Between the years 2000 and 2010 there were some massive fluctuations in the currency markets. Some currencies saw dramatic rises, while others fell just as precipitously. This was not isolated to emerging economies, but it did affect the world's reserve currencies and largest economies on the planet. Mammoth trends in currencies play a major role in how individual lifestyles and how companies and countries conduct business. In the last decade, Canada, Japan and the Eurozone all saw major moves in their currencies relative to the U.S. dollar. The mega-trends within these liquid currency pairs can be broken down into factors that resulted in the moves.

IN PICTURES: Top 6 Most Tradable Currency Pairs

Throw Out the Financial Theories
Exchange rate movements have proved to be exceedingly hard to predict using financial theories such as the purchasing power parity (PPP). In a 1983 article produced for the National Bureau of Economic Research, Richard Meese and Kenneth Rogoff found that no structural or time series models could effectively produce better forecasting results than a "random walk", and the more future expectations were built into current prices, the harder prices were to predict. (Learn more about the random walk in our Financial Concepts Tutorial)

While the study is intriguing, market participants must realize there is an extreme amount of noise in financial markets and often there are definable reasons for the dramatic moves in exchange rates, such as those seen from 2000 to 2010.

On an international scale, a currency is often defined as a way to exchange goods and services between countries with differing economies. Yet currency values determined by a free market, which is open to multiple players with differing opinions and motives, means that actual trade fundamentals and economic data can get pushed aside. According to the Bank for International Settlements, in April 2007 the foreign exchange markets did, on average, $3.2 trillion per day in transactions. Compared to the total of all world trade done in 2006 - $12 trillion - the actual trade data is dwarfed by speculation, which accounts for about 1.4% of currency transactions. Unprecedented speculation may be a major determinant of mega-trends, as positions are entered/exited by more and more participants. (Refer to What Is The Bank For International Settlements? for more information on this bank)

When we realize that a theory based on trade is unlikely to predict currency markets, other strategies can be employed.

Three methods can be used to help determine the direction of a currency and explain the mega-trends that have occurred in the decade in question. All three can be looked at to help paint a picture of what has occurred and what may occur. The three work together, feeding into and off of each other.

Method 1: Bias in One Currency Compared to a Basket of Others
While country-to-country comparisons are useful, in terms of exchange rates, much can be explained by a pervading bias in one currency versus a basket of others. When one currency is compared to a basket of other currencies, the performance within the basket can partially explain movement within specific currency pairs. The U.S. dollar is a trending currency. As the world's reserve currency, it goes through long-term trends that affect the exchange rates of individual countries. Those countries also have tendencies, which may include ranging or trending tendencies. For example, the dollar index can provide a broad context for trading that occurs within U.S. dollar related pairs. While individual pairs may deviate from the trend, Figure 1 and Figure 2 show that as the dollar index fell, so did these liquid individual pairs. This is logical, considering individual pairs compose the index, but the index provides a broader view. (For more information on the U.S. dollar, see The US Dollar's Unofficial Status as World Currency.)

Figure 1: Dollar Index, Monthly
Figure 2: USD/EUR, USD/JPY (red) and USD/CAD (green) in Percentage Terms
Source: Yahoo! Finance

Tracking the overall index also provides a picture of what is happening to currencies that are affected by other market movements. Currencies that are pegged or subject to significant government intervention may have an impact on the rise and fall of another currency. Since the pegged currency does not move on its own, there can be a spillover effect where another currency is pushed excessively higher or lower (depending on the circumstances). Due to the pegging of a currency and the rate's inability to modify risk or reward, other currencies may absorb this exposure. It is hard to predict which currencies will absorb this phenomenon; therefore, comparing individual pairs to a broader index can expose potential anomalies.

Method 2: Primary Economic Input
Some currencies have a large primary input that can have significant sway on the direction a currency moves. An example is commodity prices in relation to countries such as Canada or Australia. Figure 3 shows the inverse correlation between USD/CAD and oil prices (as oil prices rise, the USD falls and CAD rises). During this time, there was also a synonymous relationship where the declining U.S. dollar pushed up oil prices. The overall decline of the U.S. dollar (Method 1) prevented it from recovering fully, even when oil dropped drastically in 2008.

Figure 3. Oil vs. USD/CAD

Not only does the price of oil affect how the Canadian dollar performs, but also the exports of oil. Between 2002 and 2007, oil exports increased dramatically, growing from 7% of total exports in 1999 to 20% in 2007, but it came at the expense of some other imports. Therefore, the commodity price is not the only concern; one must also consider how it is dispersed. (For more insight, see Canada's Commodity Currency: Oil And The Loonie.)

In the case of the Japanese yen, low interest rates and the building and unwinding of carry trades has had a significant impact on the yen from 2000 to 2010. Despite this, the overall decline of the dollar index has been played out in the USD/JPY, as the trend was down over the time frame (see Figure 2). (Also, for a primer on the carry trade, see Currency Carry Trades 101.) Currencies tend to overshoot and finding a linkage to a certain commodity or other factors will not provide perfect results. Currencies are affected by many things, including the mass speculation that encompasses most currency transactions.

Method 3: Government Policy
In light of factors already discussed, government policy including (but not limited to) monetary policy, balance of payments and foreign assets and liabilities must also be looked at. While exchange rates are largely speculative, a primary driver for what will happen in the future is based on people's perceptions of these concepts.

Monetary policy and interest rates have an effect on exchange rates. A hike in interest rates will not always have the same effect on a currency pair, but an increasing interest rate differential between two currencies will generally increase volatility in that currency pair. Increasing interest rates can appreciate a currency as speculators seek out higher returns. If interest rates begin moving too fast or inflation accelerates, the reverse occurs, as accelerating inflation will have a dampening effect on growth prospects.

Current account imbalances also have an impact on currencies, as large deficits may make foreign countries wary of accumulating the currency. The slow accumulation will mean diminished demand and potential selling by speculators. Central banks around the globe are also partial to increasing returns (speculation) by taking on excess reserves and finding high yield investments.

The movement or return of the actual currency is not the only factor, though. A country's balance sheet and in what currencies they hold most of their assets and liabilities is a very important element. For example, a country's falling home currency may be viewed positively because it increases demand for exports, but it may harm the country if most of their liabilities are priced in another appreciating currency, as debt obligations will become harder to pay. Such relationships also exist in reverse, and in relation to assets that may be escalated or eroded by currency movements.

Tying the Methods Together
Currency movements often defy logic, moving from extreme to extreme. One reason is that speculation involves a vast number of transactions. When analyzing currencies, there is often an overshadowing bias affecting a currency against a basket of other currencies. Certain currencies are also heavily affected by a primary input. The Canadian dollar is affected by oil prices accompanied by oil exports. Other countries may be briefly affected by anomalies that affect a currency for a long time, such as low interest rates in Japan. As traders take advantage of these phenomena, it can push prices beyond what is mathematically feasible and result in greater-than-expected corrections. Finally, when looking at mega-trends, governments and global central banks play a large role by feeding information and creating policy that impacts traders' expectations for the future. As with all speculation, no matter the input (assets, liabilities, interest rates, etc.), as the currency moves to take advantage, there comes a point where profit potential becomes limited. At the same time, the movement of the currency has likely had an effect on other aspects of the economy, leading to an eventual reversal. Currencies are floated to ease economic shocks and help stabilize economies.

For more related reading, take a look at our Forex Tutorial.

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