If the U.S. financial authorities are not as scared as they want us to think, what are they really up to? Talking the dollar down is, strangely, one way of talking it up. In the peculiar way of markets, an official public acceptance of the dollar falling can have the perverse effect of lifting the dollar, at least for a while. To some extent, this is a function of relief that everything is out in the open, but it’s also a mark of respect and confidence in a government that hasn’t always earned praise from economists and financial experts on other matters, such as fiscal rectitude and trade protectionism.

But I suspect it’s not about the dollar at all. It’s not about the current account, either, except as a reflection of something else going on — the low U.S. savings rate, which is joined at the hip to the deficit. In short, it’s about nothing less than the sustainability of the U.S. economy.

It’s the other big fact of American financial life: The U.S. is not only a debtor nation, it is also a nation of debtors. The saving rate in the U.S. is only 1 to 2 percent of income, and has been falling for over 20 years. In fact, it has fallen the most since 2000. All value judgments aside, when a country imports capital but then spends it on consumption goods rather than capital investment, it is failing to prepare for the future. From the point of view of the Fed chairman and Treasury secretary as stewards of the economy, it’s not the sustainability of the current account deficit we should be questioning, but rather the sustainability of U.S. growth. Abundant, cheap foreign money has led us onto the path of profligacy, economically speaking.

The high capital inflows have led the U.S. into the bad habit of spending too much and saving too little. How do you induce people to save? In a free market economy, you give them inducements, like higher returns that are more desirable than a better car or another pair of shoes. Higher returns can be delivered via tax breaks, too, but tax breaks are not the Fed’s to give. Higher returns are.

But alas, all that foreign money is literally standing in the way. In September, San Francisco Fed President Yellen got this particular current account panic rolling by saying the Fed wants to normalize interest rates by nudging them higher, but the relatively high dollar is an obstacle. The Fed wants to normalize interest rates to a historically neutral level, thought to be about 3 to 3.5 percent (from the current 2 percent). But the Fed can manage rates only at the very short end of the yield curve. The relatively high dollar draws in foreign capital that allows rates at the longer end of the yield curve to be artificially low.

The last thing the Fed wants is a crisis where it has to raise interest rates to prevent a run on the currency, which is what happened in the UK in 1991. The Bank of England raised rates 3 percent in the space of a few days in an effort to control the pound falling out of the European Rate Mechanism (the occasion of Mr. Soros’ fabled billion-dollar profit). It may not be too fanciful to imagine that the Fed has been deliberately driving the dollar down to avoid exactly this outcome — not because it gives a fig about the dollar per se, but because it wants to set rates in its own time and according to its own ideas.

Consider the Fed’s mandate. Yes, it has to maintain financial market stability, but it’s far more interested in growth and employment than in the terms of trade, except as the terms of trade influence domestic production.

Here is the hidden agenda. The Fed wants to normalize rates, not for the sake of normalization, but to prevent a run on the dollar and to restore the incentive to save. After all, if the U.S. consumed less and saved more, the trade deficit would be substantially lower and no one would feel the urge to stage a run on the dollar in the first place. The U.S. would not need capital flow from foreign countries to fund the current account deficit — it would have sufficient domestic savings to buy all the government and corporate debt instruments on offer. This is not to say the Fed places a moral judgment on saving as a social virtue, but rather as the one truly sustainable mechanism to ensure further growth and employment.

The market talks about the sustainability of the current account deficit.

Financial economists talk about the sustainability of the inward capital flows. But the Fed and the Treasury view both the current account and the capital account as a by-product of real economic activity, and what they talk about is the sustainability of U.S. growth. If it takes a weaker dollar, so be it. The dollar is not the central thing. In this context, it’s only a unit of account. This is the sense in which all the hullabaloo about the sustainability of the current account is a hoax. It is sustainable today, but as the U.S. economy becomes less independently capable of prosperity, the longer it relies on foreign savings.

Now we have come full circle. The current account deficit is not really creating a dollar crisis — the Fed and the Treasury are talking it down. They must know the lower dollar will not cause much improvement in the current account, even if other efforts behind the scenes are successful in pressuring China to revalue the renmimbi. It’s silly to be selling the dollar against the euro and other European currencies when Europe accounts for only about 9 percent of trade. China alone accounts for 30 percent of the deficit, and a growing proportion of it. Asia, including Japan, accounts for over half of the deficit.

But negotiations to get Asian countries, especially China, to repeg or to float their currencies are matters of state, not of economic and financial management. China’s revaluation, which will probably occur within the next year, will provide some minor relief in the current account, but not a permanent fix. After all, China has billions of people willing to work for pennies in order to get a bicycle, a sewing machine and indoor plumbing.

The wildly uneven cost of labor can never be equilibrated by mere currency price adjustments. China will always be able to compete with U.S. companies and export to the U.S. more than it imports.

Because of the unique and unprecedented position of the U.S. in the world economy and financial system, devaluing the dollar is not going to take the current account deficit to zero or transform it into a surplus. Asian revaluation will go a long way toward reducing the horrendous size of the deficit, but even after China, South Korea and the others revalue, we will still have a trade deficit for decades to come. The terms of trade are against the U.S. — Americans simply have too high a standard of living relative to the rest of the world. Moreover, as Greenspan said in Berlin, raising the savings rate in the U.S. will go toward fixing the true current account problem, the dependence on foreigners, but it can’t do the whole job. So, even in the best of all possible worlds, we are stuck with a "structural" deficit. The next job for the market is to decide upon a deficit-to-GDP ratio it can live with. What’s the number? Something south of 5% of GDP.

The true solution to the U.S. current account deficit is to let it wax and wane with cyclical evelopments, but not to depend on offsetting foreign capital inflows. Foreign capital inflows should be the icing on the cake, not the cake. The cake should be domestic savings adequate to fund capital investment.

The only way to lift up the savings rate is to raise the rate of return. Who is in charge of rates of return? The Fed — but also the folks in Washington who pass tax bills. Privatization of Social Security, anyone?

Can we really say the U.S. is exempt from the same fate that befell other countries with unsustainable deficits? Well, yes, and this is the sense in which the Fed and the Treasury are begging the market, “Please don’t throw me in the briar patch, Br’er Fox.” None of the academic studies involves a country that has the world’s largest and freest economy, that is the sole military superpower, and that possesses the world’s largest financial markets boasting the highest liquidity, transparency and variety of instruments.

We honestly don’t know what constitutes “sustainability” regarding the U.S., and we don’t want to find out.

We don’t know whether the dollar should fall because of the current account deficit, but the attitude in Washington seems to be, "Let’s talk it down ahead of time, just in case."

Without some amelioration of the deficit today, by next year it could be 6.5 percent of GDP, 7.8 percent in 2008, or 13 percent by 2010, according to other studies cited by Summers. We know we can escape through the briar patch of devaluation, but we have no idea what we would do if the current account deficit was 13 percent of GDP and then the world’s investors decided to bail out of dollar assets. Other countries have survived such high deficits, but other countries don’t have the U.S.’s place in the world.

We have to ask whether the government talking the dollar down is just a precautionary measure. After all, you can argue the deficit is an integral part of the international monetary system today. Foreigners borrow in the dollar as well as hold it as a store of wealth.

In many instances, they use their store of wealth dollars as collateral for dollar debt. Recently the National Bureau of Economic Research sponsored a paper arguing the availability of these dollars “liberates” capital formation in poor countries from inefficient domestic financial markets. The economists say the empirical evidence (using China as a test case) bears out the idea.

This helps to explain why emerging market countries show an outflow of some $450 billion in the latest year to rich countries, which seems like an aberration, unless some of the capital is being recycled back to them in the form of collateralized debt.

By now, everybody is talking about the dollar’s inevitable further decline, with even an august figure such as former Fed chairman Paul Volcker speaking of a 75 percent probability of a currency “crisis” sometime in the next five years. Publications ranging from The Economist, Business Week and Wall Street Journal to mass-market magazines and network TV news all solemnly declare the dollar is going to hell in a handbasket.

Traders flinch at such a consensus, because when everybody agrees and has already positioned himself short dollars, there’s nobody left to sell and push the price down.

But academics and some analysts flinch, too, because the global imbalance is not necessarily a bad thing.

Besides, devaluing the dollar won’t fix anything — the trade deficit will not improve by much. A 10 percent drop in the dollar induces less than a 10-percent (if any) improvement in the trade balance.

Growth in the U.S. generates more imports than growth in other countries. Even if all the major countries had the same growth rate, the U.S. would still import more than other countries would import, including from the U.S. Because correcting the current account imbalance is mostly a case of correcting the trade imbalance, the only way for the U.S. to export more than it imports would be to go into slower growth or even recession.

But the rest of the world relies on the U.S. for export-led growth, so if the U.S. imports less, other countries would go into relatively deeper recessions and import even less from the U.S. This is a real Catch-22.

So why do we have the Federal Reserve and the U.S. Treasury out on the conference circuit goading the foreign exchange market into a frenzy over the current account deficit? After all, the current account deficit has been growing steadily since 2000 — the dollar has gone up, down and sideways during the same period. (In fact, it has done all three in the past year.) These moves are not correlated with changes in the deficit.

The global imbalance obviously does not have a direct one-to-one relationship with the dollar. From an economic standpoint, in the typical tradedeficit situation, importers create an oversupply of the currency. In this case, the oversupply of dollars should make it less valuable. However, when demand for dollars is high for investment purposes, the power of the trade deficit to depress the dollar’s price becomes weak, and everybody knows it.

This is why, from a trader’s viewpoint, the monthly trade figures don’t contain useful information. These days, it’s the capital flow report that counts. In September, global investors were willing to increase their net holdings of dollar-denominated assets by 5.8 percent in a month when the dollar was falling by 1.3 percent. Crisis?

What crisis? We have no hard evidence anybody is unhappy about owning dollar denominated assets. In fact, the most recent Treasury capital flow report (Nov. 16) reports that net portfolio investment rose to $63.4 billion in September (from an upwardly-revised $59.9 billion in August). Net portfolio flows into the U.S. are averaging $72.2 billion per month so far this year, compared to $58.2 billion in 2003 and $47.9 billion in 2002. And the cumulative annual inflows are stunning — $649.5 billion in the first nine months of 2004: a 26 percent increase over 2003’s $514.5 billion. Considering the actual rate of return on short-dated money is zero or negative, this is quite a feat. China, for example, is sitting on $60 billion in dollar cash.

The capital inflows are more than enough to cover the current account deficit, which is running at an annual rate of about $665 billion. To speak of a funding crisis is to cry wolf, and Greenspan admits it:

“Current account imbalances, per se, need not be a problem, but cumulative deficits...raise more complex issues. Market forces should over time restore, without crises, a sustainable U.S. balance of payments. At least this is the experience of developed countries, which since 1980, have managed and eliminated large current account deficits, some in double digits, without major disruptions.”

“Sustainable” deficits is a reference to a study in 2000 by the Fed showing the outer limit of a current account deficit is about 5 percent, and after that, currency depreciation kicks in as an balancing mechanism (www.federalreserve.gov/pubs/ifdp/2000/692/default.htm). Deficits become unsustainable when they reach or surpass 5 percent of a nation’s GDP. The U.S. is beyond that point today.

The Q2 current account deficit stands at 5.7 percent of GDP, compared to the previous high of 4.5 percent in 2000 and 3.5 percent in 1986. The U.S. deficit is also about 1 percent of global GDP and more importantly, takes back, in the form of capital flows, about two-thirds of the cumulative current account surpluses of all the world’s surplus countries, according to Larry Summers, former Treasury Secretary and now President of Harvard University. The size is unique. No country has ever run such massive deficits before.

From November 2003 to February 2004, and again going into year-end 2004, the dollar fell more than 10 percent against the Euro. In each case, the underlying cause of the dollar’s drop was universally reported to be the “structural global imbalance,” whereby the U.S. runs a huge current account deficit that is offset by foreigners, including central banks, who buy U.S. financial assets.

It’s not so much the U.S. current account deficit itself that propels the dollar downward, but the fear that foreign investors, especially central banks, will withhold demand for U.S. securities, especially Treasuries, until the dollar finishes dropping or the real return is compellingly greater than the return on equivalent assets.

We’ve been here before. In fall 1985, the countries that later came to be known as G7 (U.S., Great Britain, Germany, France, Canada, Japan, and Italy) met secretly at the Plaza Hotel in New York and decided to drive down the price of the dollar to correct a trade imbalance of about $120 billion annually. The dollar fell 21 percent against the Deutchemark the following year, and another 18 percent the year after that. In 2000, the trade imbalance again became a big topic in the foreign exchange market. That time, the dollar rose against the euro.

What’s different this time is the Federal Reserve is doing most of the talking. The fear of inadequate foreign funding of the current account deficit has been voiced by a whole slew of Fed officials, both regional Federal Reserve Board presidents such as Janet Yellen (San Francisco) and Robert McTeer (Dallas) as well as Fed Governor Ben Bernanke.

Ahead of the G20 meeting in Berlin, Fed Chairman Alan Greenspan laid down the rules for thinking about the global imbalance (www.federalreserve.gov/BoardDocs/speeches/2004):

“The question now confronting us is how large a current account deficit in the United States can be financed before resistance to acquiring new claims against U.S. residents leads to adjustment. Given the size of the U.S. current account deficit, a diminished appetite for adding to dollar balances must occur at some point.”

Once you get past the ornate language, you realize this is practically an invitation to sell dollars. It’s also a near-verbatim repeat of what Greenspan said in 2000, except then he was speaking in a considerably more relaxed, almost offhand way. This time, Greenspan was speaking at a major European conference and knew his words would flash around the world in seconds.

Treasury Secretary John Snow contributes to open acceptance of the dollar falling when he says, on principle, U.S. policy is for a stronger dollar, but if the market wants to take the dollar down, the U.S. believes in free markets.

Relative bond yields are both a cause and effect of real transaction flows. So is the level of a currency. As FX traders, we want to know whether money is going to flow to one currency over another, and also whether existing flows will be maintained at the same levels. The world’s savers generate a certain amount of investible cash every month, and it’s very much a zero-sum game as to who is going to be the beneficiary.

One way we keep score is the U.S. Treasury International Capital System after $63.1 billion in July (revised). Other revisions reduced the January- July cumulative by $17.3 billion. It’s a bit scary that foreign purchases of U.S. Treasuries were only $14.6 billion, down from $22.4 billion in July and $40.6 billion in June. Agency bonds (mostly Fannie Mae and Freddie Mac) were $21.2 billion, corporate
bonds were $26.5 billion, and foreigners sold equities to the tune of $2.1 billion after becoming buyers of $9.8 billion in July and $1.8 billion in June. This was the fourth month in six foreigners were net sellers of U.S. equities. Meanwhile, U.S. investors were sellers of foreign equities and bought only a small amount of foreign bonds ($2.6 billion). If U.S. investors had been net buyers of foreign equities, the net inflow would have been even lower. The monthly average so far in 2004 is an inflow of $73.2 billion, compared to the monthly average of $58.2 billion in 2003 and $47.9 billion in 2002. Yearto date, 2004 has seen an inflow of $585.3 billion compared to $508.3 billion last year.

By country, Japan was a buyer of $27.4 billion (up from $12.3 billion in July), mostly in Treasuries more than half the total capital inflow for the month. China actually sold $800 million in Treasuries but bought $2.5 mil lion in Agencies, while Taiwan also sold $1.1 billion in Treasuries. Hong Kong, Singapore and South Korea were all small buyers. Counties that represent speculators rather than central banks — the Caymans and Bahamas — were still buyers, but in lesser amounts.

A smaller monthly number that still has a cushion is not cause for big alarm, but we also need to worry about the variability of the inflows. The monthly number varies from as high as $104 billion (May 2003) to as low as $6.2 billion (September 2003). We care about foreign inflows into the U.S. more than any other country because the U.S. current account deficit is the gorilla in the living room, generating a need for $50-55 billion per month just to balance the outflow of dollar cash in trade.

China made $5 billion from selling to the U.S. but didn’t turn around and reinvest in it in U.S. paper; China sold U.S. Treasuries and bought only $2.5 billion in Agencies — less than half its dollar earnings. At the September Treasury auction of 10-year notes, foreign central banks bought only 2.8 percent of the offering, after taking 38 percent and 54 percent of the two previous 10-year auctions. Foreign central banks were back in October, taking 32 percent, but their mysterious absence in September is a nagging worry.

Worrywarts fret foreigners will at some point consider they have as much U.S. paper as they want to hold. Fed and Treasury officials mention the potential exhaustion of foreign demand from time to time as a key background factor for dollar depreciation forecasts, although insisting t U.S. is not in imminent danger of a wholesale pullout. Well, no wonder.

The U.S. $23 trillion bond market is the biggest in the world by far. To some extent, the falling dollar the seed of bond market salvation. Bond traders have to offer cheaper prices/higher yields to get buyers to buy, which in turn provides dollar demand to the FX market. But as we know, a trend is a hard thing to shift once it gets going. Watch the relative bond yields for clues as to the persistence of the dollar downtrend and its possible end.

So far we have looked at relative nominal returns. As mentioned, money will flow to the highest real return, which means the nominal yield minus the expected rate of inflation. Economists and analysts have fiddled around for years trying to depict expected inflation and incorporating inflation forecasts into their estimate of the real return. In late October the inflation rate in the U.S. was about 3 percent and the inflation rate in Europe was about 2 percent. And as noted in the yield-curve discussion, the market had confidence in the will of the European Central Bank to restrain inflation, more so than its faith in the Fed on the same point. It’s not that Greenspan is more tolerant of inflation — such an idea would set his socks on fire — it’s that he has a mandate to promote growth, too.

In the current environment, beset by oil price shocks, both central banks are curve on the prospect of slower growth, but at some point they may be shocked into raising the long end of the yield curve to reflect higher inflation expectations in the U.S. And while both yield curves could show a lift at the
long end, the U.S. curve may not rise enough at the long end to make up for every expectation.

Assuming the European curve rises by less, a function of confidence in the ECB, European bonds may still be preferable on a real-return basis. Never mind Europe’s slow growth and institutional problems — to the bond investor, the real return and the steadiness of the return are as important as the actual level of return.

Unless you are willing to spring for the cost of a Reuters or Bloomberg terminal abiding trust of the market in the European Central Bank’s iron determination to restrain inflation. As a general rule, you want to buy the currency whose central bank is able to maintain a flattish yield curve, which is an indicator of central bank “credibility.”

A steep yield curve may reflect the prospect of higher growth, but also of higher inflation, while a flattening yield curve can imply lower growth than once expected, especially if the short end is going up, as in the U.S., while the long end is coming down.

These yield curve effects can’t be seen on the yield differential chart of a single maturity, such as the 10-year notes, but they are a hidden factor in their construction. The lesson here is not that the U.S. 10-year note has a 20-point or 40-point advantage over the German Bund and that’s that; the point is how the differential is shifting and how that relates to the two yield curves.

This is why it’s not enough to buy the higher return or sell the lower return — the shape of the yield curve and relative changes in yield count, too.

As we know, speculative FX trading has far bigger volumes than real deal flow (actual transactions conducted in private between investors and their banks), but second-guessing potential real deal flow makes up a big part of speculative trading.

It’s easy enough to get U.S. 10-year T-note yield data (from the Federal Reserve databank) and overlay it with the euro/U.S. dollar exchange rate. The correlation looks pretty good. As the yield on the 10-year bond was falling, the euro was rising, albeit with quite a lag. But this is only one-third of the story. We also must consider what the yield is doing in the equivalent German 10-year bond (conveniently named the Bund), and we also have totake into consideration the yield shown is the nominal yield, not the real yield. Additionally, it’s not easy to get the German Bund yield. Yields are published every day by financial newspapers such as the Financial Times, but it’s impossible to get the historical data set unless you collect it yourself or pay a data vendor.

Professional FX trader shave charts of 10-year note pairs on terminals as a matter of course. In fact, they set up such charts to show only the yield differentials, and overlay the relevant currency pairs. This is illustrated which shows the U.S. 10-year Tnote/ German Bund yield differential
along with the euro/U.S. dollar rate (courtesy of currency trader Bob Sinche at Bank of America).

The chart shows a daily time frame, but in practice you could display the information in hourly bars, 15-minute bars or any other configuration. Bond traders respond to the same information we watch in the FX market — payrolls, business and consumer confidence surveys, inflation rates, etc., in both countries — and their collective judgment of fresh data is reflected on the chart.

On this chart, the euro (solid line) fell from a peak in February to lows in April and May as the differential (dotted line) went over -.40 points against the euro (right scale). Then the yield differential against the euro started to move back toward zero into September, while the euro was mostly in an uptrend.

In September, there was a curious divergence in which the euro fell while the yield differential was still shrinking. That’s a divergence that doesn’t make sense. There should not be a bias against a currency (the euro) when its return is getting closer to the return on its competitor, the dollar. Hence, if you were watching this chart, you could have predicted the euro was being oversold and was going to rise, as it
subsequently did. The euro broke upside resistance around 1.2420 on Oct. 15 and soared over 1.2800 by Oct. 26 (see chart inset), an unusually sharp breakout.

In FX trading, there are a dozen big-picture factors that set the tone for the trading environment, but one of the most consistently reliable is the bond yield differential between two countries.

The logic is straightforward: When capital flows are free from taxes and regulation, the country with the highest real return will attract the most capital inflow, with some consideration for market size, liquidity and transparency.

International bond buyers are chiefly fund managers (including pension and hedge funds) and central
banks. When buyers put new money into a country’s bonds, by definition they are also demanding the country’s currency. And while fund managers and central banks don’t make seismic shifts in their portfolios’ compositions every day (or even every week), professional FX traders keep an eye on whose bonds are looking the prettiest and plan for the day when portfolio rebalancing does take place.

The actual flow of transactions is a closely held secret because of the promise of confidentiality between banker and client.

The big banks and brokers never leak the trades of their fund managers, or disclose the finance
ministry of Country A is getting rid of some U.S. Treasuries in favor of German Bunds or UK Gilts.
Sometimes the finance ministries themselves make such announcements, such as China revealing a few years ago that it was diversifying reserves into the euro, but it’s rare.

Clearly, something must be done to restore deficits to reasonable levels. But there are several promising signs, and reasons to believe a dollar crisis may not be imminent. First, once-languishing markets like China are on a growth trajectory that could spur new demand for U.S. exports. For another, there is continuous excess capacity in post-tech-bubble markets, including IT and especially labor. Although higher energy and commodity prices remain a concern, excess capacity reduces the likelihood of runaway core inflation.

The government is also working to carefully engineer an orderly expansion, and to trim the trade imbalance by gradually reversing its accommodative interest-rate stance. Global monetary policy makers will continue to gradually raise uncommonly low interest rates but they will only have the luxury to do so at a measured pace as long as core inflation does not surprise on the upside.

As for the risk of a near-term shift in overseas competition, not even the U.S.’s most rapidly growing trading partner, China, can handle the massive export demands of a consumption- oriented market like the U.S. It will take some time before such developing markets build the necessary infrastructure to do so. Progress is quickly being made, however, as China has recently received more
direct foreign investment than any other country, including the U.S. Nonetheless, you can be sure the U.S. will take the necessary steps — e.g., bolstering research and development— to retain its position as a leading destination for foreign trade and investment.

The global rivalry for economic growth will increase, and while demand for raw materials will keep
commodity prices firm, the international competition for jobs will continue to tighten differences in the global standard of living.

Given the significant challenges the U.S. faces with respect to global competitiveness, the value of the dollar is tough to predict long term. But barring unforeseen crises, such as another terrorist attack, continued oil price increases, or a seismic stock market shock, normal cyclical forces are in place to deliver moderate U.S. economic growth that should prevent a disorderly softness of the dollar for the coming 18 months.

While a weaker USD could have the positive effect of helping U.S. exports catch up with imports, it would lessen the appeal of foreign investment in dollar-denominated assets. Even so, the U.S. remains the world’s largest market for foreign exports, the U.S. dollar is still the most widely held
reserve currency, and U.S. exports continue to be the main engine of growth for overseas markets.

Central bank intervention could be undertaken to prevent a dollar slide, as foreigners attempt to maintain their exports to the U.S. The last time an international monetary crisis of this sort occurred was in the 1980s, when the U.S. brokered the Plaza Accord to stem further increases in the dollar, which subsequently lost half its value against the yen and the mark within a two-year period. Conditions were very different then, with foreigners concerned about inflationary growth rather than the sluggish demand outlook they now face.

A weak-dollar policy would also have domestic effects, dampening growth in private U.S. consumption. Given the importance of consumer spending and today’s uncommonly high levels of personal debt, a spike in interest rates could have serious consequences, offsetting the benefits of improved trade import/export levels. The dollar’s fall, depending upon how fast and how hard, could significantly impact U.S. purchasing power, both here and abroad.

The confidence of global and domestic market participants could be compromised by several factors. Oil prices and core inflation continue to be significant risk factors that could weaken global markets.

A shift in competitive foreign markets should also be monitored. The U.S. has long been the global leader in information technology (IT), as our culture and economy are conducive to innovation, capital formation and free market competition.

Lately, however, there has been considerable media and market focus on growing forces of foreign competition. America’s general dominance in IT and the services sector is being challenged by emerging technology suppliers such as Singapore and Taiwan, as well as outsourcing destinations
like India. BusinessWeek reported (“The Promise: Global Brain Power,” Oct. 11, 2004) U.S. investment in research and development of 2.7 percent of GDP was outpaced in 2003 by two thriving innovation hotbeds: South Korea (2.9 percent of GDP) and Israel (4.7 percent of GDP).

These and other countries are becoming major contenders in the race to supply the lucrative global computer and telecommunications networking industries.

In the currency market, traders question the long-term outlook for the dollar given the rise of the euro as a major currency, and the opening of new financial markets. For instance, in an effort to develop its capital markets, China is planning to ease restrictions on foreign investments and exchange (Bloomberg, “To Rally Stocks, China Moves to Ease Foreign Trading Rules,” Sept. 23, 2004). Relaxed capital controls and the formalization of Chinese financial market rules will be key to building global confidence in that market as it matures. However, the magnetic appeal of U.S. markets remains
strong. Unfazed by such jolts as widespread U.S. financial market improprieties in recent years, foreigners continue to entrust their capital to the world’s largest and most secure marketplace. The ongoing recovery and stability of U.S. financial and trade markets is another prerequisite for continued
strength in the USD.

Employment growth will support the dollar, while the reverse is also true. U.S. consumer spending has risen steadily even through the recession, despite such setbacks as investor fears in the wake of the terrorist attacks and following high-profile accounting scandals. With nearly 70 percent of GDP driven by consumers, their ability to spend is a critical driver of currency and broader markets. Continued disappointments in job reports, as in early October, would have a tempering effect. If capital flows are attracted elsewhere and foreigners become reluctant to invest sufficiently in the U.S. to fund
our national deficits, U.S. interest rates must rise to attract foreign funds, and the dollar must fall to make the purchase of U.S. assets and exports more attractive. If interest rates rise, the amount owed to foreign investors for their dollar denominated holdings will rise, adding to the deficit, whichmust be financed.

Never before has the U.S. accumulated such staggering levels of foreign indebtedness at such a rapid pace. Over the past year, claims on the U.S. by foreigners rose by $107 trillion through August compared to U.S. investments abroad of $495 billion.

The $580 billion in net foreign capital inflows, accumulated mostly in interest-bearing liabilities, is crucial for funding the massive U.S. current account deficit. But at the same time, these unpaid claims could have calamitous repercussions.

The U.S. account deficit has continued to widen in large part because of the seemingly insatiable U.S. appetite for imports, fueled by the continued relative strength of the dollar and affordability of goods and services in foreign markets. From January through August of this year, U.S. exports of approximately $752 billion were dwarfed by imports of some $1.15 trillion in goods and services with its major trading partners, leaving a deficit of nearly $395 billion.

China plays a major role in the current deficit scenario. Less than a decade ago, the U.S. invested little in the then stagnant Chinese economy, and China’s stake in the U.S. was also relatively small. Today, China is one of the U.S.’s most important trading partners. The fastest-growing global economy, China comprises 12.1 percent of U.S. imports, compared to a mere 4.4 percent of U.S. exports to that market. Basically, U.S. consumption and investment levels continue to substantially outpace U.S. production and sales of goods and services overseas.

Our research shows the trade-weighted dollar (representing the foreign currency price, or the export value, of the U.S. dollar) has depreciated since its peak in 2002, declining by almost 20 percent from the recent February 2002 high to the end of September 2004. Meanwhile, oil prices have surged to all-time highs, troubling markets with the possibility of rising inflation.

Nonetheless, the decline in the dollar has been relatively orderly, facilitated by continued growth in productivity and gross domestic product (GDP), the recovery of U.S. financial markets, the resilience of foreign investors and, at times, the intervention of foreign central banks, which have been willing to absorb the softened dollar’s impact on trade. Central banks orchestrate monetary policy to manage
currency supplies and valuations while influencing import/export trends.

The new online forex dealers are essentially filling a gap between the institutional interbank market and exchangetraded futures markets. This industry is still young, and regulatory changes and other developments may transform it significantly in years to come.

“The learning curve in FX is different than in stocks,” says Tradesight’s Mercer. “There, you can fall back on waiting for the market to change. With FX, you can’t say, ‘I just dropped a bunch of money, but oh, the dollar will come back.’ FX forces you to educate yourself before diving in. And you’ll never get married to a particular trade.”

When you trade with an online currency firm, you’re either trading against them — they’re taking the opposite side of your trade — or you’re relying on them to provide order matching and financial integrity. In effect, the online forex trader has two layers of risk, in addition to trading risk, to consider: the capital adequacy of the broker and the adequacy of the bank.

In a sense, online forex firms function the same way market makers and specialists do in the stock market, providing (theoretically) liquidity and order in a market. However, while the NYSE and Nasdaq have rules regarding how specialists and market makers must honor bids and offers, there are no comparable regulations controlling online forex firms.

The disclosure documents of forex firms typically include language to the effect that the company is not responsible for providing liquidity. (Read: They have no obligation to take the other side of the market at any time, which technically means you can get stuck holding the bag when the market is screaming against you.) Confidence in the firm is vital.

“Pay attention to the asterisks — they are important,” EFX’s Floyd says. “[A trading platform] may claim to guarantee their trades, but the fine print says they’re not guaranteed during a volatile market. And guess what? They get to decide when conditions are normal in the market.”

Additional considerations for potential forex traders: Is there a demo of the trading platform on which you can mock trade? Do you earn interest on your account? Also, remember to find out about monthly fees for using a firm’s trading platform and any other hidden accounting or processing fees.

Because there is no centralized exchange, the firms are able to establish their own trading hours. Some are closed for all or part of each weekend. Typical trading hours are Sunday night through Friday afternoon.

Another unique aspect of online currency trading is many firms do not charge cash commission fees. As mentioned, many firms make their money by profiting off the spread — buying cheap from the bank and selling to you at a premium, and vice versa when you want to sell.

Many firms advertise consistent five-pip spreads (a “pip” is the forex term for minimum trading increment or tick). However, this actually means you’re paying an extra five pips on top of the markup the bank has already charged to the dealer. If, for example, you see a quote on a particular trade of 109.04/09, that means the bid is 109.04 and the ask is 109.09, and the spread is five pips.

However, spreads can vary widely. Generally, the larger the transaction, the tighter the spread. Interbank spreads, for example, are usually around two pips, partly because forex trading has traditionally been done almost exclusively over the telephone. Because the manpower needed to handle a $100,000 trade is about the same as a $1 million trade or even larger, companies must make up that difference by increasing the spread on the smaller deal.

Most online forex dealers use the spread model.

However, more firms (primarily of the COES variety) are offering fixed commissions. Depending on your trading style, the size you trade and the size of the spread, one method is not necessarily better than the other. Some traders hear the words “no commission” and salivate. However, a loose spread will cost you more than a reasonable commission.

Account minimums and margin rules vary from firm to firm. On the high end of the scale, one forex brokerage requires a minimum account size of $25,000 and offers 4 percent leverage, or 25:1 buying power. If the account falls below 75 percent of the minimum account level, the firm requires a wire transfer within two business days to bring the account above the 75 percent level.

A second firm has a $20,000 account minimum, 4 percent leverage and allows three hours for customers to deposit funds when they dip below the margin threshold. Like equity brokerages, both firms reserve the right to liquidate any position and freeze any account in the event minimum margin requirements are not met.

Many firms have much lower account minimums some don’t even have a minimum — and offer much higher leverage, often giving traders as much as 100:1 leverage (1 percent margin). In other words, traders can leverage $100,000 with $1,000 in their account. “A beginner’s guide to the forex market” has more information on margin in the forex market.

The forex dealer described in the previous section has been joined by a different breed of forex trading firm: online “currency ECNs” or currency order-execution systems (COES). The difference between the two is that COES, similar to their stock ECN counterparts, match orders: They allow clients to trade against each other’s bids and offers, rather than (or in addition to) the dealer’s.

Such systems typically display order books similar to stock ECNs such as Island, with bids and offers representing tradable prices. Traders can post bids and offers in a “transparent” book similar to that of the Nasdaq Level II quote screen, which shows all the levels of bids and offers, not just the inside quote (lowest offer and highest bid). A few examples of this type of firm include MatchbookFX (www.matchbookfx.com), HotSpotFX and HotSpotFXi (www.hotspotfx.com), and CoesFx (www.coesfx.com). “We’re an open marketplace,” says MatchbookFX president and CEO Mark Smith. “We just facilitate transactions.”

These kinds of firms are often targeting smaller institutional and corporate businesses that do not get preferential treatment from the direct interbank market (although many also accept retail-size accounts of $25,000 or less).

In addition to customer orders, some COES use in-house traders who provide additional liquidity to the market. According to Smith, these traders act “similar to specialists on a stock exchange floor. Their job is basically to control the markets when they get out of whack because of a lack of liquidity, and to handle the stop-order book. They don’t take proprietary trades; they just facilitate entries and exits for the customer.”

What advantages over the typical forex market do these firms see in their models?

“We allow all of our customers to trade FX on equal footing,” says John Eley, HotSpot’s chief executive officer. “All participants see the same dealable prices.”

The key to the FX world, as it stands, is finding a good platform that has the lowest spreads. However, “there are leaps coming shortly that will eliminate fixed spreads, which will make this market more accessible than it already is,” says Chris Mercer, trader and owner of Tradesight.com, an educational Web site providing market education, analysis and trading strategies.

In August, Mercer partnered with EFX Group/Arizona, a direct-access brokerage firm for FX traders, managed by Jon Floyd.

“Soon we’re going to take the deal desk away and make FX a more level playing field,” Floyd says. “We’ll have a platform that will allow clients to deal directly with each other.”

In the currency market you are trading the value of one currency relative to another. It varies from firm to firm, but most online forex dealers offer trading in the U.S. dollar vs. several major currencies: Japanese yen, the euro, British pound, Swiss franc, Canadian dollar and Australian dollar.

Most also offer trading in “cross rates,” or currency pairs not involving the U.S. dollar — the euro/yen(EUR/JPY), for instance. (For detailed information on currency quotations and trading conventions, see “A beginner’s guide to the forex market,” p. 52.)

It is important to keep in mind that when you trade with an online forex broker, you’re not really trading directly with the interbank market. The typical online currency brokerage essentially functions as a conduit or middleman.

True interbank participants operate as market makers, offering executable bids and offers (two-sided markets) in various currencies to other banks. In short, a bank belongs to the “interbank fraternity” if it has the appropriate credit lines and it provides a two-sided price quote.

Legitimate retail spot forex dealers have relationships with one or more interbank institutions with whom they can trade currencies. Typically, when you request a quote or place an order with a forex dealer, the broker contacts a bank. The currency desk at the bank gives your broker a quote, which will not be as good as the quote they’d provide to another interbank member. Your broker then gets back to you with a quote that is, in turn, inflated enough for the broker to make money off the spread. In other words, they have to sell to you high enough, and buy from you low enough, to make a profit on their offsetting transaction with the bank, which is profiting from the broker in a similar manner.

As a result, take a brokerage’s claim of “direct access” to the interbank market with a grain of salt. When you receive a quote from a firm, it’s difficult to know how accurate their market is, other than relying on the company’s reputation or contacting several firms to compare markets.

Another consideration with online forex dealers is whether the quotes they display on their systems are firm or “indicative.” If they’re firm, you can trade them immedi ately. If they’re indicative, you have to make a “request for quote” to find the actual tradable price — which means the dealer has to first get a price from the bank before he makes you a bid or offer.