As 2007 draws to a close, the Forex Blog would like to formally deliver its second annual ‘state of the markets’ address. While the picture in most capital markets was blurry and nuanced, the story for forex markets was relatively straightforward. Simply speaking, the story was all about the US Dollar, which followed up its worst year in recent memory in 2006 with an equally abysmal performance in 2007. In fact, over the last two years, the Dollar has fallen over 20% against the Euro, and even further against most of the world’s other important currencies.

During the early part of the year, evidence mounted that the current US economic cycle had peaked, and analysts began to speculate that the US Federal Reserve Bank would cut interest rates. Nonetheless, the Dollar traded sideways for the next nine months, until the housing bubble burst and the ensuing credit crisis quickly metastasized to the rest of the economy.  The Fed responded by cutting interest rates by 50 basis points, and the Dollar began to unravel, losing 10% of its value in a matter of weeks.  After that point, the bad news began to pour in.

The oil-exporting countries delivered a one-two punch to the Dollar, first by announcing that the possibility of accepting payment for oil in other currencies, than hinting towards a collective dissolution of their respective Dollar pegs. The Canadian Dollar reached parity with its counterpart to the south shortly thereafter.  Countries in the developing world, including Brazil, Russia, and India, also witnessed surges in their respective currencies. The Chinese Yuan continued its slow climb, rising over 6% for the year, though this figure is probably closer to 2-3% in real terms. Even the Japanese Yen, previously held in place by the carry trade, notched an impressive performance as the credit crunch touched off a cascade of risk aversion.  Then, of course, there was the interest rate story: by the end of the year, US interest rates were only 25 basis points above EU rates, and Dollar bears were licking their lips.

The news was not all bad, however.  Foreign investors proved that they were willing to continue to finance the US twin deficits, though perhaps to a lesser extent than before.  There were even several high-profile investments in US financial institutions, led by Sovereign Investment Funds, which collectively claim hundreds of billions of dollars at their disposal.  In addition, the world’s Central Banks announced plans to pump over $500 Billion into global capital markets, which should especially benefit the Dollar since the US bore the brunt of the credit crunch.  Finally, economic data now indicate that US exports have been helped by the declining dollar. 

All things considered, it could have been worse.  Tune in later this week, as we unveil our forecast for 2008.

Earlier this week, the Chinese Yuan recorded its highest one-day increase in value in the two years since it was famously revalued against the Dollar.  The currency rose nearly .4% and prompted renewed speculation that China’s Central Bank will either widen the trading band to .8% or will generally allow the currency to appreciate faster.  In fact, the political and economic consensus continues to maintain that the Yuan is not appreciating rapidly enough.  While it rose over 6% against the Dollar, for example, it actually lost value to several of the world’s major currencies.  Furthermore, its decline against the Dollar is less impressive when China’s skyrocketing inflation rate and burgeoning trade surplus are taken into account.

There are still a few analysts who are bucking the trend and arguing that the Yuan is fairly valued.  This notion is supported by a recent World Bank analysis, which updated its calculation of China’s purchasing power and reduced its PPP-equivalent GDP in the process. However, this opinion is echoed by only a small group of analysts, and an overwhelming majority continues to call for and anticipate a further appreciation of the Yuan.  Bloomberg News reports:

Forward contracts show traders are betting on an 8.7 percent advance in the yuan to 6.7344 per dollar in the next 12 months. The median estimate of 28 analysts surveyed by Bloomberg News is for a rate of 6.88 by the end of 2008.

Read More: Yuan Rises Most Since End of Peg as China Seeks to Curb Prices

Forex is becoming hot!  Average daily volume has surged past $3 Trillion, as the credit crunch has increased volatility and the Dollar has collapsed.  In fact, Saxo Bank, one of the most prominent acts in retail forex trading, may record $500 million in revenue this year.  As a result, several of the world’s largest investment banks have announced plans to enter the burgeoning retail forex market.  Citigroup is teaming up with a Danish bank to offer online currency trading.  Deutsche Bank is stepping up marketing of its proprietary retail trading platform.  Even Goldman Sachs is entering the fray, via a 10% investment stake in a British retail forex company.  However, not everyone is optimistic, reports GulfNews:

Some think the reputational risks of enabling individual investors who may not be able to afford to lose substantial sums in what are notoriously volatile markets outweigh the possible revenue stream.

Read More: Global banks compete for growing forex business

The Yen has received a nice boost from Japanese exporters, which moved en masse to exchange Dollars for Yen to meet certain year-end financial obligations.  The logic is that exporters had owed money in arrears to domestic Japanese producers of the goods and services being exported and needed to be paid in Yen. Such logic could theoretically be applied to exporters in ever country, which would provide the same boost to their respective currencies.   However, in addition to being the world’s fourth-largest exporter, Japan’s economy is unusually dependent on exports.  Thus, it is understandable that Japanese exporters could exert such influence on forex markets when entering the market at the same time.

Read More: Yen Rises on Speculation Japanese Exporters Buying the Currency

The British Pound has been reeling since the Bank of England cut rates at the beginning of this month, from 5.75% to 5.50%.  Last week, the minutes for the meeting were released.  They revealed that that members of the Bank were growing increasingly nervous about the state of the British economy and are worrying particularly about how fallout from the credit crunch will impact growth.  British interest rates are still among the highest in the industrialized world, behind only Australia and New Zealand.  Thus, it seems investors are punishing the Pound indirectly for the rate cuts, because of fears concerning the near-term prognosis for the British economy.  At the same time, the minutes indicated that members of the Bank were adamant about not lowering rates further, so some of the concerns may be overblown.

Read More:  Pound weakens after BoE minutes show concerns for growth

Despite its multi-year decline, the US Dollar remains the world’s undisputed reserve currency, claiming a 65% share of total Central Bank reserves. However, the chorus of soothsayers proclaiming the apocalypse for the Greenback is growing louder by the day. Every week seems to offer a new piece of news confirming that the Dollar’s reign is coming to an end. Analysts are drawing parallels between the British Pound of 50 years ago and the Dollar today. China is threatening to diversify its reserves into Euros. Iran and Venezuela are leading calls to price oil in terms of a basket of currencies, rather than in USD. The other members of OPEC are considering de-pegging their respective currencies from the Dollar. What does all of this mean? Is the Dollar truly in danger of being replaced as the world’s reserve currency?

The short answer is ‘no.’ The US twin deficits have expanded every year for the past decade and economic theory suggests that in order for a nation’s current account to rebalance itself, a decline in the value of its currency is required. At the same time, these deficits are sustainable for as long as foreign investors, sovereign and private, are willing to sustain them. And despite the looming threat of recession, economic data and anecdotal stories suggests that such investors remain willing to lend their financial support. For example, the announcement of record-breaking losses by American financial institutions has been met with solid commitments to invest by international investors.

In addition, while foreign exchange reserve diversification is certainly justifiable from a risk management standpoint, it hardly makes sense from a financial standpoint. The case could have been made for foreign Central Banks to exchange their Dollars for Euros and/or Pounds several years ago when both currencies were trading at relative bargains to the USD. Now that these currencies are more expensive, it seems harder for to justify buying assets and securities denominated in them. Furthermore, Central Banks must recognize that diversifying now would be counter-productive, by sending a wave of panic through the markets and undermining their efforts. As one analyst pointed out, Japan and China, the two largest holders of USD, both have a vested interest in an expensive Dollar.

However, the long answer to the question posed at the beginning of this article is closer to ‘maybe’ than ‘no.’  In the long-term, Central Banks will certainly move towards a more diversified portfolio of currencies.  For countries like China and Japan, this will help minimize risk.  For countries in the Middle East that peg their currencies to the Dollar, this will enable them to conduct monetary policy independent of the US.  Ultimately, US capital markets are the most stable and liquid in the world, and regardless of the value of the USD, it will serve the interests of Central Banks to denominate a large portion of their portfolios in Dollars.  Besides, analysts can be extremely fickle. It was only five years ago that the Euro was trading below parity with the USD and analysts were predicting its collapse.  The fundamentals underlying both currencies have not changed much since then, yet commentators have reversed their positions. Who knows what such analysts will be preaching five years from now…

Since even before the dawn of the Forex Blog, commentators have been speculating that the US Treasury Department would officially brand China as a "currency manipulator" in its semi-annual report to Congress.  Such a label is important because it would enable the US to levy tariffs and other economic penalties against China.  However, another report has been issued, and one more time the Treasury Department glossed over China’s de facto control over the Yuan. The report did criticize China for failing to appreciate the RMB rapidly enough, since the 12% gains it has racked up over the last two years have been largely offset by inflation.  The report also referred to China’s widening trade surplus and accompanying growth in foreign exchange reserves.  US politicians, however, are less than pleased, and are preparing to take matters into their own hands.  The Associated Press reports:

"In refusing to brand China as a currency manipulator, which is so obvious, the Administration gives Congress no choice but to act on its own. This report is the strongest case possible for our legislation," said [one high-ranking Senator] Schumer.

Read More: US stops short of accusing China of currency manipulation

It’s been rough sailing for the Yen carry trade of late; the technique had been sagging in popularity due to the credit crunch and the associated trend towards risk aversion.  Over the last few weeks, however, the Yen has fallen, which is to say the Yen Carry Trade is making a comeback.  First came the announcement that the world’s leading Central Banks would be injecting hundreds of billions of dollars in the banking system, in order to ease growing liquidity concerns.  Next, the Bank of Japan hinted that it would hold rates at .5%, the lowest in the industrialized world.  Finally, a continued surge in commodity prices virtually ensures that countries rich in natural resources, such as Canada and Australia, remain viable "targets" for carry traders.  Overall, the story remains focused around volatility.  In fact, one investment bank discovered an inverse correlation between the S&P 500 and the Japanese Yen.  In other words, the appetite for risk appears closely correlated with the strength of global capital markets and the popularity of the Yen carry trade.  Bloomberg News reports:

Over the last fortnight, that odd correlation with equities has broken down…Instead the fundamental factors behind carry trades have come to the fore again. Investors are paying attention to Japan’s economy.

Read More: The resources to carry on

The return a hedge fund delivers is separated into alpha and beta; accordingly, the goal of of a good hedge fun manager is to deliver as much alpha as possible, whereby alphas is measured by the return generated in excess of beta, what is returned "naturally" by the market.  In the case of forex, the beta is effectively zero, since one currency’s gain is automatically another currency’s loss.  Thus, any and all return generated by forex investors is officially recorded as alpha.  Historically, forex was a bonanza for hedge fund managers that speculated exclusively on currencies, who averaged annualized returns of 12%, controlling for differences in trading strategies. 

That return has steadily dwindled, and in fact, the average professional forex trader lost 2.6% in 2006.  The reasoning should be self-evident: increased competition.  From the perspective of daily trading volume, participation in the forex market has tripled since 2001.  Arbitrage (buying in one market and selling into another) has steadily eroded returns to the extent that one online forex brokerage now quotes the bid/ask spread to five decimal places!  Fortunately, the evaporation of profits should drive many hedge funds out of forex in search of other investing opportunities, creating new opportunities in forex.  The Financial Times reports:

Volatility was now back to historic norms, aiding managers. "The last three years have been really quite disappointing for the industry and it needs to produce some gains in the next couple of years to justify its existence."

Read More: Dollar slide ‘hit currency managers’

After months of delay and perhaps overly wishful thinking regarding the global credit crunch, the world’s Central Banks are finally ready to take action. America’s Federal Reserve Bank will join forces with the Bank of Canada, the Bank of England, the European Central Bank and the Swiss National Bank as part of a concerted effort to introduce greater liquidity into global capital markets.  Under the plan, the Banks will auction off tens of billions of Dollars worth of bonds denominated in their respective currencies, and lend the proceeds to commercial banks.  The goal of the plan is to to limit growing risk aversion, which has caused banks to significantly rein in lending.  Further, while the move is designed primarily to boost confidence in equity markets, certain sectors of forex may also receive a bump.  High-yielding currencies such as the New Zealand Kiwi and Australian Dollar, which have been shunned in recent months, seem to be the most likely beneficiaries.  Forbes reports:

"If the market is convinced that central banks are finally doing enough to ease the liquidity situation we are likely to see the funding currencies (the yen and the Swiss franc) fall back, and higher-risk currencies like the Aussie and Kiwi currencies, rally."

Read More: Dollar rises as Fed, other central banks move to shore up liquidity

The Organization for Economic Cooperation and Development (OECD) recently issued a report on the Chinese Yuan, which thoroughly assessed the currency’s appreciation since it was “revalued” over two years ago.  While the Yuan has technically risen over 10% against the USD, the OECD concluded that in real terms, the currency has actually fallen. The official rate of inflation hit 6.5% this year, and international economists reckon the true figure is probably much higher. Furthermore, the
government recently revised its estimate for full-year GDP growth to 11.4%, which means price levels may rise further, eating into the real value of the RMB.  In fact, the OECD estimates that the Yuan remains undervalued by as much as 40% and views the “solution” as a combination of tighter monetary policy and looser exchange rate policy.  The Associated Press reports:

While the report did not directly criticize China’s foreign exchange controls, it noted that efforts to tighten money supply to counter inflation were not having much impact.

Read More: OECD Says China Grip on Yuan Too Tight

Interest rates seem to be dominating forex newswires this week.  Yesterday, it was reported that the ECB insinuated that it will hike rates at its meeting next month.  meanwhile, America’s Federal Reserve Bank will probably cut rates at its meeting later this week.  Fortunateky for Dollar bulls, the consensus is that the Fed will only be cutting rates by 25 basis points, instead of the 50 that was predicted last week, bringing the benchmark Federal Funds rate down to 4.25%, and narrowing the gap with EU rates to 50 basis points.  However, if the rate cuts do what ther supposed to do, then the US economy should be eased out of the credit crunch and brought back to life, which would spell good news for the USD.

Read More: Dollar slips as focus turns to expected US rate cut

While holding rates steady at its meeting last week, the European Central Bank (ECB) raised the possibility of a rate hike at its next meeting, which is to be held on January 10.  Jean-Claude Trichet, President of the ECB, was especially forthright: "we will not hesitate to hike rates."  The Bank’s hawkish comments owe to a spate of recent economic data, which point to a strengthening Euro-zone economy.  At the same time, however, political pressure from certain EU member states is mounting for the ECB to rein in the Euro.  This notion is directly at odds with a rate hike, which would narrow the differential between EU and US interest rates, and provide further upward impetus for the Euro. Though, the pressure could subside since the EU economy is performing well, despite the strong Euro. DailyFX reports:

For those people who have been criticizing the Euro for hurting the Eurozone economy, their complaints continue to be refuted by economic evidence.

Read More: Euro Rallies on Strong Data and Hawkish Comments

Despite, or perhaps because of the appreciating Yuan, China’s trade surplus with the US is growing by 50% on an annualized basis, and is set to surpass $250 Billion for the year.  In theory, the more expensive Chinese currency should reduce US dependence on Chinese exports and narrow the trade imbalance.  In practice, the US is actually importing a greater quantity of goods and services from China and is also paying higher prices because of the appreciating Yuan.  Ironically, the US Treasury Secretary is scheduled to discuss this matter with his Chinese counterpart next week, and is expected to pressure China to appreciate the RMB even faster against the Dollar. Unfortunately, China’s hands are partially tied as a result of an agreement it already signed with the EU, under which it promised to appreciate the RMB against the Euro. Bloomberg News reports:

Under the current regime, the yuan is allowed to move as much as 0.5 percent against the U.S. dollar every day, from the previous limit of 0.3 percent. "There will be a broadening of the trading band again in the next few months," said one analyst.

Read More: China Trade Surplus Probably Held Near Record, Fueling Tension

While covering the emergence of the carry trade over the last couple years, the Forex Blog has echoed the sentiments of the self-proclaimed experts, who argued that Japanese interest rates would never rise enough to seriously threaten the carry trade. Instead, any threats would have to come in the form of volatility, which would theoretically drive traders to spur the comparatively high returns of carry trading in favor of low risk.  As if on cue, the carry trade has retreated significantly as the credit crisis aka housing bubble shockwave has rippled through global capital markets.  As the negative fallout builds, many of the carry traders who braved the first storm are rushing for the exits.  Bloomberg News reports:

Volatility implied by dollar-yen currency options expiring in one week with a strike price near current levels rose to 13.25 percent… Traders quote implied volatility, a gauge of expected swings in exchange rates, as part of pricing options.

Read More: Yen Advances on Concern Credit Losses Will Deter Carry Trades

Unnerved by the tremendous appreciation in its nation’s currency, Canada’s Parliament is officially mulling the possibility of pegging the Loonie to the USD.  It’s unclear at what value the two currencies would be linked, perhaps at parity.  However, in testifying before Parliament, the future leader of the Bank of Canada argued staunchly against such an exchange rate regime.  Such a relationship, he warned, would cripple Canada’s ability to conduct monetary policy, independent of the US.  So long as the Loonie remained fixed to the Dollar, Canada would be forced into mirroring US interest rate movements.  Because of several fundamental differences in their respective economies, it seems unlikely that this policy will be implemented. The CanWest News Service reports:

"It would mean that, de facto, Canada would adopt U.S. monetary policy, despite the reality that the structures of our economies are very different and, as a consequence, often require different types of adjustments in response to global developments."

Read More: Carney under fire for role in income-trusts decision

The last two years have witnessed a veritable collapse in the value of the Dollar, which has declined over 25% against the Euro, alone.  While opinion remains divided, many analysts are predicting a (temporary) cessation in the Dollar’s downward slide.  The reasoning is that the worst possible scenario involving the American housing crisis has already been priced into the Dollar.  Furthermore, experts argue that the inevitable loosening of American monetary policy will help boost the American economy by preventing it from slipping into recession. Finally, there is the notion that China will begin to take steps to appreciate its currency relative to the Euro, which has
actually risen against the RMB.  The law of triangular arbitrage requires that any rise in the Euro against the Yuan must be matched by a proportional rise in either the Dollar/Euro or the Dollar/RMB rate, the latter of which seems unlikely.  Dow Jones reports:

There is also the possibility that official Chinese purchases of the euro could decline after last week’s visit by a delegation from the European Central Bank to Beijing, anxious to reduce upward pressure on the single currency.

Read More: Chances Of Dollar Bounce May Be Rising

The Petrodollar phenomenon, analyzed recently by the Forex Blog, is now beginning to play out in real time. Last week, several high-ranking officials from the government and Central Bank of Bahrain, a small Mid East island-nation, publicly criticized the region’s collective policy of pegging their respective currencies to the USD. As a result of this and similar comments by officials from nearby countries, a flood of speculative capital has poured into the country as well as the region at large, betting that a change in the forex regime will take place as soon as next week. Now, countries such as the Bahrain are on the defensive, trying to hold down their currencies until a decision can be made. The Economic Times reports:

“Their speculation will not yield the gains they expect.” Bahrain’s central bank threatened to take action against anyone betting on dinar appreciation and accused foreign banks of spreading revaluation rumours.

Read More: UAE warns markets against betting on dirham revaluation

Now that the furor over the US housing crisis/credit crunch has begun to subside in forex markets, investors have turned their attention to what is perhaps the second biggest threat to the Dollar’s long term health: the PetroDollar phenomenon.  In short, the price oil is denominated in Dollars and many oil-exporting nations peg their currencies to the USD. Having found themselves awash in cash, such nations are beginning to ponder greater financial independence from the declining Dollar.

The anecdotal evidence for the declining importance of the Dollar among oil-exporting countries could not be stronger. Last week, the Forex Blog reported two developments. First, OPEC is considering altering the way oil contracts are settled, by pricing oil in a basket of currencies rather than in USD.  Next, the members of the Gulf Coast Council are considering de-pegging their currencies from the Dollar, due to rising inflation and the increasing opportunity cost of owning Dollar-denominated assets.

Actual data, on the other hand, suggests that OPEC may be moving in the opposite direction, towards a greater dependence on the Dollar.  The US remains the most popular destination for petrodollar investments, attracting 55% of all such investment capital. Europe comes in at a distant second, attracting just 18%. Plus, in the last year, oil money has been used to make several widely-publicized investments in American investment groups, including a recent $7.5 Billion investment in Citigroup by the Abu Dhabi Investment Authority.

The evidence is certainly nuanced. In all likelihood, OPEC will make good on Iran’s failed attempt to sell oil denominated in Euros by linking oil to a basket of currencies.  In their own words, “oil is being sold in a currency whose value was eroding by the day.”  At the same time, the US is still the home of the world’s best capital markets, from the standpoint of stability and risk. Thus, while it’s possible that some or all of the members of the GCC will de-peg their currencies from the Dollar, any relative decrease in Dollar-denominated investments is likely to be passive, rather than active. 

In the campaign to pressure China into revaluing the Yuan, the US has by far been the loudest voice.  However, the rapid decline of the USD may have unintentionally earned the US a new ally in its fight: the EU.  Since the Chinese Yuan is essentially pegged to the USD, and the USD has declined against the Euro, the law of triangular arbitrage is such that the Euro has actually appreciated significantly against the Chinese Yuan.  EU officials are no longer standing by idly, since the exchange rate is beginning to deal serious harm to its balance of trade.  In fact, the EU now occupies third position on the list of countries with the largest trade deficits with China.  Because of the nature of China’s exchange rate regime, however, China’s ability to control the relationship of the Yuan with both the Euro and the USD will be difficult, if not impossible.  The Bangkok Post reports:

Given the fact that about 70% of China’s $1.4 trillion in foreign reserves are dollar-denominated assets and the majority of foreign trade transactions are cleared in US dollars, China has focused more on the RMB-dollar rate.

Read More: A tale of two currencies