The Yen is rapidly approaching all-time lows (in real terms) against the world’s major currencies, and many analysts think they understand what’s behind this phenomenon: the carry trade. In a carry-trade strategy, investors will sell a currency that offers a low interest rate (with proportionately low borrowing costs) and will use the proceeds to buy a different currency that is supported by higher interest rates, effectively earning a return equal to the difference in rates. In the case of Japan, negative real interest rates have prompted many investors to short the Yen in favor of higher-yielding currencies, driving the currency to its current depths. However, analysts argue that a slight uptick in the Yen could drive many investors to quickly unload their positions (approximately $80 Billion outstanding), causing the Yen to appreciate. The Financial Times reports:

The potential of the carry trade as a source of future exchange rate volatility has brought back memories of October 1998 when the yen collapsed against the dollar as hedge funds unwound carry trades in response to the Russian financial crisis.

Read More: Analysts fear sudden rise in yen’s value

In 1998, the Euro and the Britsh Pound began rallying against the USD, appreciating over 30% in the following years. Then, last year, the USD staged a miraculous comeback, retracing 10% of its losses against the world’s major currencies, and costing bearish US investors (such as Warren Buffet) billions of dollars in losses. This year, the Euro and the Pound resumed their upward path against the USD, but have been stuck in a narrow range for many months. And against the major currencies of Asia, the USD has performed equally (well), prevented from depreciating by what is believed to be deliberate intervention in forex markets.

This begs the question, that if so many fundamental economic indicators seem to favor rival currencies, why has the USD remained so resilient? The answers, of course, are complicated, and not readily apparent. The key to this puzzle lies in reconciling economic theory with financial reality. In theory, the laws of purchasing power parity and interest rate parity dictate that a country’s currency should move inversely with its interest rate and price levels. However, any financial economist will tell you that these laws will only obtain in the long run, if at all. In the short term, risk-averse investors flock to the countries that offer the highest real return on investment, which ensures countries with high interest rates will rarely see their currencies depreciate, as in the current case of the US.

In addition, the laws of economics are being artificially undermined by some of the policies of Asia, namely China, South Korea, and Japan. The economies of these countries are heavily reliant on exports, rather than domestic consumption. Thus, it is in their interests to implement any measures necessary to prevent their respective currencies from appreciating. These measures include issuing forex stabilization bonds, building up massive forex reserves, threatening markets with intervention, and maintaining unnaturally low interest rates to deter speculative capital inflows.

Purchasing power parity is being undermined further by the continued willingness of foreigners to finance the American twin deficits. The globalization of capital markets enables investors, worldwide, to seek out the highest returns on invested capital. This is directly preventing the USD from appreciating and the trade deficit from narrowing, since foreigners still prefer to invest in US capital markets, which are well-established, stable, and perennially strong. Unfortunately, the Federal Reserve Bank must contend with inflation and potential asset bubbles when conducting monetary policy; lowering interest rates would push the USD downward, but it might also drive core prices and asset prices up, which the Fed seems intent on avoiding at all costs.

Speculation over whether the Federal Reserve Bank (Fed) would raise interest rates at its monthly policy meeting reached fever-pitch this week, culminating in the Fed’s announcement yesterday to leave rates unchanged. Analysts reckon the calculus of factors that weigh on Fed interest rate decisions is more complex now than ever before. The Fed must not only contend with high inflation, stubborn unemployment, and the need for economic growth, but also asset prices and the balance of trade. Everyone agrees that core inflation, at 3%, is higher than it should be. However, Ben Bernanke, chairman of the Fed, clearly realizes that while a rate hike would certainly stem inflation and limit the possibility of asset bubbles forming, it would also dampen the economic growth which has become so critical to America.

Read More: Why Fed Might Keep Rates on Hold

Last week, North Korea shook the world by admitting that it had defied international warnings and tested a nuclear weapon. As political strategists created diplomatic schemes and contingency scenarios, currency traders assessed the potential implications to forex markets. Many traders expected investors would begin to shift capital out of South Korea for fear that the North Korean political crisis would harm the economy of its neighbor to the south. However, no such capital flight materialized, and the Korean won was largely spared from depreciation. The JooAng Dail reports:

“There were some concerns…in the currency market in particular, but market sentiment stabilized faster than expected thanks to a large foreign exchange reserve and ability to manage risks,” the central bank said yesterday.

Read More: Central bank: financial, currency markets ‘stable’

In recent years, the British Pound and the Euro have begun to converge in value, so much so that both currencies have traded within 5% of each other for almost a year now. There are a couple of explanations for this trend. First, the relationship between the Pound and the Euro are largely symbolic. Perhaps, investors are grouping the two currencies together because of some perceived economic and/or political similarities. Second, it seems that all of the currencies that are supported by any semblance of sound economic fundamentals have risen against the USD, so it is possible that the Pound-Euro convergence is simply the result of both currencies simultaneously appreciating against the USD. Monetary policy and economic cycles are not aligned in Europe and Britain, so it doesn’t seem this link has any strong fundamental basis. Whatever the reason, in all aspects except for in name, the Pound has officially been absorbed into the Euro. The Financial Times reports:

From the euro’s launch in January 1999 until 2003, the pound initially traded in a wide 21.1 per cent range against the euro. Since then, volatility has been significantly reduced with the trading range falling to 8.6 per cent in 2004 and 7.1 in 2005.

Read More: Sterling in accord with the euro

By now, we all know that in the short run, interest rates and currency valuations are often correlated. In the long term, however, interest rate parity dictates that a country’s currency should move in the opposite direction as its domestic interest rates, in order to guarantee that investors in different countries receive comparable returns. This is consistent with financial economics, in that higher-yielding securities tend to elicit less demand, which means that the corresponding currencies sag due to insufficient capital inflows. Now, let’s apply this theory to the recent downgrade of Italy’s public debt. This downgrade will drive Italian interest rates higher as risk-averse investors flee Italy in search of safer investments. (Bond prices and interest rates move in opposite directions) The resulting capital outflows would cause the Italian currency (if it still existed) to depreciate. Fortunately for Italy, the capital outflows it suffers will be spread across the entire Euro-zone, and the net effect on the Euro will be negligible.

Read More: Euro shrugs off Italy downgrades

Traders bullish on the British Pound have been waiting anxiously for economic data to be released that would provide an impetus for the Central Bank of Britain to raise interest rates. On Tuesday, they got their wish, as a flurry of data revealed British price levels are slowly creeping up. Despite sagging energy prices, core inflation is running at an annualized rate of 2.4%, and retail sales are up nearly 4% in 2006. The new consensus is for the UK Bank to raise interest rates by 25 basis points at its next meeting, which is scheduled for November. The Financial Times reports:

By mid-afternoon in New York, the pound was 0.5 per cent higher at a one-week high of $1.8700 against the dollar and up 0.4 per cent to £0.6707 against the euro.

Read More: Inflation Figures Boost Sterling

Due primarily to soaring commodity prices and a strong economy, Russia has amassed the third largest stock of foreign exchange reserves in the world, now totaling $268 Billion. As a result, when Russia announced that it would begin to hold some of its reserves in Yen, forex traders stopped to listen. Previously, Russia’s reserves were denominated in USD and Euro assets. As the Yen is arguably the most undervalued currency in the world, it makes sense from both a financial and risk management standpoint. The Financial Times reports:

While the news was positive for the yen at the margin, it would be wise for investors not to overreact, given the global context in which central banks have been consistently reducing the share of yen in their foreign exchange holdings.

Read More: Russian reserve switch boosts yen

The most recent US trade statistics indicate a record trade deficit, at $70 Billion per month and growing. It bears mentioning that $22 Billion of that deficit is with China, alone. At the current rate of growth, the deficit will likely cross the symbolic $1 Trillion dollar barrier in the next few years. Despite this devastating development, the USD hardly budged in forex markets, which suggests that traders remain unfazed in their belief that foreigners will continue to finance the deficit, regardless of how large it grows. However, the current USD valuation runs contrary to the one of the most fundamental laws of classical economics: purchasing power parity. While traders may believe that they can indefinitely forestall the collapse of the USD, they are only making it more likely that a “hard landing” will take place.

Read More: Dollar holds up despite record US trade deficit

When Jean-Claude Trichet, president of the European Central Bank (ECB), threatened “vigilance” against inflation last month, markets braced for what they believed would be several consecutive rate hikes. Recently, however, inflation seems to have largely disappeared, thanks to a leveling off of commodity prices. In the eyes of Euro bulls, this trend has been offset by a spate of positive economic indicators, which suggest the EU economy is as strong as it has been in over five years. Economists are now projecting growth of 2.5% for the EU area this year, with productivity increasing and unemployment declining. The result should be higher interest rates and a proportionately stronger Euro. The Economist reports:

In the long run, theory suggests that higher growth, other things equal, should mean higher interest rates for a given rate of inflation.

Read More: The euro area’s economy

Last week, I wrote a commentary piece on the implications of the burgeoning global stock of forex reserves, the most pressing of which is the risk that the USD will plummet when/if countries decide to diversify their reserves into other currencies. Perhaps in response to my posting, an advisor to China’s Central Bank commented today that diversification would be a difficult task. He identified the Japanese Yen and the Euro as viable alternatives, but insisted that because the US was China’s primary trade partner, it makes sense for China to hold its reserves in USD-denominated assets. If the USD falls, as many expect it will, China will compensate by allowing the Yuan to depreciate proportionately. Forbes reports:

“If there’s a hard landing in the US and the dollar plunges, and we maintain a managed floating system, the yuan will fall along with the US dollar.”

Read More: China forex regime suitable, 2 pct yuan rise too small

This weekend, North Korea confirmed that it had indeed conducted nuclear weapons testing. Forex markets responded by pummeling the Japanese Yen, for no particular reason other than the proximity of Japan to North Korea. It is clear that the North Korean diplomatic crisis will not exert any effect, positive or negative, on the Japanese economy. Nonetheless, as is often the case, the markets needed something to trade on, and figured a political crisis would provide the impetus to bring the Japanese Yen lower against the USD. Forex TV reports:

“Being anywhere near the Korean peninsula this weekend is not something the foreign exchange market relishes – the yen is underperforming in that situation.”

Read More: Yen continues fall vs dollar on NKorea concerns

Last week, The Economist published a survey of the world economy, confirming what many economists have been arguing for years- that emerging markets will provide most of the world’s economic growth going forward. Led by the BRIC nations (Brazil, Russia, India, and China), emerging markets are projected to grow by 6.8% this year. These nations already consume half of the world’s energy, produce half of all exports, and contain 2/3 of the world’s population. Now, you might be wondering: what are the implications of this phenomenon for forex markets.

A few weeks ago, I argued that emerging market currencies are currently undervalued and represent attractive alternatives to the world’s major currencies. This week, I would like to explore a different effect of the rise of emerging markets: surging forex reserves. The world’s developing countries currently hold $2.7 trillion in foreign exchange reserves, the majority of which is held in USD-denominated assets. The ultimate cause of this surge is clearly strong economic fundamentals. The proximate causes, however, are more complicated.

First, the members of OPEC and other nations rich in natural resources have found themselves inundated with cash due to soaring commodity prices. However, the capital markets in these countries provide few opportunities to invest these proceeds, so countries have turned around and reinvested their windfall into American assets, notably equities and government securities. Second, since developing countries run a combined $500 Billion current account surplus, they have found themselves awash in foreign currency. In order to prevent their currencies from appreciating, they prevent this currency from circulating by holding it in reserve.

Now that we understand why the global stock of forex reserves is expanding, let’s explore why it matters. One of the only reasons that the USD has not plummeted in value as its current account deficit has ballooned is that foreigners largely remain willing to finance the deficit. If countries suddenly decide that they either want to inject their foreign currency into their economies (which would deplete their reserves) or if they decided to diversify their reserves by holding a larger fraction of them in non-USD-denominated assets, the USD would certainly suffer.

Seasoned forex traders turn to one place when they want to know how other traders believe a given currency will perform in the near-term: futures prices. There are only a few components to futures prices, namely underlying price, time to maturity, and volatility. The first two factors are usually given, which means ‘implied volatility’ can easily be calculated, providing a proxy for how the markets expect a currency to perform over the life of the futures contract. Currently, volatility in Canadian Dollar futures is virtually zero, which means despite the Loonie’s lofty valuation, the markets expect it to remain range-bound for the time being. The Globe and Mail reports:

Volatility is never far away from the currency markets. Canada could see elections in Ottawa and in some provinces within a year, and the outlook for the U.S. economy remains uncertain.

Read More: Calm currency markets? Time for hedging on the cheap

While most of the ire of Central Banks is currently focused on China, it seems Japan may also deserve some of the attention. Despite the current economic boom and concomitant current account surplus in Japan, the Japanese Yen continues to lose value against the world’s major currencies, a phenomenon that has baffled analysts. In fact, the Yen is currently nearing an all-time low in trade-weighted terms, and recently touched an all-time high against the Euro. Some have speculated that fear that the Bank of Japan will intervene if the Yen rises too sharply has depressed the Yen. Others believe that it is Japan’s low interest rates which have sustained the always-popular carry trade and driven many to sell the Yen in favor of higher-yielding currencies. Still other experts think it is Japan’s ever-growing forex reserves which keep the currency in check. The Economist reports:

Last week was the 21st birthday of the G7’s Plaza Accord, which triggered a huge rise in the yen. The yen is much more undervalued today than it was then.

Read More: Yen and yang

Canada currently had enough oil reserves to supply all US oil needs for the next three years. The only problem is that much of this oil is trapped in Canada’s oil sands, and it may be costly and difficult to extract. Once the oil starts to flow, however, Canada will likely become one of the world’s top 10 oil exporters, behind such powerhouses as Venezuela, Russia, Saudi Arabia, and Iran. The recent strength of Canada’s currency, the Loonie, can be almost entirely attributed to the high price of commodities, especially oil. It seems forex traders would benefit from studying a little geology.

Read More: Canada Becomes Northern Oil Empire