The frequency of my reports on the Chinese Yuan is admittedly much higher than it used to be. Why? Call it disbelief. More than two months have passed since China revalued its currency, and after a rapid 1% appreciation, the RMB has actually fallen back. Today, it stands only .5% higher against the Dollar compared to June 18. On a trade-weighted basis, it is actually 2.3% lower. What is going on?!

It can foremost be attributed to a disconnect between Chinese words and Chinese action. While The People’s Bank of China (PBOC) purportedly supports a stronger, flexible Yuan (“Adopting a more flexible exchange-rate regime serves China’s long-term interests as the benefits…far exceed the cost in reorganising industries and removing outdated capacities.”), in practice, it has prevented the currency from budging. On numerous occasions since supposedly allowing the RMB to appreciate, it has intervened in the forex markets through various shadow dealers to prevent this very outcome.

In fact, China has increased its purchases of South Korean and Japanese sovereign debt, ostensibly as part of its diversification strategy, but more likely to put upward pressure on those currencies. “Data from Japan’s Ministry of Finance show that China bought a net 1.73 trillion yen ($20.3 billion) of Japanese government bonds in the first half of this year, compared with a net sale of 5.9 billion yen ($69 million) a year earlier. That strong demand has been a key factor strengthening the yen in recent weeks.” This could have broad implications, since in the last quarter, China accumulated $81 Billion in new forex reserves, and seems intent on further diversifying out of US Dollar-denominated assets.

China’s general obstinacy towards in dealing with the Yuan is baffling to market observers, especially given the trade surplus of nearly $30 Billion in June, its largest since January of 2009. In fact, China can be seen moving backwards. It recently inaugurated a pilot program that will allow exporters to hold offshore accounts of foreign currency, which might be expected to relieve some of the upward pressure on both the Yuan and on China’s foreign exchange reserves: “If you don’t force firms to surrender their foreign-exchange proceeds, then they won’t be exchanged for renminbi, which is a source of appreciation pressure.” In this way, China can both limit speculative capital inflows (even by domestic investors) and inflation.

Foreign governments, led by the US, are still threatening action. Senators and Congressmen continue to harp on the issue (it is election season, after all), and are still threatening to slap a tariff on all Chinese imports. However, their efforts are being undermined by both the Department of Treasury (which refuses to label China a “currency manipulator”) and the Department of Commerce, which recently determined that the application of a broad-based tariff on all Chinese imports would violate its mandate.

I have always been cynical about China’s forex policy, on the basis that it is self-interested and disingenuous, and I think the fact that it remains pegged to the USD confirms that sentiment. In the end, China won’t bow to international pressure. It will only allow the Yuan to appreciate after it has determined that its economy won’t be negatively impacted, and even then, the pace will be glacial.

The recovery that emerging markets (their economies and financial markets) have staged since the lows of 2008 is impressive. In most corners of the financial markets, all of the losses have been erased, and securities/currencies are trading only slightly below there pre-credit crisis levels. Even compared to twelve months ago, in 2009, the performance of emerging market currencies holds up well. In the year-to-date, however, most of these currencies have appreciated only slightly, thanks to a particularly weak month of August.

The MSCI emerging market stock index is currently down 2.5% since the start of the year. You can see from the chart above that most emerging market currencies tend to track this index pretty closely, rising and falling on the same days as the index. Interestingly, emerging market stocks appear to be much more volatile than emerging market currencies. You can also see that while the Malaysian RInggit has started to separate itself from the pack, the others have moved in lockstep with each other and are all about even for the year.

On the other hand, emerging market debt – as proxied by the JP Morgan Emerging Market Bond Index (EMBI+) has been unbelievably strong. Prior to the slight correction in the last couple weeks, the index has risen a whopping 20% over the last twelve months. On the surface, this disconnect between stocks and bonds would seem to be an anomaly, or even a contradiction. After all, if investors are only lukewarm about emerging market currencies and stocks, what reason would there be for them to get so excited about bonds.

If you drill a little deeper, however, it all starts to make sense. Due to a weak appetite for risk, 2010 has been a favorable year for bonds, at the expense of stocks. I would have assumed that poor risk appetite would also have helped G7 financial markets, at the expense of the emerging markets, but you can see from the chart below (which shows the MSCI emerging markets stock index closely tracking the S&P 500) that this simply isn’t the case. On the contrary, this same dynamic is playing out simultaneously in emerging markets. “Today, we are favoring emerging-market debt over emerging-market equities because the debt provides us with a better risk-adjusted return,” summarized one portfolio manager.

When it comes to debt, emerging markets have actually outperformed G7 debt, in spite of the current risk-averse climate. “Funds investing in emerging-market local-currency debt have attracted $16.9 billion of net inflows so far, more than triple the record annual intake of $5 billion recorded in 2007.” The logical basis for this shift is surprisingly straightforward: “When we look at government debt, we’re always comparing and contrasting the yields versus the fundamentals. I just don’t know why you would want those low yields from a Treasury bond in the developed world when you can get much higher yields — and in our estimation, an improving economic story — in Indonesia, Malaysia or Brazil.”

In other words, why would you want to earn 2.65% from a country (US) whose national debt is close to 100% of GDP, when you could earn double or triple that rate from investing in the sovereign debt of countries whose Debt-to-GDP ratios are sustainable?!  In addition, when it comes to investing in debt, the lack of volatility in emerging market currencies can bee seen as a plus, since it prevents the interest rates from becoming diluted. To be fair, fundamentals don’t represent the whole story: “After 2008, you really have to take liquidity into consideration. Emerging markets are going to be some of the first to freeze up in a crisis.”

In fact, some analysts are already starting to question whether the markets haven’t gotten ahead of themselves in this regard, and that perhaps we are due for a big correction: “Come September, when trading resumes in earnest, we’ll find out if the cozy emerging markets world we have experienced over the past few months was summer laziness or strong conviction.” With vacations ending and traders set to return to their desks, we won’t have to wait long to find out.

It sounds like a play on words, based on the Karate Kid refrain, Wax-On Wax Off, and for all I know it was. Still, I rather like this characterization – coined by a research team at HSBC – of the markets‘ current performance. Moreover, you’ll notice from the placement of that apostrophe that I’m not just talking about forex markets, but about the financial markets in general.

What we mean is that when risk appetite is high, credit markets and equities and high-yielding currencies tend to rally together. When risk appetite fades, “those assets fall and government bonds and safe-haven currencies, including the U.S. dollar, the Swiss franc and, in particular, the Japanese yen rally.” Data from Bloomberg News confirms this phenomenon: “The 120-day negative correlation between Intercontinental Exchange Inc.’s Dollar Index and the Standard & Poor’s 500 Index was at 42.4 percent today, and has been mostly above 40 percent since June 2009.”

Skeptics counter that this correlation is tautological. Anyone can point to a stock market rally and declare that “Risk is Back On.” In addition, it’s not wholly unsurprising that there are strong correlations between low-risk currencies and low-risk assets, and between high-risk currencies and high-risk assets. According to HSBC, however, this time is different.

For example, models suggest that the recent decline in volatility should have caused these relationships to break down. That they defied predictions and remained strong suggests that we have witnessed a significant paradigm shift. In the past, “Rising correlations are also tied to weak macroeconomic conditions.” At the moment, this could hardly be more true, with global economic growth flagging.

Statisticians love to teach the dictum, Correlation does not imply causation. Nonetheless, I think that in this case, I’d wager to say that the equity and credit/bond markets are driving forex, rather than the other way around. Consider as evidence that, “[Retail] Investors withdrew a staggering $33.12 billion from domestic stock market mutual funds in the first seven months of this year,” and shifted this capital into bonds. While this wouldn’t in itself be enough to drive the Dollar higher, it epitomizes the steady shifts that have been taking place in capital markets for nearly a year, broken only by the S&P/Euro rally in the spring (which now appears to have been an aberration).

In fact, these shifts are once again creating shortages of Dollars: “This week, two banks bid at the European Central Bank’s weekly dollar liquidity providing auction – the first time there have been any bids since May – suggesting that they could not raise dollars in the market.” This suggests that demand for the Dollar could continue to grow.

Some analysts have suggested that the low-yielding US Dollar is already on its way to becoming a funding currency for carry traders, but I think this is wishful thinking. The HSBC report supports this conclusion, “A weakening of the ‘risk on-risk off’ paradigm is likely only once macro conditions are improved in a sustainable way…Currency performance will likely be tied to the ebb and flow of the perception of risk for some months to come.” In short, until there is solid proof that the global economy has emerged from recession (even if ironically it is the US which is leading the pack downward), the Dollar will probably remain strong.

The rally in the Pound, which lifted it 10% from trough to peak, appears to be fizzling. The Pound is already down 3% in the last two weeks, and is trending downward. It now stands at a four-week low against the Dollar.

Looking back at the Pound’s two-month rise, it’s not hard to understand why it was unsustainable. You can see from the charts below that there was a strong correlation with the Euro and the S&P 500 over the same period of time. This suggests that the Pound rally was less a product of changing fundamentals and more due to a sudden decrease in risk aversion.

By no coincidence the rally in equities, the Euro, and a handful of other proxy vehicles for risk, all came to and end at the same time as the Pound. In a nutshell, the markets are back to focusing on fundamentals. Namely, the risk of a double-dip recession, combined with a lack of resolution in the Eurozone debt crisis is causing investors to think twice about making bets that entail any kind of risk.

In this regard, the Pound is especially vulnerable. On the economic front, the UK economy only grew by 1.1% in the second quarter, with economists predicting only modest growth for the year. According to an economist for the Bank of England, “It would be ‘foolish’ to rule out a renewed downturn.” Evidently, his bosses agree: “The Bank of England last week said growth will be weaker than it forecast in May, citing “continuing fiscal consolidation and the persistence of tight credit conditions.”According to a recent poll, almost half of British households are pessimistic about the country’s economic prospects in the near-term: “The proportion of pessimists is marginally lower than in July, but is higher than in any other month since March last year.”

Ironically, the efforts of the British government to curb spending and cut the deficit are perceived as making matters worse. Since these measures won’t be offset by lowered taxes, they will directly lead to lower economic growth. Given that both the Pound and UK bond prices are rising (implying an increased risk of default), I think this reinforces the point I made last week about the markets not caring at all in this economic climate about increasing national debt.

The icing on the cake is inflation. A British think-tank made headlines by predicting that the UK economy will emerge from recession next year, “But once recovery is under way, he thinks, then the Bank of England’s quantitative easing scheme, which pumped £200 billion into the economy in the wake of the credit crunch, will have terrible consequences.” Specifically, the think-tank is forecasting inflation of 10% and a benchmark interest rate of 10%.

For now, this remains a distant prospect, and analysts are focusing on the fact that the economy will probably re-enter recession before it can officially exit from it. As for the Pound, forecasts are not optimistic: “Bears in a Bloomberg survey of strategists outnumber bulls 29 to 12, while TD Securities in Toronto, the most-accurate forecaster in the six quarters ended June 30, has the lowest estimate, predicting sterling will depreciate 15 percent versus the dollar by year-end.” According to the most recent Commitments of Traders report, institutional investors were still net long the Pound as of August 10. Futures prices, meanwhile, have moved in lockstep with spot prices, which suggests that futures traders are still waiting for more data before they weigh in on the Pound.

Personally, I’m having a tough time coming up with a prediction. I tend to agree with the characterization of “the foreign exchange markets post-crisis as a beauty parade with ugly contestants.” In other words, all of the major currencies are currently plagued by poor fundamentals. It’s hard to say that the Pound is in better or worse shape than the Dollar or the Euro. Still, given the way that markets have been trading, a return to (global) recession would not be kind to the Pound.

The Canadian Dollar was supposed to be one of the “hot” currencies of 2010. Given that it’s now exactly where it started the year, I think it’s safe to say that this isn’t the case. On the one hand, it would seem that the markets are still confused about how much the CAD should be worth, as Adam recently pointed out. An alternative interpretation is that investors believe the Loonie should trade near parity with the US Dollar; it has hovered just above that mark since breaching it in April.

The Canadian Dollar has benefited from strong fundamentals, especially compared to the US. Inflation is low and the economy is stable. “The International Monetary Fund (IMF) recently said that Canada is likely to be the first of the seven major industrialized democracies to return to a budgetary surplus status by 2015.” 2010 GDP growth is projected at 3.3%, compared to around 2.5% in the US.

For this reason, “Pacific Investment Management Co. founder Bill Gross said he favors Canada…he’s ‘in awe’ of countries such as Canada that have a low debt-to-gross-domestic- product ratio and solvent financial institutions. ‘North of the border’ has become a ‘preferable destination’ to what he sees in the U.S.” As a result, analysts have started to look beyond commodities, historically seen as the cornerstone of Canada’s economy. When the price of oil collapsed in May, the Loonie hardly budged. Given that Canada’s balance of trade is negative in spite of its commodity exports, maybe in focus is justified.

The Loonie is also benefiting from a positive interest rate differential with the US. Thanks to two consecutive rate hikes by the Bank of Canada (BOC) – which was the first G7 Central bank to tighten – Canada’s benchmark rate now exceeds the Federal Funds Rate by .5%. If the BOC fulfills expectations and hikes rates again at its meeting on September 8, this differential will widen further. In fact, it could continue expanding well into 2011, since the BOC is well ahead of the Fed in its monetary policy cycle. Here, again, the contrast with the US is self-evident: “The Canadian central bank has been raising interest rates, and has signaled that it will continue to raise interest rates. And with the Fed’s decision today reaffirming its dovish position, the interest rate differential will continue to favor increasingly Canada, and higher interest rates in Canada will continue to favor Canadian dollar strength.”

Throughout the rest of the summer, the Loonie will likely remain rangebound. Most traders are on vacation and trading volume is low. Besides, risk appetite is currently weak. When the markets return to full swing in September, I expect the Loonie will experience in a surge in volatility. In fact, investors are already starting to adjust their positions, with the most recent Commitment of Traders report showing an increase in Net Longs, bringing the total to $4.2 Billion.

There is certainly a basis for predicting continued strength, but I think much depends on how commodity prices perform. As I pointed out above, the Loonie remains somewhat decoupled from commodities. That it nonetheless got a boost from strong wheat prices and the $40 Billion takeover bid for Potash Corp by mining giant BHP Biliton shows that investors still view Canada as a resource economy. If the global economy avoids a double-dip recession, commodities prices will probably recover and the Loonie will probably rise slowly towards parity. On the flip-side, the Loonie would be one of the big losers of a global slide back into recession.

It was only a few weeks ago that I last wrote about the possibility of intervention on behalf of the Japanese Yen, and frankly, not a whole lot has changed since then. On the other hand, the Japanese Yen has continued to appreciate, the Japanese economy has continued to deteriorate, and the Bank of Japan has continued to ratchet up its rhetoric. In short, whereas intervention once loomed as a distant prospect, it has now become a very real possibility

Last week, the Yen touched touched 84.73 (against the Dollar), the strongest level since July 1995. In the year-to-date, it has appreciated 10%. There are a handful of analysts, including the anointed Mr. Yen, who believe that the Yen will rise past its all-time high of 79.75, recorded in April 1995. At the same time, analysts caution that Yen strength is better interpreted as Dollar weakness, and that its overall performance is much less impressive: ” ‘Against a broader range of currencies, particularly in real terms, the yen is far less strong than it looks against the US$ in isolation.’ ”

As the global economic recovery has faded, so has investor appetite for risk. The Japanese Yen has been a big winner (or loser, depending on your point of view) from this sudden sea change. Investors are dumping risky assets and piling back into low-yielding safe havens, like the Yen and the Franc. Ironically, the US Dollar has also benefited from this trend, but to a lesser extent than the Yen. It’s not entirely clear to me why this should be the case. As one analyst observed, “The zero-yielding currency of a heavily indebted, liquidity- and deflation-trapped economy should hardly be the go-to currency of the world.” At this point, it’s probably self-fulfilling as investors flock to the Yen instinctively any time there is panic in the markets.

Some of the demand may be coming from Central Banks. The People’s Bank of China, for example, “has ramped up its stockpiling of yen this year, snapping up $5.3 billion worth of the currency in June, Japan’s Ministry of Finance reported Monday. China has already bought $20 billion worth of yen financial assets this year, almost five times as much as it did in the previous five years combined.” Given that “a one percentage point shift of China’s reserves into yen equals a month’s worth of Japan’s current account surplus,” it wouldn’t be a stretch to posit a connection between the Yen’s rise and China’s forex reserve “diversification.” Officially, China is trying to diversify its foreign exchange reserves away from the Dollar, but the Yen purchases also serve the ulterior end of making the Japanese export sector less competitive.

In this sense it is succeeding, as the economic fundamentals underlying the Yen could hardly be any worse. “Real gross domestic product rose 0.4% in annualized terms in the April-June period, the slowest pace in three quarters…GDP grew 0.1% compared with the previous quarter.” This was well below analysts’ forecasts, and due primarily to a drop in consumption. Exports increased over the same period, causing the current account surplus to widen, but it wasn’t enough to prevent GDP growth from slowing. Meanwhile, unemployment is at a multi-year high, and deflation is threatening. With such persistent weakness, it’s no wonder that China has officially surpasses Japan as the world’s second largest economy.

The Yen is a convenient scapegoat for these troubles. The Japanese Finance Minister recently declared: “Excessive and disorderly moves in the currency market would negatively affect the stability of the economy and financial markets. Therefore, I am watching market moves with utmost attention.” It is rumored that the government has convened high level meetings to try to build support for intervention, such that it could apply political pressure on the Bank of Japan and cajole it into intervening. “With regard to problems such as the strong yen or deflation, we want to cooperate with the Bank of Japan more closely than ever before.”

In the end, domestic politics are a paltry concern compared to the backlash that Japan would receive from the international community if it were to intervene: “Any U.S.-endorsed intervention would be interpreted in Beijing as hypocrisy. How can the U.S. criticize China for intervening in support of a weaker currency, Chinese officials would ask, while it does so itself in support of a weaker yen?” In other words, there is no way that any country would support the Bank of Japan because such would make it less likely that China would allow the Yuan to further appreciate.

For this reason, many analysts still feel that the possibility of intervention is low. According to Morgan Stanley, however, there is now a 51% chance of intervention, based on its forex models. From where I’m sitting, it’s basically a numbers game. As the Yen rises, so does the possibility of intervention. The only question is how high it will need to appreciate before a 51% probability becomes a 100% certainty.

Pessimists love to point to the surging US National Debt as an indication that the Dollar will one day collapse. And yet, not only has the US Dollar avoided collapse , but is actually holding steady in spite of record-setting budget deficits. That being the case, one has to wonder: As far as the forex markets are concerned, does this debt even matter?

In attempting to answer this question, it makes sense to start by asking whether investors in general care about perennial budget deficits and an-ever increasing national debt. A rudimentary examination suggests that they don’t. Treasury Bond Yields have been falling slowly over the last 30 years. In fact, this fall has accelerated over the last two years, to the point that US Treasury Yields touched an all-time low in 2009, and are currently hovering close to those levels. As of today, the 10-year Treasury rate is an astonishingly tiny 2.7%.

Of course, everyone knows that this most recent drop in Treasury rates is not connected to the creditworthiness of the federal government, but rather an increase in risk aversion engendered first by the credit crisis and second by the EU Sovereign debt crisis. The Federal Reserve Bank and other Central Banks should also receive some of the credit, thanks to their multi-billion Dollar purchases. Still, the implication is that US Treasury securities are the safest investment in the world and that a default by the US government is seen as an unlikely outcome. Thus, investors are willing to accept meager returns for lending to the US.

While demand has remained strong in spite of record issuance of new debt, the structure of that demand has undergone a profound shift. Less than 20 years ago, the overwhelming majority (~85%) of Treasury Bonds were held by domestic investors. In 2010, that proportion had fallen to about half. The largest individual holders of US debt are no longer US institutional investors, but Central Banks, namely those of China, Japan, and Oil Exporting countries. Due to the continued expansion of its quantitative easing program, The Federal Reserve Bank has also become a major buyer of US Treasuries.

It’s tempting to dismiss these purchases as unrepresentative of overall market sentiment, since Central Banks have objectives different from private investors. What matters, though, is that ultimately, such Central Banks would not continue lending to the US government is they thought there was a real possibility of not being repaid. To illustrate this point, consider that the People’s Bank of China (PBOC) actually jettisoned nearly $100 Billion in Treasury debt over the last year as part of a restructuring of its foreign exchange reserves. However, it still has $840 Billion in its possession.  In contrast, the Bank of Japan increased its reserves over the same time period by a similar amount.

As for the forex markets’ assessment of the US debt situation, this is difficult to isolate. There appears to be a relatively stable correlation between the Dollar (vis-a-vis the Euro) and long-term US interest rates, as exemplified by the Euro rally and simultaneous fall in US interest rates. One explanation for the fall in the Dollar, then, could be that falling interest rates made it an attractive funding currency for a carry trade strategy. On the other hand, there would also appear to be an inherent contradiction here, since a rising Euro is an indication of increased risk tolerance and, thus, should be accompanied by a sell-off in US Treasury bonds and rising yields. That in reality, rates fell as the Euro rose confounds our efforts means any correlation is probably dubious.

You don’t need me to tell you that in the short-term, the skyrocketing US debt is of zero concern to the forex markets. There is simply too many other issues on the radar screens of investors for them to make a meaningful attempt at assessing the likelihood of default. Such concerns might become more pronounced in the long-term, but it seems kind of silly to incorporate them into present forecasts. Even if the Eurozone debt crisis were to resolve itself and the global economy managed to avoid a double-dip recession, some other crisis or development – especially one more concrete and immediate than the distant possibility of a US debt default – would materialize. In short, it will be many years before the US debt problem becomes serious enough as to warrant serious consideration by the forex markets.

I shouldn’t have been so complacent in declaring the paradigm shift in forex markets, whereby risk aversion had given way to comparative growth and interest rate differentials. While such a shift might have been present – or even dominant – in forex markets over the last couple months, it appears to have once again been superseded by the so-called safe haven trade.

In hindsight, it wasn’t that the interplay between risk appetite and risk aversion had ceased to guide the forex markets, but rather that they had been deliberately been put on the backburner. In other words, it’s now obvious that investors have remained vigilant towards the possibility of another crisis and/or an increase in risk/volatility.

How do I know this is the case? This week, there was a major correction in the markets, as diminished growth prospects for the global economy led stocks down, and bonds and the Dollar up. If investors were truly focused on growth differentials, the Dollar would have declined, due to a poor prognosis for the US economy. Instead, investors bought the Dollar and the Yen because of their safe-haven appeal.

What exactly was it that produced such a backlash in the markets, sending both the DJIA and the Euro down by 2% apiece in less than one trading session? First, the most recent jobs report confirmed that unemployment is not falling. Then, the Commerce Department released trade data which showed that the recovery in US exports has already leveled off. This sent economists scrambling to adjust their forecasts for 2010 GDP growth: “After downward revisions to other economic data like inventories and the export figures, even that 2.4 percent annual rate is now looking too rosy — and may even be as low as 1 percent.”

To top it all off, the meeting of the Fed Reserve Bank confirmed investors’ worst fears as the Fed warned of continued economic weakness and voted to further entrench its quantitative easing program. According to the official FOMC statement: “The pace of recovery in output and employment has slowed in recent months. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit…Bank lending has continued to contract….the pace of economic recovery is likely to be more modest in the near term than had been anticipated.”

The Fed also indicated slowing inflation, which set off a debate among economists about the once-unthinkable prospect of defaltion. While the consensus is that deflation remains unlikely, investors are no longer automatically inclined to give the Fed the benefit of the doubt: “The Fed’s determined effort to build up its inflation-fighting credibility over the past few decades may be working against it here.”

It was no wonder that the markets reacted the way they did! Cautious optimism has now given way to unbridled pessimism: “Given the uneven rebound in the United States, and now signs that the world’s other economic engines are slowing, economists say Americans may confront high unemployment and lackluster growth for some time to come.” Ironically, if such an outcome were to obtain, it could provide a boost for the Dollar, and even for the Yen.

Since the beginning of this week, the Euro has retreated 3% against the US Dollar, including a 2% dip in Wednesday’s trading session, alone. Is it possible that the Euro rally was too good to be true, or is this correction only temporary?

Earlier this week, Adam reported that China (via the institution that manages its foreign exchange reserves) was at least partially responsible for the Euro rally. If/when China desire to swap Dollars for Euros has been sated, the Euro rally could theoretically lose steam. At this point, it’s too early to call the end of the rally, since its steady appreciation has been marked by a handful of short-lived corrections. However, if this is indeed the start of a U-Turn, hindsight might show that it was inevitable that it would occur at this level.

As an aside, the kinds of back-and-forth swings that have become commonplace in forex markets may be attributable to large-scale investors, such as Central Banks. As currencies (or other securities, for that matter) decline, investors will often take advantage of low prices and enter the market. When prices rise, these same investors (joined by long-term investors) will often take profits and sell. As a result, it is hard for currencies to rally continuously without any kind of correction.

Back to the Euro, there are a handful of Central Banks who are making their presence known on this front. On several occasions over the last few weeks, the Central Bank of Switzerland (SNB) has unloaded massive quantities of Euros. If you recall, the SNB amassed nearly €200 Billion over the previous year, as part of a massive buying spree aimed at holding down the value of the Franc. Given that the Franc has appreciated by more than 15% against the Franc this year, it’s perhaps unsurprising that the SNB is throwing in the towel. (Oddly, it waited until Euros were cheap before it started selling).

Analysts from Morgan Stanley foresees a similar trend: “Central banks are likely to let their euro holdings slide as a percentage of the total, reflecting lingering concerns about the euro zone’s fiscal outlook…’We do not expect that central banks will provide as much support for euros as in the past. They have prevented the euro from depreciating more rapidly… but they are unlikely to stop its depreciation.’ ” The implication is clear: the Euro is facing (passive) pressure on multiple fronts.

In fact, the kinds of back-and-forth swings that have become commonplace in forex markets may be attributable to large-scale investors, such as Central Banks. As currencies (or other securities, for that matter) decline, investors will often take advantage of low prices and enter the market. When prices rise, these same investors (joined by long-term investors) will often take profits and sell. As a result, it is hard for currencies to rally continuously without any kind of correction.

While it’s true that the average daily turnover of the global forex markets now exceeds $4 Trillion, the majority of this represents the rapid opening and closing of positions by the same group of traders. Only a small portion of this actually represents meaningful changes in portfolio allocation. Thus, when the SNB or the Central Bank of China buys or sells €15 Billion, it can seriously alter the course of the Euro, even though it would seem to represent an insubstantial portion of trading volume. Thus, market participants (especially amateurs) are advised to watch these market movers for signs of changes in their respective portfolios, because they will often signal the direction of the market.

For example, from 2002 to 2009, “The euro’s weighting in global reserves rose to 28% from 23%, according to International Monetary Fund data,” and over the same time period, the Euro rose 50% against the US Dollar. It’s possible that the Euro’s appreciation drove Central Bank purchases of the Euro, rather than the other way around. The truth is probably that the two trends reinforced each other. Given that Central Bank reserves are once again rising, any changes in portfolio allocation could have significant implications for the forex markets.

I concluded my last post (Euro Recovery: Paradigm Shift Confirmed) by musing about how interesting it is that nobody has taken credit for predicting/profiting from the sudden reversal in forex markets, whereby the Euro has surged and the Dollar has tanked. Two days later, I think I can offer an explanation: China.

That’s right. The force behind the sudden sea change might not be private investors, which up until the spike entrenched itself as a full-fledged connection, remained firmly behind the declining Euro. Instead, it seems quite reasonable that China – via its sovereign wealth fund, which is charged with investing its foreign exchange reserves – might be the responsible party.

That China is buoying the Euro would make sense on a couple fronts. First of all, it would explain the mysterious silence behind the rally. China is naturally secretive in pretty much everything it does, especially in the way it conducts currency policy and manages its forex reserves. That China hasn’t even formally announced, let alone bragged about, “diversifying” its reserves, makes perfect sense.

More importantly, that China is responsible also makes sense from a strategic standpoint. China has long spoken about its intentions to change the allocation of its forex reserve holdings, and in hindsight, its timing was perfect. In the beginning of June, the Euro stood at a multi-year low, and the price of US Treasury Bonds stood at a multi-year high. Thus, China’s sovereign wealth fund was able to simultaneously lock in some profits from lending to the US and dissipate risk by swapping US assets for those denominated in Euros and Yen. “China has already bought $20 billion worth of yen financial assets this year, almost five times as much as it did in the previous five years combined.” [Analysts have noted that buying Yen also achieves the peripheral end of making Japanese exports less competitive relative to those from China].

Moreover, China can achieve this diversification without influencing the value of the Yuan, since Dollars can be exchanged directly for Yen and Euros. That is important, since the RMB is still effectively pegged to the Dollar. Speaking of which, the Yuan has hardly budged since its 1% revaluation in June. On a trade-weighted basis, it has actually fallen.

Pressure continues to mount on China to allow the RMB to appreciate. As a result of the 1% nudge in June, speculative hot money is now flowing into China at an increasing rate, because investors are “thematically looking for ways that they can participate in the currency markets in China.” They are supported by the IMF, which most recently called on China to re-balance its economy away from exports and towards trade. Its report included predictions that China’s currency account / trade surplus will continue to rise, seemingly for as long as the RMB remains undervalued. Due to pressure from China, however, it removed precise figures on the recommended extent of said revaluation.

According to a consensus of analysts, China’s exports were probably lower in the month of July, which could give the Central Bank pause in allowing the RMB to rise too much too soon. Instead, it has announced that it will make a more sincere effort to tie the Yuan to a basket of currencies, rather than just the Dollar. ” ‘The yuan should be kept stable at a reasonable and balanced level overall, while it may have two-way moves against particular currencies,’ Hu [XiaoLian, Deputy Governor] said, adding that the composition of the central bank’s currency basket should be mainly based on trade weightings.”

Going forward, then, the Yuan will probably remain basically stable against the Dollar. As China moves towards a trade-weighted peg, however, it is conceivable that it will continue to buy Euros (and Yen, for spite) against the Dollar. As this could have a confounding effect on currency markets, traders should plan accordingly.

In early July, when the Euro rally was (in hindsight) just getting under way, I reported on the apparent paradigm shift in forex markets, whereby risk-driven trades that benefited the Dollar were giving way to trades driven by fundamentals, which could conceivably favor the Euro. Since then, the Euro has continued to rally (bringing the total to 12% since the beginning of June), confirming the paradigm shift. Or so it would seem.

Euro fundamentals are indeed improving, with an improvement in the German IFO Index, which measures business sentiment, seen as a harbinger for recovery in the entire Eurozone economy. To be sure, Spain and Italy, two of the weakest members, registered positive growth in the most recent quarter. Contrast that with the situation across the Atlantic, where a growing body of analysts is calling for a double-dip recession with a side of deflation. The Fed has certainly embraced this possibility, and seems set to further entrench – if not expand – its quantitative easing program at its meeting next week.

As a result, investors are rushing to reverse their short EUR/USD bets. What started as a minor correction – and inevitable backlash to the record short positions that had built up in April/May – has since turned into a flood. As a result, shorting the Dollar as part of a carry trade strategy is back in vogue. According to Pi Economics, “The dollar carry trade may now be worth more than $750bn, approaching the size of the yen carry trade at its peak in 2004-07.”

Naturally, all of the big banks were completely caught off guard, and are rushing to revise their forecasts, with UBS calling the Euro “exasperating” and HSBC comparing the USD/EUR to a “lunatic asylum.” An analyst at the Bank of New York summarized the frustration of Wall Street: ” ‘I’ll put my hands up on this—I have had a difficult time trying to call the market. The last time I remember it being this hard was in 2001 to 2002.’ ”

In this case, hindsight is 20/20, and if it wasn’t the stress tests that buoyed the Euro, it must be the acceptance that an outright sovereign default is unlikely. Personally, I’m not really sure what to think. There isn’t anyone who has come out to say I told you So, in the context of the Euro rally, which means it’s ultimately not clear who/what is driving it, and who is profting from it. In fact, you can recall that many hedge fund managers referred to shorting the Euro as the trade of the decade. It’s certainly possible that some of these investors took their profits from the Euro’s 20% depreciation in ran. It’s equally possible that investors are once again behaving irrationally.

The latter is supported by volatility levels which are gradually falling. Still, something smells fishy. A rally in the Euro only a few months after analysts were predicting its breakup is hard to fathom, even in these uncertain times. A columnist from the WSJ may have unwittingly hit the nail on the head, when he mused, “So, unless a European bank goes belly up or some other stink bomb explodes in the region’s debt markets, the old-fashioned relationship between [economic] data and currencies looks set to persist.”

To borrow his terminology, a stink bomb is probably inevitable. That’s not to say that investors aren’t focused on fundamentals; on the contrary, any stink bomb would probably directly harm the currency with which it is associated, rather than radiate through forex markets based on some convoluted sorting of risk . The only question is where the stink bomb will explode: the EU or the US?

Next week, the Open Market Committee (OMC) of the Federal Reserve Bank will hold its monthly meeting. Even without checking futures prices, it’s obvious that the probability of an interest rate hike is nil. [In fact, the odds of a rate hike in November have already converged to 0%]. Why, then, are investors keenly awaiting the outcome of the meeting?

In a nutshell, they will be watching for two things. The first is any changes in the statement released at the close of the meeting. According to James Bullard, President of the St. Louis Fed, “If any new ‘negative shocks’ roiled the economy, the Fed should alter its position that interest rates would remain exceptionally low for ‘an extended period.’ ” If the OMC determines that the prospects for continued economic recovery are good, and/or the inflation hawks get their way, we could see subtle – but meaningful – changes to statement.

More importantly, the Fed must make a decision regarding the other tools in its monetary arsenal. Of immediate concern is what to do with the more than $200 Billion in mortgage bonds (representing less than 20% of the Fed’s total purchases of MBS) that mature in the next six months. The original plan was to allow the securities to mature and take no new action, as part of a gradual exit from the credit markets. As a result of changing economic conditions, however, the Fed is debating rolling the cash over into new mortgage securities or Treasury Bonds.

Inflation hawks (at the Fed) are skeptical and have vowed to press for the start of the unwinding the Fed’s portfolio. They have the support of traders in the MBS market, who insist that, ” ‘The MBS market currently does not need added Fed support.’ ” Meanwhile, “Treasury-market participants suggest the central bank should use the money to support small businesses or commercial real estate.”

Analysts are divided as to what the Fed will do. According to Nomura Securities, “We expect the Fed to at least stop the passive contraction of its balance sheet.” According to another analyst, “The temptation to jump from a decision to maintain the balance sheet’s size at current levels to a new round of easing is understandable but probably premature.” Based on the economic data, both sides have legitimate cases. On the one hand, the economy is still in recovery mode. On the other hand, unemployment remains stubbornly high, and certain leading indicators would seem to suggests a return to recession, which means there is pressure for the Fed to act. [“Since Fed officials last met in June, data on consumer confidence and spending have softened and job data haven’t improved. But overall financial conditions have improved somewhat, with a rebounding stock market”].

Currently, it is expected that the Fed won’t hike rates until the end of 2011. In addition, while it probably isn’t ready to embark on a fresh round of quantitative easing, it is more likely than not that it will channel the cash from the expiring bonds back into the markets. As far as forex markets are concerned, the Dollar will remain unmoved if the Fed conforms to these expectations. Dovishness – such as an expansion of quantitative easing – will almost certainly hurt the Dollar, while the flip side – exiting the credit markets and/or hinting towards rate hikes – would give the Greenback a solid boost.

Today, we bring you an interview with Roland Manarin, founder of Manarin Investment Counsel and Manarin-On-Money. Below, he shares his thoughts on risk management and the EU Sovereign Debt Crisis, among other topics.

I last mused about the possibility of Japanese Yen intervention in June (Japanese Yen: 90 or 95?): “It seems that anything between 90 and 95 is acceptable, while a drop below 90 is cause for intervention.” Since then, the Japanese Yen has fallen below 86 Yen per Dollar (the USD/JPY pair is now down 7% on the year), and analysts are beginning to wonder aloud about when the Bank of Japan (BOJ) will step in.

The BOJ last intervened in 2004. Given both the price tag ($250 Billion) and the fact that in hindsight its efforts were futile, it appears somewhat determined to avoid that route if possible. In addition, any intervention would have to be implemented unilaterally, since the goal of a cheaper Yen is not shared by any other Central Banks. As if that were not enough, the cause of intervention would be further contradicted by improving reports on the economy and by higher-than-forecast earnings by Japanese exporters, both in spite of the strong Yen.

Finally, the Bank of Japan would be wise to consider that it is impossible to calculate an ideal exchange rate, since prior to intervening in 2004, it declared that ” ‘a dollar at ¥115.00 is the ultimate life-and-death line for Japanese exporters.’ ” Six years later, the Yen is 25% more expensive, and Japanese exporters appear to be doing just fine. On the other hand, “If the yen keeps rising, BOJ officials may become more concerned over whether exports will really continue to grow and prop up the economy.”

Analysts remain mixed about the likelihood/desirability of intervention. Most admit that as with the last time around, it would be an exercise in futilty, since “the yen’s gain isn’t being driven by speculation,” and investors would probably be willing to buy any Yen that the Central Bank sells. Instead, the BOJ will probably continue to pursue a policy of vocal intervention, which can be equally effective and much less expensive.

Government officials – at least the ones with any jurisdiction in currency issues – have remained reticent on the topic of intervention. That’s not to say that they couldn’t be swayed by pressure from the Minister of Trade and others, which have repeatedly voiced their irritation over the Yen’s strength.

Ultimately, trying to predict whether intervention will take place is probably just as futile as any intervention, itself. Still, 85 is a level of obvious psychological importance, as is 84.83, the 14-year high set last November. If the Yen drifts below that, one would expect the Bank of Japan to at least make a token effort to depend the Yen. Even if the economy can withstand a weaker Yen, it will nonetheless benefit from a stronger Yen, and regardless of what the BOJ says, that is what it would like to see.