The three rules of monetary policy- goes the old adage- are inflation, inflation, inflation.  Well, maybe not.  But that is certainly the story in the Middle East; Saudi Arabia’s official inflation rate is the highest in 12 years, and Qatar and the UAE have witnessed double-digit percentage increases, in annualized terms. Since their currencies are pegged to the USD, however, their Central Banks are unable to raise rates accordingly, leaving them with a tough decision: allow the currency to appreciate or watch prices spiral out of control.  It is the same story being told in every developing country that pegs their currency to the Dollar, and the members of the Gulf Cooperation Council (GCC) are certainly not exempt. As the ranking member, Saudi Arabia will all but determine if and how the official forex policy changes.  An announcement could come any day. The Gulf Times reports:

Mohammed al-Jasser, Saudi Arabia’s deputy central bank governor, had said last month that the Gulf Arab states should maintain their currency pegs to the US dollar regardless of rampant inflation in the region or the impact of US rate cuts.

Read More: Saudi to mull forex policy as more US rate cuts loom

Recent news reports have painted a downright bleak picture of the US economy. Home prices are now falling. Equity prices are also falling, at an annualized rate of 20%.  Meanwhile, energy and food prices are rising, dipping into what little purchasing power consumers can still claim.  Somehow, as DailyFX, recently reported, the Dollar has held its own. Their reasoning is that there is a struggle being waged in forex markets between yield and growth. On the one hand are investors who are bearish on the Dollar because of interest rates that are headed downwards, despite already being low.  On the other hand are investors who think that yield is comparatively unimportant, since the rate cuts are needed to shore up the economy. While interest rate differentials do not favor the US, the economic growth that they are intended to bring about tell a different story. DailyFX reports:

The only problem with this thesis is that 2 percent interest rates or 100bp is about as low as the market expects the Fed will go. If banks are forced to take more write-offs and the US economy deteriorates further, the Federal Reserve may be forced to go below 1.00 percent.

Read More: What Matters More For the US Dollar:  Yield or Growth?

While the Chinese Yuan quickly ascended the ranks of the world’s most important currencies, the Indian Rupee has not yet made it.  But that might change in 2008, as the Royal Bank of India ("RBI") will be forced to decide between a more valuable rupee and price stability.  Until now, the RBI has successfully pursued the "impossible trinity of a fixed exchange rate, independent monetary policy, and open capital account" through judicious use forex intervention and the issuance of sterilization bonds. Now, as prices are creeping up, the RBI has found itself constrained in its ability to hike rates because of the resulting pressure on its currency. Furthermore, the rupee has already begun to appreciate, costing jobs in certain export-dependent (and politically sensitive) industries. The Economic Times reports:

Monetary policymakers have been torn between letting the rupee appreciate and intervening in the currency markets to inject more rupee liquidity which could be potentially inflationary in nature.

Read More: Gazing through the crystal ball

Remember the expression "Goldilocks economy," used to to characterize the Fed’s perennial aim of simultaneously pursuing economic growth and price stability?  How about "stagflation," a term coined in the 1970s to describe a unique period in US economic history where low growth coincided with inflation.  Now, these two scenarios are being juxtaposed as the Goldilocks economy gives way to stagflation. The Fed is trying to delicately toe the line, as equity and home prices sink while prices rise; one index suggests prices have risen over 7% year-over-year.  The index more often cited, the CPI, reads 4.3%.  Both of these figures exceed current interest rate levels. 

What, then, is the Fed’s proper course of action, especially as far as Dollar bulls are concerned?  If it holds rates or contindfues to lower them, the economy could avert recession but prices would likely continue to climb, eroding the value of the Dollar.  On the other hand, if rates are hiked to mitigate against inflation, a recession would almost become inevitable, and the Dollar would feel the drag of capital being pulled overseas. The New York Times reports:

“February may go down in history as the month that the previously indefatigable U.S. consumer finally threw in the towel, beaten by a combination of deteriorating labor market conditions, surging prices for food and energy and collapsing house prices,”

Read More: As Inflation Rises, Home Values Slump, Data Show

Although the Chinese Yuan is ostensibly allowed to fluctuate in value, the reality is that the size of its fluctuations and the pace of its appreciation are tightly controlled by China’s Central Bank.  Since its currency is still effectively fixed to the Dollar, China is severely curtailed in its ability to conduct monetary policy and must closely mirror US policy.  Same goes for the rest of Asia, excluding Japan. While US monetary policy was relatively tight, as it has been for the last five years, this necessity didn’t cause too many problems; most of these economies would have kept interest rates high irrespective of the US.

Since the Fed began loosening monetary policy over the last six months, however, many of the emerging economies in Asia, especially China, have been forced into a bind.  On the one hand, lowering interest rates is exacerbating the problem of inflation.  On the other hand, they want to keep their currencies stable so as not to limit economic growth.  In short, Central Banks must determine which is more important: fighting inflation or promoting growth. According to some economists, these economies are so strong, having grown by nearly 10% collectively last year, that they can afford to slow down, if it will result in greater price stability.  But the only way to stabilize prices is to drastically raise interest rates, which will put even greater pressure on their currencies to appreciate.

In addition, the Central Banks of Asia have amassed a staggering $4 Trillion in foreign exchange reserves.  In the past, this has been a neutral, sometimes profitable activity.  Since the Fed began cutting rates, the interest rate differential has been turned upside-down such that Central Banks are now losing money on each unit of local currency they sell in exchange for Dollars.  According to one analyst, over $160 Billion has been lost since July 2006, and those losses will mount with each additional intervention.

Read More: Fed’s Lower Rates Pressure China to Strengthen Yuan

Every month seems to witness the induction of a new country into the pantheon of those with burgeoning forex reserves.  The new member for the month of February is…Iran?  Most of the attention Iran receives is political rather than economic, but with oil prices recently topping $100 a barrel for the second time, you can bet that Iran will start appearing on the radar screens of more and more analysts.  Iran’s reserves currently total $76 Billion, which is unimpressive in itself, but represents a 30% year-over-year increase.  Of more significance, perhaps, is that Iran is leading the charge against the Dollar by actively diversifying its reserves into Euros. It remains to be seen whether any "non-rogue" countries will follow suit.  The Economic Times reports:

Iran, the world’s fourth largest oil
exporter and the second ranking in OPEC, has benefited from record crude prices
which have helped it to weather domestic economic problems.

Read More: Iran’s forex reserves top $76 bn

Over the last few years, commodity prices, equity values, and interest rate differentials all favored Canada.  By no coincidence, the Loonie rallied to such an extent that it soon reached parity with the USD. The relationship between these trends and the Canadian Dollar seemed so cut-and-dried that few analysts paid attention to anything else.  In the last couple months, however, these relationships seem to have suddenly dissolved.  For example, as the price of oil has begun to rise again, the Loonie has unexpectedly lost value.  Meanwhile, the inverse correlation between risk aversion and the Loonie has lost all validity, such that if the S&P 500 increases, the odds that the Canadian Dollar will also appreciate is essentially an even money bet. The Canadian Economic Press reports:

"The breakdown is still quiet tentative but it’s weakened in the last few sessions. For Canada in particular there isn’t one story in the market. We have several different stories going on at the same time."

Read More: Breakdown of Forex Correlations Has Market Participants on Guard

China’s trade surplus grew 22.6% year-over-year for the month of January, on top of export growth of 26.7%.  If there is any silver lining to what many policymakers would consider bad news, it is that growth in imports is slightly outpacing growth in exports.  Unfortunately, that is unlikely to allay the critics, and there are still many of them. The argument remains unchanged- that China is not allowing its currency to rise fast enough.  On paper, however, the Yuan has appreciated by 15% since China officially de-pegged it from the Dollar in July 2005.  In addition, the G7 failed to scold China in its annual meeting, which suggests that economic policymakers are becoming less concerned with China’s forex policy.  Ironically, the revaluation of the Yuan is probably boosting the value of of China’s exports in the short-term, because other countries are now paying more for the same quantity of imports.  AFP reports:

The International Monetary Fund…urged the Chinese government to loosen the reins on the yuan. "We encourage a faster pace of appreciation that would be helpful for addressing China’s key economic challenges and would also contribute to preserving global economic stability."

Read More: China’s trade surplus rises 22.6 percent in January

In testifying before the Senate Budget Committee, Ben Bernanke, Chairman of America’s Federal Reserve Bank, hinted strongly that further rate cuts would be necessary to stabilize the US economy.  Last week, the Forex Blog covered an editorial which suggested that Bernanke knew something about the state of the economy that the American public did not, which his testimony seemed to confirm.  Bernanke testified that the Fed is also committed to fighting inflation, but the emphasis was clearly on spurring economic growth. As a result, futures markets are pricing in a rate cut of 50 basis points, projected for the next month.  The forex markets were unambiguous about the implications of this development for the Dollar.  Thomson Financial reports:

‘By highlighting the downside risks to growth, Bernanke confirmed prevailing aggressive rate cut speculation, which currently keeps the dollar under broad pressure,’ said Antje Praefcke, currency strategist at Commerzbank.

Read More: Dollar remains under pressure following Bernanke’s testimony

The Israeli Shekel has surged over 15% against the Dollar in the last six months, and by over 20% in the last two years. Analysts have suggested that the appreciation is due to the strength of Israeli’s economy vis-a-vis the US economy, which seems headed for recession.  In addition, Israeli citizens have repatriated billions of dollars in capital that had been held overseas and invested it in Israel’s financial markets, which in itself, has exerted much of the pressure on the Shekel.  There is now a surplus in the balance of payments, which means more capital is coming in to Israel than is being taken out.  As a result, Israeli exporters are getting nervous about the perceived consequences of a relatively expensive currency and are pressuring Israeli political leaders to take action.  The Central Bank, understandably, is reluctant to do so. Haaretz.org reports:

"Intervening in [the currency] market is risky and inefficient," [said] Bank of Israel Governor Stanley Fischer…earlier this week.

Read More: Dollar falls as Fischer says won’t intervene in currency market

Forex Forecast- try saying that three times fast! The Market Oracle, an online financial publication, has done even better, preparing a one-year forecast for all of the major currencies along with a detailed analysis of the major factors driving each currency in the month of February. The Dollar and Yen are projected to be the strongest performers in this time frame, benefiting from a trend towards risk aversion.  It should be noted that this prediction is consistent with news reported by the Forex Blog earlier this week. On the other hand, currencies that have been propped up by the Yen carry trade, namely those of Australia, New Zealand, Canada and South Africa, will face selling pressure.  The British Pound is projected to underperform slightly, due to an easing of British monetary policy, which will narrow the interest rate advantage claimed over the US.

Finally, the Euro is something of a wildcard.  On the one hand, the EU economy is stagnating, and the ECB has hinted that rate cuts are a possibility. On the other hand, the Euro theoretically stands to inherit a significant amount of risk-averse capital, especially from foreign investors looking for a stable alternative to the Dollar.  Accordingly, the Market Oracle forecasts a short-term decline in the value of the Euro but a long-term appreciation.

Read More: Currency Market Strategy and Forecasts for February 2008

In its annual meeting, the G7 virtually ignored the situation in forex markets.  In previous years, the G7 used the so-called "communique," which essentially functions as a summary of the meeting, to rebuke China for not allowing the Yuan to appreciate at a satisfactory pace. This year, the RMB has appreciated markedly- by 9% on a trade-weighted basis- and thus, the G7 opted not to apply further rhetorical pressure.  In addition, several of the most prominent EU member states had hoped to work a discussion of the Dollar into the communique, but alas, any mention was notoriously absent. Analysts have speculated that this is due both to America’s political indifference towards the valuation of the Dollar as well to a disagreement over what the correct valuation should be, if indeed it is undervalued. Thomson Financial
reports:

"It was clear a few days ago that there was going to be no change in the (currency section) of the communique and that really spoke of a lack of consensus about mainstream currencies."

Read More: China spared ritual lambasting as yuan slips down G7 agenda

Last week, the USD recorded its best weekly performance since 2006, rising 3 cents against its chief rival, the Euro.  Apparently, analysts are becoming increasingly pessimistic about the effect of the America recession on the global economy.  The consensus is now that a dampened global economy will induce a trend towards risk aversion, which favors the world’s #1 and #2 reserve currencies, the Dollar and the Euro, respectively.  However, it also appears the near-term economic prospects for Europe are less rosy than originally forecast,.  Thus, if last week is any indication, the Dollar should receive a larger proportion of risk-averse capital. Reuters reports:

"Despite a torrent of bad economic news the dollar has been
on a tear this week, as the currency market recognized the fact that the slowdown in U.S. economic activity is likely to drag down growth in the rest of the G10 universe…"

Read More: Dollar set for biggest weekly rise since June 2006

At its meeting last week, the European Central Bank (ECB) held its Euro-zone benchmark lending rate at 4.00%.  While the decision itself came as no surprise, analysts were nonetheless waiting with baited breath to hear what remarks would accompany it.  Jean Claude Trichet, the Bank’s President, eased up on hawkish comments he made the previous month, when he signaled that his primary concern was inflation rather than the risk of economic recession. This month, however, he changed his rhetoric markedly, indicating that the ECB was less willing to preempt rising price levels and would instead shift its focus to the possibility of a ‘sharp slowing’ of EU growth. Forbes reports:

Our view [is] that rate hikes are definitely off the agenda at this stage and by bringing a greater degree of uncertainty on the growth assessment, the ECB may be getting ready for a shift towards a more dovish policy language.

Read More: Euro sags after Trichet tones down hawkish stance

As talk and evidence of a US economic recession builds, the Dollar has witnessed a slight upswing.  How to explain these seemingly contradictory trends? The rationale is surprisingly simple.  While a US recession would predictably hit the US harder than other countries, it would still hamper growth abroad, especially in emerging markets that have come to depend on exports to the US to drive growth.  Accordingly, investing in such emerging markets becomes relatively more risky than investing in the US, which is still considered to have the world’s most stable investing climate from a long-term perspective.  Thus, as risk aversion rises, so does the Dollar. Thomson Financial reports:

The combination of poor data weighed on stock markets in the US and Asia, while major bourses in Europe have all opened lower today. This meant the dollar gained support as investors shy away from riskier emerging market assets.

Read More: Dollar gains on the back of rising risk aversion

China’s foreign exchange reserves currently approximate $1.5 Trillion, the majority of which is denominated in USD.  Moreover, the Central Bank of China earns interest on every Dollar it adds to its reserves but must also pay interest on every RMB note that it must issue to offset the Dollars. Since the Fed began easing monetary policy, the amount of carry (the difference between what the Central Bank receives on Dollars and pays on RMB) earned by the Central Bank has completely inverted, such that it now loses 250 basis points on average for each Dollar exchanged for RMB. 

Based on the rate at which China is currently accumulating reserves, this amounts to between $5 Billion and $10 Billion per month, depending on which method of accounting is utilized. Furthermore, this trend has been exacerbated because China is accumulating reserves at a faster rate than its economy is growing. Some analysts have speculated that this could turn into a major political issue, with important implications for the RMB/Dollar exchange rate. The Financial Times reports:

The renminbi has started to appreciate more rapidly in recent months, rising at an annualised rate of about 20 per cent, compared with 6-7 per cent over the whole of 2007.  In the longer-term, say economists, China will have no choice but to allow its currency to appreciate faster, even in the face of entrenched domestic resistance.

Read More: Beijing starts to pay for forex ‘sterilisation’

It seems self-evident that the Fed is easing monetary policy because it is trying to stimulate the economy and shore up confidence in capital markets by making credit less expensive.  Dig a little deeper, however, and a more nuanced picture begins to emerge.  Conspiracy theorists believe that the Fed knows something that investors don’t, perhaps that the subprime mortgage situation is more serious than the public is being led to believe. Accordingly, the theory goes, it is trying to prevent a complete collapse of the financial system.  Another theory holds that the Fed is cutting rates because it has nothing to lose by doing so. Inflation is still low, from a historical standpoint, and the Fed may be trying to inject liquidity into the financial markets before it is too late.  Yet another theory holds that the Fed is deliberately targeting a weak Dollar and high commodity prices, as the former benefits the US directly by narrowing the trade imbalance, and the latter benefits the US indirectly by helping emerging market economies, which are relatively more dependent on commodities.  The Chicago Tribune reports:

An increase in exports was one of the
positive features of Wednesday’s disappointing fourth-quarter report on U.S. gross domestic product. The cheaper dollar is a major factor in export growth, both in terms of current sales and expansion of overseas market share by U.S. manufacturers.

Read More: Fed rate cut conspiracy or power play?

Those who make a living tracking and betting on the foreign exchange reserves of Central Banks officially have a new player to keep tabs on: India.  Nearly 17 years ago, India’s reserves dipped below $1 Billion, and government ministers began sounding the alarm bells. In comparison, fiscal 2007 witnessed a rise of $47 Billion in India’s reserves, bringing the total to $280 Billion.  The government is projecting an even greater increase in 2008, estimated at $100 Billion.  Now, the challenge is what to do with all of the reserves; investors will be tracking developments in this regard because of the implications for the currencies of which the reserves are denominated in.  The Dollar and Euro are currently jockeying for position; while the Dollar is way ahead, the Euro is quickly closing in.

Read More: India expects to add $100 bn to forex reserve in FY’08

Most of the world’s major currencies are affected by a variety of technical and fundamental factors, such that only taking into account one factor is tantamount to using P/E multiples as the sole basis for purchasing shares of stock. The New Zealand Dollar, which barely qualifies as a major currency seems to be one of the few exceptions to this common sense rule.  The preponderance of carry traders involved in trading the Yen ensures that the NZD inversely tracks the Japanese Yen.  In addition, the demand for Kiwi is directly proportional to appetite for risk, such that when risk aversion declines, the Kiwi increases, and vice versa.  The reasoning is quite simple: the Kiwi boasts the highest interest rates in the industrialized world. Because the investment climate in New Zealand is less stable than in other industrialized countries, New Zealand often witnesses capital flight during periods of global economic uncertainty.  The New Zealand Herald reports:

Gains in equities markets emboldened investors to take chances, prompting use of the low-yielding yen to buy assets in higher-yielding currencies like the kiwi in carry trades.

Read More: Equities send dollar up

As far as Dollar bulls are concerned, all news is bad news. An economic recession seems inevitable. Interest rates are already negative in real terms, and are now the lowest in the industrialized world, save Japan.  It’s still unclear how much subprime debt will be written down by financial companies before all is said and done.  But analysts from Brown Brothers Harriman, an investment bank, think the Dollar’s multi-year decline is coming to an end.  There are two main reasons underlying their rationale.  The first point is purely technical- that the all of the bad news and in fact, the worst possible scenario, has already been priced into the Dollar.  The second point is fundamental- that the speculative hot money that has poured into the US as foreign investors take advantage of a weak Dollar and that is sustaining the US current account deficit is now transitioning into long-term foreign direct investment.  The Financial Post reports:

In addition, BBH believes that in a weak dollar environment, foreign companies will now start looking to move production and sourcing to the United States, following the successful example of Japanese auto makers.

Read More: Greenback is nearing bottom, currency experts say

The US stock market has lost over 10% of its capitalization since reaching an all-time high in October of last year.  Meanwhile, the Japanese Yen has climbed at least as much in proportional terms since bottoming out around the same time.  Coincidence?  At least one analyst doesn’t think so. Because of the steadfast popularity of the carry trade, the Japanese Yen appears to have developed an inverse correlation with the US stock markets.  The reasoning is actually quite simple. When aversion to risk is low, investors borrow in Japanese Yen and make investments denominated in other currencies, the Dollar for one.  When risk-aversion increases, as it has in the current economic environment, investors have been quick to close out their carry trade positions, causing the Yen to rise. Maktoob Business reports:

If the situation of stock markets is improving, the USD/JPY is likely to be increasing. It means that more carry trade transaction are being carried out.

Read More: Fundamental analysis – Market Correlations