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Archive for November, 2009

Dubai and the Dollar

Nov. 28th 2009

The big story of the week was the announcement by Dubai World, the investment arm of Dubai, that it is having trouble making payments on nearly $60 Billion. The funds were borrowed for various large-scale projects, ranging from man-made islands to massive hotels and skyscrapers, many of which are hemorrhaging money in the wake of the real estate crisis.

This announcement has implications both for the direct stakeholders in Dubai as well as for investors, generally. Dubai World’s bondholders were taken aback by its financial troubles, as well as by the suggestion of the United Arab Emirates that it would not come to the rescue. Apparently, it had always been assumed that oil-poor Dubai would be bailed out by its oil-rich neighbors in the event of insolvency. While it’s possible that this still applies, at the very least, investors will have to squirm/suffer a bit in the short-term. “Moody’s Investors Service and Standard & Poor’s cut the ratings on Dubai state companies yesterday, saying they may consider state-controlled Dubai World’s plan to delay debt payments a default.”

The news rattled forex markets, predictably sending “safe-haven” currencies (is anybody actually still using this term?) like the Dollar and Yen up, while sending everything else down. The reasoning is that the Dubai debt bomb could easily spread to other emerging market economies, triggering a wave of sovereign defaults and even a second credit crisis. Credit default swaps (which function as insurance against default) on emerging market bonds soared on the news, by 60% for Dubai bonds and 16% for Greece, for example. The situation has been likened to the defaults of Russia in 1998 of Argentina in 2002, both of which massively destabilized global capital markets at the time. Despite the recent gains, financial markets remain shaky and a sovereign default would likely reverberate around the financial world. “It will tarnish the reputation of the Gulf region a bit, and it will certainly make investors more bearish again about emerging markets,” explained one analyst.

At the same time, there are reasons to believe that this incident, should it erupt into a full-blown crisis, can easily be contained. For one thing, the situation in Dubai is unique. While many governments and institutions borrowed heavily during the height of the bubble, few came close to matching the scale and audacity of Dubai. In addition, Dubai doesn’t have any natural resources that it can fall back on during the ongoing recession; its pillar industries of tourism and finance were damaged heavily by the credit crisis, and it will be a while before they recover.

At the same time, some investors have been looking for a chance to “take profits” as the end of the year approaches and concerns mount that new bubbles might be forming in certain sectors of the market. “The news seems to have rattled a market already skeptical about the sharp rise in share prices in recent months. Financial instability in Vietnam and widening bond spreads in Greece and Spain have revived concerns that the global financial system is overleveraged.” Added another market observer: “This may be the trigger to allow for the market to take a rest and pull back. I felt that there would be a significant correction in what is an ongoing bull market.”

In the end, it’s hard to assess how significant this Dubai crisis actually is. As one analyst pointed out, the exposure of financial institutions to the UAE “is a negligible 0.4 percent of foreign banks’ total cross-border exposure.” Moreover, there’s not much of a connection between Dubai and China and Brazil, the latter of which largely escaped the economic downturn and have been two of the hottest performing economies over the last year. Still, with the end of the year approaching, investors will probably take this opportunity to book some of their profits so they can make a fresh start in 2010, which means December could see a small rally in the Dollar. For what it’s worth, that’s where my money is.

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

Central Banks of the World: Unite!

Nov. 26th 2009

Karl Marx would be pleased…well, maybe not. In any event, the world’s Central Banks are tired of the weak Dollar, and are separately taking matters into their own hands. [Before I continue, I should probably acknowledge the inherent dangers of lumping every Central Bank together under one umbrella. Still, given the current market environment, and the fact that all Central Banks are acting uni-directionally, it seems like a fair categorization].

As I was saying, Central Banks – especially in the developing world – are extremely unhappy with the Dollar’s continued decline, and with the opposing strength in their respective currencies. Over the last year, these Central Banks have waded into the forex markets, one after another, in a non-concerted effort to stem the gains in their currencies. As the Dollar’s decline has gained new momentum, so have they redoubled and intensified their efforts.

In the last couple weeks alone, at least a dozen (and these are only the ones on my radar screen) have issued threats and/or taken action aimed directly at the “speculators,” which are blamed for the across-the-board rise in emerging market currencies and asset prices. Their concerns are twofold: that currency appreciation could choke off economic recovery, and that speculative investment is driving the creation of new asset price bubbles.

While their goals are largely the same, their tactics differ. Some are testing the old approach of simply buying Dollars on the spot market. Thailand, Israel, South Korea, Philipines, and Russia, for example, are now intervening heavily on a regular basis. “Experts estimate that some of the largest emerging economies may have spent as much as $150 billion on currency intervention over the past two months, judging from the growth of their international reserves, according to data from Brown Brothers Harriman.”

Central Bank Forex Intervention

Other Central Banks have resorted to policy-making measures; Taiwan and Brazil are perhaps the best examples here. The former has essentially banned foreigners from opening new time deposits in the country, while the latter has just imposed a 1.5% tax on investment in Brazilian ADR shares to match the 2% tax on new FDI. In addition, sources claim that other measures are being considered, including “an overseas sovereign bonds issue denominated in Brazilian reals and a change in rules that would allow foreign equities investors to deposit guarantees overseas.”

South Korea and Sri Lanka have been even more creative in restraining their currencies. Sri Lanka is now making it easier for its citizens to take money out of the country, while South Korea is now placing limits on the hedging activities of exporters, who “have sold large amounts of dollars in the forward market to hedge foreign orders, putting upward pressure on the won.”

Still other Banks are still in the “rhetorical” stage of intervention, whereby they simply convey to investors that they are monitoring forex markets for “instability” and “irregularities.” Such code-words are designed to signal that rapid currency appreciation will not be accepted idly. “People see the central bank looking closely at the dollar and think maybe it’s a good time to unwind some of their positions,” explained one analyst in response to “rhetorical intervention” by the Bank of Chile.

Unfortunately for these Central Banks, their efforts are ultimately unlikely to be successful. They can probably succeed in slowing, or even temporarily halting the rise in their respective currencies, but won’t be able to achieve a permanent cessation. That’s because the forces they are fighting against are simply too large ($3 Trillion per day of forex turnover) and too determined (Russian and Brazilian interest rates are both above 8%, compared to 0% in the US) to be stopped. “It’s [intervention] not working, and it’s a good thing that it’s not working. Emerging-market currencies are appreciating and they’re going to keep on appreciating against currencies from the old world. [Central Banks] has to adapt to that,” declared one trader. Still, you can’t blame them for trying.

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Posted by Adam Kritzer | in Central Banks, News | 1 Comment »

“Strong Dollar” Policy is a Joke

Nov. 23rd 2009

US economic officials have been busy of late, propagating the “Strong Dollar” farce to anyone who will listen. “I believe deeply that it’s very important for the U.S. and the economic health of the U.S. that we maintain a strong dollar,” said Treasury Secretary Timothy Geithner at last week’s APEC summit in Singapore. Added Ben Bernanke, Chairman of the Federal Reserve, “We are attentive to the implications of changes in the value of the dollar and…will help ensure that the dollar is strong and a source of global financial.”

The markets hardly reacted to Geithner’s assertions, probably because he has parroted this same promise on several occasions since assuming office last January. Investors can be excused for their jadedness, since similar promises were repeatedly made during the Bush administration, during which time the Dollar registered some of its steepest declines in memory.

Still, you’ve got to give Geithner an A for effort, since he  has seemingly taken advantage of nearly every opportunity to pontificate about the Strong Dollar policy. ” ‘The dollar isn’t strengthening in the real world, but I told him [Geithner] I value his stance. The fact that I value his stance means that I believe things will develop that way, and that I believe the U.S. is making efforts to make that happen,’ ” said new Japanese Finance Minister Hirohisa Fuji. By his own admission, Fuji’s remarks were somewhat perfunctory, and it’s obvious to him the Dollar will continue depreciating

Bernanke, meanwhile, has more credibility on this issue, especially since the Fed so rarely discusses forex in public domain, which is why the Dollar initially spiked after he spoke. However, investors quickly registered the contradiction inherent in his remarks, which contained repeated promises about keeping rates low. Not to mention that the wording he used was almost identical to a speech from 2008. It’s no wonder, then, that the Dollar actually finished down on the day.


So if the markets aren’t taking this talk about a Strong Dollar seriously and Bernanke/Geithner know they aren’t being taken seriously, what’s the point of these vain pronouncements? [After all, it’s not even clear that a strong Dollar is in the best interest of the US, which has benefited economically from a narrowing of the trade deficit]. A few explanations have been suggested.

The first is that the rhetoric is intended to re-assure foreign investors and creditors that their assets/loans in the US will be safe from massive devaluation. While foreign Central Banks continue to purchase US Treasury Securities, their have been increasing grumblings that loaning to the US government is a losing proposition. Second, a weak Dollar is inherently inflationary, since it makes imports more expensive. The reverse correlation between oil (and other commodities) and the Dollar means that a weak Dollar could feed back into higher prices double time. Towards that end, Bernanke was actually speaking earnestly about the Fed’s intentions to monitor forex markets, as they bear on inflation.

Finally, while US policymakers seem resigned to the Dollar’s continued decline, they need to make sure that it remains “orderly” (this characterization has cropped up repeatedly in political circles, of late). “We believe Chairman Bernanke’s comments reflect a desire to prevent a disorderly decline in the currency, rather than halt its depreciation altogether.” There is an obvious recognition that a complete collapse in the value of the Dollar would be terrible for everyone, of which Bernanke no doubt also undersds.

Still, the markets are keenly aware that the US (i.e. the Fed) is not prepared to put  its money where its mouth is. The reason for the current bout of Dollar weakness is almost entirely connected to the Fed’s easy monetary policy (and its quantitative easing program) and the never-ending US budget deficit. If the US was seriously committed to a strong Dollar, then the Fed could simply tighten monetary policy. (The federal government could make more of an effort to balance its budget going forward, but this is currently less of a concern to forex markets).

Alas, the Fed is nowhere near ready to hike rates, nor is it willing to contemplate unwinding its quantitative easing program.  Most analysts expect interest rates to remain at the current record lows well into next year. Futures contracts expiring in June 2010 are pricing in a Federal Funds Rate of only .42% at that time. Most telling is that Bernanke, himself, has declared rates will remain low for an “extended period.” In hindsight, using the same speech to talk up the Dollar probably wasn’tthe best idea.

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Posted by Adam Kritzer | in News, US Dollar | 1 Comment »

Everyone Thinks the Yuan is Undervalued….Except for China

Nov. 21st 2009

Subtle title, right? I couldn’t resist, considering that literally all economists and government officials (outside of China, of course) have sounded off on the Chinese Yuan in the last month. Recent additions to this list include President Obama, Chiefs of the IMF and World Bank, President of the Asian Development Bank, US Commerce Secretary Locke and Treasury Secretary Geithner, Nobel Laureate Paul Krugman, ECB Chief Jeane-Claude Trichet, Harvard University Professor Martin Feldstein, Japan’s finance minister…not to mention the thousands of others that didn’t make international news for their denunciation of China’s currency policy.

This rhetoric has also been accompanied by several important developments, including a Presidential visit to China, several meeting of the G20, a summit in Singapore, a slight change in the wording of China’s forex strategy, the release of economic data that suggest China’s economy is strengthening, etc. At the same time, their remains an obstinate  insistence from every corner of the CCP that despite this pressure, there are no imminent plans to further revalue. Investors are erring on the side of appreciation, however, and futures prices reflect a 3.5% rise in the value of the RMB over the next 12 months.

rmb dec 2010 futures

This disconnect is indicative of the fact that there is both a political and an economic side to this issue. When examined exclusively from either side, it looks like pretty cut-and-dried, since economics suggests that a revaluation is both necessary and desirable, but the misalignment of political interests suggests that it won’t be carried out any time soon.

More specifically, a chorus of economists (backed by hard data) is arguing that the RMB is one of the foremost causes of the widening imbalances. After a brief hiccup, China’s trade surplus is once again expanding, and is on pace to reach $300 Bill ion in 2009, more than half of which can be attributed to the US. Meanwhile, while GDP is projected at 10.5%, the rest of the world is still sputtering along. “China is ‘stealing’ jobs from developing countries and hindering a global recovery by keeping the yuan low, Nobel laureate Paul Krugman says. ‘China’s bad behavior is posing a growing threat to the rest of the world economy.’ ”

Economists also argue that a revaluation would also be in China’s own best interest. Foreign capital is now pouring into China at a record pace – largely in anticipation of an imminent appreciation in the Yuan – such that asset prices have almost doubled over the last year. “Risks of asset-price bubbles and misallocation of resources amidst abundant liquidity need to be addressed,” said the Chief Economist from the World Bank. Echoed the head of the IMF: “An undervalued currency encourages companies to invest in ways that may not be viable once the currency rises. ‘If you have wrong prices, you make wrong decisions, especially concerning investment in the long run.’ ”

Foreign politicians, especially those from the US, have been hammering these points home. President Obama made the RMB a key issue during his visit to China this week. Senator Chris Dodd chimed in with his two cents, that “You can’t give your competitor, your adversary in this case, a 40 percent advantage in global economies.” As analysts pointed out, the US, unfortunately, doesn’t have any leverage on this issue, as it is basically dependent on China to fund its budget deficits through Treasury Purchases. Thus, Chinese Prime Minister Hu JinTao couldn’t even be bothered as to so much mention the RMB when summarized the meeting with Obama for reporters.

Other Chinese Ministers rebuffed reporters in separate sessions who even dared to bring up the RMB: “Any policy changes by China, including on the exchange rate, will be based on its assessment of its own interests, not on external pressure.” Meanwhile, “Chinese officials refused to sanction a statement at the Asia Pacific Economic Co-operation summit in Singapore that would have pressed it to adopt ‘market-oriented’ exchange rates for the yuan.” In fact, they have begun to push back against criticism, by arguing that a weak Yuan has actually been economically beneficial. “China keeping a basically stable exchange-rate policy is, in reality, good for the global economic recovery,” argued the Minister of Commerce .

This political/economic dichotomy is also evident within China. The Central Bank recently changed some of the language which governs its forex policy; going forward, the Yuan will apparently be tied to a basket of currencies, with its value also influenced by trends in capital flows. However, “The central bank’s position is getting a determined push-back from manufacturers and exporters –especially along China’s wealthy coast –who stand to reap significant gains in the short term.” Given that the decision to lift the RMB will ultimately be made in the political arena, it’s understandable that the latter group has such a strong bearing on the process.

As I indicated above, investors are cautiously optimistic that the government will eventually relent to its critics and allow the currency to resume its steady upward path. Futures prices have risen steadily since September, when they reflected a flat RMB over the next twelve months. According to one analyst, ” Officials may, starting in the second half of 2010, allow it to recoup the drop of about 10 percent on a trade-weighted basis it’s had since March.” Goldman Sachs, long respected for its economic forecasts, remains one of the lone naysayers, arguing that the Yuan isn’t going anywhere until at least 2011.

Personally, my money is an appreciation in the near-term, as soon as the first quarter of 2010. Chinese leaders are stubborn, but they aren’t stupid. It won’t be pressure from the US that will shake them from their moorings – but a further inflation of property and stock market bubbles and concerns over the economy’s unhealthy dependence on exports for growth.

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

Kiwi and Aussie Diverge, then Re-Unite

Nov. 18th 2009

Over the last few months, the New Zealand Dollar and Australian Dollar have largely moved in tandem (see chart below). When the Reserve Bank of Australia raised its benchmark interest rate earlier this month, it shocked the markets and the Aussie shot up, while the Kiwi remained fixed in place. Many observers predicted that such was the beginning of a divergence in the two currencies. Less than one week later, however, the New Zealand Dollar hitched itself back to the Australian Dollar, and the two currencies have since traded in lockstep.

Aussie - Kiwi comparison November 2009
Investors have long tended to view the currencies (and economies) of New Zealand and Australia as one. Both economies boast large export sectors, and for much of the last decade, high interest rates. Given that the carry trade has been (and continues to be) one of the largest forces in forex markets, it makes sense that the Kiwi and Aussie would be grouped together.

Both these superfical similarities mask substantive differences, which have only become more accentuated as a result of the global economic crisis. Alan Bollard, Governor of the Bank of New Zealand summarized this disparity as follows: “Australia has avoided negative growth, and its prospects are driven by strong terms of trade, vast mineral deposits, the Chinese market, and rapid population growth. New Zealand has had a recession, and the pick-up is slower and more vulnerable – a difference financial markets do not appear to appreciate.”

While both economies are currently experiencing negative trade imbalances, New Zealand’s deficit was 5.9% at last count, while Australia’s is closer to 2%. Given that Australia’s (energy and commodity) exports have surged by nearly 30% in the last few months, while New Zealand exports are stagnating, this discrepancy could widen in the coming months. Investment is also surging in Australia, as “The value of advanced resource projects — those that are either committed or under construction — jumped 41% to a record 112.46 billion Australian dollars (US$104.03 billion) in the six months to the end of October.” And of course, the most obvious point of differentiation is between the two economies’ respective benchmark interest rates. Thanks to the aforementioned rate hike, Australian rates stand at 3.5%, exactly 1% higher than comparable New Zealand rates.

Australia Balance of Trade 2009

Many analysts point to Australia’s improving fundamentals (higher rates, positive GDP growth, booming investment in the energy sector, increasing exports) as the basis for the strong appreciation in the Australian Dollar. Given that the New Zealand Dollar has kept pace with the Australian Dollar (it is in fact the world’s best performing “major currency” over the last six months), this kind of analysis seems dubious, if not completely irrelevant.

It should be clear to most observers that the carry trade is dominating activity in the forex markets. Carry traders, relatively speaking, are undiscriminating, with the main factor of importance being interest rate differentials. Despite the fact that New Zealand interest rates are only 2.5% higher than US rates (and actually less than Australian rates) – hardly enough to compensate investors for volatility risk – the markets are awash in liquidity, and investors are once again chasing yield wherever they can find it.

One analyst offered a frank summary of this phenomenon: “It’s all about the carry trade. The Fed can’t do anything; certainly they can’t raise rates and the market knows that, and is exploiting it for the carry trade, borrowing in U.S. dollars, and the Kiwi is a beneficiary of that…That’s the only game in town. You can forget most economic data, it’s all about…the Fed.” Given that Australian rates are projected to rise faster and higher than New Zealand rates (beginning as soon as December 1), it’s conceivable that the Aussie will outpace the Kiwi. At the same time, the fact that US interest rates will likely remain low for a while means that both currencies will continue to benefit in the short term.

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Posted by Adam Kritzer | in Australian Dollar, News | No Comments »

Emerging Markets Bubble Continues to Inflate, but for How Long?

Nov. 13th 2009

Yesterday, emerging markets (proxied by the MSCI Emerging Markets Index) recorded their biggest fall since July, ending a week of solid gains. Still, this one-day slide of 1.4% pales in comparison to the nearly 100% gain that the index has achieved since bottoming last March. In other words, while investors might be starting to pull back, the direction of asset prices is still upward.

Emerging Market Stocks

As for what’s causing this across-the-board appreciation, that was the subject of my previous post (Inverse Correlation between Dollar and Everything Else…Still), in which I merely stated the obvious; that the Fed’s year-long program of negative real interest rates and quantitative easing (i.e. wholesale money printing) has unleashed a flood of cash into global capital markets. Since we’re not just talking about the Dollar, here, it makes sense to point out that the Fed’s easy money policies have been copied by Central Banks in most other industrialized countries, including the UK, Canada, Switzerland, Sweden, and to a lesser extent, the EU.

As for why emerging market assets and currencies seem to be outpacing appreciation in other asset classes, that’s also not difficult to explain. First of all, by some measures, emerging market stocks have hardly outperformed other assets. Oil, for example, has risen by 131% in less than a year, to say nothing of other commodities. Still, by other measures, growth has been remarkable. Most emerging market stock indexes and currencies have fully erased (or come close to erasing) the losses recorded during the peak of the credit crisis. Bonds, meanwhile, have gone one step further. Yields are collapsing, and prices have exploded – by 25% in the last year, sending the JP Morgan Emerging Market Bond Index to a new record.

Emerging Market Currencies

Is it safe to call this a bubble? Intuition would suggest so; given that all assets are rising across the board, without regard to particular fundamentals, it would seem that only a herd/bubble mentality could offer an explanation. Some analysts, in fact, have given up completely on fundamental analysis, instead using fund inflows (i.e. investor demand) to predict whether some emerging market assets will continue rising. As Nouriel Roubini (the NYU economist that famously predicted the credit crisis) summarizes: “Traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade.” P/E ratios are nearly twice as high in some emerging markets, compared to stocks in the S&P 500.

On the other side of the equation are the bulls and the efficient market theorists.”By historical price-to-earnings ratios — the ratio of stock prices to per-share profits — these levels can be justified, if the economic recovery continues. With massive layoffs, business costs have been cut sharply. “The hope is that when consumers and companies start spending, the added sales will drop quickly to the bottom line [profits].” Other proponents argue that the rise in asset prices is exactly what the Fed wants, since it implies that the markets are once again characterized by stability and liquidity.

Regardless of whether growth materializes, however, that doesn’t change the fact that the free ride can’t and won’t last forever. At some point, Central Banks will be forced to raise interest rates and start withdrawing Trillions of Dollars from global capital market. This will cause the Dollar to rise, and investors to rapidly unwind their carry trade positions. Warns Roubini, “A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.”

If the tech-bubble and real-estate bubble taught us anything, it is that there is no free lunch in the markets. It is not possible for all investors in all assets classes to simultaneously win. At least, in the long-term. In the short-term, meanwhile – it pains me to say this – let the party continue. My only warning is this: when the music stops, don’t be the one caught with your pants down…

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Inverse Correlation between Dollar and Everything Else…Still

Nov. 11th 2009

Almost two months ago, I wrote a series of posts (Dollar Down, Everything Else Up and Dollar Down, Gold Up) with self-explanatory titles. Last week, the Wall Street Journal finally got around to covering this story, and were able to quantify the extent of the trend with the use of statistical analysis. Accordingly, they observed an incredible 71% correlation between the Dollar and the S&P 500, compared to an average correlation of 2%. This implies that every 1% rise in the S&P is matched by a .71% fall in the value of the Dollar, and vice versa.

Furthermore, this trend appears to be both strengthening and spreading. The average correlation between the Dollar and stocks since July is 60%; given that it’s now 71%, this suggests that it was closer to 50% over the summer. In addition, the correlation between stocks and oil has touched 75%, the highest level since 1995. By extension, this implies a proportionately high correlation between the Dollar and gold. In short, the notion that as the Dollar is tanking, virtually every other commodity/asset under the sun is rising, now has some weight behind it.


Understanding the basis for this relationship is not complicated. You can think of it in terms of the Fed’s liquidity program or in terms of the carry trade, but regardless of what you call it, the concept is the same. Basically, the Federal Reserve Bank has printed nearly $2 Trillion as part of its quantitative easing program. For better or worse, most of this money found its way into the markets, rather than into the economy. Investors have been faced with the dilemma of either holding the currency in cash or investing it. (Here, I would argue that “speculate” is a more appropriate descriptor than “invest,” but anyway…) The simultaneous rise in stocks, bonds, emerging market currencies, commodities, and even real estate is proof enough about where that money went.

Stepping outside of forex markets a moment, the fact that all asset prices are rising in unison suggests that a new bubble is forming. Normally, one would expect that in a bull market, some assets would outpace others, but in this case, it seems that fundamentals are being pushed to the backburner, and investors are piling into anything and everything that’s liquid. Even traditional relationships, like that which leads bond prices to fall as stock prices rise seems to have broken down.

Getting back to the Dollar, the fact that bubbles are forming in stocks/bonds/commodities probably means that an inverse bubble is forming under the Dollar. One can draw understanding from last year’s partial collapse of the Yen carry trade, which began to deflate after several reliably strong years. The same could very well happen to the Dollar carry trade.

If and when the Fed raises interest rates, and/or begins to draw the excess liquidity out of the markets by offloading its inventory of securities, well, the markets should witness a simultaneous correction. How violent the correction is depends largely on the degree to which the markets anticipated it as well as the finesse of the Fed. If everybody rushes for the exits at the same time, it could create the same kind of panic that ensued after Lehman Brothers went bankrupt, whereby asset prices collapsed and the markets flooded into the Dollar.

History is never far from repeating itself.

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

Forex Implications of China-US Economic Codependency

Nov. 8th 2009

The Economist recently published a special report on China and America (“Round and round it goes“). As the title suggests, the article described the increasing interdependency between the economies of the US and China. In a nutshell, China maintains an undervalued currency, in order to stimulate exports. The resulting overseas (American) demand puts upward pressure on the RMB, which China defuses by buying US Treasury securities. This results in artificially low US interest rates, causing American consumers to import more, putting even more pressure on the RMB, which is further defused by buying more US Treasuries. And the cycle continues ad nauseum.

The article focused primarily on the political side of this precarious relationship, at the expense of the financial implications. It got me thinking about the forex forces at work, and how a disruption in the cycle could have tremendous ramifications for currency markets. It’s clear that in its current form, this system keeps the Yuan artificially low, but does that means that the Dollar is also being kept artificially high.

Given the depreciation of the Dollar over the last six months, this seems almost hard to believe. Over the same time period, though, China (as well as many other Central Banks) have vastly increased their Treasury holdings. This would seem to imply that indeed, the Dollar’s fall has been slowed to some extent by the actions of China. It’s kind of a paradox; as US consumers recover their appetite for Chinese goods, the Dollar should decline. But as China responds by plowing all of those Dollars back into the US, then the net effect is zero.

Biggest holders of US Treasuries
As the Economist article intimated, there are a couple of developments that would seem to upset this equilibrium. The first would be if the Central Bank of China began diversifying its forex reserves into other currencies. By definition, however, it would be impossible for China to continue pegging the RMB to the Dollar without simultaneously buying Dollars. Thus, the day that China stops recycling its export proceeds into the US, the RMB would start to appreciate, almost instantaneously. In addition, the sudden surcease in US Treasury bond purchases would cause interest rates to rise. Both higher rates and a more expensive currency would presumably result in lower demand for Chinese exports, and hence eliminate some of the need to recycle its trade surplus back into the US. In this way, we can see that China’s Treasury purchases are actually self-fulfilling. The sooner it stops purchasing them, the sooner it will no longer need to purchase them.

I’m tempted to elaborate further on this point, but it seems that I’ve already taken it to its logical conclusion. China must recognize the dilemma that it faces, which is why it refuses to break from the status quo. If it allows the Yuan to appreciate, it will naturally face a decline in exports AND the relative value of its US Treasury holdings will decline in RMB terms. Both would be painful in the short-run. However, by refusing to concede the un-sustainability of its forex/economic policy, China is merely forestalling the inevitable. With every passing day, the adjustment will only become more painful.

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Posted by Adam Kritzer | in Chinese Yuan (RMB), News, US Dollar | 3 Comments »

How will Foreign Investment Tax Affect the Real?

Nov. 4th 2009

On October 20, the executive office of the government of Brazil enacted an emergency measure, calling for a 2% tax on on all foreign capital inflows. And with one foul swoop, this year’s 35% rise in the Real had come to an end, right?

The tax certainly took investors by surprise, with the Brazilian stock market falling by 3% and the Real falling by 2%, the largest margins for both in several months. The tax is comprehensive and applies to essentially to all foreign capital deployed in Brazilian capital markets, whether fixed income, equities, or currencies. While the tax doesn’t apply to those currently invested in Brazil, the possibility that it would cause potential investors to stay away was enough to cause a sell-off.

The ostensible reason for the tax levy is to prevent a further rise in the Real. By most measures, the currency’s rise has been excessive, more than erasing the losses incurred during the credit crisis. The concern is that a more expensive currency will derail the Brazilian economic recovery before it has a chance to firmly get off the ground. “Brazil’s currency needs to weaken as much as 19 percent for sustainable economic growth, said Nelson Barbosa, the Brazilian Finance Ministry’s top policy adviser.”

According to cynics, however, the tax is a backhanded effort to raise revenue to fund a growing budget deficit. The government continues to spend money (perhaps to offset the negative impact on exports brought on by the Real’s rise) as part of its stimulus plan, but is increasingly tapping the bond markets to do so. The tax is expected to bring in an impressive $2.3 Billion over the next year, which could go part of the way towards fixing the government’s fiscal problems.

The real question, of course, is how the Real will fare going forward. The initial reaction, as I said, was ‘The Party’s over…‘ But investors with a longer-term horizon aren’t fretting. “In the medium term, the measure will have a limited impact. The fundamentals point to a stronger real, with commodities rising and the dollar weakening globally,” asserted one economist. While investors aren’t happy about paying an arbitrary 2% fee to the government, such pales in comparison to the 10%+ returns that investors still aim to reap from investing in Brazil over the long-term.

Ignoring the possible bubbles forming in Brazilian capital markets (admittedly, a dubious suggestion), Brazil still looks like a good bet, especially on a comparative basis. Interest rate futures point to a benchmark interest rate of 10.3% at this time next year, compared to ~1% in the US. Even after accounting for inflation and the 2% tax levy, the yield spread between Brazil and the US remains impressive. For that reason, the Real has already stalled in its expected fall against the US Dollar, standing only 1.7% below where it was on the day the tax was declared.


It’s unclear how determined the Brazilian government is towards pushing down the Real. The comments by its finance minister suggest that the consensus is that it is not slightly – but extremely overvalued. Thus, it’s likely that the government will enact other aggressive measures to prevent it at least from rising further. It continues to buy Dollars on the spot market, and is trying to make it easier for Brazilians to take money out of Brazil. It is not yet ready to tamper with its floating currency, but by its own admission, the “government was studying additional measures to regulate the heavy inflow of foreign investments and its impact on the country’s currency.”

There are also implications for other (emerging market) currencies. As I wrote earlier this week (“Central Banks Prop Up Dollar“) a number of Central Banks have already intervened or are currently mulling intervention in forex markets, to push down their currencies. You can be sure that other governments will be studying the situation in Brazil closely, with the possibility of implementing such policies themselves.

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Posted by Adam Kritzer | in Emerging Currencies, Exotic Currencies, News | No Comments »

Central Banks Prop Up Dollar

Nov. 2nd 2009

By all accounts, the decline of the US Dollar has been measured, and without incident. This, despite the fact that most investors reckon the Dollar is doomed, both from a long-term and a short-term perspective. What, then, is preventing an all-out collapse?

Personally, I think the best answer is that Central Banks (and their sponsoring governments) don’t want the Dollar to collapse. In other words, a schism is forming between private investors and public government, whereby investors (on a net basis) are rooting against the Dollar, while Central Banks are rooting for it. That’s not to say that there is a global conspiracy involving Central Banks, designed to prop up the Dollar. Rather, it is that Central Banks are simply trying to protect their short-term financial interests, and long-term economic interests. By this, I mean simply that foreign Central Banks have everything to gain from a strong Dollar, and seemingly everything to lose from its collapse.

From an economic standpoint, foreign Central Banks also benefit from a strong Dollar, especially those whose economies are powered by exports. “A stronger local currency relative to the dollar attracts foreign investment and tempers domestic price pressures by keeping import prices in check, but also cuts into the competitiveness of the country’s export sector.” Given that inflation is currently a moot issue whereas economic growth remains tenuous, Central Banks have made it clear that they currently favor weak currencies. “If (their currencies have) too much strength and the U.S. recovery falters, it’s bad for emerging market growth,” and could even lead to a so-called “double-dip recession.”

In order to alleviate this possibility, many Central Banks have intervened directly in forex markets and depressed their currencies through the purchase of Dollars. During only one trading session earlier this month, “Asian central banks said to be intervening in currency markets overnight by buying dollars included South Korea, Hong Kong, Taiwan, Thailand, the Philippines and possibly, Indonesia, according to analysts.”

Meanwhile, Central Banks in industrialized countries are using increasingly strong rhetoric to try to talk down their currencies. The Banks of Canada and England have achieved modest success in the last few weeks in convincing investors that overvalued currencies would be met with decisive action. The Royal Bank of Switzerland has intervened several times, while the European Central Bank has expressed concerns about “volatility” (code for the rapid appreciation in the Euro) in forex markets. It’s still not clear where the Bank of Japan stands. The newly appointed Finance Minister has already flip-flopped several times, settling finally on a course of action that would prevent the Yen from rising too high and threatening the nascent recovery.

Consider also foreign Central Banks’ collective holdings of US Treasury securities, which increased by nearly $800 Billion over the last year, a large portion of which was accounted for by the Banks of China and Japan. According to the most recent Federal Reserve data, they are collectively adding to their stockpile at a pace of $10 Billion per week. As the WSJ explains, “The inflows highlight the challenges facing nations with large dollar holdings, particularly developing countries. A weaker dollar is, in theory, bad for their investments as it eats into returns when translated back into local currencies.”

Major Holders of US Treasury Securities ($ Billions)

In other words, continued foreign Central Bank investment in US Treasury securities is perhaps rooted less in investment strategy, then in the simple desire to prevent their current holdings from depreciating. At the same time, those banks that intervene directly in forex markets often have little choice other than to hold their forex reserves in US Treasuries.

You can see from this that the idea of an alternative reserve currency would actually run counter to the interests of many of these Central Banks. With the exception of a few (i.e. Iran, and to a lesser extent, China) that would like to see the Dollar fail for political reasons, the vast majority of banks have a vested interest in the Dollar remaining where it is. Otherwise, they would witness the value of their Dollar-denominated assets collapse, as well as a collapse in exports to the US.

It looks like, then, there will be a showdown at some point between the Central Banks and investors. If you accept the notion of efficient markets, then it should be obvious who will win in the long-term. On the other hand, you can’t underestimate the determination of some of these banks.

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Posted by Adam Kritzer | in News, US Dollar | 12 Comments »

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