Prospective Capital Flows and Currency Movements:
U.S. Dollar versus Euro
This case revolves around fictional foreign-exchange strategist named Luke Anthony, as he attempts to predict the likely future path of the dollar/euro rate. In order to come to this hypothesis, the reader is presented a slew of financial information, ranging from detailed capital flows, interest rate differentials, and recent central bank press releases. This data in turn must be must be analyzed and synthesized in order to develop a proper thesis on future exchange rate pricing. To compound matters further, the evidence is no way clear cut, with some factors pointing towards a resumption of the Euro’s upward march, but others seemed to favor the dollar.
While a large variety of variables can potentially impact currency movements, the cases focuses primarily on the correlation between currency movements and capital flows. As such, filtering the evidence will require both standard thinking on FX markets and an analysis of past and prospective international capital flows. In terms of structure, we will begin by our review by assessing the types of capital flows, describe the variables/trends affecting each, and conclude with the final prediction (up, down, sideways).
In terms of standard thinking on FX markets, A historical review of the Euro and US dollar relationship reveals 3 primary scenarios, the initial strengthening of the dollar on the onset of the creation of the Euro (99-00), a subsequent multiyear strengthening of the Euro through April 2008 (01-08), save for brief pause in 2005, and a choppy phase from 2008 to the present (Graph Below). Many factors were thought to have weighted the dollar during the second phase, including the interest rate differentials and the U.S current account deficit.
On the issue of capital flows, our primary assertion revolves around the positive correlation between increased capital flows into a country and the associated strengthening of said country’s currency (specifically as it pertains to the Dollar/Euro FX rate, trading at USD 1.35 as of Feb 2013). Capital flows specifically refers to the process of money (capital) moving from one jurisdiction to another, with this movement happening via 4 primary mechanisms: 1. Flows chasing higher short- to medium-term interest rates (Fixed Income) 2. Flows to invest in equity markets that would likely outperform (Equity) 3. Flows associated with foreign direct investment (FDI)
4. Flows associated with potential reserves diversification (Central Banks)
These 4 mechanisms are all influenced by several variables, including inflation, unemployment, GDP growth, monetary policy, political uncertainty, and tax holidays; which are in term acted upon by central banks, investors, and multi-national corporations.
Central Banks (FED & ECB)
While inflation does not typically affect exchange rates, except for extreme situation, in the short-to-medium term; however, their response to inflation (known as monetary policy) can affect rates by artificially modifying interest rate differentials. Given that current policy is already factored into current FX rates, a focus on when the FED and ECB will alter policy is necessary in predicting associated changes in capital flows. In order to better understand the policy decisions of these 2 organizations, it’s important to factor in their varying organizational mandates. While both organizations primary responsibility revolves ensuring inflation is maintained at a reasonable level, the FED (unlike the ECB) has an additional mandate of fostering maximum employment. Additionally, while the ECB HICP inflation, the FEB considers Core inflation (excluding food and energy prices).
This differences in metrics and mandate between the 2 central banks can result in diverging monetary policy stances, and as such interest rate differentials, as took place during the summer of 2010. At the time highlighted during the summer. At...
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