PROFILES AND UNIQUE CHARACTERISTICS OF MAJOR CURRENCY PAIRS

CURRENCY PROFILE: JAPANESE YEN (JPY)
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Broad Economic Overview

Japan is the third largest economy in the world with GDP valued at over US$4.2 trillion in 2006 (behind the United States and the entire Eurozone or EMU). It is the second largest single economy. The country is also one of the world’s largest exporters and is responsible for over $500 billion in exports per year. Manufacturing and exports of products such as electronics and cars are the signature drivers of the economy, accounting for nearly 20 percent of GDP. This has resulted in a consistent trade surplus, which creates an inherent demand for the Japanese yen, despite severe structural deficiencies. Aside from being an exporter, Japan is also a large importer of raw materials for the production of goods. The primary trade partners for Japan in terms of both imports and exports are the United States and China. China’s inexpensive goods have helped the country capture a larger share of Japan’s import market. It is becoming an increasingly important trade partner, and has even surpassed the United States to become Japan’s largest source of imports in 2003. 

Leading Export Markets


  1. United States
  2. China 
  3. South Korea 
  4. Taiwan 
  5. Hong Kong 


Leading Import Sources


  1. China
  2. United States
  3. South Korea
  4. Australia 
  5. Taiwan


Japan’s Bubble Burst

Understanding the Japanese economy first involves understanding what led to the Japanese bubble and its subsequent burst.

In the 1980s, Japan’s financial market was one of the most attractive markets for international investors seeking investment opportunities in Asia. It had the most developed capital markets in the region, and its banking system was considered to be one of the strongest in the world. At the time, the country was experiencing above-trend economic growth and near zero inflation. This resulted in rapid growth expectations, boosted asset prices, and rapid credit expansion, leading to the development of an asset bubble. Between 1990 and 1997, the asset bubble collapsed, inducing a US$10 trillion fall in asset prices, with the fall in real estate prices accounting for nearly 65 percent of the total decline, which is worth two years of national output. This fall in asset prices sparked a banking crisis in Japan. It began in the early 1990s and then developed into a full-blown systemic crisis in 1997 following the failure of a number of high-profile financial institutions. Many of these banks and financial institutions had extended loans to the builders and real estate developers at the height of the asset bubble in the 1980s, with the land as the collateral. A number of these developers defaulted after the asset bubble collapse, leaving the country’s banks saddled with bad debt and collateral worth sometimes 60 to 80 percent less than when the loans were taken out. Due to the large size of these banking institutions and their role in corporate funding, the crisis had profound effects on both the Japanese economy and the global economy. Enormous bad debts, falling stock prices, and a collapsing real estate sector have crippled the Japanese economy for almost two decades.

In addition to the banking crisis, Japan also has the highest debt level of all of the industrialized countries, at over 140 percent of GDP. As a result of the country’s deteriorating fiscal position and rising public debt, the country experienced over 10 years of stagnation. With this high debt burden, Japan still stands at risk of a liquidity crisis. The banking sector has become highly dependent on a government bailout. As a result, the Japanese yen is very sensitive to political developments and to any words in speeches by government officials that may indicate potential changes in monetary and fiscal policy, attempted bailout proposals, and any other rumors.

Monetary and Fiscal Policy Makers—Bank of Japan

The Bank of Japan (BOJ) is the key monetary policy making body in Japan. In 1998, the Japanese government passed laws giving the BOJ operational independence from the Ministry of Finance (MOF) and complete control over monetary policy. However, despite the government’s attempts to decentralize decision making, the MOF still remains in charge of foreign exchange policy. The BOJ is responsible for executing all official Japanese foreign exchange transactions at the direction of the MOF. The Bank of Japan’s Policy Board consists of the BOJ governor, two deputy governors, and six other members. Monetary policy meetings are held twice a month with briefings and press releases provided immediately. The BOJ also publishes a Monthly Report issued by the Policy Board and a Monthly Economic Report. These reports are important to watch for changes in BOJ sentiment and signals of new monetary or fiscal policy measures, as the government is constantly trying to develop initiatives to stimulate growth.

The MOF and the BOJ are very important institutions that both have the ability to impact currency movements. Since the MOF is the director of foreign exchange interventions, it is important to watch and keep abreast of the comments made from MOF officials. Being an export-driven economy, the government tends to favor a weaker Japanese yen. Therefore, if the Japanese yen appreciates significantly or too rapidly against the dollar, members of the BOJ and MOF will become increasingly vocal about their concerns or disapproval in regard to the current level or movements in the Japanese yen. These comments do tend to be market movers, but it is important to note that if government officials flood the market with comments and no action, the market would start to become immune to these comments. However, the MOF and BOJ do have a lengthy history of interventions in the currency markets to actively manipulate the JPY in Japan’s best interests; therefore, their comments cannot be completely disregarded. The most popular tool that the BOJ uses to control monetary policy is open market operations.

Open Market Operations These activities are focused on controlling the uncollateralized overnight call rate. The Bank of Japan has maintained a zero interest rate policy for some time now, which means that the Bank of Japan cannot further decrease this rate to stimulate growth, consumption, or liquidity. Therefore in order to maintain zero interest rates, the BOJ has to manipulate liquidity through open market operations, targeting zero interest on the overnight call rate. It manipulates liquidity by the outright buying or selling of bills, repos, or Japanese government bonds. A repo transaction involves a cash taker (borrower) selling securities to a cash provider (lender), while agreeing to repurchase 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.

In terms of fiscal policy, the Bank of Japan continues to consider a number of methods to deal with its nonperforming loans. This includes inflation targeting, nationalizing a portion of private banks, and repackaging the banks’ bad debt and selling it at a discount. No policies have been decided upon, but the government is aggressively considering all of these and other alternatives.

Important Characteristics of the Japanese Yen


  • Proxy for Asian strength/weakness.

     Japan tends to be seen as a proxy for broad Asian strength because the country has the largest GDP in Asia. With the most developed capital markets, Japan was once the primary destination for all investors who wanted access into the region. Japan also conducts a significant amount of trade with its Asian partners. As a result, economic problems or political instability in Japan tend to spill over into the other Asian countries. However, this spillover is not one-sided. Economic or political problems in other Asian economies can also have dramatic impacts on the Japanese economy and hence movements in the Japanese yen. For example, North Korean political instability poses a great risk to Japan and the Japanese yen since of the G-7 nations Japan has the strongest ties to North Korea.


  • Bank of Japan intervention practices.

     The BOJ and MOF are very active participants in the FX markets. That is, they have a lengthy history of entering the FX markets if they are dissatisfied with the current JPY level. As Japan is a very political economy, with close ties between government officials and principals of large private institutions, the MOF has a very narrow segment in mind when it decides to depreciate a strong JPY. Since the BOJ is such an active participant, it is very much in tune with the market’s movements and other participants. Periodically the BOJ receives information on large hedge fund positions from banks and is likely to intervene when speculators are on the other side of the market, allowing them to get the most bang for the buck. There are typically three main factors behind BOJ and MOF intervention:


  1. Amount of appreciation/depreciation in JPY. Intervention has historically occurred when the yen moves by seven or more yen in less than six weeks. Using the USD/JPY as a barometer, 7 yen would be equivalent to 700 pips, which would represent a move from 117.00 to 125.00.
  2. Current USD/JPY rate. Historically, only 11 percent of all BOJ interventions to counter a strong JPY have occurred above the 115 level.
  3. Speculative positions. In order to maximize the impact of intervention, the BOJ and MOF will intervene when market participants hold positions in the opposite direction. Traders can find a gauge for the positions of market participants by viewing the International Monetary Market (IMM) positions from the CFTC.



  • JPY movements are sensitive to time.

     JPY crosses can become very active toward the end of the Japanese fiscal year (March 31), as exporters repatriate their dollardenominated assets. This is particularly important for Japanese banks because they need to rebuild their balance sheets to meet Financial Services Authority (FSA) guidelines, which require the banks to mark to market their security holdings. In anticipation of the need for repatriation-related purchases of the Japanese yen, speculators frequently also bid the yen higher in an attempt to take advantage of this increased inflow. As a result, following fiscal year-end, the Japanese yen tends to have a bias toward depreciation as speculators close their positions. 

FIGURE  USD/JPY Five-Year Chart

Aside from the fiscal year-end, time is also a factor on a day-to-day basis. Unlike traders in London or New York who typically have lunch at their trading desk, Japanese traders tend to take hourlong lunches between 10 and 11 p.m. EST, leaving only a junior trader in the office. Therefore, the Japanese lunchtime can be volatile, as the market gets very illiquid. Aside from that time frame, the JPY tends to move in a fairly orderly way during Japanese and London hours, unless breaking announcements or government official comments are made or surprising economic data is released. During U.S. hours, however, the JPY tends to have higher volatility, as U.S. traders are actively taking both USD and JPY positions. 


  • Banking stocks are widely watched.

     Since the crux of Japan’s economic crisis stems from the nonperforming loan (NPL) problems of the Japanese banks, banking sector stocks are closely watched by FX market participants. Any threat of default by these banks, disappointing earnings, or further reports of significant NPLs can indicate even deeper problems for the economy. Therefore, bank stock movements can lead movements in the Japanese yen.


  • Carry trade effects.

     The popularity of carry trades has increased in recent years, as investors are actively seeking high-yielding assets. With the Japanese yen having the lowest interest rate of all industrialized countries, it is the primary currency sold or borrowed in carry trades. The most popular carry trade currencies included GBP/JPY, AUD/JPY, NZD/JPY, and even USD/JPY. Carry traders would go short the Japanese yen against the higher-yielding currencies. Therefore reversal of carry trades as a result of spread narrowing would actually be beneficial for the Japanese yen, as the reversal process would involve purchasing the yen against the other currencies.

Important Economic Indicators for Japan

All of the following economic indicators are important for Japan. However, since Japan is a manufacturing-oriented economy, it is important to pay particular attention to numbers from the manufacturing sector.

Gross Domestic Product Gross domestic product is a broad measure of the total production and consumption of goods and services measured over quarterly and yearly periods in Japan. GDP is measured by adding total 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. Preliminary reports are the most significant for FX market participants.

Tankan Survey The Tankan is a short-term economic survey of Japanese enterprises published four times a year. The survey includes more than 9,000 enterprises, which are divided into four major groups: large, small, and medium-sized as well as principal enterprises. The survey gives an overall impression of the business climate in Japan and is widely watched and anticipated by foreign exchange market participants.

Balance of Payments Balance of payments information gives investors insight into Japan’s international economic transactions that include goods, services, investment income, and capital flows. The current account side of BOJ is most often used as a good gauge of international trade. Figures are released both monthly and semiannually. 

Employment Employment figures are reported on a monthly basis by the Management and Coordination Agency of Japan. The employment release is a measure of the number of jobs and unemployment rate for the country as a whole. The data is obtained through a statistical survey of the current labor force. This release is a closely watched economic indicator because of its timeliness and its importance as a leading indicator of economic activity. 

Industrial Production The industrial production (IP) index measures trends in the output of Japanese manufacturing, mining, and utilities companies. Output refers to the total quantity of items produced. The index covers the production of goods for domestic sales in Japan and for export. It excludes production in the agriculture, construction, transportation, communication, trade, finance, and service industries; government output; and imports. The IP index is then developed by weighting each component according to its relative importance during the base period. Investors feel IP and inventory accumulation have strong correlations with total output and can give good insight into the current state of the economy. 

CURRENCY PROFILE: AUSTRALIAN DOLLAR (AUD)
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Broad Economic Overview

Australia is the fifth largest country in terms of GDP in the Asia-Pacific region. Its gross domestic product was approximately US$674 billion in 2006. Although its economy is relatively small, on a per capita basis it is comparable to many industrialized Western European countries. Australia has a service-oriented economy with close to 79 percent of GDP coming from industries such as finance, property, and business services. However, the country has a trade deficit, with manufacturing dominating the country’s exporting activities. Rural and mineral exports account for over 60 percent of all manufacturing exports. As a result, the economy is highly sensitive to changes in commodity prices. The breakdowns of Australia’s most important trading partners are important because downturns or rapid growth in Australia’s largest trade partners will impact demand for the country’s imports and exports.

Largest Export Markets


  1. Japan
  2. European Union
  3. China
  4. ASEAN (Association of Southeast Asian Nations) 
  5. Republic of Korea
  6. United States


Largest Import Sources


  1. European Union
  2. ASEAN (Association of Southeast Asian Nations)
  3. China
  4. United States


Japan and the Association of Southeast Asian Nations (ASEAN) are the leading importers of Australian goods. The ASEAN includes Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand, and Vietnam. Therefore, it may be logical to assume that the Australian economy is highly sensitive to the performance of the countries in the Asian-Pacific region. However, during the Asian crisis, Australia grew at an average rate of 4.7 percent per year from 1997 to 1999 despite the fact that Asia is the central destination for the bulk of Australian exports. Australia was able to maintain strength as a result of the country’s sound foundation of strong domestic consumption. As a result, the economy has been able to withstand past crises. Consumption has been on a steady rise since the 1980s. Therefore consumer consumption is an important indicator to watch during times of global economic slowdown for signals of the slowdown’s spillover effects onto Australia’s domestic consumption.


Monetary and Fiscal Policy Makers—Reserve Bank of Australia

The Reserve Bank of Australia (RBA) is the central bank of Australia. The monetary policy committee within the central bank consists of the governor (chairman), the deputy governor (vice chairman), secretary to the treasurer, and six independent members appointed by the government. Changes on monetary policy are based on consensus within the committee. 

Central Bank’s Goals The RBA’s charter states that the mandate of the Reserve Bank Board is to focus monetary and banking policy on ensuring:


  • The stability of the currency of Australia.
  • The maintenance of full employment in Australia.
  • The economic prosperity and welfare of the people of Australia.

In order to achieve these objectives, the government has set an informal consumer price inflation target of 2 to 3 percent per year. The RBA believes that the key to long-term sustainable growth in the economy is to control inflation, which would preserve the value of money. In addition, an inflation target provides a discipline for monetary policy making and guidelines for private sector inflation expectations. This also increases the transparency of the bank’s activities. Should inflation or inflation expectations exceed the 2 to 3 percent target, traders should know that it would raise red flags at the RBA and prompt the central bank to favor a tighter monetary policy—in other words, further rate hikes.

Monetary policy decisions involve setting the interest rate on overnight loans in the money market. Other interest rates in the economy are influenced by this interest rate to varying degrees, so that the behavior of borrowers and lenders in the financial markets is affected by monetary policy (though not only by monetary policy). Through these channels, monetary policy affects the economy in pursuit of the goals outlined earlier.

Cash Rate This is the RBA’s target rate for open market operations. The cash rate is the rate charged on overnight loans between financial intermediaries. As a result, the cash rate should have a close relationship with the prevailing money market interest rates. Changes in monetary policy directly impact the interest rate structure of the financial system, and also impact sentiment in a currency. The chart in graphs the AUD/USD against the interest rate differential between Australia and the United States. Broadly speaking, there is a clear positive correlation between the interest rate differential and the movement in the currency. That is, between 1990 and 1994 Australia aggressively cut interest rates from a high of 17 percent to 4.75 percent, leading to a sharp decline in the AUD/USD. A different scenario was seen between 2000 and 2004. At the time, Australia was raising interest rates while the United States was cutting interest rates. This divergence in monetary policies led to a very strong rally in the AUD/USD over the next five years.

Maintaining the Cash Rate: Open Market Operations The focus of daily open market operations is to keep the cash rate close to the target by managing money market liquidity provided to commercial banks. If the Reserve Bank wishes to decrease the cash rate, it would increase the supply of short-dated repurchase agreements at a lower interest rate than the prevailing cash rate, which would in essence decrease the cash rate. If the Reserve Bank wishes to increase the cash rate, it would decrease the supply of short-dated repurchase agreements, which would in essence increase the cash rate. A repurchase agreement involves a cash taker (commercial bank) selling securities to a cash provider (RBA), while agreeing to repurchase 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.


FIGURE  AUD/USD and Bond Spread


FIGURE  AUD/USD Five-Year Chart

Australia has had a floating exchange rate since 1983. The Reserve Bank of Australia may undertake foreign exchange market operations when the market threatens to become excessively volatile or when the exchange rate is clearly inconsistent with underlying economic fundamentals. The RBA monitors a trade-weighted index as well as the cross-rate with the U.S. dollar. Intervention operations are invariably aimed at stabilizing market conditions rather than meeting exchange rate targets.

Monetary Policy Meetings The RBA meets every month (except for January) on the first Tuesday of the month to discuss potential changes in monetary policy. Following each meeting, the RBA issues a press release outlining justifications for its monetary policy changes. It releases a statement regardless of whether interest rates are changed. The RBA also publishes a monthly Reserve Bank Bulletin. The May and November issues of the Reserve Bank Bulletin include the semiannual statement on the Conduct of Monetary Policy. The February, May, August, and November issues contain a Quarterly Report on the Economy and Financial Markets. It is important to read these bulletins for signals on potential monetary policy changes.

Important Characteristics of the Australian Dollar


  • Commodity-linked currency.

     Historically, the Australian dollar has had a very strong correlation (approximately 80 percent) with commodity prices and, more specifically, with gold prices. The correlation stems from the fact that Australia is the world’s third largest gold producer, and gold represents approximately $5 billion in exports for the nation each year. As a result, the Australian dollar benefits when commodity prices increase. Of course, it also decreases when commodity prices decline. If commodity prices are strong, inflationary fears start to appear and the RBA would be inclined to increase rates to curb inflation. However, this is a sensitive topic, as gold prices tend to increase in times of global economic or political uncertainty. If the RBA increases rates during those conditions, it leaves Australia more vulnerable to spillover effects.


  • Carry trade effects.

     Australia has one of the highest interest rates among the developed countries. With a fairly liquid currency, the Australian dollar is one of the most popular currencies to use for carry trades. 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. The popularity of the carry trade has contributed to the 95 percent rise of the Australian dollar against the U.S. dollar between 2001 and 2007. Many foreign investors were looking for high yields when equity investments offered minimal returns. However, carry trades last only as long as the actual yield advantage remains. If global central banks increase their interest rates and the positive interest rate differentials between Australia and other countries narrow, the AUD/USD could suffer from an exodus of carry traders.


  • Drought effects.

     Since the majority of Australia’s exports are commodities, the country’s GDP is highly sensitive to severe weather conditions that may damage the country’s farming activities. For example, 2002 was a particularly difficult year for Australia, because the country was experiencing a severe drought. The drought had taken an extreme toll on Australia’s farming activities. This is especially important because agriculture accounts for 3 percent of the country’s GDP. The RBA estimates that the “decline in farm production could directly reduce GDP growth by around 1 percentage point.” Aside from exporting activities, a drought also has indirect effects on other aspects of Australia’s economy. Industries that supply and service agriculture, such as the wholesale and transport sectors, as well as retail operations in rural farming areas may also be negatively affected by a drought. However, it is important to note that the Australian economy has a history of recovering strongly after a drought. The 1982–1983 drought first subtracted, then subsequently added, around 1 to 1.5 percentage points to GDP growth. The 1991–1995 drought reduced GDP by around 0.5 to 0.75 percentage points in 1991–1992 and 1994–1995, but eventually boosted GDP by 0.75 percentage points.


  • Interest rate differentials.

     Interest rate differentials between the cash rates of Australia and the short-term interest rate yields of other industrialized countries should also be closely watched by professional traders of the Australian dollar. These differentials can be good indicators of potential money flows as they indicate how much premium yield Australian dollar short-term fixed income assets are offering over foreign short-term 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.

Important Economic Indicators for Australia

Gross Domestic Product Gross domestic product is a measure of the total production and consumption of goods and services in Australia. 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 Australia finds itself. Fast growth often is perceived as inflationary while low (or negative) growth indicates a recessionary or weak economy.

Consumer Price Index The consumer price index (CPI) measures quarterly changes in the price of a basket of goods and services that account for a high proportion of expenditure by the CPI population group (i.e., metropolitan households). This basket covers a wide range of goods and services, including food, housing, education, transportation, and health. This is the key indicator to watch as monetary policy changes are made based on this index, which is a measure of inflation. 

Balance of Goods and Services This number is a monthly measure of Australia’s international trade in goods and services on a balance of payments basis. General merchandise imports and exports are derived mainly from international trade statistics, which are based on Australian Customs Service records. The current account is the balance of trade plus services.

Private Consumption This is a national accounts measure that reflects current expenditure by households, and producers of private nonprofit services to households. It includes purchases of durable as well as nondurable goods. However, it excludes expenditures by persons on the purchase of dwellings and expenditures of a capital nature by unincorporated enterprises. This number is important to watch, as private consumption or consumer consumption is the foundation for resilience in the Australian economy.

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 month-onmonth, quarter-on-quarter, half-year-on-half-year, and year-on-year basis. Australia’s PPI data is released on a quarterly basis. 


CURRENCY PROFILE: NEW ZEALAND DOLLAR (NZD)
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Broad Economic Overview

New Zealand is a very small economy with GDP valued at approximately US$107 billion in 2006. In fact, at the time of publication the country’s population is equivalent to less than half of the population of New York City. It was once one of the most regulated countries within the Organization for Economic Cooperation and Development (OECD), but over the past two decades the country has been moving toward a more open, modern, and stable economy. With the passing of the Fiscal Responsibility Act of 1994, the country is shifting from an agricultural farming community to one that seeks to become a leading knowledge-based economy with high skills, high employment, and high value-added production. This Act sets legal standards that hold the government formally responsible to the public for its fiscal performance. It also sets the framework for the country’s macroeconomic policies. The following are the principles outlined under the Fiscal Responsibility Act:


  • Debt must be reduced to prudent levels by achieving surpluses on the operating budget every year until such a level is reached.
  • Debt must be reduced to prudent levels and the government must ensure that expenditure is lower than revenue.
  • Sufficient levels of Crown net worth must be achieved and maintained to guard against adverse future events.
  • Reasonable taxation policies must be followed.
  • Fiscal risks facing the government must be prudently managed.


New Zealand also has highly developed manufacturing and services sectors, with the agricultural industry driving the bulk of the country’s exports. The economy is strongly trade oriented, with exports of goods and services representing approximately one-third of GDP. Due to the small size of the economy and its significant trade activities, New Zealand is highly sensitive to global performance, especially of its key trading partners, Australia and Japan. Together, Australia and Japan represent 30 percent of New Zealand’s trading activity. During the Asian crisis, New Zealand’s GDP contracted by 1.3 percent as a result of reduced demand for exports, as well as two consecutive droughts that reduced agricultural and related production. New Zealand’s most important trading partners are:

Leading Export Markets


  1. Australia
  2. United States
  3. Japan


Leading Import Sources


  1. Australia 
  2. China 
  3. United States



Monetary and Fiscal Policy Makers—Reserve Bank of New Zealand

The Reserve Bank of New Zealand (RBNZ) is the central bank of New Zealand. The Monetary Policy Committee is an internal committee of bank executives who review monetary policy on a weekly basis. Meetings to decide on changes to monetary policy occur eight times a year or approximately every six weeks. Unlike most other central banks, the decision for rate changes rests ultimately on the bank’s governor. The current Policy Target Agreements set by the minister and the governor focus on maintaining policy stability and avoiding unnecessary instability in output, interest rates, and the exchange rate. Price stability refers to maintaining the annual CPI inflation at 1.5 percent. If the RBNZ does not meet this target, the government has the ability to dismiss the governor of the RBNZ, though this is rarely done. This serves as a strong incentive for the RBNZ to meet its inflation target. The most common tools used by the RBNZ to implement monetary policy changes are: 

Official Cash Rate The official cash rate (OCR) is the rate set by the RBNZ to implement monetary policy. The bank lends overnight cash at 25 basis points above the OCR rate and receives deposits or pays interest at 25 basis points below this rate. By controlling the cost of liquidity for commercial banks, the RBNZ can influence the interest rates offered to individuals and corporations. This effectively creates a 50-basis-point corridor that bounds the interbank overnight rate. The idea is that banks offering funds above the upper bound will attract few takers, because funds can be borrowed for a lower cost from the RBNZ. Banks offering rates below the lower bound also will attract few takers, because they are offering lower yields than the RBNZ. The official cash rate is reviewed and manipulated to maintain economic stability.

Objectives for Fiscal Policy Open market operations are used to meet the cash target. The cash target is the targeted amount of reserves held by registered banks. The current target is NZ$20 million. The RBNZ prepares forecasts of daily fluctuations on the cash target and will then use these forecasts to determine the amount of funds to inject or withdraw in order to meet the cash target. The following objectives from the New Zealand Treasury provide a guideline for fiscal policy measures:


  • Expenses. Expenses will average around 35 percent of GDP over the horizon used to calculate contributions toward future New Zealand superannuation (NZS) costs. During the buildup of assets to meet future NZS costs, expenses plus contributions will be around 35 percent of GDP. In the longer term, expenses less withdrawals to meet NZS costs will be around 35 percent of GDP.
  • Revenue. Raise sufficient revenue to meet the operating balance objective: a robust, broad-based tax system that raises revenue in a fair and efficient way.
  • Operating balance. Operating surplus on average over the economic cycle sufficient to meet the requirements for contributions toward future NZS costs and ensure consistency with the debt objective.
  • Debt. Gross debt below 30 percent of GDP on average over the economic cycle. Net debt, which excludes the assets to meet future NZS costs, below 20 percent of GDP on average over the economic cycle.
  • Net worth. Increase net worth consistent with the operating balance objective. This will be achieved through a buildup of assets to meet future NZS costs.


Important Characteristics of the New Zealand Dollar


  • Strong correlation with AUD.

     Australia is New Zealand’s largest trading partner. This, coupled with the proximity of the countries and the fact that New Zealand is highly trade oriented, creates strong ties between the economies of the two countries. When the Australian economy does well and Australian corporations increase their importing activities, New Zealand is one of the first to benefit. In fact, since 1999, the Australian economy has performed extremely well with a booming housing market that created a need to increase imports of building products. As a result, this strength translated into a 10 percent increase in Australia’s imports from New Zealand between 1999 and 2002. Illustrates how these two currency pairs are near-perfect mirror images of each other. In fact, over the past five years, the two currency pairs have had a positive correlation of approximately 97 percent.


  • Commodity-linked currency.

     New Zealand is an export-driven economy with commodities representing over 40 percent of the country’s exports. This has resulted in a 50 percent positive correlation between the New Zealand dollar and commodity prices. That is, as commodity prices increase, the New Zealand dollar also has a bias for appreciation. The correlation between the Australian dollar and the New Zealand dollar contributes to the currency’s status as a commodity-linked currency. However, the New Zealand dollar’s correlation with commodity prices is not limited to its own trade activities. In fact, the performance of the Australian economy is also highly correlated with commodity prices. Therefore, as commodity prices increase, the Australian economy benefits, translating into increased activity in all aspects of the country’s operations, including trade with New Zealand.


  • Carry trades.

     With one of the highest interest rates of the industrialized countries, the New Zealand dollar has traditionally been one of the most popular currencies to purchase for carry trades. 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. The popularity of the carry trade has contributed to the rise of the New Zealand dollar in an environment where many global investors are looking for opportunities to earn high yields. However, this also makes the New Zealand dollar particularly sensitive to changes in interest rates. That is, when the United States begins increasing interest rates while New Zealand stays on hold or reduces interest rates, the carry advantage of the New Zealand dollar would narrow. In such situations, the New Zealand dollar could come under pressure as speculators reverse their carry trader positions.


FIGURE  AUD/USD vs. NZD/USD Chart 

  • Interest rate differentials.

     Interest rate differentials between the cash rates of New Zealand and the short-term interest rate yields of other industrialized countries are closely watched by professional NZD traders. These differentials can be good indicators of potential money flows as they indicate how much premium yield NZD short-term fixed income assets are offering over foreign short-term 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.


FIGURE  NZD/USD Five-Year Chart 

  • Population migration.

As mentioned earlier, New Zealand has a very small population, equal to less than half that of New York City. Therefore, increases in migration into the country can have significant effects on the economy. Between 2006 and 2007, the population of New Zealand increased by 161,276 people versus an increase of 1,700 between 2001 and 2002. Although these absolute numbers appear small, for New Zealand they are fairly significant. In fact, this strong population migration into New Zealand has contributed significantly to the performance of the economy, because as the population increases, the demand for household goods increases, leading to an increase in overall consumption.


  • Drought effects.

Since the bulk of New Zealand’s exports are commodities, the country’s GDP is highly sensitive to severe weather conditions that may damage the country’s farming activities. In 1998, droughts cost the country over $50 million. In addition, droughts are also very frequent in Australia, New Zealand’s largest trading partner. These droughts have cost Australia up to 1 percent in GDP, which also translated into a negative impact on the New Zealand economy.

Important Economic Indicators for New Zealand

New Zealand does not release economic indicators often, but the following are the most important.

Gross Domestic Product GDP is a quarterly measure of the total production and consumption of goods and services in New Zealand. 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 New Zealand finds itself. Fast growth often is perceived as inflationary while low (or negative) growth indicates a recessionary or weak economy.

Consumer Price Index  The consumer price index (CPI) measures quarterly changes in the price of a basket of goods and services that account for a high proportion of expenditure by the CPI population group (i.e., metropolitan households). This basket covers a wide range of goods and services including food, housing, education, transportation, and health. This is the key indicator to watch as monetary policy changes are made based on this index, which is a measure of inflation.

Balance of Goods and Services  New Zealand’s balance of payments statements are records of the value of New Zealand’s transactions in goods, services, income, and transfers with the rest of the world, and the changes in New Zealand’s financial claims on the rest of the world (assets) and liabilities to the rest of the world. New Zealand’s International Investment Position statement shows, at a particular point in time, the stock of a country’s international financial assets and international financial liabilities.

Private Consumption  This is a national accounts measure that reflects current expenditure by households, and producers of private nonprofit services to households. It includes purchases of durable as well as nondurable goods. However, it excludes expenditures by persons on the purchase of dwellings and expenditures of a capital nature by unincorporated enterprises.

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 month-onmonth, quarter-on-quarter, half-year-on-half-year, and year-on-year basis. New Zealand’s PPI data is released on a quarterly basis. 


CURRENCY PROFILE: CANADIAN DOLLAR (CAD)
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Broad Economic Overview

Canada is the world’s seventh largest country with GDP valued at US$1.178 trillion in 2006. The country has been growing consistently since 1991. It is typically known as a resource-based economy, as the country’s early economic development hinged upon exploitation and exports of the country’s natural resources. It is now the world’s fifth largest producer of gold and the fourteenth largest producer of oil. However, in actuality nearly twothirds of the country’s GDP comes from the service sector, which also employs three out of every four Canadians. The strength in the service sector is partly attributed to the trend by businesses to subcontract a large portion of their services. This may include a manufacturing company subcontracting delivery services to a transportation company. Despite this, manufacturing and resources are still very important for the Canadian economy, as they represent over 25 percent of the country’s exports and are the primary source of income for a number of provinces. 

The Canadian economy started to advance with the depreciation of its currency against the U.S. dollar and the Free Trade Agreement that came into effect on January 1, 1989. This agreement eliminated almost all trade tariffs between the United States and Canada. As a result, Canada now exports over 78 percent of their goods to the United States. Further negotiations to incorporate Mexico created the North American Free Trade Agreement (NAFTA), which took effect on January 1, 1994. This more advanced treaty eliminated most tariffs on trading between all three countries. Canada’s close trade relationship with the United States makes it particularly sensitive to the health of the U.S. economy. If the U.S. economy sputters, demand for Canadian exports would suffer. The same is true for the opposite scenario: if U.S. economic growth is robust, Canadian exports will benefit. The following is a breakdown of Canada’s trading partners: 

Leading Export Markets


  1. United States
  2. United Kingdom
  3. China
  4. Japan
  5. Eurozone 


Leading Import Sources


  1. United States
  2. China
  3. Eurozone
  4. United Kingdom
  5. Japan


Monetary and Fiscal Policy Makers—Bank of Canada

Canada’s central bank is known as the Bank of Canada (BOC). The Governing Council of the Bank of Canada is the board that is responsible for setting monetary policy. This council consists of seven members: the governor and six deputy governors. The Bank of Canada meets approximately eight times per year to discuss changes in monetary policy. It also releases a monthly monetary policy update every quarter.

Central Bank Goals  The Bank of Canada’s focus is on maintaining the “integrity and value of the currency.” This primarily involves ensuring price stability. Price stability is maintained by adhering to an inflation target agreed upon with the Department of Finance. This inflation target is currently set at 1 to 3 percent. The bank believes that high inflation can be damaging to the functioning of the economy, while low inflation on the other hand equates to price stability, which can help to foster sustainable long-term economic growth. The BOC controls inflation through short-term interest rates. If inflation is above the target, the bank will apply tighter monetary conditions. If it is below the target, the bank will loosen monetary policy. Overall, the central bank has done a pretty good job of keeping the inflation target within the band since 1998.

The bank measures monetary conditions using its Monetary Conditions Index, which is a weighted sum of changes in the 90-day commercial paper rate and G-10 trade-weighted exchange rate. The weight of the interest rate versus the exchange rate is 3 to 1, which is the effect of a change in interest rates on the exchange rate based on historical studies. This means that a 1 percent increase in short-term interest rates is the same as a 3 percent appreciation of the trade-weighted exchange rate. In order to change monetary policies, the BOC would manipulate the bank rate, which would in turn affect the exchange rate. If the currency appreciates to undesirable levels, the BOC can decrease interest rates to offset the rise. If it depreciates, the BOC can raise rates. However, interest rate changes are not used for the purposes of manipulating the exchange rate. Instead, they are used to control inflation. The following are the tools most commonly used by the BOC to implement monetary policy. 

Bank Rate  This is the main rate used to control inflation. It is the rate of interest that the Bank of Canada charges to commercial banks. Changes to this rate will affect other interest rates, including mortgage rates and prime rates charged by commercial banks. Therefore changes to this rate will filter into the overall economy.

Open Market Operations  The Large Value Transfer System (LVTS) is the framework for the Bank of Canada’s implementation of monetary policy. It is through this framework that Canada’s commercial banks borrow and lend overnight money to each other in order to fund their daily transactions. The LVTS is an electronic platform through which these financial institutions conduct large transactions. The interest rate charged on these overnight loans is called the overnight rate or bank rate. The BOC can manipulate the overnight rate by offering to lend at rates lower or higher than the current market rate if the overnight lending rate is trading above or below the target banks.

On a regular basis, the bank releases a number of publications that are important to watch. This includes a biannual Monetary Policy Report that contains an assessment of the current economic environment and implications for inflation and a quarterly Bank of Canada Review that includes economic commentary, feature articles, speeches by members of the Governing Council, and important announcements.

Important Characteristics of the Canadian Dollar


  • Commodity-linked currency.

     Canada’s economy is highly dependent on commodities. As mentioned earlier, they are currently the world’s fifth largest gold producer and the fourteenth largest oil producer. The positive correlation between the Canadian dollar and commodity prices is close to 60 percent. Strong commodity prices generally benefit domestic producers and increase their income from exports. There is a caveat, though, and that is eventually strong commodity prices will hurt external demand from places like the United States, which could filter into reduced demand for Canadian exports.


  • Strong correlation with the United States.

     The United States imports 78 percent of Canada’s exports. Canada has been running merchandise trade surpluses with the United States since the 1980s. The current account surplus with the United States reached a record high of $90 billion in 2003. Strong demand from the United States and strong energy prices led to record highs in the value of energy exports of approximately $36 billion in 2001. Therefore the Canadian economy is highly sensitive to changes in the U.S. economy. As the U.S. economy accelerates, trade increases with Canadian companies, benefiting the performance of the overall economy. However, as the U.S. economy slows, the Canadian economy will be hurt significantly as U.S. companies reduce their importing activities.


  • Mergers and acquisitions.

Due to the proximity of the United States and Canada, crossborder mergers and acquisitions are very common, as companies worldwide strive for globalization. These mergers and acquisitions lead to money flowing between the two countries, which ultimately impact the currencies. Specifically, the significant U.S. acquisition of Canadian energy companies in 2001 led to U.S. corporations injecting over $25 billion into Canada. This led to a strong rally in USD/CAD, as the U.S. companies needed to sell USD and buy CAD in order to pay for their acquisitions.


  • Interest rate differentials.

     Interest rate differentials between the cash rates of Canada and the short-term interest rate yields of other industrialized countries are closely watched by professional Canadian dollar traders. These differentials can be good indicators of potential money flows as they indicate how much premium yield Canadian dollar short-term fixed income assets are offering over foreign short-term 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.


FIGURE  USD/CAD Five-Year Chart 


  • Carry trades.

     The Canadian dollar became a popular currency to use for carry trades after its three-quarter-point rate increases between April and July of 2002. 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. When Canada has a higher interest rate than the United States, the short USD/CAD carry trade becomes one of the more popular carry trades due to the proximity of the two countries. The carry trade is a popular trade, as many foreign investors and hedge funds look for opportunities to earn high yields. However, if the United States embarks on a tightening campaign or Canada begins to lower rates, the positive interest rate differential between the Canadian dollar and other currencies would narrow. In such situations, the Canadian dollar could come under pressure if the speculators begin to exit their carry trades. 

Important Economic Indicators for Canada

Unemployment  The unemployment rate represents the number of unemployed persons expressed as a percentage of the labor force.

Consumer Price Index  This measures the average rate of increase in prices. When economists speak of inflation as an economic problem, they generally mean a persistent increase in the general price level over a period of time, resulting in a decline in a currency’s purchasing power. Inflation is often measured as a percentage increase in the consumer price index (CPI). Canada’s inflation policy, as set out by the federal government and the Bank of Canada, aims to keep inflation within a target range of 1 to 3 percent. If the rate of inflation is 10 percent a year, $100 worth of purchases last year will, on average, cost $110 this year. At the same inflation rate, those purchases will cost $121 next year, and so on. 

Gross Domestic Product  Canada’s gross domestic product (GDP) is the total value of all goods and services produced within Canada during a given year. It is a measure of the income generated by production within Canada. GDP is also referred to as economic output. To avoid counting the same output more than once, GDP includes only final goods and services—not those that are used to make another product: GDP would not include the wheat used to make bread, but would include the bread itself.

Balance of Trade  The balance of trade is a statement of a country’s trade in goods (merchandise) and services. It covers trade in products such as manufactured goods, raw materials, and agricultural goods, as well as travel and transportation. The balance of trade is the difference between the value of the goods and services that a country exports and the value of the goods and services that it imports. If a country’s exports exceed its imports, it has a trade surplus and the trade balance is said to be positive. If imports exceed exports, the country has a trade deficit and its trade balance is said to be negative.

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 month-on-month, quarter-on-quarter, half-year-on-half-year, and year-on-year basis.

Consumer Consumption  This is a national accounts measure that reflects current expenditure by households, and producers of private nonprofit services to households. It includes purchases of durable as well as nondurable goods. However, it excludes expenditures by persons on the purchase of dwellings and expenditures of a capital nature by unincorporated enterprises.

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