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Why Currencies Matter to You

Dan Caplinger
August 19, 2010

When you think of a risky investment market, stocks immediately come to mind. Yet amid a turbulent roller-coaster ride for stocks lately, the currency markets have seen even more volatility in recent months. The dollar's big moves could have a big impact not just on the investors who trade currencies but also shareholders of ordinary companies.

Where the dollar's been
It wasn't that long ago that many were thinking that the dollar was on its way to near-extinction. Pundits around the globe were calling for the euro to take the dollar's place as the world's new reserve currency, while gold and other commodities soared in the belief that huge deficit spending and the Federal Reserve's moves to increase liquidity in the money supply would bring on inflation that would hurt the purchasing power of the greenback.

Then, of course, came the European sovereign debt crisis, which sent the euro tumbling from $1.50 to below $1.20 in early June. As investors realized that the European Union faced many of the same challenges as the U.S., confidence in the dollar rose, at least in relative terms. That made those who bought dollar-bullish ETFs like the anti-euro UltraShort Euro ProShares (NYSE: EUO  ) and PowerShares DB US Dollar Index Bullish (NYSE: UUP  ) quite happy, but sent Europe-centered currency ETFs CurrencyShares Euro Trust (NYSE: FXE  ) and CurrencyShares Swiss Franc Trust down sharply.

In just the past couple of months, though, the dollar has given up a good chunk of those gains. So what's going on, and how can you predict what the next move for the dollar will be?

Navigating the crosscurrents
Investors in the foreign exchange markets look at a huge number of different factors in choosing what trading positions to take. Here are just a few:

  • Interest rate policy. One reason to hold a given currency is the prospect of earning income on your investment. If you expect rates in a particular country to rise in the near future, then cash in that country will produce more income, making the currency more attractive.
  • Lending dynamics. Many traders use carry trades that involve borrowing in one currency and lending in another, hoping to take advantage of interest rate differentials. With short-term rates near zero, Japan and the U.S. have been prime candidates for borrowing, while higher-interest areas like Brazil and Australia have been good targets for investment.
  • Economic conditions. Forex markets are closely linked to world trade. Demand for imports and exports drives demand for currencies, and changes in trade and forex rates feed back on each other over time.

These factors interplay in ways that are hard to predict. For instance, carry trade investors borrowing U.S. dollars made money for quite a while, but when the dollar bounced back, they took a quick beating, pushing some to cover their positions. Given that many forex traders use immense amounts of leverage when they take positions, the forex markets can be extremely volatile and respond quickly to changing conditions.

How to play
All that complexity makes directly investing in forex markets a dicey propositio