The Bank of Japan released its Tankan survey this week, which measures Japanese producers’ confidence in the economy. The numbers were not good, meaning Japanese are not optimistic about the state of their economy. Many fear Japan is headed towards its 4th recession in less than 15 years. As a result, Japan experienced a substantial outflow of capital, as nervous investors moved their money to more stable economies. The removal of assets trickled down to the exchange rate, as the Japanese Yen fell over 1% against all major currencies. Business confidence is at a 4 year low, and investors are already speculating on the results of next month’s survey. Bloomberg news reports:

A foreign-exchange strategist in Tokyo at Deutsche Bank AG said, "People want proof the economy is recovering. The yen is going to fall."

Read More: Yen Falls on Tankan

In a recent article, former vice presidential nominee Jack Kemp defied economic logic when he defended fixed exchange rates. The crux of his argument was that currency markets are inherently imperfect, as the prices (exchange rates) are determined by governments, who control the supply of money. He argues that national governments monopolize the supply of money, and are thus able to manipulate their exchange rate. Fixed exchange rate regimes, on the other hand, are impervious to government manipulation, because they are artificially held in place, even when a country’s money supply changes. He goes so far as to recommend the US resurrect the Gold standard in some form, so that dollars can be traded like a commodity.

There are two responses to Mr. Kemp’s fallacious reasoning. First, while no markets can be perfectly efficient, currency markets come as close as can be expected. Money supply is unarguably an important factor in a country’s exchange rate, but it is one of many factors. Institutions and banks consider inflation, interest rates, and general political circumstances when trading currencies. The price of a nation’s currency therefore, should be a near perfect indication of what foreign holders of that nation’s currency feel it is worth.

Second, Mr. Kemp fails to understand the dilemma facing all central banks. When a central banks tries to control its currency, it loses the ability to conduct an independent monetary policy. A central bank can control interest rates, inflation, or its exchange rate- never all three. Therefore, because China maintains a fixed exchange rate, it is unable to control the supply of Yuan, and is also unable to control inflation and long term interest rates.

Read the full article: Faux Foreign Exchange Signals

The Central Bank of Indonesia admitted that it has been intervening on behalf of its domestic currency, the Rupiah. However, it is not trying to depreciate its currency like other developing countries in the region. Rather, it is fighting to prop up its currency to stem recent declines, caused by two distinct phenomena. First, when the Federal Reserve raised interest rates, many investors moved money back into American treasuries. Second, many Japanese firms have unexpectedly begun to repatriate more of their profits earned in Indonesia, which have been substantial of late. In response, Indonesia’s Central Bank has been selling off USD, and buying Indonesian bonds in bulk. AFX News Financial reports:

A sell-off by foreign investors in the stock market has also led to increasing demand for dollars.  "In fact dollar supply was limited. It was just about 300-400 million dollars per day. So even a small increase in demand could trigger a big volatility," a bank official said.

Read More: Bank Indonesia confirms forex market intervention

A new study by the IMF calls China foolish for liberalizing its capital controls before adjusting its exchange rate regime. The study criticized China for recently allowing capital to enter and exit the country more freely than before. Chinese banking officials believe looser controls on capital inflow and outflow are a prerequisite to a floating exchange rate, but experts argue that this theory is fallacious. In reality, the ability for foreign and domestic firms to exchange Yuan for foreign currency- and vice versa- may exert extreme pressure on the Yuan, to the point of instability. Currently, all international capital movement must be approved by Chinese government officials, so that the central bank can offset changes with commensurate changes in forex reserves. After China opened its borders to foreign capital to boost economic growth, the demand for Yuan soared. In order to maintain the fixed exchange rate with the USD, the central bank was forced to purchase massive blocks of USD, which now total over $600 Billion. China tried to offset these inflows by allowing select Chinese companies to invest abroad, but this only triggered more foreign investment in China. The Economist reports:

The combination of fixed exchange rates and open capital accounts has caused financial crises in many emerging economies, especially when financial systems are fragile. China would therefore be wise to move cautiously in liberalising its capital account, but should move more rapidly towards greater exchange-rate flexibility. 

Read More: Putting Things in Order

At a recent automobile show in New York, auto manufacturers were talking about more than just the new models they planned to unveil- they also talked about how changes in the exchange rate were affecting business. American manufacturers have been the largest beneficiaries of the USD depreciation. In fact, many are beginning to export American-made cars to Europe, something which has been done only on a very limited basis in the past. Some foreign manufacturers are shifting production of cars sold in the US, to the US. Mitsubishi and Toyota are two examples of such companies. While clearly upset at the current situation, other foreign manufactures are using the poor exchange rate as an excuse to become more efficient and drive down costs. In the early 1990’s, Toyota adopted many changes in response to a Strong Yen. After the Yen stabilized, Toyota was left with a vastly improved workforce and streamlined operations, and became even more profitable than it had been prior to the Yen’s rally. Forbes.com reports:

Automakers outside the United States have born the brunt of the exchange-rate damage, but they shrugged off the currency effects in interviews this week. That’s because most remember that last time the dollar was weak, their factories were mainly overseas. Since then, many have opened factories in the U.S.

Read More: Yen-Euro Salvation 

A British regulatory agency recently announced its belief that global currency markets should be regulated. Equity and debt markets are already heavily regulated, so why not currency markets, in which $2 trillion+ worth of currencies are exchanged every day. The regulatory agency’s main suggestion was to separate analysts and traders, similar to what has been done in banks’ debt and equity departments. There is a clear conflict of interest, or ability to manipulate currency markets, when analysts and traders collude. If a bank’s analysts advise the bank’s clients on the direction it believes a particular currency to be headed, that bank’s traders could profit from the information. The analogy to equity markets is self-evident. The problem is one of jurisdiction and boundaries. Capital markets are regulated by an agency within the nation that the capital is invested in. Currencies, on the other hand, are often traded by parties outside of the currency’s home country. Scotsman.com reports:

THE Forex market’s argument is that practitioner regulation, or self-regulation, is a better tool in fighting tricks of the trade and loophole hunting, rather than forced compliance with a one-size-fits-all rule.

Read More: Banking on a regulated market for currencies

Malaysia announced that it expects its economy to grow at only 5-6% this year, down from 7%. Economists attribute the slowdown to a decline in exports. As an emerging economy, Malaysia is heavily depend on exports (especially technology related exports) to fuel economic growth. However, a global decline in IT and technology spending has hit Malaysian exporters especially hard. Even with the artificially favorable exchange rate, maintained at value which experts estimate to be 20% below fair value, exports are declining.

Malaysia will be forced to rely on the other factors of GDP if its economy is to grow. The first factor is government spending, which on outlays such as education, agriculture, and health care, looks to remain constant this year. Consumption, on the other hand should drive Malaysia’s economy. Consumption and growth effect each other in a circular manner. As the economy grows, consumers are left with more disposable income which they typically use to purchase more goods and services. This increases aggregate demand which increases GDP growth, which then increases consumption, until the process diffuses. Finally, investment in Malaysia continues to strengthen. as speculators pour money into Malaysian capital markets. Such speculators anticipate a revaluation in the exchange rate, which Malaysia insists will not happen. Reuters reports:

Bank Negara indicated speculation and short-term capital flows would not spark a change in currency policy. "The basis for any change would therefore be made on long-term structural considerations and not short-term movements in capital flows or transient shifts in exchange rate expectations," it said, adding that it could continue to absorb foreign inflows through money market operations.

Read More: Malaysia GDP growth seen slowing to 5-6 pct in ’05

Analysts are increasingly calling on South Korea to accept a strong Won as unavoidable, regardless of its desirability. They say the strong Won is not driven by factors that South Korea can control; rather, it is a product of a weaker dollar. South Korea should accept that the effects of any intervention to stabilize the USD-Won exchange rate will be ephemeral at best, and South Korea will be stuck with more USD reserves. South Korea has recently asserted that the Won’s weakness is a result of hedge fund speculation, which may or may not be true. Regardless, analysts call on South Korea to identify new markets outside of the US for their products. They argue the value of the Won has not changed relative to other nations’ currencies; therefore, they could just easily increase market share in those countries, instead of relying on the USD to strengthen.  The Korea Times reports:

“At the same time, we must realize that this appreciation is only relative to dollar-based currencies, and it has not affected our competitiveness in other markets such as the euro area and the British pound,’’ one insider stressed. “So, strategically it’s time to try and protect our market position in dollar-based markets to avoid losing market share, while actively using our continuing competitiveness in non-dollar markets to continue building successful market positions in other currency areas like Europe.’’

Read More: Strong Won: Undesirable, But Unavoidable

New Zealand economists have revised the country’s growth prospects downward by .6%. Despite the forecasted change, New Zealand’s economy is still growing at an annualized rate of 3.9%, which is nothing to scoff at. In fact, it now has the fastest growing economy in the developed world. Economists attributed the slowdown to decreased milk production and new construction. New Zealand actually welcomed the news, which forced the New Zealand dollar downward against the USD. This will give New Zealand’s exports a prayer at remaining competitive, after the NZD has risen by double digits against the USD. Yesterday’s rise in US interest rates should help to prevent the NZD from rising in the short term. It is worth noting however, that New Zealand offers the highest interest rates in the developed world, despite having the strongest economy. Thus, we shouldn’t expect investors to start taking capital from New Zealand just yet. The Financial Times reports:

The slowdown in the economy, which has been tipped for some time, follows a sharp tightening in monetary policy. Earlier this month the central bank raised rates for the seventh time in just over a year, to 6.75 per cent.

Read More: New Zealand sees unexpected slowdown in growth

Despite raising interest rates to 19.25% this month, Brazil’s Central Bank is drawing increasingly harsh criticism from economists around the world. Their complaints are contrary to what you would expect, as many think interest rates are still too low! Under pressure to contain aggregate demand and inflation, the bank has raised rates by over 3% in less than a year. Last year, critics chastised the bank for not dropping rates quickly enough, when Brazil’s economy began to spiral into recession. This year, they have argued the bank’s monetary policy has had no discernible effect on Brazil’s economy.

Analysts have observed a few factors which may diffuse the effect of interest rates. First, borrowing rates are actually decreasing despite an increase in federal funds rates. Second, there are still too many loans made below the prevailing interest rate. Brazil’s government makes many exceptions for those who cannot afford to pay such high rates of interest on housing loans, for example. What should Brazil’s Central Bank do? Some say it should continue to raise rates at a pace consistent with inflation. Other say it should wait until the effects of previous rate hikes trickle down through the economy, and run their course. Morgan Stanley reports:

Brazil’s economy has long shown that it is responsive to interest rates.   If there is an anomaly in the Brazilian case, it is not the limited potency of monetary policy or the lag between monetary tightening and the slowdown in the economy, but the starting point for interest rates.  Brazil has only briefly seen real interest rates in the single digits twice in the past decade.

Read More: Brazil: The Monetary Policy Blame Game

Today, Alan Greenspan and the Federal Reserve raised the federal funds rate from 2.5% to 2.75%. Most analysts have been predicting this change for over a month, which may explain the USD’s recent rally. The Federal reserve has been remarkably transparent in its monetary policy, which has depressed risk premiums on interest rates. The Fed abandoned its use of ‘measured’ in characterizing the pace of future interest rate movements, and intimated that it would likely raise rates by 25 basis points at each of its next two meetings. Investors unanimously agree that the Fed will continue to raise rates, but the pace is somewhat unpredictable. The Fed noted that the weak dollar is driving up the costs of imports and raw materials. This phenomenon, combined with the effects of broad economic growth, may lead to inflation, in which case the Fed would likely accelerate the rise in interest rates. The Wall Street Journal Reports:

Fed officials believe the U.S. has been at "price stability" — a zone where inflation, at about 1.5% by their preferred measure, doesn’t figure significantly in companies’ or households’ decisions.

Read More: Fed lifts rates, warns on inflation

India’s forex reserves set a new record. At $140 Billion, the reserves are now the 6th largest in the world. The record is due mostly to foreign capital inflows, which also continue to set records. Foreigners are pouring money into Indian stocks and bonds, in search of the typically high returns that emerging markets offer. Not only have share prices reached new highs, but so has the value of the Indian Rupee.

India derives much of its economic growth from growth in the export sector. Thus, the Reserve Bank of India has been working overtime to ‘sterilize’ the exchange rate, and prevents India’s exports from becoming too expensive. This sterilization typically assumes the form of buying bonds from the public, which increases India’s money supply. However, this increase in the money supply can spur inflation, and India cannot afford this. Nonetheless, India will likely continue to sterilize for as long as it can, taking cues on exchange rate manipulation from its neighbor to the North. Reuters reports:

They say signs China is still reluctant to allow its tightly pegged currency to strengthen had hardened the resolve of countries like India to keep their currencies under check.

Read More: India’s forex reserves peak to $140 billion

Members of the EU finally reached an agreement that budget deficits should be limited to 3% of national income. Only member nations which use the Euro currency are required to stay within the limit. However, many critics say the statute has little real significance, as a similar agreement has been place for several years. Nonetheless, France and Germany have managed to spend beyond 3% of their respective national incomes in each of the last 3 years. The Euro situation is a sticky one, as member nations are essentially free to conduct independent fiscal policies, but must loosely adhere to a universal monetary policy. In this case, if one nation exercises too much fiscal discretion (runs a large budget deficit) it may have ramifications for the the other member nations. BBC News reports:

The EU is struggling to emerge from an economic slowdown and wanted limits on public spending and debt levels – known as the Stability and Growth Pact – to be made more flexible.

Read More: EU ministers finalize Euro deal

The US trade deficit is widening, despite the weakening of the USD. In theory, a weaker dollar should make US goods and services more attractive to foreign consumers. Moreover, foreign goods and services should become more expensive. The former has proved true, as American exports have surged. However, foreign businesses have reacted to increasingly unfavorable exchange rates by lowering their prices, so as not to lose market share. There are two factors in the trade balance- exports and imports. And imports have not shown any signs of slowing, as the booming American economy has left American consumers with more disposable income, which they have used to import more foreign products. Furthermore, the Chinese Yuan is pegged to the dollar, so a weaker dollar has had no effect whatsoever on the US-China trade deficit, which grows wider every day. The World Peace Herald reports:

With the dollar declining, it was expected that exports would surge. They are not, and part of the problem is that U.S. firms are increasing prices rather than going all out to get market share. That is a short-term profit maximization philosophy that will not leave the country or the firms in a whole lot better shape than before the dollar decline.

Read More: Weak Dollar not improving US trade

A recent survey attempts to identify the most important people in foreign exchange markets. Topping the list, unsurprisingly, is Alan Greenspan, chairman of the US Federal Reserve. The USD is the world’s reserve currency, and Greenspan largely determines US interest rates. However, Greenspan will be stepping down in less than one year, and Ben Bernanke is rumored to be his replacement. He is an advocate of ‘neutral’ interest rates, and increased monetary transparency.

Jean-Claude Trichet, president of the European Central Bank, is probably the most influential foreigner. Although his past has been characterized by scandal, Trichet has earned the respect of most of the EU for his leadership during the transition to one universal European currency. Trichet is known for predicating monetary policy decisions on inflation expectations, rather than on economic growth. Accordingly, most economists agree that EU rates will continue to climb. Herve Gaymard, French minister of finance, has also achieved notoriety for his loud criticism of the weak dollar. He is encouraging Asian and European Central Banks to intervene and stem the dollar’s decline.

Gordon Brown, chancellor of the UK exchequer, is probably as important more popular than Tony Blair, and a fiscal conservatist. He has managed to contain government spending, and prevented tax rates from increasing. Finally, Alan Bollard, governor of the reserve bank of New Zealand, has also achieved prominence, as New Zealand’s interest rates are the highest in the developed world. As New Zealand’s economy continues to grow, so may its interest rates.

View the Complete List: 20 Most Influential People in FX

For those unfamiliar with the term, FOREX (FOReign EXchange market), refers to an international exchange market where currencies are bought and sold. The Foreign Exchange Market that we see today began in the 1970’s, when free exchange rates and floating currencies were introduced. In such an environment only participants in the market determine the price of one currency against another, based upon supply and demand for that currency.

FOREX is a somewhat unique market for a number of reasons. Firstly, it is one of the few markets in which it can be said with very few qualifications that it is free of external controls and that it cannot be manipulated. It is also the largest liquid financial market, with trade reaching between 1 and 1.5 trillion US dollars a day. With this much money moving this fast, it is clear why a single investor would find it near impossible to significantly affect the price of a major currency. Furthermore, the liquidity of the market means that unlike some rarely traded stock, traders are able to open and close positions within a few seconds as there are always willing buyers and sellers.

Another somewhat unique characteristic of the FOREX money market is the variance of its participants. Investors find a number of reasons for entering the market, some as longer term hedge investors, while others utilize massive credit lines to seek large short term gains. Interestingly, unlike blue-chip stocks, which are usually most attractive only to the long term investor, the combination of rather constant but small daily fluctuations in currency prices, create an environment which attracts investors with a broad range of strategies.

How FOREX Works

Transactions in foreign currencies are not centralized on an exchange, unlike say the NYSE, and thus take place all over the world via telecommunications. Trade is open 24 hours a day from Sunday afternoon until Friday afternoon (00:00 GMT on Monday to 10:00 pm GMT on Friday). In almost every time zone around the world, there are dealers who will quote all major currencies. After deciding what currency the investor would like to purchase, he or she does so via one of these dealers (some of which can be found online). It is quite common practice for investors to speculate on currency prices by getting a credit line (which are available to those with capital as small as $500), and vastly increase their potential gains and losses. This is called marginal trading.

Marginal Trading

Marginal trading is simply the term used for trading with borrowed capital. It is appealing because of the fact that in FOREX investments can be made without a real money supply. This allows investors to invest much more money with fewer money transfer costs, and open bigger positions with a much smaller amount of actual capital. Thus, one can conduct relatively large transactions, very quickly and cheaply, with a small amount of initial capital. Marginal trading in an exchange market is quantified in lots. The term "lot" refers to approximately $100,000, an amount which can be obtained by putting up as little as 0.5% or $500.

EXAMPLE: You believe that signals in the market are indicating that the British Pound will go up against the US Dollar. You open 1 lot for buying the Pound with a 1% margin at the price of 1.49889 and wait for the exchange rate to climb. At some point in the future, your predictions come true and you decide to sell. You close the position at 1.5050 and earn 61 pips or about $405. Thus, on an initial capital investment of $1,000, you have made over 40% in profits. (Just as an example of how exchange rates change in the course of a day, an average daily change of the Euro (in Dollars) is about 70 to 100 pips.)

When you decide to close a position, the deposit sum that you originally made is returned to you and a calculation of your profits or losses is done. This profit or loss is then credited to your account.

Investment Strategies: Technical Analysis and Fundamental Analysis

The two fundamental strategies in investing in FOREX are Technical Analysis or Fundamental Analysis. Most small and medium sized investors in financial markets use Technical Analysis. This technique stems from the assumption that all information about the market and a particular currency’s future fluctuations is found in the price chain. That is to say, that all factors which have an effect on the price have already been considered by the market and are thus reflected in the price. Essentially then, what this type of investor does is base his/her investments upon three fundamental suppositions. These are: that the movement of the market considers all factors, that the movement of prices is purposeful and directly tied to these events, and that history repeats itself. Someone utilizing technical analysis looks at the highest and lowest prices of a currency, the prices of opening and closing, and the volume of transactions. This investor does not try to outsmart the market, or even predict major long term trends, but simply looks at what has happened to that currency in the recent past, and predicts that the small fluctuations will generally continue just as they have before.

A Fundamental Analysis is one which analyzes the current situations in the country of the currency, including such things as its economy, its political situation, and other related rumors. By the numbers, a country’s economy depends on a number of quantifiable measurements such as its Central Bank’s interest rate, the national unemployment level, tax policy and the rate of inflation. An investor can also anticipate that less quantifiable occurrences, such as political unrest or transition will also have an effect on the market. Before basing all predictions on the factors alone, however, it is important to remember that investors must also keep in mind the expectations and anticipations of market participants. For just as in any stock market, the value of a currency is also based in large part on perceptions of and anticipations about that currency, not solely on its reality.

Make Money with Currency Trading on FOREX

FOREX investing is one of the most potentially rewarding types of investments available. While certainly the risk is great, the ability to conduct marginal trading on FOREX means that potential profits are enormous relative to initial capital investments. Another benefit of FOREX is that its size prevents almost all attempts by others to influence the market for their own gain. So that when investing in foreign currency markets one can feel quite confident that the investment he or she is making has the same opportunity for profit as other investors throughout the world. While investing in FOREX short term requires a certain degree of diligence, investors who utilize a technical analysis can feel relatively confident that their own ability to read the daily fluctuations of the currency market are sufficiently adequate to give them the knowledge necessary to make informed investments.

The US current account balance encompasses all capital inflows and outflows, in investment, trade, etc. At $650 Billion and climbing, it continues to set records. American businesses and consumers have a seemingly insatiable appetite for foreign goods, namely oil. The foreign businesses which sell to the US, also seem to have no problem reinvesting their dollar-denominated profits into American debt and equities. But, warn economists, this may well change if the USD continues its decline. In which case, foreign investors and creditors would likely rush for the exits en masse, exerting severe downward pressure on the dollar and upward pressure on American interest rates. This would have a detrimental impact on economic growth. CBC news reports:

The administration has insisted it believes in a strong dollar for fear of provoking a sharp sell-off in the currency. That would destabilize U.S. financial markets while doing nothing to halt the greenback’s gradual decline.

Read More: US Current Account deficit hits record in 2004

Some people believe foreign exchange markets are too big to be manipulated. Not so, says South Korea. It believes American hedge funds are responsible for the Won’s recent appreciation. South Korea has experienced net positive foreign capital inflows for quite some time. Hedge funds have been pouring capital into South Korea, hoping to simultaneously profit from the Won’s appreciation and the appreciation of South Korean equities. The hedge funds have also increased their purchase of non-deliverable forward contracts of Won. According to South Korea, this proves that speculators are the main culprit in the Won’s strengthening.

To prevent further appreciation, South Korea announced that it will intervene, by selling $5 Billion worth of special foreign exchange stabilization bonds. However, economists fear this will only accelerate the Won’s appreciation. The reason is investors will probably not be deterred from buying Won, expecting that it will continue on its tear after the effects of the stabilization effort wear off. The Korea Times reports:

The government is trying to control the foreign exchange rate by intervening in the market to enjoy short-term economic growth, which leads foreign investors to believe that the won-dollar rate will further decline.

Read More: Korean Won Falls Prey to Foreign Hedge Funds

Japan recently threatened to intervene on behalf of the Yen, which has appreciated by over 30% against the dollar, over the course of 3 years. The reason for the intervention is a decline in Japanese exports, due in part to a stronger Yen, which may be preventing Japan’s economy from achieving real economic growth. As a result, Japan threatened to intervene if the Yen continues to appreciate against the USD.

The announcement was made almost exactly a year after Japan’s last bout of intervention ended. In the first few months of 2004, Japan’s Central bank bought large blocks of USD, to prevent the Yen from strengthening. Sure enough, the Yen stabilized. Since then however, the Yen has resumed its climb, and the value of the USD that Japan purchased has declined proportionately. In fact, it is estimated that Japan lost over $100 Billion as a result of the intervention. Some analysts believe that Japan made the announcement to try to drive down the Yen, without actually intending to deliver on its threats. The Times Online reports:

Currency analysts said that the comments were part of a strategy used by Japan of first using the threat of intervention to move the markets before stepping in with massive buying of dollar assets. Observers also pointed out that the statement used the same language as earlier pre-intervention speeches, including the notorious line that Japan will step in “if exchange rates do not reflect economic fundamentals”.

Read More: Japan threatens to resume artificial weakening of yen

American manufacturers and labor unions are fed up with the Chinese government’s stubborn refusal to revalue the Yuan, which may be undervalued by as much as 40%. Manufacturers are declaring bankruptcy in droves, unable to compete with their Chinese counterparts, who have the advantage of being able to sell their goods for artificially low prices. This has caused the US trade deficit with China to balloon to $150 Billion. In addition, as many as 3 million manufacturing jobs have been directly lost to China, as firms outsource most of their production to a region where wages are lower. Many American firms have tried to lobby the US government to pressure the Chinese, but to no avail. Apparently, the current administration is afraid of the impact this applied pressure would have on diplomatic relations. There are alternatives, however, as the Miami Herald reports:

Various bills in Congress seek to address the issue. One would require negotiations with China and, if the currency isn’t re-valued, tariffs of 27.5 percent on Chinese goods to make up for the price difference. The China Currency Coalition, a group that includes more than 30 business and labor unions, plans to push for additional legislation on the issue.

Read More: U.S. Manufacturers, unions losing patience with China currency

When the Federal Reserve meets in 2 weeks, it will in all likelihood raise interest rates by 25 basis points (.25%). Investors will be focusing less on the actions of the Fed, and more on the words behind those actions. Alan Greenspan has acknowledged on previous occasions that interest rates are currently ‘accommodative,’ meaning they are too low. As a result, the Fed will continue to raise interest rates at a ‘measured’ pace until they reach a neutral level, and neither accelerates nor inhibits economic growth. The clarity with which Greenspan has explained the Fed’s current monetary policy has given investors a great deal of confidence in predicting future interest rate movements. As a result, the risk premiums which are usually tacked onto interest rates to account for interest rate uncertainty are pitifully low. Many investors think Greenspan will reverse course and try to infuse a healthy amount of vagueness into American monetary policy, so as to raise risk premiums. The Wall Street Journal reports:

[Greenspan] implied the markets may underestimate the extent of Fed rate increases to come, by calling the low level of bond yields a "conundrum." Partly in response, Treasury bond yields have since shot up to almost 4.5% from 4.1%, riskier corporate and emerging-market bond yields have risen even more, and volatility has increased.

Read More: Will Fed Continue to Describe Its Rate Boosts as ‘Measured’?

In a new study released by the Bank of International Settlements, the world’s central bank, Asian central banks have been slowly diversifying their foreign exchange reserves. This news belies frequent announcements by these Central Banks to the contrary. Leading the pack is China, which has reduced the portion of its forex reserves held in Dollars by more than 15%. The collective process of diversification is intended to undue the buildup of reserves that took place over the last couple decades, as Asian Central Banks willingly financed widening US trade and current account deficits. The study also confirmed earlier reports that trading in Asian currencies and currency derivatives have increased multifold over the last few years. In fact, somewhat incredulously, trading in Yuan forward contracts has increased almost 300,000%. Asia Times Online reports:

It appears that Asian currencies have become more elastic and their central bankers increasingly determined to pursue an independent course as financial markets gain greater depth and begin to more accurately mirror the region’s importance to world trade.

Read More: Dollar catching Asian flu

Central European currencies have been aberrantly strong of late.  The Polish zloty has appreciated more than 20% against the Euro this year alone. Additionally, the currencies of Hungary, Slovakia, and Czechoslovakia have each appreciated more than 8% against the Euro, a currency that has itself appreciated by over 10% against the dollar. What is responsible for the sudden strength of Central European currencies? The answer is a combination of low interest rates and high economic growth.

Investors have been pouring money into Central European equities, which offer the high returns characteristic of a developing economy. If this were not enough, creditors have been all too eager to lend money to buy Central European government bonds. Investors have been looking for an alternative to EU debt, which pays interest at a negative rate, adjusted for inflation. Spurned by interest rates of over 8%, creditors have sold EU bonds and snatched up ‘CU’ bonds.  Moreover, investors do not regard Central European debt as incredibly risky, as EU is soon expected to extend membership to these nations.

Subsequent cuts in interest rates have not had any effect on deterring foreign capital inflows. Central European governments have begun to worry that the sudden strength of their domestic currencies, could have a stultifying effect on their respective economies, which are largely driven by exports. They will most likely accelerate the pace of interest rate drops, to prevent any such slowdown.

Read More: Central European currencies: Too strong for comfort

The UK Central Bank voted today to keep interest rates constant at 4.75%.  The Bank’s decision not to raise rates was based on the economy’s recent stagnation, and general sentiments that inflation was where it should be. Most economists agree there is still downside risk in Britain’s economy, as the housing market and the manufacturing sector are still weak. Investors anxiously await the publishing of the Bank’s minutes, to see if there were any dissenting votes, as was the case at last month’s meeting. Such dissension, combined with a release of new macroeconomic projections, might lead to a rate hike in the coming months. But, as BNP Paribas reports, such is unlikely:

Nevertheless, the MPC is likely to keep rates on hold in the coming months as more evidence of sub-trend growth is likely to appear. A possible rate cut will crucially depend on the next Chancellor’s fiscal policy. A tighter fiscal stance could pave the way for more monetary relaxation, but such a change can for the moment be ruled out.

Read More: United Kingdom: Bank of England keeps repo rate unchanged at 4.75%

Junichiro Koizumi, prime minister of Japan, sent the dollar reeling as he warned  diversification of Japan’s foreign exchange reserves may be "necessary." This announcement comes in the wake of a similar warning issued by South Korea’s Central Bank. The difference being Japan’s dollar reserves, at $840 Billion, more than quadruple those of South Korea. Japan’s finance minister was quick to qualify Koizumi’s comments, saying that the prime minister was referring to diversification of the dollar reserves into different dollar-denominated assets, not into different currencies. However, the damage had already been wrought, as the dollar reached short-term highs against both the Euro and the Yen. The news also sent US treasury yields soaring, as bondholders feared the US might have to offer a higher return to prevent the banks from diversifying. The Financial Times reports:

Although the market remains skeptical of any imminent Japanese diversification, Tony Norfield, global head of foreign exchange strategy at ABN Amro, said: “If there is a political debate about in Japan about what to do with their reserves, that will put the spotlight on the dollar.”

Read More: Koizumi puts markets in a spin

Since the year 2000, daily trading (buying or selling) of Chinese Yuan has increased over 500%. This spike in volume can be attributed to two closely related factors. First, as China becomes more prominent in the global economy, foreign currency must be exchanged for Yuan in order to complete transactions in which one of the parties is Chinese. Second, speculators have been buying up large quantities of Yuan, anticipating a near-term appreciation.

Contrary to popular belief, the Yuan is allowed to fluctuate on a daily basis. However, this fluctuation is tightly controlled within a band set by the Chinese Central Bank, and is thus rendered irrelevant. Many investors believe the Central Bank will soon expand the band, leading to the Yuan’s eventual appreciation against the Dollar. Forward-rate agreements, which allow investors to exchange dollars for yuan at a fixed date in the future, reflect investor expectations of future exchange rates. In this case, the price of the forwards indicate that investors expect the yuan to appreciate against the dollar within the next couple of years.

Read More: Yuan Tipped as Key Play

In nominal terms, the Euro has appreciated over 50% against the USD, over the course of the last few years. When examined in trade weighted terms, the Euro only appreciated 20% against the dollar over the same time period. Finally, when prices and unit labor costs are taken into account, this change in the real exchange rate reduces to below 10%. In other words, despite an enormous change in the nominal EUR/USD exchange rate, American goods and services are only 10% cheaper than they were 3 years ago.

Although there is officially only one exchange rate for the Euro, exchange rates for individual European countries can still be calculated. The Euro is unique, in that it is used by 12 different countries, each one with different domestic, economic circumstances (prices, interest rates,etc.) and independent fiscal policies. Therefore, the Euro exchange rate can be thought of as a composite of all of the member countries’ domestic exchange rates.

As it happens, some of the Euro area’s most prominent members, namely France and Germany, are characterized by below average prices and unit labor costs. In addition, these nations have increased the amount of trade they conduct with nations besides the US. The result is that when examined from the perspective of such individual countries, the Euro’s appreciation is not nearly as significant as it would appear.

Read More: The Real Picture   

Led by Alan Greenspan, the Federal Reserve has raised interest rates 6 times since the year 2000, when rates stood at an all-time low. Each time it has raised rates, the Fed has been abundantly clear in signaling future hikes. A common misconception is that the Federal Reserve actually determines the federal funds rate (ffr), from which all other important interest rates derive. In actuality, the Fed merely sets a ‘target’ for the ffr. Alan Greenspan has a great deal of credibility among investors and creditors; thus, the actual ffr is usually quick to converge to the target he sets.

This can have the unintended consequence of depressing risk premiums, which are usually tacked on to the ffr to account for general economic and monetary uncertainty. The result is below average treasury and corporate bond yields (which are derived from the ffr). It is any body’s guess as to the whether Greenspan and the current administration are deliberately pursuing a weak dollar policy. One thing is for sure: if Greenspan continues to telegraph future interest rate movements, bond yields will remain comparatively low. And that spells trouble for the Dollar. 

Read More: A new communication strategy to raise real yields?

China’s Central Bank announced today that it will maintain interest rates at current levels, despite foreign pressure to raise them. In the past 9 years, China’s Central Bank has only raised interest rates one time. China’s economy is unusual in that it requires an extraordinary amount of investment (40% of GDP) to continue expanding. As a result, the central bank must maintain cheap and easy access to capital. For many years, Chinese interest rates have been kept below the rate of inflation, allowing investors and entrepreneurs to borrow at negative rates, in real terms. China refuses to capitulate to international pressure, and adjust its exchange rate regime to a floating system. CNN reports:

"We are gradually moving toward allowing the market to determine the yuan’s exchange rate. But there’s no timetable for that to happen," the news agency quoted Guo [a senior Chinese official] as saying.

Read More: Beijing says no move on yuan

South Korea’s behavior with regard to its USD reserves has been nothing short of erratic. A few weeks ago, rumors that South Korea was planning to ‘diversify’ a large portion of its reserves (mostly into Euros), began to circulate.  Economists and traders, alike, feared the worst. Would the rest of Asia, which collectively holds over $2 trillion in USD reserves, follow suit?

Later in the week, South Korea publicly announced that it had no intention of diversifying its reserves. What was responsible for the sudden about-face?  One must look no further than the dollar’s recent decline. Asian central banks are in a bind- they are damned if they do and they are even more damned if they don’t. If they sell USD en masse, they will probably send the dollar spiraling downward, as the market would not be big enough to support the surplus of USD. However, if they maintain their reserves in the form of USD, they run the risk of a further devaluation of reserves. A slight deprecation in the dollar would significantly stunt the unbelievable growth occurring in the region. Bloomberg Reports:

The current system is looking more and more like a huge pyramid scheme. As long as Asian central banks stick together and buy dollar-denominated securities, things are fine. Once they start selling, virtually everyone loses — central banks experience capital losses and economies become less competitive.

Read More: Is Kafka Running Korea’s Currency Policy?

Lebanese bankers are starting to worry that the nation’s spreading political crisis will affect the value of its currency. Political instability has racked Lebanon for several decades, and with the resignation of its current administration, the situation is likely to get worse before it gets better. Each time there is a crisis, many Lebanese citizens move to convert their savings into dollars as quick as possible. Such is the case now. Lebanon’s central bank has pledged to maintain full convertibility, but it is quick to acknowledge it cannot create a liquid market for Lebanese dollars forever. Its USD reserves have fallen by almost 20% in the last week. If a new government is not formed soon, the country could witness a run on its currency which would irrevocably destabilize its economy. The Financial Times reports:

"It’s not a monetary problem, it’s a political problem," said a finance official on Thursday. "Economic sectors are urging politicians to come up with a solution [as fast as] possible. The more the crisis lasts, the longer the pressure."

Read More: Bankers urge swift end to Lebanon crisis

The most most obvious way to earn money as the dollar declines involves shorting dollars (buying foreign currencies). In the medium and long term, these non-dollar currencies can be re-converted into dollars for a seemingly risk less profit. However, currency trading is typically a highly leveraged proposition, for in absolute terms, currencies are not nearly as volatile as equities. Leveraging, which is essentially trading on margin allows traders to magnify small changes in exchange rate into large profits. However, when times are bad, losses are magnified by the same factor. In addition, when trading on margin, interest must be paid on the money that your broker loaned you, which can significantly eat into returns. For those of you who are reluctant to trade currencies, because of the inherent risks, there is a simpler, less risky way to earn money when the dollar declines: buy foreign equities.

Most of these stocks trade in the form of American Depository Receipts. Basically, an American holding company will purchase a large block of shares of the foreign company, and the share prices trade on an American exchange and are quoted in dollars. As a result, no foreign exchange is necessary to invest in ADR’s. In any event, when you buy a foreign stock in the form of an ADR, the net return on investment is equal to the change in the stock price + change in the exchange rate that took place while you were holding the ADR.

The best ADR’s to invest in are usually those which pay dividends, so that you receive income while you hold the stock. If the dollar depreciates, these dividends (which are denominated in foreign currencies) are worth more USD. Foreign banks, that do not have large USD holdings and that conduct the majority of their business outside of the US are excellent investments, as the value of deposits they hold in foreign currencies, appreciates as the USD depreciates. There is one caveat when investing in foreign companies: those which conduct much of their business in the US or in terms of Dollars are actually less profitable as the Dollar depreciates. As a general rule, these companies should be avoided.

The Canadian Dollar has been losing ground to the USD of late, as Canadians are rushing to invest in foreign capital markets. Canadian law previously forbade pension funds from investing more than 30% of their assets in foreign securities. After the rule was scrapped, Canadian pension funds rushed to invest capital in foreign (US) debt and equity markets, which caused the Canadian Dollar to depreciate. Nonetheless, most experts remain bullish on their CAD forecasts. Rising commodity prices and a loosening of foreign ownership restrictions, will more than offset the outflow of CAD. BMO Nesbitt Burns reports:

For instance, 2004 saw portfolio capital inflows of $53.2 billion into Canada compared with a mere $16.2 billion outflow from domestic investors.

Read More: Greenback Treading Water

Members of the Federal Reserve today warned of increasing inflation, which could ultimately lead to higher interest rates.  They cited such causes as rising oil prices and increased demand for American products, due in part to a weaker dollar.  Wages and employment, however, are not keeping pace with price increases in other areas, which may help to keep inflation in check.  However, most economists forecast above average growth this year, as well as increased employment and productivity.  They note that as productivity returns to normal levels, it wil exert upward pressure on wages, and thus inflation.  Inflation is a core consideration of the Federal Reserve when it guides interest rates.  Forex-markets.com reports:

When productivity grows at a faster rate, the economy can grow faster — resulting in higher incomes and producing more goods and services for all of us to enjoy — without generating inflationary pressures.  This ultimately makes our job at the Federal Reserve easier, because our mandate is to set monetary policy to support maximum sustainable economic growth and price stability.

Read More: Fed presidents stress vigilance on inflation