Forex markets punished emerging market currencies this week, due to heightened economic and political risk. Many traders had piled into carry trade positions, selling low-yielding, stable currencies in favor of higher-yielding, but more volatile currencies. After a string of negative political and economic developments, many traders unwound their positions and moved back into the more stable currencies. After all was said and done, the currencies of Turkey and South Africa had declined more than 3%, while those of Brazil and Mexico declined by almost 2%. However, analysts now feel the sudden drop was nothing more than a long overdue correction, and remain bullish on emerging markets. Daily News and Analysis Online reports:

Post that shake-out, high risk currencies enjoyed a strong rebound. Low interest rates encouraged speculators to re-enter carry trades and build up large speculative positions, going short on the Yen and Swiss Franc.

Read More: Emerging currencies slip on risk aversion

Of the world’s 16 major currencies, the New Zealand Dollar (NZD) has been the best performer over the last couple months, having appreciated 10% since July. The strength of the Kiwi has baffled central bankers, who have been unable to connect the currency’s rise to any economic or technical indicators. Their only explanation is that hedge funds have piled into the Kiwi, in search of an attractive, relatively stable return. Hedge funds would use the carry trade technique to short low-yielding currencies and use the proceeds to purchase New Zealand short-term debt, which is currently yielding 7.25%. However, the Central Bank urges caution, insisting that the Kiwi could suffer a collapse at any moment. Bloomberg News reports:

“The assumption certainly of the Reserve Bank and which I share is that the medium-term trend in the New Zealand dollar is down.”

Read More: Cullen Says Hedge Funds May Be Behind New Zealand Dollar Surge

Since reaching a one-year high over the summer, the Euro has been punished in forex markets, due primarily to a less favorable outlook for ECB rate hikes. Previously, analysts were expecting the ECB to raise rates three to four more times, raising the base rate to 4%. Now, however, analysts have revised their models to reflect one to two rate hikes. Forecasts for the Euro have been adjusted proportionately to undo the narrowing of interest rate differentials that Euro appreciation had been predicated on. The Daily News reports:

Steve Pearson at HBOS said the scaling back in rate hike predictions is probably a reaction to the drop in oil prices which should in turn drag euro zone inflation well below the European Central Bank’s 2 pct target rate.

Read More: Euro continues lower as investors rethink ECB rate hike prospects

The role of Central Banks in forex markets has become a hotly debated topic, as banks around the world continuously to intervene to prevent their currencies from appreciating. Canada is one of the few countries that has not attempted to stifle a significant rise in its currency. By all accounts, Canada should be an obvious candidate for intervention, for a strong Canadian Dollar (“Loonie”) has punished its export-driven economy. Canadian leaders, however, argue that the appreciating Loonie has forced Canadian businesses to become more efficient, and thus, welcome a more expensive currency. It has pledged to stay out of currency markets and allow market forces to determine the value of the Loonie. Bloomberg News reports:

Canada, which buys more U.S. goods than any other country, suggested it will keep out of currency markets for another five years and warned other nations to follow suit or face a global slowdown from trade imbalances.

Read More: Canada to Keep Out of Exchange Markets, Wants Others to Follow

Last week, the Thai military usurped control of Thailand’s government while the Prime Minister was in New York attending a United Nations conference. Thailand’s currency, the Baht, immediately lost over 1% of its trade-weighted value, as analysts feared the military coup would harm Thailand’s economy. In the following week, the Baht retraced almost all of its losses, as the markets reacted positively to promises by the leader of the coup, that democracy would be returned to Thailand as soon as the Constitution could be rewritten. This episode was the most significant interruption to the Thai Baht in over a year, during which time the currency appreciated over 10% against the USD. The Globe and Mail reports:

Many analysts agree that King Bhumibol Adulyadej’s support of the coup and any timeline for fresh elections to restore democratic government will be key in determining when, or if, the Baht will recover.

Read More: Thai Baht hits currency markets

An exchange-traded-fund (ETF) is similar to an index fund in that both types of securities are designed to track the performance of the index to which they are assigned. The crucial difference, however, lies in the fact that there is no centralized market for mutual funds, whereas ETFs trade on exchanges, and hence, charge lower fees to investors. At first, investment companies were reluctant to create currency ETFs, because they weren’t sure if demand was large enough to justify such products. Since currency trading surged in popularity, a spate of new currency ETFs have been introduced, the newest of which is designed to track the performance of a composite of ten of the world’s most important currencies. Previously, this type of product was only available to wealthy investors. Now, anyone with a brokerage account can index in such a way, and would be smart to do just that, in order to hedge against the decline in any single currency. The Daily News reports:

The fund is managed by DB Commodity Services LLC. “DBV will offer investors easy access to the returns of the currency markets by following a highly developed index previously available only to very sophisticated investors.”

Read More: New Means of Access to Currency Markets

This month, the locomotive that is China’s stockpile of forex reserves surged ahead, to $954 Billion, with economists now predicting that the $1 Trillion mark will be breached in October. Export-dependent countries-notably China and Japan- have accumulated gargantuan reserves over the last decade, as an alternative to allowing their currencies to appreciate. In most countries, Central Banks take the currency that foreigners used to pay exporters, and allow it to circulate in the economy. China and Japan have instead taken to hoarding their reserves in order to decrease demand and thud hold down the value of the Yuan and Yen, respectively. The Asia Times Online reports:

More foreign-exchange reserve demands more hedging money in local currency, which may weaken the controlling capacity of China’s monetary policy, impose pressure on the appreciation of the yuan, and exacerbate foreign-trade frictions.

Read More: China’s mushrooming forex reserves

Over the Last three months, the New Zealand Dollar (affectionately known as the Kiwi) has been on a tear, having appreciated 10% against the USD. At first, traders just assumed the upward price movement was a correction of sorts- to offset the Kiwi’s slide over the previous months. Now, however, forex experts believe they are witnessing a bona fide uptrend, and it is anyone’s guess when the Kiwi will return to earth. Analysts are attributing the currency’s strength to a renewed focus on yield, which had previously been placed on the back-burner in place of fundamentals-based trading. Since New Zealand currently offers the highest interest rates in the developed world, traders hungry for yield began flocking to the Kiwi when the carry trade became trendy again. The New Zealand Herald reports:

[One analyst] said the yield story had been underestimated by local markets, which had focused on pessimism from economists and the “tsunami of uridashi redemptions” which would bring the kiwi down as overseas investors withdrew their money.

Read More: Experts pick kiwi to keep on flying

While many topics were mooted at last weekend’s G7 summit, there was only one subjected that forex traders cared about: whether the world’s developed nations would publicly urge Japan to lift the value of the Yen. Unfortunately, the only reference to the Japanese Yen at the meeting was a comment that suggested the Yen was undervalued and should more closely reflect economic fundamentals. Whether this will actually translate into a stronger Yen remains to be seen. However, most analysts do not expect Japan will take any steps to appreciate the Yen unless the country is pressured to do so. Reuters reports:

Some traders were also disappointed that the G7 dropped the annex from the April meeting’s statement calling explicitly for Asian currencies to appreciate.

Read More: Yen slides back towards all-time lows vs euro

A couple weeks ago, I posted on this very subject- that the value of the Chinese Yuan is largely tied to inflation and interest rate differentials. With this week’s commentary piece, I wish to further expound upon this theory, because it appears to really carry weight. Most traders who have an opinion on the Chinese Yuan base their forecasts for the Yuan’s appreciation on political developments: how much diplomatic pressure the world will apply to China and how much China will capitulate on this most delicate of economic issues. A Stanford economist, however, has demonstrated that political guesswork might not be necessary, by connecting the Yuan’s appreciation to several important economic indicators.

Let me explain. There are two closely related theories in classical economics which attempt to account for changes in the relative value of currencies: interest-rate parity and purchasing power parity. The theories hold that the relative value of a nation’s currency should move inversely with price levels and interest rates, respectively. The reasoning is straightforward enough: the return on risk-free investments denominated in two different currencies should be equal in order for the markets to clear. However, as in many areas of economics, the gap between theory and reality in currency markets is significant, for high interest rates often attract risk-averse foreign investors instead of repelling them, which ultimately leads to the currency increasing in value.

In contrast, the Stanford economist seems to have established that the laws of parity seem to be holding in the case of the Chinese Yuan. It turns out the China-US inflation and interest rate differentials have almost perfectly mirrored the movement of the Yuan in the past year. As growth in the US began to drive inflation, the Fed raised interest rates to the extent that they currently exceed Chinese rates by over 3.5%- the precise amount by which the Chinese Yuan has appreciated against the USD this year! This phenomenon indicates that the Central Bank has allowed the Yuan to appreciate only so much as to offset the value by which the USD has been eroded by inflation. Coincidence? Probably Not. In short, we should expect the Yuan to appreciate only by the amount that American price and interest rate levels exceed those of China.

The G7 nations have decided to make a late addition to the agenda for their meeting in Singapore later this month: the weakness of the Japanese Yen. The Yen managed to stay below the radar for years, but due to growing trade imbalances, leaders from other industrialized nations have begun to complain that Japan’s Central Bank is artificially depressing the Yen to give Japanese exporters an unfair advantage. Especially now that Japan’s economy seems to have definitely emerged from its recessionary and deflationary period, it no longer requires a cheap Yen. This development could have important ramifications in forex markets, if G7 leaders decide to sanction Japan. Forbes reports:

“The G7 is no longer willing to allow the yen weakness to continue as Japan does not require a weak currency given the growth/inflation outlook.”

Read More: Yen surges on confirmation G7 will discuss currency

The US Bureau of Economic Statistics today released its monthly report on America’s trade balance, and the numbers were not pretty. The monthly current account deficit has reached a new high, at $68 Billion, attributed primarily to soaring commodity prices. As the trade balance (exports minus imports) represents one of the components of production, economists are now revising their GDP growth estimates downward to reflect this latest development. The Federal Reserve Bank would love to see the USD depreciate in order to stem the balance, but it may have to wait for interest rates to narrow further before it sees its wish fulfilled.

Read More: Dollar survives knee-jerk selling after record US trade deficit

The UK Pound has stood in virtual lockstep with the Euro, as both currencies have steadily appreciated against the USD. The UK Pound is poised to breakout, however, due to relatively high inflation. Inflation, in and of itself, would theoretically be expected to erode purchasing power and thus lead to currency depreciation. In this case, the opposite will likely obtain, as the byproduct of inflation will likely be a rate hike by the UK Central Bank to keep pace with price levels. The move will bring the short-term UK rate to 5%, just below the US Federal Funds Rate. AFX News reports:

”With consumer price inflation unexpectedly moving back up in August and core inflation rising, another interest rate hike in November remains very much on the cards.”

Read More: Pound gets lift from stubbornly high UK inflation

For the first time, officials from China’s Central Bank will meet publicly with their counterparts in Japan, a nation that knows a thing or two about currency appreciation. Over 20 years ago, the world’s industrialized nations signed the Plaza Accord Agreement, which laid out a plan for devaluation of the USD against the Japanese Yen. The purpose of the agreement was to help the US stem its current account deficit and simultaneously emerge from an economic recession. [Note the similar circumstances which currently surround the attempt by the US to depreciate the USD against the Yuan.] Anyway, the result of the agreement was a Japanese recession, and ultimately, an asset price bubble which continues to plague Japan to this day. Chinese officials hope to learn from Japan’s travails and avert a similar economic implosion.

Read More: China seeks to learn from mistakes of 1985 Plaza Accord

China’s foreign exchange reserves may soon surpass the mystical threshold of $1 trillion. This month, they soared to $950 Billion, as China’s current account surplus was promptly reinvested in foreign securities. If China allowed the new Yuan to circulate in the money supply, the result would be double-digit inflation. Instead, China holds all of the surplus yuan in the form of foreign currency, a habit which exerts severe upward pressure on the yuan and may soon overwhelm China’s monetary system to the point where it has no choice but to allow the yuan to appreciate. China Daily reports:

“We will take comprehensive measures to avoid further significant growth in the foreign exchange reserves,” said the vice president of China’s Central Bank.

Read more: China forex reserves hit $954.5 billion

Two weeks ago, I reported that the carry trade would soon come to an end, and traders would have to develop alternative strategies in order to continue profiting in forex markets. While interest rate differentials still remain sizable, it seems traders are finally beginning to take heed of this message by building future rate changes into their models. Japanese interest rates remain effectively negative, but a spate of recent data indicated that Japan’s economy has recovered from its multi-year recession. The Yen has sunk to a 20 year low in real terms, and the only place it can go is up. Those who continue to rest on carry trading risk getting burned. The Financial Times reports:

[The data] did not alter the prognosis for Japanese rates, which are still expected to remain unchanged when the BoJ meets this week – but it derailed the carry trade, as attempts to short the yen were by this point wildly overdone.

Read More: The Short View: Risk appetite

Many investors watched the recent Israel-Lebanon conflict with bated breath, in order to gauge how the crisis would affect Israel’s economy. While the conflict will certainly diminish Israel’s prospects for growth this year, economists are predicting that its economy will still expand by a healthy 5%. Venture capital and private equity continue to flood Israel, and Israel’s interest rates remain at an attractive level. Meanwhile, its current account surplus exceeds 3.5% of GDP. In short, economists estimate the Israeli Shekel is undervalued by 13.5% against the USD and up to 30% against a broader basket of currencies. The Business Online reports:

These two trends are likely to continue thanks to strong growth in productivity which is making Israeli goods and services more competitive in the world markets, further boosting the case for a stronger shekel.

Read More: Shekel is proving to be bullet-proof

Speculation has been building in forex markets over whether the European Central Bank (ECB) will raise interest rates at this week’s meeting. Previously, the consensus among traders was that the ECB would continue to tighten through the end of this year in order to keep pace with inflation. Since then, however, new data has been released, indicating that the European economies may have already peaked. Germany’s economy, for example, is now predicted to expand by less than 2% this year. Combined with moderating inflation, these new numbers indicate that another rate hike may not yet be needed. As a result, the narrowing interest rate differentials that USD bulls were fearing will not likely be realized for a few more months. Dow Jones News reports:

“There has been little indication that the central bank is prepared to step up the pace of its interest rate hikes and the likely timing for the next move is the meeting Oct. 5, with a further one in December leaving interest rates at 3.5% by year-end.”

Read More: ECB Unlikely To Hold Surprises For Euro