It's the Capital Account, Stupid

It is difficult to prove this thesis true, but consider how Copernicus proved that the earth went around the sun. The short answer is, he didn't. But by assuming that the earth went around the sun, Copernicus was able to explain other "facts," or more correctly, observations.

Similarly, if we assume that the foreign-exchange market is being driven more by capital account considerations than by trade factors, a number of other "facts" make sense. This thesis helps explain why the Swiss franc is weak as well. After Japan, Switzerland offers the lowest interest rates in the world. The Swiss National Bank key rate stands at 2.0% (the midpoint of the 1.5%-2.5% three-month London interbank offered rate, or LIBOR, band). Speculators at the International Money Market have not been net long Swiss francs since early June.

Flush With Liquidity

In addition to the price of money, the quantity of money is an issue for the capital markets. Global liquidity, measured by money supply, is ample. A contrarian indicator of the importance of money supply is the fact that the Federal Reserve stopped reporting the broad-based measure called M3 almost a year ago.

However, other measures suggest that U.S. money supply is growing at a robust pace. Consider that when the Fed began raising interest rates in this cycle back in mid-2004, M2 was growing at an annualized rate of 4.6%. As of the end of December 2006, M2 was growing at a 5.3% clip. The growth rate accelerated in the fourth quarter of 2006, and the December reading was the highest since February 2005.

A year after the European Central Bank began raising interest rates, money supply is expanding at its fastest rate in nearly two decades. The ECB reported Friday that December 2006 money supply rose 9.7% above year-earlier levels. This is more than twice the 4.5% reference rate. In November 2005, the month before the ECB began entered its tightening cycle, M3 was growing at a 7.5% pace.

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Marc Chandler has been covering the global capital markets in one fashion or another for nearly 20 years, working at economic consulting firms and global investment banks. Currently, he is the chief foreign exchange strategist at Brown Brothers Harriman. Recently, Chandler was the chief currency strategist for HSBC Bank USA. He is a prolific writer and speaker and appears regularly on CNBC. In addition to being quoted in the financial press, Chandler is often a guest writer for the Financial Times. He also teaches at New York University, where he is an associate professor in the School of Continuing and Professional Studies. While Chandler cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.