How Markets Interact, Part 1: Currencies

Have you ever noticed that when the stock market goes up, the dollar goes down? Or when bonds go up, the stock market goes down? Maybe you've noticed that when oil goes up, the dollar goes down.

What’s going on here? Just how do the markets influence each other? In today’s financial markets, just about everything is interconnected.


There are four main markets which trade globally on an almost daily basis. These are stocks, bonds, commodities and currencies.

• Stocks represent part-ownership in companies, like Apple or Google.
• Bonds are IOUs for money loaned to companies, nations or cities.
• Commodities are basic goods with a standard price, like oil, gold or grains.
• Currencies are the money used for exchange in countries or regions, like the U.S. dollar, the European euro or the Swiss franc. 

You may have heard of other markets, like futures or real estate. Futures includes commodities as well as derivatives of the other three markets. Real estate is an important market and does have influence, but it is not an easily tradable, or liquid, market like the main four. For this discussion we'll focus on these main four globally liquid markets.

Currencies

Since finance starts with money, let's start with currencies. Almost all currencies today are "fiat" currencies, which means they have value based solely upon the relative strength of the economy which issues them. Relative is an important word. All currencies values "float" based on their value as compared to other currencies. If you have U.S. dollars and want to buy something from Europe, you must convert your dollars to euros. How many euros you get for your dollars depends on how the two compare in strength at the moment. So a "strong" dollar compared to the euro is good for our imports, because it makes European goods cheaper for us. Then again, a "weak" dollar is good for exports, because it makes it easier for Europeans to buy our goods.

Since currencies are themselves kind of commodity, they are bought and sold on the open market. When the dollar is in demand, its value goes up. Again this makes sense, because the dollar wouldn't be in demand unless people thought it had value; and if it does have value, then that must mean there is some strength in our economy. If there is strength, it makes sense that foreign products should be affordable for us, since that is one thing a strong currency tends to ensure--low inflation.

Why would a certain currency be in demand? Well, if a lot of people want to buy products from a particular country, they need to use its currency. This is how strong exports strengthen the currency of the exporting country. But in the case of the U.S. dollar, there is an added feature. Our dollar is the world's "reserve currency." This means that it is the standard currency for much international trade. For example, oil prices are tracked in U.S dollars. This reserve currency status gives the dollar added demand and strength. This can be good and bad. It can be good because it adds resilience to our economy. It can be bad because it masks real underlying problems in our economy which might have been exposed earlier. This is exactly what is going on now.

Currencies are directly affected by inflation, and they themselves affect inflation. When the dollar goes down, that means inflation is up, because the dollar has lost buying power. So a strong dollar tends to keep prices down, while a weak one tends to do the opposite. When you see the prices of commodities rising, that means the dollar is losing value.

Another way to view inflation is that it is directly influenced by the amount of currency in the market place. If the U.S. Treasury suddenly doubles the amount of dollars in circulation, that will weaken the dollar and increase inflation. This is why the actions of the Fed in increasing the money supply can have a major affect on the future buying power of Americans.

I'll talk more about currencies and inflation in the coming segments.

Next up: Commodities.