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Forex capital flows
Capital flows are made up of all of the money moving between countries as a consequence of investment flows into and out of countries around the world. In this case rather than money flowing between countries to purchase each otherís goods and services, we are referring to money flowing into and out of the stock and bond markets of countries around the world, as well as factors such as real estate and cross border mergers and acquisitions.
In the same way that imports and exports of goods shift the supply/demand balance for a particular country, so do the flows of money coming into and out of the country due to capital flows. As the barriers to investment in foreign countries have reduced, as a result of many factors including the introduction of the internet, it is much easier for investors, such as fund managers, to take advantage of opportunities not only in their domestic markets, but anywhere in the world.
Therefore, when a market in a particular country is displaying above average returns, foreign investors will often enter the market with capital, purchasing the assets of that country that are also looking to earn above average returns. When this occurs it not only affects the markets of that country, but it also affects the value of its currency, due to the fact that foreign capital must be exchanged into local currency to be able to participate in the markets there.
While in general people are most familiar with the equities markets, it should be noted that the bond markets in most countries are much larger than the equities markets, and can therefore have a greater affect on the currency. When the interest rates on bonds in a particular country are high, this will normally attract capital to that country from foreign investors seeking to take advantage of that higher yield, which also has the effect of creating a demand for the local currency as well.
Finally, cross border mergers and acquisitions are also part of the capital flows category, and when they happen on a large scale, they can move the market as well. For example, if Citibank (a large US bank) were to buy Royal Bank of Scotland, this would create a large demand for pounds and increase the supply of dollars on the market as Citibank sold dollars for pounds in order to complete the transaction.
There are a plethora of factors that can affect both trade and capital flows for a particular country, and therefore its currency. As currency traders it is up to us to know what to expect in terms of a reaction in the FX market when various things occur, so always think of things in terms of how something affects the supply demand relationship. Once you understand this it is next important to understand whether that effect fits into the trade flow or capital flow category since, as we will discuss later, some countries are more susceptible to trade flows than capital flows and vice versa.
The Capital Account and Measuring Capital Flows.
The basic formula for calculating the capital account is:
Increase in Foreign Ownership of Domestic Assets (e.g. real estate, cross boarder M&A, and Investments by Foreign Companies in local operations)
– Increase in Domestic Ownership of Foreign Assets.
+ Portfolio Investment (e.g. stocks and bonds)
+ Other Investment (e.g. loans and bank accounts).
In the same way as the current account, it is not important to understand all the intricate details of the capital account, but simply to understand that where the current account measures money flowing in and out of a country as a result of trade flows, the capital account measures money flowing in and out of the country as a result of capital flows.
As we discussed in the previous lesson on capital flows, when a countryís market is performing better than the markets in other countries of the world, money will flow into the country from foreign investors seeking to participate in those inflated returns. The country’s capital account reflects these flows. This is the case whether we are talking about a country’s bond market, stock market, real estate market or any other market.
For example, letís assume that a fund manager located in Great Britain invests $1 Million Dollars in the Canadian Stock Market, and a Canadian real estate firm buys the equivalent amount of real estate in Great Britain. For the purposes of simplicity, if these were the only transactions that took place between these two countries and any other country, the Capital Account for both Great Britain and Canada would show a balance of zero, as the two transactions would have offset themselves to the penny.
In the same manner with the current account when a country has strong inflows or outflows of capital, this will have a direct impact on its currency. When there are considerable inflows this creates demand for the currency, pushing the value of the currency up, all else being equal. On the other hand, when there are considerable outflows, this creates a market supply of the currency, pushing its value down all else being equal.
It should be noted that it is the interaction of both the current account and the capital account that fundamental traders focus their attention on, as it is the disparities here that theoretically trigger the value of a currency to rise and fall over the long term.
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Forex capital flows
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How Treasuries Impact Forex Capital Flows.
Price action and Macro.
In the first part of our series we learned how United States Treasury Debt began to become accepted as the safest investments in the world.
In the second installment , we looked at the pricing and structure of the Treasury Debt market to learn how government debt affects Forex traders.
In this article, we are going to put this knowledge to work, learning how capital flows can affect currency exchange prices; and how we, as traders, might be able to use this to our advantage.
The Yield Curve.
Bond investors will pay higher prices for higher degrees of safety. And this makes sense because, after all, when investing in bonds (also known as ‘fixed-income) one is often doing so for the safety of the investment – not the return.
The longer the bond has to maturity, the less relative safety it is perceived to have. Investors will often look at a 6 month Treasury bill as carrying considerably less risk than a 30 year Treasury Bond. A lot can happen in 30 years; and although the US government is anticipated to play a large role of the economy in 30 years: its exact role is uncertain, as are a litany of other factors.
Bond investors don’t like uncertainty. This is reflected in the ‘Yield Curve,’ which is a graphical representation of rates at an approximate maturity. In most cases, the higher the maturity, the higher the rate. This is a ‘normal’ yield curve, and this is what most investors expect to see in the Treasury debt market.
Normal Yield Curve – Return increases with Maturity.
When investors around the world are concerned about economic growth, they will often place a higher value on the safety of their invested principal. Think about it for a moment –
What does a 10% return on investment produce if you’ve lost 15% of your principal?
This produces a negative return, right?
Well, if an investor is anticipating that this may happen – they have the option to put their money in an investment that will, likely, not lose any of the principal if held to maturity. We examined this in The History of US Debt, as the Treasury bill is considered the ‘risk-free rate of return.’
As investors flock towards US Treasuries, increased buying pressure will often push prices higher. Since prices and yields move inversely, we will often see yields move lower.
The below graphic will show you an example of a Treasury Yield Curve before, and after a ‘flight-to-quality.’ Notice that red line, symbolizing the Treasury Yield Curve after the ‘flight-to-quality’ has pushed yields lower at all maturities. This expresses the new higher price of treasuries after investors have bid prices higher.
Treasury Yield Curve before and after a ‘flight-to-quality’
The red line on the above chart shows where yields moved during a ‘risk-off’ market, as treasury prices were pushed higher (and yields lower) at all relevant maturities.
While investors can potentially profit by buying treasuries before a ‘flight-to-quality’ and selling them after prices have moved higher – there are quite a few other ways to speculate on these moves. Investors in the Forex market have access to vast amounts of leverage that can potentially turn one of these events into a very profitable endeavor (or potentially a losing endeavor depending on whether the trader was on the right or wrong side of the move).
How to Play Risk-Off in the Forex Market.
The first thing that needs to be learned by traders and investors looking to profit during these bearish times is the fact that when US Treasuries are purchased, the transaction is performed in US Dollars.
If a Hedge Fund Manager in Berlin wants to buy Treasuries, they need US Dollars to do so.
As Treasury prices are increasing during ‘flights-to-quality,’ we’ll also often see a rise in the price of the US Dollar (since investors are exchanging into US Dollars to buy Treasuries).
For example, during the Financial Collapse of 2008 – in which the United States was mired in an almost literal collapse of the financial system – investors flocked to Treasuries, and further, the US Dollar at a breakneck pace.
The chart below shows the rise in the US Dollar (and fall of British Pounds) sparked by the 2008 Financial Collapse:
GBP/USD fall sparked by 2008 Financial Collapse – Created with Marketscope/Trading Station.
As the 2008 Financial Collapse circulated across the globe, the chart above shows us that investors sold British Pounds for US Dollars to the tune of a 27% move.
This in-and-of-itself might not be all that exciting, but when you consider the fact that traders and investors could have leveraged this situation up to 50 times their equity (or perhaps even greater leverage depending on where one lived and what leverage was allowed); we begin to see how these ‘risk-off’ movements can potentially be very profitable.
Let’s look at a few other currencies performance during the 2008 Financial Collapse:
Major Currencies against the US Dollar during 2008 Financial Collapse.
Notice that the US Dollar strengthened in each of the charts above (It is of note that the US Dollar is the base currency in the USDCAD pair, which is why price went up on the pair as the Dollar strengthened.)
And once again, these moves can be magnified significantly with the usage of leverage. We always advise traders to control their leverage, and we found that a level of 5-to-1 may be preferable for most traders in the FX Market in our Traits of Successful Traders series.
But even leveraging these moves by a factor of 5-to-1 could have doubled a trader’s account! If the EURUSD move above was leveraged 5 times, the trader could have seen a 100% return on the trade to double their investment (you can multiply the percentage of the move by the leverage factor to find the investors return.) Keep in mind – leverage is a double-edged sword that could also deplete funds from traders’ accounts.
Investors looking to play risk-off moves in the Forex market can look to do so buying US Dollars.
As increased worry and panic permeates the financial markets, we could see investors eschewing higher rates of return to buy one of the safest investments on the planet: US Treasuries. As investors and capital flow into Treasuries (and out of other investments), one could expect the Yield curve to fall (remember, as prices increase – yields decrease): And as the yield curve is falling, the US Dollar is usually strengthening against many of the world’s major currencies (because investors need US Dollars to buy Treasuries).
And leverage – well, leverage allows the FX Trader to see MASSIVE changes in account equity during these tumultuous times; when the rest of the world is running for cover attempting to shield from the pervasive losses of equity markets across the world – the Forex Trader can potentially profit (or lose) very large amounts of money very quickly.
This is why Forex is one of the best markets in the world for Active Traders and Passive Investors alike: With a 2-sided currency quote, in which you can generally buy just as easily as you can sell, a bear market is merely a frame-of-mind. When it looks as though the economy is headed for a downturn, as we saw in 2008 with the Financial Collapse, or 2011 with the European Debt Crisis – FX Traders can look to ‘go long’ US Dollars by shorting the EURUSD, or GBPUSD pairs.
--- Written by James B. Stanley.
To contact James Stanley, please email Instructor@DailyFX.Com. You can follow James on Twitter @JStanleyFX.
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