107. Fundamentals that Move Currencies – Balance of Payments

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As we discussed briefly in our last lesson it is the interaction of flows of money relating to international trade and investment that ultimately determines the value of a currency over the long term. When demand strengthens for the exports of a particular country and/or investments by foreigners into that country increase, then, all else being equal a currency should strengthen. Conversely, when demand weakens for the exports of a particular country and/or investment by foreigners in that country falls, then, all else being equal a currency should weaken.

It is the interaction of the current account and the capital account that measures this, and when combined these make up a country’s balance of payments. The balance of payments is very simply the total transactions by a country with all other countries in the world, or in other words the combination of both trade flows and capital flows into one report. By following a country’s balance of payments and its related indicators, an FX trader can gain great insight into the potential future direction of a country’s currency.

To help understand this better lets look at the example of the US Dollar. As we’ve discussed in previous lessons, the United States has run a very large current account deficit for quite some time, meaning that the country has imported many more goods and services than it has exported. As this chart of the US Dollar Index shows however, for a number of years the US Dollar continued to strengthen, despite this large current account deficit.


As you can see here going up into 2000 although the US ran a persistent current account deficit, the currency overall continued to strengthen before starting to sell off from late 2000 forward. Now I am making some pretty significant generalizations here for simplicities sake, but there are two major reasons that fundamental traders will point to as reasons for this:

1. Although this is starting to change somewhat, there has for many years been a strong demand for US Dollars because the US Dollar is the currency of choice for many major central banks to hold as their reserve currency, with Japan and China being the countries you will hear most about in this regard. This creates a demand for dollars on the capital flows side of the equation that helped to offset the persistent current account deficit going into 2000.

2. As most of you will remember the NASDAQ top which happened in March of 2000 was preceded by a major bull market in the United States, one in which foreign investors were active participants. As we learned about in our lesson on capital flows this also created a large demand for dollars, further helping to offset the large current account deficit.

After the sell off of the NASDAQ however, foreign investors fled the US Stock market along with a lot of other traders and investors. As there was no longer as much foreign capital flowing in to offset the large current account deficit, the US Dollar began to weaken. As the dollar began to weaken this created a chain reaction with the central banks who began to diversify into the EURO and other currencies, further exacerbating the dollar’s sell off.

This created a situation where the current account deficit in the United States remained large (creating a market surplus of US Dollars from an international trade standpoint) and the inflows of capital into the US stock and bond markets began to fall, lowering the demand for dollars which was offsetting the current account deficit.

While it is not important to understand all the intricate details at this point, what you do need to understand is that in order to have a feel for the long term fundamentals of a currency, it is important to have a general understanding of what is happening from both a trade flows and a capital flows standpoint, and how these two things interact with one another. As we will learn in coming lessons all fundamentals with currencies can be related back to these two basic concepts, so for your homework assignment for this lesson I encourage you to consider the following question:

As the value of the US Dollar falls what effect if any should this have on the large current account deficit in the United States and why?

If you would like to post your answer in the comments section of this lesson on InformedTrades.com for discussion this is something that I always encourage.


4 thoughts on “107. Fundamentals that Move Currencies – Balance of Payments”

  • Not exactly whats happening in Japan right now. Bank rates are near zero, foreign investments are reducing, people are taking their money out, yet the Yen is only getting stronger. between the time you did the video and now, the US has gone through some tough times. So a strong Yen is because of a weak dollar. Currency strength is relative, especially so when trading as you are looking currency pairs and not a single currency. I am open to correction, though.

  • hi joshrain1, Thanks for posting that is a well thought out answer which is moving in the right direction. While it is true that the US is the worlds largest importer the country is also one of the worlds largest exporters. Much of the exporting power that has been lost in manufacturing has been made up for in exports of services so as a result the current account deficit is slowly starting to decrease as the dollar weakens and exports have picked up significantly. Best Regards, Dave

  • the current account deficit in theory should decrease as exports become cheapear. however, for the US that is not the case since we import a lot more and don't have a manufacturing base. because we import a lot more and pay in USD's this results in foreigners holding more USD reserves which can result in capital inflow into the US, over the long run this deteriorates the USD purchasing power thus causing price rises domestically and lack of confidence in the USD. let me know what you think.

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