Today saw the release of the ‘minutes’ from last month’s meeting of the UK Central Reserve Bank, revealing that members of the Bank’s monetary policy committee voted 7-2 to hold rates at their current levels. That there were two dissenting votes is confirmation to some economists that the Bank is planning to hike rates again in the near-term, perhaps as soon as March. British short-term interest rates, at 5.25% are already on par with American rates, and another rate hike would further lessen the appeal of risk-averse investment in America. Investors will be eying inflation data closely over the coming weeks, which could provide the impetus for a rate hike at the next meeting.

Read More: MPC voted 7-2 to hold rates

Since reaching a 14-month low earlier this month, the Canadian Dollar has rebounded, thanks to data which indicate the Canadian economy is emerging from a mild recession. The currency was also helped by surging prices for commodities, which account for more than half of the country’s exports. As the summer draws closer, the currency will likely accelerate upwards, helped by predictably strong energy prices. In short, it seems the Canadian Dollar’s recent sluggishness is probably just a seasonal adjustment rather than a long-term correction. Bloomberg News reports:

“The agency didn’t see any need for revising either the growth, or job numbers, which is the Canadian dollar positive development.”

Read More: Canada’s Dollar Rises a for Third Week as Economy Strengthens

In continuing with this week’s unofficial theme of Asia on the forex blog, I have chosen to cast a spotlight on Singapore’s currency, the Dollar, which typically receives scant coverage. Singapore pegs its Dollar to a basket of currencies, allowing it to fluctuate tightly within a carefully managed range. In fact, Singapore has been known to adjust the relative value of its currency-rather than interest rate levels- as a means of conducting monetary policy. Towards this end, it recently announced that it would induce its currency to appreciate, in order to combat domestic inflation. Bloomberg News reports:

Singapore’s policy contrasts with Thailand and South Korea, who are seeking to stem currency gains to protect exporters. Stronger currencies may cut demand for goods sent overseas as they increase costs to buyers based abroad.

Read More: Singapore will manage currency, bank says

Before I attempt to answer the following question, let’s examine where the Japanese Yen is today and more importantly, how it got there. The story begins around the establishment of the second Bretton-Woods agreement, which de-linked the USD from gold, and ushered in the modern era of freely floating currencies. In the 30 years that have elapsed since this period began, the Yen has never been less valuable. In fact, in trade-weighted terms, the Japanese Yen is at an all-time low!

The decline began in 1995, touched off by a nagging recession and the accompanying easy monetary policy, in which Japanese real interest rates were effectively negative. The decline seems to have accelerated over the past five years, due to the proliferation of the carry trade. In this type of trade, investors borrow Japanese Yen at a low interest rate, and sell the Yen for a currency which is supported by higher interest rates. The profit, known as carry, is the spread between the two rates. Hedge funds have piled into the carry trade, driving the Yen to lower and lower depths.

Politicians, relying on economists, have begun to clamor for reform. For a while, trade representatives and politicians insisted Japan was intervening on behalf of the Yen, which was ostensibly keeping the Yen grounded. They have since retreated from this position and embraced the carry trade theory as being responsible. Regardless of the causes, everyone agrees that the Yen’s undervaluation is not only destabilizing, but is economically inefficient. After all, Japan is home to the world’s largest trade surplus, and its economy is growing at an annualized rate of almost 5%!

So why doesn’t Japan give in and raise rates? The answer, it turns out, may not even matter. Traders have speculated that it require a rise of 200 basis points in Japanese interest rates for the carry trade to lose its appeal, an event which is extremely unlikely to occur by the end of 2007. Instead, a little bit of volatility in forex markets might go a long way in coaxing the currency upward. The Economist has drawn an analogy of the current situation to 1998, when the Russian default made hedge funds nervous, and they unwound their carry positions in the Yen. The result was a rapid 15% appreciation in the Yen.

China and Japan are no longer alone in their unofficial quest to pile up foreign exchange reserves. Indonesia just announced that its reserves have surpassed the $45 Billion mark, and to the surprise of no one, these reserves are largely held in USD-denominated assets. The announcement is significant for a few reasons. First, it means that Asian nations not lumped in with the Asian Tiger economies – Taiwan, Hong Kong, South Korea, and Singapore – have begun to reap some of the fringe benefits of economic growth, notably surging forex reserves. Second, it is symbolic of the fact that the USD remains the world’s de facto reserve currency. At the same time, it should make USD bulls quiver, because such countries could conceivably pile out of the USD just as quickly as they have piled in.

Read More: Indonesia says forex reserves hit 45 bln USD

The Japanese Yen had a strong opportunity to reverse its long-term slide against the USD this week after the release of economic data, which indicated the Japanese economy is now expanding at an annualized rate of 4.8%. This is the fastest growth recorded by Japan in almost a decade, increasing the likelihood that the Central Bank of Japan will finally raise rates at its meeting next week, and induce an end in the carry trade, which has prevented the Yen from rising in accordance with what analysts believe are strong economic fundamentals. Unfortunately, the Yen largely failed to move against the USD, which means it will probably take more than a rate hike to drive the Yen out of its entrenched pit. FxStreet reports:

Read More: Dollar takes breather vs yen after sell-off

At its monthly meeting to determine the region’s monetary policy, the European Central Bank decided to leave rates unchanged at 3.5%, but signaled that it would likely hike rates next month. The Bank’s president, Jean-Claude Trichet, who is an advocate of transparency, used his trademark phrase of “strong vigilance” to convey the Bank’s intentions to financial markets. The move will propel European rates ever closer to US rates, narrowing the differential which many believe is the only thing standing in the way of a long-term USD decline. However, European political pressure will likely prevent rates from being raised too high, as politicians fear an expensive Euro is hampering the EU economic recovery. The Financial Times reports:

Mr Trichet, who stressed the ECB’s independence, expected inflation to rise again this year and said that “the decisions we take today are to ensure price stability later on”.

Read More: ECB signals rate increase in March

The USD has been trading sideways over the last couple of months, leaving investors scratching their heads and searching for insight into the currency’s future direction, which will probably take the form of a big jump out of the channel it has been trapped in. Even the release of monthly trade statistics, which can usually be counted on to elicit some response in forex markets, fell flat this month, despite surpassing economists’ predictions and setting a new record. Next, investors will be turning their gaze onto Ben Bernanke, chairman of America’s Federal Reserve Bank, who is scheduled to deliver his semi-annual testimony before Congress this week. If Dollar bulls are lucky, he will provide a hawkish outlook on near-term monetary policy. The International Herald Tribune reports:

“If he says anything more upbeat about the U.S. economy or reaffirms the Fed’s concerns about inflation, the dollar is likely to gain.”

Read More: Dollar down but calm awaiting Fed chief Bernanke’s testimony

China recently announced plans to begin actively managing its foreign exchange reserves, currently valued at more than $1 Trillion. Concurrent with this announcement, China formally created The State Foreign Exchange Investment Company, which will initially be capitalized with more than $200 Billion. Another Chinese investment company will be given $100 Billion. These steps represent the culmination of several years of intense speculation that China would make more of an effort to manage its burgeoning reserves in order to maximize returns. Whether these two investment companies intend to diversify the reserves by investing in non-US assets is anyone’s guess, but at the very least, the US cannot be certain that China will continue to support the USD through its purchase of US Treasury bonds, which offer minimal yields.

Read More: China to set up firm for managing forex reserves

The European Central Bank (ECB) is scheduled to meet tomorrow to mull the region’s monetary policy. With the Euo/USD exchange rate relatively unchanged over the last couple months, investors will be closely eying the ECB for signals about the direction of European interest rates over the coming months. The consensus is that the Bank will leave rates unchanged at the current meeting, but commentators have been quick to point out that inflation is slowly inching up, which could precipitate future hikes. Either way, Jean Claude Trichet, the notoriously transparent president of the Central Bank, will likely give investors a very clear picture of where he expects European interest rates will move in the near-term. DailyFX reports:

CB President Jean-Claude has been eager in the past to correctly steer market expectations, so if there is a chance of further hikes beyond March, the central bank will not want markets to totally dismiss the possibility of further moves.

Read More: Euro Price Action Contingent on ECB Decision, Commentary by Trichet

The European Central Bank (ECB) is scheduled to meet tomorrow to mull the region’s monetary policy. With the Euo/USD exchange rate relatively unchanged over the last couple months, investors will be closely eying the ECB for signals about the direction of European interest rates over the coming months. The consensus is that the Bank will leave rates unchanged at the current meeting, but commentators have been quick to point out that inflation is slowly inching up, which could precipitate future hikes. Either way, Jean Claude Trichet, the notoriously transparent president of the Central Bank, will likely give investors a very clear picture of where he expects European interest rates will move in the near-term. DailyFX reports:

CB President Jean-Claude has been eager in the past to correctly steer market expectations, so if there is a chance of further hikes beyond March, the central bank will not want markets to totally dismiss the possibility of further moves.

Read More: Euro Price Action Contingent on ECB Decision, Commentary by Trichet

In response to an outpouring of anger and frustration by EU officials that the subject of the Japanese Yen be discussed at this week’s G7 meeting, US Treasury Secretary Henry Paulson has publicly stated that he does not believe there is anything to talk about. For two years, the Yen has remained the world’s most conspicuously undervalued currency. American trade lobbyists and EU trade officials insist it is because of the perceived threat of intervention by the Central Bank of Japan should the currency ever appreciate. However, most traders and financial economists would tell you that the cause is simple: low Japanese interest rates have resulted in carry trading, which by definition puts downward pressure on the Yen. It is on this side of the fence that Paulson seems to be standing. Reuters reports:

“I think the big point I made at the hearing yesterday was that — in counter-distinction to China — the Japanese have a currency that is traded in an open and competitive marketplace based upon economic fundamentals,” Paulson said.

Read More: Paulson satisfied yen value set by markets

The USD has begun 2007 in neutral, idling against most of the world’s currencies, even gaining a few PIPS. However, this current period most likely represents a respite-rather than a reversal-from the USD’s long-term downward trend. The fundamentals behind the USD haven’t changed; if anything, they have worsened. Meanwhile, as the price of oil sinks back to sustainable levels and Central Banks move to diversify their reserves, governmental demand for USD-denominated assets may begin to stall.

The British Pound and Euro represent suitable alternatives to the USD. Both are strong currencies backed by political and monetary stability, as well as strengthening economies and rising interest rates. Risk-averse investors can already earn comparable returns from the side of the Atlantic opposite the US. In addition, as European capital markets expand and develop, foreign investors are discovering new assets to scoop up. Private equity and other forms of alternative investing are booming in Britain and the EU, which means even investors in search of risk have options in Europe.

Moreover, Asia and the Middle East are in early stages of developing regional currencies, which would also pose a threat to the dominance of the USD as the world’s reserve currency. As the global economy becomes more stable and as European and Asian capital markets surpass their American counterparts in size and clout, investors will no longer feel compelled to pool their wealth in American securities.

As former Treasury Secretary Robert Rubin recently noted, the only thing that is propping up the USD is that the demand for US assets (i.e. stocks and bonds) still exceeds supply. However, as equity prices approach levels never before seen and as the supply of bonds either dries up or yields are driven down to completely unattractive levels, the US will certainly lose its appeal to foreign investors and the USD will follow the foreign demand for US assets downward.

The Yen is by far the weakest major currency in the world, having recently touched an all-time low against the Euro and a four-year low against the USD, despite strong economic fundamentals and a positive current account balance. It has been reported exhaustively that the cause of the Yen weakness are low interest rates, which has spurred investors to borrow cheaply in Yen and invest in higher-yielding currencies. Even domestic Japanese investors are exerting downward pressure on the Yen by shifting funds abroad in the search for yield. The lower the Yen drifts-in complete defiance of economic fundamentals-the greater the risk a sudden reversal poses to global forex markets; at this point, it could be devastating. The Wall Street Journal reports:

The extent of this kind of trading is notoriously difficult to measure. But, according to a Jan. 26 report by Barclays Capital, the magnitude of yen-funded carry trades “is reaching scary levels” not seen since 1998.

Read More: As Yen Slides, Fears Mount Of a Shakeout