David Waring

In our last lesson we began the third module of our free forex trading course with a look at the basics of how the trade flows between countries can affect the value of those countries currencies. In today’s lesson we are going to look at the second category of things that move the forex market, capital flows.

Capital flows encompass all of the money moving between countries as a result of investment flows into and out of countries around the world. Here instead of money flowing between countries to buy each others goods and services, we are talking about money flowing into and out of the stock and bond markets of countries around the world, as well as things such as real estate and cross boarder mergers and acquisitions.

Just as the importing or exporting of goods shifts the supply demand balance for a particular country, so do the flows of money coming into and out of the country as a result of capital flows. As the barriers to investing in foreign countries have come down as a result of the internet and other factors, it is much easier for fund managers and other investors to take advantage of opportunities not only in their domestic markets, but anywhere in the world. As this is the case, when a market in a particular country is showing above average returns, foreign investors will often flood the market with capital, buying up the assets of that country looking to earn above average returns as well. When this happens it not only affects the markets of that country, but also the value of its currency, as foreign capital must be converted into local currency in order to participate in the markets there.

While most people are more familiar with the equities markets, an important thing to note here is that the bond markets in most countries are much larger than the equities markets, and therefore can have a greater affect on the currency. When the interest rates being paid for the bonds in a particular country are high, this tends to attract capital to that country from foreign investors seeking to take advantage of that higher yield, creating a demand for the local currency here as well.

Lastly, cross boarder mergers and acquisitions are also part of the capital flows category and when they happen on large levels can move the market as well. As an example, if Deutsche bank (a large German bank) were to buy Washington Mutual here in the United States, this would create a large demand for dollars and increase the supply of Euros on the market as Deutsche Bank sold Euros for dollars in order to complete the transaction.

As you can probably imagine there are a myriad of factors that can affect both trade and capital flows for a particular country, and therefore its currency. As currency traders it is our responsibility to know what to expect in terms of a reaction in the FX market when different things happen, so always think of things in terms of how something effects 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 learn in later lessons, some countries are affected more by trade flows than capital flows and vice versa.

That's our lesson for today. In our next lesson we will look at something which is known as the current account which is the tool used to measure a country's trade flows so we hope to see you in that lesson. As always if you have any questions or comments please leave them in the comments section below, and good luck with your trading!

kernel001

Worked

shibuphilip

please help me to understand the rational behind, even after quantitative easing the US Dollar is still getting stronger against most of the currencies except the JPY.PLEASE HELP.
THANK YOU

Tekmnd

Hi shibuphilip,

In my opinion, the reason why the dollar is getting stronger is because it is a "safe haven" currency.
With the global recession getting worse, people are placing their money into the USD because they consider it the safest place to be right now.
Even though it was made before the crisis, this video applies to the current situation.-
Why the US Dollar is Still King of the Currency World

Cheers
Tek

Ilivebythesea

Hi

Tek

I've been trading on a Micro Account for about 5 weeks.

I've read that daily falls in world equity markets lead to more risk aversion and a move to "safe haven" curriencies such as the Dollar and Yen, on the other hand, if the equity markets rose the dollar and Yen have tended to fall whilst commodity\high yield currencies such as the AUD and NZD have risen - more appetite for risk.

Today though Bloomberg reports that the dollar index has had it's biggest weekly gain in 3 months and yet world stock markets rose strongly this week with the S+P up 3.8% yesterday. Now the word is that the dollar is advancing because people believe that the worst of the crisis may be over for the worlds largest economy.

My question - how, from a trading point of view, do you reconcile these apparently contradictory views?

David Waring

Hi Ilivebythesea,

Glad to hear from you, I will take a crack at this one.

You are correct that the theme during the financial crisis has generally been when global equities markets selloff and people pull back on risk taking then the US Dollar benefits from Safe haven flows.

There is another important factor that is always at the front of the forex traders mind in any currency however which is interest rates. With this in mind if for example the market begins to expect that the US (which is currently right at Zero interest rates) is going to be the first to start growing again, the the US Dollar can benifit here as well. The reason why is that under this scenario expectations in the market would most likely pick up that the Fed would have to start raising interest rates which generally benifits the currency of the country where that happens. There is more on this below:

Interest Rates and Trading - The Basics You Have To Know

While that could be one fundamental argument as to why the US Dollar rallied, in my opinion this was more of a correction from the big selloff in the US Dollar that we saw a couple of weeks ago and shows up on pretty much any chart.

Hope that helps.

Best Regards,
Dave

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My Free Courses: Forex Course - Stock Course - Futures Course - Basics of Trading - Subprime Crisis - Prorealtime Charts

Disclaimer: Trading is risky and can result in substantial financial loss. As always my posts are simply one traders opinion and should not be taken as trading advice. I am not a financial adviser so everyone please do their own analysis and take responsibility for their own trades.

Unregistered

Hi David, great lessons.

I would really like to understand the following better:

"as we will learn in later lessons, some countries are affected more by trade flows than
capital flows and vice versa."

Do you have any examples of currencies that are more affected by tradeflows than by capital flows?

I suppose you have to look for countries with HIGH debts (both private and public) if you want to point out a currency that is very sensitive to CAPITAL flows? So: US, UK, Japan???

And potentially you need to look for countries with large differences in import/export to determine a country that's very sensitive to tradeflows?

Not sure, just guessing. Would love your comments - and best of all would be specific examples.

Thanks, best,

Andersxman.