Economic theory suggests a nation experiencing a trade imbalance will witness an adjustment in its currency, which will ultimately correct the imbalance. Empirical evidence has shown that this ‘correction’ usually occurs 18 months after the currency begins to depreciate. In this case, the astronomical $650 Billion US current account deficit should have declined 18 months after the USD began to depreciate. However, the USD began a downward trend several years ago, and the US trade deficit has shown no signs of narrowing.

Analysts have tried to explain this phenomenon by arguing the US is an economic anomaly. First, a significant portion of US trade takes place between US companies located in different nations. This type of trade is based on microeconomic factors, and is not conditional on exchange rates. Second, American consumers represent the largest market in the world. Thus, foreign businesses have reacted to a declining USD by lowering their prices proportionately, so as to mitigate changes in the exchange rate and preserve market share. The Wall Street Journal reports:

Importers are hesitant to raise prices to offset a falling dollar, because that would likely cut into market share.  That, in turn, short-circuits of of the main ways a falling currency is supposed to curb imports.

Read More: Dollar-Deficit Ties go awry

In the early 1990’s, Japan’s economy plunged into recession. Japanese Central Bankers were dumbfounded, and uncertain as to how they could induce a recovery.  10 years later, it seems they have finally figured out the formula: a loose monetary policy- and then some. First, the central bank lowered real interest rates, until they were effectively negative. This resulted in a multiplication of the money supply.  Next, the bank injected fresh cash reserves into insolvent banks, which had suffered as a result of massive unpaid loans brought on by recession. These banks, in turn, used the cash reserves to lend money to struggling businesses in an effort to revive the economy. It seems to have worked.  Now, as the economy is growing at a healthy rate, the Central Bank must slowly unwind this policy, by raising interest rates. This, however, is easier said than done. The Wall Street Journal reports:

If it [Central Bank] ends the easy-money policy too soon, it could snuff out economic growth. But maintaining super-loose credit too long during an economic recovery could be like spraying gasoline onto a fire, causing a flare-up of inflation.

Read More: The Real Trick to Japan’s Easy-Money Policy is How to End It

Over a month ago, the forex blog announced the strong possibility of France rejecting the EU Constitution.  Over the weekend, those concerns were borne out when 55% of French voters rejected the Constitution, which was intended to simplify the structure and operations of the EU. Analysts have attributed France’s rejection to citizens’ concerns over its domestic economy and immigration policy. While France’s rejection will not likely lead to the dissolution of the EU or the end of the Euro common currency, it could spell trouble for the Euro area. European leaders have decided to wait until Holland and Britain have voted on the Charter before deciding on a new course of action.  The New York Times reports:

At the moment there is no plan to revise the constitution and put it before member states again. If the Dutch also reject the constitution, it would be that much harder to persuade the rest of the member states to go forward with putting any document up for ratification, particularly those that plan to do it by popular vote.

Read More: French No Vote on European Constitution Rattles Continent

Alan Greenspan’s chairmanship of the Federal Reserve Bank officially comes to an end on January 31, 2006. The process of choosing a replacement has already begun, and investors have already begun to speculate as to who (he) will be. Two favorites have already emerged; both are prominent republicans and have served in the Council of Economic Advisors (CEA) under a Republican president. This is no coincidence, as president Bush will personally select the new chairman. The current front runner is Harvard economist Martin Feldstein. Feldstein has been an outspoken critic of the current administration’s budget deficits, calling them "unsustainable." However, he has since abandoned this position, possibly to curry favor with President Bush. Ben Bernanke is currently second in line for the position. His calls for a more  transparent  monetary policy have earned him the respect of many economists and politicians. Business Week reports:

His stated preference for inflation targeting — or shooting for an identifiable target range on inflation…risks asserting hard numbers over rationality, rendering him a risky choice for the Administration.

Read More: Who will fill Greenspan’s shoes?

For the last month few months, Canada has been embroiled in a political conflict with potentially far-reaching ramifications. The ruling Liberal Party stands accused of accepting bribes in exchange for doling out lucrative advertising contracts. Although no formal charges have been brought, many politicians have lobbied aggressively for a recall election of some kind. The action reached a climax last week, when it was expected the House of Commons would vote "no confidence" in the liberals. At the last minute, a prominent conservative switched parties, and was suspiciously awarded a cabinet position. The upshot is the Liberal Party will remain in power, but conservatives remain undeterred in their push for a change in power. However, this defeat has dealt a serious blow to their campaign. The Wall Street Journal reports:

[A conservative] said she had been troubled by Mr. Harper’s strategy of trying to force a snap election by allying with the bloc Quebecois, which advocates independence for French-speaking Quebec province.

Read More: Canada’s Liberal Government Survives vote

As I reported last week, a high ranking official in South Korea’s Central Bank announced the end of his organization’s routine intervention in currency markets. The official’s comments sent the dollar reeling, as investors feared a significant drop in future demand for US Treasury securities. The Central Bank made similar comments last month, only to retract them later in the week.

Once again, the Central Bank has erred: it will not stop buying US treasuries, in an effort designed to prevent the Won from appreciating too rapidly. Apparently, the official’s comments had been "distorted" by the Financial Times, which originally reported the development. To prove its intentions were genuine, South Korea immediately bought a bundle of US treasury notes. The announcement and its subsequent denial are not significant developments, in and of themselves. What is more interesting is the way in which currency traders responded to the news, without first stopping to question its authenticity. Perhaps, this proves that investors are not confident about the dollar’s future. The Wall Street Journal reports:

But beyond dispute is how jittery the currency market has turned- and how eager many traders are to pull the trigger- on any news or market talk related to Asian Central banks and a Chinese Yuan revaluation. "The market has become very sensitive to these themes right now," said a director from Barclays Capital.

Read More: More ‘Distorted’ Comments Roil Markets

At 2%, the official EU interest rate is one of the lowest among developed nations. The European Central Bank (ECB) has been been asked to use momentary policy as a means for boosting growth in the struggling Euro-zone. In fact, several prominent members of the EU are calling for the ECB to lower interest rates. The ECB has refused to consider this as an option, arguing that it would likely do more harm than good. The ECB has cited wide macroeconomic disparities throughout the EU as one of the key reasons it will not adjust interest rates. The ECB is unable to cater to individual nations’ economies; rather, it must set policy based on the performance of the aggregate EU economy. There are currently significant differentials in growth and inflation throughout the EU. Germany, for example, is struggling with lackluster growth and high unemployment, and is lobbying for interest rates to be lowered. Spain, on the other hand, is growing at a healthy clip. Low interest rates are boosting demand and prices to unhealthy levels. Reuters reports:

But what is different, and is cause for concern, is that the inflation rate divergence in the euro zone is persistent. [ECB president] Trichet said national governments could help close the gap by introducing structural reforms, which would also boost growth and create jobs.

Read More: ECB rate cut would only harm euro zone

Brazil has raised its interest rate to 19.75%, which in real terms, is the highest in the world. Brazil’s Central Bank bank is determined to avoid the hyperinflation of the early 1990’s, which peaked at 2500%.  It has set an inflation target of 5% for the year, 3% below the current rate of 8% and will stop at nothing to hit this target. The Central Bank includes many goods which are regulated by the government in the models it uses to forecasts inflation. This approach is flawed because the government is unlikely to respond to interest rate pressures when setting prices for certain goods, namely utilities. Moreover, inflation has become a self-fulfilling prophecy as foreign investors have flocked to Brazil en masse, lured by sky-high interest rates. The Wall Street Journal reports:

A number of economists think Brazil needs to readjust its inflation targets and also better control government spending. Brazil’s debt is so huge that interest expenses put the country deeply in the red. Indeed, when interest expenses are factored in, the country runs a deficit of 2.6% of GDP.

Read More: Brazil raises interest rate to 19.75%

In response to mounting pressure from their constituents, American lawmakers are bullying China into revaluing the Yuan. China, they argue, is using its artificially cheap currency to ‘steal’ manufacturing jobs from the US. They cite the rising current account and trade deficits to buttress their claims. Logically, if China revalues its currency, American manufacturers will become more competitive and will not be forced to outsource their manufacturing to China. Alan Greenspan refuted such logic in a speech he delivered last week. The trade deficit, he said, us unlikely to improve if China allows the Yuan to appreciate. If anything, it will worsen.

The outsourcing of manufacturing to China typically involves large-scale, long-term commitments. Hundreds of millions of dollars are often spent to build plants and train new workers. As a result, American firms will not simply return their operations to the US following an appreciation in the Yuan. Suppose that the Yuan appreciates 40% against the dollar (unlikely) and manufacturing in China became uneconomical. Foreign firms will simply move production to other developing (Asian) economies, where labor costs are marginally more expensive than in China. The upshot is that American jobs which have already been outsourced are unlikely to return, and the twin deficits are unlikely to decline anytime soon.  Reuters reports:

But Greenspan poured cold water on the idea that a revaluation will shrink a record bilateral deficit with China that hit $162 billion last year. It will mean that suppliers will turn to other countries like Malaysia or Thailand for cheap textiles and other goods that China now supplies. "So essentially what we will find is we are importing from a different area but we’ll be importing the same goods," Greenspan said.

Read More: Greenspan-no U.S. trade benefit from China revaluation

The Canadian Dollar or ‘Loonie’ has declined to 7-month lows against the US Dollar, due largely to political uncertainty. And some analysts believe the worst is yet to come. The reason is most currency traders are valuing the loonie as though the current political crisis will soon resolve itself. In all likelihood, the current Prime Minister, Paul Martin, will soon be impeached. The PM’s budget is currently being mooted by Canadian Parliament; if conservatives have their way, the budget will soon be rejected. Such an event would likely send the loonie spiraling downward to new lows. Analysts are also careful to note other macroeconomic factors which may be contributing to the loonie’s decline. For instance, the recent decline in commodity prices has resulted in lower export revenues. In addition, a rising interest rate differential between Canada and the US may be driving risk-averse investors to move capital to the US. The Canadian Press reports:

The risk now is, the market is ill-prepared for the government to lose the vote. Even if risk-averse traders saw their worst fears realized and a federal election was called, experts say the volatility wouldn’t likely have lasted more than a few days. International traders would quickly lose interest and avoid buying or selling the dollar until election day.

Read More: Currency turmoil could continue following crucial Commons budget votes

China has moved one step closer to revaluation. In its latest move, China officially opened a foreign exchange market, where the Yuan may eventually trade against other currencies. The electronic system currently allows eight currency pairs to be traded, none of which include the Yuan. Some analysts have questioned the short term viability of this exchange. Its success will be entirely conditional on the participation of foreign banks and institutions, they argue. The move occurred just hours after the US warned China that failure to float the Yuan within 6 months could result in China being labeled a "currency manipulator." Such a distinction would have serious implications for Sino-US trade. China insists that it still needs to liberalize some if its capital controls, as well as move towards market-driven interest rates, before it can make the switch. Nonetheless, this electronic forex system is a step in the right direction. The Financial Express reports:

Shanghai Securities and Futures Institute economist Jin Dehuan said in the longer term the system would help China find more effective ways to determine the yuan exchange rate. It offers an example that regulators can draw on before breaking the yuan’s dollar peg.

Read More: China prepares for flexi-yuan with new trading platform

The Hong Kong Dollar is similar to the Chinese Yuan, in that both are effectively pegged to the dollar. Many speculators suspect a more profound relationship between the two currencies, and have begun using the HKD as a vehicle for betting on the Yuan’s revaluation, because the HKD is more convertible than the Yuan. The massive inflow of ‘hot money’ in Hong Kong is driving down interest rates and causing putative bubbles to form in various asset markets. In a move designed to thwart the efforts of speculators, Hong Kong has announced that it will float the HKD. Sort of. Currently, the HKD is allowed to trade within a tight band, much like the Yuan. Hong Kong banking officials have decided to raise the upper limit on the band, while leaving the lower band fixed. Hong Kong simply wants to remind speculators that betting on the Yuan’s revaluation is not a sure thing. However, this move is more symbolic than anything, as the HKD is unlikely to appreciate against the USD. The Financial Times reports:

While the move does re-introduce an element of downside risk…this decision could simply herald increased speculation as the market tests the limits of the new trading band. “This is a trial balloon. What is happening in Hong Kong is not separate and distinct from China’s programme of moving towards greater flexibility,” said a senior currency strategist.

Read More: Hong Kong moves to deter speculation on its currency

At $206 billion, South Korea’s foreign exchange reserves are currently the fourth largest in the world. However, this distinction may be short-lived. The Bank of Korea announced today that it will no longer intervene in forex markets, which it had done previously to prevent the Won from appreciating against the USD. This reversal in policy is sensible, as its previous intervention efforts were all in vain. The Won has appreciated 17% against the dollar this year alone. Banking officials indicated that the profitability- or lack thereof- of its reserves is behind the decision. When measured in terms of Won, South Korea’s dollar-denominated forex reserves depreciate in value every day. Some analysts reacted to the news with mixed feelings, fearing that South Korea would begin diversifying its reserves, after foreswearing intervention. The Financial Times reports:

Mr Park said he did not envisage changing the currency mix of the reserves, about two-thirds of which is thought to be in dollar-denominated assets. In February the dollar recorded its biggest drop in five months when a Bank of Korea report said it would diversify its foreign exchange reserves.

Read More: South Korea rules out further currency intervention

The USD has appreciated over 7% against the Euro in the past six months. Should this trend reversal be attributed to American optimism or European pessimism? Both sentiments play a role, argue analysts. Most economists’ forecasts for the US economy are positive- and that may be an understatement. Real GDP forecasts are high and inflation forecasts are low. Consumer confidence is increasing at the same rate unemployment is decreasing.

The prospects for Europe, on the other hand, are not very good. The developed countries in the region continue to stagnate. Unemployment is high and growth is low. When investors began buying Euros en masse a few years ago, many cassandras predicted the end of American economic preeminence and the subsequent end the the USD as the world’s reserve currency. Needless to say, their predictions could not have been more wrong. Despite the recent reversal, many investors continue to bet against the dollar. Warren Buffet has not abandoned his multi-billion dollar bet against the USD, even after sustaining $350 million in losses! He is not alone in his belief. The Wall Street Journal reports:

Some think 2005 could mark a transitional year, one in which the Euro loses its role as the highest-flying currency against the dollar and Asian currencies take over the leadership role when the dollar turns down again, as dollar skeptics expect it to do.

Read More: Dollar Rebound Builds on Stronger Economic Data

A recession is defined as two quarters of negative real GDP growth. By definition, Japan experienced a protracted recession last year. However, the recent release of positive first quarter economic data heralded the end of negative growth. Japan’s economy grew at an annualized rate of 5.3% in the first quarter, which represents a significant increase from the past couple of years. It seems Japan’s recovery was spurred by a variety of factors. Increases in disposable income coupled with a rise in consumer confidence triggered a significant increase in consumption. Japanese consumers are notoriously frugal, hoarding disposable income in expectation of future recession. This sudden change may prove momentous, as Japan may be able to rely on internal rather than external demand as a source of future growth. In fact, Japanese exports have actually begun to decrease, due largely to the the Yen’s appreciation. BNP Paribas reports:

Net exports contributed negatively to GDP growth, cutting it by 0.1 percentage points. Real exports have fallen for the first time in more than four years, down by 0.2% q/q, while real imports were up a mere 0.5% q/q. According to customs data, the nominal drop in exports over the quarter mainly results from the fall in exports towards Asia, which roughly represent about half of Japanese total exports.

Read More: Japan: GDP growth strongly rebounded in Q1

As chairman of America’s Federal Reserve Bank, Alan Greenspan is arguably the most important economic policy maker in the world. As a result, every speech he gives and every move he makes his scrutinized by analysts and economists. One particular analyst, CNBC’s Lawrence Kudlow believes Greenspan is misguided. Greenspan’s reasoning for raising interest rates 8 consecutive times is ostensibly to keep pace with rising inflation, brought on by an expanding economy. However, writes Kudlow, Greenspan might be relying on irrelevant indicators to build his forecasts for inflation. Bond yields and commodity prices, which often mirror investors’ inflation expectations, are both plummeting. Measures of the money supply, which are economically correlated with inflation, seem to suggest that inflation is insignificant. Instead, Greenspan may be predicating monetary policy on asset prices. For example, there are bubbles forming in regional real estate markets, throughout the country. Perhaps, Greenspan is raising interest rates to prevent these bubbles from further expanding. However, writes Kudlow, this reasoning is fallacious:

If he [Greenspan] is watching housing, he is looking the wrong way. The key reason behind the surge in housing investment is the shower of tax advantages on this sector since the 1997 tax bill. On a tax basis, it’s much better to invest in homes than in stocks as home-sale profits are tax-free up to $500,000.

Read More: Economy in Fed’s Hands?

Last week, the Canadian Dollar began to fall precipitously, reaching a 7-month low. There were several factors which help to explain the sudden drop. First, Canadian Parliament passed a bill which effectively called into question the Prime Minister’s leadership. The bill goes so far as to demand the PM’s (Paul Martin) resignation. Next week, Parliament will vote on Martin’s federal budget proposal. Analysts agree that a rejection of the budget is tantamount to a vote of no-confidence in the prime minister. A second cause for the decline in the Canadian Dollar may in fact be Canada’s declining trade surplus. As the Canadian Dollar has appreciated, Canadian exports have become less competitive. As a result, manufacturing output and exports have both declined in recent months. The Canadian Dollar may suffer a "correction" in the short term as investors brace for political and economic uncertainty. Bloomberg News reports:

Canada’s dollar has slipped 3.3 percent since April 7, when Justice John Gomery released the first portions of testimony from an inquiry that showed the ruling Liberals received payments in exchange for government advertising contracts in the province of Quebec. The scandal prompted the Conservatives to call for a no- confidence vote.

Read More: Canadian Dollar Drops to 7-Month Low on Trade, Election Concern

Earlier this week, a Hong Kong journalist single-handedly sent shock waves through currency markets. It began when the reporter independently decided to construct a story on the potential effects of the Yuan’s revaluation. The article was picked up by a semi-official Chinese news service, which performed a cursory translation of the article before publishing it. Bloomberg news and Reuters instantly noticed the article, which claimed China was officially revaluing the Yuan. Without offering sources, the article claimed the Yuan would be allowed to appreciate by 1% next month, and 6% by the end of the year. Within a few minutes, traders had sold $2 Billion of USD on forex markets, sending the USD reeling. The traders snatched up currencies of other developing Asian nations, with the expectation that these other nations would follow China’s lead and allow their currencies to appreciate. After a few phone calls, however, it was revealed that the story was a product of inaccurate translation, and traders poured back into the USD. The Wall Street Journal reports:

The Bloomberg story flashed across trading screens just as Asian currency traders were ending their day and European markets were opening. Traders instantly dumped dollars and bought any Asian currency they could lay their hands on…When Bloomberg and its rival news service Reuters started casting doubt on the report, traders just as quickly tried to buy back the dollar.

Read More: How a News Story,Translated Badly,Caused Trading Panic

The April US trade deficit was $55 Billion, down from the record of $60 Billion set in March. The always controversial trade imbalance with China also declined. This is especially impressive, in light of soaring oil-prices and oil related imports. Always the voice of reason, economists have urged investors to proceed with caution. Monthly figures are notoriously volatile, they argue. April may represent an anomaly. If, however, the monthly figures are reflective of a general decline in imports, it will have serious implications for economic growth forecasts. In fact, many economists are already revising their estimates upwards, to levels exceeding 4%. In any event, the Federal Reserve will probably continue to raise interest rates, more certain than ever that the economy is healthy and expanding. The Financial Times reports:

Alan Greenspan, Fed chairman’s favored risk management approach suggests that at the moment the priority is too continue raising rates, to avoid a rise in inflation expectations, at a time when the Fed is more confident on the outlook for robust growth and has stressed uncertainty in the inflation front.

Read More: US trade gap narrows unexpectedly to $55bn

As rumors of Chinese Yuan revaluation intensify, investors have been searching for ways to profit. Many have simply purchased massive quantities of Yuan, guided by the belief that the Yuan will instantly appreciate upon China’s allowing it to float. Other investors have found a more creative way to play the rumors, by investing in Japanese Yen. Such investors speculate that Japanese exports will instantly become more attractive when the Yuan is allowed to appreciate. Certainly, Chinese revaluation will make Japanese imports more affordable to Chinese consumers. However, experts insists this increase will be negligible.

Many investors also believe that more expensive Chinese products, brought on by Yuan revaluation, will also increase exports for other Asian countries. While such logic can be extended to other countries with low cost labor forces, it does not apply to Japan. Experts point out that Japan and China have vastly different economies, and do not compete in the same markets. China is known for its textiles and labor-intensive wares, while Japan is known for its technology, and machine production. Reuters reports:

[A Representative for] JP Morgan Chase Bank said Japan’s exports to China did not grow even when the yuan, along with the dollar, gained against the yen. He noted that much of Japan’s exports to China are parts for products that are then exported again to markets such as the U.S. and Europe. Global demand is far more important in determining the strength of Japan’s exports, he said.

Read More: Yen to rise when China frees yuan? Don’t bet on it

Britain’s Labor Party has been re-elected, albeit by a narrow margin. While still a healthy 66 seats, the party’s majority in the House of Commons has been greatly diminished. This election has several important implications for Britain’s economy. First, the defeat of the conservative party mitigates the likelihood that there will be tax cuts and/or decreases in government spending over the next few years. More importantly, Britain may now become more integrated in the European Union. Tony Blair is notorious for his support of the EU. Accordingly, he will likely campaign for Britain to ratify the EU Constitution if such a referendum is posed to its people. However, this is conditional on France and the Netherlands first approving the Constitution, which is by no means guaranteed. If Britain were to ratify the EU Constitution, it could conceivably abandon the pound in favor of the Euro. However, Labor’s narrow majority over conservatives will likely preclude this from happening. Morgan Stanley reports:

All in all, the reduced Labour majority perhaps makes it more likely that continuity, rather than radical reform, will characterise economic policy over the next four years.

Read More: Closer than the last one

After their victory in last month’s election, Australia’s center-right coalition has announced sweeping tax cuts. The government will return a $16 Billion budget surplus to citizens and businesses over the next four years. The purpose of the tax cuts is to stimulate an economy that has never fully recovered from the recession which occurred several years ago. Economists predict real GDP growth of 3% this year, which seems respectable until you compare it to rates of 4-5% which Australia perennially grew at in the late 1990’s. Most of the tax cuts will take the form of a drop in personal income taxes, although retirees and businesses will also receive some of the surplus. Economists believe the tax cuts will be effective in stimulating the economy. However, not everyone is satisfied. The Financial Times reports:

“There is a lot in this budget that deserves a tick but it is also a budget of missed opportunities,” said Peter Hendy of the Australian Chamber of Commerce and Industry.

Read More: Australia cuts taxes in post-election budget

Citing the millions of jobs ‘lost’ to China, American manufacturers have clamored for the US to pressure China to float the Yuan. The US capitulated, and agreed to use diplomacy as a means of applying such pressure. Such has characterized the US approach for a couple years. Beginning last month however, it seems the US has changed tactics. First, Congress voted to threaten China with a 27.5% across-the-board tariff if the Yuan was not permitted to float, although no official timetable was included in the bill. Next, American manufacturers lobbied for China to be officially labeled a "currency manipulator." Moreover, many prominent economists and central bankers have spoken publicly, urging China to implement currency reforms. Alan Greenspan warned of rising inflation in China and widening trade imbalances. John Snow, Secretary of the Treasury, claims China has all of the necessary mechanisms in place to support a floating currency. At this point, the US could rightfully use the WTO as a means of forcing China into revaluing with the threat of heavy tariffs on all Chinese imports. The Canadian Press reports:

While the administration rejected that approach last year in favor of using diplomatic channels, Vargo said he believed U.S. officials now favor a tougher line. "The administration has made a major shift by saying the time for China to act is now," he said.

Read More: U.S. officials ditch quiet diplomacy for tougher stance on China’s currency

Last month, the story in Canada was of political fraud. However, the situation has been neutralized, and a recall election is no longer likely. As a result, Canadian investors have turned to economic statistics to shed light on the future direction of the Canadian dollar (loonie). The recent release of Canadian employment statistics underscores the strength of the vigor of the Canadian economy. Nearly 30,000 new jobs were created last month, the most in over six months. However, note analysts, many of these jobs were created in the public sector, and growth in manufacturing jobs is sluggish. The next major event will be the publication of Ontario’s budget, noteworthy because Ontario is the largest Canadian province. Investors also await the release of new housing starts, and the trade balance with the US, expected to be positive. With the recall election a moot point, currency traders expect the loonie to continue to appreciate against the Dollar. The Canadian Press reports:

"I don’t want to ignore the political backdrop, but I think a lot of that got factored into the currency in April when the Canadian dollar was the weakest major currency in the world," said a senior economist. "And to some extent the currency markets have already moved on and are looking at other things now."

Read More: Investors watching Ontario budget, housing starts

Various economic statistics indicate the US economy is in a stage of "cooling off." Is this downturn temporary, or it a sign of things to come? Some analysts think the economy needs a recession to let the air out of bubbles that have formed in various asset markets. Many investors have already priced slower growth expectations into stock prices, which explains the recent stock market decline. Other analysts think the current down-turn represents an anomaly, and predict a full recovery to be borne out in the next release of economic statistics. They point to slight decline in inventory statistics, which signal an increase in aggregate demand. Consumption will also be buoyed by a recent decline in energy prices, which will trickle down into lower fuel costs. IT and transportation spending have witnessed double digit percentage increases in recent months. Analysts from Morgan Stanley are wary:

To be sure, risks abound: A resumption of stronger domestic demand growth is no guarantee that US output will follow; some will doubtless spill into imports.  And weakness abroad still menaces exports. [We think] the Eurozone economy is on the brink of recession, with the decline in business confidence raising the risk of a self-fulfilling prophecy.

Read More: United States: Roadmap for the Rebound

With regard to the Yuan’s revaluation, it is no longer a question of if- but when. Investors are extremely confident that China will soon revalue, with some predicting it will occur as soon as this summer. Most investors have backed up their predictions with bets in the currency. Non deliverable forward contracts are currently trading at a 6% premium, which reflect investors’ collective expectation that the Yuan will appreciate by 6% this year. Last quarter alone, $30 billion of speculative capital trickled into China. While some of this money is clearly ‘hot money,’ most of the investments represent long term commitments in China. In response, China may delay revaluation, so as not to reward all of the speculators, who stand to earn massive capital gains when China revalues. To stem the inflow of speculative capital, China has continued to squash rumors of revaluation. The Financial Times reports:

The expectation of this event will keep hot money flowing into China and the longer China delays the exchange rate adjustment, the more hot capital will move into China.

Read More: Asian currencies withstand Chinese talk

Earlier this week, the Federal Reserve raised interest rates for the ninth consecutive time, to a more neutral level of 3%. This came as no surprise to analysts, who had already priced this move into most securities. The real shock occurred two hours later, when the Fed issued a statement regarding an omission in its earlier testimony. Apparently, it had forgotten to include its belief that inflation remains ‘well-contained.’ Many analysts found this omission to be all too coincidental, arguing that the Fed used the omission to draw special attention to inflation. Despite its comments which hinted otherwise, the Fed is still clearly concerned about inflation, and will probably predicate future rate hikes solely on inflation expectations. On the other hand, many investors still believe the Fed is ‘behind the curve,’ and is not raising rates as a pace which mirrors the growth of the US economy. The Fed is in a bind, as it may try to cool off an economy that just doesn’t need any help cooling off.  Forbes online discusses the implications for currency markets:

The dollar initially rose on the rate hike news. But dollar gains were limited by investor frustration that the Fed statement did not provide bolder clues about the central bank’s intentions for future interest rate increases. "These currency moves are not huge because we are not seeing a huge change in the language," said a senior trader.

Read More: Dollar weakens after surprise FOMC statement change

India’s central bank recently raised interest rates to 5%, in a focused effort to contain inflation. India’s economy has been nothing short of impressive, and it is expected to grow by 7% this year. This is despite a below-average monsoon season, which is a perennial driver of Indian economic growth. Unfortunately for India, high economic growth has also been accompanied by high inflation, which India is now fighting to reign in. Indian central bankers also commented on the imminent revaluation of the Yuan. India has over $200 Billion in foreign exchange reserves, some of which is held in Chinese Yuan. Nonetheless, India is optimistic, asserting that the revaluation will actually benefit its economy, by making its own exports more competitive with Chinese exports. Reuters reports:

"We will have a look at it, watch it carefully. Our exposure to the Chinese economy is mainly through trade and there is nothing for us to be concerned about a trade effect," Reserve Bank of India (RBI) governor Yaga Venugopal Reddy told reporters.

Read More: Any yuan revaluation unlikely to hurt India

On May 29th, France will vote on the EU constitution. If the people vote ‘no,’ as most polls currently predict, the EU’s future  will be severely jeopardized.  With a sluggish economy and high unemployment, France’s economy is among the worst in the EU. The French have found scapegoats for their economic malaise in the newest members of the EU, certain central European nations, who are enjoying unparalleled growth. France has accused these nations of stealing valuable capital and jobs, with their high interest rates and low wages. Much of the reason these economies are performing so well however stem from expectations that they will soon be allowed to switch over to the Euro currency. A French rejection of the Constitution will delay this change, as well as many other economic benefits promised to the new members within a few years. The International Herald Tribune reports:

Eastern European currencies may look a little rich at present, but valuations are being supported by large capital inflows into the region and the buildup of foreign reserves. A decrease in foreign direct investment would be…damaging to Eastern Europe’s capital markets.

Read More: Stocks to adopt if the French vote no

Central Banks are essentially banking monopolies, and often earn great sums of money. America’s Federal Reserve Bank earned $23 Billion last year, for example. But what happens when central banks lose money? This issue is becoming increasingly pertinent in the context of Asia’s Central Banks, which continue to build up the foreign exchange reserves in the face of looming capital losses.

Many Asian economies have pursued economic policies of export promotion, the success of which is conditional on a cheap, domestic currency. Some nations have explicitly fixed their currencies to the USD; other have intervened on a regular basis to prevent their currencies from rising too much. The means to achieving the end of a cheaper currency is to purchase USD, usually in bulk. As a result, Asian Central Banks have collectively amassed $2 trillion worth of USD. If the USD continues to decline in value, Asian Central Banks will sustain massive capital losses. When measured as a percentage of GDP, these losses could reach double digits. For this reason, Asian central banks are sitting tight on their reserves. The Economist reports:

There is now no way that Asia’s central banks can sell their reserves, reinvesting the proceeds in higher-yielding assets, without triggering the very capital losses they would hope to avoid. If they try to rouse these dormant assets, they will empty them of value. If they wish to preserve their worth, they must let them lie.

Read More: Should Central Banks worry about capital losses?

Central Banks are essentially banking monopolies, and often earn great sums of money. America’s Federal Reserve Bank earned $23 Billion last year, for example. But what happens when central banks lose money? This issue is becoming increasingly pertinent in the context of Asia’s Central Banks, which continue to build up the foreign exchange reserves in the face of looming capital losses.

Many Asian economies have pursued economic policies of export promotion, the success of which is conditional on a cheap, domestic currency. Some nations have explicitly fixed their currencies to the USD; other have intervened on a regular basis to prevent their currencies from rising too much. The means to achieving the end of a cheaper currency is to purchase USD, usually in bulk. As a result, Asian Central Banks have collectively amassed $2 trillion worth of USD. If the USD continues to decline in value, Asian Central Banks will sustain massive capital losses. When measured as a percentage of GDP, these losses could reach double digits. For this reason, Asian central banks are sitting tight on their reserves. The Economist reports:

There is now no way that Asia’s central banks can sell their reserves, reinvesting the proceeds in higher-yielding assets, without triggering the very capital losses they would hope to avoid. If they try to rouse these dormant assets, they will empty them of value. If they wish to preserve their worth, they must let them lie.

Read More: Should Central Banks worry about capital losses?

Last week, the Yuan briefly traded outside of its prescribed band, breaching 8.27 Yuan/USD for the first time in over 10 years. Immediately, traders began to float rumors that China was conducting a "dry run," and would soon allow the Yuan to float. China’s Central Bank, however, quickly sold USD, and the Yuan returned to its normal level of 8.28, which was set in 1994. China issued an official press release following the event, stating the fluctuation was an anomaly, and revaluation was not ‘imminent.’ The damage had already been done however, as investors seem more confident than ever that China will soon switch to a floating exchange rate regime. Trading in Yuan futures has reached a feverish pitch. These futures reflect investors’ future expectations. In this case, the increasing futures prices indicate that traders believe revaluation is still imminent. Most analysts concur, arguing that the revaluation will likely take place before the year ends. The Taipei Times reports:

Beijing says it will eventually let the yuan trade freely on world markets, but that doing so immediately would damage the country’s frail banks and financial industries. J.P. Morgan Chase & Co predicted China will loosen its decade-old peg to the US dollar next week.

Read More: Beijing official quashes rumors of revaluing the yuan