Two terrific definitions

Thanks to a client in my real 'job,' who also trades, I have tried to learn something new every day about fundamental analysis. Being a technician at heart, I am surprised how simple understanding of what is being reported on the basic Forex news sites has helped my trading.

So below are two excellent and easy to understand pieces I found on what quantitative easing is and what an exchange rate really means:

Quantitative Easing

The government stimulates economic growth without incurring more debt, and indeed has the option of reducing the carrying cost of its debt as an added bonus? Sounds too good to be true. And it is, beyond the short term. Central banks can print money but the taxpayer can't buy a free lunch with it. The fiscal payback comes when the CB eventually goes to sell the accumulated financial assets (in particular, government bonds). They will wait until the economy has recovered. By this time the prices of these assets will almost certainly have fallen - i.e. their yields risen - to more normal levels, and the CB will make a loss. Depending on the scale of QE that has been undertaken, this could make an enormous hole in the government books further down the track.

However, the main macroeconomic risk around quantitative easing is unleashing a serious inflation problem. Central banks have a tendency to be quicker off the mark cutting rates than hiking them (a fact that must take its share of the blame for the current mess the world economy finds itself in). Similarly, with quantitative easing, the temptation will be to wait too long, to be sure the recovery and asset markets are robust, before unwinding the stimulus by dumping the assets back into the markets. Indeed, a commitment to keep QE in place well into the recovery is a necessity to make it effective. Hence, while QE is not in and of itself inflationary, the risks are biased towards a policy mistake in the future that is. If the money trees start selfseeding, policymakers may find themselves requiring a pretty serious bushfire to restore faith in the value of their sheaves of green.

An exchange rate (e.g. Sterling/Greenback aka 'Cable')

In the first quarter of 2009, the U.S. dollar appreciated materially which can negatively impact U.S. companies that are selling products aboard by reducing the value of their international sales. To explain this further, imagine that McDonald’s sell a Big Mac in the U.K. for 2 British pounds at a GBP/USD exchange rate of 1.80. For U.S. based McDonald’s, that would mean revenue of $3.60 per Big Mac. Suppose that the British pound weakens 20 percent, bringing the GBP/USD exchange rate down to 1.44. The 2 British pounds that they charge for each Big Mac now equals revenue of only $2.88 instead of $3.60. Compound this by millions of Big Macs sold abroad and you understand how a strong dollar can hurt a company like McDonald’s. This leaves the companies faced with the difficult of decision of raising prices to keep margins intact or maintain their competitiveness by reducing prices and taking a hit to profitability.