For the better part of a year, the Australian Dollar (AUD) has remained relatively constant in value, hovering around .75 USD. Economists and analysts have identified several factors that are preventing the AUD from moving by pulling the currency in opposite directions. On one hand, commodity prices and Australian economic fundamentals continue to perform strongly, which would seem to drive the AUD upward. On the other hand, the interest rate differential between the US and Australia has narrowed to only 100 basis points, which may not be enough to bring the capital of risk-averse foreigners to Australia. By the same token, many investors are moving funds to New Zealand, where interest rates exceed 7%. The Sydney Morning Herald reports:

All told, last year saw the lowest degree of variability in the Aussie’s value in any year since the float in December 1983.

Read More: Goodness knows why our dollar’s so stable

According to a variety of economic indicators, Japan is now the fastest growing economy in the G8 Industrialized countries. Further, it seems Japan has definitively succeeded in ending a decade-long deflationary spiral, during which its nominal GDP declined. Japanese economists have hinted that the Bank of Japan may soon end its ultra-loose monetary policy. This move, which will take the form of higher interest rates, has even received the support of Japanese politicians, who previously seemed ambivalent. While the rate hikes will not occur for a couple of months, currency traders are already beginning to buy Yen based on the prospect of a narrowing interest rate differential between Japan and the rest of the developed world.

Read More: Policy hope propels yen’s rally

Earlier this week, a credit rating agency downgraded Iceland’s government debt, calling the country’s current account deficit unsustainable. Iceland’s national currency, the Krona, instantly plummeted 10% as currency traders rushed en masse for the exits. This, in turn, sent a shock wave throughout global forex markets, causing all emerging market currencies to decline. As the currencies affected by the crisis seemed unrelated, analysts pointed to hedge funds to explain the ripple effect. Apparently, several prominent emerging markets funds were forced to sell their positions in other parts of the world in order to offset their losses in Iceland. The Financial Times reports:

The icy blast spread, prompting the Brazilian real to fall 3 per cent, the South African rand more than2 per cent, the Indonesian rupiah and Polish zloty1.5 per cent and the Mexican peso and Turkish lira 1 per cent.

Read More: Iceland’s headline grabbing woes snowball across globe

Since China famously revalued the Yuan last summer, trade lobbyists and protectionists have continued to urge the Bush administration to pressure China on its exchange rate policy. In a sign that it may be bowing to popular demand, the US Treasury Department recently announced it may officially label China a ‘currency manipulator,’ in its biannual report to be released in April. The label would provide a basis for trade and economic sanctions. Chinese officials have considered the possibility of such an accusation, but continue to maintain that the Yuan will be adjusted at China’s pace. This is not surprising, as China’s exchange rate policy is determined at the highest level of political decision-making. The Wall Street Journal reports:

Chinese exchange-rate policy will be guided not by politics but by calculations on how any changes will affect domestic growth. “Nobody thinks” the U.S. will label it a currency manipulator, which would require formal talks with China on the issue.

Read More: China Holds Line on Yuan Policy Despite Risk of `Manipulator’ Tag

On paper, the collective economies of the European Union appear stagnant and pathetic, having grown by only 1.6% per year, from 1999-2004. However, it is important to note that when GDP figures are first released, they represent educated guesses, at best. After thorough re-calculation, Euro-area real GDP actually averaged 2.1% in the same time period. Meanwhile, Britain’s economy grew by 2.7% annually during those years, a figure that was revised upwards from 2.1%. As a result, it seems the current performance of the EU economies is being understated, which could provide a case for eventual Euro appreciation. The Economist reports:

On past experience, Europe’s statisticians should add half a percentage point to their first guesses of GDP growth. By also switching to American practices, they could boost growth even further.

Read More: A numbers racket

For a few weeks, currency traders and economists, alike, waited with baited breath for America’s Federal Reserve Bank to release the ‘minutes’ from its most recent meeting. Upon their release, USD bulls responded with joy, as the minutes seemed to suggest that multiple rake hikes will ensue. Previously, many economists had expected the Fed to raise interest rates only one more time as part of the current cycle of tightening. The latest forecasts, however, indicate that an almost certain rate hike in March will be reinforced by further rate hikes in the following months. In short, it looks like the interest rate differential between the US and the rest of the world will continue to widen. Reuters reports:

New Fed Chairman Ben Bernanke has commented extensively on monetary policy, indicating that the Fed would be vigilant in holding down inflation expectations.

Read More: Dollar mostly up, takes FOMC minutes in stride

A few weeks ago, the Bank of Japan released official data that indicated it had not intervened in forex markets in over 18 months. It was expected that this data would exonerate Japan from the accusations of American auto makers, who insisted Japan was artificially holding down the value of the Yen. Sure enough, representatives from these auto makers have backed away from their claims of forex intervention, arguing instead that the bank’s threat of intervention is tantamount to actual intervention. It has also begun to shift some of its attention to Korea, where the Central Bank routinely intervenes to hold down the value of the Won. United Press International reports:

Despite strong economic growth, over the past five years Japan’s currency has been undervalued by as much as 36 percent against the dollar. This means a car imported from Japan has had an unfair subsidized cost advantage over U.S. cars.

Read More: Outside View: U.S. cars need Bush’s help

Over the past few years, the failure of the USD to decline in response to soaring trade deficits has baffled economists, leading some to propose that the only reason the USD has not depreciated is foreigners’ continued willingness to finance the deficits. A new theory, however, is quickly gathering support among economists. It suggests that the common interpretation of current account deficits is unreasonable. Basically, a significant portion of US trade takes place between US companies and their foreign subsidiaries. A change in exchange rates, thus, would not cause much of a change in trade patterns. As a result, a rising current account deficit may not be as large of a problem as has long been argued, as a decline in the USD would not produce a significant drop in the deficit. Reuters reports:

One reason put forward for the growing impotence of currency rates in synching trade accounts is that national trade statistics disguise the real nature of trade flows.

Read More: The gravity-defying dollar

In recent months, prices of commodities and precious metals have begun to soar, a phenomenon that typically precedes a fall in the value of the USD. Many analysts have begun to speculate that a massive correction will soon beset the Dollar, as investors face the reality that the US twin deficits must be reined in before it is too late. Currency traders who remain bullish on the USD are now turning to technical analysis to justify their positions, rather than fundamental economic analysis. Based on current exchange rates, US consumers simply have no reason to slow their consumption of foreign imports, which remain relatively cheap. A depreciation in the USD will send consumers the signal they need and restore the current account balance to a sustainable level. The Asia Times reports:

Some believe higher interest rates may save the dollar as higher rates attract more investments. This analysis ignores the fact that as of the end of last year, the US pays more in interest to overseas creditors than it receives from overseas investment.

Read More: The psychology of a falling dollar

Earlier this week, Japan released a slew of economic data, all of which underscore the likelihood of future rate hikes by the Bank of Japan. First, Japan announced that annualized GDP growth for Q4 exceeded 5.5%, which exceeded growth in both the US and EU. Further, Japanese prices increased by 1.6% on an annualized basis, which indicates Japan seems to have finally escaped from the throes of deflation. If growth and inflation numbers continue to exceed expectations, you can assume Japan will begin raising rates by the end of this year. Currency traders are already beginning to build models around such interest rate hikes, all of which favor the Yen.

Read More: Yen tumbles on fresh deflation fear

As the US twin deficits expanded over the last decade, economists and currency traders have turned a blind eye, pointing to foreigner’s continued willingness to finance the deficit as the reason for their indifference. However, such economists are the first to admit that as soon as foreigners lose their appetite for investing in US assets, the USD will surely suffer. That day may come sooner as later, if viewed from the perspective of the latest release of US capital flows data. In December, foreigners invested 57$ Billion into the US, a sharp drop from the $90 Billion invested in November. This represented the first time in almost a year that the monthly trade deficit exceeded capital inflows, and could serve as a harbinger for a massive USD ‘correction,’ to occur over the next few years. The Financial Times reports:

The drop in net US inflows was almost all the result of a sharp fall in net buying of Treasuries. Foreigners bought a net $18.3bn worth in December – the weakest in six months and down from a record $54.4bn in November.

Read More: Drop in US inflows spooks dollar

Despite the continued lackluster performance of the EU’s largest economy, the European Central Bank (ECB) is still expected to raise interest rates next month, for the second time in over five years. Traders were undeterred by the release of economic data, which indicated Germany’s economy stalled over the last quarter and that investor confidence is sagging. Economists still expect the EU economy, as a whole, to grow by 2.3% this year, and further expect the ECB to move ahead with monetary tightening in order to keep pace with inflation. A narrowing interest rate differential between the EU and US will surely benefit the Euro in the short term. AFX News Limited reports:

One economist noted that the [German] economic sentiment indicator points to significant optimism in Germany, providing further evidence that the outlook is relatively bright. “There is nothing here to stop the ECB from raising rates in March,” she added.

Read More: Euro steady as market continues to price in ECB rate hike

Any doubts over the short-term future of American monetary policy have been sufficiently erased, as the strong economic data foreshadow a rate hike at next month’s Fed meeting. Economists were previously unsure as to whether the US economy could support an additional rate hike. By some approximations, however, the economy is as strong as it was in the late 1990’s. On a seasonally-adjusted basis, retails sales data recorded the largest monthly increase in over five years. Accordingly, it looks like Ben Bernanke’s first task as new Chairman of the Federal Reserve Bank will be to raise the federal funds rate to 4.75%. AFX News Limited reports:

Analysts said the data provided further evidence that the US labour market is strong enough to warrant at least one more Fed rate hike, in contrast to expectations last month that the central bank was about to end its policy of raising rates.

Read More: Dollar firms further after US retail sales surge in Jan

Over the last few years, so-called ‘hot-money’ has poured into China, as investors sought to capitalize on a revaluation of the Chinese Yuan. In order to prevent these capital inflows from exerting severe upward pressure on the Yuan, China’s Central Bank was forced to turn around and buy USD. Since the US began raising interest rates, however, inflows of hot-money have declined, as the opportunity cost of waiting for a revaluation has increased. As a result, representatives from China’s Central Bank were excited to announce that managing the de-facto Yuan peg has become easier, much to the dismay of Western policy-makers. Bloomberg News reports:

The U.S. Treasury refrained from naming China a currency manipulator in a twice-yearly review of trading partners’ exchange-rate policies released on Nov. 28. The next report is due April 15.

Read More: U.S. Interest Gap Keeps Yuan Stable, Central Banker Says

As evidence that Japan has emerged from recession continues to mount, economists and analysts have begun to speculate that the country’s Central Bank will raise rates from their current level of zero. According to the most recent inflation data, Japanese prices have increased for two consecutive months, a feat that had not occurred in nearly a decade. Governors from the Bank of Japan, have themselves hinted that it may be time to stop pumping liquidity into the Japanese economy via an ultra-loose monetary policy. As a result, the consensus is that Japan will begin raising interest rates at the end of this year. Yen bulls have reacted to the prospect of rate hikes with veritable jubilation, arguing that higher interest rates would surely translate into Yen appreciation. The Financial Times reports:

Although the BoJ is not expected to end its zero interest rate policy until next year, any pre-emptive rise in borrowing costs could reduce the use of the yen as a funding currency for the infamous carry trade. This would allow the currency, which most strategists view as undervalued on a fundamental basis, to appreciate.

Read More: Yen climbs on hopes of BOJ policy shift

This week witnessed several important developments in China’s efforts to eventually allow the Chinese Yuan to float freely. First, China announced it may soon allow interest rates to fluctuate in accordance with market forces, rather than rigidly controlling rates. In response, one of China’s largest banks announced the completion of China’s first ever interest rate swap agreement, which serves as a proxy for expectations surrounding future interest rates. These developments are important because higher interest rates would surely put strong upward pressure on the Yuan. Meanwhile, the Yuan has continued to appreciate in forex markets (albeit slowly), and is on pace to breakthrough 8.05 RMB/USD next week.

Read More: China launches RMB interest rate swap transaction

Based on the steady expansion of the US twin deficits over the last decade, economic theory suggests that the USD should have plummeted proportionately. In hindsight, it seems the only reason that the value of the USD was not severely eroded has been the status of the dollar as the world’s reserve currency. It has been known for years that the Central Banks of Asia have been stockpiling USD towards the dual ends of holding down the value of their respective currencies and guarding against the possibility of future financial crisis. However, as the price of oil has exploded, oil exporters have begun to amass similar quantities of foreign exchange reserves. Much of this can be attributed to the fact that oil contracts are priced and settled in USD. However, as tensions with Iran have escalated, many pundits have begun to speculate that Iran will retaliate by introducing oil contracts denominated in Euros, which would severely threaten the dollar’s reserve status.

Read More: The Proposed Iranian Oil Bourse

Currency traders have had veritable months to mull the widening interest rate differential between Japan (where interest rates have remained effectively negative for several years) and the rest of the developed world. Accordingly, many traders have turned to technical analysis in order to gauge sentiment surrounding the Yen. The consensus, which is supported by data, indicates the Yen has been heavily sold short, as institutional and retail investors, alike, have bet against the Japanese currency. While this might suggest the Yen is due to fall, many analysts have reached the opposite conclusion. Basically, many retail investors have leveraged their positions to the degree that any Yen appreciation would force them to quickly buy Yen to cover their positions, resulting in a so-called “short squeeze.” If thousands of traders bought to cover en masse, this would likely feed back into the Yen causing an even larger appreciation. The Financial Times reports:

Trader data released on Friday showed a huge jump in short-yen positions to 43,126 in the week ending January 31, from just 8,839 a week earlier. This would have provided significant fuel for a yen bounce once an initial move higher had been made.

Read More: FX markets focus on fate of yen

As financial markets grow increasingly sophisticated, individuals and businesses are now able to insure themselves against most conceivable risks. Specifically, as forex markets have grown more volatile in the last decade, many businesses have begun to hedge against the risk of rapid currency appreciation/depreciation. An array of financial products can be used towards this end, including options, forwards, futures, and swaps. The principal tool used in currency hedging continues to be currency futures, in which one party agrees to buy/sell a fixed amount of a given currency at a fixed exchange rate, on a fixed date in the future. While most large corporations now have entire departments devoted solely to hedging and risk management, small firms lack the resources necessary to engage in currency hedging. Anecdotal evidence suggests that small firms that import/export simply hope that relative changes in currency values balance out in the long run. This is a risky strategy, as the Times Online reports:

If the currency strengthens the price of the goods increases, making it difficult for companies to plan accurate revenue forecasts and ultimately putting stress on cashflow. Exporters selling into foreign markets face the risk of the currency weakening.

Read More: Currency game is risky for the smaller players

According to the most recent financial data, the Central Bank Japan has stayed out of currency markets for 22 consecutive months. If this is indeed true, the implications are potentially far-reaching, as accusations of intervention have reached fever pitch in the US. In the last few weeks, several prominent American manufacturers have publicly insisted that Japan’s Central Bank is helping Japanese exporters by intervening in forex markets to hold down the value of the Yen. However, Japan’s innocence has been borne out by a slew of data, which suggest that the value of the Yen is consistent with economic fundamentals.

Read More: Japan stays out of currency markets in January for record 22nd month+

Last week, the USD surged to one-month highs against both the Euro and the Yen, on the heels of a hike in American interest rates. As this week will not offer much in terms of economic releases, currency traders will likely remain focused on interest rates. A slew of USD-positive economic data has many economists convinced that the Fed will hike interest rates by 25 basis points at its next meeting. Based on credit futures (which serve as a proxy for future interest rates), traders believe there is a 40% probability of such a hike. Traders are expecting the USD to benefit from the building anticipation, and expect a similar surge in the USD to occur if the Fed delivers on expectations. The Wall Street Journal reports:

“The dollar has gotten a lot of strength [last week] alongside a recovery in interest-rate expectations, and we’re likely to see more of that focus on rates and yields,”

Read More: Lack of New Data Is Likely to Crimp Dollar This Week

For several years, real interest rates in Japan have remained effectively negative, allowing those who were creditworthy to borrow enormous sums of money at improbably low rates. It was hoped that the extremely loose monetary policy would stimulate the Japanese economy, by encouraging consumers and businesses to borrow money towards consumption and investment, respectively. While the Japanese economy is finally beginning to show signs of life, and the risk of deflation is waning, Japan’s Central Bank still appears unwilling to lift interest rates. In a recent press conference, representatives from the bank indicated that it would first need to see strong evidence of economic growth and inflation before it would even consider raising interest rates. The news sent a shiver through currency markets, as traders priced in the possibility that interest rates would remain low for a while longer. The Financial Times reports:

Steven Pearson, chief currency strategist at HBOS, saw signs of rising inflation expectations, with the BoJ likely to fall behind the curve. In this environment he saw Japanese retail investors continuing to buy gold, selling yen in the process.

Read More: Yen slides on monetary policy fears

The European Central Bank met today to discuss the near-term future of European monetary policy. As analysts expected, the ECB left rates unchanged. The body also reinforced analysts’ expectations by hinting it would raise rates at its next meeting, which is scheduled to take place in March. In fact, credit markets have already priced in a 25 basis point rate hike at such a time. While Jean-Claude Trichet, president of the ECB, announced that the performance of Euro-zone economy supported a tightening of monetary policy, he cautioned pundits not to expect multiple rate hikes. Euro bulls are eagerly awaiting the rate hike, which represents a step towards narrowing the interest differential between the EU and the rest of the developed world. Forbes reports:

“The press conference has effectively endorsed the markets expectation for an interest rate rise at the March meeting, without giving further clues as to the likely progression of rates thereafter,” said a …senior FX strategist.

Read More: Euro steady after Trichet hints at March ECB rate hike