Generally speaking, investors are bullish about Brazil. The emerging market superstar emerged from the credit crisis essentially unscathed, and some believe that “Brazil will be the world’s fifth-biggest power by the next decade.” This year, the IMF is forecasting GDP growth of 5.5%, while the Central Bank of Brazil is projecting 6%.

But this post isn’t about the economy of Brazil. It’s about its currency, the Real. To put it mildly, investor sentiment surrounding the Real is slightly less rosy. The 30% appreciation (from trough to peak) against the Dollar has come to an end. “ ‘Buyers are exhausted. The real has been a pretty crowded trade and what’s happening is a lot of these long-term crowded positions are getting sold,’ ” summarized one money manager.

There are a handful of issues. First is the technical concern that the Real simply rose too far, too fast. “The currency’s weekly TD Sequential indicator suggests an almost yearlong rally against the dollar ended in October, while the moving average convergence/divergence, or MACD, chart shows the real is likely to weaken.  ‘A new trend has started and it’s strongly bearish.’ ” This notion is supported by an explosion in the so-called risk-reversal rate on the Real, in favor of options that give investors the right to sell. In fact, “insurance” on the Real is now the most expensive of any emerging market currency.

Investors are also nervous about the sovereign debt crisis in the EU, and are responding by temporarily moving funds back to safe haven currencies. “ ‘We’re seeing a lot of declines on top of concerns about Greece and Europe. Flows will come back to Brazil when you have signs of stability out there, and it doesn’t look like that will happen in the short term.’ ” Of course, this is also impacting the carry trade, as investors re-examine their models governing the trade-off between risk and return.

To be fair, increased risk could be accompanied by increased returns. Even withstanding a poor performance by the Real, itself, the benchmark Brazilian Selic rate stands at a healthy 9.5%. In all likelihood, it will be hiked past 10% next month, and to 11% by the end of the year. On the flipside, inflation is also surging (5.5% at last count). From the standpoint of investors, this is not really a concern, since there is no intention of using invested capital for consumption purposes. In fact, it could even be seen as positive, insofar as it will force the Central Bank of Brazil to continue to be aggressive in conducting monetary policy.

There seems to be a slight dichotomy between the data and the markets. On the one hand, there is plenty for investors to be excited about when looking at Brazil. On the other hand, the reality is that there just isn’t much excitement at the moment being channeled towards the Real. If interest rates continue to rise, and the debt crisis in Euro can achieve some kind of (stopgap) resolution, perhaps this will change.

Even before the sovereign debt crisis in Europe damped confidence in the world’s second most important reserve currency, the Chinese Yuan was on the cusp of being accepted as a global reserve currency.

We’re all familiar with the arguments attacking the Yuan in this context: its currency is pegged, its capital controls are rigid, and its capital markets are shallow and illiquid. Say what you want about the world’s major currencies (volatile, debt-ridden, etc.), but at least none of these factors applies, goes this line of thinking. With the Euro’s future up in the air, however, a potential hole has been created in Central Banks’ respective forex reserves. As replacement(s) for the Euro are sought, such long-held assumptions are being challenged.

The Chinese Yuan is attractive for a number of reasons. First, investors and Central Banks want exposure to China’s economy; its average annual growth rate of 10% over the last 30 years is far-and-away the highest in the world. “China’s economic output will be more than $5 trillion, or around 9% of the world’s economy, according to the International Monetary Fund.” Second, the fact that the RMB is fixed is in some ways a perk: the wild fluctuations that most currencies witnessed as a result of the credit crisis has made some wonder if market-determined exchange rates aren’t overrated. Finally, the widespread consensus is that the RMB will appreciate anyway, so holding it seems like a safe bet.

Therefore, “Central banks or sovereign wealth funds from Malaysia, Norway and Singapore have received special quotas from the Chinese government to allow them to gain a bit of exposure to China’s currency. The bet is that holding yuan-denominated assets is an important feature of a diversified national reserve.” In addition, China has signed Yuan-denominated swap agreements with a handful of its most important trade partners, totaling $100 Billion over the last year.

Still, these are small-scale agreements, and Central Banks are really just testing the waters. According to a recent study by the Reserve Bank of India (RBI), “The Chinese yuan is ‘far from ready’ to gain reserve currency status. Rather, it said China’s yuan was likely first to become a regional currency as trade links with its neighbours expand.” The main issue is not one of stability, but rather of supply. Simply, there are not enough liquid, attractive investments, denominated in RMB. China’s stock and bond markets are filled with unreliable companies, whose primary loyalty is to the State, rather than to investors. Buying Chinese government bonds seems like a safe option, but given, that China finances most of its spending with cash, such bonds are not widely available.

For now, the Chinese Yuan will remain most attractive (from the standpoint of a reserve currency) to regional trade partners, because such countries have a genuine use for RMB. Investors seem to understand this idea, and are using the currencies of such countries to bet indirectly on the RMB. According to one analyst, “On days when trading is especially volatile, the Singapore dollar moves in tandem with the yuan bets. The Malaysian ringgit, Taiwanese dollar and Korean won are also high on the list of currencies affected by the yuan.” In short, the RBI’s assessment of the Yuan seems pretty apt. It will probably be at least a decade before holding the Yuan is as viable (not to say attractive) as the Japanese Yen. For investors who don’t want to wait that long, there are a handful of other regional currencies that they can hold in the interim.

Given that only a week has passed since the bailout of Greece was formally unveiled, it’s still too early to determine whether the plan will be success. Regardless of how it ultimately plays out, though, the bailout (not too mention the concomitant crisis) is shaping up to be THE big market mover of 2009. As investors reposition their chips, some early front-runners are emerging. It might surprise you that one such leader is the Japanese Yen.

On the surface, the Japanese Yen would seem to be an excellent candidate for shorting, especially in the context of the the Greek fiscal crisis. Its fiscal and economic fundamentals are abysmal, and by most measures, it’s debt position is among the least sustainable in the world, behind even Spain, Portugal, and the US. At the same time, the Yen has risen by an unbelievable 8% against the Euro in the last week alone, and many analysts are predicting it will emerge as one of the winners of this episode.

Why? First of all, with confidence in the Euro flagging, the Yen (and the Dollar) gain luster as the only viable reserve currencies. Regardless of what you think about Japan’s fiscal fundamentals, the longevity at the Yen means that it is inherently safer than the Euro, which may not even exist (in its current form, at least) in a few years time. Second, the current consensus is that the Euro bailout will fail, and as a result, risk tolerance is running low at the moment. With this in mind, it’s no surprise that traders are unwinding their carry trades and that the Yen – “The low-yielding currency of a deflation-prone economy of high savers…entrenched as the world’s funding currency” – has rallied.

Analysts have been quick to point out that the rest of Asia (among other regions) are on the other side of this trend. The concern is that the bailout won’t be enough to prevent a repeat credit crunch and that confidence in investments/currencies that are perceived as risky will remain low.

China could be hit especially hard. Since the Chinese Yuan is pegged to the Dollar (and even it wasn’t), it has risen by a whopping 15% against the EUro over the last six months, severely crimping exports to the EU. In addition, “Chinese exporters rely very heavily on bank letters of credit to finance their shipments…When banks have trouble borrowing money themselves — as has been happening as a result of worries about European banks’ possible losses from the region’s sovereign debt crisis — they tend to cut sharply the issuance of letters of credit for trade finance.” It’s no wonder that the Chinese stock market has tanked 21% so far in 2010, and that the Central Bank continues to delay revaluing the RMB.

Of course, if the plan turns out to be a success, than the opposite will probably obtain. “In this case…the currency of any emerging market or advanced economy exposed to the Asian region’s impressive, China-led economic growth,” will probably rally. “It could be the South Korean won, the Australian dollar, or the currencies of commodity-producing countries like Brazil.” The Japanese Yen, meanwhile, will probably be hit with a dose of reality, followed by a double dose of the carry trade.

The fiscal crisis ravaging the Euro and the Pound has sent the Dollar skyward. On the one hand, the prospect of continued uncertainty and dissolution of the Euro would seem to be an excellent harbinger for continued appreciation in the Dollar. On the other hand, it should only be a matter of time before investors recognize that the Dollar’s fiscal fundamentals are also quite weak.

Unlike during the last few years, analysts are no longer talking about (forex reserve) diversification. It was once widely predicted that the Euro would rival the Dollar for a place in the portfolios of foreign Central Banks. As expected, preferences are now shifting back in favor of the Dollar and to a lesser extent, the Yen. The Pound and Swiss Franc may have a small role, as will the “New” Euro. Over the short-term, however, Central Banks (and investors) will continue to eschew the Euro, if only due to sheer uncertainty.

Given that everything is relative in forex, investors and Central Banks only have so many options when it comes to choosing which currencies in which to denominate their portfolios. Thus, it’s understandable that a sudden crisis in the EU would buoy the Dollar. At the same time, it’s not exactly a good bet that the US isn’t destined to suffer a similar fate.

Due to extremely low short-term interest rates, most investors have been willing to accept low returns when lending to the US (by buying Treasury Securities, and indirectly by simply holding Dollars). At some point, both short-term interest rates and the rate of inflation will rise, and investors will have to re-examine their risk/reward schemes. My suspicion is that investors will demand higher yields in exchange for lending to the US.

Just like with Greece, a US fiscal crisis would probably emerge suddenly. While the US government pays lip service to the notion of balancing its budget and reducing its sovereign debt, even the most optimistic projections show a budget deficit for the next 10 years. Beyond that, the retirement of the baby boom generation and their “entitlement” payment will make it nearly impossible for the US to operate a budget surplus.

In short, the only hope is for the US economy to grow faster than the national debt. If the US economy grows at 4% per year, for example, it will have to run a budget deficit less than 4% of GDP in order to reduce its relative level of debt. On the surface, this seems like a reasonable possibility, but given trends over the last three decades (covering periods of both recession and economic boom), it doesn’t seem likely.

This is not new information. Doomsday theorists have been predicting the bankruptcy of the US for two centuries. Don’t mistake me for doing the same. Rather, I only wish to point out how ironic it is that the Dollar’s fiscal conditions are comparable (and in some ways worse) than some of the problem countries that investors are currently focusing on.

Then again, forex is relative. Some analysts have suggested that the new reserve currency will be gold, oil, and other commodities. Unfortunately, there isn’t nearly enough (liquid) supply of these materials to occupy more than a small portion of reserves. Under the current system, then, investors are pretty much stuck with the Dollar. At this point, betting to the contrary is tantamount to betting on the complete collapse of the modern financial system. A reasonable bet, perhaps, but you can forgive investors for being hesitant to embrace it.

Compared to the Euro, the Pound is Gold (figuratively speaking). Compared to everything else, well, the Pound is probably closer to linoleum. Bad geology metaphors notwithstanding, there really isn’t much to get excited about when looking at the Pound.

Let’s take the election, for example. Originally billed as a chance for a fresh start, politically, for the UK, the election has turned out to be nothing short of disastrous. Rather than producing a clear-cut victory, it has resulted in a hung Parliament. The way talks are currently shaping up, it looks like power will be shared by the Liberal Democrats and Conservatives. This is problematic,because neither party has a clear vision for dealing with the skyrocketing UK national debt; with the two parties working together, meanwhile, a compromise seems even more unlikely. “Investors are worried that a hung parliament will result in a weak government that will be unable to force through measures to reduce the UK’s high borrowing levels.”

As a result, many analysts now believe that the UK could lose its coveted AAA credit rating: “We believe that a downgrade…is more than likely since both parties agree that early expenditure cuts could harm the economy. The alternative could be that both parties agree on tax hikes to be implemented with the next budget. Both outcomes would be equally bearish for sterling.’ ”

Even aside from the imminent UK fiscal crisis, there is the fact that its economy continues to stagnate, its capital markets remain languid, and its balance of trade remains perennially mired in deficit. “Figures from the Office for National Statistics (ONS) showed that gap between the UK’s imports and exports hit a massive £7.5bn in March. The deficit — well ahead of an upwardly revised £6.3bn for |February — came as total imports surged £1.4bn over the month compared with a meagre £200m rise in exports.” From a fundamental standpoint, then, there is very little reason to own the Pound.

The picture is slightly more nuanced, when viewed through the lens of technical analysis. The most recent Commitment of Traders report, meanwhile, has showed short interest in the Pound building to record levels. In addition, the ratio of long/short positions is approaching 5:1. Some analysts believe this is inherently unsustainable, and that as net positions become more lopsided, a sharp reversal becomes even more likely. Then again, some analysts had the same theory about the Euro, which was solidly disproved after the short-squeeze rally was soon followed by a steady decline and a re-accumulation of short positions.

Other technical analysts are waiting to see where the Pound moves in the near-term before placing their bets. ” ‘Last week the market eroded the 15-month uptrend from the January 2009 low at $1.3500’…the $1.4255 Fibonacci level is the last defence for the pound ahead of the $1.3500 2009 low. For the downside pressure to be taken off, key resistance at $1.5055, the May 10 high, would need to break.’ ” The Pound is hovering dangerously close to a number of psychologically important levels. If it breaches $1.40, it would signal a 5-year low. Consider also that the Pound last touched $1.38 in 2001 and $1.35 in 1987.

To be fair, the Pound has hovered around $1.50 for most of the last 20 years, so its current level against the Dollar is not that low, relatively speaking. If investors come to their senses, and realize that the likelihood of UK sovereign default is probably not any higher than the US, and the coalition government is able to produce a convincing plan for reducing the deficit, then the Pound could bounce back. If the safe-haven mentality remains in force, however, the Pound will continue to be one of the big losers.

In my last post, I reported that the markets were incredibly bearish on the Euro, due to concerns that the Greek debt crisis could neither be mitigated nor contained. By following up on this report with another incantation of Euro bearishness, I certainly run the risk of belaboring the point. Still, the fact that since then, a $1 Trillion bailout was announced means that at the very least, I need to offer an update!

Anyway, in case you have been living in a cave, the EU finally put its money where its mouth was by forming a €750 Billion Special Purpose Vehicle (SPV) to address the fiscal problems of currently-ailing and potentially-ailing economies. The brunt of financing the SPV will fall on individual Eurozone countries, though the European Commission and the International Monetary Fund (IMF) will also make sizable contributions. In addition, the European Central Bank (ECB) has agreed to purchase an indeterminate amount of government and corporate bonds, while other Central Banks will use currency swaps to ease pressure on the Euro.

The reaction to the news was quite positive, with the Euro reversing its 6-month slump and rallying 2.7% against the Dollar. Equity shares surged on the news: “A a 50-stock mix of European stocks jumped 10.4 percent, Spain’s market soared 14.4 percent, France’s rose 9.7 percent and Germany’s gained 5.3 percent.” Sovereign debt and credit default swap prices also rose as investors moved to price in a decreased likelihood of default.

The celebration was short-lived, and by Tuesday (yesterday), the Euro had already returned to its pre-bailout level against the Dollar. In hindsight, it looks like the rally was the result of a classic short-squeeze. On Sunday, the Financial Times reported that “Positioning data from the Chicago Mercantile Exchange, often used as a proxy for hedge fund activity, showed speculato,rs increased their short positions in the euro to a record 103,400 contracts, or $16.8bn in the week ending May 4.” After the most exposed short positions were covered, however, the rally quickly came to an end: “By the time markets opened in the United States, and American hedge funds entered the market, the euro’s rally began to flag.”

Indeed, it’s hard to find anyone that has anything positive to say about the bailout, even among the bureaucrats and politicians that contrived it. Here’s a smattering of soundbites:

• “Angela Merkel, the Iron Chancellor, has rolled over and we are being taken to the cleaners.”
• “We’ve just kind of kicked the can down the road. Sovereign debt, like all debt, ultimately has to be repaid.”
• “The bailout is ‘another nail in the coffin…This means that they’ve given up on the euro.”
• “Lending more money to already overborrowed governments does not solve their problems.”
• “It was crucial to stop the panic, and this package has done it, but it doesn’t solve the longer-term problems which are slowly undermining the value of the euro.”
• “It’s pretty disappointing that [the] euro only rallied a couple of cents on the back of a trillion dollars.”

There are a few specific concerns about the bailout. First of all, it’s still unclear how it will be paid for and how it will be implemented. How will specific loans be issued, and what will be the accompanying terms? Second, it does nothing to address the underlying fiscal problems that precipitated the crisis, and may in fact exacerbate them since countries have less of an incentive to rein in spending. As one analyst summarized, “Bailing out economies creates moral hazard. Other countries may continue to skirt the kinds of actions that would lower their budget deficits and debt loads…because they too can expect to be rescued.” Finally, the bailout does nothing to mitigate credit risk for private lenders; it merely transfers and expands it, since money that would have been lent to Greece (and other problem countries) anyway, will still be lent to them, after first being funneled through the SPV. In short, “Once market participants look at the actual details of this plan, they are not going to want to buy the euro either.”

As everyone has been quick to point out, the bailout probably makes a (partial) dissolution of the Euro even more likely, because it is tantamount to deflating the currency. As one economist opined, “The euro zone does not look viable in its current form. The basic premise…to unify monetary policy….while keeping fiscal policy completely separate…has completely broken down.” The only solution which will leave the Euro intact is for the weakest members to leave, and for a solid core of economically and fiscally sound economies to remain behind.

To be fair, the EU has certainly bought itself some time. Given that the amount of money pledged to fight the debt crisis well exceeds Greece’s public debt, it won’t be Greece that brings down the Euro. If/when the debt problems of Spain, Portugal, and Ireland become insoluble, however, the futility of the bailout will become abundantly clear.

I must confess: I never expected the Greek debt crisis to reach such a dire threshold in such a short time period. Over a matter of mere months, the Euro has fallen 15% against the Dollar. That’s the kind of drop that you would have expected from the Greek Drachma, not from the Euro!

Moreover, it’s not as if this slide is anywhere close to abating. “I don’t think you’d want to bet on a bottom, at this stage, in euro. We’re headed closer to $1.2000 at some point in the game. It’s just a question of when,” said one prominent analyst. Meanwhile, net shorts against the Euro have reached a record 89,000 contracts, according to the weekly Commitments of Traders report. What is producing this swell of bearish sentiment, which is causing the markets to trade in a manner best described as “panic mode?”

The answer, it seems, is a self-fulfilling belief not only that Greece will default on its debt, but also that the credit crisis will spread to the rest of Europe. Greek interest rates recently topped 8%, and the spread with comparable German bonds (this spread has become a crude way of gauging the seriousness of the crisis) is close to an all-time record. Credit default swaps, which insure against the risk of default, surged to 674 bas points, reflecting a 15% probability of default. Meanwhile, credit default swap spreads on Spanish and Portuguese debt is also creeping up.

At this point, there seems to be very little that Greece can do to mitigate the crisis. It has already announced a series of austerity measures, including wage cuts and tax hikes, designed to narrow its budget deficit. In addition, it has successfully obtained an aid package from the EU and IMF, valued at $160 Billion. In April, it successfully refinanced $12 Billion in debt, even though experts insisted that such would be very difficult, given current investor sentiment.

On the other hand, the austerity measures were met with riots, which left 3 people dead, and signaled that the Greek citizenry would sooner vote out the incumbent government than accept their proposals to reduce the budget deficit. Speaking of which, under the best case scenario, the deficit will decline to a still-whopping 8% of GDP in 2010 (from a revised 13% in 2009), and Greece’s budget will remain in the red until at least 2014, by which point its gross national debt is projected to have reached 140% of GDP. Of course, this assumes that GDP growth will turn positive in 2012, and this is no guarantee. Meanwhile, the aid package will probably be enough to tide Greece over for only about 18 months, after which point it will have to return to the capital markets. Even before it can tap the bailout, it must first refinance another $10 Billion in debt in May.

In other words, even if Greece can forestall default for 2010 and 2011, who’s to say that it won’t default in 2012? With this possibility in mind, it makes it very unlikely that investors will continue to buy Greek bonds at all, let alone at affordable interest rates. “People are becoming well aware of the fact that the solvency issue for Greece hasn’t been resolved with the aid package. They still have to repay the money. They still have to repay the interest.”

Finally, there is the risk that the crisis will spread to the rest of Europe. Both the IMF and the Spanish government have been busy refuting rumors that Spain is seeking a similar bailout. Regardless of its veracity, the fact that such a rumor even exists will be enough to make investors sweat. When investors get nervous, they stop buying government bonds and/or demanding higher interest rates, which ironically only makes it more likely that the government in question will default. Fortunately, it seems that Spain (and its neighbor, Portugal) are in strong enough shape that they could survive a sudden speculative attack from investors.

Greece, however, is basically a lost cause. “Greece is functionally bankrupt,” and the only solution is for it to leave the Euro and/or default. Until that day comes, uncertainty will persist, and investors will continue to doubt the Euro.

The rally in emerging markets that I wrote about in April is showing no sign of abating. The MSCI emerging market stocks index is back to its pre-crisis level, while the EMBI+ emerging market bond index has surged to a record high. While no such index (that I know of) exists for emerging market currencies, one can be quite certain that at the very least, it too would also have returned to its pre-crisis level.

The Greek fiscal crisis, far from discouraging risk-averse investors from emerging markets, appears to instead be spurring them closer. From a comparative standpoint, emerging market governments are in much better shape than their industrialized counterparts, to say nothing of Greece. Credit ratings on a handful of emerging market debt issues are gradually being raised, whereas Greece was downgraded to junk status. Summarized one investor: “This is a group of countries with relatively strong balance sheets offering attractive levels of yield.”

It’s no wonder then that capital inflows into emerging market debt has already set an annual record (for 2010), despite the fact that we are only four months into the year! “The World Bank predicts as much as $800 billion in global capital flows this year, compared with about an annualized $450 billion to developing economies in the second half of 2009.” In addition, whereas institutional investors previously insisted on funding only those issues that were denominated in foreign currency (such as Dollars or Euros), now they seem to have a preference for so-called local currency debt. According to one emerging markets fund manager, “We expect local currency to be our biggest theme going forward.”

The real story here, however, is less the growing investor interest in emerging markets (which is now well established), and more the growing ambivalence of emerging markets. No doubt grateful to be attracting record sums of capital at lower-than-ever interest rates, emerging market governments are nonetheless unhappy about the resulting currency appreciation.

Taiwan has emerged as the unlikely voice of emerging markets on this issue. Its Central Bank recently “asked 65 banks for details of their foreign-currency lending to make sure exporters and importers aren’t using the loans to speculate on the island’s dollar,” and urged its peers to “adjust their monetary policies to address the disorderly movements of exchange rates.”

It doesn’t need to prod too hard, however, since a handful of Central Banks have either already intervened or are seriously considering intervention. Last month, Poland intervened by selling the Zloty against the Dollar. The Central Bank of South Africa cut interest rates by 50 basis points in March, despite surging inflation. Brazil continues to hold auctions to buy Dollars on the spot market, while India mulls implementing some form of a Tobin tax on currency transactions.

Not long ago, such measures would have been criticized as protectionist and against liberal, free-market principles. Not anymore. The International Monetary Funds (IMF), recently “urged developing nations to consider using taxes and regulation to moderate vast inflows of capital so they don’t produce asset bubbles and other financial calamities.” Private-sector economists agree, with Standard Chartered Bank arguing that “Emerging markets need to take ‘urgent action’ on the surge of liquidity and capital flowing into their economies because they could spur inflation and trigger another crisis,” much like “excess liquidity contributed to problems in the Western developed economies ahead of the financial crisis.”

In short, emerging markets have the green light to go ahead and stop their currencies from appreciating. But will they act on it?