Most Dollar bulls cringe when they hear the word “diversification.” Within the context of forex, diversification usually refers to the shift towards non-Dollar denominated assets among Central Banks.  The thinking is that with the declining Dollar, it probably makes sense to hold reserves in non-US investments.  However, analysts have begun to realize that this only represents a small segment of entities that could harm the Dollar by diversifying.  The world’s Central Banks probably hold at most $5 Trillion of reserves, whereas US institutional investment funds probably have over $20 Trillion collectively invested in US assets.  Thus, diversification in this segment probably poses a much greater threat to the long term health of the USD.  The Economist reports:

American mutual funds have gradually increased their overseas allocation of equities since 2003 from 15% to 22.5% of assets. If this portfolio shift mirrors the behavior of all pension, insurance and mutual fund managers, it would imply an outflow from dollar assets of $1.16 trillion since 2003.

Read More: Soft currency

Last week witnessed a sudden unwinding in the yen carry trade, as a global market downturn affected investor sentiment towards risk. Volatility is the only market force that could seriously contend at collapsing the carry trade, and last week produced significant volatility. All of the world’s majors fell against the Yen, namely the New Zealand Kiwi, which fell by 7.5%. The kiwi, you may recall, has been one of the main currencies on the other end of the carry trade, due to its high interest rates. However, analysts are reluctant to proclaim an outright end to the popular carry trade, preferring to wait and see how volatile the world’s capital markets appear in
the coming weeks. The Financial Times reports:

The wave of risk reduction also prompted investors to take profits in the Australian and New Zealand dollars, which have surged this year from central bank credit tightening or expectations of more tightening to come.

Read More: Yen hits 3-month high versus euro

Nearly one year ago, Thailand’s military overthrew the government in a bloodless coup, and commentators immediately began painting doomsday scenarios around the country’s economy. Since then, the Thai economy has surged, and the Baht has appreciated by over 20% and isn’t showing any signs of slowing. In response to concerns that the rising currency would begin to hinder exports and economic growth, Thailand has introduced a spate of measures designed to hold the currency in check. Namely, Thai businesses and citizens will be afforded more flexibility in transferring money outside of the country and keeping Thai currency in offshore accounts. MarketWatch reports:

“In the absence of a clear softening in the currency’s upward momentum, we expect Thai authorities to continue to apply a variety of measures — including further reductions in interest rates…”

Read More: Thailand relaxes currency rules to curb baht

The Euro’s rise against the USD over the last year has been swift and unimpeded.  Many commentators have theorized that it is intense pessimism surrounding the US economy and economic conditions-namely the burgeoning twin deficits-that is responsible for the Dollar’s demise.  Now, a new theory is being batted around, one that is quickly gaining traction with analysts:
perhaps it is optimism directed towards the EU economy rather than pessimism towards the US that is causing the Euro to spike.  After all, the European economy has rebounded nicely and boasts stable monetary and trade statistics. However, this notion of European optimism, if it in fact exists, has some analysts worried that the markets are becoming too optimistic, and that if they are not careful, they will end up wrecking the European economy by driving up the Euro too high. The Times Online reports:

If the euro keeps rising without limit, Europe’s export industries will be decimated, as they were not only in Britain, but also in America in the mid-1980s and also in Japan after 1995.

Read More: The euro’s rise and rise is unsustainable

The story behind the Dollar’s decline contains two threads:
narrowing interest rate differentials and growing concerns surrounding the US economy. With most of the industrialized world’s Central banks not scheduled to meet again for a few weeks, the interest rate story can temporarily be placed on hold in favor of the economic story, which is becoming uglier every day. The centerpiece remains the US housing market, which many analysts believe will soon slide into a major rut. There is a great deal of uncertainty over whether homes can retain their value and if borrowers will be able to pay off their mortgages. Rising rates have squeezed many low-income, high-risk borrowers, causing a crisis of growing proportions in the market for mortgage-backed securities, which is at risk for spreading to other areas of securities markets. Forbes reports:

“Credit concerns, rating reviews, yields tumbling; it has been one-way traffic against the dollar in recent minutes and euro/dollar has rallied up a fresh all-time high.”

Read More: Dollar slump sends euro
to record high

The Economist just released its an updated iteration
of its famous Big Mac Index, underscoring growing disparities in currency valuations. For those of you that aren’t familiar, the Big Mac Index uses the price of a McDonald’s Big Mac sandwich in different countries as a proxy for measuring purchasing power parity (ppp), that perennial staple of economics that theorizes a country’s currency and its inflation rate should move in opposite directions. Thus, where a Big Mac is observed to be more expensive than in the US, it would suggest that country’s currency is overvalued relative to the USD. Of course there are numerous other factors in the local price of a Big Mac, including raw materials and taxes, but the index still packs a pretty profound punch. Unsurprisingly, the most undervalued currencies can be found in Asia – notably the currencies of Japan, China, Thailand, Indonesia, etc. The most comparatively expensive Big Macs (and hence most overvalued currencies) can be found in Europe, especially in Scandinavia and Northern Europe.

Read More: The Big Mac Index

The Norwegian Krone is certainly not a very popular currency among participants in the forex markets.  Nonetheless, the currency has enjoyed a strong year, having moved away from clinging to the coattails of the Euro and has actually surpassed the common currency by a considerable margin.  In fact, the Krone recently touched a 10-month high against the Euro, and a multi-year high against the USD, spurred on by a rate increase by the Central Bank of Norway.  In addition, the consensus among analysts is that the Central Bank will hike rates several more times over the next year, bringing the benchmark rate to 5.75% by 2008.  Surely, the most opportunistic among us has already begun searching for a broker that facilitates trading in Krone!

Read More: Norwegian krone jumps as central bank hikes interest rates

With the Euro handily outperforming the USD, Japanese Yen and certain other major currencies, many EU leaders have begun lamenting the impact they foresee on the EU economy. As most amateur economists are doubtlessly aware, however, there is a tradeoff between control over one’s currency and control over one’s domestic economy. In other words, if the EU acted in concert to hold down the value of the Euro, the ability of the European Central Bank to conduct monetary policy would be severely constrained. Accordingly, Jean-Calude Trichet, President of the ECB, is insisting that any efforts directed towards holding down the Euro be political, rather than economic in nature. Surprisingly, he is not opposed to EU political leaders holding talks with their Japanese and possibly American counterparts to discuss the growing perceived “misalignment” between the Euro and the Dollar. The Financial Times reports:

Mr Trichet had made it very clear in his comments to the European Parliament last week that there should be a dialogue between European countries and their partners over currency matters.

Read More: View of the day: Currency Misalignment

Since it was freed from its fixed exchange rate regime two years ago, the Chinese Yuan has appreciated nearly 9% against the USD. While the Yuan’s exchange rate is clearly managed by the Chinese government, many commentators agree that its rise has given off the aura of a floating currency. One economist thinks China will cement this perception the conclusion of the Beijing Olympics-to be held in 2008-and allow the currency to float freely, at which point it could surge by as much as 10% against the USD. Evidently, China is growing tired of the lack of control it has over its domestic economy due to its exchange rate policy and is clearly overwhelmed by the need to continue growing its forex reserves (which now stand at $1.33 trillion) in order to control the Yuan. Bloomberg News reports:

“They have to adopt a free-float system; it’s not a question of whether they will, but a question of when. After the Olympics, the new leadership will be firmly in place.”

Read More: Yuan May Trade Freely After Olympics, UOB’s Suan Says

It has been a while since forex markets have been as focused on interest rate differentials as they are now. With the exception of the Canadian Loonie and Australian Dollar, all of the world’s major currencies are rising and falling almost entirely on the basis of interest rates. Until recently, the USD had forestalled its inevitable decline because interest rate levels were significantly higher than in other countries, and foreigners remained willing to finance the US trade deficit. Since the respective Central Banks of Britain and the EU began hiking rates, however, the Euro and British Pound have risen while the Dollar has plummeted. 

Meanwhile, the Japanese Yen is near historic lows because carry traders are borrowing at low Japanese rates and investing abroad. On the flipside, the New Zealand Dollar has surged, and the country is having a difficult time keeping investors away because its interest rates are so high. Interest rates have achieved such force that even changes in expectations, rather than changes in actual rates, are now more than capable of moving the market significantly.

Read More: Back to Interest Rate Expectations

If you’re interested in a financial career, you might be curious about how your interests can lead to reconciliation between your job and your belief system. Social finance might open the door to several solutions for your dilemma. While social financing might seem new, it’s been around since the first individual took a stand against profit at any cost. A Quaker would no more finance slavery before the Civil War than a conscientious objector would finance war machines today.

Before you have an epiphany about your career goals, you might want to learn more about the various facets within social financing, the career opportunities that are open to you, and the education you may need to pursue your dreams.

These days, the US economy seems to rise and fall on the wings of the housing sector.  Unfortunately, this sector is in a tailspin as higher interest rates have left many homeowners unable to pay their mortgages, causing a crisis in the oft-cited subprime market.  Already, several hedge funds have nearly collapsed due to subprime mortgage uncertainty, and nearly 600 portfolios of subprime mortgages (representing $12 Billion) have been downgraded as a result of declining creditworthiness.  Investors fear that instability in the subprime market could spread to the rest of the US economy and/or drive the Federal Reserve Bank to lower interest rates, which would narrow the interest rate differential between the US and most of the west. Reuters reports:

Lower U.S. bond yields arising from problems in the subprime sector have diminished the allure of U.S. Treasury debt. The yield on the benchmark 10-year U.S. Treasury note…is at 5.08 percent, down from about 5.29 about a month ago.

Read More: Dollar hits record low vs euro on subprime woes

The Japanese Yen has slid to a record low against the Euro, with no obvious end in sight to the wounded currency’s multi-year decline. The basis for the continued yen weakness is the expectation that Japan will hold interest rates at current levels until the end of the summer, a notion that was reinforced by the Bank of Japan yesterday. As a result, carry traders, who categorically fear volatility, can feel confident that a continued low interest rate environment will support the viability of the Yen carry trade in the short term. However, there are a few risks in the horizon, namely that Japan’s economy and stock market are outperforming and could prompt a series of rate hikes in the fall and lure Japanese capital back to Japan. DailyFX reports:

The rallies are becoming overextended of course and the risk of some action by the Japanese government is increasing, but until carry traders have a reason to bail, they probably will not.

Read More: Japanese Yen Continues to Fall

The political furor surrounding the soaring Euro is reaching fever pitch, as European politicians clash with central bankers over the role of the state in determining exchange rates. Jean-Claude Trichet, President of the European Central bank (“ECB”) has argued that the Euro should be valued strictly by the markets. Politicians from EU-member states, on the other hand, have frequently argued that the surging Euro is hampering economic growth and should be used as a tool in economic policy-making. The newly-elected president of France, Nicolas Sarkozy, has been a vocal critic of the ECB, arguing that the Euro should actively be held down. The Financial Times reports:

In contrast to the US and Japan, where the finance ministry sets the exchange rate regime and intervenes in exchange markets, eurozone central banks hold and manage foreign exchange reserves and have responsibility for any market intervention.

Read More: ECB takes aim at Sarkozy over euro

The Bank of England raised interest rates for the second time in as many months yesterday, to 5.75%. As a result, the UK has widened its lead over the US as the country with the highest interest rates in the industrialized world, after New Zealand. Moreover,  the UK is becoming an increasingly viable alternative to the US as a target for risk-averse investors. The British Pound is hovering around a record high against the USD, which can probably expect to suffer prolonged decline against the world’s majors if it falls behind in attracting risk-free foreign capital. The Financial Times reports:

“The statement accompanying the rate hike gives few firm clues as to future interest rate movements, with the Bank of England…concluding that the risks to the inflation outlook are still tilted to the upside.”

Read More: BoE rate decision boosts pound

Most commentators assume that the only thing currently keeping the USD afloat is high interest rates. While attractive rates have certainly encouraged an inflow of (risk-averse) foreign capital in the short term, they may ultimately be harming the currency in the long-term. In fact, the economic law of interest rate parity dictates that currencies and interest rates should move away from each other in the long term. Stated differently, high interest rates should imply a less valuable currency. Since US rates are among the highest in the world, the USD should decline in the long term in order to compensate US investors in foreign securities for the lower risk-free returns they are implicitly accepting.

The reasoning is simple enough: since the advent of currency futures, traders have been able to speculate on future exchange rates. In order for futures to be priced fairly (such that arbitrage is impossible) the difference between a currency’s current value and its implied future value should perfectly equal the difference between domestic interest rate levels and international interest rate levels. In the case of the US, bets on the USD made during the recent period that US interest rates have exceeded European and British interest rates, must have been predicated on a declining USD in the future, which is now the present.

Several months have now passed since China announced that it had created a state agency to oversee the investment of its foreign exchange reserves, the bulk of which are held in USD-denominated assets.  It now appears that the ensuing hysteria, which speculated that China would begin diversifying its reserves into other currencies, was overblown.  The same applies to speculation that other countries would follow suit.  In fact, the International Monetary Fund (“IMF”) announced today that fully 65% of the world’s forex reserves ($2.24 trillion) are still held in USD, which represents a 4% increase over last year. In short, the data suggests that all of the talk surrounding a shift away from the USD did not really translate into much action. The Economic Times reports:

Emerging market countries…are thought to be the main dollar holders. High oil prices bring dollars flooding into the Middle East, while in China’s case, intervention to keep the yuan weak keeps export revenues pouring into Beijing’s coffers.

Read More: Move away from dollar reserves still all talk