Currencies are wonderful markets to invest in.  A country’s currency is a barometer of how well that country’s economy is doing.  Since the direction of an economy, once in motion, either up or down, is difficult to reverse, it’s not surprising that the currency will tend to do the same. Thus, the trends in currencies tend to be long in one direction, and it takes quite a lot of fundamental change to reverse that direction.  Recessions, for example, are hard

to get out of because declining profits come from declining sales.  Declining sales cause unemployment to go up, which in turn further deflates sales.  It’s a vicious cycle that often can only be broken by changes in governmental fiscal and monetary policies, and even then the effects of those changes can take months before they grab hold.

Therefore, once an economy moves in a particular direction it will likely stay in that direction for some time and so will its currency.  One of many, but among the most significant, tests as to whether a currency is going to move higher or lower can be determined by its real rate of return calculation.  The real rate of return for a countries currency is a risk-free short term interest rate, like a 90-day Treasury bill rate, minus the inflation rate of that country.  (I like to use the latest six months annualized).

Currently the United States has a 3% real rate of return.  The short-term interest rate is 5.25% and the inflation rate is 2.25% based on the core-rate from the GDP numbers.

Now compare our real rate of return with other countries; Canada +2.50, Britain +2.50, Euro FX +0.25, and Japan +1.15.  If you are an investor, where would you like to park your money?  Usually, money flows to where the best rate of return is.  In this case, money did flow to the U.S. over the past several years ever since the monetary policy was changed and interest rates in the U.S. started to rise.  Since we still have the best real rate of return, you would expect the dollar to be strong now, but it isn’t.  So what gives?

Markets anticipate change down the road and look for those policy changes that can make an economy and its currency reverse direction.  Prior to our fed funds rate hitting 1.0% several years ago, the dollar was getting trashed.  Even with a low 2.0% inflation rate, we were offering a negative real rate of return.

As soon as the Fed changed policy, and started raising rates, the dollar reversed course and started climbing, even though our real rates of return were still along way from being the best in the world.  Investors knew that the U.S. economy was primed to grow and the increased interest rates were their cue to move money into dollars.  The dollar soared and so did the U.S. economy.  The fact that the other nations held their rates flat or even lowered them a bit also helped support the dollar.

However, things are changing and the dollar has started to drop even though we still have the best real rate of return.  The reason is because the marketplace is beginning to sense that the Fed is about to change its policy of increasing interest rates, while at the same time the other major currency countries are just beginning a sustained campaign to raise their rates.  This reversal of monetary policies around the world is why the dollar is falling and the other currencies are rising against ours.

So whenever you want to get a quick handle on which direction a currency ought to be moving, just look at the real rate of return that is offered in that country and you will get a sense of which currencies ought to be in demand.