The ForexBlog recently reported that investors were cautiously wading back into emerging market currencies. In hindsight, it looks like this report was delivered prematurely, as this week marked a return to the notion of the Dollar as save haven currency, having displaced even the Japanese Yen. While President Obama did his best to assure taxpayers and investors that the economic stimulus would bring the economy out of its slump, the markets were unconvinced. Economic data, especially as it pertains to the housing market, has become increasingly grim, and even Chairman Bernanke of the Federal Reserve conceded that a recovery is unlikely before 2010. Given that the government will have to issue a tremendous quantity of Treasury Bonds in order to fund its ambitious spending plans, however, it’s possible that foreign investors will soon lose their appetite for low-yielding American securities. Reuters reports:

Any optimism that the global economy could be recovering, however, should prompt investors to sell the dollar and buy riskier assets and currencies.”When panic and risk aversion abate, money will start flowing into other regions such as Europe,” said a portfolio manager.

Read More: Dollar gains broadly as safe-haven demand rises

I recently stumbled across an article that argued that forex trading is not a zero-sum game. The author is (unwittingly) correct in his conclusion, although not in his reasoning that it is possible for a trade to produce two winners. The conclusion verged on truth only because after accounting for broker commissions (i.e. the bid/ask spread), forex trading is actually a negative-sum game. It is important to recognize that the nature of forex is such that all currencies cannot simultaneously appreciate, and hence, every trade involves a winning party and a losing party. Even if all parties manage to break even over the long run, the existence of spreads and commissions ensures a long-term average return that is negative. This does not mean that it is impossible to to profit in forex, but rather that the profits of the winners are underwritten by the losers. While one cannot expect to always occupy the winning side, there are steps that can be taken to minimize being on the losing side. Admittedly this is vague; the idea here is simply that it’s vitally important to be well-informed when investing in forex so as to enter and exit trades only at levels that are “fundamentally” sound.

After nearly six months of currency depreciation, the nations of Asia have finally been spurred to action. Japan, China, and South Korea have joined together with the 10 ASEAN economies to form a $120 Billion pool of foreign exchange reserves, which contributors can tap into to protect their currencies. The goal is to prevent capital flight and currency weakness from engendering the same kind of financial crisis that only 10 years ago ravaged Asia. Fortunately, this time around, the 13 countries possess a combined $3.6 Trillion in reserves, which can be deployed in forex and securities markets in order to restore investor confidence. Ironically, the bulk of these reserves belong to China and Japan (who are also funding a large portion of the forex pool), both of whose currencies remain strong in spite of the crisis. Bloomberg News reports:

Read More: Asia Agrees on Expanded $120 Billion Currency Pool

In the last few weeks, investors have waded cautiously back into emerging markets. Spurred in part by the Obama economic stimulus plan and pending US investment in Citigroup, investors have evidently been persuaded to take on more risk. The Japanese Yen, accordingly, has already begun to beat a retreat from the highs it reached earlier this year. If this trend continues, the US Dollar could become the next “victim.” On the other side of the equation are currencies such as the South African Rand, which have benefited from a renewed interest in yield, as well as increased monetary stability driven by lower inflation. Ultimately, this movement of capital can just as easily reverse itself, which it no doubt will at the next economic hiccup. Bloomberg News reports:

Read More:  South African Rand Gains as Investors Return to Riskier Markets

The credit crisis continues to exact a devastating toll on the economies of Eastern Europe, and capital flight has caused the region’s currencies to plummet precipitously. This has prompted internal debate in countries such as Poland, Czech Republic, and Latvia – to name a few- as to whether the effects of the crisis would have been so blunt had they adopted the Euro. While certainly Euro membership would have spared them from currency instability, it would not have necessarily facilitated financial and economic stability, as Italy, Spain, and Greece have learned the hard way. Regardless of whether Eastern European countries are politically willing to commit to the Euro (itself doubtful), this debate is largely moot, since the credit crisis has all but eliminated their ability to meet the preconditions of membership in the short run. The New York Times reports:

Read More: Currency Issues Weigh on Eastern Europe

While China remains committed, in rhetoric at least, to a flexible Chinese Yuan that rises and falls in accordance with market forces, its actions suggest otherwise. Beginning in the second half of 2008, China stopped allowing the Yuan to appreciate, for fear that a more expensive currency would exacerbate the domestic effects of the credit crisis by making exports less competitive. What China fails to realize however, is that a more valuable Yuan is not only conducive to global economic stability, but also to its own economic well-being. In fact, the artificially cheap Yuan may have actually worsened the economic downturn in China, because de-incentivized the creation of a domestic economic base. Now that overseas demand has dried up, it is left feeling the consequences of this neglect. The San Francisco Chronicle reports:

Read More: Undervalued currency helps, hurts U.S. economy

After months of speculation, it appears that forex markets have finally concluded that the Central Bank of Japan is now prepared to bring down the Yen. On the one hand, the Finance Minister of Japan very publicly denied that the overvalued Yen and the consequent need for forex intervention was discussed during either his personal conversation with US Treasury Secretary Geithner or at the most recent G7 conference. At the same time, he pledged the willingness of Japan to fight “excessive swings” in forex and capital markets. Meanwhile, the expensive Japanese Yen has already trickled down to the economy, driving a 12.7% decline in GDP (in annualized terms) for the most recent quarter. The Yen, accordingly, has begun its retreat, already erasing nearly 10% of the gains it racked up against the Dollar over the last year. Reuters reports:

Read More:  Japan to act vs FX swings

At its next meeting, to be held in March, the European Central Bank is all but certain to bow to pressure and cut its benchmark interest rate to a record low. This should not come as a surprise, for the ECB’s February decision to hold rates constant was met with a large outcry, in both public and private circles. Soon-to-be-released inflation data is expected to confirm that prices are rising at a slower pace, perhaps even below the ECB’s 2% benchmark. Members of the Bank are also paying attention to the Euro, the continued weakness of which is ironically a product of the ECB’s comparatively tight monetary policy, as investors guard themselves against the risk of deflation. The Guardian reports:

As the economy falters, speculation is also increasing that the ECB may expand its monetary toolbox, possibly through asset purchases, to boost growth while keeping rates relatively high compared to other central banks.

Read More: ECB’s Liikanen, Bini Smaghi say rates could move in March

Convention forex wisdom, as well as the "immutable" laws of economics, have long held that higher interest rates correspond with currency appreciation. This has been especially true in recent years, as risk-hungry investors used low-yielding currencies to fund carry trades, the proceeds of which were invested in higher-yielding alternatives. In the context of the credit crisis, however, this logic has been turned on its head, as the countries with the lowest interest rates have seen their currencies outperform. Emerging market economies that have turned bearish on inflation have likewise been rewarded with strong currencies, despite a potential imbalance in the risk/reward profile. This phenomenon suggests that investors are primarily concerned with deflation, and are parking their money in the countries they believe can best preserve their capital, even if the real rate of return is negative. One analyst argues this could spur further interest in gold, reports SeekingAlpha:

If it [the Euro] also joins the zero interest band-wagon then one may wonder what’s left for the currency markets to play with? Is this is a precursor to a crisis brewing here? Does gold get a further leg up – it’s a zero yield currency anyway!

Read More: The Currency Conundrum: Is It Another Leg Up for Gold?

Prevailing wisdom has long held that the accumulation of foreign exchange reserves has helped stabilize emerging market economies by cushioning them against economic shocks. The economies of Asia, in particular, were praised by economists for responding to the 1997 Southeast Asian economic crisis by building up their reserves to guard against runs on their currencies in the future. In hindsight, however, the accumulation of reserves may have actually contributed to the current economic crisis, by facilitating the formation of massive global economic imbalances. High savings rates in Asia, for example, enabled western countries to run continuous current account deficits. Now, the chickens are coming home to roost, and developing economies are once again finding themselves vulnerable to recession, since their forex reserve policies came at the expense of developing domestic economic bases. The Times of India reports:

Re-balancing means that Asian countries must stop piling up ever-rising forex reserves (and trade surpluses). Such reserves represent excessive saving, excessive exports and insufficient imports.

Read More: High forex reserves can worsen recession

Speculation surrounding the Chinese Yuan has been mounting for months, beginning with a sudden halt to the currency's appreciation and continuing with the insinuation of the Obama administration that China is a currency manipulator. In the context of falling exports and a sagging economy, meanwhile, the Chinese Ministry of Finance has issued a research report encouraging the Central Bank to allow the currency to appreciate. Despite the Central Bank's insistence that it wants a "stable" currency, futures prices indicate a mean expectation that in fact, the Yuan will be nudged downward over the next twelve months. On the other side of the equation are financial analysts, who collectively forecast a slightly stronger Yuan, with one bullish analyst projecting a 3.5% appreciation in 2009, on the basis of selectively culled economic data. Bloomberg News reports:

“The consensus around China has been weak growth and falling reserves. The recent data challenges both views. Lending looks good, money supply looks good, and the PMI balanced to slightly bad from very bad levels.”

Read More: Citigroup Is Bullish on Yuan, Bets for 6.60 Year-End

While continuing to deny the possibility of direct forex intervention, Japan is nonetheless desperate to halt the rise in the Yen. The primary concern of the US government, meanwhile, is not that the Dollar is becoming too valuable, but rather that it will face great difficulty in funding its economic stimulus plan. Perhaps there exists a golden opportunity to simultaneously alleviate both of these quandaries; Japan should be solicited to buy US government bonds. A large-scale purchase of US Treasury securities by the Central Bank of Japan would be tantamount to intervention, and would probably lead to a decline in the Yen, at least against the Dollar. Of course the US would benefit not only by the direct purchase of its bonds, but also by the positive signal that this would send to other institutional investors. Besides, given that China is in no position to increase its holdings of US Treasury securities, Japan represents the best candidate for partnership. The Washington Post reports:

Achieving such a currency adjustment may seem farfetched, but the yen-dollar exchange rate historically has been heavily influenced by the market's perception of the U.S. and Japanese governments' comfort level for the currency relationship.

Read More: America's New Rescuer: Japan

While the year-long surge in the Dollar has been a welcome development for American consumers and the US government (in terms of cheaper imports and easy credit, respectively), American businesses are not smiling. The strong Dollar has resulted in decreased competitiveness in the eyes of foreign consumers, and consequently, lower exports. For this reason, the US trade deficit has not shrunk significantly, despite a slight down-tick in imports. One must also look at the overseas earnings of American multinational corporations, which are frequently repatriated to the US and booked in Dollar-terms. In fact, as much as 50% of S&P 500 member company profits now come from overseas. Simply, lower exchange rates mean lower profits. In short, investing in the stocks of companies as a proxy for the markets in which they do business is not (as) profitable when the Dollar is strong. The Financial Times reports:

As a result of this greater impact of currency swings, companies are starting to put greater emphasis on trying to hedge their foreign exchange exposure, according to a recent survey from JPMorgan.

Read More: US company earnings hit by turbulence in currency markets

In accordance with yesterday's post, it appears that this February is set to continue the trend of low volatility observed in previous years. With the US government on the verge of passing a record economic stimulus package, investors are becoming increasingly confident about the prospects of the global economy to avoid recession. On the surface, it would seem that the stimulus should benefit the economy, and by extension the Dollar. However, this ignores the fact that the Dollar is currently being driven by fear- the idea that the US remains a safe haven for investing- rather than by economic fundamentals. The same holds true for the Japanese Yen. Accordingly, regardless of how the stimulus ultimately impacts the economy, it will certainly increase risk tolerance in capital markets, potentially leading investors to shift capital out of the US and Japan into higher-yielding sectors. Bloomberg News reports:

"A lot of money that sat on the sideline is now being put back to work," said [one analyst]. "People are starting to move to make risky bets."

Read More: Yen, Dollar Fall as U.S. Stimulus Prospects Reduce Haven Demand

Efficient markets theory would suggest that the inherent randomness of commodity prices should be preserved from month to month, such that on average, prices are equally likely to go up as they are to fall. In practice, we know that earnings and tax calenders are such that stocks consistently perform better in some months, than they do in others. Such patterns can also be observed in forex markets.The Dollar, for example, typically rises in January, probably as a result of the US stock market to rise likewise. In February, meanwhile, one analyst has observed a consistent decline in volatility between the Yen and the Dollar. The implication is that with lower volatility will follow a sell-off in the Yen, due to renewed interest in the carry trade. Of course, this may not hold in the current market environment, as both currencies are now being used to fund carry trades and are being punished accordingly when risk tolerance increases.

Read More: What Is Unique About Forex in February?

After "profound" debate, the European Central Bank voted yesterday to hold its benchmark interest rate constant at 2%. Despite the acknowledged fact that EU inflation has slid to the lowest level in a decade, the ECB remains unconvinced that it has been tamed. It is apparently concerned that further interest rate cuts could trigger a loss of confidence and hyper-inflationary spiral, from which it would be difficult to escape. The Bank's critics, meanwhile, insist that it is increasingly out of touch with economic reality and is falling further behind the curve, especially compared to the Fed and bank of England, which have already lowered rates to record lows. They further argue that this viewpoint is reflected in the Euro, which is losing the battle as safe haven currency with the Dollar. Nonetheless, it appears that investors accept the reasoning of the ECB, and the Euro reacted to the rate hold with indifference. The Financial Times reports:

The ECB president…said only that a zero interest rate policy had a “number of drawbacks” that should be avoided, without specifying what they were.

Read More: ECB halts rate cut after profound debate

Most of the speculation in recent weeks concerning forex intervention has focused on Japan and Russia. The Central Bank of Mexico, meanwhile, has slipped quietly into forex markets to protect its battered Peso, which has fallen over 30% over the last six months. It's unclear whether Mexico's efforts, combined with support from the US, will be enough to stem further decline, considering that economic fundamentals continue to deteriorate. At the very least, the move serves as a symbolic warning to market bears, that the Central Bank is monitoring the situation, and is prepared to defend its currency accordingly. Mexico could also serve as a case study for other emerging market economies, most of which have witnessed minor runs on their currencies since the inception of the credit crisis. At the same time, it would be a mistake for them to assume that they could protect their currencies at fixed exchange rates, given Russia's recent failure to achieve such a result. Bloomberg News reports:

Russia “bungled by trying to draw a line in the sand,” said [one analyst]. “Emerging market currencies won’t see any relief till crisis is past.”

Read More: Mexico’s Central Bank Intervenes to Halt Peso Slide

Investing wisdom has long held that gold is used to hedge (Dollar) inflation; historically, the two commodities have tended to trade inversely with one another. In the last month, this relationship appears to have broken down. As the credit crisis has entered a new critical stage, investors have come to view both the Dollar and the gold as safe havens in a sea of uncertainty. To elaborate, the Dollar is being purchased primarily to pay down debt, with the proceeds invested in low-risk, low-return vehicles. Gold, in turn, is being used as a form of insurance, as a "deflationary backstop" in case the bets on the Dollar miss the mark. In short, the Euro and Gold are no longer friends. BullionVault reports:

"The new dynamic in risk aversion now means that when the EUR/USD goes up then traders must sell their gold – since a higher Euro implies lower risk in the overall markets and hence less need to hoard the yellow stuff."

Read More: Gold and the Dollar Running Together: Why?

It appears Timothy Geithner, recently-appointed US Treasury Secretary, was not exaggerating when he declared that the Obama administration intends to address China's currency policy. No less than President Obama himself rrecently called Hu JinTao, President of China, to inform him likewise. Unfortunately, the administration does not exactly have support from political and economic analysts. They argue that not only is the Yuan's "true" value debatable, but also that now is not an opportune time to pursue this issue, due to current economic circumstances. Givent that the Yuan has been permitted to appreciate almost 20% in the last four years and that the Chinese accumulation of forex reserves has begun to slow, perhaps Obama's prodding could even backfire. Bloomberg News reports:

There’s also a be-careful-what- you-wish-for angle here: If China tomorrow let the yuan trade freely in markets, it’s more likely to drop in value than surge. So-called hot money may flee, global companies may repatriate profits and Chinese savers might buy overseas assets.

Read More: China Tells Obama What to Do With His Yuan Views

Since the inception of the credit crisis, perhaps no currency has been beaten down more than the British Pound, with analysts bitterly divided about whether the currency will fall further. A lot depends on whether the British efforts to save its devastated banking sector are successful. The government has already moved to nationalize the Bank of Scotland, and is quickly moving to shore up the capital positions of other vulnerable banks. Experts point to the Pound's historic volatility, however, as an indication that investors have always fled, and will continue to flee the UK in times of uncertainty. Jim Rogers, whose partner George Soros famously "broke" the Bank of England in 1992, forecasts a bleak future, although his motives are questionable. Ultimately, the fate of the Pound is entirely relative, as is the case with all currencies. In other words, if investors suddenly changed their minds about the perceived stability of the Dollar and Yen, the Pound could quickly recover. Business Week reports:

As investors begin to renew their focus on the problems of other economies, the pressure on sterling may ease. The selling could turn to buying if investors suddenly decide they'd rather take a little risk to earn return, rather than watching their cash evaporate.

Read More: Playing a Rebound in the Pound