The Euro is currently hovering above its all-time high against the USD, and is flirting with levels never-before-seen in the Euro’s brief, eight-year history.  The Euro had
toyed with the record for the last couple of weeks, before finally breaching it upon last Friday’s release of US GDP data, which indicated the US economy had weakened to its slowest pace of growth in over four years. Investors are now waiting to see how the Fed responds to this latest development, as the bank has found itself in the unenviable position of navigating rising inflation and a slowing economy. Reuters reports:

Benign inflation data and modest growth in Midwest business activity provided more evidence of slowing U.S. economic growth, keeping sentiment bearish for the dollar, traders said.

Read More: Dollar stays near record low vs euro in quiet
trade

This week witnessed a flurry of economic data, capped by tomorrow’s scheduled release of employment and GDP statistics.  At the beginning of the week, the perennially pointless monthly durable goods statistics indicated a rise in durable goods orders, which Dollar bulls interpreted as a good sign.  However, real estate data indicated a lower-than-expected rise in new home sales as well as a dramatic decline in the sale of existing homes.  Polled economists are predicting that tomorrow’s news will likely fall into the dovish category, painting a picture of an economy that has already peaked and making the case for the Fed to hold interest rates at current levels.  However, the bond markets are still pricing in 1-2 rate hikes over the near-term, which currency markets may use to prop up the Dollar.  The Daily Reckoning reports:

Money supply growth has a negative impact on the dollar. Inflation is a currency killer, and looking at the broadest measure (M3), money supply growth is out of control.

Read More: Currency Markets Take a Rollercoaster Ride

The Euro is quickly closing in on its all-time record against the USD.  The record exchange rate was clocked in December 2004, at $1.37 Euro/USD, but I suppose records exist for the sole purpose of being broken.  Besides, it was never really a question of if, but rather when the Euro would smash through the record.  If current trends continue, it looks like the when will be sooner rather than later, since the European economy appears to be entering a period of pronounced growth while the US economy has probably already peaked.

Analysts are now predicting that the European Central Bank will raise its benchmark lending rate by 25 basis points to 4% at its June meeting, which should give the Euro a further boost.

Read More: Euro nears record high against dollar

Despite a surging economy, Vietnam’s currency, the Dong, has managed to escape the attention of international traders and investors.  Last year, Vietnam registered the strongest economic growth in Southeast Asia, at 7.7%, and is projected to grow by over 8% this year.  However, due to a devaluation program maintained by the government to support the Vietnamese export sector, the Dong has remained low.  In addition, the government does not allow speculators to buy Vietnamese currency unless it is being used for a specific purpose, typically investment.  As a result, the market for currency derivatives is beginning to take-off in Vietnam, as speculators seek a means of capturing some of the strength in Vietnam’s economy that is sure to lift its currency.  The International Herald Tribune reports:

Vietnam this year ended a decade-long policy of “managed devaluation” that caused the dong to weaken 30 percent. The central bank will “keep the dong stable, in a flexible manner, so that it can help our exports,” said one analyst.

Read More: Currency is Vietnam’s new lure

“Pick your battles,” seems to be the mantra that Jean-Claude Trichet, President of the European Central Bank (“ECB”), is currently living by.  While the Euro is slowly inching closer to record levels against the USD, Trichet has largely been content to focus his energy on a different nagging currency: the Japanese Yen.  Trichet has invoked the phrase “two-way risks” in cautioning investors to beware the enormous potential upside of the Yen.  Trichet realizes that the Japan-EU interest rate differential, manifested through the carry trade, is responsible for the diverging Euro-Yen exchange rate.  Ultimately, it remains unclear whether the EU will continue to limit itself to rhetoric in the battle to hold down the Euro, or whether it will use more heavy-handed tactics.  Forbes reports:

“We believe the Japanese economy is on a sustainable path and that foreign exchange rates should reflect that,” Trichet said.

Read More: ECB’s Trichet says currency markets should be
aware of ‘two-way risks’

While the foreign exchange reserves of China and Japan attract the brunt of the media’s attention, India’s reserve are slowly creeping up.

Over the last two years, India’s reserves have surged by $60 Billion, and now exceed $200 Billion.

There are only five countries with reserves greater than those of India: the aforementioned China and Japan, as well as Russia, Taiwan and South Korea. As India’s economy has taken off, the reserves of its Central Bank have grown proportionately, such
that India is now exposed to a great deal of exchange rate risk; should its currency, the Rupee, appreciate, the value of its reserves will fall.  Just when you thought things couldn’t get any worse for the Dollar…

Read More: India’s forex reserves at $200 billion

As the Euro has gradually risen over the last year, EU leaders have been conspicuously silent.  Sure, generic comments had been made lamenting “volatility” in the forex markets.  But few politicians had made overt declarations that Euro’s appreciation was a matter that merited attention from EU member governments. This week, the silence was broken, as two notable politicians, the Prime Minister of Luxembourg and the Finance Minister of France, commented on the Euros’ appreciation, going so far as to discourage market participants from coaxing the Euro upward. IOL News reports:

“The markets should not embark on one-way bets.” Asked about the apparently resigned attitude of European countries…on exchange rates, Juncker [Luxembourg’s PM] hinted that there was more attention paid to the euro’s strength than reflected in the final statement.

Read More: EU finance chiefs to focus on surge of euro

In recent years, the performance of the USD has been dismal. The currency is near historic lows against most of the world’s major currencies (with the notable exception of the Japanese Yen), and in fact, just yesterday, the USD dropped to a 15-year low against the British Pound.  And yet, it is my belief that when all is said and done, the USD will have fallen much further in value.  You are probably wondering, ‘If the USD has already depreciated significantly, how could it still be overvalued.’

The answer is simple: the USD is currently suffering a correction relative to other currencies. Simply put, economic fundamentals and monetary benchmarks are becoming stronger in other countries, which is putting downward pressure on the USD, relative to other currencies.  The decline that I am presaging is a decline in the absolute value of the USD, which is more of a structural change in the USD than a financial or economic change. 

The primary driver of the decline of the Dollar is inflation. On the surface, inflation has been stable over the last decade, averaging about 3% per year.  There are a few things worth noting here. First, this statistics does not services for which prices are rising much faster than the general rate of inflation, such as taxes, education, and health insurance. Second, and perhaps more importantly, this statistic is net of the deflation that is wrought by inexpensive foreign-produced goods. In other words, if cheaper imports save us 3% annually, then domestic inflation is probably closer to 6%. When outsourcing the production of key goods and services no longer produces savings, then consumers can expect a rise in overall rate of inflation.

It should also be noted that since the stock market crash of 1929, the Dollar has lost 95% of its value, whereas in the previous 125 years, the purchasing power of the USD had hardly changed.  Meanwhile, the twin deficits (trade deficit and budget deficit) have ballooned, to the extent that the national debt now measures approximately $9 Trillion and the annual US trade deficit is fast approaching $1 Trillion!  The result is that the government has been forced to print tremendous amounts of new paper money.
This phenomenon is evident in US capital markets, where yields are anomalously low, credit spreads are non-existent, corporate earnings are at record levels, and there is a general excess of liquidity. 

The bright side is that this trend could be reversed if the government was able to balance its budget.  However, this is probably impossible since some estimates of the government’s future liabilities exceed $50 Billion, which would be required to plug the holes in social security and other government entitlement programs. Some sectors of the market have already sprung into motion: the price of gold, which is normally used to hedge inflation, has doubled over the last decade. Central Banks are formulating plans to diversify their foreign exchange reserves (i.e. get rid of USD assets as fast as possible before the currency depreciates further).

Since 1992, two macroeconomic events had not occurred in Britain: price inflation has no exceeded 3% annually and the British Pound has not surpassed the $2 barrier.  Both events were realized today, however, as an early-morning release of economic data indicated inflation in Britain was hovering around 3.1% and the British Pound quickly rose above 2 USD/Pound.  Interest rate futures also witnessed an immediate correction, to the extent that the markets are now pricing in a British benchmark interest rate of 5.75% 6 months from now, .5% above the current rate.  Meanwhile, US inflation statistics were dovish, suggesting the gap between British and US interest rates is set to widen, which should propel the Pound further upwards.  The Financial Times reports:

There is little that is inevitable about currencies moving in line with expected interest rates and nothing in long-term trends that allows people to predict currency movements in connection with inflation and other variables. But on Tuesday, the currencies moved exactly as if they were linked to the inflation figures by an umbilical cord.

Read More: Pound rises on prices and rates fears

Several months ago, I wrote a commentary piece on why it was wise for forex traders to abandon in the carry trade in favor of more innovative trading strategies.  I may have to eat my words, since interest in the carry trade hasn’t waned as expected, but rather has grown.  Economic data support the notion that the carry trade is almost fully responsible for the plight of the Yen, as Japan is experiencing a net outflow of capital on paper.  Anecdotal evidence is also abounding; dozens of forex firms have sprung in Japan to help retail investors take advantage of the declining Yen.  Meanwhile, when probed on the issue, the Chief Economist of the International Monetary Fund (“IMF”) indicated that he does not think it necessary for Japan to intervene in forex markets and prop up the Yen.  Dow Jones reports:

“The weakness of the yen in particular suggests that the forthcoming G7 meeting is having little impact on market psychology and focus is instead on declining volatilities, which has served to attract market flows back into carry trades.”

Read More: Interest In Carry Trades Likely To Intensify

Last fall, China’s reserves officially surpassed the $1 Trillion mark, a watershed event that would have been nearly unthinkable several years ago.  This week, China announced that its reserves now exceed $1 Trillion, having grown by almost 40% year-over-year and showing no signs of slowing.  Most of the increase can be attributable to growth in China’s trade surplus, which now exceeds $40 Billion, on a quarterly basis.  China has already delegated the management of $250 Billion of its reserve to a state agency; perhaps this latest development will compel it to further delegate active management of the reserves.  Xinhua News reports:

Continuous growth of forex reserve has in fact increased the pressure on appreciation of the Chinese currency, which in turn has exerted greater pressure on value preservation of China’s forex reserves, which are estimated to reach 2.9 trillion U.S. dollars in 2010.

Read More: China’s forex reserve tops 1.2 trillion USD

Six years ago, Brazil’s economy was in shambles, annual price inflations routinely exceeded 10%, and Brazilian interest rates were hovering around 20%.  Its currency, the Real, traded at roughly 4/USD.  Flash forward to the present: Brazil’s economy is now on solid footing, inflation has been held in check, and Brazilian asset prices are strong.  The result is a much stronger Real, which has doubled in value since 2002. Of course, many analysts have been quick to point out that the Real is benefiting from high commodity prices, which are unlikely to be sustained in the medium-term.  The Financial Times reports:

Brazilian assets suffered during recent nervousness over the troubled US mortgage market. But this seems to have passed and confidence in the global economy and strong commodity prices have caused a return of investment flows.

Read More: Brazilian currency set to hit fresh peak

To no one’s surprise, the Bank of Japan has announced that it would maintain Japanese interest rates at the current level of .25%.  Carry traders seized upon the opportunity to continue borrowing Yen at near-record lows, and selling the Japanese currency in favor of higher-yielding alternatives.  In fact, the news was met with such gusto that the Euro was almost immediately propelled to an all-time high against the Yen, which continues to plumb the depths of forex disfavor.  At this point, analysts and economists are feeling fairly certain that Japanese interest rates will remain at current levels in the near-term, a sentiment which supports the viability of the carry trade. Forbes reports:

One analyst commented: “with BoJ expectations stable, currency market volatility subsiding and risk aversion abating, carry trades are recovering, keeping the yen under pressure.” He sees no immediate catalyst for a yen recovery.

Read More: Euro hits record high against yen as carry trades continue

In theory, trading in capital markets should be a zero-sum game; since all participants are seeking to maximize profits, one participant’s gain should come at the expense of another.  Forex markets, however, appear immune to this phenomenon, due to the presence of participants that don’t seek to necessarily maximize profits.  Stated another way, there are many participants that exchange currencies because they have to (i.e. tourists, exporters/importers) or because they are trying to achieve political/economic ends (think central banks).  Such participants’ relative price inelasticity generates excess profits that can be extracted by shrewd traders: they key is having a strategy, such as carry trading, momentum trading, or fundamentals trading.  The Economist reports:

[Forex] returns do not appear to be correlated with the other main asset classes of shares and bonds. A currency fund can thus be a useful source of diversification for the average investor’s portfolio, improving the trade-off between risk and reward.

Read More: Soros on the cheap

The demise of the USD continues, as the Euro rolls in the opposite direction, touching a two-year high against its American counterpart currency.  Analysts attribute the Euro’s sudden resurgence to the opposite directions that EU and US monetary policy appear to be headed.  In America, the question is no longer if rates will be lowered, but rather when they will be lowered.  Meanwhile, as Europe’s economy expands on the heels of export growth and strong industrial activity,
prices are rising and the European Central Bank is talking about raising rates. Bloomberg News reports:

ECB President Jean-Claude Trichet said he wants to ensure price stability in the euro region. Interest-rate futures contracts show the ECB is likely to raise borrowing costs by a quarter-percentage point by September while the Fed makes cuts.

Read More: Euro Jumps to Two-Year
High Versus Dollar on ECB Rate Outlook

Most analysts reckon that the USD has resumed its downward path against the world’s major currencies, after a two month hiatus.  The fear is that the mess in the real estate market (via subprime mortgages) will spread to the rest of the economy, with loan defaults and a decline in consumption.  In such a case, the Federal Reserve Bank would be forced to cut interest rates dramatically in order to prevent the US from sinking into a full-fledged recession, which would decrease the relative attractiveness of US assets.  Traders will be eying a couple pieces of economic data this week for any indication as to the direction of the economy. 

The Wall Street Journal reports:
This week’s data parade is bracketed by two key releases: Monday’s national report on U.S. manufacturing activity in March from the Institute for Supply Management and Friday’s payrolls report.

Read More: U.S. Economic Reports Could Ease Dollar’s Woes

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China, which recently unveiled plans to set up an agency under the aegis of the state that would manage the country’s surging forex reserves, is having second thoughts of sorts.  While the plan to more actively manage its reserves remains on coarse, the likelihood that this result in diversification has been somewhat diminished.  Estimates of the fraction of China’s reserves held in USD-denominated assets fall in the 70% range, which means that any decline in the USD could have multi-billion dollar ramifications for the value of China’s reserves.  And surely diversification would put tremendous downward pressure on the USD, which means China would likely experience the offsetting of gains from diversification with the relative decline in the value of its USD-denominated assets.  Forbes reports:

“Everyone knows that they should try to cut their US dollar assets. But, of course, if China wanted to make such a move, a big cut, our losses would be large as well. That would be very difficult to do.”

Read More: China diversification away from dollar would mean forex losses