Currency Trading For Dummies. Kathleen Brooks

trade surpluses will accumulate reserves of foreign currency over time. Trade surpluses arise when a nation exports more than it imports. Because it is receiving more foreign currency for its exports than it is spending to buy imports, foreign currency balances accumulate. China, one of the world’s largest exporters, has many trillions of dollars as reserves.

      The USD has historically been the primary currency for international reserve holdings of most countries. International Monetary Fund (IMF) data from December 2020 showed that the USD accounted for just over 59 percent of global currency reserve holdings, with EUR (20 percent) and remaining currencies (such as the Japanese yen, British pound, and so on) all under 10 percent. You can see more currency data at the IMF’s site at https://data.imf.org.

      In recent years, however, the United States has run up massive trade and current account deficits with the rest of the world. The flip side has been the accumulation of large trade surpluses in other countries, most clearly in Asia. The U.S. deficits essentially amount to the United States borrowing money from the countries with trade surpluses, while those other countries (think China) buy IOUs in the form of U.S. Treasury debt securities.

      The problem is one of perception and also of prudent portfolio management:

       The perception problem stems from the continuing growth of U.S. deficits, which equates to your continually borrowing money from a bank. At a certain point, no matter how good your credit is, the bank will stop lending you money because you’ve already borrowed so much in the first place. In the case of the United States, no one is sure exactly where that point is, but let’s just say we don’t want to find out. In recent years, the U.S. Congress has had to raise its debt ceiling to accommodate its growing need to borrow. At the time of writing, the U.S. debt ceiling stood at more than $28.5 trillion.

       The portfolio-management problem arises from the need to diversify assets in the name of prudence. Due to the high proportion of U.S. dollars in global forex reserves, forex reserve managers need to be cognizant of the risks they face if there is a sharp drop in the U.S. dollar’s value. This was particularly relevant after the financial crisis when the U.S. dollar started to weaken.

The result has been an effort by many national governments to begin to diversify their reserves away from the USD and into other major currencies. The euro, the Japanese yen, the British pound, and to a lesser extent the Australian dollar have been the principal beneficiaries of this shift. But before you think the sky is falling, the USD remains the primary reserve currency globally.

      In terms of daily forex market trading, national governments (or their operatives) have become regular market participants over the last few years. Generally speaking, they appear to be engaging in active currency reserve management, selling USD on rallies, and buying EUR on weakness. But they’re also not averse to then selling EUR on subsequent strength and buying USD back on weakness.

      

Currency reserve management has taken on a market prominence in recent years that never existed before. Market talk of central bank buying or selling for reserve management purposes has become almost a daily occurrence. The impact of this in the market varies, but it can frequently lead to multiday highs and lows being maintained in the face of an otherwise compelling trend.

      

Traders need to closely follow real-time market commentaries for signs of central bank involvement.

      The Bank for International Settlements

      The Bank for International Settlements (BIS) is the central bank for central banks. Located in Basel, Switzerland, the BIS also acts as the quasi-governmental regulator of the international banking system. It was the BIS that established the capital adequacy requirements for banks that today underpin the international banking system.

      As the bank to national governments and central banks, the BIS frequently acts as the market intermediary of those nations seeking to diversify their currency reserves. By going through the BIS, those countries can remain relatively anonymous and prevent speculation from driving the market against them.

      

Market talk of the BIS being active in the market is frequently interpreted as significant reserve interest to buy or sell. Keep an eye out for market rumors of the BIS, but also keep in mind that the BIS performs more routine and smaller trade execution on behalf of its clients.

      The Group of Twenty

      The Group of Twenty, or G20, is a forum for the governments and central bank governors of the world’s 20 largest economies. Members include the developed markets and the larger emerging markets, including Mexico, Brazil, China, and South Korea, along with Saudi Arabia. The G20 superseded the G7 and the G8 as the global leaders’ summit to keep an eye on. G20 summits take place each year; depending on the circumstances, currency values may be on the agenda for these meetings, and the communiqué, the official statement issued at the end of each gathering, may contain an explicit indication for a desired shift among the major currencies. If currencies are not a hot-button topic, the G20 will include a standard boilerplate statement that currencies should reflect economic fundamentals and that excessive currency volatility is undesirable.

      

Forex markets closely follow the preparations leading up to the meetings for several weeks in advance. Traders are looking first to see whether currencies will even be discussed, and then to see which currency or currencies will be on the agenda. The market will generally have a sense of whether currencies are an issue, and the general feeling of what the G20 would like to see done, well in advance. Still, comments from ministers and their deputies holding the preparatory consultations set the stage for the market’s expectations and can provoke market reactions even before the G20 meets, although this can be rare.