money school

The Dollar (USD) and Mexican Peso (MXN) Currency Example

Fiat currencies are supported by buying soverign bonds (debt). The US is the only nation that can print money and buy it's own bonds to support it's currency.

What Does Defending Your Currency Mean?

Why Do Nations Have to Raise Rates to Defend Their Currency?

This article explains the strong indirect relationship (connection) between a national (sovereign) bond and it's associated currency on the global foreign exchange markets.

What does the following technical language mean? ...The dollar's [USD] sharp ascent has put pressure on emerging market currencies and stocks, driven by a surge in U.S. Treasury bond yields. The higher U.S. rates are attracting funds currently invested in emerging markets and forcing central banks from Mexico [MXN] to South Africa to raise interest rates to defend their currencies. ... [U.S. Dollar Hits 14-Year High Against Euro, Puts Pressure On Emerging Markets (2016)]

Also see: Fed Chair Powell To Emerging Markets: You Are On Your Own (2018) ...As Powell explained... the Fed's gradual push towards higher interest rates shouldn't be blamed for any roiling of emerging market economies...

All else equal, when a central bank raises the interest rate (also called yield or profit) on it's debt-bonds within a range, investors have a profit incentive to purchase more bonds. Because they must purchase with the national currency for that bond, the demand for the currency goes up.

Fyi: When bond interest rates (yield) goes up, bond prices go down and vice versa. More on bonds here.

For example, a 2 Year Treasury bond or bund or gild gives you a profit of 2% at it's maturity of 2 Years. If the interest rate moves to 3%, your profits increase. This is incentive to buy more.

The Connection to Currencies

The problem with fiat-currencies is that there is no constant to measure against. The historical constant, gold, is heavily suppressed.

This means that fiat-currencies must always compete against other fiat-currencies. This causes investors to constantly shift their fiat-denominated wealth.

Central bank bonds-bunds-gilts are typically purchased in the currency of that nation. To purchase a bund I would pay EU euros. To purchase a gilt I would pay English pounds. To purchase a bond I would pay US dollars.

So, all else being equal, when investors buy a bond-bund-gilt they 1.) sell-off assets in currency A, exchange currency A into currency B, then they 2.) purchase the bond-bund-gild in currency B. This is what 3.) creates demand for currency B and often drives the price up.

To translate the article above using USD and MXN: When the US bond interest yield (profit) is going up. Investors sell their MXN denominated assets, exchange the MXN for USD, and purchase more US bonds with USD.

This process can drive up demand for USD. As investors-traders purchase USD to buy more US bonds. The value (purchasing power) of the USD against the MXN goes up. The purchasing power of the MXN goes down.

Currency Volatility

There can be multiple reasons for currencies to rapidly increase or decrease in value (volatility). These include: the currency is interpreted as a safe haven, a specific currency is required to purchase a commodity (oil) or pay off a loan, and hedge funds - traders see an opportunity for momentum profits.

The USD has historically been interpreted as a safe haven currency because it is used as the world reserve currency to purchase oil. Historically, the US has run an oil monopoly where any nation wishing to purchase oil on the international markets must first exchange their currency to USD or US bills-bonds and then purchase the oil.

How Banks Create Debt-Money

The current global fiat-currency system depends on creating new debt (credit). If and when new debt cannot be generated somehow, the system begins to fail.

Modern fiat currencies are debt notes, also called IOU's. In other words, the money is created when debt (credit) is issued by banks. If the banks cannot issue more debt, the purchasing power of the currency falls and no one want to use the currency. The banks issue debt and create money with a keystroke on their computers.

Central banks create money by issuing bonds and hope for lots of buyers. The regional banks create money by issuing loans and hope for lots of loan applications.

The Insanity of Debt-Based Money: Step by Step Process

How the interest rate on a bond-bund-gilt is directly related to the value of that currency.

• The interest rate for 10 Year US bonds moves from 1.2% to 2.5%, resulting in more purchasing power.
• The interest rate for 10 Year Mexican bonds is falling in comparison and results in less purchasing power.
• Investors rush to sell their Mexican investments and exchange their currencies into USD (dollars) and purchase 10 Year US bonds.
• The bonds must be purchased in USD. This creates the demand for USD dollars.
• This indirect relationship of raising rates has created demand, which then raised the currency value (purchasing power).
• The global market is flooded with Mexican Pesos (MXN).
• The flood of supply can cause the purchasing power (value) of the currency to fall.
• The national central bank usually steps in to stabilize the situation by raising the interest rate (yield) on their bond. So the Mexican central bank would raise their interest rates to give buyers an incentive.
• This in turn creates a demand for MXN Pesos.
• This entire process repeats itself and all central banks are incentivized to keep their bond interest rates at a level that will attract new buyers. So one of the priorities of the central banks is to keep interest rates within a certain range.
• All of the global currencies compete with each other in this fashion. They are referred to as floating currencies.