Welcome to a four part series covering the highs and lows of the foreign exchange market, specifically focusing on the U.S. Dollar and the Euro. This series of articles is designed to give you an insight into what factors have been causing such drastic price swings in the exchange rate between the world’s two most important currencies. This first article will try and define the relationship of the Dollar and Euro, and how commodities as well as inflation have played a central role in the forex markets over the last two years. I want to begin by offering a brief overview of the foreign market and its importance in the global economy. The forex exchange market is one of the largest and most liquid securities exchanges in the world with over $3.2 trillion in average daily turnover. This equates to 10 times the average daily turnover of global equity markets and 35 times the average daily turnover of the New York Stock Exchange. The forex market is open 24 hours a day, 6 days a week, with the EUR/USD accounting for 27% of total turnover. There is plenty of opportunity to make and lose money in currency exchange. Over the last 3-4 years as the Euro has risen to all-time versus the Dollar and more recently has faced intense selling pressure with the steep decline in oil prices and the global economic recession. The Gold Standard No More The gold standard era in the U.S. officially began with the passing of the Gold Standard Act in 1900. But it was not until World War II that there first arose a need for a worldwide standard for currency values and exchange rates. The Bretton Woods Agreement in 1944 established two very important international institutions: the International Monetary Fund [IMF] and the International Bank for Reconstruction and Development (now the World Bank). What came from this agreement was that all the world’s currencies would be pegged against the value of gold, and with the U.S. dollar on the gold standard, the U.S. dollar effectively became the world’s reserve currency. The value of gold was fixed at $35 per ounce until the gold standard was effectively withdrawn in 1971 as President Nixon ordered an end to the out-dated system and the price of gold was allowed to “float”. Now, every major currency is no longer on the gold standard but rather is referred to as “fiat” currency. This basically means that a country’s own currency is intrinsically worthless because it is not backed by any type of reserve, such as gold. The value each currency is therefore based citizen’s perception of their economy, supply and demand for money in general, and how their currency is compared to other country’s currency. Something to think about though is that 40 years ago, the world’s currencies used to be pegged against the price of gold and ultimately the Dollar. Now it would not be a stretch to say that global currency is on an Oil Standard. When the U.S. Government made a deal with Saudi Arabia and OPEC to only trade oil in U.S. Dollars, their “partnership” effectively gave the USD a monopoly over all other currencies when it comes to oil trading. The Dollar/Oil/Inflation Revolving Door The big thing to realize when it comes to comparing these three, is that when one moves the others will move as well. There is really no way to explain one without going into detail about how they affect one another. The perceived driving force behind all of this is commodities. The commodities market includes trading everything from cotton and orange juice to corn and gold, but is ruled by those investors who are placing bets on where they think oil prices are going next. Prices of the most valuable commodity in the world tend to primarily change based on supply and demand factors, geo-political concerns, and most importantly for this article, the value of the U.S. dollar. With crude oil denominated in U.S. Dollars across the world, there is a clear negative correlation between oil prices and the value of the Dollar. Even before the oil is pulled from the ground, it has immense power that can easily influence the world’s currency markets. When countries go to the commodities markets and try and sell their oil, the purchaser must buy the oil with U.S. Dollars. If you have U.S. Dollar reserves to make the purchase then great, but if you don’t then you head to the forex and change your money, Euros for example, into Dollars. This is where the Euro/Dollar relationship takes flight. Over beginning of the 21st century, the dollar depreciated against the Euro largely due to high supply of Dollars and low demand. This meant that as oil prices began to rise, it would have been wise for countries to keep their oil reserve money in Euros instead of Dollars, even though they needed to pay in Dollars. This can be understood by simply looking at the exchange rate between the Euro and the Dollar over the last ten years. As the USD gradually depreciated against the Euro and oil became nominally more expensive across the board, if you were buying oil strictly with Dollars, you would be paying a much higher real rate then if you had Euros and exchanged them for Dollars to buy the oil. One way to combat currency exchange risk is to hold assets in the countries where you are planning on buying oil from because you will hedge yourself against future currency changes. For example, if the United States planned on buying oil from Australia in five years but was worried that their currency might appreciate against the USD, then the U.S. could buy Australian assets now and help offset a weaker USD with more valuable Australian assets. The other obvious way to hedge yourself is to simply buy Australian Dollars and minimize future losses tied to USD depreciation. To get at inflation directly, I think it is necessary to point out the U.S. trade deficit. As the U.S. continues to print money and buy more good than it exports, the attractiveness of the USD abroad is dwindling. When foreign countries receive seemingly endless Dollars for their exports, our trade imbalance grows larger and larger, thus driving the value of the Dollar down further and further. As the value of the Dollar falls, domestic as well as imported goods and services cost more as inflation rises. This can be linked to the price in oil because if the value of the Dollar drops, oil producing countries such as Saudi Arabia raise the nominal price of crude because the dollars they are receiving for payment are worth less and less in the global market. Some experts propose that crude oil should be traded with Euros instead of U.S. Dollars, and if that would happen, the USD would surely see steep price depreciation as oil-hungry countries could sell their USD for Euros. Wrap-Up Commodities are king these days, even after oil has plummeted from its record $147 per barrel price over the summer and gold prices have moderated some. And with the global credit crisis and recession-like conditions in many countries, a lot of the world’s currencies will be trading under pressure and intense scrutiny as central banks across the world continue to meet and make decisions on the future.

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