In a bold but perhaps necessary move, the Central Bank of Brazil recently announced an injection of $50 Billion into forex markets intended to stem the 30% fall in the value of the Brazilian Real that has taken place so far this year. Unfortunately for Brazil, the forces tugging on emerging market currencies far exceed the potential counter-efforts that such a country is capable of waging. Call it a lack of confidence, or a sudden aversion to risk. Either way, investors are fleeing regions that only months ago, they were still flocking to in droves. High interest rates, strong economic fundamentals, even capital injections and liquidity initiatives are no match for the financial tsunami. In addition, it’s not as if the Brazilian economy is necessarily in a good position to emerge from the crisis unscathed, as its neighbor Argentina could soon default on its debt…again. Bloomberg News reports:
The real has sunk 31 percent from a nine-year high of 1.5545 reached on Aug. 1 as the global crisis has driven down prices on the country’s commodity exports and eroded demand for higher- yielding, emerging-market assets. Only the South African rand, down 35 percent, has fallen more over that time.
The Australian Dollar has lost nearly 1/3 of its value (relative to the USD) over the last few months, as the credit crisis continues to drive investors away from areas perceived as risky. In other words, the best (and perhaps the only reasonable) explanation for its fall has very little to do with Australian economic fundamentals. Then again, the rise in the currency that took place over the last decade was also rooted in technical and financial trends, although rising commodity prices were also a factor. The Australian Dollar (as well as the New Zealand Kiwi) was one of the prime beneficiaries of carry-trades, due to unusually "generous" interest rate levels. Now that investors are chasing stability/capital preservation instead of yield, however, the currency has seriously fallen out of favor. The Australian reports:
Equity markets would continue to drive currency markets, while being influenced by the ongoing financial crisis. "These are unprecedented times in volatility for the Australian dollar and currencies," said [one analyst].
While the Dollar rally may ultimately prove beneficial to US consumers (due to cheaper imports), it is certainly not helping US-based multinational corporations. Companies that earn a significant portion of their revenue abroad would normally be considered stable investments during times of economic uncertainty, since their exposure to individual economies is minimal. In the context of the current crisis, however, such companies have struggled; since they must report earnings in terms of USD, a strong Dollar is equivalent to lower earnings on foreign sales. Some companies have turned to hedging their exposure, while others have opted to either ride out the fluctuations and/or hope that they cancel each other out, banking on the notion that forex is ultimately a zero-sum game. Dow Jones reports:
To be sure, such global currency fluctuations are hard to manage and even those companies that do have hedges in place may only be able to limit and not completely offset the pressures of a strengthening greenback and oscillating exchange rates.
The G7 Industrialized Nations met today in Tokyo to discuss the credit crisis, with a focus on its impact on forex markets. The Japanese Yen, specifically, has exploded in recent weeks, as nervous investors have fled emerging markets and other risky sectors, and have unwound carry trades (funded with Yen) in the process. Evidently, this is wrecking havoc on the Japanese economy, which has a notoriously frail domestic sector and is heavily reliant on exports to drive growth. The Central Bank of Japan has recently threatened intervention, and now that the G7 is presumably on board, it may do just that. The New York Times reports:
The statement, which said the G-7 would "monitor the markets closely and cooperate as appropriate," came as countries in Asia, spooked by the relentless sell-offs in the stock markets, scrambled to support their economies.
One can usually assume that any talk of the carry trade is in reference to the Japanese Yen. In this case, however, it is the Dollar that is being driven by a shift away from the popular strategy of borrowing in one currency and investing the proceeds in assets dominated in another. In explaining the recent Dollar rally, analysts have tended to focus on the pall of risk aversion that has descended upon global capital markets, coupled with the spread of the credit crisis from the US to the rest of the world. While these are certainly contributing factors, perhaps they should also look at the repatriation of Dollars that were initially sent abroad over the last decade in search of loftier returns. Hedge funds and other institutions, including those based outside of the US, took advantage of record-low interest rates to borrow Trillions of Dollars and invest them abroad. Due to a combination of margin calls and client "withdrawals," however, such investors have been forced to not only unwind such positions, but return the proceeds of the US. The Guardian UK reports:
Data collected by the Bank for International Settlements shows that European and UK banks have five times as much exposure to emerging markets as US and Japans banks, with surprisingly big bets in Latin America and emerging Asia – where they rely on dollar funding rather than euros.
Emerging Market currencies are becoming the latest victims of financial derivatives, proving Warren Buffet’s claim that such contracts represent "financial weapons of mass destruction." Apparently, companies throughout the developing world (although predominantly in Latin America) had used derivatives to bet on the strength of their home currencies, relative to the US Dollar. Given their record appreciation over the preceding few years, such bets probably appeared risk-less. As investors have fled emerging markets en masse, however, such currencies have tumbled. This has forced companies that had bet against the Dollar to rapidly unwind their derivative positions, which only caused their currencies to decline further. The Mexican Peso and Brazilian Real, to name the most prominent examples, are now in a virtual tailspin. Another "short squeeze" is probably not far away. The Wall Street Journal reports:
[Investors] had begun pulling money out of Mexico and other emerging markets. Since Aug. 1, the peso has dropped 24% against the dollar, and in October careened through its biggest daily drops since a 1994 currency crisis.
Last week, China revealed that in the most recent quarter, its economy grew at the slowest pace in nearly five years. It also revealed that its foreign exchange reserves crossed $1.9 Trillion, due to a record monthly trade surplus. How can this seeming contradiction in economic peformance be reconciled? In my opinion, the Chinese economy will continue to slow as a result of a generalized post-olympics slowdown and falling export demand brought on by the global economic crisis. The consequent collapse in risk appetite will bear negatively on investing in Chinese assets. Its stock market has already lost 50% of its value this year, and foreign direct investment (which is more difficult to monitor) is certainly sliding. In other words, there will be less foreign capital for the Central Bank to soak up, and less pressure on the RMB to appreciate. AFP reports:
The various factors at play could actually be causing some capital outflows as troubled foreign firms and investors may need the money overseas.
The word "confidence" has become ubiquitous when talking about the credit crisis. Policymakers talk casually about the lack of confidence and offer solutions for its restoration. But wasn’t it a surplus of confidence that was responsible for the credit crisis? Banks confidently extended loans to less-than-credit-worthy borrowers, who confidently took on more debt than they could repay, which was then confidently repackaged and underwritten by Wall Street, and sold to unassuming Central Banks abroad, who confidently believed that the Dollar was tantamount to gold. Ironically, their confidence has been (falsely) confirmed by the recent Dollar rally, as investors flocked to the eye of the global financial storm because of the perceived safety of investing in the US. If confidence is indeed restored, it will not be cheap, as the US government bailout will probably be highly inflationary. Central Banks may soon catch on and realize that if they are to continue financing an annualized current account imbalance of $700 Billion, they will need to be compensated accordingly. The Wall Street Journal reports:
Our foreign creditors accepted dollars in payment for their goods and services — and then obligingly invested the same dollars in America’s own securities. It’s as if the money never left the 50 states.
Policymakers are once again uttering the dreaded D-word. Not "depression," but rather "deflation." Food and energy prices have retreated from record highs, and the economic downturn is threatening to crimp demand further. In addition, the deleveraging brought about by the credit crisis has sent asset prices (real estate, stocks) tumbling, and it’s not clear when they will stabilize. Economists are also forecasting that a tightening labor market and decreasing demand could force workers to accept pay cuts in return for job security. In short, a sustained period of deflation, such as that which plagued Japan in the 1990’s, is becoming a very real possibility. Last week’s coordinated interest rate cut was motivated by financial and economic factors; it was aimed at providing liquidity to financial markets and stimulating aggregate demand. Future rate cuts, however, may be driven by monetary concerns. One thing to keep in mind is that deflation can be kind to currencies; witness the strength of the Japanese Yen despite its long-term economic malaise. If the entire world experiences falling prices simultaneously, however, its not clear how forex markets would respond. Bloomberg News reports:
The deflation scenario might go like this: Banks worldwide, stung by $588 billion in writedowns related to toxic assets — especially mortgage-related securities — will further reduce the flow of credit, strangling growth. As the credit crisis worsens, businesses will find it almost impossible to raise prices.
The credit crisis has not been kind to emerging market currencies. Virtually all of them have declined by double digits (in percentage terms) against the USD. Such currencies may receive a boost from the International Monetary Fund, which recently announced plans to make more cash available, especially on a short-term basis. Previously, many analysts and policymakers had written off the IMF as irrelevant, since private sources of capital had gradually become available to countries that previously depended on the IMF for funding. However, as investors flee emerging markets en masse, such countries once again find themselves in dire straits. Iceland, for example, is likely to take advantage of the offer, as it has exhausted most of its other options for shoring up its ailing economy and currency. Bloomberg News reports:
The IMF has been at the center of some of the biggest financial bailouts of the past three decades, helping broker solutions to the Latin American debt crisis in the 1980s and rescues for Mexico, Russia, Brazil and Asia in the 1990s.
Forex traders, and by extension, forex analysts, tend to focus on the Euro-Dollar currency pair because the two currencies are the most highly-traded and perceived as the most stable. As the financial crisis swirls with renewed vigor, however, the Pound and the Yen have been thrust into the spotlight, although for opposite reasons. The Pound has been Pounded (for lack of a better word) by dismal economic data emanating from the UK; investors remain pessimistic that the UK will recover since housing prices are tanking and the Central Bank has been slow to react. In the case of the Yen, the picture is more financial than economic. Japan’s economy and its capital markets have been pummeled by the credit crisis, but ironically, its currency is considered one of the safest. The reason is that investors have dramatically reduced their short-Yen positions which had been built up as part of carry trade strategy. Now, the name of the game is risk avoidance, which is good for the Yen but bad for the Pound. Seeking Alpha reports:
Out of the currency majors, USD/CHF and EUR/USD are the tamer pairs whereas GBP/USD and USD/JPY are pairs which are seeing the most volatile moves in forex trading, reflecting the strong bias of the underlying sentiment.
Today marked the official launch of financial news website Tip’d, which combines news, social networking, and investing. The site enables users to upload news stories which fit into several categories of finance and economics. Stories are ranked in terms of popularity (based on the number of times that users "tip" them), with the most-read stories appearing on the front page. Users can post comments, as well as forge relationships with other users, perhaps based on common interests. I am posting about Tip’d here on the Forex Blog, because of the amalgamation of forex news that can be found on the site. In addition, the democratic nature of the site should ensure that only top-quality (or at least interesting) forex stories make the cut.
Update 1/15/09: The guys over at Tip’d have just posted this short video tutorial on how to use the site.
That the credit crisis has been kind to the US Dollar is possibly the understatement of the century. In other words, despite the rapid drop in US equity prices and the impending economic recession, the Dollar has gained over 15% against its chief rival, the Euro. The cause of the Dollar bounce is a perception that the US is a safe place to invest during periods of economic uncertainty. This may or not be true. Regardless, some analysts insist that the Dollar remains doomed in the long-term. The US government has already spent $2 Trillion trying to restore confidence in capital markets and/or forestall recession. It seems unlikely that this entire amount can be raised from foreign investors, in which case the Federal Reserve Bank will be forced to print money to make up the difference. Even if the federal government can recover half of this outlay in the form of higher tax receipts and returns on its bailout "investments," the increase in the money supply will nonetheless be tremendously inflationary. The Market Oracle reports:
Americans will soon learn to change their mindset from focusing on their return on capital, to worrying about conserving the capital they have left. We have seen the beginning of this paradigm shift in the run on banks, and the flight to Treasury instruments.
It seems the Korean Won has (temporarily) bottomed out, reversing one of the largest declines in its history. The currency’s 5% daily jump has made it one of one of the few bright spots in Asia this week, where stock markets and currencies collapsed due to a complete lack of confidence. Analysts attribute the jump to a rumor that Korean regulators are trying to ferret out speculators, who are believed to have driven the Won down over the last few months. As a result, a sudden surge of foreign capital poured into Korea, as investors returned with renewed vigor, confident that the Korean government is prepared to deal domestically with the crisis that is gripping global financial markets. Bloomberg News reports:
South Korea’s won completed its biggest jump since March 1998 after a meeting among financial regulators prompted speculation that the government will step up support for the currency.
Developing countries (in Asia) responded to the 1997 financial crisis by prudently building up massive stocks of foreign exchange reserves to mitigate the risk of another crisis. In August, the reserves of eight of these countries (excluding China and Japan) promptly fell by a combined $36 Billion, setting a monthly record in the process. The flow of capital into the developing world has gradually reversed itself over the last year, as investors have fled emerging markets as part of a broad strategy to limit exposure to risk. Central Banks have responded by using their reserves as a means to restoring confidence and to propping up their respective currencies. Unfortunately, such countries remain vulnerable to the whims of institutional investors; while they can use their reserves to cushion the fall, they cannot prevent a collapse if that is what the markets ultimately will. Fortunately, the sheer size of their reserves makes such a repeat regional financial crisis unlikely. The Business Standard reports:
"Uncoupling is a myth. The region still depends on industrial countries to fuel its growth. If the global slowdown extends beyond 2009, the repercussions for the region could be severe."
As Karl Marx once proclaimed, "Central Banks of the world: Unite!" Well, not exactly….
In any event, six of the world’s largest Central Banks have come together in an unprecedented display of force, simultaneously lowering their benchmark interest rates. The Federal Reserve bank and European Central Bank appear to have spearheaded the effort, and were joined by the Banks of China, Switzerland, Britain, and Canada. The Bank of Japan remained on the sidelines, but it probably wouldn’t have made a difference given its already record-low rates. Obviously, the global rate cut was designed to be as much symbolic as economic. However, it’s not clear whether investors will take the hint, given that they have already ignored the Trillions of Dollars that have been spent by Central Banks and governments around the world. As far as currencies are concerned, if the global ship continues to sink, the two proxies for risk aversion- Dollar and Yen- will continue to lead the pack. In other words, fear is proving itself a much more powerful force than economic reality. The New York Times reports:
“The move is to be applauded but there is more to come. The playbook to avoid depressions says rates need to be as close to zero as possible.”
Over the last two months, the South African Rand has plummeted, losing nearly 20% of its value against the US Dollar en route to a five-year low. It seems the currency has become the latest victim of the credit crisis and the resulting widespread risk aversion. The sudden exodus away from the carry trade, for example, has affected the Rand disproportionately, as many foreign investors had come to South Africa over the last few years to take advantage of the country’s 12% interest rate. Now, the country is facing a horrible crisis, and is worrying about its ability to finance its current account deficit, which already exceeds 7% of GDP. Accordingly, analysts predict the Rand will continue to drop. Bloomberg News reports:
"The portfolio flows we have seen over the past couple of years are going to dry up and we will not be able to fund the deficit with the portfolio flows." The rand may slide to 9.20 rand by the end of the year…
The rapid and insidious spread of the credit crisis to Europe and even farther afield is catching Central Bankers completely off guard. In fact, they have been forced to rapidly shift gears from fighting inflation to preventing recession. Depending on how you look at it, the Fed was actually ahead of the curve in this regard, having moved to adjust its monetary policy and facilitate greater liquidity in credit markets nearly one year ago, well before other Central Banks. Since such policymaking usually takes about 18 months to trickle down to the grassroots of the economy, the US could conceivably begin the long road to economic recovery well before the rest of the world. As a result, the Dollar is rapidly reversing the multi-year decline it has suffered against the Euro, and analysts are predicting that in a few years the flow of tourists across the Atlantic Ocean will reverse directions. The Times Online reports:
In the longer term, rising productivity and lower domestic inflation, should enable Americans to stomp across the pleasure spots of Europe, paying only $1.25 for each euro.
In times of financial crisis, investors can reasonably be expected to park their money in the least risky capital markets. In this case, that means those in the US and Japan. Compare this so-called "safe haven" trade with the "carry trade" that preponderated in previous years, as investors shifted capital away from Japan in order to earn higher yields. Now, as volatility surges to dangerous levels, investors are going to increasingly great lengths to mitigate risk. At least until the negotiations surrounding the US government bailout are resolved (whether in success or failure), big bets are off the table. In other words, few investors continue to scour the globe for yield, which eliminates the raison d’etre of the carry trade. Bloomberg News reports:
"These are not the right times to be putting on any bold trades because it’s the perfect environment for getting whipsawed,” said [one analyst]. "I think waiting on the sidelines is probably the most prudent thing to do.”
At the end of each quarter, banks usually make an effort to balance their books. As a result of the ongoing credit crisis, however, completing this task at the end of the 3rd quarter fiscal 2008 was nearly impossible for most banks. Fortunately, the Federal Reserve Bank intervened to relieve the situation. In conjunction with the world’s major Central Banks, the Fed moved to make hundreds of Billions of Dollars in short-term capital available to financial institutions. The Fed will utilize swap agreements, which involve the exchange of blocks of currencies at agreed-upon exchange rates on agreed-upon dates. These particular swaps should help both to mitigate the shortage of Dollars on the open market and to further buttress the Greenback. AFP reports:
These expanded facilities will now support the provision of US dollar liquidity in amounts of up to 120 billion dollars by the ECB and up to 30 billion dollars by the Swiss National Bank.
