The basic idea behind this model is that the flow of money into a country's other financial assets, such as bonds and securities, increases the demand for its currency and vice-versa. As proof, the proponents of this theory claim that the amount of money directed toward investment products such as bonds and stocks is currently much higher than the amount of funds exchanged for transactions in goods and services for export and import.
In general terms, asset market theory is the opposite of balance of payments theory, because it takes into account a country's capital instead of its current account.
In 2000, many experts said that the USD would fall sharply against the euro, due to the current account deficit and the overvaluation of Wall Street at the time. This was based on the idea that foreign (non-US) investors would begin to withdraw their capital from US assets to invest in more attractive economic markets, which would likely affect the price of the dollar. Despite this, these fears have certainly existed since the early 1980s, when the US current account deficit had reached 3.5% of its GDP.
In recent years, the use of the balance of payments model to analyse the behaviour of the dollar has given way to use of the asset market model. In fact, this theory is among those that are more commonly used and influential among expert analysts due to the huge size of the US financial markets.
For example, between May and June 2002, the dollar dropped by over 1,000 points against the yen as equity investors hastily left the US stock markets due to the accounting scandal affecting Wall Street. When these scandals then faded away towards the end of the year, the dollar appreciated by around 500 pips versus the yen, despite the fact that the current account still had a huge deficit.
The main limitation of the asset market model is that it is relatively new compared to the other ones and hasn't yet been properly tested. It is often argued that in the long run, there is no relationship between the performance of a country's stock markets and its currency. For example, over the 1986-2004 period, the US dollar index and the S&P 500 index had a low correlation (only 39%).
What happens to a country's currency when the stock market moves in ranges, caught between a bullish and a bearish sentiment? This was this scenario that developed in the United States during most of 2002. As a result, traders had to revert to old models such as interest rate arbitrage.
Over time, we will know whether the asset market theory will remain or whether it will just be a passing fad in the field of exchange rate behaviour analysis.