The last few weeks have witnessed a number of major developments in the retail forex world: more mainstream firms  entering the fold, and existing firms are moving to beef up their forex operations. Not only will this permanently alter the competitive landscape, but it should also benefit traders in the form of more choice, lower prices, and increased transparency.

The Wall Street Journal was first to report that Charles Schwab is in the early stages of introducing forex to the array of financial products available to its customer base: “Schwab, the largest online broker, disclosed in a slide presented at its recent winter business update that it was ‘analyzing the forex opportunity’ in 2011.” Unbeknownst to me, TD Ameritrade made a stealthy entry into forex in 2009, though its purchase of ThinkorSwim. Ameritrade offers more than 100 currency pairs (and its trading platform even has information on the Netherlands Guilder!), and currency and futures trading now accounts for 6% of its volume. E-Trade (which rounds out the “Big 3” online discount brokers) currently enables customers to convert their unused account balances into five major currencies, but has yet to roll out a platform for trading currencies in real-time.

Some of the impetus is apparently coming from FXCM, which went public in 2010 and is aggressively marketing its trading platform to brokers which don’t specialize in forex. Given the surging volume and healthy spreads in forex, its probably not difficult to sell its appeal. Online brokers have also acknowledged that the majority of its profits are generated by a minority of its customers. Given that most currency traders tend towards being extremely active, it won’t be long before they are courted by traditional brokers.

As LeapRate pointed out in a recent report, what we are witnessing is a consolidation and mainstreaming of retail forex.In 2010, the US Commodity Future Trading Commission (CFTC) moved to bring retail forex out of the shadows and under its regulatory umbrella. New rules raised registered capital requirements, lowered leverage ratios, and generally increased the amount of scrutiny applied to brokers. This forced smaller players to either merge, move overseas, or quit the retail forex business. It also galvanized the major brokers, in the form of two Initial Public Offerings (IPOs), capital infusions, and a blitz of advertising. This week, CitiFX introduced a new forex pricing structure, major currency spreads to under 2 pips for its favored customers. TradeStation Forex also announced plans “to launch and offer exclusively the company’s new forex brokerage offering beginning later this quarter.”

In the next few years, I think we will witness further consolidation, with ~10 brokers accounting for the majority of retail forex trading volume. Online discount brokers may also establish themselves as a major force, luring customers through the strength of their brands and the accompanying guarantee of transparency, as well the ability to trade different types of securities using a single, integrated platform. Spreads will continue to fall for the major currencies, and even for some of the exotics. In fact, it probably won’t be long before retail forex becomes completely commoditized, and it loses its novelty.

When analyzing forex, nothing is more satisfying than establishing a strong correlation between a particular currency pair and another quantifiable investment vehicle. You see – we fundamental analysts love to kid ourselves that we can actually explain what’s going in the forex markets, but it’s only when you can visually observe (and statistically confirm) a correlation can you actually pretend that this self-assuredness is justified.

On that note, I found myself looking at in interesting chart today: the EUR/USD vs. CHF/USD vs. S&P 500 Index. My purpose in drawing this particular chart was to ascertain how risk appetite (represented by the S&P) is being reflected in forex markets. As you can see, two observations can immediately be made. CHF/USD very closely tracks the S&P (or vice versa), while the EUR/USD similarly mirrored the S&P for most of the last 12 months, before suddenly diverging in November 2010.

By extension, this raises two questions. First, why should a rising S&P be accompanied by the Swiss Franc? After all, the former is a proxy for risk appetite, while the latter is a symbol of risk aversion. That means that tither the S&P is a weak indicator of risk appetite, or the Swiss France is not being driven by risk aversion. In a way, I think both notions are true. Specifically, US equity prices are are primarily a sign of US economic recovery and strong corporate profits. It’s probably equally accurate to say that the S&P promotes risk appetite, as saying it reflects risk appetite.

Moreover, as US stocks and investor risk appetite have increased, interest in the US Dollar has (somewhat ironically) decreased. One would think that this would spur a depreciation in the Swiss Franc, but I guess this was superseded by the falling Dollar. [For that reason, I actually added the MSCI Emerging Markets Stock Index after I started writing this post, because I realized it was a better proxy for global investor risk appetite. Sure enough, the recent continuation in the Franc’s rise has coincided with a correction in emerging market stocks].

While this explains why the Euro should also appreciate for five consecutive months, it doesn’t offer any insight into why the EUR/USD correlation with the S&P should suddenly breakdown. [Question #2]. Recall from my earlier posts that there was a sudden flareup in the Eurozone sovereign debt crisis in November 2010. Around that time, there were a handful of debt downgrades, Ireland received an EU bailout, and there was heightened concern that the crisis would soon spread from Greece to the rest of the PIGS.

This caused a bout of intense Euro instability, against both the US Dollar and Swiss Franc. While the S&P continued rising, interest in emerging market stocks began to flag. It’s extremely tempting to posit a connection between these two trends, especially since it would seem to be implied by the chart. However, I think the correction in emerging markets is due more to Central Bank intervention and a recognition that a bubble was forming, than to the EU sovereign debt crisis. That the Euro has rallied in 2011 even as emerging market stocks have begun to decline, supports this interpretation.

Trying to draw meaningful conclusions from these correlations is frustrating at best, and dangerous at worst. Namely,  that’s because it’s impossible to completely distinguish cause from effect. The two stock market indexes are probably the least dependent of the four items. For instance, the Euro is derived in part from the Dollar, which is derived in part from the S&P. You could say that the Franc takes its cues from the S&P (as a proxy for risk appetite) and the Euro. Second of all, the strongest correlation on the chart (CHF/USD and S&P) is also the most unexpected.

In the end, I think only one solid conclusion can be drawn: uncertainty surrounding the Euro will continue to boost the Franc. While I probably could have told you that without the use of this chart, at the very least, it reinforces the interconnectedness of all financial markets and that even if poorly understood, all trends are ultimately related.

Relatively speaking, the Chinese Yuan has been on a tear, appreciating ~1% in a little more than a month. One has to wonder whether this is a concession by the People’s Bank of China (PBOC) that its exchange rate regime is not viable or whether its instead a political sop. The question on everyone’s minds, of course, is, will it continue?

Countries around the world have continued to criticize China for its unwillingness to allow the Yuan to appreciate. At last week’s G20 meeting, US Treasury Secretary Timothy Geithner and Fed Chairman Ben Bernanke separately took aim. “They’re still heavily leaning against the forces trying to push their currency up,” complained Geithner. “The maintenance of undervalued currencies by some countries has contributed to a pattern of global spending that is unbalanced and unsustainable,” intimated Bernanke.

However, it was only when fellow emerging market economies – namely Brazil – voiced similar concerns, that China was finally forced to concede partial defeat. It signed on to an official G20 communique that declared that exchange rates and current account balances would be used to determine whether a particular country’s policies were contributing to global economic imbalances. Alas, the Communique (and the G20, for that matter) is deliberately vague and unenforceable; it’s more symbolic than anything else.

Still, China is not one to take its cues – especially on issues as important as the Yuan – from the international community. That the Yuan is now appreciating at a steady clip (~5% in annualized terms) is almost certainly being driven more by pragmatism than politics. Specifically, it represents the most effective tool to combat inflation, which has already breached 5% and continues to tick higher.

China critics forget that China’s fixed exchange rate regime is not a free lunch. While it almost certainly gives the export sector a competitive advantage, it also deprives the PBOC of the ability to conduct monetary policy and is inherently inflationary. That’s because the policy necessitates soaking up all of the foreign currency that enters the country (hence the ~$3 Trillion in forex reserves) and instead printing new Chinese Yuan and putting into circulation. When you combine a 15% annual increase in the money supply with soaring economic growth, a surge in bank lending, real estate boom, and rising commodity prices, the inevitable result is inflation. The country’s economic officials have responded by tightening credit and raising interest rates, but these will ultimately fail as long as the Fed’s QE2 program continues to send US Dollars into China.

In addition to allowing the Yuan to slowly appreciate, China has also moved to make the Yuan more convertible. This has the dual advantages of making China less reliant on the US Dollar and on relieving upward pressure on the Yuan. More of its trade is being settled directly in Chinese Yuan. Chinese companies are being encouraged to invest outside of China, and foreign companies inside of China are gradually being permitted to issue Yuan-denominated bonds, rather than import Dollars to fund new investments.

It appears that all of these measures are actually starting to have some impact. China’s trade surplus is shrinking. The IMF has suggested that the Chinese Yuan could one day be an international reserve currency and could be a component of its Special Drawing Rights (SDR) currency. Less hot money (distinct from investment inflows) is finding its way into China.

Unfortunately, most analysts are skeptical that it will last. Futures markets reflect a modest 2.5% appreciation against the Dollar over the next 12 months. I’m personally anticipating a rise of 4-5%, though I think it will ultimately be tweaked depending on inflation.

Only two years after the worst financial crisis in decades, the DJIA is now back above 12,000. Yield-hungry investors are pouring record amounts of cash into emerging markets. Commodities and food prices are rising into bubble territory. In fact, not a single meaningful reform has yet to be passed that would prevent such an event from erupting again. The EU, however, is trying to change that, with the proposed introduction of the first-ever Tobin tax on foreign exchange trades.

The campaign is being led by French President Nicolas Sarokozy, who happens to be the current Chairman of both the G8 and G20. Recently, he has used his podium for populist rants against the international financial system. To his credit, Sarkozy has done more than bluster. He is fighting to advance the idea for a minute tax on all financial transactions, with the aim of reducing volatility and raising money for cash-strapped governments.

The so-called Tobin tax was first proposed in 1971 by Nobel Laureate James Tobin. While it has always enjoyed support from a handful of leftist economists, it has never been seriously considered by any western country. In the wake of the financial crisis, however, anger towards speculation seems to be peaking, and some governments might finally have enough political capital to push forward the idea. In fact, France has already obtained the tepid support of other EU members, notably Austria. In addition, the Economic and Monetary Affairs Committee of the European Parliament has backed the idea. The EU is fighting to keep the Euro alive and its member states solvent, and it clearly resents the (perceived) role of speculators in betting on default and breakup.

Proponents of the Tobin tax generally cite the amount of revenue it could raise as its chief benefit. For example, it has been estimated that a .005% on forex transactions could raise $26 Billion worldwide, while a .05% tax on all financial transactions could generate as much as $700 Billion in revenue. Even though studies suggest that it wouldn’t do much to reduce volatility (and perhaps speculation), the fact that it shouldn’t destabilize markets is enough to satisfy some of its naysayers.

Not surprisingly, the US remains opposed to such a policy, on the grounds that it could “send misleading signals that could hamper investment to end extraction and cause production bottlenecks.” This kind of incantation rings hollow, however, and it’s clear that the biggest obstacle to its being implemented is almost certainly the bank lobby, which has insisted that a Tobin tax would “cause serious damage to this highly efficient [forex] market.”

Personally, I’m a cautious advocate of the Tobin tax. At .005%, it would levy $10 on every round-trip lot ($100,000) forex transaction. This would punish those that engage in leveraged account-churning and computerized, rapid-fire trading, without impacting those that take a longer-term approach to forex. In addition, it would impact institutional traders and investment banks (which currently monopolize all financial markets) much more than retail traders. Then again, they would probably just shift more of their trading into unregulated, private markets.

At this point, the Tobin tax is still probably a long-shot. The fact that it’s being seriously considered, however, is nothing short of remarkable.

Last week, the Obama Administration released its fiscal 2012 budget to much fanfare. Unfortunately, the budget makes only a token effort to address the rising National debt, and forecasts a budget deficit of $1.1 Trillion. While the release of the budget failed to make a splash in currency markets, traders would be wise to understand its implications for the future.

The budget proposes spending of $3.7 Trillion in 2012, and forecasts receipts of only $2.6 Trillion. As usual, entitlements (Social Security, Medicare, and Medicaid: $2 Trillion+), Defense ($760 Billion), and net interest on debt ($250 Billion) are projected to consume the brunt of spending. The Departments of State, Education, Energy, and Veterans Fairs will receive an increased allocation, while almost all other Departments face drastic cuts. (For more comprehensive breakdowns, the WSJ and NY Times offer excellent graphical representations of how the federal budget is funded and disbursed).

The proposed budget allows for a deficit of $1.1 Trillion (7% of GDP), which unbelievably represents a significant decrease from the $1.6 Trillion (11% of GDP) that is projected for fiscal 2011. The Congressional Budget Office (CBO) forecasts the deficit to return to a more “sustainable” level of 3% of GDP beginning in 2014, which should allow the national debt to remain constant in relative terms for the following decade. Beginning in 2021, however, entitlement spending is projected to skyrocket, which would cause debt to rise similarly.

CBO projections are based on a handful of rosy assumptions. First of all, it assumes that the US economy will grow at 3%+ for the indefinite future. Second, it assumes that deficit spending can be financed at reasonable interest rates. Third, it assumes that tax receipts will rise from current lows and revert back to historical levels. Given the ongoing economic uncertainty, high unemployment rates, tax cuts, rising interest rates, the difficulty of cutting spending, etc., there is reason to believe that actual deficits will be even higher.

In fact, net interest payments on national debt will rise 33% over the next year even as Treasury rates remain at record lows. If the economic recovery gathers momentum (something that the budget is counting on), risk appetite and interest rates must rise. In addition, given that the national debt will probably double from 2009 to 2012, it seems likely that investors will demand an increased risk premium for lending to the US. On the other hand, demand for Treasury Securities continues to remain strong: “Net long-term securities transactions showed total buying of $65.9 billion in long-term U.S. securities in December, after purchases of $85.1 billion the month before.” Many Central Banks continue to be net buyers.

In addition, there are some commentators that think the Fed will abet the US government in deflating the real value of its debt. Since the majority of US Treasury Securities are not inflation-protected, 15 years of high inflation (~5%) would be enough to decrease the real debt burden by half. Especially when you account for “contingent obligations,” this might be the only feasible way for the government to deal with its debt burden over the long-term. Then again, higher inflation would probably drive proportional increases in yield, such that the Treasury Department would have a tough time rolling over existing debt (let alone in issuing new debt) at reasonable interest rates.

The main variable in all of this is politics. Specifically, this budget is still only a proposal. The actual budget won’t be ratified for at least another six months, and only after tense negotiations with the Republican Party. (There is also the possibility that it won’t be passed at all, which is what happened with the fiscal 2011 budget). “House Majority Leader Eric Cantor, a Virginia Republican, said his party will propose ‘very bold’ changes to entitlements in their 2012 budget resolution.” Anything short of this wouldn’t dent the projected deficits and would push Social Security / Medicare closer towards the brink of insolvency.

In the end, the deficit merely represents business as usual for the US government. Barring a double-dip recession, it probably won’t be enough to seriously impact the Dollar’s status in the short-term as preeminent global reserve currency. However, that could start to change over the next decade, as the government either takes steps or does nothing to mitigate the looming entitlements crisis. At that time, the long-term viability of the Dollar (and the financial system as we know it) will become clear.

In forex, everything is relative. That is no less the case for forex volatility, which is low relative to the spikes in 2008 (credit crisis) and 2010 (EU Sovereign debt crisis), but high relative to the preceding 5+ years of stability. On the one hand, volatility is approaching a two year low. On the other hand, analysts continue to warn of high volatility for the foreseeable future. Under these conditions, what are (currency) investors supposed to do?!

Despite the steady pickup in risk appetite in 2010, there remains a whole a host of forex risk factors. On the economic front, GDP growth remains anemic in western countries, unemployment is high, and consumer confidence is low. Budget deficits and national debts are rising, perhaps to the point that default by a major industrialized countries is inevitable. Emerging market countries seem to be ‘suffering’ from the opposite problem, whereby rapid growth, high commodities prices, and capital inflow has caused inflation to rise precipitously. Some Central Banks will be forced to hike interest rates, while others will try to maintain an easy monetary policy for as long as possible. Political crises flare-up without warning, the Euro risks breaking up, and inclement weather is wreaking havoc on food production.

As a result, most currency-market watchers expect 2011 to be a continuation of 2010. In other words, while we might be spared a major crisis, a generalized sense of uncertainty will continue to pervade forex. According to JP Morgan, “Implied volatility on options for major exchange rates averaged 12.34 percent this year, compared with an average of 10.6 percent since January 2000.”  The currency team of UBS predicts, “The divergence between the strength in emerging markets and the unusual levels of uncertainty in the world’s major economies will cause…super volatility,” whereby massive swings in exchange rates will become the norm.

In this environment, there are a number of things that currency traders should do. The first step is simply to be aware that volatility remains high, which means that wider-than-average fluctuations shouldn’t be a surprise. The next step is to decide whether you think that this volatility will remain at an elevated level for the near-term, or whether you expect it to continue declining. (It’s worth pointing out that volatility is not necessarily a perception of absolute risk, but investor perception of risk). The final step is deciding if/how you will tailor your trading strategy in response to changes in volatility.

In fact, you don’t necessarily need to limit your exposure to volatility. If you are a fundamental investor with a long-term approach, you may very well choose to write-off short-term fluctuations as noise. (Of course, if you are a short-term swing trader, you can’t afford to be quite so indifferent). In addition, if your primary interest is in another asset type, you may choose not to hedge any currency risk. Perhaps you believe that the base currency will continue appreciated and/or you relish the exposure to currency movements as an added benefit of asset price exposure. Along these lines, “During the planning stages of the UBS Emerging Markets Equity Income fund, UBS Global Asset Management considered offering investors a hedged share class. The team abandoned the idea when investors showed a preference for unhedged share classes.”

In addition, hedging currency risk is expensive, especially for exotic/illiquid currencies, and currencies characterized by above average volatility. Not to mention that currency hedges can still move against investors, resulting in heavy losses. Still, in 2010, “Corporations from the U.S., Japan and Europe increased the percentage of projected income protected against swings in exchange rates to a record,” which suggests that fear of adverse exchange rate movements still predominates.

Finally, there are those that want to construct second-order currency strategies based entirely on volatility. Using basic options techniques, such as spreads and straddles, it’s possible to profit from volatility (or lack thereof) regardless of which direction the underlying currencies move in. In fact, the CME Group recently introduced a new product series which seeks to perform this very function. Investors can already buy and sell futures based on short-term volatility in the EUR/USD, which will soon be replicated for all of the major currency pairs.

For those of you who like to keep it simple, it’s probably enough to monitor the JP Morgan G7 Currency Volatility Index, which is a good proxy for the risk associated with trading (major) currencies at any given time. When this index spikes, chances are the US Dollar and other safe haven currencies will follow suit.

There are a number of forces currently competing for control of forex markets: the ebb and flow of risk appetite, Central Bank currency intervention, comparative economic growth differentials, and numerous technical factors. Soon, traders will have to add one more item to their list of must-watch variables: interest rates.

Interest rates around the world remain at record lows. In many cases, they are locked at 0%, unable to drift any lower. With a couple of minor exceptions, none of the major Central Banks have yet raised their benchmark interest rates. The same applies to most emerging countries. Despite rising inflation and enviable GDP growth, they remain reluctant to hike rates for fear that they will invite further speculative capital inflows and consequent currency appreciation.

Emerging markets countries can only toy with inflation for so long. Over the medium-term, all of them will undoubtedly be forced to raise interest rates. The time horizon for G7 Central Banks is a little longer, due to high unemployment, tepid economic growth, and price stability. At a certain point, however, inflation will compel all of them to act. When they raise rates – and by much – may well dictate the major trends in forex markets over the next couple years.

Australia (4.75%), New Zealand (3%), and Canada (1%) are the only industrialized Central Banks to have lifted their benchmark interest rates. However, the former two must deal with high inflation, while the latter’s benchmark rate is hardly high enough for carry traders to take interest. In addition, the Reserve Bank of Australia has basically stopped tightening, and traders are betting on only one or two 25 basis point hikes in 2011. Besides, higher interest rates have probably already been priced into their respective currencies (which is why they rallied tremendously in 2010), and will have to rise much more before yield-seekers take notice.

China (~6%) and Brazil (11.25%) are leading the way in emerging markets in raising rates. However, their benchmark lending rates belie lower deposit rates and are probably negative when you account for soaring inflation in both countries. The Reserve Bank of India and Bank of Russia have also hiked rates several times over the last year, though again, not yet enough to offset rising prices.

Instead, the real battle will probably be fought primarily amongst the Pound, Euro, Dollar, and Franc. (The Japanese Yen is essentially moot in this debate, and its Central Bank has not even humored the markets about the possibility of higher interest rates down the road). The Bank of England (BoE) will probably be the first to move. “The present ultra-low rates are unsustainable. They would be unsustainable in a period of low inflation but they are especially unsustainable with inflation, however you measure it, approaching 5 per cent,” summarized one columnist. In fact, it is projected to hike rates 3 times over the next year. If/when it unwinds its quantitative easing program, long-term rates will probably follow suit.

The European Central Bank will probably act next. Its mandate is to limit inflation – rather than facilitate economic growth, which means that it probably won’t hesitate to hike rates if inflation remains above its 2% threshold. In addition, the front runner to replace Jean-Claude Trichet as head of the ECB is Axel Webber, who is notoriously hawkish when it comes to monetary policy. Meanwhile, the Swiss National Bank is currently too concerned about the rising Franc to even think about raising rates.

That leaves the Federal Reserve Bank. Traders were previously betting on 2010 rate hikes, but since these have failed to materialized, they have pushed back their expectations to 2012. In fact, there is reason to believe that it will be even longer than that. According to a Bloomberg News analysis, “After the past two U.S. recessions, the Fed didn’t start raising policy rates until joblessness had fallen about three- quarters of the way back to the full-employment level…To satisfy that requirement, the jobless rate would need to be 6.5 percent, compared with today’s 9 percent.” Another commentator argued that the Fed will similarly hold off raising rates in order to further stabilize (aka subsidize) banks and to help the federal government lower the real value of its debt, even if it means tolerating slightly higher inflation.

When you consider that US deposit rates are already negative (when you account for inflation) and that this will probably worsen further, it looks like the US Dollar will probably come out on the losing end of any interest rate battles in the currency markets.

In 2010, the US Commodity Future Trading Commission (CFTC) formally released a series of new regulations governing all retail foreign exchange dealers. Having given all applicable firms almost six months to bring their operations up to speed with the new regulations, the CFTC is now moving to bring enforcement actions against those that are still not in compliance.

Among other things, the regulations required all retail forex broker-dealers to register accordingly with the National Futures Association (NFA), and for firms that “solicit orders, exercise discretionary trading authority or operate pools with respect to retail forex” to register as introducing brokers. Out of curiosity, I scoured the NFA Background Affiliation Status Information Center (BASIC) to see if/how forex brokers have registered themselves.

As you can see from the table above, there are approximately [I would be grateful if you could inform me of any known omissions!] 28 registered forex firms, and the CFTC recommends that (US) retail forex traders that manage their own accounts should deal with these firms exclusively.

Unfortunately, many firms continue to advertise that themselves as forex brokers when they aren’t registered as such, or even worse, aren’t registered at all. As a result, the CFTC recently filed simultaneous enforcement actions against 14 forex firms, alleging that, “In all but two of the complaints…a defendant acted as an RFED; that is, it offered to take or took the opposite side of a customer’s forex transaction without being registered. In the remaining two complaints, ZtradeFX LLC and FXPRICE, the CFTC alleges that the defendant solicited customers to place forex trades at an RFED without being registered as an Introducing Broker.” The following companies stand accused:

To be a fair, NFA membership doesn’t necessarily imply compliance with NFA regulations, nor does it even guarantee upright behavior. In fact, the NFA is currently scrutinizing all of its member firms “for any signs they are designing computer systems to take advantage of what is known in the industry as ‘slippage,’ or small price movements that happen between the time a customer orders a trade and when that trade is actually executed.” In October, the NFA settled two such cases with IKON FX and Gain Capital, assessing a combined $800,000 in fines. Let’s hope that this isn’t the real explanation for the fact that forex trading is vastly more profitable for brokerages than other types of retail securities trading.

While the NFA hasn’t indicated that this is the case, the current retail forex MO (whereby brokers also act as market-makers) could be under attack. As one advocate for traders told the WSJ, “If a foreign-exchange firm is acting as a market-maker, or taking the other side of a client’s trades, it is doubtful the investor is getting the best possible price.” The problem is at the moment, the industry remains far from transparent, and if not for the NFA investigations, traders probably wouldn’t be able to establish whether their broker(s) acted unscrupulously.

The second half of 2010 witnessed a 20% rise in the Swiss Franc (against the US Dollar), which experienced an upswing more closely associated with equities than with currencies. It has managed to entrench itself well above parity with the Dollar, and has become a favored destination for investors looking for a safer alternative to the Euro. Still, there are reasons to wary, and it could be only a matter of time before the CHF bull market comes to a screeching halt.

The forces behind the Franc’s rise are easily identifiable. It basically comes down to risk aversion. While it can’t compete with the Dollar and Yen – its main safe haven rivals – in size and liquidity, it benefits from its perceived economic and fiscal stability, as well as through contradistinction with the surrounding Eurozone. In fact, the Franc’s rise against the Euro has been even steeper than its rise against the Dollar. As the Eurozone crisis radiates further away from Greece, Switzerland has come to seem more like an island in a sea of chaos.

Even an abatement in the EU storm has failed to produce a Swiss Franc correction. That could be because the bad news coming out of Europe seems to be never-ending; one country’s rescue is followed by the downgrade of another country’s sovereign credit rating and warning of imminent collapse. In addition, even as investors have embraced risk-taking, they still remain prone to sudden backtracking. Thus, the Franc has been one of the primary targets of risk-averse capital fleeing the Egyptian political turmoil.

Capital controls and intervention have scared investors away from some currencies, but the Swiss National Bank (SNB) lacks the credibility afforded to other Central Banks. The SNB lost $25 Billion in 2010 in a vain effort to hold down the Franc, and currency investors believe that it has neither the stomach nor the mandate to engage in a similar loss-making campaign in 2011. Besides, the Swiss economy has held up remarkably well, and the trade surplus has actually widened in the face of currency appreciation. The markets might be keen to test the limits of the Swiss export sector, in much the same way that they have challenged Japan by pushing up the Yen.

Still, their are limits to high the Franc can rise, and it appears that I’m no longer the only analyst who thinks it’s undervalued. Don’t forget- the Swiss economy is comparatively minuscule. Its capital markets can absorb only a small fraction of the inflows that the US and Japan can handle, and the Swiss Franc represents a mere 3.5% of all foreign exchange volume, 12 times less than the US Dollar’s share. In other words, it’s only a matter of time before investors run out of Swiss assets to buy, at which point they will have to decide whether to accept short-term returns of 0% in exchange for capital preservation and financial security. My bet is that they’ll walk.

Of course in the short-term, it’s possible that a handful of risk-averse investors will continue to steer capital towards Switzerland, and/or that another mini political or economic crisis will trigger a spike in risk-aversion. When investors once again look at fundamentals, they will be forced to reckon with the Franc’s 40% appreciation over the last five years, and probably conclude that perhaps it was a bit much…

As the Euro moves past $1.38 per Dollar towards a 1-year high, many traders are wondering if perhaps the common currency’s woes aren’t in the past. This would be a mistake. That’s because most of the forces behind the Euro’s rally actually have very little to do with the Euro.

The main cause of Euro strength has been a pickup in risk appetite. Investors are becoming increasingly more confident in the prospects for global economy recovery, and the crisis mentality is rapidly fading. Ironically, the flurry of positive economic data emanating from the US has been terrible for the Dollar. You can see from the chart below that except for a gap in 2010 Q4 (due to a flareup in the EU sovereign debt crisis….more on that below), the US stock market rally has coincided with a shift away from the Dollar and towards the Euro.

In fact, the Euro still remains extremely vulnerable to the ebb and flow of investor risk tolerance. That applies not only to events endogenous tot the EU, but also to global market shocks. That means that any reminder of the Eurozone’s fiscal issues (such as last week’s downgrade of Ireland’s credit rating) is likely to be reflected in a weaker Euro. For another example, look no further than the recent political turmoil in Egypt and the wider Middle East. Summarized one analyst, “In itself, Egypt is not that big an economy. But there is some worry about the supply of oil through the Suez Canal. It does impart a negative vibe on risk.”

The Euro’s recent appreciation is also rooted in technical factors. What began as a modest rally quickly turned into a upward surge as investors moved to cover their short positions. The WSJ reported that “much of the recent rally was fueled by hedge funds and other speculative investors covering short positions…Investors are ‘not going out and buying the euro because they love it.’ ” This apparent short squeeze can be seen in the sudden and massive reversal of positions that was documented in the most recent CFTC Commitment of Traders Report.

On a related note, there are signs that Euro puts (which allow investors to hedge Euro exposure by giving them the right to sell) are unusually cheap at the moment. “Demand for euro puts, which give investors the right to sell the euro in the future, appears to be growing, relative to euro calls, which allow them to buy, analysts say. That reverses a recent trend that had investors actively selling euro puts or sitting on their hands as the euro climbed…[and] suggests investors are becoming more biased towards selling the euro.” If speculators think that the options market is mis-pricing risk, they might start buying up puts and exert downward pressure on the Euro.

The only factor which could be construed as legitimately positive for the Euro pertains to interest rate differentials. Currently, Euro rates are just as low as in the US and the rest of the G4 world. However, that could soon change. The European Central Bank (ECB) is notoriously hawkish when it comes to conducting monetary policy. If you recall, it foolishly raised its benchmark interest rate during the height of the credit crisis. With inflation already running above 2%, you can bet that it will only be a matter of time before it reacts in kind. For the sake of contrast, consider that the Fed is still in the process of easing, via QE2.

While rate hikes would certainly provide a boost for the Euro, it is unlikely that rate differentials will be wide enough to spur any serious among yield-seeker in the immediate future. In short, I think the downside risks to the Euro (which is apparently on the verge of “disintegration,” according to George Soros) far outweigh any further upside support, and I think the rally will peter out soon.

Last week, S&P fulfilled rumors by lowering the Sovereign credit rating of Japan. The move immediately sparked headlines filled with words like “roil” and “turmoil,” and analysts predicted the beginning of a massive correction, like the kind that I forecast in January. I decided to wait a few days before posting on this story, in order to wait for the dust to settle. I’m glad I did, since the Yen’s stubborn refusal to slide further beggars some kind of explanation!

In hindsight, the Yen’s 1% fall during that day’s trading session was modest by any standards, despite the financial media’s attempt to characterize it as extraordinary. Even those analysts which conceded that the decline in the Yen was pretty mundane argued that depreciation would begin in earnest after the forex markets had a chance to digest the full impact of the downgrade. Simon Derrick, senior currency strategist at Bank of New York Mellon told the Wall Street Journal, “I would not be surprised if there is a second wave of yen weakness associated with the New York open.”

As much as one would have expected the downgrade to make a bigger splash, there are a couple of explanations for why it didn’t. First of all, the move was relatively modest – from AA to AA- – and S&P indicated that there wasn’t any risk of further downgrades in the immediate future. Second, as I reported in mid-January, rumors of a rating cut have been circulating for quite some time. When you look at the abysmal state of Japanese government finances, it was really only a matter of time before the rating agencies woke up to reality. Japanese public debt is projected to reach a whopping 204% of GDP this year, and according to S&P, it has no “coherent strategy” to address the problem.

Most important, the majority of Japan’s sovereign debt (~95%) is held by domestic investors, which means that the impact of any foreign capital flight would have been extremely limited. Due to perennially low interest rates, Japanese savers have few options but to stash their cash in Japanese government bonds, the yields on which hardly budged as a result of the downgrade and are still extraordinarily low.

It’s hard to say whether this situation will change. On the one hand, a substantial portion of Japanese investors seem to recognize that keeping money at home is a losing proposition. “According to the Bank of Japan, individuals held about 4.83 trillion yen ($58.87 billion) in foreign-currency deposits at Japanese banks as of the end of November last year, up 2.8%from a year ago and the highest since the central bank started providing the data in April 1999.” Due to an aging population, increased appetite for risk, and widening yield differentials, this trend is projected to continue for the immediate future.

On the other hand, all of this capital outflow is necessarily already reflected in the Yen, which has remained strong in spite of the carry trade. Perhaps the Japanese economy has been underestimated. While the current account surplus has showed signs of narrowing, it nonetheless remains a surplus. Perhaps that’s because Japanese companies are have proven that they are capable of adapting to the rising Yen, by either lowering costs or shifting production abroad. While Japanese retail investors move money abroad, Japanese companies are repatriating a steady stream of profits back home.

Personally, I stand bythe claims that I made in my last post and my prognosis that the Yen will depreciate in 2011. I guess it’s going to take more than a ratings downgrade to ignite the correction. Maybe another intervention from the Bank of Japan will get it moving in the opposite direction…but that’s a topic for another day.