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Archive for September, 2009

SNB Could Intervene…Again

Sep. 29th 2009

After a brief “hiatus,” the Swiss Franc is once again rising, and is now dangerously close to the $1.50 CHF/EUR “line in the sand” that spurred the last two rounds of Central Bank Intervention.

Both from the standpoint of the Swiss National Bank (SNB) the Franc’s appreciation is vexing, while from where ordinary investors are sitting, it’s downright perplexing. That’s because based on the standard litany of factors, the Franc should be falling.

SNB Swiss Franc Intervention
The Swiss economy remains mired in its worst recession in 17 years, and is projected to shrink by at least 2% this year. In addition, deflation has already set in, with prices falling at an annualized rate of .8%. To be fair, signs of recovery are emerging, and a plurality of economists believe that growth will return in 2010, as will inflation.

But downside economic risks remain, namely the worsening labor market. There is also the fact that the Swiss economy remains heavily weighted towards exports, the demand for which remains slack. From a comparative standpoint, though, projections of recovery are not unique to Switzerland. Financial markets have long since stabilized in most industrialized countries, which many have interpreted as a harbinger for better things to come.

On the monetary front, Swiss interest rates remain among the lowest in the world, as the SNB has gradually guided its benchmark lending rate to .25%. It is also in the process of expanding its quantitative easing program, by pumping liquidity directly into the credit markets, in order to mitigate against deflation. In this sense, the SNB is arguably behind the curve. In the US and EU, for example, speculation is already mounting that interest rate hikes will take place as soon as 2010. Economists are less concerned about a shortage of liquidity in those economies, and more nervous about how the potential excess of liquidity can be withdrawn from the financial system before it turns into a problem. Economists in Switzlerland aren’t even close to beginning to have that conversation.

According to the SNB, the problem lies in the Swiss Franc, which has remained oddly buoyant. While capital has flowed out of the US, for example, it actually seems to flowing into Switzerland. Members of the SNB have attributed this to the “safe haven,” notion, whereby investors still view the country as a safe haven from the financial turmoil. Perhaps slightly irrational, but real nonetheless.

Despite strong rhetoric and equally strong action, the Franc has slowly edge back to the 1.50 mark. Policymakers have pledged to defend the currency vigorously, and it now appears as though another intervention is looming. Given that the SNB has intervened to depress the Franc twice in the last six months, you would think that it would have some credibility with some investors. It seems the lesson is that Central Banks are no match for the markets, and investors realize that ultimately, the SNB is no exception.

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Posted by Adam Kritzer | in Central Banks, News, Swiss Franc | 3 Comments »

Dollar Down, Gold Up

Sep. 26th 2009

As an unintentional extension to an earlier post (Dollar Down, Everything Else Up), I want to use this post to highlight the appreciation of gold in particular, against the Dollar. After a brief decline following the credit crisis, Gold has resumed its upward path. It has appreciated 15% year-over-year, and recently cracked $1,000/oz for the only the fourth time in history.

The general factors behind the price of gold are too broad and numerous to be captured in this post. In addition, many of these factors have little to do with currencies (including the Dollar), and thus don’t warrant much space on a blog devoted to forex. At the same time, conspiracy theorists, doomsday predictors, and even some mainstream economists have long argued in support of gold as a hedge against inflation (otherwise understood as currency devaluation). In fact, I am only posting about gold now is because that notion has become much more popular over the last few years, to the point where pundits have come to see the current appreciation almost solely in terms of the decline in the Dollar.

That’s because many of the more conventional factors – the same ones that affect prices for other commodities – suggest that gold prices should be declining. Non-speculative demand (i.e. jewelry, industry) remains subdued as a result of the economic recession. Speaking of which; while there is now some evidence of recovery, it is nowhere near robust enough to support a return to bubble prices. In addition, the International Monetary Fund (IMF) just approved a massive sale of its gold reserves, equivalent to 15% of the world’s annual gold production.

Yet the price of gold remains not only stable, but positively buoyant. According to analysts, this is because of an increasing sense of anxiety about the viability of the Dollar as the world’s reserve currency. Euro Pacific Capital’s Peter Schiff, an effusive source of commentary on the markets, believes the price of gold will skyrocket to $5,000 per ounce. “Schiff’s forecast is based on his view the U.S. dollar is going to collapse under the weight of our massive deficit and reckless policies of the Obama administration, which he compares to the massive spending programs of the 1960s, which paved the way for gold’s ascent in the 1970s.”

Other analysts take Schiff’s view one step further by arguing that a shortage of viable alternative reserve currencies (Euro, Yen, Pound, Yuan, etc are plagued by similar fundamental flaws as the Dollar) makes gold the best candidate to replace the Dollar. Some people even hold the extreme view that the entire fiat monetary system will collapse, with the result being a barter system centered around gold. In any event, people are nervous: “That means a growing number of investors, traders — and, most troublingly, foreign governments — don’t believe in the strength of the U.S. dollar, analysts warn. People buy gold when there’s fear.”

On the other hand, it seems reasonable that gold is appreciating for the same reason that everything else is. In this sense, rising gold prices are hardly remarkable. Silver and platinum, for instance, have risen nearly 50% year-after-year, despite similarly weak fundamentals. There is a danger in connecting the Dollar’s decline too closely with the rise in gold, since the former is largely a function of short-term factors such as low interest rates and increasing risk appetite. “With the Fed confirming that interest rates could be steady for a long time, the dollar may continue to be dumped in favor of higher yielding currencies, which may favor the yellow metal.”

While there’s reason to be alarmed or even angry about deficit spending, quantitative easing, money printing, and unsustainable debt, there’s very little to support the notion that inflation is taking hold.  In fact, based on both Treasury bonds and inflation securities, inflation is the last thing on the minds of investors. In addition, while gold represents a conceptual reserve commodity, it’s not very practical. It has very little utility (especially compared to other commodities), and its supply can be easily manipulated by producers and central banks. One analyst explains, “Even a rather wobbly reserve currency is better than gold. Gold is far less liquid than U.S. Treasury securities, costly to store and insure, and above all more volatile in price.”

Still, perception is reality in financial markets. If investors want to see a connection between a weak Dollar and strong gold, they will simply contrive one. But if the Fed raises interest rates and/or the Dollar stabilizes, you can expect gold prices to follow suit. If this happens, it won’t imply that confidence in the Dollar has been restored. Instead, it will only imply that investors can earn a higher return investing in Dollar-denominated assets and no longer need to speculate in gold.

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Posted by Adam Kritzer | in Features, News, US Dollar | 8 Comments »

Dollar Down, Everything Else Up

Sep. 21st 2009

Since March, the financial markets have been characterized by several generalizable trends, which can pretty accurately be distilled into the title of this post: Dollar Down, Everything Else Up. To illustrate just how intertwined these two trends are, consider that on the same day, “U.S. stocks rose, sending the Standard & Poor’s 500 Index to an 11-month high,” and “The dollar slid to an almost one-year low.” Two perfect to be a coincidence. Look at the charts below, which show the performance of the US Dollar and Emerging Market Stocks, respectively. Subtract out the stochastic fluctuations, and you’re left with two mirror images!

charts

In this case, connecting the dots is not difficult. In fact, I don’t know of any analyst that has argued against an airtight inverse correlation between the Dollar and virtually every other commodity/security/currency. A solid explanation can be found in an earlier Forex Blog post “Dollar Under Pressure on All Fronts,” which detailed both the short-term and long-term drags on the Dollar, but I’ll summarize and expand upon it below for those of you who didn’t read the first iteration.

In the short-term, the Fed’s easy monetary policy is one of the most salient factors. It has injected more than $2 Trillion in US capital markets since the start of the credit crisis, and lowered interest rates close to 0%. In fact, the Dollar is now the cheapest funding currency in the world, recently eclipsing Japan, the perennial home of cheap capital. Moreover, US rates are expected to remain low for the near future. According to one analyst, “Congressional elections in November 2010 represent a strong incentive for the Fed to stand pat. That is because going into an election, there often is political pressure to keep rates low and give a boost to the economy.” This belief is reflected clear in US Treasury rates, which remain relatively close to the all-time lows touched in 2008.

_tnx
In other words, it’s a classic carry trade scenario, with the US footing the bill. Of course, there’s a twist, namely that there’s so much cash floating around the system, that all of it can’t be invested abroad. Hence, the whopping 58% rise in the S&P 500, from trough to present, as well as the recovery in gold, oil, and other commodity prices. You will find plenty of analysts who point to impressive graphs and quote equally impressive statistics to explain these seemingly distinct instances of appreciation. But from where I’m standing, the fact that everything is under the sun (except for real estate, but that’s another story) is rising would lead the proverbial alien watching from outer space to conclude that investors have adopted a bubble mentality, and are once again chasing returns wherever they can be found.

The strongest support for this explanation can be seen in the fact that signs of US recovery have not been accompanied by Dollar strength. By most estimations, the US economy is now stronger (despite the employment picture) than the UK and the EU, at the very least. Yet the Euro and British Pound have far outpaced the Dollar over the last few months, picking up steam once again over the last few weeks.

You don’t need me to tell you that this is a product of risk aversion; that, ironically, signs that the US economy is strengthening/stabilizing causes investors to move capital out of the US economy. If investors were betting on fundamentals, as stock market bulls would have you believe, this would be plain irrational. But the fact is, US economic growth makes investors more confident in global growth, and causes them to turn towards more speculative investments to achieve yield.

In analyzing whether this phenomenon is sustainable, then, it doesn’t make sense to look at the different markets, in isolation. Rather, you must be holistic in your approach, basically by examining whether investors are justified in their overall complacency. If ever it was the case, it certainly is now: perception is reality.

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Posted by Adam Kritzer | in News, US Dollar | 2 Comments »

Bank of Canada Versus the Loonie

Sep. 18th 2009

I toyed with the title of this post for a while, and ultimately settled on the current iteration, because it reflects the battle that is being waged between the Bank of Canada and the forex markets. Simply, the Loonie is moving in one direction (up!), while the BOC would prefer that it moves in the opposite direction.

Let’s start with some context: the Canadian Dollar’s performance this year has been impressive, to say the least. 2009 is far from over, and yet the Loonie has already risen 14% against the Dollar, almost completely undoing the record 18% slide in 2008. Analysts are quick to point to the nascent Canadian economy, fading risk aversion, and the ongoing boom in commodities prices as behind the currency’s rise.

While all of these reasons are certainly valid, they hardly tell the whole story. Consider that Canadian growth remains tepid, deflation is now a reality, its currency is outpacing commodity prices, and its budget deficit will probably set a record this year. Regardless of what the future holds for the Canadian economy, the present remains nebulous. Thus, it seems the best explanation for Loonie strength is not to be found in Canada, but across the border in the US. Specifically, it is US Dollar weakness, and momentum-driven speculation based on the expectation of further weakness, that is driving the Canadian Dollar.

From the Bank of Canada’s standpoint then, the Loonie’s move back towards parity has nothing to do with fundamentals, which is why the BOC maintains that the currency represents a threat to both recovery and price stability. He has a point on the second front, since inflation is currently running at an annualized rate of -.8%, marking three consecutive months of deflation. “The [inflation information] has proved the Bank of Canada’s concerns are justified,” confirmed one analyst.

The Million Dollar Question then, is how far the BOC is willing to go to halt the Loonie’s ascent. Bank of Canada Governor Mark Carnet has already intervened vocally, by repeatedly signaling his displeasure with recent developments in forex markets, and suggesting that all options remain on the table. But rhetoric only goes so far, and after a brief pause, the Canadian Dollar has resumed its rally. “We think [rumors of intervention] it’s 100 percent untrue. I don’t think the bank has the ammunition or the desire to intervene. This is a story about U.S. dollar weakness across the board,” said one trader.

cad
The Bank has already exhausted most of the tools in its monetary arsenal. It recently voted to maintain its benchmark interest rate at the current record low level of .25%, and beyond extending the period of time during which it maintains low rates, there isn’t much more it can do on this front. Besides, conveying an intention to hold rates at .25% beyond June 2010 might not influence investors, who don’t seem too concerned about low yields offered by the Loonie. Moreover, it remains loath to copy the quantitative easing implemented by the Fed and Bank of England, because of the tremendous amount of work required to mop up“that increase in liquidity when the time comes.

In other words, the only thing the BOC can do at this point is to actually intervene, probably by buying US Dollars on the spot market. A couple obstacles are the fact that the BOC hasn’t intervened for over 10 years, and that Prime Minister Stephen Harper is simultaneously trumpeting the importance of “flexible exchange rates” in speeches intended to denigrate China.

In fact, the BOC may not have to get involved, since the consensus among analysts is that the Loonie will trade sideways for the next year. “According to…52 strategists polled by Reuters…In three, six and 12 months, the median estimate of those polled had the domestic currency steady at $1.100 to the U.S. dollar, or 90.91 U.S. cents.” Moreover, polled analysts based their forecasts on a mere 17.5% of intervention, which means that irrespective of the BOC, most forecasters think that the Loonie has reached its potential…for now.

Of course, if the Loonie fulfills estimates at the high end of the poll – especially in the short-term, and if inflation remains negative, the BOC could find itself with no other choice. But for now, investors aren’t holding their breath.

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Posted by Adam Kritzer | in Canadian Dollar, Central Banks, News | No Comments »

Asia (China) Continues to Build Reserves, but Forex Diversification Slows

Sep. 16th 2009

After a brief pause, the world’s Central Banks (or at least those in Asia) have begun to once again accumulate foreign exchange reserves. I’m not one for hyperbole, but the figures are downright eye-popping: “Reserves held by 11 key Asian central banks totaled $2.625 trillion at the end of August, up from $2.569 trillion at the end of July, according to calculations by Dow Jones Newswires.” Most incredible is that this total doesn’t even include China. whose reserves could exceed $2.3 Trillion by now.

The credit crisis was initially marked by a collapse in trade and an exodus of capital from Asia, as western consumers tightened their wallets and investors flocked to so-called safe havens. As developing countries fought off currency depreciation, forex reserve levels plummeted. Less than a year later, trade has already picked back up, investors have returned en masse to emerging markets, and Central Banks are once again sterilizing capital inflows so as to mitigate upward pressure on their respective currencies. [Chart Below courtesy of Council of Foreign Relations.]


“Taiwan and Thailand, the most aggressive in defending the U.S. currency, have logged record-high reserves every month since December.” Japan, whose reserves are the second highest in the world (after China), is the lone holdout. As the Forex Blog reported yesterday, the newly elected Democratic Party of Japan will pursue an economic policy that depends less on exports, and has pledged to stay out of the forex markets.

The prospects for further reserve accumulation remain reasonably bright, as emerging markets lead the global economy towards recovery. “The outlook for key Asian economies is improving faster than that of developed economies. For the time being, this should accelerate flows into these markets, making it harder for central banks to keep their currencies in check.”

While China’s economy is no exception, its nascent recovery is being driven by capital investment, government spending, and (ultimately?) consumer spending. As a result, it is forecast that “China’s current-account surplus will fall to under 6% of GDP this year and 4% in 2010, down from a peak of 11% in 2007. Exports amounted to 35% of GDP in 2007; this year…that ratio will drop to 24.5%.” If such an outcome obtains, it will almost certainly lead to a slower accumulation of reserves.

China Trade Surplus

While this is all well and good, the more important question for most (forex) analysts is how these reserves are being held. The vast majority of these reserves are still denominated in US Dollar assets, and in fact, the proportion may have risen slightly since the beginning of the credit crisis. Asian Central Banks are particularly biased towards the Dollar, which accounts for 70% of their reserves, compared to the worldwide Central Bank average of 64%.

Moreover, it doesn’t look like plans are afoot to change this trend anytime soon. China has maintained its push (though less vocally) to turn the Chinese Yuan into a global reserve currency, declaring that its capital markets and currency controls will open accordingly to facilitate such. It is in preliminary talks with Thailand for yet another currency swap agreement, to supplement the $95 Billion in such deals signed since December. For its part, the Bank of Thailand has insisted that the Yuan is not even close to challenging the supremacy of the Dollar: “You have to accept that the dollar is going to be a reserve currency for quite some time. You don’t have any alternatives.”

Even China, despite its rhetoric, remains committed to the Dollar. The only talk of diversification in Chinese investment circles is in regards to what kinds of US assets they should invest in, not whether they should be invested in the US or somewhere else. Said the manager of China Investment Corp, which has a mandate to invest nearly $300 Billion of China’s FX reserves, “The risk of a decline in the dollar risks was more of a national issue for China than for CIC because its capital is in dollars.”

This last quote inadvertently confirms that the role of the Dollar as the world’s reserve currency is being treated as a political issue, when in fact it is a financial economic issue. In other words, while many countries want to limit the influence of the US by limiting the power of the Dollar, their Central Banks are stuck with it because it remains the most practical, and advantageous option. Dumping it would be akin to punishing themselves.

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Posted by Adam Kritzer | in Central Banks, News | 2 Comments »

Japanese Elections and the Yen

Sep. 14th 2009

In what could be be called an “earth-shattering” election, Japan’s incumbent Liberal Democratic Party (LDP) was finally unseated, after a 50-year stretch in power (excluding an 11-month “hiatus” in 1993). Given both the historic nature of the defeat and the margin of victory, it’s surprising that the election took place with so little fanfare. This is perhaps because the defeat was grounded more in opposition to the LDP than in support for the victorious Democratic Party of Japan (DPJ), of which little is surprisingly known. For that reason, it’s extremely difficult to assess/predict the implications of the election, and I should preface this post by noting how speculative its conclusions are. Still, a few meaningful observations can be made.

First, the DPJ appears to be somewhat liberal when it comes to economic policy. “Yukio Hatoyama, who is poised to be named prime minister, has railed against ‘unrestrained market fundamentalism and financial capitalism.’ ” It’s not clear exactly what was meant by this pronouncement, although it’s certainly connected with the LDP’s pledge to increase spending on social programs: “It says it will improve health care, expand payments for the unemployed and provide a minimum monthly pension…and remove the tuition fees for public high schools of around ¥120,000 a year.”

japan gdp

It also aims to spearhead a change in the structure in Japan’s economy, away from big government projects and export-dependent industries, in favor of consumers and small businesses. Through a combination of tax cuts, transfer payments, and certain spending initiatives, it is intended that consumers will feel a greater sense of financial security, and open up their wallets. “If they succeed, firms that cater to domestic consumers, from clothing retailers to restaurants, are expected to prosper.” Given that the unemployment rate just touched a record low and that deflation has now set in, it certainly has its work cut out for it in this regard.

Second, a crisis is looming in Japan’s public debt, and it’s not clear if/how the DPJ can solve it. The spending measures approved by the LDP while its leaders were still in power are projected to bring Japan’s national debt to 200% of GDP, by far the highest in the industrialized world. Some analysts have ascribed a fiscal hawkishness to the DPJ, and believe that despite its campaign promises, it will actually move to rein in spending.

Japan national debt to GDP ratio
Other analysts are skeptical, and have argued that unless (consumption) taxes are raised, Japan will soon face a crisis of epic proportions. “We have a government coming in that’s committed to spend even more than the previous government at a time when increased borrowing to spend is just not a plausible option…A catastrophic breakdown of Japan’s public-sector finances will be the biggest story ever to hit the world economy in our times, eclipsing the current financial crisis,” said one economist. Given that the the DPJ has promised not to touch the consumption tax rate for at least four years, such a crisis could come sooner rather than later.

Third, DPJ leadership has pledged not to intervene on behalf of the Japanese Yen, as part of its program to re-structure the economy away from exports. This marks a huge shift from the previous LDP administration, whose policies and rhetoric were consistently geared towards helping exporters and holding down the Yen. “I basically believe that, in principle, it’s not right for the government to intervene in the free-market economy using its money, either in stock or foreign-exchange markets,” declared Hirohisa Fujii, Japan’s soon-to-be-appointed finance minster, who has voiced support for a strong Yen policy on the grounds that it will boost Japanese purchasing power. This contradicts his exchange rate policy during his first stint as finance minister, during which he managed repeated interventions on behalf of the Yen. Still, it should be noted that during his tenure, the Japanese Yen rose against the Dollar.

What do the markets think? The Japanese Yen rose on the news of the DPJ victory, which suggests that investors are inclined to give the new administration the benefit of the doubt when it comes to its pledge not to intervene in forex markets. At the same time, Japanese equities sank, consistent with expectations that the DPJ will be less supportive of big business then its predecessors. In the end, nothing is written in stone, and if the Japanese economy fails to revive, don’t be surprised if the DPJ does an about-face and decides that maybe a weak Yen isn’t so bad after all.

yen

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Posted by Adam Kritzer | in Japanese Yen, News, Politics & Policy | 4 Comments »

China’s Economic Recovery and the RMB

Sep. 9th 2009

By now, the notion that the nascent global economic recovery is being and will continue to be led by China has become cliche. The NY Times summarized: “In past global slowdowns, the United States invariably led the way out, followed by Europe and the rest of the world. But for the first time, the catalyst is coming from China and the rest of Asia, where resurgent economies are helping the still-shaky West recover from the deepest recession since World War II.”

The statistics are certainly compelling. After a brief dip in the first quarter, GDP grew by an impressive 7.9% in the second quarter. In hindsight, the downturn in Chinese economic output was so slight as to hardly warrant use of the term recession to describe it; any other country would have rejoiced after achieving 6.1% (2009 Q1) growth, especially in the context of the current economic climate.

While stock market investors are evidently optimistic that the economy will continue to gather momentum, China-watchers and policymakers are more cautious. Wen Jiabao, premier of China, insisted that, “We must clearly see that the foundations of the recovery are not stable, not solidified and not balanced. We cannot be blindly optimistic.”

Wen’s downbeat prognosis should be seen in the context of China’s massive stimulus plan, which delivered an immediate jolt to the economy, but is already winding down. “The flood of bank lending in the first half of this year — equivalent to more than half of gross domestic product in the period…is ebbing. Net new lending in July was 355.9 billion yuan ($52.13 billion), the lowest figure so far this year and well below the first half’s monthly average of 1.2 trillion yuan.” Some analysts believe that this sudden decrease is due to seasonal factors, but others argue that it is a sign that the boost in lending (and spending) from the stimulus may have already exhausted itself.

In addition, the stimulus itself was not necessarily geared towards sustainable growth (in the economic, not the environmental sense). Over the last two decades, China embraced an economic model focused around exports and capital investments, at the expense of domestic consumption. While it will certainly be years before economists can determine whether the recession changed the structure of China’s economy, the earliest indications point to business as usual. “This year the bulk of the government’s stimulus is going into infrastructure, further swelling investment’s share. Chinese capital spending could exceed that in America for the first time, while its consumer spending will be only one-sixth as large.”

Composition of China's GDP
To be sure, the government has rolled out incentives and subsidies designed to reduce savings and increase consumption. However, Chinese cultural mores and the government’s lack of social services represent a formidable obstacle to any opening-up of the mentality of Chinese consumers- and their wallets. In fact, while China’s government is still nominally Communist, spending on public services is among the lowest in the developed world. Despite doubling to 6% of GDP, such spending is still well below the OECD average of 25%. The widening rich-poor gap, meanwhile, suggests that most of the windfall from China’s economic boon has been bestowed upon a relative handful of businesses and people, such that the majority of China’s 1.3 Billion populace simply doesn’t have the means to increase consumption.

For better or worse, the global economic downturn has severely crimped demand for Chinese exports, and this component of GDP could remain depressed for quite some time. After a record $400 Billion in 2008, the trade surplus plummeted in 2009, “to $35 billion in the same [second] quarter, 40% down on a year earlier…the decline is even more impressive in real terms (adjusting for changes in export and import prices), with the surplus shrinking to less than one-third of its level a year ago.” In fact, some analysts project that China could soon experience a trade deficit, if current trends continue.

All of this suggests that the Chinese RMB is not likely to return to its path of rapid appreciation (28% in real terms), observed from 2005-2008. (The currency has essentially been fixed at 6.83 RMB/USD since December 2008, leading to an 8% decline in real terms to match the decline of the Dollar.) China’s foreign exchange reserves, which have come to mirror the appreciation of its currency, are once again expanding. ($2.13 Trillion at last count). Given the decline in the trade balance and the explosion in the budget deficit, however, much of this increase must be attributed to the inflow of speculative capital, which will not necessarily translate into currency appreciation.

Some economists insist that the Yuan is still undervalued by as much as 25%, but investors don’t believe that it will bridge this gap anytime soon. While the spot exchange rate has risen to the strongest level since May, futures prices indicate a modest 1.5% appreciation against the Dollar over the next twelve months. This is an improvement from expectations of a flat exchange rate, but still a long way away from what some economists think is reasonable.

RMB September 2009 Futures

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Posted by Adam Kritzer | in Chinese Yuan (RMB), Commentary, News | 1 Comment »

Dollar Under Pressure on All Fronts

Sep. 7th 2009

I concluded a recent post with a reference to the X-factor in forex markets: the US National Debt. In fact, the surging debt is only one of several factors that is exerting downward pressure on the Dollar, though it is perhaps the one that receives the most attention, and it probably represents the most pernicious threat to the Dollar’s long-term viability as the world’s reserve currency.

It’s difficult to say for sure how large the federal government debt currently is, and even more difficult to forecast. We can begin by looking at gross debt (Treasury securities) outstanding, which is around $11.4 Trillion. Since half of this represents intra-governmental debt, debt owed to external parties is probably about $6 Trillion. Going forward, meanwhile, the latest government projections indicate a $9 trillion increase over the next decade, touching a whopping $20 Trillion in 2020. In absolute terms, it would smash all previous records, while in real terms (as a percentage of GDP), it would be the largest increase since World War II.

US National Debt: 1940 - 2080
Over the long-long-term, the growth in national debt is projected to be catastrophic, as the baby boomer retirement leads to an explosion in entitlement spending. The resulting strain on the system is summarized by the Government Accountability Office: “Without changes, spending for Social Security, Medicare, and Medicaid would permanently and dramatically increase the Government’s budget deficit and debt, leading eventually to renewed financial and economic instability.”

US government spending: 1970 - 2080

For simplicity’s sake, let’s ignore the politics of deficit spending and national debt expansion, and focus on the implications for the Dollar. “Major investors like Berkshire Hathaway Inc. Chairman Warren Buffett and bond investment firm Pimco fear the government’s fiscal and monetary stimulus programs could end up fueling inflation in coming years and hammering the dollar.” Buffet’s prognosis is grounded in the beliefs that government will be too timid to raise taxes, and that growth in new Treasury issuance will outpace investor buying capacity. In other words, even if we make the (dubious) assumption that Central Banks remain committed to holding US Treasuries, their needs/finances will constrain their collective ability to absorb more than a fraction of new debt.

The result, predicts Buffet, will be a calculated political preference for inflation: “Legislators will correctly perceive that either raising taxes or cutting expenditures will threaten their re-election. To avoid this fate, they can opt for high rates of inflation, which never require a recorded vote and cannot be attributed to a specific action that any elected official takes.” If this (potential) inflation is not accompanied by higher interest rates, it would erode returns on US investments, and by extension, interest in the Dollar.

Ironically, the Dollar is being driven down in the short-term because inflation (and crucially, interest rates) are too low. In fact, the Dollar is now the cheapest currency in the world to borrow, since the Dollar LIBOR rate fel below than the corresponding Japanese rate for the first time in 16 years. “The historic shift — and the decrease in the three-month dollar Libor — underscores how global financial markets are now awash in liquidity, especially dollars, as central banks have flooded their economies with low rates and cheap financing.”

Japan LIBOR falls Below US LIBOR

This pessimism in the Dollar has been accompanied by a search for an alternative, with all parties so far coming up empty-handed. The Euro is a logical choice, but mounting economic and political problems equate to high levels of uncertainty. The Chinese Yuan has also been proposed, but its capital markets and economy remain too opaque for it to be taken seriously as a reserve currency. The final possibility is the Japanese Yen, which is characterized by a perennial stability and transparent capital markets. Unfortunately, Japan’s economy is both too small and too weak for the Yen to be a serious candidate. Not to mention that its national debt already exceeds 170% of GDP and its looming entitlements crisis will make America’s look mild in comparison.

In short, it looks like investors are stuck with the Dollar – for now at least. Actually, a rise in interest rates would alleviate both the short-term and long-term pressures on the Greenback, by making it more expensive to short, and offering a higher risk-adjusted return for investors concerned about the ever-increasing national debt. But, this could create a whole new set of economic pressures, and make US investments just as unattractive in nominal terms. Sounds like a lose-lose currency.

US Dollar Index - 2005-2009

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Posted by Adam Kritzer | in Investing & Trading, News, US Dollar | 6 Comments »

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