This year, there have been two issues on the minds of currency traders that employ ‘fundamental analysis:’ global imbalances and interest rate differentials. While the last two posts attempted to bring clarity to the role of interest rates in forex markets, this post will explore the effect of widening global imbalances.

The laws of economics imply that a nation experiencing a current account or trade deficit should witness a depreciation in its currency, so as to cheapen its goods and assets in the eyes of foreign consumers and investors, respectively. While the US twin deficits have soared to record levels, however, the USD has appreciated against a broad basket of currencies. The reason, as I have reported on numerous occasions, is tied to the continued willingness of foreigners to invest in the US. But is this phenomenon sustainable?

Some economists have argued that these deficits are a natural outgrowth of globalization and/or a global savings glut; accordingly, they believe the current value of the USD is economically defensible. Other economists have adopted a more cynical outlook, arguing that foreigners’ current penchant for US assets will eventually wane, at which point the USD will plummet. Unfortunately, this is a debate that will not soon be settled, and it may be years before the sustainability or lack thereof of the current global imbalances can be measured.

Read More: US deficits put cloud over outlook for 2006