Based on the title, you’re probably groaning: ‘Wait, I thought this was supposed to be a forex blog?” Bear with me, however, as this subject is extremely pertinent to forex.

Last week, it was revealed that China has been clandestinely adding to its gold reserves since 2003, to the extent that its holdings increased by 76%, to approximately 1,050 tons. The news initially sent a ripple through forex and commodities markets, which were overwhelmed by the figures involved. After analysts had a chance to gather some perspective, however, the markets relaxed. You see, although the increase seems tremendous in size, it is quite small in relative terms.

It is relatively small compared to other countries: “This places China fifth in the world, ahead of Switzerland’s 1040 tons but behind the U.S. ranked first with 8,133 tons, followed by Germany (3,412 tons), France (2,508 tons) and Italy (2,451 tons).”

It is relatively small given the six-year duration of accumulation: “I think as soon as people realized it’s not a year-on-year increase, or a quarter-on-quarter increase, people realized it should not have that big an impact.”

It is small relative to China’s mammoth $2 Trillion forex reserves: “As a proportion of foreign exchange reserves, which have risen five-fold over the same period, gold now stands at a tiny 1.6 percent, versus 1.7 percent in 2003.”

On some level, the development has at least some symbolic importance, as it demonstrates that it cannot be taken for granted that China will simply continue to plow its (dwindling) trade surplus into Dollar-denominated securities, or even currencies in general. This is underscored by the suspicious timing of the announcement; China essentially waited six years before revealing its buildup in gold, probably in order to coincide with the uproar surrounding the Dollar’s role as global reserve currency. In other words, even though China’s gold purchases in and of themselves don’t amount to much, the Central Bank of China is trying to send a message that it will defend itself against “the depreciation risk of some foreign currencies.”

The announcement also explains the recent buoyancy of gold prices. Historically, there existed an inverse correlation between gold and the Dollar. This correlation has all but broken down as a result of the credit crisis, and for the first time a strong Dollar has been accompanied by high gold prices. Part of the reason may be increased buying activity by Central Banks, including the Bank of China: “The physical market remained well-bid by an unknown buyer despite bullion prices spiking to levels that normally cooled demand…Purchases were made in Shanghai, traders said, in an effort to absorb domestic production and lessen the impact of bullion prices on global markets.”

The one-year chart of the EUR/USD depicts a general downward trend, punctuated with steep “blips.” Every couple of months or so, it seems traders are temporarily jarred loose from their mindset of Euro bearishness, and find an excuse to bid up the common currency. Invariably, the Euro then resumes its downward course a few weeks later.

The Euro’s recent trading activity fits this mold perfectly. The global stock market rally in March was accompanied by a spike in the Euro. While equities, commodities, and even other currencies continued to rise, however, the Euro peaked after a couple weeks and has since hovered around the $1.30 mark.  As one currency strategist summarized: “A breakdown of the correlation between the euro-dollar exchange rate and the S&P index indicates the currency pair ‘ has become a trade that is less about risk, a little more about euro rate specifics.’ ”

In other words, the decline in risk aversion has not expanded to include the Euro. This is somewhat surprising, since EU economic indicators have rebounded in the last month. The oft-cited German IFO index “rebounded from a 26-year low,” while “retail sales declined the least in 11 months in April after government stimulus packages improved consumer confidence.” On the other hand, EU lending activity, which is more correlated with economic growth, continues to decline. “The European Central Bank Wednesday released figures showing that banks in the currency area cut their lending to both companies and households in March.”

This is a huge problem for the EU, where the banking sector represents a comparatively important component of the economy.. “At the end of 2007, the stock of outstanding bank loans to the private sector amounted to around 145 percent of gross domestic product, compared to 63 percent in the United States.” This is belied by newspaper headlines that maintain the banking crisis is most severe in the US. In nominal terms, this might be true, but in relative terms, the EU is in much worse shape. Given that exchange rates are all relative, it is worth paying attention to this phenomenon.

The ECB is doing all that it can to help the situation, but many analysts and even some of the Bank’s own members remain critical. “The ambiguity of the ECB’s stance is not helping [the Euro,” offered one analyst. The ECB’s next meeting is scheduled for May 7, when economists predict the benchmark lending rate will be lowered to 1%. This will appease some investors, but not all. The head of Germany’s IFO organization, for instance, has urged the ECB to slash rates down to .25%.

As ECB President Jean Claude Trichet has pointed out, lower rates will not automatically stimulate the economy: “Owing in particular to the very low rate on our deposit facility of 0.25 percent, this difference in policy rates doesn’t translate into equivalent differences in money market rates.” In fact, money market rates have largely converged across the EU and US, despite the divergence in short-term rates, vindicating Trichet.

More important, then is the ECB’s non-monetary initiatives. To quote Trichet again, “Comparing only the levels of policy rates without consideration of the resulting market rates and other economic variables is looking at just one part of a far broader canvas.” The Economist recently published an excellent comparison of the various Central Banks’ responses to the credit crisis. While some have embraced their newfound prominence, other Central Banks have shied from the spotlight, insisting that their mandates are limited to inflation targeting. The ECB probably falls into this category, as it has thus far stood on the sidelines – for better or worse- as its counterparts have turned on the printing presses and flooded their respective credit markets with liquidity. [Chart courtesy of The Economist].

This could soon change, and “A commission headed by Jacques de Larosière, a former head of both the Bank of France and the IMF, has recommended that the ECB chair a new European Systemic Risk Council made up of its member central banks and supervisors.” Not all investors are convinced that the ECB can successfully break with tradition. “Alan Ruskin, head of international currency strategy in North America at RBS Securities…recommends investors sell the euro on ‘upticks’ as the ECB abandons ‘monetary orthodoxy’ and uses unconventional measures to spur growth.”

The value of the Thai Baht continues to erode, and the currency has now fallen 10% in the last year. It recently touched a two-year low against the Dollar. Weighing primarily on the Baht is the global economic crisis, so it is hardly unique in this regard. “The government has forecast the economy will contract by 3% this year, which would be the first time it has shrunk in more than a decade.”

Thailand’s economy is heavily reliant on exports, a category which also includes tourism.  “The tourism council forecast revenue for the industry this year could drop 35 percent to only 350 billion baht in 2008,” and “The commerce ministry announced that Thai exports fell by 23.1 percent in March year-on-year, the fifth consecutive month of decline.” This is certainly the worst economic crisis to hit since the 1997 Southeast Asian economic crisis, but the country is in much stronger shape this time around. ” ‘Both at the national government level and in the private sector, the balance sheets are much stronger.’ ” As a result, Thailand has thus far managed to stave off a run on its currency, even despite a decline in investment- both direct and speculative. The Thai stock market is sagging; according to one commentator, “Fund flows could continue to drag the market down as we see profit-taking in this region.”

The government and the Central Bank are working in tandem to relieve the situation, but there isn’t much optimism surrounding their efforts. The Minister of Finance recently announced an (attempted) expansion of Thailand’s own version of an economic stimulus plan, to $40 Billion. Funding will be provided for “investment projects in a wide range of industries such as logistics, agriculture and energy.  The Bank of Thailand recently slashes rates to 1.25%, tying a record low that was set in 2003.

However, “The decision to cut the rate by a quarter percentage point to 1.25 percent came as more than 40,000 protesters seeking to oust the government were massed in the capital Bangkok.” The political unrest in Thailand is old news at this point. It began over a year ago when then-Prime Minister Thaksin Shinawatra was ousted in a military coup. Since then, there have been an unending series of protests and counter-protests aimed at keeping him out or bringing him back. Basically, no one is happy with the current situation, but still there are no signs of political change. The Prime Minister has refused requests to resign, and Thaksin remains in exile outside the country.

The political uncertainty isn’t really weighing on the Baht, but one analyst warns this could change: “The baht is likely to underperform in the near term due to political tensions, which have prevented the government from undertaking aggressive fiscal stimulus.” In other words, while tourism has been impacted by the protests, the biggest problem is that the government is being hamstrung in its efforts to forge a strong response to the economic crisis.

Everyone has heard the cliche that currency markets are the most viable because there’s no such thing as a bear market; a decline in one currency must necessarily be offset by a rise in at least one other currency. This truism has taken on a new significance in the context of the credit crisis, where sell-offs in virtually every other asset class has sent investors scrambling in search of yield. Despite even the current rally in stocks and commodities, forex volume is surging.

Aggregate forex data is essentially nonexistent, and also unreliable since its based on surveys rather than actual numbers. But anecdotal evidence from the major players in forex suggests that interest has exploded. “Volumes on dbFX, the online retail trading platform from Deutsche Bank, increased 37% in the first quarter of 2009 from the same period a year earlier. ….particularly impressive given sharp volume gains in October, at the height of market fears, when retail investor interest spiked due to intensified volatility.”

Ironically, the increase in retail forex trading has coincided with a relative decline in institutional trading, as banks collectively make an effort to get back to their roots of providing financial services and move away from position-taking. “The crisis has also led many houses to disable algorithmic trading models, which had been big volume drivers.”

Japanese retirees were probably the first, or at least the most famous, mainstream group to trade in the currency markets. They famously used the carry trade to bet against the Yen. When this strategy imploded, it was left to investors from other countries to pick up the slack. “Contracts for Difference (CFD) providers [in Australia] are noticing the shift. Many newcomers to CFDs, they say, are overlooking margin trading over shares for the prospect of trading currencies instead.”

Equity traders are also starting to pay attention to forex. The Dollar’s recent volatility has effected significant changes in corporate profitability. For companies that are export-oriented and/or are net buyers of commodities, the strong Dollar has provided a windfall. One analyst added, “Travel and leisure companies will also benefit from the weak dollar as this means that travel is now more affordable for foreigners.” If and when the Dollar recovers, companies that do business overseas are poised to reap the benefit.

For novice forex traders, the most important decision involves choosing a trading approach; “The type of forex trader you are will determine how frequently you trade, the type of currency pairs you choose to trade, the charts you use, and even the strategies that you employ to make money on the markets.” Generally speaking, day traders churn their portfolios daily, and hence stick to the most volatile currency pairs. Swing traders typically hold positions from one day to several weeks, and rely on a combination of technical and fundamental analysis.

Position traders, in contrast, don’t worry about “short-term market movements like the day trader or swing trader, but about long-term trends spanning weeks or months.” These types of traders, as well as those who aren’t ready to take the plunge directly into forex, should also consider currency ETFs, currency options, and currency CDs. As one instructor summarized, “The upside to these is that you can get started in currencies right through the same stock brokerage account that you would buy IBM, GE or Google.”

Today, the Bank of Canada followed up on an earlier promise by formally clarifying its position on quantitative easing. Suffice to say that the markets breathed a huge sigh of relief when it was revealed that the BOC was not committing itself to such a program. ” ‘The market has always had great trepidation about the idea of printing money…As the Bank of Canada has pushed back at that notion, the Canadian dollar is having a little party of its own,’ ” quipped one analyst.

In other words, the BOC would like to avoid following in the footsteps of its counterparts in the US, UK, Japan, and perhaps the EU, by pumping newly-minted money directly into credit and government bind markets. At the same time, the Bank admitted that a rapid deterioration in the Canadian economy would certainly prompt it to reconsider. Governor Mark Carney et al have approached the subject of quantitative easing coyly. On the one hand, today’s report (as well as the BOC website) contain detailed explanations of what quantitative easing would hypothetically entail. On the other hand, they insist that such a scenario does not fit with their economic projections, and hence remains unlikely. “The need to do extraordinary easing is a ‘big if,’ ” in the words of Governor Carney.

This is largely consistent with analysts’ expectations, one of whom had predicted that “it’s also quite possible the bank could simply lay out a framework on Thursday and not take any action at all.” Even ignoring the inflationary implications of quantitative easing, it’s not clear whether such a policy could even be effective. “The corporate bond market is reviving, with spreads narrowing and issuance levels improving, raising the question of whether central bank involvement is necessary or appropriate in a market that seems to be healing itself.” Granted, most investors are now wearing their rose-tinted glasses, but the data speaks for itself.

The BOC’s estimation that it can avoid quantitative easing is somewhat dubious, since it is predicated on overly optimistic economic forecasts, as well as because it has already exhausted the primary tool in its monetary arsenal. Earlier this week, it lowered interested rates to a record low of .25%, capping a 16-month period of easing, during which it slashed rates by 4.25%. By the Bank’s own reckoning, interest rates will remain low until mid-2010, as inflation is now comfortably within the target range of 1-3%.

Given the abysmal economic situation, it is no surprise that inflation has moderated. Commodity prices are well below the record highs of 2008. Aggregate demand, and GDP by extension, are retreating in kind. According to one economist, ” ‘When you do that math, no matter how optimistic you are, you are talking about a time frame of years before things like the unemployment rate (are) back down to historically normal levels.’ ”

Still, traders remain bullish on the Loonie. “Since March 9, the loonie has climbed 6.2 percent…The loonie will appreciate to C$1.19 by the end of March next year, according to the median forecast of 38 economists and analysts in a Bloomberg survey.” As the Forex Blog reported in yesterday’s post, the carry trade has returned, which is good news for commodity currencies, low interest rates are not. Meanwhile, low interest rates could stimulate corporate borrowing and home buying. Given the Central Bank’s reluctance to print money, the economic recovery would even unfold without the drag of inflation. Maybe the excitement is justified…

Yesterday’s post on the resurgence of the Australian Dollar largely ignored a broader trend in forex markets: the return of the carry trade. This strategy, which involves borrowing in low-yielding currencies, and selling them in favor of higher-yielding ones (such as the Aussie) is making a comeback, as risk aversion ebbs and investors resume the search for yield. As Bloomberg News outlined in an excellent piece on the subject, “Stimulus plans and near-zero interest rates in developed economies are boosting investor confidence in emerging markets and commodity-rich nations with interest rates as much as 12.9 percentage points higher.” [Chart below courtesy of the WSJ.]

Technically, the change in investor sentiment has already been manifesting itself (in the form of higher asset prices) for a couple months. In reality, it wasn’t until Goldman Sachs published a report entitled “Time to Reconsider Carry” on April 8 that analysts began to specifically focus on the decline of risk aversion in forex markets. In the report, GS argued that “There are increasing signs that FX volatility has peaked” and “The conditions are about to fall in place to make carry strategies attractive again.”

The point is well-taken when you consider the paltry yields offered by the Euro, Dollar, and Yen, for example, combined with the fact that these currencies are now expensive, relative to a few years ago. “Borrowing U.S. dollars at the three-month London interbank offered rate of 1.13 percent and using the proceeds to buy real and earn Brazil’s three-month deposit rate of 10.51 percent rate would net an annualized 9.38 percent,” according to Bloomberg.

Investors could theoretically choose between any of these currencies, as well as the Swiss Franc, Canadian Dollar, and British Pound, all of which are backed by benchmark interest rates less than or equal to 1.25%. Ironically, the New Zealand and Australian Dollars- which could still be considered candidates for the long side of a carry trade – now feature interest rates well below those of the US and EU when they were at that their peak in 2008. This gives you an idea just how far rates have fallen since the inception of the credit crisis. It looks like the Yen has emerged as the favorite among the spectrum of funding currencies. The Yen makes a good choice because inflation and interest rates are extremely likely to remain close to zero for the foreseeable future.

The hard part is choosing which currency to go long. A summary of interest rates for actively-traded currencies reveals several yielding more than 10%. “Goldman Sachs recommended on April 3 that investors…buy Mexican pesos, real, rupiah, rand and rubles from Russia.” Bloomberg meanwhile pointed out that “An equally weighted basket of currencies consisting of Turkish lira, Brazilian real, Hungarian forint, Indonesian rupiah, South African rand and Australian and New Zealand dollars — bought with yen, dollars and euros — earned an annualized 196 percent from March 2 to April 10.” Standard Chartered Bank, meanwhile, recommends the Indonesian rupiah, the Indian rupee and the Philippine peso. Investors not wanting to trade forex directly can buy the iPath Optimized Carry Trade Fund (ICI), an ETN which trades on the NYSE Arca exchange.

During the run-up in asset prices that preceded the current downturn, investors could count on stability, maybe even appreciation in riskier currencies that constituted the long end of their trades. This time around, such an assumption is not wise. One analyst warns investors not to be “caught short on the unwind.”

Risks also need to be evaluated specifically to the currencies on the short and long ends of the trade. In analyzing the worth of the Brazilian Real as a long currency, one analyst notes that, “Lower commodity prices, a sudden dive back to safe haven currencies and fluctuation in inflation numbers all have the potential to squeeze the spread on carrying the real.” On the flip side, there is a risk that rates will increase for the funding currencies, although probably not for at least the next 12 month, if not longer.

When two weeks ago the Royal Bank of Australia (RBA) cut interest rates, one would have expected the Australian Dollar to suffer proportionately. Instead, the currency continued its steady upward rise, and touched a six-month high, before falling back slightly. One surprised analyst lamented, “These types of inconsistencies can make trading forex difficult or down right frustrating at times.”

The interest rate cut marked the sixth since September, since which point the RBA has trimmed its benchmark lending rate by 425 basis points, leaving it at 3%. [See chart below courtesy of “The Fundamental Analyst.”] Traders have reacted to the successive declines in yield and simultaneous pickup in risk aversion by unwinding carry trades, many of which had been long the Australian Dollar. The massive sell-off that ensued left the Aussie a long way below the level of parity with the USD, which only last year many analysts had viewed as inevitable.

The most recent rate cut, in contrast, was greeted positively by traders, perhaps because they were expecting a larger (50 basis point) rate cut, but more likely because their priorities had changed. A pickup in risk aversion in recent weeks has definitely reinvigorated interest in comparatively risky currencies such as the Australian Dollar. Overall, the markets remain risk-averse, and investors are increasingly making bets in accordance with economic fundamentals, rather than yield levels. ” ‘The focus will remain on the global backdrop…Risk appetite is still fragile and the market is increasingly realizing that the recent recovery was excessive.’ ”

In the case of the Australian Dollar, traders were heartened by the RBA’s decision to lower interest rates to a 49-year low since it reflected the Bank’s commitment to dealing with the economic crisis. But at this point, the Australian economy is still in poor shape. “Prime Minister Kevin Rudd said yesterday for the first time that a recession in Australia is inevitable amid a slump in global growth that is eroding demand for natural resources from the world’s biggest shipper of coal and iron ore.”

Meanwhile, “The global economic downturn has pushed Australia’s economy into its first recession since 1991, Reserve Bank of Australia Governor Glen Stevens said.” According to the minutes from the RBA’s last meeting, “Conditions in the labor market continued to soften” and “Further falls in employment and rises in unemployment were expected.” These observations should be viewed in the context of a 5.7% unemployment rate.

The near-term prognosis for the Australian economy remains quite poor, regardless of whether a recovery materializes in 2010, as forecast by economists. Accordingly, analysts expect the RBA to lower its benchmark interest rate further, probably to 2.25% or 2.5%; there is a “bias toward further modest rate cuts, although we continue to think that the RBA may well pause for a few months to assess the impact of the current round of fiscal stimulus,” offered one forecaster.

Given the lull in market activity, some commentators have turned to technical analysis. “Westpac Currency strategist Robert Rennie said their own risk measurement models are clearly flagging a bumpy period ahead for high yielding currencies. ‘Our proprietary models are…clearly telling us to watch risk sentiment and data much more closely than we have over the past six weeks.’ ” In short, traders should not become complacent as result of the Aussie’s recent rally, and should continue to monitor economic data for signs of progress and/or hiccups on the road to recovery.

The British Pound recently touched a 3-month high against the US Dollar, and market players are betting the currency’s run will continue: “Traders are paying a 0.25 percentage-point premium for one- week call options on the pound relative to puts, according to data compiled by Bloomberg.” In other words, more investors believe the Pound will rise than believe it will fall.

The Pound is faring especially well against the Euro, and the possibility of parity is becoming increasingly remote. “ ‘There are more and more people thinking there will be prolonged declines in the euro, especially against the pound,’ ” summarized one analyst.

Bulls attribute the sudden strength to an improvement in the real estate market. “A survey from the Royal Institution of Chartered Surveyors (Rics) found that new inquiries in the housing market had increased for the fifth consecutive month in March, ” en route to breaching a six-year high. Mortgage lending, which would necessarily be required to support this increased demand, are also rising, albeit from an “abysmal low.” Meanwhile, prices are still falling in the majority of markets, and real estate agents remain pessimistic.

The economic picture is still grim. A review of the UK economic timeline reveals that while the financial sector seems to have (been) stabilized, most economic indicators continue to trend downwards. “Economists predict the Treasury will anticipate a 3-3.5 percent slowdown in the economy this year, much more than a forecast in November for a 0.75-1.25 percent slowdown.” The budget is scheduled to be released later this week, and analysts expect a wide budget deficit that will need to be fueled by an increase in borrowing and/or the printing of new money. Speaking of which, the Bank of England is in the same position as its counterparts in the EU and US, which implies that the Pound should be trading at a consistent level with the Dollar and Euro.

In short, it’s difficult to ascertain whether the Pound’s recent upside is a product of technical factors or a genuine improvement in the fundamental situation. On the technical side, the currency had probably become oversold from irrational risk aversion, and the current rally could represent a pullback. Until there is definitive evidence that the British economy has turned the corner and/or that the BOE plan shows signs of success, I would advise skepticism.

As part of a new series, the Forex Blog will begin interviewing other financial columnists/bloggers. The following represents an interview with Karl Denninger of The Market Ticker.

The stock market rally that has unfolded over the last month is nothing short of incredible; stocks have now risen 25% since bottoming on March 9. Unsurprisingly, the rally has been deeply intertwined with an ebb in volatility. “The VIX, which measures options trading sentiment on the S&P 500 Index has crashed from a high of 80.86 to 38.85 ahead of Thursday’s trading, a 52% decline.” [Chart below courtesy of DailyFX]

This decline in volatility can be witnessed in all corners of the financial markets, including forex. “The lack of volatility in currency markets has been especially mysterious considering the relationship between the dollar and risk adversity since the onset of the credit crisis almost 20 months ago.” The Dollar has been locked in a comparatively tight range, with one analyst even using the word “listless” to describe its recent performance. With the exception of the Japanese Yen- which is declining for economic reasons- most currencies are gradually stabilizing.

Does this lull represent the end of the storm or the metaphorical eye of the hurricane? Naturally, the answer depends on who you ask. Personally, I am inclined to believe that it is only temporary. The last year has already witnessed two “false starts,” and it wouldn’t surprise me if this time around proved to be yet another one in hindsight.

Whether or not the economic picture is “less bad” than before, it remains grim. “The system is bursting with overcapacity. Demand is falling faster than any time since the 1930s. Inventories will have to be trimmed and budgets cut to muddle through the downtimes. Foreign trade has slowed to a crawl, auto sales are down by 40 percent or more, and unemployment is rising at 650,000 per month.” Two economists, meanwhile, have published a widely-circulated piece which uses juxtaposed graphs as a basis for comparing the current downturn to the Great Depression. Of course, this comparison has become hackneyed, but from a purely statistical standpoint, it’s hard to dispute.

The difficulty with forecasting the current recession is that its causes are structural rather than cyclical. Argues one analyst: “It is unwise and foolish to treat this bear market like any other in the post-WW II period because it is totally unique; the scope and depth of the ongoing destruction of consumer and business credit, bank balance sheet compression and insolvency, consumer retrenchment and soaring unemployment should not be underestimated.” As a result, many economic models are out of date. “Economic forecasters have underestimated how bad it is because they have over-estimated the strength of the real economy and failed to take into account the extent of its dependence upon a buildup of debt that relied on asset price bubbles.”

Not only will future growth have to be built on actual wealth (rather than debt), but the mountain of debt that fueled the most recent economic expansion will also have to be resolved. The most recent IMF estimates imply that “Toxic debts racked up by banks and insurers could spiral to $4 trillion.” Until all of this bad debt can be identified and sorted, economic recovery will remain illusory.

There was tremendous speculation surrounding today’s release of the US Treasury’s semi-annual report to Congress on exchange rates. Considering that Treasury Secretary Geithner accused China unequivocally of currency manipulation during his confirmation hearing in January, it would seem that an official condemnation was inevitable.

Alas, the report once again exonerated China: “In the current Report, Treasury did not find that any major trading partner had manipulated its exchange rate for the purposes of preventing effective balance of payments adjustment or to gain unfair competitive advantage.” The press release accompanying the report made a point of justifying the decision to exclude China: “First, China has taken steps to enhance exchange rate flexibility….Second, the Chinese currency appreciated by 16.6 percent in real effective terms between the end of June 2008 and the end of February 2009….Even so, Treasury remains of the view that the renminbi is undervalued.”

There was certainly a political calculus that went into the decision. There has been a great deal of talk recently regarding China’s growing unease over its US investments, and its consequent willingness to contribute to funding the upcoming US budget deficits. Asks one analyst rhetorically, “If the Obama administration encourages the Chinese government to keep rolling their dollars into US Treasury bonds, then how can the Chinese do this without stabilizing the exchange rates?”

There is also mounting economic evidence that China is no longer manipulating the Yuan, at least not to the same extent as before. China’s foreign exchange reserves, which it must accumulate as part of its efforts to depress its currency, are growing at the slowest pace in nearly a decade. In the first quarter of 2009, its reserves grew by only $7 Billion, compared to an increase of $150 Billion in the first quarter of 2008. This can be explained as follows: “China’s first-quarter trade surplus shrank 45 percent from the previous three months and foreign direct investment tumbled as the global recession choked off demand.” According to another economist, “Inflow through buying properties and speculation was a big part of foreign exchange increase in the past few years, and we are seeing a bit of unwinding as new money is not coming in.”

On the other hand, there are signs that China’s economic stimulus plan has begun to trickle down to the bedrock of the economy. The Chinese money supply expanded by a record 25.5% in March, as a result of a six-fold increase in lending. Today’s release of GDP figures revealed that “By March the economy was gaining more speed, with the year-on-year increase in industrial production rising to 8.3% from an average of 3.8% in the previous two months. Retail sales were 16% higher in real terms than a year ago, and fixed investment has soared by 30%.” In short,  it looks like the increase in investment and government spending will at least partially offset the projected 10% decrease in 2009 exports. [Chart below via The Economist].

Last week marked the beginning of earnings season, as corporations release the results from the first quarter of 2009. The season got off to a strong start with financial heayweights Goldman Sachs and Wells Fargo both smashing analysts’ expectations with large profits. Over the next few weeks, most listed companies will report earnings, which could collectively set the pace for financial markets for the next couple months. “Markets will continue to watch the corporate earnings data very closely in the short term with company comments on prospects also very important for sentiment with any optimism liable to curb defensive dollar demand.”

The last few weeks have witnessed a general decline in risk aversion, as investors have selectively interpreted economic data to support the notion that the economy as bottomed out. Improvements in corporate earnings could reinforce this trend, especially if a majority of companies beat analysts’ expectations. In short, “Forecast-busting first quarter results from Goldman Sachs on Monday encouraged optimism that the worst may be over for financial firms, but investors stayed cautious given that there are many more results to concern.”

It will be interesting to see if and how the strong Dollar will affect corporate earnings. On the one hand,the expensive currency would be expected both to drive a decrease in exports as well as a decrease in earnings from companies that do significant business overseas, since such companies earnings appear relatively smaller in Dollar-terms when exchange rates are more favorable. On the other hand, the decrease in the US trade deficit (to a nine-year low), suggests that the strong Dollar is not exerting a negative impact. “Exports sprang back in February after six months of decline, increasing by 1.6 percent to 126.8 billion dollars and comprising mostly consumer goods, automotive vehicles, foods, feeds and beverages.”

Ironically, an improvement in corporate profitability would further drive risk-taking and would thus have the effect of weakening the Dollar. One would think that an improved economic outlook would strengthen the Dollar. In actuality, financial and psychological factors continue to predominate in financial markets, and investors are looking for an excuse to dump the Dollar in favor of higher-yielding alternatives.

Their is a danger in currency markets taking their cues from stocks, given that the bear-market rally that unfolded over the last month is one of the most dramatic in history. The herd mentality has caused investors to become complacent about risk and pile willy-nilly back into the markets. Writes one analyst, “The growing potential for economic disappointment due to further growth contraction as well as overly confident, economically myopic policy-makers leaves stocks set up for a major wave of selling.”

Only two months ago, the Wall Street Journal published an article under the headline “Slowdown hits Emerging Markets.” Buttressed with economic data and testimony from economists, the piece underscored the notion that “The global downdraft is hitting the world’s emerging economies with a speed and ferocity few imagined possible.” On Monday, the same newspaper published an article entitled “Emerging Markets Go on a Tear,” exploring how emerging markets have outperformed in 2009.

That these stories are built around opposing themes is not surprising, but given that they were published only two months apart, it seems impossible that they could both be meaningful. A deeper analysis, however, reveals some powerful insights, namely that investors seem to be flocking back to emerging markets despite poor fundamentals.

It’s difficult to pinpoint the start of the rally, but it accelerated in earnest in early March for no apparent reason other than investors arbitrarily decided to collectively increase risk-taking. This seems like a classic case of ‘making one’s own reality,’ given that the economic picture continues to deteriorate, and “positive” developments were limited to an increase in government intervention and stimulus plans. But, perception is everything in financial markets, and if investors collectively decide they want a rally, then a rally will indeed obtain.

In the case of emerging markets, the rally has certainly surpassed all expectations. “A Morgan Stanley index tracking emerging-market stocks is up 12% in dollar terms. By contrast, its index following stocks in developed markets outside the U.S. and Canada is down 9%.” Meanwhile, “The extra yield investors demand to own developing nation debt instead of U.S. Treasuries narrowed 10 basis points, or 0.1 percentage point, to 5.68 percentage points.

Emerging market currencies have also enjoyed a nice bounce, led by an across-the-board 7% gain in the Mexican Peso, Brazilian Real, and Russian Ruble over the last five weeks. Analysts at both Citigroup and Goldman Sachs are now encouraging clients to pile back into such currencies, evidently confident that the rally is sustainable: “Valuation has become very attractive in many cases, in particular in historically higher-yielding currencies.”

The concern, however, is that this rally is a product of financial and technical factors, and is not underlied by macroeconomic fundamentals. Exports and confidence have tumbled at a record pace, such that “J.P. Morgan forecasts at least 11 emerging economies — among them South Korea, Taiwan, Russia, Turkey, and Mexico — will shrink in 2009, with another 4 posting no growth.” Instead, investors are using low prices and a lull in bad news – rather than a change in economic tenor – as a basis for buying.

Of course, the bulls will selectively point to data which paint a different picture.  “From monetary easing to joint fiscal policy to capital becoming less constrained at banks, the potential for a recovery in 2010 and 2011 seems more likely.” Some analysts have argued that they believe emerging markets have been, and will continued to be cushioned from the worst of the financial crisis due to their conservative financial sectors, but this argument strikes me as self-justification. Others point to the $500 Billion increase in capital that the IMF (via the G20) will potentially make available to developing countries. As I wrote in a recent post, however, much of the perceived increase is redundant and/or has not yet been guaranteed by rich countries.

Personally, I fall in the “cautiously pessimistic” camp, summarized as follows: “The economic picture is cloudy enough that a number of investors say it is worth adopting a more nimble approach in the short run.” In other words, a wait-and-see approach is probably more prudent than following the crowd, especially since it was the crowd that as originally responsible for the bubble.

This week, the Yen continued its decline against the Dollar and Euro, dipping well below 100 Yen/Dollar en route to a six-month low. Most analysts attribute this trend to a pickup in risk aversion: “Some kind of optimism is returning to the market and that’s putting pressure on the yen,” explained one analyst succinctly.

An ongoing rally in stocks and commodities is reinforcing investor attitudes that the economic recession is under control, and is stimulating risk-taking. In other words, the same forces that contributed to the unwinding of the carry trade during the beginning of the credit crisis, are now working in reverse and causing investors to flee from the Yen en masse. “As long as stocks can retain their buoyancy… risk appetite and risk-based trades will be in vogue and investors will continue to add to and rebuild yen short positions.”

According to the most recent International Monetary Market report, “Short positions on the currency have been building up for three consecutive weeks, and are now at levels last seen in the late summer of 2008,” which means the Yen’s slide has basically become self-fulfilling. From a technical standpoint, “A move above 101.00 yen was technically significant as it was a 38.2 percent Fibonacci retracement of its decline from a peak in 2007 to its 13-year low in January.” Even domestic Japanese investors have signaled their bearishness by taking advantage of last week’s Yen upswing by making “aggressive purchases of foreign bonds.”

From a fundamental standpoint, the decline in the Yen makes sense, given the abysmal economic situation in Japan. In fact, the “Minutes from the Bank of Japan’s March meeting showed members of the central bank were leaning toward cutting the bank’s economic forecast in April, and that they believed the BOJ would need to continue to provide substantial liquidity to financial markets that they see as still under substantial stress.”

The government is finally responding to the economic crisis, having most recently unveiled a $150 Billion plan, to supplement the $100 Billion initiative announced earlier this year. “If implemented competently, these steps could stabilize the domestic economy and stop the bleeding in labor markets.” At the same time, the intertwined tailspin in confidence and spending suggest that the government’s efforts could be in vain.

While equity investors have reacted positively – pushing the stock market into positive territory for the year- bond and currency traders are understandably concerned. Yields on Japanese bonds are already rising in anticipation of $100 Billion in bonds that the government will have to issue in 2009 alone. Naturally, the burden to purchase these bonds will fall on the Bank of Japan, which will be forced to print money and contribute to the further devaluation of the Yen in the process.

Ultimately, the duration of the Yen’s slide depends on the duration of the global stock market rally. If you believe that the global economy has turned a corner, then the Yen is done. If, on the other hand, you are inclined to side with George Soros, who opined recently that “It’s a bear-market rally because we have not yet turned the economy around,” then there is still cause for Yen bullishness.

Last week, SDR became the latest addition to the growing list of forex acronyms. So-called Special Drawing Rights are a unit of account used by the IMF, “defined as the value of a fixed amount of yen, dollars, pounds and euros, expressed in dollars at the current exchange rate. The composition of the basket is altered every five years to reflect changes in the importance of different currencies in the world’s trading system.”

The sudden rise to popularity of SDRs (in spite of their 40 year history) can be attributed both to developing countries’ growing unease about the status of the Dollar, as well as to their perceived usefulness as a tool in fending off economic depression. Ignoring the latter- for the purpose of this post- let’s look, at how SDRs will impact the role of the Dollar as the world’s reserve currency.

First of all, as I noted in Tuesday’s post, the success/scope of the SDR program depends on the positions of the US and EU, the largest and most important members. In the case of the US, the most recent SDR expansion (1997) was never implemented because the US blocked it. Neither can the support of the EU be taken for granted. According to one member of the European Central Bank, “There was no examination of whether there is a global need for additional liquidity at all… One used to take a lot of time to examine something like this.”

In addition, it’s not clear what benefits the synthetic currency would yield. Asks one commentator: “What is one to tie it to?…in a world of depleting resources it is difficult to fathom how to create a list of constituents which would not constrain global growth and tie us into many years of deflation.” In other words, given that the SDRs will derive their value from underlying currencies, it doesn’t seem like the end result would be anymore stable than the current system.

China, meanwhile, has showed fervent support for the expansion in the form of a $40 Billion pledge, which is not surprising since a report issued by the head of its Central Bank provided some of the impetus. This $40 Billion is tantamount to an exchange of Dollars for a basket of currencies. The benefit to China is articulated by one analyst as follows: “ ‘We could see the IMF being put in a position where it could raise in the capital markets funds in SDR-denominated debt….The debt could be used ‘by China and other central banks to be put into their currency reserves, at the expense of the U.S. dollar.’ “

The period leading up to the G20 meeting was generally marked by optimism and hopefulness. One commentator urged his readers: “Don’t write off the London G20 meeting. It could lay the foundations for fundamental global change, impacting currencies, gold and bond markets.”

On some level, the meeting probably did fulfill expectations. After only a few hours of discussions, the G20 agreed to “stricter limits on hedge funds, executive pay, credit-rating companies and risk-taking by banks. The summit also committed more than $US1 trillion to boost the resources of the International Monetary Fund and provide emergency cash to help distressed countries.”

Investors rejoiced and the markets rallied, with the Dow rising above 8000 points and capping “the best four-week rally since the week ending May 12, 1933.” Bulls can now retort that the stock market bust of 1929 took four years to recover, while the recession of 2008-2009 required less than one year. Forex markets also reacted “positively” to the G20 summit, lifting the Dollar above the important psychological barrier of 100 Yen/USD, and causing emerging market currencies to rise across the board.

Monday, however marked a return to business as usual: “Post-G20 euphoria, which had helped to boost market confidence about a global recovery, proved short-lived as investors once again focused on the continued risks to the banking system.” It was probably only a matter of time before investors drilled beneath the surface of the impressive-sounding G20 rhetoric and large numbers, into the nuts and bolts of the summit’s policy prescriptions. [The chart below comes courtesy of the New York Times].

The headline-grabbing $1.1 Trillion figure, for example, is somewhat misleading. Over half of the $500 Billion “pledged” to the International Monetary Fund has either not been raised or not been explicitly authorized. Then, there is $350 Billion in trade credit, most of which is either redundant or double-counted, since “trade financing is rolled over every six months as exporters get paid for their goods and repay the agencies that lent them the money.” The remaining $250 Billion is accounted for in the issuance of IMF synthetic currency to member nations. However, given that the synthetic currency derives a significant portion of its value from the Dollar and Euro, this program cannot be effective if the US and EU opt out, of which there is a real possibility.

The summit also failed to meaningfully address concerns of the continued ole of the USD as the world’s de facto reserve currency. The expansion of the IMF synthetic currency program represents an important starting point, but at this point, it looks like China and the other supporters of an alternative system will have to wait for the next G20 meeting, to be held in September.

One commentator captured this frustration quite well: “The G20 Plan…tries very hard to preserve and perpetuate the existing US helmed global financial and economic order. An act of commission, on the one hand— buttressing the IMF— and an act of omission, on the other— remaining silent on the position of the US dollar— bear testimony to this.”

Despite an ebb in risk aversion, the Canadian Dollar is once again falling. Since touching a high of $1.18 in January, the Loonie has zigzagged its way downwards and hovered around $1.25. March 31 marked the end of its third straight quarterly decline.

With the exception of the Japanese Yen (which is declining due to economic factors), virtually every currency has risen against the US Dollar in recent weeks. Stock market rallies have been accompanied by a general pickup in risk tolerance, and investors are piling back into assets and currencies that had been abandoned during the worst of the credit crisis. Why, then, has the Canadian Dollar been excluded from this rally?

Investors cannot be faulted for focusing on the abysmal Canadian economic situation. Employment, public and private spending, and construction – to cite a few indicators – are all falling at alarming speed. As a result, “the nation’s economy, the world’s eighth largest, will shrink at an 8.5 percent annualized pace in the first quarter, the largest decline since at least 1961.” Given that the picture is equally grim throughout the world, however, there must be another explanation.

Cue Mark Carney, head of Canada’s Central Bank, who has announced that Canada will “adopt a much milder version of the U.S. and U.K. strategy of printing more money to fight the recession.” Euphemistically referred to as “quantitative easing,” such a policy involves the injection of cash directly into credit markets and government bond markets, with the dual purpose of creating liquidity and stimulating the economy.

The concern, especially among forex traders, is that printing money will lead to inflation further down the road. When similar policies were announced by the Central Banks of the US, UK, and Switzerland, for example, their currencies plummeted instantly. In the words of one trader, “The precedent is a haircut right off the currency.” The Central Bank of Canada does have a reputation for being conservative, which suggests that it is likely to pursue quantitative easing only as a last step, and in a measured dose.

Accordingly, there is still some bullish sentiment surrounding the Canadian Dollar. One analyst even urges readers to “Consider the Canadian Dollar as a Possible Inflation Hedge,” partly on the basis that “The Loonie is a commodity based currency, so stronger commodity prices mean a stronger Loonie.” Given that crude oil and base metals prices are extremely correlated with the Loonie, this is a fair point.

“Canada’s currency will fall 3.3 percent to C$1.27 to the U.S. dollar by July, from C$1.2298 on April 3, according to the median forecast in a Bloomberg News survey of 40 economists and analysts.” Whether this prediction actually obtains depends primarily on what, if anything, Mark Carney and his colleagues at the Central Bank of Canada decide at their next meeting, scheduled for April 23.

Yesterday, the European Central Bank delivered a surprise to the forex markets; instead of cutting rates by the consensus expectation of 50 basis points, the ECB knocked down its benchmark lending rate by only .25%. The Bank also opted against certain non-standard measures that would accompany a change in monetary policy. At this point, all investors can do is wait until the next meeting to see if the ECB will finally intervene in credit markets as well as on behalf of beleaguered Eastern European currencies.

While Jean-Claude Trichet, President of the ECB, coyly refused to rule out the possibility of further rate cuts, analysts are puzzling over the relatively minuscule cut. After all, the consensus was that the ECB had already fallen well behind the curve, and was not struggling as quickly as possible to play catch up with its counterparts in the UK, US, and Switzerland. “ ‘By again buying time, the ECB risks falling further behind the curve…You cannot buy time forever.’ ”

There are a few explanations. First of all, it’s possible that the ECB is selectively interpreting data as a basis for deriving a more optimistic economic forecast. Given the spate of recent bad news emanating from Europe, however, this seems unlikely. Besides, no less than Trichet himself has suggested that an economic recovery is unlikely to occur before 2010. There is also the possibility that the ECB is simply prioritizing its mandate to guard against inflation, rather than to stimulate economic growth. This theory is also unconvincing, given that price inflation has already fallen well below the ECB’s target of 2%.

Perhaps, the best explanation is technical: “A 50 basis point cut would have required the ECB to cut the interest that it pays on deposits by banks to zero, from 0.5%, in order to maintain the current spread between the two of 1 percentage point.” Along the same lines, “European interest rates are lower than those in the U.S. when making a comparison of real inter-bank lending.” Ultimately, it’s probably the Bank’s conservatism that is behind both its comparatively tight monetary policy and its failure to unveil a quantitative easing plan that would mirror those put forth by the Fed and Bank of England. In other words, the door for more drastic monetary prescriptions has been strategically left open in the EU, while all but closed in the US and UK.

Curiously, the “the smaller-than-expected rate cut ‘remains an all-round booster for the single currency.’ ” Prevailing trading patterns and market sentiment seemed to herald a decline in the Euro, as investors have recently prioritized capital preservation and vigilance against deflation. Based on the positive market response, however, we can conclude that there are still some traders for whom interest rate differentials are important. After all, the only remaining alternatives to the EU (from the standpoint of yield) are Australia and New Zealand, but both of these economies/currencies are perceived as risky.

Alas, the ECB’s role is not to make currency traders happy. Unless the ECB follows up with a big move next month, the result could be a “very prolonged slump in euro-zone activity.”

This week marked a couple milestones for the Japanese Yen. First, the Yen fell below 100 JPY/USD for the first time in five months. Second, the Central Bank of Japan “celebrated” five years of not having intervened in forex markets. Of course, the relationship between these two events is not difficult to ascertain; as the Yen retreats from the stratospheric highs of 2008, intervention is becoming progressively less necessary (and hence less likely).

Risk aversion, or in this case a decline thereof, has been identified as the likely cause of Yen weakness, although as I alluded in an earlier post, there is still a question of causation, as opposed to correlation. Is it higher equity and commodity prices that are driving risk tolerance, or the other way around?

Regardless of whether the chicken or the egg comes first, higher asset prices have recently been accompanied by modest declines in so-called “safe haven currencies,” namely the Dollar and the Yen. In the case of the Yen, there were previously two different narratives, one that underlies the Yen’s performance solely against the Dollar, and another thread seems to govern its fluctuations against virtually all other currencies.

In recent weeks, however, a combination of forces have come together to drive the Yen down against all currencies. First, of course, is the theme of declining risk aversion: ” ‘The euro was bought for the yen on the back of recent firm stock markets and this supported the dollar relative to the yen,’ ” summarized one analyst. The $1 Trillion economic stimulus plan unveiled today by the G20 will also have the effect of “sapping demand for Japan’s currency as a refuge.”

There are also end-of-quarter factors that have played a role in the Yen’s decline. ” ‘The dollar is being buoyed as Japanese investors try to secure currency on the last day of the fiscal year. Investors’ demand for the yen stemming from repatriation flows, on the other hand, appears to have peaked,’ said a trader at a Japanese bank.”

Last but not least, there is the Japanese macroeconomic picture, which shows a country that is headed towards a deep recession. The latest monthly figures show a 49% year-over-year decline in exports, which is contributing to rising pessimism among Japanese businesses. According to a recent survey by the Bank of Japan, “Confidence among Japan’s large manufacturers dropped to minus 55 in March from minus 24 in December, [which]…would be the lowest since 1975 and the biggest drop since the bank started the survey.” Given that Japanese household spending is also falling, “Japanese companies are caught in a double bind, facing markets at home that are shrinking with the population as well as the global downturn.”

Having appealed unsuccessfully to the G20 to create a viable reserve currency, China is now taking matters into its own hands, by pushing the Chinese Yuan as a viable alternative.

Earlier this week, it signed a $10 Billion+ swap agreement with Argentina, involving an exchange of Argentine pesos for RMB. The agreement is ostensibly designed to benefit Argentina, whose economy has been hit hard from the global credit crisis: “The peso has been weakening slowly but consistently since mid-2008, when a major farm strike here spooked investors and led many Argentines to trade in their pesos for dollars.” By guaranteeing a large quantity of RMB – which is generally considered undervalued- China is effectively providing the peso with more solid backing.

In actuality, the swap was probably proposed by China in order to demonstrate its sincerity in seeing the Dollar replaced as reserve currency. Especially among developing countries and/or Asian countries, many of which represent major trading partners, China is keen to increase the supply of Yuan. One analyst wrote that ” ‘We expect more agreements with other emerging market countries will be in the pipeline,’ as the swaps will help ‘Chinese slumping exports by making access to finance easier.’ ” Accordingly, the swap agreement with Argentina represented the sixth bilateral currency agreement signed by China in recent months. The other five countries are Belarus, South Korea, Hong Kong, Malaysia, and Indonesia, with the total nominal swap value of nearly $100Billion ($650 Billion RMB).

China is also moving to make the Yuan fully convertible, such that it can be exchanged freely both inside and outside China. It is intended that Chinese banks and exporters, for example, will now be able to accept payment directly in foreign currencies, rather than first being forced to convert them into RMB. In addition, the government “will triple the amount of domestic securities that overseas funds can buy under the qualified foreign institutional investors program to $30 billion” in order to make it easier for foreigners to invest directly in China.

While the moves announced so far are too small to make any meaningful waves in the forex world, investors seem generally supportive of China’s efforts. Remember that only two years ago, hedge fund manager Jim Rogers famously announced that the RMB was due to appreciate 500% over the next couple decades and subsequently moved much of his personal savings into RMB-denominated bank accounts.

A recent note by Citigroup analysts perfectly encapsulates this sentiment: “In the longer term, we think it is China’s strategic economic and political interest to promote the broader use or internationalization of CNY. While the internationalization of CNY has a very long way to go, we see China as using the global crisis as an opportunity to take early steps.” Of course, China itself is conscious that such a process will require decades to complete, but it remains cautiously optimistic: “It’s not really up to China to determine this. It’s up to the market…The best the government can do is to permit yuan-denominated trade. And then it’s up to the market to decide whether it wants to use that.”