Despite all of the talk of currency war (a term first introduced by Brazili’s Finance Minister) and volatility in forex markets, the Brazilian Real is on pace to finish 2010 only slightly higher from where it began the year. While fundamentals would seem to support a further rise, Brazil’s government and Central Bank have made it clear that they will do everything in their combined power to prevent such an outcome. In short, the outlook for the Real in 2011 is incredibly uncertain.

There are two (somewhat contradictory) trends that have played a role in driving the Real to its current level. The first is the resurgence of the carry trade, whereby investors shift capital from low-risk, low-yield investments to higher-yield, higher-risk alternatives. With interest rates that are among the highest in the world – and certainly the highest among stable currencies – Brazil has been one of the prime recipients of carry trade funds. Since 2009, when concerns over the credit crisis began to ebb, the Real has risen a whopping 40%!

Moreover, the Central Bank might have no choice but to hike its benchmark Selic rate further over the next couple years. Inflation, at 5.5%, has already breached the Bank’s 4.5% target, and is projected to remain at an elevated level throughout 2011. According to futures prices, investors expect the bank to lift the Selic rate (currently at 10.75%) by 1.5% over the next twelve months, including a 50 basis point hike at its scheduled meeting in January. When you factor in low rates in the rest of the world, this would lift the yield spread between the Brazilian Real and most other comparable currencies to astronomical levels.

Alas, this first trend started to abate in the second half of 2010, due primarily to the EU sovereign debt crisis. Fortunately, the consequent move towards risk aversion hasn’t hurt the Real much. To be sure, Brazil is still an emerging-market economy, and is still perceived as being fraught with risk. However, when you consider that (certain) commodities prices (sugar, cotton) are at record highs and that the Brazilian economy barely dipped during the credit crisis, there are certainly riskier locales to park capital. Besides, many investors have determined that the interest rate premium that they receive from investing in Brazil is more than enough to compensate them for any added risk.

All else being equal, then, the Brazilian Real would probably continue rising at a measured pace in 2011. As I said, however, all else is not equal, since Brazil has pledged to do everything in their power to hold down the Real. According to the WSJ, “Earlier this year Brazil raised the IOF tax on foreign investment in fixed-income securities to 6% from 2% and also raised the tax for guarantees on derivatives investments.” Meanwhile, the Central Bank has intervened regularly in the spot market to purchase Dollars. The Bank’s newly appointed President, Alexandre Tombini, has voiced concerns over the Real’s rise: “We can’t let the economic policies of other countries determine the direction of foreign exchange.” On the day that he testified before the Senate’s Economic Affairs Committee, the Real fell by a substantial margin, suggesting that investors take his warnings seriously.

The Central Bank will also work closely with the new Brazilian administration to combat inflation, in a way that doesn’t cause the Real to appreciate. Rather than raise interest rates – which invites speculative capital inflows – the Bank will probably put pressure on the government to rein in spending and tighten access to credit. Over the long-term, this should allow it to lower rates to more sustainable levels, and prevent an expensive Rea from eroding the competitiveness of its export sector before it is too late.

Over the short-term, however, the immediate focus is to bring down inflation, most likely through rate hikes. That means that the Ministry of Finance will have to resort to more conventional weapons – such as taxes and intervention – to stem the Real’s rise. It managed to hold the Real to a 3% rise in 2010, but it remains to be seen whether it can repeat this feat in 2011.

In the last two weeks, the Swiss Franc rose to record highs against not one, not two, but three major currencies: the US Dollar, Euro, and British Pound. The Franc is now entrenched well above parity against the Dollar, and is closing in on the magical level of 1:1 against the Euro. With market uncertainty projected to run well into 2011, continued strength in the Franc is all but assured.

The Franc’s rise is due entirely to its being perceived as a safe haven currency. Its debt levels are comparable to other industrialized countries, its economy is in mediocre shape, and interest rates are the lowest in the entire world (the overnight lending rate is a paltry .1%). Some analysts have cited the “strong Swiss economic outlook” and “the health of Swiss public finances” as two factors buttressing its strength, but make not mistake: if not for the tide of risk aversion sweeping through the world’s financial markets, the Franc would hardly be attracting any attention.

As I have reported recently, the Dollar and the Yen have also benefited from the spike of risk aversion caused by renewed concerns over the fiscal health of the EU and the prospect of conflict in Korea. Perhaps owning to nothing more than proximity, the Franc has been the primary beneficiary from EU sovereign debt crisis. “It appears that smart money investors are pre-emptively bailing funds out of the eurozone with Switzerland providing a safe port to ride out the eurozone sovereign debt storm that appears to loom on the horizon,” summarized one analyst.

Unfortunately, it looks like the situation in the EU can only become serious. Despite a collective move towards fiscal austerity, all of the problem countries are still running budget deficits. As a result, members of the EU are set to issue no less than €500 Billion of new debt in 2011. To make matters worse, “The onslaught of credit warnings and downgrades of sovereign ratings over the past few days added to worries that borrowing costs in many euro zone nations could rise further.” This could trigger a self-fulfilling descent towards default and further buoy the Franc.

As far as I can tell, the notion that, “Despite the Swiss franc’s recent sharp gains, we still believe there is plenty of room for further upside ahead,” seems to encapsulate current market sentiment. According to the most recent Commitment of Traders Report, investors continue to increase their long positions in the Franc. According to Bloomberg News, “Options traders are more bullish on the franc for the next three months than any major currency except the yen.” Meanwhile, a sample of analysts’ forecasts suggests that the Franc could appreciate another 5% over the next six months.

At this point, the main variable the Swiss National Bank (SNB), which could resume intervention on behalf of the Franc. After spending close to €200 Billion to depress the Franc, the SNB accepted the futility of its efforts and formally renounced intervention in June. However, Swiss National Bank President Philipp Hildebrand recently referred to the Franc’s rise as a “burden,” and warned that the SNB “would take the measures necessary to ensure price stability” in the event of  “renewed financial market tensions.”

As to whether intervention is likely, analysts remain divided. “The timing [for intervention] would certainly be perfect, with liquidity very thin….pre-holiday markets are ideal for springing a surprise,” said one strategist. According to Morgan Stanley, however, the SNB is “unlikely to intervene in the near term to stem the rise in the franc. The previous intervention earlier this year has left a huge overhang of liquidity in the economy and the Swiss National Bank doesn’t want to further boost the money supply.” In addition, the SNB experienced losses of €22 Billion on its forex reserves in the first nine months of this year, and will be reluctant to incur further losses by resuming intervention.

In short, aside from this lone point of uncertainty, all factors point to continued upside.

If you look at a chart of currency volatility over the last five years, two major spikes immediately jump out. The first took place in the wake of the collapse of Lehman Brothers in late 2008, while the second occurred earlier this year during the height of the EU sovereign debt crisis. While volatility has gradually subsided since then, it is still well above its historical average, and many analysts forecast that it will remain at an elevated level through at least 2011.

2010 was a volatile year for the forex markets for good reason. The EU sovereign debt crisis officially emerged, and spread from Greece to Ireland, and potentially to Portugal and Spain as well. There was uncertainty surrounding the impact of the Fed’s second quantitative easing program (QE2), as well as the impact of similar plans announced by the Bank of England and Bank of Japan. A handful of Central Banks ignited what has since been termed the “currency war,” which the G7/G20 are still trying to end. China allowed the Yuan to resume its upward march against the US Dollar, but at a pace that has failed to satisfy most critics. Emerging market currencies in general, and Asian currencies in particular surged, despite the best efforts of their respective Central Banks to contain them.

As a result, investors struggled to figure out what the right levels to buy and sell even the major currency pairs.  The Euro has ranged from $1.1877 to $1.4579 (against the Dollar) so far this year; and the Yen has ranged from 80.22 to 94.99. Amidst this backdrop of volatility, investors once again flocked to the US Dollar. On a trade-weighted basis, it appreciated 5% for the year. Against its arch-rival, the Euro, it gained an impressive 10%. The Japanese Yen and Swiss Franc – the other two major safe-haven currencies – also outperformed, even touching record levels against some other currencies.

At this point, the only certainty is that uncertainty will persist well into 2011. Economic and monetary policymakers around the world will continue to struggle to keep (or merely put) their economies on the recovery track, while minimizing the risk of inflation in the medium-term. According to the currency strategy team at UBS, “There is…high risk of policy-maker error in relation to interest rates, quantitative easing and fiscal tightening.” To make matters worse, there is still a lack of coordination among, and in some cases, outright contradiction between countries’ respective policies. “There are doubts about the mutual consistency in economic strategies pursued by major economies…We have seen in recent weeks a tendency by countries to publicly challenge each others’ monetary or exchange rate policies,” said European Central Bank governing council member Christian Noyer.

As a result, it’s more than likely that volatility levels will remain proportionately high. Added UBS, “The euro may range from $1.1 and $1.5…and U.S. dollar may touch as low as 70 yen and high as 100 yen in 2011…Overall investors will have to be more aware of foreign exchange risk in 2011. For at least several more years, volatility will be structurally higher.”

In this kind of environment, the implications are clear. While commodity and emerging market currencies may still be girded by strong fundamentals, a lack of investor risk appetite could trigger another round of capital flight. Meanwhile, the US Dollar (and other safe haven currencies) will benefit, and the Euro will suffer.

Today, we bring you an interview with Boris Schlossberg, director of currency research at GFT Forex, co-founder of BK Forex Advisors, and co-contributor to FX360. He is also a weekly contributor to CNBC’s Squawk Box and a regular commentator for Bloomberg radio and television. His daily currency research is widely quoted and appears in numerous newspapers worldwide. He is the author of Technical Analysis of the Currency Market (2006) and Millionaire Traders (2007). Below, Mr. Schlossberg shares his thoughts on risk management, leverage, currency wars, and other assorted topics.

It has been said before, but now I think it’s official: retail forex has entered the mainstream. In the month of December, two retail forex brokerages – Forex Capital Markets (FXCM) and Gain Capital Holdings (GCAP) – went public on the New York stock exchange. Combined with some juicy information revealed in their regulatory filings, I think this event raises some interesting questions about the future of forex.

Some background: both FXCM and Gain Capital operate trading platforms and news/analysis websites (DailyFX.com and Forex.com, respectively). FXCM has a current market capitalization of $850 million, compared to $250 million for Gain Capital. The former earned net income of $98 million last year on revenue of $339 million, and it has 135,000 active clients. The latter earned $36 million net income on $188 million revenue, and its client base totals 52,000. (For the sake of comparison, consider that ETrade has more  than $4 million and its ttm revenues exceeded $2.5 Billion).

If you do some simple arithmetic, you will discover that revenue per account is substantially higher for forex brokers than for stock brokers: $2,500/account for  FXCM versus $100-200 that I’ve been told is standard for retail stock brokers. Of course, some of that disparity is natural, given that the average forex account-holder trades at a higher frequency and higher volume than the average stock investor, who apparently only makes one round-trip trade per month, on average. However, the bulk of that discrepancy is probably due to a lack of transparency/competition.

Although information on average account size was not released, it nonetheless stands to reason that a significant portion of forex account-holder equity is being “transferred” to brokers every year. (Interestingly, FXCM loses money on the majority of its accounts.  Accounts worth more than $10K – which presumably do the most trading – generate the most revenue, and yet more than half of them are still unprofitable for FXCM).

I think this raises some serious questions about transparency in forex commissions. While other brokers make money from the bid/ask spread (which also suffers from a lack of transparency) and by taking offsetting positions, FXCM boasts that it “makes an identical amount of money in the form of pip markups (which are really commissions) regardless of whether the customer made or lost money on the account.” Basically, FXCM matches up buyers/sellers with banks and financial institutions, and takes a cut for facilitating the transaction. While this is somewhat less opaque than filling orders directly for customers, the fact that it doesn’t disclose its commissions should be cause for concern. For the sake of comparison, consider that when you buy/sell stock, the commission that you pay the broker is clearly disclosed.

Someone recently asked me if trading commissions (i.e. spreads) in forex were fair/stable, and in the context of this data, I think it shows that there are is still room for commissions to fall. As the number of retail forex traders grows, you would expect spreads to tighten further, and profit/account to decline from the current level of $700+ per year.

Since both FXCM and Gain Capital are now public companies, they will be subject to increased scrutiny and regulatory oversight, and will henceforth be required to make frequent disclosures. If Oanda and other top-tier brokers accede to competitive pressures and also go public, the result should be increased transparency for the industry and better pricing for traders. In short, daily volume figures ($4 Trillion/day) notwithstanding, retail forex trading still has a ways to go before it can really be compared to retail stock trading.

Based on nominal exchange rates, the Chinese Yuan has appreciated by a modest 2% against the US Dollar since the month of September (when the People’s Bank of China (PBOC) adjusted the currency peg for the first time in nearly two years). If you take inflation into account, however, the Chinese Yuan has risen by much more. In fact, if current trends persist, the Chinese Yuan exchange rate controversy might resolve itself.

Demands from the international community for China to appreciate its currency hinge on two related arguments. The first is that at its current level, the artificially low exchange has allowed China to build up a massive trade surplus. The second is that Chinese prices seem to be lower than they should be (when quoted in other currencies), and the economic principle of Purchasing Power Parity (PPP) suggests that for this discrepancy to be eliminated, the Chinese Yuan must rise.

As it turns out, both of these claims are more problematic than they would appear. For example, China’s official trade surplus is already massive, and is steadily increasing. For 2010, it will probably near $200 Billion. However, it turns out that majority of that surplus is being captured by foreign-funded companies: “Their 112.5-billion U.S.-dollar surplus accounts for 66 percent of China’s total surplus over the past 11 months.”

In addition, trade statistics are calculated in such a way that the country that assembles the finished product gets credit for the full export value of that product. By looking specifically at Apple’s popular iPhone, researchers calculated that the product officially contributed $2 Billion to the US trade deficit with China. When the nuances of the iPhone’s supply chain are taken into account, that figure swings to a surplus of $48 million. In both of these cases, the fact that these products are manufactured in China doesn’t detract from US GDP (though it probably does cost the US jobs). Hence, the US probably isn’t hurting as much from the weak RMB to the extent that some lobbyists insist.

As for inflation, the official rate is now 5.1% on an annualized basis. Even if we accept this (and living in China, I can tell you that the actual rate is much, much higher), that means that the value of other currencies is eroding at a much faster rate than is implied by official exchange rates. That’s because a currency is only worth its purchasing power; as prices and wages in China rise, the purchasing power of the US Dollar (and other currencies) falls.

The Chinese government is trying to address the problem in the form of price controls and mandated increases in supply, but it is still reluctant to rein in inflation using conventional monetary policy measures. M2 money supply in China is increasing at a rate of 20% a year, the majority of which is being spent on another boom in fixed asset investment. While the PBOC has responded by increasing the required reserve ratio of Chinese banks, it remains reluctant to raise interest rates lest it contribute to further inflows of “hot money” on more upward pressure on the Yuan. As a result, the consensus among economists is that inflation will continue rising unabated: “We see a strong chance of underlying price pressures continuing to build over the medium-term.”

Unless circumstances change, then, the argument for further RMB appreciation is somewhat weak. Nonetheless, analysts remain optimistic: “A Bloomberg survey based on the median estimates of 20 analysts predicts the yuan to increase 6.1 percent to 6.28 percent by the end of 2011.” Given that Hu Jintao is schedule to visit the US in January – and China’s fondness for symbolic policy gestures – a token move of 1% or so before then wouldn’t be surprising. As for the predicted 6% rise next year, well, that depends on inflation.

It seems the gods of the forex market read my previous post on the Japanese Yen, in which I puzzled over the currency’s appreciation in the face of contradictory economic and financial factors. Since then, the Yen’s 6-month, 15% appreciation (against the US Dollar) has arrested. It has retreated from the brink of record highs, and undergone the most significant correction since March of this year. Have investors come to their senses, or what?!

You certainly can’t give the Bank of Japan (BOJ) any credit. Aside from its single-day $25 Billion intervention in September, it hasn’t entered the forex markets. In fact, it has already repaid the funds lent to it by the Ministry of Finance, which suggests that it doesn’t have any intention to replicate its earlier intervention in the immediate future, regardless of where the Yen moves.

Perhaps the BOJ foresaw the current correction in the Yen, which was probably inevitable in some ways. After all, Japanese interest rates – while gradually rising – still remain at levels that are unattractive to investors. While US short-term rates are low, long-term rates are more than 1.5% higher than their Japanese counterparts. When you factor in that Japan’s fiscal condition is worse than the US, there is really very little reason, in this aspect, to prefer Japan. As one analyst summarized, “The whole interest-rate differential argument is turning out to be dollar supportive, at least in the near term.”

The same is true for risk-averse capital. For reasons of liquidity and psychology, the Japanese Yen will continue to be a safe-haven destination in times of distress. Still, it’s hardly superior to the Dollar, in this sense. Inflation is slowly emerging (or at least, the risk of deflation is slowly abating) in Japan, and it could conceivably reach 1% this year if the Bank of Japan has its way. Its proposed 35 trillion yen ($419 billion) of asset purchases dwarfs the comparable Federal Reserve Bank’s QE2 program (in relative terms) and contradicts the notion that the Yen is the best store of value.

Finally, the Japanese economy remains weak, and vulnerable to a double-dip recession. On the one hand, “Japan’s economy expanded at an annual 4.5 percent rate in the three months ended Sept. 30.” On the other hand, its economy remains heavily reliant on exports (see chart above, courtesy of Bloomberg News) to drive growth, which is complicated by the expensive Yen and concerns over a drop-off in demand from China and the rest of the world. In fact, “Exports rose 7.8 percent in October, the slowest pace this year, while industrial production fell for a fifth month and the unemployment rate climbed to 5.1 percent.” In addition, the closely watched Tankan survey registered a drop in September, “the first fall in seven quarters.” While Japanese companies are still net optimistic, analysts expect that this to change in the beginning of 2011.

For the rest of the year, how the Yen performs will depend largely on investor risk-appetite. If risk aversion predominates, then the Yen should hold its value. In addition, it’s worth pointing out that even as the Yen has fallen against the Dollar, it has appreciated against the Euro, and remained flat against a handful of other currencies. Against the US Dollar, however, I still don’t see any reason for why the Yen should trade below 85, and I expect the correction will continue to unfold.

After a stellar 2009, the Canadian Dollar (“Loonie”) has had a relatively lackluster 2010 against the Dollar, rising by only 3-4%. As the Loonie has inched (back) towards parity, it has encountered significant resistance. I think there is reason to believe that the currency has reached its limit, and that there are little prospects for further appreciation for at least the first half of 2011.

Everyone likes to think of the Canadian Dollar as a commodity currency, but I don’t think this is an accurate representation. Net energy exports account for only a small portion (2.9%) of Canadian GDP, a fraction which is dwarfed by the export of automobiles, for example. In fact, eastern Canada, which is comparatively poor in natural resources, is actually a net energy importer. I think that investors have largely come to the same conclusion, and significant rallies in oil and other commodity prices in the second half of 2010 spurred only a modest appreciation in the Loonie.

The currency has risen so fast over the last couple years that Canada has run a trade deficit for six consecutive months, including a record $2.5 Billion in July. (In some ways, doesn’t this prove that economic imbalances will ultimately self-correct?!). In addition, to say that Canadian export sector is heavily reliant on the US would be an understatement: “The U.S. bought 70 percent of Canada’s exports in October, down from 75 percent in June, and a record of about 85 percent in 2001.” It’s no wonder that Canadian economic officials have defended the Fed’s QE2 monetary easing program; they know that Canada’s economic health is contingent on a strong US economy.

As for how fluctuations in risk affect the Loonie, it’s not clear. On two separate occasions, the WSJ reported first that “With investors more willing to take on riskier assets than they were the day before, the Canadian dollar was able to move sharply higher,” and then that “Canada’s relatively strong fiscal and economic fundamentals attract safe-haven flows when investors are fleeing from risk.” What a blatant contradiction if there ever was one! Personally, I think that Canada’s economic structure and relatively high debt levels disqualify the Loonie from consideration as a safe-haven currency. That being said, it has notched some impressive gains against other non-safe haven currencies.

If not for its low interest rates, nobody would even mention it in the same breath as the US Dollar or Japanese Yen. Speaking of low rates, the Bank of Canada voted last week to keep its benchmark interest rate on hold at 1% and indicated that it won’t consider raising them for quite some time. Said Central Bank Governor Mark Carney, “There are limits to the divergence that there can be between Canada and the United States.” In other words, the BOC probably won’t hike rates until the Fed does, at which point there will be very little basis for buying the Loonie over the US Dollar.

Analysts tend to agree with this assessment: “The loonie will trade at parity by the end of March and weaken to C$1.01 per dollar through the end of third-quarter 2011, according to…a Bloomberg survey: ‘We still think the Canadian dollar will continue to hover around here and test parity; we don’t think the Canadian dollar is going to back up against the U.S. dollar until the new year.’ Interestingly enough, Canadian investment advisers echo this sentiment: “We’re saying to clients that the Canadian dollar is strong right now, so buying U.S. assets is cheaper than it would be if the dollar were weak.”

It’s a bad sign for the Loonie when even Canadians think it’s overvalued.

In the midst of the currency war controversy, there is one emerging market country that continues to insist that its currency is undervalued: Russia. While being a member of the illustrious group of BRIC (Brazil / Russia / India / China) countries would seem to guarantee an appreciating currency, there are strong forces weighing on the Ruble. In other words, that it remains weak is not due to investor oversight.

If you view the performance of the Russian Ruble over the last few years, it’s clear that it never recovered from the rapid depreciation that took place during the height of the credit crisis. Given that nearly every other emerging market currency is either closing in on or has already breached its pre-credit crisis level, there must be something holding down the Ruble.

That something happens to be a sizable current account deficit. Unlike with other emerging markets, capital is actually flowing out of Russia. There are a few reasons for this: first of all, much of Russia’s debt is denominated in foreign currency, as a consequence of its massive default in 1998. Specifically, “The private sector has about $16 billion in foreign debt, including interest-rate payments, due this month [December], double the $8 billion of redemptions in October and November.” This means that every month, Russian companies must scramble to exchange Rubles for Dollars and Euros.

Next, the real returns of investing in Russia are currently negative. Russia’s Central Bank (Bank Rossii) continues to maintain the benchmark refinancing rate at a record-low 7.75%, and the 10-year yield on Russian bonds is even lower, at ~5%. This would seem to compare favorably with the 2.75% yield on comparable US Treasury Securities until you account for inflation, which is projected to top 8% for the year. While Ruble-denominated bonds pay a higher interest rate (7.75%), they also carry higher risk. For that reason, Russian yields and credit default swap spreads (which insure against default) are much higher in Russia than in other BRIC countries.

Meanwhile, Russian companies are taking advantage of low borrowing rates to engage in a reverse carry trade and invest in western countries: “Russian companies have announced $27 billion of foreign purchases this quarter, the most since the third quarter of 2008 and triple the amount in the last three-month period.” Finally, the reemergence of the EU fiscal crisis, combined with the skirmish in Korea has spurred a decrease in risk appetite. As one analyst summarized, “The whole of the emerging markets are on the back-foot at the moment and the ruble is no exception…it’s definitely risk off at the moment.”

As a result, Bank Rossii finds itself in a somewhat unique position among Central Banks of having to try to prop up its currency. Technically, the Rouble is pegged to a basket (consisting of 55% Dollars and 45% Euros), but pressure on it has been so intense that the range in which it is permitted to trade has been adjusted downward five times since the middle of October. To prevent it from declining further, Bank Rossii has been dipping into its $450 Billion stock of forex reserves, and selling foreign currency at the rate of $150 million per day. It insists that it will “allow” the Rouble to appreciate in 2011 in order to fight inflation, but that obviously depends on whether the current account shifts back to surplus.

What do investors think? According to a Bloomberg survey of currency analyst, “The Ruble will strengthen 4 percent versus the basket by the end of the first quarter of 2011. On the other hand, “Options traders are still bearish on the ruble with the currency’s one-week risk reversal rate — the premium of put options over calls — at 1.25 percent for the tenth straight day, from 0.5 percent at the end of October.” Non-deliverable forward contracts, meanwhile, reflect a weaker Ruble three months from now.

If the Bank Rosii fulfills analysts’ expectations and hikes rates in March, it will be step towards reinvigorating investor interest in Russia. More importantly, however, is that inflation is brought under control. Until that happens, the Ruble will remain the main standout in a sea of emerging market currencies that otherwise continues to outperform.

As one strategist recently put it, we seem to be witnessing Deja Vu in the forex markets. The US Dollar in general, and the USD/EUR currency pair in particular, are behaving exactly the same as one year ago: “The greenback rose back then…on a combination of strong U.S. November jobs numbers…and the triple downgrades of Greece later in the month by Fitch, S&P and Moodys.” This time around, a similar combination of US optimism and EU pessimism are once again buoying the Dollar.

It all started about a month ago, when the EU sovereign debt crisis flared up again in the EU. Initially, investors were focused on the fiscal plight of Ireland, but quickly became nervous about the possibility that the crisis would spread to Portugal and even Spain, which would tax the finances/ability of the EU and put extreme pressure on the European Monetary Union (EMU). With this in mind, investors have fled the Euro, sending it down more than 7% – from peak to trough – against the Dollar.

The skirmish between North and South Korea further added to the climate of heightened risk, and reinforced the position of the Dollar as the world’s safest currency, ahead of even the Swiss Franc and Japanese Yen: “Recent events just reinforce the underlying message that during times of turmoil, almost no matter what the source, the U.S. dollar is seen as a safe harbor for investors.” Basically, there is still nothing that can compare to US Treasury securities in terms of liquidity and security. In fact, demand for Dollars has become so acute in recent weeks that some analysts are already bracing for the (still-distant) possibility of another Dollar shortage, like the one that plagued the markets following the collapse of Lehman Brothers in 2008. In short, “The strong dollar thirst linked to dollar-funding needs is, as usual, supporting the dollar.”

Meanwhile, the markets are becoming less pessimistic about the impact of the Fed’s $600 Billion expansion of its Quantitative Easing Program (QE2) and consequently more optimistic about US growth prospects. Even before the drama in the EU and Korea, investors had already started to adjust their positions. Since mid-October, “Futures traders have slashed bets for a decline in the dollar against the euro, yen, Australian dollar, and Swiss franc, data from the U.S. Commodity Futures Trading Assn. show…Strategist forecasts for the dollar to weaken have all but disappeared.”

While the employment picture remains a dim spot, the economy is still growing. In a recent televised interview, Ben Bernanke declared that, “Another recession appeared unlikely.” He also added that QE3 is also a possibility if banks continue to hoard capital, eroding the effectiveness of QE2. The positive reaction of forex markets shows that investors are less concerned about inflation and more focused on whether QE2 will facilitate economic growth. It “absolutely can be dollar-positive if the markets decide that [it is] going to be part of the package that brings about a revival in economic growth,” summarized one analyst.

If the markets continue to bet on (as opposed to against) QE2, and uncertainty persists in the EU, the Dollar will continue to rally and finish off the year in positive territory.

Only last month, the Euro was on top of the forex markets. Especially relative to its “G4” competitors (Dollar, Yen, Pound) – all of which are plagued by economic uncertainty and loose monetary policies – the Euro was seen as a smart bet. In the last few weeks, however, the EU sovereign debt crisis resurfaced, and the Euro has plunged, losing 7.5% of its value against the Dollar. As a result, investors have pulled an about-face: instead of banking on the European Central Bank (ECB) to buoy the Euro through monetary restraint, they are now counting on it to hold the Euro together by adopting the same tactics as its counterparts.

Before I explain what I mean here, I’d like to offer an update on the EU fiscal situation. In the last week, there were a handful of developments. First, Ireland accepted a tentative €85 Billion in aid from the EU/IMF, officially joining the ranks of an infamous club that also includes Greece. Still, it wasn’t clear whether such a bailout would also include Irish banks, which are seen as perhaps in deeper trouble than the Irish government. As a result, investors were unmoved, and S&P moved ahead with a cut to Ireland’s sovereign credit rating.

Naturally, rumors began to circulate that Portugal was also preparing a formal bailout request. Said one trader, “In Portugal the kind of language you’re hearing is similar to what you heard in Ireland a few weeks ago.” Despite promises to the contrary, Portugal’s budget deficit has widened in 2010. Interest in its most recent bond issue was healthy, but at the highest interest rate since the Euro was introduced in 1999 and more than .5% higher than last month.

Ultimately, bailouts of Greece, Ireland, and Portugal can be managed. It is a default and/or preemptive rescue of Spain – the other PIGS member – that worries investors. Its economy represents more than 11% of the EU and any hiccup would seriously shake the foundations of the Euro: “It may well be that we are approaching the endgame of this part of the crisis as Spain is of such importance that one can only imagine that the EU will regard it as the line in the sand that cannot be crossed.” While Spain is working hard to cut its budget deficit to a still-stratospheric 9.3% in 2010, investors have balked. As a result, interest rates in its bonds have surged to a post-Euro high (relative to German bonds), and credit default swap spreads (which insure against the risk of default) have risen substantially.

The problem with the EU sovereign debt crisis – like most credit crises, for that matter – is that they tend to be self-fulfilling. As investors begin to doubt the ability of institutions (governmental and otherwise) to service their debts, they naturally demand greater compensation for the (perceived) increase in risk. This further inhibits that institution’s ability to repay its loans, which only makes funding more difficult to attract, and so on.

It is ironic on multiple levels then that even as investors abandon the debt of EU member countries, they are hoping that the ECB steps in to fill the void they create. As I alluded to the title of this post, this marks a stunning about-face from only a few months ago, when the Euro was rising against the Dollar because of the ECB’s commitment to a responsible monetary policy. Nowadays, the Euro rallies only on news that the ECB is maintaining or expanding its intervention. For example, the Irish banking sector is “increasingly more reliant on the ECB funding,” and as a result, “The euro edged up…as the European Central Bank continued buying Portuguese and Irish government bonds.”

Based on this change in investor mentality, it seems unlikely that the Euro will recover its losses anytime soon. Of course, the ECB has nearly unlimited resources at its disposal. German central bank chief Axel Weber declared confidently that, “An attack on the euro has no chance of succeeding.” However, the ECB can never hope to fully supplant the important role played by private capital, and besides, “What we are experiencing at present is not a speculative attack but a justified depreciation due to unsolved problems.”

There are still plenty of optimists who believe that the fear will soon die down and that higher interest rates will attract some of the yield-hungry investors that are currently focused on emerging markets. Goldman Sachs forecast “the euro will rise to $1.50 by year-end 2011 as big economies in the area continue expanding.”

I think the most realistic assessment is somewhere in between. On the one hand, it seems unlikely that the Spain will default on its debt at anytime in the near future or that the Euro will cease to exist. On the other hand, the fact that investors now see the ECB as a savior for following in the footsteps of the Fed implies that there is no reason for investors to buy the Euro against the US Dollar.

All things considered, Asian currencies have had an okay 2010 (and there’s still another month to go). After a modest first half, they started to rise in unison in June, and several are poised to finish the year 10% higher than where they began. While the last few weeks have seen a slight pullback, there is cause for cautious optimism in 2011.

At this point, I think the rise in Asian currencies has become somewhat self-fulfilling. Basically, investors expect Asian currencies to rise, and the consequent anticipatory capital inflows cause them to actually rise, thereby reinforcing investor sentiment. For example, the co-head of emerging markets for Pacific Investment Management Company (PIMCO) is “investing in local currency debt and foreign exchange contracts in Asia on the basis that…emerging market currencies are bound to rise for…fundamental reasons.” Upon being asked to elaborate on such fundamentals, he answered lamely that, “One big driver for emerging markets in coming years will come from investors’ relatively low allocations to these fast-growing regions.”

When pressed for actual reasons, investors can glibly rattle off such strengths as high growth and low debt and wax bullish about the emerging market ‘story,’ but ultimately they are chasing yield, asset appreciation, and strengthening exchange rates. It doesn’t matter that P/E ratios for (Asian) emerging market stocks are significantly higher than in industrialized economies, or that bond prices are destined to decline as soon as (Asian) emerging market Central Banks begin lifting interest rates, or that Purchase Power Parity (PPP) already suggests that some of these currencies are already fairly valued. In a nutshell, they continue to pour money into Asia because that’s what everyone else seems to be doing.

Personally, I think that kind of mentality should inspire caution in even the most bullish of investors. It suggests that if bubbles haven’t already formed in emerging markets, they probably will soon, since there’s no way that GDP growth will be large enough to absorb the continuous inflow of capital. According to the Financial Times, “Data suggest that emerging market mutual funds, including those invested in Asian markets, have received about 10 per cent of their assets in additional flows over the past four to five months.” Meanwhile, a not-insignificant portion of the $600 Billion Fed QE2 program could find its way into Asia, exacerbating this trend.

In addition, emerging markets in general, and Asia in particular, have always been vulnerable to sudden capital outflow caused by flareups in risk aversion. For example, Asian currencies as a whole (see the US Dollar Asian Currency Index chart above) have declined 2% in the month of November alone, due to interest rate hikes in China and a re-emergence of the EU sovereign debt crisis. The former sparked fears of a worldwide economic slowdown, while the latter precipitated a decline in risk appetite.

As a bona fide fundamental analyst, it pains me to say that emerging market Asian currencies can expect some (modest) appreciation over the next year, barring any serious changes to the EU fiscal and global economic situations. It seems that capital will continue to pour into Asia, which – rather than fundamentals – will continue to dictate performance.