[David Waring]

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In our last lesson we learned about the capital account and how this measures flows relating to foreign investment into and out of a country. In today's lesson we are going to combine what we have learned about the current and capital accounts by looking at something which is known as the balance of payments.

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.

That's our lesson for today. In our next lesson we will look at some additional examples of how trade flows and capital flows are moving the market right now in today's market so we can have a better understanding of both and can generate some potential trading ideas as well.

As always if you have any questions or comments please leave them in the comments section below, and good luck with your trading!

[rocketman7]

Well, as the US dollar becomes weaker, it takes more to buy foreign goods thus increasing the deficit.

rocketman7

[David Waring]

Originally Posted by rocketman7

Well, as the US dollar becomes weaker, it takes more to buy foreign goods thus increasing the deficit.

rocketman7

Hey Rocketman7,

You are correct that as the US Dollar becomes weaker it takes more to buy foreign goods. If this happened in isolation then you would also be correct that the deficit would increase. What else would happen as a result of the fact that as you have pointed out it would become more expensive to buy foreign goods? Looking for two things here.

Best Regards,
Dave

[Gaffa]

From a US perpective I would think domestic products would become more attractive than imports thus helping the export market of the US.... and reducing the trade deficit.

I live in a logging town on Vancouver Island and I know a weak US dollar has a negative impact on that industry. We export alot of lumber to the US.

Gaffa

[David Waring]

Originally Posted by Gaffa

From a US perpective I would think domestic products would become more attractive than imports thus helping the export market of the US.... and reducing the trade deficit.

I live in a logging town on Vancouver Island and I know a weak US dollar has a negative impact on that industry. We export alot of lumber to the US.

Gaffa

Hi Gaffa,

You are correct that in general when price rises for something including imports then demand is going to drop. You are also correct that goods and services which are produced domestically become more attractive as a result of this as since they are priced in USD they will generally be comparatively cheaper.

So the fact that the US will generally import less when the USD weakens is one factor that should contribute to a reduction in the deficit.

The other factor which you have also alluded to in your above post is that as the USD weakens this naturally means that the currencies of foreign countries are strengthening against the USD. So where imports become more expensive for the US, the goods and services that the US exports become less expensive for foreigners, driving up demand there and further reducing the deficit.

So as you have pointed out here the short answer is when the USD weakens the current account deficit should shrink.

Best Regards,
Dave

[kawola17]

Wow that is amazing insight! This means that as the USD continues to weaken, the huge deficiet we see now should start to decrease.

Such as foreigners buying up US products since they get good "bang for the buck."

But once foreigners buy, this means the USD will eventually strengthen again.

Thanks Dave!

[David Waring]

Originally Posted by kawola17

Wow that is amazing insight! This means that as the USD continues to weaken, the huge deficiet we see now should start to decrease.

Such as foreigners buying up US products since they get good "bang for the buck."

But once foreigners buy, this means the USD will eventually strengthen again.

Thanks Dave!

Hey Bill,

Yep that is the basic concept of how things will work assuming everything else remained constant. Remember however that there are many factors at play here other than just trade such as the capital flow side of things so be sure to keep an eye on that as well.

Best Regards,
Dave

[emdium]

Originally Posted by David Waring

Remember however that there are many factors at play here other than just trade such as the capital flow side of things so be sure to keep an eye on that as well.

Best Regards,
Dave

I've seen new lately of forien investors buying up real-estate and offers on domestic companies (Budwieser). Is this influx of capital flow or speculation the cause of the recent uptrend of the USD?

[David Waring]

Originally Posted by emdium

I've seen new lately of forien investors buying up real-estate and offers on domestic companies (Budwieser). Is this influx of capital flow or speculation the cause of the recent uptrend of the USD?

Hi Emdium,

Glad to hear from you and welcome to the community.

These capital flows definitely help the US Dollar out however I think that most would attribute the US Dollar's recent bout of strength to the fact that the federal reserve has come out wit more aggressive talk on inflation which directly mentioned the US Dollar weakness.

This is the first time that the fed has mentioned the US Dollar which is normally the domain of the US Treasury so the fact that they mentioned it at all was seen as highly significant.

Hope that helps. If there are any other comments or questions please feel free to post them.

Best Regards,
Dave

[g man]

Quote

I think that most would attribute the US Dollar's recent bout of strength to the fact that the federal reserve has come out wit more aggressive talk on inflation which directly mentioned the US Dollar weakness.

This is the first time that the fed has mentioned the US Dollar which is normally the domain of the US Treasury so the fact that they mentioned it at all was seen as highly significant.


Hello david, before I raise my point of contention, I would like to thank you for your free website as I'am a beginner to forex trying to gather information on this market before I make any moves. Now my contention, Whilst I recognise that the fed's tough talk on the dollar was indeed unprecedented, talk of a meaningful dollar rally is hopeful because the fed would need to raise interest rates and with the commercial markets and housing markets being the way they are, not to mention to $400 billion or so dollars that the fed has taken up from the investment banks, it would be clearly dangerous to raise interest rates in this environment. Wouldn't it?