Europe. The EU currently consists of 15 member countries: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, and the United Kingdom. All of these countries share the euro as a common currency, except for Denmark, Sweden, and the United Kingdom. The 12 common currency countries constitute the European Monetary Union (EMU) and also share a single monetary policy dictated by the European Central Bank (ECB).

The EMU is the world’s second largest economic power, with gross domestic product valued at approximately US$12 trillion in 2006. With a highly developed fixed income, equity, and futures market, the EMU has the second most attractive investment market for domestic and international investors. In the past, the EMU has had difficulty in attracting foreign direct investment or large capital flows. In fact, the EMU is a net supplier of foreign direct investments, accounting for approximately 45 percent of total world capital outflows and only 19 percent of capital inflows. The primary reason is because historically U.S. assets have had solid returns. As a result, the United States absorbs 71 percent of total foreign savings. However, with the euro becoming a more established currency and the European Monetary Union beginning to incorporate even more members, the euro’s importance as a reserve currency is rising in tandem. As a result, capital flows to Europe have been increasing. With foreign central banks expected to diversify their euro reserve holdings even further, demand for euros should continue to increase.

The EMU is both a trade-driven and capital flow–driven economy; therefore trade is very important to the economies within the EMU. Unlike most major economies, the EMU does not have a large trade deficit or surplus. In fact, the EMU went from a small trade deficit in 2003 to a small trade surplus in 2006. EU exports comprise approximately 19 percent of world trade, while EU imports account for only 17 percent of total world imports. Because of the size of the EMU’s trade with the rest of the world, it has significant power in the international trade arena. International clout is one of the primary goals in the formation of the EU, because it allows the individual countries to group as one entity and negotiate on an equal playing field with the United States, which is their largest trading partner. The breakdowns of the most important trading partners for the EU are:

Leading Export Markets

1. United States
2. Switzerland
3. Japan
4. Poland
5. China

Leading Import Sources

1. United States
2. Japan
3. China
4. Switzerland
5. Russia

The EMU is primarily a service-oriented economy. Services in 2001 accounted for approximately 70 percent of GDP, while manufacturing, mining, and utilities accounted for only 22 percent of GDP. In fact, a large number of the companies whose primary purpose is to produce finished products still concentrate their EU activity on innovation, research, design, and marketing, while outsourcing most of their manufacturing activities to Asia.

The EU’s growing role in international trade has important implications for the role of the euro as a reserve currency. It is important for countries to have large amounts of reserve currencies to reduce exchange risk and transaction costs. Traditionally, most international trade transactions involve the British pound, the Japanese yen, and/or the U.S. dollar. Before the establishment of the euro, it was unreasonable to hold large amounts of every individual European national currency. As a result, currency reserves tended toward the dollar. At the end of the 1990s, approximately 65 percent of all world reserves were held in U.S. dollars, but with the introduction of the euro, foreign reserve assets are shifting in favor of the euro. This trend is expected to continue as the EU becomes one of the major trading partners for most countries around the world.

Monetary and Fiscal Policy Makers—The European Central Bank

The European Central Bank (ECB) is the governing body responsible for determining the monetary policy of the countries participating in the EMU. The executive board of the EMU consists of the president of the ECB, the vice president of the ECB, and four other members. These individuals along with the governors of the national central banks comprise the Governing Council. The ECB is set up so that the executive board implements the policies dictated by the Governing Council. New monetary policy decisions are typically made by majority vote, with the president having the deciding vote in the event of a tie, in biweekly meetings. Although the ECB meets on a biweekly basis and has the power to change monetary policy at each of those meetings, it is only expected to do so at meetings where an official press conference is scheduled afterward.

The EMU’s primary objective is to maintain price stability and to promote growth. Monetary and fiscal policy changes are made to ensure that this objective is met. With the formation of the EMU, the Maastricht Treaty was developed by the EU to apply a number of criteria for each member country to help the EU achieve its objective. Deviations from these criteria by any one country will result in heavy fines. It is apparent, based on these criteria, that the ECB has a strict mandate focused on inflation and deficit. Generally, the ECB strives to maintain annual growth in Harmonized Index of Consumer Prices (HICP) below 2 percent and M3 (money supply) annual growth around 4.5 percent.

The EMU Criteria In the 1992 Treaty on European Union (the Maastricht Treaty) the following criteria were formulated as preconditions for any EU member state joining the European Monetary Union (EMU).

• A rate of inflation no more than 1.5 percent above the average of the three best-performing member states, taking the average of the 12-month year-on-year rate preceding the assessment date.
• Long-term interest rates not exceeding the average rates of these lowinflation states by more than 2 percent for the preceding 12 months.
• Exchange rates that fluctuate within the normal margins of the exchange-rate mechanism (ERM) for at least two years.
• A general government debt/GDP ratio of not more than 60 percent, although a higher ratio may be permissible if it is “sufficiently diminishing.”
• A general government deficit not exceeding 3 percent of GDP, although a small and temporary excess can be permitted.

The ECB and the European System of Central Banks (ESCB) are independent institutions from both national governments and other EU institutions, granting them complete control over monetary policy. This operational independence is accorded to them as per Article 108 of the Maastricht Treaty, which states that any member of the decision-making bodies cannot seek or take instructions from any community institutions, any government of a member state, or any other body. The primary tools the ECB uses to control monetary policy are:

Open Market Operations  The ECB has four main categories of open market operations to steer interest rates, manage liquidity, and signal monetary policy stance.

1. Main refinancing operations. These are regular liquidity-providing reverse transactions conducted weekly with a maturity of two weeks, which provide the bulk of refinancing to the financial sector.
2. Longer-term refinancing operations. These are liquidity-providing reverse transactions with a monthly frequency and a maturity of three months, which provide counterparties with additional longer-term refinancing.
3. Fine-tuning operations. These are executed on an ad hoc basis with the aim of both managing the liquidity situation in the market and steering interest rates, in particular in order to smooth the effects on interest rates caused by unexpected liquidity fluctuations.
4. Structural operations. These involve the issuance of debt certificates, reverse transactions, and outright transactions. These operations will be executed whenever the ECB wishes to adjust the structural position of the Eurosystem vis-a-vis the financial sector (on a regular or ` nonregular basis).

ECB Minimum Bid Rate (Repo Rate) The ECB minimum bid rate is the key policy target for the ECB. It is the level of borrowing that the ECB offers to the central banks of its member states. This is also the rate that is subject to change at the biweekly ECB meetings. Since inflation is of high concern to the ECB, it is more inclined to keep interest rates at lofty levels to prevent inflation. Changes in the ECB’s minimum bid rate have large ramifications for the euro.

The ECB does not have an exchange rate target, but will factor in exchange rates in its policy deliberations, as exchange rates impact price stability. Therefore, the ECB is not prevented from intervening in the foreign exchange markets if it believes that inflation is a concern. As a result, comments by members of the Governing Council are widely watched by FX market participants and frequently move the euro.

The ECB publishes a monthly bulletin detailing analysis of economic developments and changes to its perceptions of economic conditions; it is important to follow the bulletin for signals to changes in the bias of monetary policy.

Important Characteristics of the Euro

• The EUR/USD cross is the most liquid currency; all major euro crosses are very liquid.

     The euro was introduced as an electronic currency on January 1, 1999. At this time, the euro replaced all pre-EMU currencies, except for Greece’s currency, which was converted to the euro in January 2001. As a result, the EUR/USD cross is now the most liquid currency in the world and its movements are used as the primary gauge of the health of both the European and U.S. economies. The euro is most frequently known as the “anti-dollar” since it is dollar fundamentals that have dictated the currency pair’s movements between 2003 and 2008. 

EUR/JPY and EUR/CHF are also very liquid currencies that are generally used as gauges to the health of the Japanese and Swiss economies. The EUR/USD and EUR/GBP crosses are great trading currencies, as they have tight spreads, make orderly moves, and rarely gap.

• The euro has unique risks.

     Having been launched in 1999, the euro is still a relatively new currency. There are a number of factors that need to be considered as risks to the euro that may never be problems for other currencies: namely, the exposure to the economic, political, and social developments of 15 member countries. Although the number of countries using the euro is expected to grow, if any countries start dropping the euro and reverting back to their original currency because they do not believe that the ECB’s actions are in their best interest, it could affect the stability of the entire region. The euro is the only currency in the world without a country. Even though Germany, France, Italy, and Spain are the largest and most economically dominant countries within the Eurozone, the European Central Bank has the power and the responsibility to determine monetary policy for all 15 of its member countries. With that comes the political pressure of 15 governments that frequently test and criticize the actions of the European Central Bank. 

FIGURE  EUR/USD Five-Year Chart 

Up until the subprime crisis, the ECB was a new and untested central bank. However, its rapid response to the credit crunch and its deep liquidity injections have transformed its reputation. 

• The spread between 10-year U.S. Treasuries and 10-year bunds can indicate euro sentiment.

     The 10-year government bonds serve as an important indicator of future euro exchange rates, especially against the U.S. dollar. The differential between the 10-year U.S. government bond and the 10-year German bund rates can provide a good indication for euro movement. If bund rates are higher than Treasury rates and the differential increases or the spread widens, this implies euro bullishness. A decrease in the differential or spread tightening tends to be bearish for the euro. The 10-year German bund is typically used as the benchmark bond for the Eurozone.

• Predictions for euro area money flows.

     Another useful interest rate is the three-month interest rate, also known as the euro interbank offer rate (Euribor rate). This is the rate offered from one large bank to another on interbank term deposits. Traders tend to compare the Euribor futures rate with the Eurodollar futures rate. Eurodollars are deposits denominated in U.S. dollars at banks and other financial institutions outside the United States. Because investors like high-yielding assets, European fixed income assets become more attractive as the spread between Euribor futures and Eurodollar futures widens in favor of the Euribors. As the spread narrows, European assets become less attractive, thereby implying a potential decrease in money flows into the euro.

Merger and acquisition activity also has important implications for EUR/USD movements. Recent years have seen increased M&A activity between EU and U.S. multinationals. Large deals, especially if in cash, often have significant short-term impacts on the EUR/USD. 

Important Indicators for the Euro

All of the following economic indicators are important for the euro. However, since the EMU consists of 12 countries, it is important to keep abreast of political and economic developments such as GDP growth, inflation, and unemployment for all member countries. The largest countries within the EMU are Germany, France, and Italy. Therefore, in addition to the overall EMU economic data, the economic data of these three countries are the most important.

Preliminary GDP Preliminary GDP is issued when Eurostat has collected data from a sufficient number of countries to produce an estimate. This usually includes France, Germany, and the Netherlands. However, Italy is not included in the preliminary release and is only added in the final number. The yearly aggregates for EU-15 and EMU-11 are a simple sum of national GDP. For the quarterly accounts, the aggregation is more complex since some countries (Greece, Ireland, and Luxembourg) do not yet produce quarterly national accounts data. Moreover, Portugal produces only partial quarterly accounts with a significant lag. Thus, both the EU-15 and EMU-11 quarterly paths are the result of estimates from quarterly data based on a group of countries accounting for more than 95 percent of total EU GDP.

German Industrial Production The industrial production data is seasonally adjusted and includes a breakdown into four major subcategories: mining, manufacturing, energy, and construction. The manufacturing aggregate comprises four main product groups: basic and producer goods, capital goods, consumer durables, and consumer nondurables. The market tends to pay attention to the annual rate of change and the seasonally adjusted month-on-month figure. Germany’s figure is most important since it is the largest country in the Eurozone; however, the market also occasionally reacts based on French industrial production. The initial industrial production release is based on a narrower data sample and hence subject to revision when the full sample has become available. The Finance Ministry occasionally indicates the expected direction of the revision in the initial data release. 

Inflation Indicators

Harmonized Index of Consumer Prices The EU Harmonized Index of Consumer Prices (HICP) published by Eurostat is designed for international comparison as required by EU law. Eurostat has published the index since January 1995. Since January 1998, Eurostat has published a specific index for the EMU-11 area called MUICP. Information on prices is retrieved by each national statistical agency. They are required to provide Eurostat with the 100 indexes used to compute the HICP. The national HICPs are totaled by Eurostat as a weighted average of these subindexes. The weights used are country specific. The HICP is released at the end of the month following the reference period, which is about 10 days after the publications of the national CPIs from Spain and France, the final EMU-5 countries to release their CPIs. Even if the information is already partly in the market when the HICP is released, it is an important release because it serves as the reference inflation index for the ECB. The ECB aims to keep Euroland consumer price inflation in a range of 0 to 2 percent. 

M3 M3 is a broad measure of money supply, which includes everything from notes and coins to bank deposits. The ECB closely monitors M3, as it is viewed as a key measure of inflation. At its session in December 1998, the Governing Council of the ECB set its first reference value for M3 growth at 4.5 percent. This value supports inflation below 2 percent, trend growth of 2 to 2.5 percent, and a long-term decline in the velocity of money by 0.5 to 1 percent. The growth rate is monitored on a three-month moving average basis in order to prevent monthly volatility from distorting the information given by the aggregate. The ECB’s approach to monetary targeting leaves considerable room for maneuver and interpretation. Because the ECB does not impose bands on M3 growth, as the Bundesbank used to do, there will be no automatic action when M3 growth diverges from the reference value. Moreover, although the ECB considers M3 to be the key indicator, it will also take into account the changes in other monetary aggregates.

German Unemployment The release by the Labor Office contains information on the number of unemployed, as well as the changes on the previous month, in both seasonally adjusted (SA) and nonseasonally adjusted (NSA) terms. The NSA unemployment rate is provided, along with data on vacancies, short-shift working arrangements, and the number of employees (temporarily suspended in 1999). Within an hour after the Federal Labor Office (FLO) release, the Bundesbank releases the SA unemployment rate. The day ahead of the release, there is often a leak of the official data from a trade union source. The leak is usually of the NSA level of unemployment in millions. When a precise figure is reported on Reuters as given by “sources” for the NSA level of unemployment, the leak usually reflects the official figures. Rumors often circulate up to one week before the official release, but these are notoriously imprecise. Moreover, comments by German officials have in the past been mistranslated by the international press, so care needs to be exercised in interpreting news reports of rumors.

Individual Country Budget Deficits The Stability and Growth Pact states that deficits must be kept below 3 percent of GDP. Countries also have targets set to further reduce their deficits. Failure to meet these targets is widely watched by market participants.

IFO (Information and Forschung [research]) Survey Germany is by far the largest economy in Europe and is responsible for over 30 percent of total GDP. Any insight into German business conditions is seen as an insight into Europe as a whole. The IFO is a monthly survey conducted by the IFO institute in which over 7,000 German firms are asked for their assessment of the German business climate and their short-term plans. The initial publication of the results consists of the business climate headline figure and its two equally weighted subindexes: current business conditions and business expectations. The typical range is from 80 to 120, with a higher number indicating greater business confidence. The measure is most valuable, however, when measured against previous data. 

CURRENCY PROFILE: BRITISH POUND (GBP)
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Broad Economic Overview

The United Kingdom is the world’s fourth largest economy with GDP valued at approximately US$2 trillion in 2006. With one of the most effective central banks in the world, the U.K. economy has benefited from many years of strong growth, low unemployment, expanding output, and resilient consumption. The strength of consumer consumption has in large part been due the country’s strong housing market, which peaked in 2003. The United Kingdom has a service-oriented economy, with manufacturing representing an increasingly smaller portion of GDP, now equivalent to only one-fifth of national output. The capital market systems are one of the most developed in the world, and as a result finance and banking have become the strongest contributors to GDP. Although the majority of the United Kingdom’s GDP is from services, it is important to know that it is also one of the largest producers and exporters of natural gas in the EU. The energy production industry accounts for 10 percent of GDP, which is one of the highest shares of any industrialized nation. This is particularly important, as increases in energy prices (such as oil) will significantly benefit the large number of U.K. oil exporters. (The United Kingdom did become a net oil importer for a brief period due to disruptions in the North Sea in 2003, but has already resumed its status as a net oil exporter.)

Overall, the United Kingdom is a net importer of goods with a consistent trade deficit. Its largest trading partner is the EU, with trade between the two constituencies accounting for over 50 percent of all of the country’s import and export activities. The United States, on an individual basis, still remains the United Kingdom’s largest trading partner. The breakdowns of the most important trading partners for the United Kingdom are:

Leading Export Markets

1. United States
2. France
3. German
4. Ireland
5. Netherlands

Leading Import Sources

1. Germany
2. France
3. United States
4. Netherlands
5. Belgium 

Although the United Kingdom rejected adopting the euro in June 2003, the possibility of euro adoption will still be a factor in the backs of the minds of pound traders for many years to come. If the United Kingdom decided to join the EMU, doing so would have significant ramifications for its economy, the most important of which is that U.K. interest rates would have to be adjusted to reflect the equivalent interest rate of the Eurozone. One of the primary arguments against joining the EMU is that the U.K. government has sound macroeconomic policies that have worked very well for the country. Its successful monetary and fiscal policies have led the United Kingdom to outperform most major economies through a recent economic downturn, including the EU.

The U.K. Treasury has previously specified five economic tests that must be met prior to euro adoption.

United Kingdom’s Five Economic Tests for the Euro

1. Is there sustainable convergence in business cycles and economic structures between the United Kingdom and other EMU members, so that the U.K. citizens could live comfortably with euro interest rates on a permanent basis?
2. Is there enough flexibility to cope with economic change?
3. Would joining the EMU create an environment that would encourage firms to invest in the United Kingdom?
4. Would joining the EMU have a positive impact on the competitiveness of the United Kingdom’s financial services industry?
5. Would joining the EMU be good for promoting stability and growth in employment?

The United Kingdom is a very political country where government officials are highly concerned with voter approval. If voters do not support euro entry, the likelihood of EMU entry would decline. The following are some of the arguments for and against adopting the euro.

Arguments in Favor of Adopting the Euro

• Reduced exchange rate uncertainty for U.K. businesses and lower exchange rate transaction costs or risks.
• The prospect of sustained low inflation under the governance of the European Central Bank should reduce long-term interest rates and stimulate sustained economic growth.
• Single currency promotes price transparency.
• The integration of national financial markets of the EU will lead to higher efficiency in the allocation of capital in Europe.
• The euro is the second most important reserve currency after the U.S. dollar.
• With the United Kingdom joining the EMU, the political clout of the EMU would increase dramatically.

Arguments against Adopting the Euro

• Currency unions have collapsed in the past.
• Economic or political instabilities of one country would impact the euro, which would have exchange rate ramifications for otherwise healthy countries.
• Strict EMU criteria are outlined by the Stability and Growth Pact.
• Entry would mean a permanent transfer of domestic monetary authority to the European Central Bank.
• Joining a currency union with no monetary flexibility would require the United Kingdom to have more flexibility in the labor and housing markets. 
• There are fears about which countries might dominate the ECB.
• Adjusting to new currency will require large transaction costs.

Monetary and Fiscal Policy Makers—Bank of England

The Bank of England (BOE) is the United Kingdom’s central bank. The Monetary Policy Committee (MPC) is a nine-member committee that sets monetary policy for the United Kingdom. It consists of a governor, two deputy governors, two executive directors of the central bank, and four outside experts. The committee was granted operational independence in setting monetary policy in 1997. Despite this independence, their monetary policies are centered around achieving an inflation target dictated by the Treasury Chancellor. Currently, this target is retail price index (RPIX) inflation of 2.5 percent. The central bank has the power to change interest rates to levels that it believes will allow it to meet this target. The MPC holds monthly meetings, which are closely followed for announcements on changes in monetary policy, including changes in the interest rate (bank repo rate). 

The MPC publishes statements after every meeting, along with a quarterly Inflation Report detailing the MPC’s forecasts for the next two years of growth and inflation and justification for its policy movements. In addition, another publication, the Quarterly Bulletin, provides information on past monetary policy movements and analysis of the international economic environment and its impacts on the U.K. economy. All of these reports contain detailed information on the MPC’s policies and biases for future policy movements. The main policy tools used by the MPC and BOE follow. 

Bank Repo Rate This is the key rate used in monetary policy to meet the Treasury’s inflation target. This rate is set for the bank’s own operations in the market, such as the short-term lending activities. Changes to this rate affect the rates set by the commercial banks for their savers and borrowers. In turn, this rate will affect spending and output in the economy, and eventually costs and prices. An increase in this rate would imply an attempt to curb inflation, while a decrease in this rate would be to stimulate growth and expansion.

Open Market Operations The goal of open market operations is to implement the changes in the bank repo rate, while assuring adequate liquidity in the market and continued stability in the banking system. This is reflective of the three main objectives of the BOE: maintaining the integrity and value of the currency, maintaining the stability of the financial system, and seeking to ensure the effectiveness of the United Kingdom’s financial services. To ensure liquidity, the bank conducts daily open market operations to buy or sell short-term government fixed income instruments. If this is not sufficient to meet liquidity needs, the BOE would also conduct additional overnight operations.

Important Characteristics of the British Pound

• GBP/USD is very liquid.

     The GBP/USD is one of the most liquid currencies in the world, with 6 percent of all currency trading involving the British pound as either the base or counter currency. It is also one of the four most liquid currencies available for trading (among the EUR/USD, GBP/USD, USD/JPY, and USD/CHF). One of the reasons for the currency’s liquidity is the country’s highly developed capital markets. Many foreign investors seeking opportunities other than the United States have sent their funds to the United Kingdom. In order to create these investments, foreigners will need to sell their local currency and buy British pounds.

• GBP has three names.

     The U.K.’s currency has three names—the British pound, Sterling, and Cable. All of these are interchangeable. 

• GBP is laden with speculators.

     At the time of publication, the British pound has one of the highest interest rates among the developed nations. Although Australia and New Zealand have higher interest rates, their financial markets are not as developed as that of the United Kingdom. As a result, many investors who already have positions or are interested in initiating new carry trade positions frequently use the GBP as the lending currency and will go long the pound against currencies such as the U.S. dollar, Japanese yen, and Swiss franc. A carry trade involves buying or lending a currency with a higher interest rate and selling or borrowing a currency with a lower interest rate. In recent years, carry trades have increased in popularity, which has helped spur demand for the British pound. However, should the interest rate yield differential between the pound and other currencies narrow, an exodus of carry traders will increase volatility in the British pound.

FIGURE  GBP/USD Five-Year Chart

• Interest rate differentials between gilts and foreign bonds are closely followed.

Interest rate differentials between U.K. gilts/U.S. Treasuries and U.K. gilts/German bunds are widely watched by FX market participants. Gilts versus Treasuries can be a barometer of GBP/USD flows, while gilts versus bunds can be used as a barometer for EUR/GBP flows. More specifically, these interest rate differentials indicate how much premium yield U.K. fixed income assets are offering over U.S. and European fixed income assets (the German bund is usually used as a barometer for European yield), or vice versa. This differential provides traders with indications of potential capital flow or currency movements, as global investors are always shifting their capital in search for the assets with the highest yields. The United Kingdom currently provides these yields, while also providing the safety of having the same credit stability as the United States.

• Eurosterling futures can give indications for interest rate movements.

Since the U.K. interest rate or bank repo rate is the primary tool used in monetary policy, it is important to keep abreast of potential changes to the interest rate. Comments from government officials is one way to gauge biases for potential rate changes, but the Bank of England is one of the few central banks that require members of the Monetary Policy Committee to publish their voting records. This personal accountability indicates that comments by individual committee members represent their own opinions and not that of the BOE. Therefore, it is necessary to look for other indications of potential BOE rate movements. Three-month eurosterling futures reflect market expectations on eurosterling interest rates three months into the future. These contracts are also useful in predicting U.K. interest rate changes, which will ultimately affect the fluctuations of the GBP/USD. 

• Comments on euro by U.K. politicians will impact the euro.

     Any speeches, remarks (especially from the prime minister or Treasury chancellor), or polls in regard to the euro will impact the currency markets. Indication for adoption of the euro tends to put downward pressure on the GBP, while further opposition to euro entry will typically boost the GBP, the reason being that in order for the GBP to come in line with the euro, interest rates would have to decrease significantly (at the time of this writing, the United Kingdom interest rate is 5.00 percent, versus euro interest rate of 4.00 percent). A decrease in the interest rate would induce carry trade investors to close their positions, or sell pounds. The GBP/USD would also decline because of the uncertainties involved with euro adoption. The U.K. economy is performing very well under the direction of its current monetary authority. The EMU is currently encountering many difficulties with member countries breaching EMU criteria. With one monetary authority dictating 12 countries (plus the United Kingdom would be 13), the EMU has yet to prove that it has developed a monetary policy suitable for all member states. 

• GBP has positive correlation with energy prices.

     The United Kingdom houses some of the largest energy companies in the world, including British Petroleum. Energy production represents 10 percent of GDP. As a result, the British pound tends to have a positive correlation with energy prices. Specifically, since many members of the EU import oil from the United Kingdom, as oil prices increase, they will in turn have to buy more pounds to fund their energy purchases. In addition, higher oil prices will also benefit the earnings of the nation’s energy exporters.

• GBP crosses.

Although the GBP/USD is a more liquid currency than EUR/GBP, EUR/GBP is typically the leading gauge for GBP strength. The GBP/USD currency pair tends to be more sensitive to U.S. developments, while EUR/GBP is a more pure fundamental pound trade since EUR is Britain’s primary trade and investment partner. However, both currencies are naturally interdependent, which means that movements in the EUR/GBP cross can filter into movements in the GBP/USD. The reverse is also true; that is, movements in GBP/USD will also affect trading in EUR/GBP. Therefore it is important for pound traders to be consciously aware of the trading behavior of both currency pairs. The EUR/GBP rate should be exactly equal to the EUR/USD divided by the GBP/USD rate. Small differences in these rates are often exploited by market participants and quickly eliminated.

Important Economic Indicators for the United Kingdom

All of the following indicators are important for the United Kingdom. However, since the United Kingdom is primarily a service-oriented economy, it is particularly important to pay attention to numbers from the service sector.

Employment Situation A monthly survey is conducted by the Office of National Statistics. The objectives of the survey are to divide the working-age population into three separate classifications—employed, unemployed, and not in the labor force—and to provide descriptive and explanatory data on each of these categories. Data from the survey provides market participants with information on major labor market trends such as shifts in employment across industrial sectors, hours worked, labor force participation, and unemployment rates. The timeliness of the survey makes it a closely watched statistic by the currency markets as it is a good barometer of the strength of the U.K. economy.

Retail Price Index The RPI is a measure of the change in prices of a basket of consumer goods. The markets, however, focus on the underlying RPI or RPI-X, which excludes mortgage interest payments. The RPI-X is closely watched as the Treasury sets inflation targets for the BOE, currently defined as 2.5 percent annual growth in RPI-X.

Gross Domestic Product A quarterly report is conducted by the Bureau of Statistics. GDP is a measure of the total production and consumption of goods and services in the United Kingdom. GDP is measured by adding expenditures by households, businesses, government, and net foreign purchases. The GDP price deflator is used to convert output measured at current prices into constant-dollar GDP. This data is used to gauge where in the business cycle the United Kingdom finds itself. Fast growth often is perceived as inflationary while low (or negative) growth indicates a recessionary or weak economy.

Industrial Production The industrial production (IP) index measures the change in output in U.K. manufacturing, mining and quarrying, and electricity, gas, and water supply. Output refers to the physical quantity of items produced, unlike sales value, which combines quantity and price. The index covers the production of goods and power for domestic sales in the United Kingdom and for export. Because IP is responsible for close to a quarter of gross domestic product, IP is widely watched as it provides good insight into the current state of the economy.

Purchasing Managers Index The purchasing managers index (PMI) is a monthly survey conducted by the Chartered Institute of Purchasing and Supply. The index is based on a weighted average of seasonally adjusted measures of output, new orders, inventory, and employment. Index values above 50 indicate an expanding economy, while values below 50 are indicative of contraction.

U.K. Housing Starts Housing starts measure the number of residential building construction projects that have begun during any particular month. This is important data for the United Kingdom as the housing market is the primary industry that is sustaining the economy’s performance.

CURRENCY PROFILE: SWISS FRANC (CHF)
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Broad Economic Overview

Switzerland is the nineteenth largest economy in the world, with a GDP valued at over US$255 billion in 2006. Although the economy is relatively small, it is one of the wealthiest in the world on a GDP per capita basis. It is prosperous and technologically advanced with stability that rivals that of many larger economies. The country’s prosperity stems primarily from technological expertise in manufacturing, tourism, and banking. More specifically, Switzerland is known for its chemicals and pharmaceuticals industries, machinery, precision instruments, watches, and a financial system historically known for protecting the confidentiality of its investors. This coupled with the country’s lengthy history of political neutrality has created a safe haven reputation for the country and its currency. As a result, Switzerland is the world’s largest destination for offshore capital. The country holds over US$2 trillion in offshore assets and is estimated to attract more than 35 percent of the world’s private wealth management business. This has created a large and highly advanced banking and insurance industry that employs over 50 percent of the population and comprises more than 70 percent of total GDP. Since Switzerland’s financial industry thrives on its safe haven status and renowned confidentiality, capital flows tend to drive the economy during times of global risk aversion, while trade flows drive the economy during a risk-seeking environment. Therefore trade flows are important, with nearly two-thirds of all trade conducted with Europe. Switzerland’s most important trading partners are:

Leading Export Markets 

1. Germany 
2. United States 
3. Italy 
4. France 
5. United Kingdom 
6. Japan 

Leading Import Sources 

1. Germany 
2. Italy 
3. France 
4. Netherlands 
5. United States 
6. United Kingdom

In recent years, merchandise trade flow has fluctuated between deficit and surplus. The current account, on the other hand, has reflected a surplus since 1966. In 2006, the current account surplus reached a high at 14.5 percent of GDP. This is the highest current account surplus among all of the industrialized countries (aside from Norway, Singapore, and Hong Kong). Most of the surplus can be attributed to the large amount of foreign direct investment into the country in search of safety of capital, despite the low yields offered by Switzerland.

Monetary and Fiscal Policy Makers—Swiss National Bank 

The Swiss National Bank (SNB) is the central bank of Switzerland. It is a completely independent central bank with a three-person committee responsible for determining monetary policy. This committee consists of a chairman, a vice chairman, and one other member who constitute the Governing Board of the SNB. Due to the small size of the committee, all decisions are based on a consensus vote. The board reviews monetary policy at least once a quarter, but decisions on monetary policy can be made and announced at any point in time. Unlike most other central banks, the SNB does not set one official interest rate target, but instead sets a target range for the three-month Swiss LIBOR rate.

Central Bank’s Goals In December 1999, the SNB shifted from focusing on monetary targets (M3) to an inflation target of less than 2 percent inflation per year. This measure is taken based on the national consumer price index. Monetary targets still remain important indicators and are closely watched by the central bank, because they provide information on the long-term inflation. This new inflation focus also increases the central bank’s transparency. The bank has clearly stated that “should inflation exceed 2 percent in the medium term, the SNB will tend to tighten its monetary stance.” If there is a danger of deflation, the National Bank would loosen monetary policy. The SNB also closely monitors exchange rates, as excessive strength in the Swiss franc can cause inflationary conditions. This is especially true in environments of global risk aversion, as capital flows into Switzerland increase significantly during those times. As a result, the SNB typically favors a weak franc, and is not hesitant to use intervention as a liquidity tool. SNB officials intervene in the franc using a variety of methods including verbal remarks on liquidity, money supply, and the currency.

Central Bank’s Tools The most commonly used tools by the SNB to implement monetary policy include: 

Target Interest Rate Range The SNB implements monetary policy by setting a target range for their three-month interest rate (the Swiss LIBOR rate). This range typically has a 100-basis-point spread, and is revised at least once every quarter. This rate is used as the target because it is the most important money market rate for Swiss franc investments. Changes to this target are accompanied with a clear explanation in regard to the changes in the economic environment.

Open Market Operations Repo transactions are the SNB’s major monetary policy instrument. A repo transaction involves a cash taker (borrower) selling securities to a cash provider (lender), while agreeing to repurchase the securities of the same type and quantity at a later date. This structure is similar to a secured loan, whereby the cash taker must pay the cash provider interest. These repo transactions tend to have very short maturities ranging from one day to a few weeks. The SNB uses these repo transactions to manipulate undesirable moves in the three-month LIBOR rate. To prevent increases in the three-month LIBOR rate above the SNB’s target, the bank would supply the commercial banks with additional liquidity through repo transactions at lower repo rates, and in essence create additional liquidity. Conversely, the SNB can reduce liquidity or induce increases in the three-month LIBOR rate by increasing repo rates.

The SNB publishes a Quarterly Bulletin with a detailed assessment of the current state of the economy and a review of monetary policy. A Monthly Bulletin is also published containing a short review of economic developments. These reports are important to watch, as they may contain information on changes in the SNB’s assessment of the current domestic situation. 

Important Characteristics of the Swiss Franc

• Safe haven status.

     This is perhaps the most unique characteristic of the Swiss franc. Switzerland’s safe haven status is continually stressed because this and the secrecy of the banking system are the key advantages of Switzerland. The Swiss franc moves primarily on external events rather than domestic economic conditions. That is, as mentioned earlier, due to its political neutrality, the franc is considered the world’s premier safe haven currency. Therefore, in times of global instability and/or uncertainty, investors tend to be more concerned with capital retention than appreciation. At such times, funds will flow into Switzerland, which would cause the Swiss franc to appreciate regardless of whether growth conditions are favorable.

• Swiss franc is closely correlated with gold.

     Switzerland is the world’s fourth largest official holder of gold. The Swiss constitution used to have a mandate requiring the currency to be backed 40 percent with gold reserves. Since then, despite the removal of the mandate, the link between gold and the Swiss franc has remained ingrained in the minds of Swiss investors. As a result, the Swiss franc has close to an 80 percent positive correlation with gold. If the gold price appreciates, the Swiss franc has a high likelihood of appreciating as well. In addition, since gold is also viewed as the ultimate safe haven form of money, both gold and the Swiss franc benefit during periods of global economic and geopolitical uncertainty.

• Carry trades effects.

     With one of the lowest interest rates in the industrialized world over the past few years, the Swiss franc is one of the most popular currencies used by traders in carry trades. As mentioned throughout this book, the popularity of carry trades has increased significantly over recent years, as investors are actively seeking high-yielding assets. A carry trade involves buying or lending a currency with a high interest rate and selling or borrowing a currency with a low interest rate. With CHF having one of the lowest interest rates of all industrialized countries, it is one of the primary currencies sold or borrowed in carry trades. This results in the need to sell CHF against a higher-yielding currency. Carry trades are typically done in cross-currencies such as GBP/CHF or AUD/CHF, but these trades will impact both EUR/CHF and USD/CHF. Unwinding of carry trades will involve the need for investors to purchase CHF.

• Interest rate differentials between Euro Swiss futures and foreign interest rate futures are closely followed.

     Interest rate differentials between three-month Euro Swiss futures and Eurodollar futures are widely watched by professional Swiss traders. These differentials are good indicators of potential money flows as they indicate how much premium yield U.S. fixed income assets are offering over Swiss fixed income assets, or vice versa. This differential provides traders with indications of potential currency movements, as investors are always looking for assets with the highest yields. This is particularly important to carry traders who enter and exit their positions based on the positive interest rate differentials between global fixed income assets.

• Potential changes in banking regulations.

     Over the past few years members of the European Union have been exerting significant pressure on Switzerland to relax the confidentiality of its banking system and to increase transparency of customers’ accounts. The EU is pressing this issue because of its active measures to prosecute EU tax evaders. This should be a concern for many years to come. However, this is a difficult decision for Switzerland to make because the confidentiality of customers’ accounts represents the core strength of its banking system. The EU has threatened to impose severe sanctions on Switzerland if it does not comply with the proposed measures. Both political entities are currently working to negotiate an equitable resolution. Any news or talk of changing banking regulations will impact both Switzerland’s economy and the Swiss franc.

• Merger and acquisition activity.

Switzerland’s primary industry is banking and finance. In this industry, merger and acquisition (M&A) activities are very common, especially as consolidation continues in the overall industry. As a result, these M&A activities can have significant impact on the Swiss franc. If foreign firms purchase Swiss banks or insurance companies, they will need to buy Swiss francs and in turn sell their local currencies. If Swiss banks purchase foreign firms, on the other hand, they would need to sell Swiss francs and buy the foreign currencies. Either way, it is important for Swiss franc traders to frequently watch for notices on M&A activity involving Swiss firms.

• Trading behavior, cross-currency characteristics.

     The EUR/CHF is the most commonly traded currency for traders who want to participate in CHF movements. The USD/CHF is less frequently traded because of its higher illiquidity and volatility. However, day traders may tend to favor USD/CHF over EUR/CHF because of its volatile movements. In actuality, the USD/CHF is only a synthetic currency derived from EUR/USD and EUR/CHF. Market makers or professional traders tend to use those pairs as leading indicators for trading USD/CHF or to price the current USD/CHF level when the currency pair is illiquid. Theoretically, the USD/CHF rate should be exactly equal to EUR/CHF divided by EUR/USD. Only during times of severe global risk aversion, such as the Iraq War or September 11, will USD/CHF develop a market of its own. Any small differences in these rates are quickly exploited by market participants.

FIGURE  USD/CHF Five-Year Chart 

Important Economic Indicators for Switzerland

KoF (Konjunkturforschungsstelle der eth, Zurich) Leading Indicators The KoF leading indicators report is released by the Swiss Institute for Business Cycle Research. This index is generally used to gauge the future health of the Swiss economy. It contains six components: (1) change in manufacturers’ orders, (2) expected purchase plans of manufacturers over the next three months, (3) judgment of stocks in wholesale business, (4) consumer perception of their financial conditions, (5) backlog in the construction sector, and (6) orders backlog for manufacturers.

Consumer Price Index The consumer price index is calculated monthly on the basis of retail prices paid in Switzerland. In accordance with prevalent international practice, the commodities covered are distinguished according to the consumption concept, which includes in the calculation of the index those goods and services that are part of the private consumption aggregate according to the National Accounts. The basket of goods does not include so-called transfer expenditure such as direct taxation, social insurance contributions, and health insurance premiums. The index is a key measure of inflation. 

Gross Domestic Product GDP is a measure of the total production and consumption of goods and services in Switzerland. GDP is measured by adding expenditures by households, businesses, government, and net foreign purchases. The GDP price deflator is used to convert output measured at current prices into constant-dollar GDP. This data is used to gauge where in the business cycle Switzerland finds itself. Fast growth often is perceived as inflationary while low (or negative) growth indicates a recessionary or weak economy. 

Balance of Payments Balance of payments is the collective term for the accounts of Swiss transactions with the rest of the world. The current account is the balance of trade plus services portion. Balance of payments is an important indicator for Swiss traders as Switzerland has always kept a strong current account balance. Any changes to the current account, positive or negative, could see substantial flows.

Production Index (Industrial Production) The production index is a quarterly measure of the change in the volume of industrial production (or physical output by producers).

Retail Sales Switzerland’s retail sales report is released on a monthly basis 40 days after the reference month. The data is an important indicator of consumer spending habits and is not seasonally adjusted.