The Japanese Yen has not performed well against most currencies so far this year. Recently, however, the Japanese economy has shown signs of life and the Japanese government now seems committed to making certain structural reforms, which should further spur growth. In response, the Bank of Japan has hinted that as soon as it can be validated that the economy is on solid footing, it will begin raising interest rates, ending a period of negative real interest rates. This, in turn, should stem the Yen’s decline against the USD. Forexnews.com reports:

Looking forward, the looming end of the Bank of Japan’s quantitative easing by Q1 2006 coupled with and an eventual subsequent yuan revaluation against the US dollar, explains our medium-term yen bullish position, with 108 by year-end and 103 by end of Q1.

Read More: How Much More for the Yen?

Initial reactions to Hurricane Katrina were focused around the devastating impact it would have on the economy and whether the Federal Reserve would forestall its planned monetary tightening. Now that economists have had adequate time to asses the hurricane, the consensus is that the macroeconomic impact will be negligible, and in any event will be offset by inflation. As a result, two regional Federal Reserve Presidents hinted that the Fed would continue to raise interest rates, with a consensus year-end forecast of 4.25%. This will further drive interest rate differentials between the US and other industrialized nations, and underscore support for the USD. The Financial Times reports:

“While initially viewed as a supply-side shock that would raise the odds of a US recession, the popular consensus now argues that Katrina will promote an easy fiscal/tight monetary policy mix that will prove dollar supportive.”

Read More: Outlook positive for greenback

In the latest chapter of the revaluation saga, China will allow the Yuan to fluctuate more against most major currencies, excluding the USD. While this move has already ignited speculation among currency traders that another revaluation is imminent, closer analysis reveals this latest decision was motivated chiefly by practical considerations. For all intents and purposes, the Yuan remains pegged to the USD but can freely fluctuate against other currencies.

When China revalued the Yuan in July, it announced that the Yuan would not be permitted to fluctuate by more than 1.5% against non-USD currencies. In a recent trading session, however, the Euro appreciated almost 1.5% against the USD. If the Euro had appreciated further, it would have created a triangular arbitrage scenario whereby the Yuan-USD and Euro-USD exchange rates were not consistent with the Euro-Yuan rate. In order to prevent such a situation from occurring, China will now allow the Yuan to fluctuate up to 3% against major currencies.

In addition to serving as CEO o Legg Mason Capital Management, Bill Miller manages a fund that has outperformed the S&P 500 for 15 consecutive years. When Mr. Miler speaks, others typically listen. In a recent interview with the Financial Times, Mr. Miller defended the sustainability of the US current account deficit, arguing that as long as it is accompanied by economic growth, it will not pose a significant problem. While large currency account deficits have historically preceded national economic crises (Brazil and Argentina, for example), the US current account deficit is unique because the USD is the world’s reserve currency. As long as foreigners continue to hold most of their foreign exchange in USD, the deficit will sustain itself. While the deficit may not directly hinder US GDP growth, it may necessitate a long term correction in exchange rates. The Financial Times reports:

The fast-expanding US current account deficit, which the IMF estimates will spiral to 6.1 per cent of GDP this year, has been behind the dollar’s 23 per cent slide against the euro since January 2001. Many economists argue the dollar needs to fall further to bring the deficit to a “sustainable level of about 3 per cent of GDP.

Read More: Miller sanguine about US deficit

The USD has moved in tandem with oil prices over the last few weeks, which have largely been shaped by the impact of hurricanes. A popular joke holds that currency traders spend more time watching the weather channel these days than CNBC. Suffice it to say that when Hurricane Katrina was downgraded to a Category 3 hurricane, currency traders instantly turned bullish on the USD, on the basis that oil producing facilities would likely sustain minimal damage as a result of the hurricane. At this point, unless Hurricane Rita changes course and/or intensifies (both of which are unlikely), you can expect support for the USD to continue into next week. Reuters news reports:

The hurricane was expected to make landfall late on Friday or early Saturday and had veered away from Houston, Texas — a major metropolitan center and the heart of the U.S. oil refining industry.

Read More: Dollar rises as Hurricane Rita downgraded to 3

Today marks the two-month anniversary of China’s landmark decision to revalue the Yuan. American policymakers have since had much time to reflect on the move, and the consensus is predictably, that China still needs to do much more. In theory, because China permits the Yuan to fluctuate .3% daily against a basket of currencies, the Yuan should appreciate by .3% every day. However, China has massive forex reserves and is thus able to maintain the Yuan’s peg fairly easily. In the beginning of November, the US Treasury is scheduled to release a report on currencies, in which it may officially label China a ‘currency manipulator.’ Irrespective of this report, several prominent politicians have threatened to reintroduce legislation that will slap a 27.5% tariff on all Chinese goods. The Washington Post reports:

“We’re still in the very early stages of what is, for them, a new regime,” said Timothy D. Adams, undersecretary of the Treasury for international affairs. “And thus far, I think we — the United States, the G-7 and other institutions — have been both supportive and patient. But we have expectations that greater flexibility will occur over time.”

Read More: ‘Watershed’ Yuan Revaluation Has Made Few Waves

Two prominent economists recently conducted a thorough analysis of Asia’s increasing foreign exchange reserves, the majority of which are held in US Treasury Securities, which are of course denominated min USD. The economists argue that the while the collective forex reserves of Asian nations have indeed skyrocketed in recent years, this does not necessarily signify that outright currency manipulation is taking place. Rather, they believe that these nations use their reserves as tools of monetary policy. For example, Japan may have grown its reserves to try to mitigate the possibility of deflation. Other nations view their reserves as a sort of contingency, to be used if the 1997 Southeast Asian economic crisis (which caused regional currency depreciation) repeats itself. China’s increasing reserves, argue the study’s authors, are largely a product of ‘hot money’ inflows, rather than a proactive attempt by China to hold down its currency. The Economist reports:

It is hard to accuse China of running a cheap-currency policy, since it passed up an opportunity to devalue the yuan at the time of the Asian crisis.

Read More: Asian squirrels

While Hurricane Rita has yet to land, its impact is already being felt in capital and currency markets as traders and investors begin to quantify its potential effect on the Gulf coast economy, which remains fragile in the wake of Hurricane Katrina. While Rita is unlikely to wreck the same amount of damage as Katrina, local authorities have adopted a better-safe-than-sorry attitude, and have already moved to shore up local infrastructure and evacuate those in harm’s way, so as to mitigate the impact. Experts are also concerned that Rita will disrupt oil production, which caused the price of oil to spike almost 10% last week. However, if Hurricane Rita passes without incident, the USD should see some strength. The Federal Reserve raised interest rates yesterday, which will drive long term interest rate differentials between the US and other developed countries, indirectly providing support for the USD. The Financial Times reports:

“The message from the FOMC was clear,” said Derek Halpenny, senior currency economist at Bank of Tokyo-Mitsubishi: “Increasingly inflationary pressures are a greater concern within the FOMC than the slowdown in economic growth post-Katrina.”

Read More: Rita brings weakness to dollar

At this point, a play on the Canadian Dollar is tantamount to a play on oil, for the two have risen in synch for the past couple of years. While the USD-Yen and USD-Euro pairs have routinely hogged the spotlight, the Canadian Dollar has silently and steadily crawled higher and higher against the USD. Concerns of oil shortages and interminable demand have driven the price of oil to unfathomable levels. As Canada is one of the few developed nations that exports more raw energy stocks than it imports, the Canadian economy, and hence the Canadian Dollar, have benefited. Meanwhile, the Canadian economy is as strong as it has been in recent memory and interest rates are rising. Canada.com reports:

“The market is starting to refocus on the positive correlation between oil prices and the Canadian dollar. So, obviously with oil up, we’ve seen some fairly substantial interest to by the Canadian dollar on the back of that,” said one currency trader.

Read More: Canadian dollar surges to 13 1/2-year high as crude oil futures spike

The German elections are now history, and any prospects for economic reform are all but lost. Most political commentators agree that the near-split between Merkel and Schroeder represents the worst-case scenario for Germany, from the perspective of reform. In fact, it is still unclear as to who the official Chancellor of Germany is, as both candidates have separately claimed victory. Regardless of who ultimately prevails, it seems the most plausible outcome will be a sort of ‘grand coalition,’ in which several parties share power. In any event, Germany will likely fail to achieve meaningful economic reforms. Fundamental and technical analysts alike have already proclaimed the Euro will suffer. The Financial Times reports:

The euro was pummelled by investors as political chaos loomed in Germany after the weekend election failed to provide a clear winner. The euro sank to a low of $1.2101, a decline of about 1.6 per cent from Friday’s intra-day high.

Read More: Euro falls as German political chaos looms

‘Politischer stillstand,’ a German phrase which translates literally into ‘political gridlock,’ perfectly characterizes the current German political situation. Investors and traders are becoming increasingly concerned that one of two scenarios will emerge following the election. First, Gerhard Schroeder could win, and forestall the implementation of much-needed structural and economic reforms. Second, if either Merkel or Schroeder win by a slight margin, and no clear-cut majority is produced, it could also sabotage any attempts at reform. It seems, therefore, that only a clear Merkel victory will be enough to reverse the Euro’s recent declines. You can bet currency traders will be waiting anxiously for the results of the election, which will likely determine the short-term course of the Euro. The Wall Street Journal reports:

The election victors will almost certainly have to make concessions to form a coalition, which could hinder its ability to deliver on its most ambitious promises for economic overhaul.

Read More: Euro Falls Anew Amid Uncertainty Over German Vote

German elections are scheduled for this weekend, and currency traders are beginning to price their predictions into the forex markets. The consensus implications for the Euro are as follows: a Gerhard Schroeder victory will likely send the Euro reeling, while an Angela Merkel victory will likely prop of the currency. Schroeder is the incumbent German Chancellor, and Merkel is the challenger. Investors generally feel a Merkel victory will benefit the German economy, for she has promised to implement certain structural reforms intended to revive Germany’s ailing economy. Regardless of who wins, you can expect significant Euro volatility in the days following the election. The Wall Street Journal reports:

“Germany faces the risk of a political deadlock after the elections . . . this doesn’t bode well for further reforms in Germany and therefore could weigh on the euro,” said a senior currency strategist.

Read More: Euro Falls on Views on Election

The short term outlook for the USD is becoming more bearish, as investors continue to gauge how the fallout from Hurricane Katrina will impact American monetary policy. A majority of economists now believe the Federal Reserve will hold interest rates constant at its next meeting, for reasons related to the hurricane. First, estimates of the damage wrought by the hurricane now exceed $100 Billion, much of which was fixed capital and business infrastructure. Second, the complete devastation of the Gulf Coast economy means millions of residents are now jobless, which will weigh on growth in the region. Finally, and perhaps most importantly, the impact on refining capacity will ensure fuel prices remain high in the near-term, leaving consumes with less disposable income. In short, the Federal Reserve will likely forestall its planned monetary tightening and wait for the consequences of Hurricane Katrina to fully manifest themselves before acting. ForexNews reports:

The most plausible scenario is for the Fed to leave rates unchanged at 3.50% (60% chance) into the end of the year, and a 40% chance of a rate cut in November or December.

Read More: Katrina to Trigger Fed’s Rethink, Dollar Retreat

The Bank of Canada has raised its benchmark lending rate by 25 basis points to 2.5%, as the Canadian economy continues to perform well. Central Bank officials have credited high commodity/energy prices as a key driver of economic growth. Because Canada runs a surplus in international energy trading, the economic impact of higher energy prices has more than offset any potential inflationary consequences. Moreover, the Central Bank noted growth and inflation expectations remain high and low, respectively, for the rest of the year, signaling the possibility of future rate increases. This latest move by the Central Bank will likely provide further impetus for foreign investors, who have already moved capital en masse into Canada. The Globe and Mail reports:

“What happens going forward remains a little uncertain,” amid higher energy prices, a strengthening Canadian dollar and a cloudy outlook for the U.S. economy,

Read More: BoC raises rate to 2.75%

In a startling development, Junichiro Koizumi, Prime Minister of Japan, was overwhelmingly backed in the elections held over the weekend. Koizumi had called for the election after his bid to privatize Japan Post failed to pass in Japan’s Parliament, which was summarily dissolved. In a show of solidarity, Japanese voters have given Koizumi the power to make sweeping political changes and implement structural economic reforms. By coincidence, the election coincided with the release of certain economic data, which indicated Japan is now growing at a healthy 3.3%. It seems Japan’s economy is finally on solid footing, which certainly bodes well for the Yen. The Economist reports:

Investors also applauded revised economic figures that were released on the same day, showing that GDP grew at an annual rate of 3.3%, more than previously announced, in the second quarter.

Read More: Japan’s voters back Koizumi

In a startling development, a prominent financial journalist has alleged governmental manipulation of currency markets. In his report, Richard Russell has accused Central Banks around the world of covertly intervening in gold and forex markets, as a form of monetary policy. Russell cites a memo published by an advisor to President Clinton that directed large banks to support the USD in the wake of the collapse of a prominent hedge fund. Russell also purports an agreement between US and Japanese officials to stabilize the Yen-USD exchange rate, which coincided with the two countries becoming allies in the Iraq war. If such allegations are true, investors should beware. CBS Marketwatch reports:

Sprott [a prominent Canadian money manager] doesn’t necessarily oppose government intervention in principle — the apparent interventions after 9/11 or the 1987 crash, for instance — but says such intervention requires “the most stringent safeguards and transparency.”

Read More: Report suggests U.S. market manipulation is for real

The flagging Australian Dollar received a boost from the release of certain economic data, which seemed to paint an upbeat picture of the Australian economy. Australia recorded real GDP growth of 2.7%, marking the 14th consecutive year of economic expansion. In addition, Australian companies are realizing record profits, which they have promptly reinvested to drive growth. Coupled with falling energy prices and low levels of inflation, increased corporate investment signals Australia’s economy is in excellent shape. Forex traders reacted positively to the economic data and the subsequent decision by the Bank of Australia to maintain interest rates at current levels. The Financial Times reports:

The news, combined with Wednesday’s decision by the Reserve Bank of Australia, the central bank, to hold interest rates steady, helped nudge up the Australian dollar toward 77 cents against the greenback, outperforming other major currencies.

Read More: Australian GDP boosted by corporate investment

It seems the worst of Hurricane Katrina is finally behind us. The cleanup effort is underway, and the gulf region has achieved relative stability. Investors’ concern that higher energy prices would weigh on the US economy were allayed, as oil producers around the world released inventories in order to prevent the price of oil from spiraling out of control. Investors have also priced rate hikes back into interest rate futures, whereas before there was some uncertainty as to whether the Fed would continue raising interest rates in the wake of the hurricane. The renewed optimism in the American economy has buoyed the USD, which rose from a 3-month low. The Financial Times reports:

“Therefore, with oil prices now back below the levels seen before the hurricane hit and the relief work in the affected areas seemingly becoming more effective, we believe that the Fed will continue hiking rates for now.”

Read More: Data and disaster relief lift the dollar

According to Bloomberg News, the correlation of the Canadian Dollar with the price of oil is currently .88, meaning there is an 88% of the Canadian Dollar appreciating following an increase in the price of oil. This relationship seems to explain much of the Canadian Dollar’s recent strength; the currency has appreciated against the USD for four consecutive weeks. Hurricane Katrina indirectly provided additional support for the currency, as Canadian oil and gas exporters have benefited from commodity prices, which are expected to remain high in the near-term. On September 7, the Central Bank of Canada is expected to raise interest rates and provide guidance for future rate hikes. Bloomberg News reports:

Stronger growth may prompt the Bank of Canada…to raise its benchmark interest rate more than once this year after keeping it unchanged since [last] October.

Read More: Canada’s Dollar Climbs for Fourth Week in Five on Higher Oil

The Central Bank of Indonesia has finally raised interest rates, in a move that may turn out to be too little too late. In the past month, Indonesia’s currency, the Rupiah, has depreciated 10% against the USD. Indonesia notoriously spends almost 1/3 of its annual budget on artificially fixing energy prices for its citizens vis-à-vis fuel subsidies. As the price of oil has risen, the cost of dispensing fuel subsidies has risen proportionately. In the last month, Indonesia’ current account surplus has shrunk dramatically and may soon become a deficit. The failure of Indonesia to stabilize the imbalance through appropriate monetary and fiscal policy measures irked currency traders, who responded by thrashing the Rupiah in forex markets. The Economist reports:

[The Central Bank] revealed that it had squandered one-tenth of its reserves in a vain attempt to stem the rupiah’s fall. Despite a few high-profile foreign investments, the capital account remains lamentably in the red.

Read More: Rupiah ructions

The USD continued its decline against all major currencies, amidst higher commodity prices and the release of disappointing economic data. Analysts have already started to quantify the economic impact of Hurricane Katrina, with some estimates topping $100 Billion. Insurance payouts, alone, could exceed $25 Billion. If energy prices continue to rise, growth may slow further. Investors have adjusted to the dual prospects of slower growth and constant interest rates by sending the USD to a near 3-month low against the Euro. Technical analysts have noted that the Euro’s sudden appreciation represents a breakout and could ignite a prolonged period of appreciation. The Wall Street Journal reports:

Katrina effects weighing on the dollar included concerns that the Federal Reserve may not push ahead with its measured rate-increase approach in the coming months.

Read More: Dollar Is Driven Broadly Lower By Growing Surplus of Bad News

The USD has taken a nosedive, as investors and traders continue to assess the economic impact of Hurricane Katrina. There is the direct effect of lost productivity in the affected regions, as well as the peripheral consequence of higher commodity prices. Short term energy futures have soared in the last week, as markets brace for shortages. Bond traders have already priced an expected rate increase out of bonds, meaning they no longer expect Alan Greenspan to raise interest rates at the next Fed meeting. Currency traders responded to the news of a weaker economy by punishing the USD, which has fallen 2% in as many days. The Financial Times reports:

Worries about the US economy had been reinforced earlier by data that showed the US economy was already under the pressure of rising energy prices even before Katrina struck.

Read More: Dollar hit by US growth fears

Chinese officials recently approved a preliminary list of banks to make the market in currency forwards. Foreign banks, including HSBC and Deutsche Bank AG, were heavily represented, although the ‘Big 5’ Chinese Banks were predictably included. The move is a large step forward for China, as currency derivatives experience a surge in popularity. Currency forwards allow traders to essentially bet on the future direction of a currency, by entering into an agreement to buy or sell currency at a fixed exchange rate on a fixed date in the future. Yuan-denominated forwards are especially popular, as traders can speculate if, when, and by how much China will revalue its currency. Dow Jones News reports:

Once foreign-exchange fowards trading on the interbank market becomes active, it could affect the yuan spot rate and offshore yuan forwards markets. But it’s still not clear how much freedom the People’s Bank of China is likely to give banks in trading fowards.

Read More: China OKs 14 Local,Foreign Bks For Interbk Forex Forwards