By Ed Ponsi, Online Trading Academy Forex Instructor
One of the most stunning currency moves in recent memory occurred earlier this month, when the U.S. Dollar gained nearly 400 pips in just one hour against the Swiss Franc. I have no doubt that fortunes were made and lost on this sudden and relentless move. So what happened to create this much excitement in the Swiss Franc? (see figure 1)
Figure 1: USD/CHF blasts higher on comments from the Swiss National Bank. Source: Trade Station
On March 12, the Swiss National Bank, the central bank of Switzerland, cut its benchmark rate by 25 basis points, as expected. What was not expected was the SNB's statement that it would take steps to force its currency to fall. Surprised traders were caught flat-footed and immediately started selling CHF with both hands, creating the incredible rip shown in the chart.
The Swiss Franc, known as a safe-haven currency, has performed well during these troubled economic times – too well, according to the SNB. By weakening the Franc, the SNB hopes to boost sales for big Swiss exporters like the Swatch Group, the world's largest watch maker.
The question is, will history repeat itself? In the 1930s, one country after another pushed down its exchange rate in a desperate effort to export its way out of the Great Depression. But each country's depreciation only aggravated the problems of its trading partners, who saw their own depressions deepen. Eventually even countries that valued currency stability were forced to respond by weakening their currencies. Let's hope that the actions of the Swiss National Bank do not initiate a similar spiral.
The Parent and the Child
China's Premier, Wen Jiabao, shocked the credit markets with the following comments on Friday, March 13th, 2009:
"We have lent a huge amount of money to the U.S., so of course we are concerned about the safety of our assets. I do in fact have some worries," Mr. Wen said in response to a question. He called on the U.S. to "maintain its credibility, honor its commitments and guarantee the safety of Chinese assets."
China holds the world's largest foreign-exchange reserves, reported at nearly $2 trillion at the end of 2008, and about two-thirds of that sum is believed to be held in U.S. dollar assets, primarily Treasury bonds. Mr. Wen repeated China's position that those investments are to be managed with a view to "safety, liquidity and profitability."
Why is Wen suddenly concerned about the safety of his nation's investments? As Wen mentioned, the U.S. borrows huge sums of money from China through that country's purchases of U.S. Treasuries. Now he sees the U.S. taking on astronomical debt, the scope of which has never been seen in modern history, and guess where the U.S. expects to get that money? They expect to obtain it by borrowing it from other nations, especially China, and by printing more money, which will potentially devalue the currency.
Wen's concerns are well-founded. Throwing money at our problems is clearly not the answer. Just look at the horrible, wasteful results of the AIG bailout; there are still no clear rules about how bailout money is to be distributed, or under what circumstances bailout money should be distributed at all. The United States wants to borrow trillions more, but it has no clear plan for correcting the housing crisis or the banking crisis. Instead, it passed a pork-laden stimulus package which contains some good provisions but also contains a fair amount of irresponsible spending. The bailouts and spending bills guarantee a huge debt in the future, but there is no guarantee that any of this spending will improve our current economic situation.
China sees how we waste the money they lend to us, and they have taken note. Put yourself in Wen's shoes - China is like a bank that is being asked by an irresponsible consumer to raise its credit limit on the consumer's maxed-out credit cards. Not just raise the credit limit, but quadruple or quintuple it. By borrowing so much money, we have put our future in China's hands. We no longer control our own destiny. China could simply stop lending money to the U.S., and we're toast.
By continuously borrowing large sums of money over the years, we have essentially created a parent–child relationship between the U.S. and China. The U.S. is like an irresponsible child that cannot balance a checkbook and is always asking Mom and Dad for money. China is like a concerned parent that is wondering whether he should cut off his child's allowance – or at the very least, require that the child do more chores around the house.
We all know what happens to people who miss payments on their credit cards; they are charged astronomical rates of interest. That's exactly what could happen to the U.S.; if we fail to maintain credibility, we will have to compensate by paying a higher rate of interest on our debts. It's just like any other loan; when banks are afraid to lend because of concerns that the counterparty might not be able to pay them back, they charge a higher rate of interest. Similarly, if we stay on our current path, there might come a day when China will refuse to purchase our bonds unless we agree to pay a higher interest rate on our debt. Not only are we planning to saddle future generations with massive debt, but we could be limiting their capacity to pay it off.
Have a question about Forex trading? Send an email to eponsi@tradingacademy.com and we may use your question in an upcoming newsletter. Until next time, best of luck to you in trading.
Ed Ponsi
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