Aug. 30th 2006
While interest rate differentials have been closely linked to relative values of the USD, Euro, and Japanese Yen, most people never figured the hot topic would ever be applied to the Chinese Yuan. After all, few international investors seriously care about interest rates in China, right? One economist, however, has established a strong relationship between the China-US interest rate differential and the value of the Chinese Yuan. Specifically, he figures that the Yuan’s annual appreciation will equal or come close to equaling the difference in American and Chinese interest rate levels. His reasoning is that those who invest in Chinese assets require a return equal to the yield on comparable US investments. Since American interest rates are currently 3.3% above Chinese interest rates, he theorizes that the Yuan will appreciate 3.3% this year to make up the difference. The Wall Street Journal reports:
The bottom line is that China’s Central Bank must carefully watch inflation and interest rates in the U.S. when formulating its own exchange-rate-based monetary policy.
Read More: The Yuan and the Greenback
Aug. 29th 2006
The last few months have witnessed a spate of bad news surrounding the USD. First, quarterly GDP data indicated the US might already have entered a period of recession, due in part to a slowing housing market. Then, the Federal Reserve Bank announced that it was halting its interest rate hikes, after raising rates 17 consecutive times. Today, monthly inflation data revealed prices are growing faster than most economists had predicted, at an annualized rate of 5.5%. The sudden jump in inflation is being attributed to you guessed it- soaring energy costs. While economists would argue inflation is bad for the USD because it erodes the currency’s real value, many traders reacted positively to the news because they believe it might drive the Fed to hike rates further. AFX News reports:
“The Fed has been focused on the consumers’ perceptions of inflation of late and this may set off some alarm bells among the FOMC hawks.”
Read More: Dollar edges up along with US inflation expectations
Aug. 28th 2006
The Yen continues to take a beating from currency traders, who seem intent on wringing profits out of the Japanese currency before the Central Bank raises interest rates. Two weeks ago, I reported that the carry trade would soon lose steam as central banks around the world hike rates and interest rate differentials begin to narrow. However, Japan’s Central Bank has assured investors that any monetary tightening will be implemented gradually, in order to avoid a rapid Yen appreciation. As a result, investors seem confident that the carry trade remains a safe bet in the short term. If the Yen contineus to depreciate, and real interest rates remain negative, such investors will look pretty savvy. Bloomberg News reports:
Investors are using the so-called carry trade to borrow yen at rates barely above zero percent and use the money to speculate in the markets where central bank rates are as much as 14.5 percentage points higher.
Read More: Yen Slumps Most in Nine Months as Interest-Rate Trades Resume
Aug. 25th 2006
For many decades, it was an accepted truth that the fate of the global economy depended largely on the state of the US economy. Over the last few years, however, this link has gradually eroded and many economists now believe the global economy can expand even when the US is in recession. As it becomes more apparent that the US economy is peaking, this belief will soon be put to the test. US housing data, which is closely followed by economists because of the important role it plays in the US economy, indicates that the real estate market is beginning to recede. If emerging markets-which are most dependent on the US as an export market- are able to cushion their economies from the looming US recession, their currencies will be the first to gain. AFX News reports:
Major currencies were stuck in narrow ranges against each other amid concerns about the prospect of a slowdown in the US spilling over to affect growth elsewhere in the world dampening sentiment all around.
Read More: Major currencies rangebound amid worries about slowing growth outlook
Aug. 24th 2006
One of the most popular trading techniques used by forex traders is known as the carry trade. The goal of the carry trade is to find two countries with vastly different interest rates, and profit by buying the currency of one and selling the currency of the other. This trade is popular precisely because it is safe and somewhat predictable. By borrowing in denominations of the lower-yielding currency and lending in denominations of the higher-yielding currency, a savvy investor can capture a spread equal to the interest rate differential, as long as the values of the currencies themselves do not change. Towards this end, most of the talk in forex markets over the last year has focused around interest rate differentials.
However, the prominence of the carry trade is coming to an end for the time being, since Japan and the EU have begun to raise interest rates and erode the profits of carry traders. If forex traders are to survive this period of narrowing interest rate differentials, they must become more creative. In short, it means they must stop focusing on interest rates, and begin focusing on currency fundamentals, such as economic indicators and the actual supply & demand relationship for particular currencies.
The currencies of many emerging markets represent strong candidates on both fronts. Brazil, Mexico, Eastern Europe, India, SE Asia, have all witnessed rapid appreciation in the values of their currencies on the heels of a global economic boom. Many of these nations have implemented important structural changes to their economies and have begun to see prolonged periods of political stability. This has resulted in an improved investment climate, and foreign companies have been quick to capitalize through portfolio and direct investment. This, in turn, has driven increases in productivity and exports, spurring economic growth, which only makes foreigners even more eager to invest. Since the respective money supplies of each of these countries are quite small, all it takes is a slight uptick in foreign capital inflows to drive significant appreciation in the value of their currencies.
Aug. 23rd 2006
The last couple of weeks have witnessed a few milestones in emerging market currencies, which have largely outperformed the major currencies. The Thai Baht is the latest storybook currency, having appreciated over 10% in the last year, on the heels of a booming economy. The Thai Baht still remains well below its 1997 value, when the Southeast Asian economic crisis forced many nations to devalue their currencies. As a result, Thailand’s Central Bank is not sounding the alarm bells quite yet. Besides, inflation rates are edging up, and an expensive currency could help keep Thai prices in check. The Bangkok post reports:
“If the baht is allowed to become too weak it could affect inflation and if it is too strong, Thailand could suffer a greater trade imbalance, as Thai products will become more expensive and less competitive in the international market.”
Read More: Central bank unworried by strong baht
Aug. 22nd 2006
Brazil’s currency, the Real, is currently hovering around a five-year high against the USD, after an historic run-up in value. In recent months, the Central Bank of Brazil has begun to grow nervous that a more expensive Real could stifle Brazil’s economy by crimping exports. Accordingly, the bank has purchased massive quantities of USD in a bid to hold down the value of the Real. While the Real has certainly stabilized, such intervention is misguided and probably doomed to fail in the long run. Other Latin American countries have followed suit, since western investors began pouring in investment money. Reuters reports:
Brazil’s central bank has been aggressively buying U.S. dollars on the spot foreign exchange market in recent months to build up reserves and, indirectly, prevent the country’s currency, the real, from strengthening too much.
Read More: Brazil’s foreign reserves rise to $70 billion
Aug. 21st 2006
Charting the value of the Chinese Yuan (RMB) against the USD reveals the currency is appreciating at a snail’s pace. When you add volatility to the chart, the story becomes less black-and-white. Over the last six months, the RMB has begun to test the limits of the .3% daily trading band imposed on it by China’s Central Bank. Now, the currency routinely gains or loses .2% in a single day. While the gains have largely been offset by losses, this is still a positive development because it shows China is slowly moving towards a point in which the Yuan is allowed to freely fluctuate against the USD. China is certainly not going to capitulate to western interests by drastically revaluing its currency; rather, it will continue to move slowly and test the waters, until it is clear that China’s economic and financial infrastructure can accommodate a floating currency. The Economist reports:
[HSBC] puts weight on a recent statement by …the central bank’s monetary policy committee, that China could cope with an annual appreciation of 5%. That’s slower than America would like—but about as fast as it can expect.
Read more: China’s currency- Ups and downs
Aug. 17th 2006
With today’s post, I thought I would take a break from reporting on the major currencies and interest rate speculation, a topic which I feel has been beaten to death. A few weeks ago, Zimbabwe announced that it was issuing a new currency, in order to rein in activity in black market currency exchange. Many countries, including Zimbabwe, with ill-defined economic policies, are often severely constrained in their ability to conduct monetary policy because they don’t know how much cash is circulating. By issuing a new currency, the Zimbabwe government is effectively forcing its citizens to make known the amount of currency they possess, and may enable the country to draft a more practicable economic policy.
Central bank Governor Gideon Gono knocked three zeros off all banknotes and devalued the local dollar by 60 percent in a bid to snuff out a thriving forex black market, where the exchange rate is nearly three times the official one.
Read More: Panic as currency deadline looms in Harare
Aug. 16th 2006
Last week, Ben Bernanke, Chairman of America’s Federal Reserve Bank, announced that rates would be left unchanged due to slowing economic growth. USD bulls cringed at the possibility that the Fed was done finished hiking rates. Unfortunately for them, Mr. Bernanke’s assessment was born out by CPI data, released today, which revealed growth in prices is indeed slowing. In fact, the monthly change in inflation was only .2%, the smallest increase in almost half a year. Yields on US debt instruments, including Treasury securities, fell across the board- bad news for traders who are hoping foreigners will continue to finance the US trade deficit. Bloomberg News reports:
The Fed is now done raising rates and will be cutting them next year, said Andrew Balls, a global strategist at Pacific Investment Management Co.
Read More: U.S. Economy: Slowing Inflation Validates Bernanke
Aug. 15th 2006
Rydex funds, a leader in exchange traded funds, recently introduced six new currency funds, to supplement the Euro-based fund it released last year. FYI, an exchange traded fund (ETF) is a closed end investment trust that trades on an exchange, much like a stock or bond. More specifically, currency ETF’s sell shares to the public which track the performance of actual currencies. Buying a currency ETF is comparable to buying the currency itself; you gain money when the currency appreciates, and lose money when it depreciates (relative to the USD). The advantage of speculating on currencies by purchasing an ETF instead of the actual currency is the ease of investment, for you can quickly buy and sell ETF’s and hold them in the same account that you use to trade other securities. The Motley Fool reports:
This past June, Rydex added six more currency-based exchange-traded funds to the market when it launched the the CurrencyShares Australian Dollar (NYSE: FXA), British Pound Sterling (NYSE: FXB), Canadian Dollar (NYSE: FXC), Mexican Peso (NYSE: FXM), Swedish Krona (NYSE: FXS), and Swiss Franc (NYSE: FXF) funds.
Read More: The ABCs of Currency ETFs
Aug. 14th 2006
Emerging markets have fared well this year, due to a combination of increased investor appetite for risk and strong fundamentals. Many emerging countries have also witnessed a rapid appreciation in their currencies, as foreigners pored money into direct and portfolio investments. As rates have risen in the developed world, however, many investors have begun to reevaluate the economics of such investments. In fact, the risk-return profile is changing to the extent that it may prove more efficient to invest money in lower-yielding, but safer American and European debt securities. The Financial Times reports:
“The market is only pricing in a 36 per cent chance of a rate rise in September…, so there is room for dollar upside, which would squeeze emerging markets.”
Read More: Emerging market currencies lower on profit taking
Aug. 12th 2006
Over the past 6 months, the Euro and Pound Sterling have risen steadily in value against the USD. Labor and market reforms are forcing European companies to become more competitive. Hence, the economies of Britain and the EU are finally beginning to show signs of life. While economic fundamentals have certainly contributed to currency appreciation, they must take a back seat to interest rate differentials in any analysis of currency markets. Economists reason that interest rate differentials represent a leading indicator for foreigner’s willingness to continue financing the US current account deficit. That is, if US capital markets can continue to offer foreigners attractive returns, then they will continue to park their savings in the US.
Ben Bernanke, Chairman of the US Federal Reserve Bank, recently announced that the Fed is approaching the peak in the current interest rate cycle. It has raised interest rates more than a dozen consecutive times over the last two years, and may finally have achieved a point of balance, whereby growth is neither restrained nor excessive. Inflation has reared its ugly ahead, driven by rising food and commodity prices, but American consumers have learned to adapt.
Meanwhile, the Central Banks of Britain and Europe have independently begun to tighten money supply in order to preempt inflation. Most economists expect them to hike rates several times over the next 6 months, which will narrow the gap between American and European interest rates. This could be bad news for the US. For many years, OPEC nations and the Asian exporting nations have ‘threatened’ to diversify their forex reserves out of USD-denominates assets. They may finally have the impetus they need, because now they can earn attractive returns in Europe, whereas before they were limited to American securities. In short, foreigners may soon become far less willing to lend to and invest in the US if they can earn comparable returns (without sacrificing stability) in Europe. In such a scenario were to be realized, the result would surely be a weaker USD.
Aug. 10th 2006
Last week, the European Central Bank raised interest rates to 3%. This move had been telegraphed to investors over the preceding few weeks, and the markets hardly stirred when the rate hike became official. Investors are much less certain about what the future will bring, but the consensus is the ECB will continue to hike rates. Growth is slowly picking up, and decreasing unemployment is removing slack from the labor markets. Meanwhile, Europe’s inflation rate, the indicator which the ECB openly uses a basis for conducting monetary policy, is hovering around 2.5%, which means the bank could certainly stand to raise rates further, to the tune of 50 or 100 basis points. Unfortunately for USD bulls, the ECB is beginning to tighten just as the Fed nears a peak in its interest rate cycle, which will make investing in the EU a more attractive option. The Economist reports:
The ECB has said for a while that the euro area’s recovery is becoming more broadly based, shifting from exports towards domestic demand. If the American economy is slowing sharply, that is just as well.
Read More: Monetary policy in the euro area
Aug. 9th 2006
This week, Japanese automakers reported strong earnings for the latest quarter, and American trade groups are furious. If you remember, American automakers have been complaining for the better part of this year that the Japanese government is depressing the value of the Yen in order to make Japanese exports more competitive. When confronted with the fact that the Bank of Japan has not officially intervened on behalf of the Yen since 2004, the automakers respond that the government continues to threaten intervention in the event that the Yen actually appreciates. This is tantamount to currency manipulation, they argue, because traders are reluctant to bid up the value of the Yen lest the government actually intervene to force it back down. Reuters reports:
“Every time the yen starts to move in a substantial way, ‘Japan Inc.’ and the Japanese finance minister roll out thundering noises” discouraging currency traders from betting on a stronger yen.
Read More: US automakers say Japan profits fueled by cheap yen
Aug. 8th 2006
For the first time in almost two years, the Federal Reserve Board left interest rates unchanged at its monthly meeting. While interest rate futures indicated that there was only a 20% chance that rates would be raised, the markets still reacted with vigor when the announcement was made. In the forex market, economists and traders were quick to recalibrate their models and adjust their assumptions to reflect the possibility of future interest rate moves. At this point, most analysts are uncertain about the outlook, and the consensus is neutral. The Fed has explicitly sated that it will continue to hike rates if inflation doesn’t moderate and/or the economy continues to expand at a rapid pace. Barring such developments, it seems US rates may have peaked for the time being, which means interest rate differentials will only grow narrower in the coming months. USA Today reports:
The central bank is trying to balance evidence of slower growth, against continuing inflation worries. Oil prices are at near-record levels,…and a government report showed big gains in wage costs, another inflation driver.
Read More: Fed, worried about slowdown, leaves rates unchanged
Aug. 7th 2006
With the exception of small transactions negotiated directly between institutions, the majority of the world’s currency trading is conducted on the interbank market. This market consists of a few centralized exchanges around the world, where financial institutions exchange large blocks of currency, usually in denominations of $1 million or greater. This may change, however, as the Chicago Mercantile Exchange announced it will soon debut an electronic exchange, with the help of Reuters. The exchange was designed for hedge funds, which began a mass foray into foreign exchange several years ago. Since hedge funds typically trade on margin, this platform could inject new volatility into the forex markets. Last year, the volume of forex trading increased over 30%! This new platform will ensure that forex trading continues to burgeon in popularity.
Read More: New FX platform eyes hedge funds
Aug. 3rd 2006
The two most important Central Banks in Europe independently raised interest rates today. The European Central Bank (ECB) was first to announce a rate hike, in a move that was widely predicted by investors. The Central Bank of UK, however, caught most investors completely off guard when it announced a rate hike of its own. It appears to be a coincidence that both banks raised rates on the same day, as the economic policies of the UK and of Europe are not entirely related. The news made USD bulls nervous on two fronts: first, the narrowing of interest rate differentials means it is more attractive to move capital to Europe. Second, and less obvious, is the implication that growth is picking up in Europe, at the very moment it is slowing down in the US. The Financial Times reports:
Jean-Claude Trichet, ECB president… said that if the eurozone economy performed as the bank expected, “a progressive withdrawal of monetary accommodation will be warranted”.
Read More: ECB and UK join drive to raise rates
Aug. 2nd 2006
Since peaking at the end of May, the Canadian Dollar has declined by almost 4% against the USD. Will the Loonie recover and continue to move towards parity with the USD, as many analysts predicted, or will it move further towards a more stable long term value? Despite soaring commodity prices, the Canadian economy is not growing as fast as many economists had projected. As a result, the Central Bank of Canada is unlikely to raise interest rates at its next meeting, which means the interest rate differential between the US and Canada will probably continue to widen, and the Canadian Dollar will continue to sell-off. Bloomberg News reports:
One analyst opined, “Market players are eager to test the Canadian dollar weakness…the Canadian dollar will almost certainly fall back into favor later this year, but not before sustaining further losses.”
Read More: Canada’s Dollar Pares Gains After Economy Fails to Grow in May
Aug. 1st 2006
With my first commentary piece, I would like to address several issues concerning the Chinese Yuan. Let me begin by saying there is a tremendous amount of information and a wide array of often-conflicting opinions surrounding the Chinese Yuan. The problem with most financial analysts is that they often fail to grasp the big picture: in this case, the determinants of the Chinese Yuan’s value are multifarious, and take in financial, economic, and political factors, which most analysts fail to consider.
As most of you are probably aware, the Chinese Yuan has appreciated over 3.5% in the last year, including the 2.1% revaluation that the Chinese government effected last July. Many economists insist the Yuan is still undervalued by 35%, a figure that politicians love to quote. Analysts have also backed this estimate and incorporated it into their models that predict the Yuan will appreciate by 5% this year. You can look at RMB currency futures for proof that this is indeed the consensus forecast.
Both of these figures are ill-conceived and downright misleading. First of all, while the Yuan could clearly stand to appreciate, the extent to which it’s undervalued is probably closer to 10-15%. A true estimate of the Yuan’s fair value must make adjustments for inflation in order to account for differences in purchasing power. As China’s economy has expanded, inflation has grown at a proportional rate, eroding the value of the Yuan. At this point, China’s ability to produce cheap goods is probably more closely related to a surplus of unskilled labor and free capital, than to an undervalued currency.
Secondly, and just as important, is the fact that China will likely continue to appreciate the Yuan at its own pace. On several occasions, Chinese political leaders have invoked an ancient Chinese proverb when discussing the revaluation of the Yuan. The proverb states that one should take small steps in this type of situation. Whether China is genuinely nervous about revaluing or whether it simply wants to keep benefiting from an undervalued currency is anyone’s guess. What is not debatable is China’s stubbornness, reflected in its refusal to bow to western pressure when shaping its economic policy. In short, when an analyst tells you that the Yuan will appreciate by more than 3% this year, you should react with skepticism.