Correlation or Causation

The slight recovery of the USD has been accompanied by a couple of other interesting trends: falling gold and oil prices, and rising equity and bond prices. What is the connection here? With regard to gold and commodity prices, the prevailing theory was previously that high prices were caused not by supply issues, but rather by the Fed's easy monetary policy, which was stoking the embers of inflation. The recent rise of the Dollar has poked a broad hole in this theory, because of the simultaneous fall in prices for certain commodities, namely gold. This has led some analysts to conclude that commodity prices are fluctuating irrespective of the Dollar.

With regard to oil, there does exist a 95% correlation between the price of oil and the EUR/USD exchange rate. However, it now appears that strong oil had been driving the weak Dollar, and not vice versa. The Dollar is also deriving some impetus from a rally in equity and bond markets, which have outperformed their European rivals.  Bond yields remain lower in the US, but with the stabilization of the Dollar, perhaps foreign investors will be convinced that the US is the least risky place to invest during the global economic downturn.

Read More: The dollar rallies at last

UK: No rate Cuts for 2 Years

The US Federal Reserve Bank is known for ambiguity and vagueness. The Bank of England, it appears, is not trying to emulate this approach. The Bank put an end to speculation about its near-term monetary policy by announcing that it does not plan to cut interest rates for at least two years. Apparently, inflation has breached the Bank's 2% target, and its internal models are forecasting that it won't be until 2010 that price inflation returns to a more palatable rate. This is bad news for the British economy, which is in the throes of an economic downturn precipitated by the housing crisis and would surely benefit from a loosening of monetary policy. By extension, the British Pound should also suffer a "correction," as a combination of inflation and lack of suitable investment opportunities will send investors rushing for the exits. The Financial Times reports:

Mr King contrasted his position – and its focus on controlling inflation – with that of Ben Bernanke of the US Federal Reserve. “We did not fall prey to the sirens to cut interest rates further as some other central banks have done,’’ he said.

Read More: No interest rate cut for two years, Bank warns

Canadian Dollar Spurred by Oil

Just a few weeks ago, the Central bank of Canada aggressively cut interest rates in order to slow the spread of the US economic downturn to Canada. Accordingly, investors were quite bearish on the Canadian Dollar. With the price of oil surging, however, the Loonie has regained some of its luster, inching back towards parity with the Dollar. If commodity prices remain at current levels, Canada may avoid an economic recession. Economists have scaled back expectations that the BOC will have to continue cutting interest rates. Nonetheless, the median investor expectation is for a sustained decline in the Loonie, perhaps to $1.08 by year end. Bloomberg News reports:

The loonie, as the currency is known because of the image of the bird on the one-dollar coin, has traded near parity with its U.S. counterpart this year after climbing 17 percent in 2007.

Read More: Canada's Dollar Reaches Two-Month High as Oil Surges to Record

Q1: Dollar Down 4%

Although the first quarter of 2008 ended on March 31, it wasn't until last week that the Federal Reserve Bank finally finished tallying all of the data and released its obligatory report on the performance of the Dollar. On a trade-weighted basis, the Dollar declined 4%, a figure which accounts for a whopping 11% decline against the Japanese Yen and an 8% decline against the Euro. According to the Fed's analysis, January was relatively kind to the Dollar, as traders remained uncertain as to how the credit crisis would affect the US economy. An outpouring of negative data in the next 4-6 weeks sent the Dollar spiraling downward, although it recovered at the end of March, as the Fed moved to build liquidity in the financial markets. The Fed also noted that it did not intervene in currency markets during the first quarter, firmly putting to rest rumors to the contrary. Forbes reports:

There had been intermittent discussion in the markets of a coordinated foreign exchange intervention by the G-3 central banks, but the Fed report confirmed officially what markets already realized.

Read More: NY Fed reports trade-weighted dollar down more than 4% in first quarter 

Yen Falls on Risk Aversion

"The credit crisis is over! No it's not! Yes it is!"

Such back and forth represents the tenor of the debate currently transpiring in the financial markets. Every day seems to bring new economic data, which is quickly seized upon by both sides as evidence for their respective positions, causing the markets to rise and fall accordingly. In this regard, the Japanese Yen and the Swiss Franc serve as proxies for investor sentiment. When the markets rally, investors are quick to dump both currencies in favor of higher-yielding alternatives. On the other hand, when a large investment bank announces a write-down on its subprime investments, or when economic data indicate falling housing prices, investors are quick to unwind their short positions (carry trades). The advice of the Forex Blog is to take every development in stride and to remember that no definitive conclusions can be reached at this point.

Read More: Yen Weakens on Speculation Worst of Financial Crisis Is Over

New Forex ETFs

WisdomTree and Dreyfus Funds recently unveiled five new currency ETFs in order to fill a broad gap in the emerging markets category. Previously, investors were limited to such mainstay currencies as the US Dollar, Euro, Japanese Yen, British Pound, Australian Dollar, Canadian Dollar, and Swiss Franc. These new ETFs will expand this list to include the Indian Rupee, Brazilian Real, and the much-anticipated Chinese Yuan. It will also offer products for the Euro and Yen, but these probably won't draw much attention. The RMB ETF, especially, will be pounced on by investors, who have been clamoring for years for a cheap and easy way to capture the upside of the Yuan's inevitable appreciation. In addition, all of the ETFs will also return modest yields based on prevailing interest rates in the representative countries. Reuters reports:

In the case of India, Brazil and China, the yields on the ETFs may differ from yields available locally due to restrictions on foreign investors.

Read More: WisdomTree, Dreyfus to offer five currency ETFs

Chinese Exporters Dump Dollar

The anecdotal evidence that China is diversifying its forex exposure away from the Dollar continues to mount. To date, most of the focus has centered around the Central Bank of China, which is passively diversifying its reserves into European and higher-risk assets. Apparently, Chinese exporters are also getting nervous about the impact of a falling Dollar on their respective bottom lines. The RMB has risen 11% since the beginning of 2007, which means Chinese companies now receive 11% less on sales to destinations abroad than they did for equal-priced goods in 2007. As a result, some companies have taken to quoting prices in Euros or to adjusting Dollar-denominated prices every few months. Other companies are building assumptions of a more valuable RMB into their profit models, and setting prices accordingly. The New York Times reports:

“We are gradually increasing our emphasis on the domestic market until we can forget about the export market, because the profit margins on exports are so thin,” [said one exporter].

Read More: Some Chinese Exporters Prefer Euros to Dollars

Commentary: The Dollar Conundrum

The Dollar is currently teetering on the edge of a precipice.  Many analysts are predicting that, having recently retreated from a record low against the Euro, the Dollar's best days are still in front of it. On the other hand, the economic data and interest rate pictures remain nuanced, and still favor the Euro on paper. In this article, we aim to sort through this morass, and produce a clear summation of the factors which bear on the Dollar in the short term.

Let's begin with the bullish side of the equation, which is supported by the Dollar's recent upside swing. First of all, while interest rate differentials are currently hurting the Dollar, the Fed is probably near the end of its loosening cycle, while the ECB has yet to begin. The best-case scenario would be a tightening of US monetary policy simultaneous with a loosening of EU policy. Next, there is the economic picture. The most recent GDP data indicates an economy that is still growing, albeit slowly. In addition, the unemployment rate declined in the most recent month for which data is available. The US stock market has regained half the value it lost in the first three months of 2008, and the overall P/E ratio is close to its long-term average, which suggests the markets could appreciate further. Finally, the economic stimulus package that was approved by Congress in March will go into effect this month, as tax rebates worth $150 Billion are distributed to consumers and businesses.

On the bearish side, let's return to the interest rate story. While the future certainly bodes well for the US, the present still favors the EU. US interest rates are currently negative in real terms, and investors have already turned the Dollar into a funding currency for carry trades. Moreover, negative real interest rates implies high inflation. US CPI is hovering around 4.0%, and could continue to climb in proportion with surging food and energy prices. In fact, inflation is now viewed by economists as more problematic than the economy, itself. While US exporters have benefited from the resulting cheap Dollar, US consumers- which account for 75% of the US economy- have not. The economic downturn still has not officially been labeled a recession by the Bureau of Economic Research, but the situation remains tenuous, and the scales could easily be tipped by a few pieces of negative economic data.

The wild card in this mess is housing. In certain regional markets, real estate prices have tumbled by 30%.  In other markets, they have hardly budged. While an estimated $350 Billion in subprime debt has already been written down, analysts disagree over the eventual total.  Estimates vary from $1 Trillion to less than $350 Billion, which would imply "write-ups" on debt that was erroneously declared worthless. The difference represented here amounts to 6% of GDP, which could mean the difference between growth and contraction, a strong Dollar and a weak Dollar, respectively.

Korean Won is Worst in Asia

In the year-to-date, the Korean Won has recorded the worst performance of any currency in Asia, having recently fallen to a 6-week low. The story is being driven as much by Dollar strength is by Won weakness. US equities have rallied over the last month, as investors may have been overly pessimistic in the previous months regarding near-term US economic prospects.  In addition, the Fed has probably lowered interest rates for the last time, whereas the Central Bank of Korea has held its benchmark lending rate at 5% since the summer. This yield differential, which currently favors Korea, may narrow substantially over the coming months, as the Bank of Korea is forced to reckon with slowing growth and rising inflation. Bloomberg News reports:

Growth, at the slowest in more than three years last quarter, is losing momentum, the Bank of Korea said in a report on May 1. Policy makers next meet on May 8 to decide on the benchmark seven-day repurchase rate.

Read More: Won Declines to Six-Week Low

Fed Lowers Rates

The Federal Reserve Bank recently lowered interest rates for the seventh, and perhaps final, time, bringing its benchmark federal funds rate to 2.0%. Since inflation is still hovering around the 4% mark, the Fed will probably be reluctant to lower rates further. Thus, the markets have been given all of the boost that they are likely to receive, and it is "fate" that will determine whether the economy will find its footing. (GDP growth clocked in at an anemic .6% for the last two quarters). The most recent data (including the just-released jobs data) indicate that the economy may be stabilizing, although consumption and the employment situation are still deteriorating. As a result, the National Bureau of Research has yet to officially declare the current economic downturn a "recession," since the picture remains nuanced. The New York Times reports:

The recession-or-not question is now almost entirely academic, Mr. Bernstein contended, given the steady erosion of American spending power and soaring costs for food and gasoline.

Read More: Low Spending Is Taking Toll on Economy

Turkish Lira Set for Decline

2007 was a banner year for the Turkish Lira, which appreciated 21% against the US Dollar. However, in the year-to-date, the currency has returned nearly 10% of this gain, making it the third worst performing currency in the world. Turkey generally, and the Lira specifically, are considered by investors as proxies for emerging markets. The global trend towards risk aversion, as well as skyrocketing inflation, are hurting many such currencies. In Turkey, inflation is so problematic (9.4% at last count) that the Central Bank has raised its benchmark interest rate to 15.25%. Ironically, the more the Lira depreciates, the harder it becomes for the Central Bank to control inflation, causing the Lira to slide further as part of a self-perpetuating free-fall. In addition, the country is beset by political uncertainty, as the courts determine whether the nation's current government can stay in office. Bloomberg News reports:

"The recent political developments are likely to complicate policy-making and the investment climate. The deteriorating political backdrop will in turn undermine the prospects for restoring fiscal discipline and reviving the reform agenda."

Read More: Lira Goes From First to Worst as Politics Whack Bulls