In the last month, volatility in the forex markets touched both a two-year low and a one-year high. In the beginning of March, volatility essentially returned to pre-credit crisis levels. One week later, when the earthquake and inception of the nuclear crisis in Japan, volatility surged 40%. While it has since resumed its downward path, investors are still bracing themselves for continued uncertainty.

The carry trade has perhaps born the brunt of the volatility spike. The carry trade depends on interest rate differentials – as opposed to currency appreciation – to drive profits, and  thus demands stability. When the markets become choppy and exchange rates spike wildly in one direction or another, it makes the carry trade significantly more risky. Hence the paradoxical rise of the Japanese Yen to a record high following a series of crushing disasters, as highly leveraged traders moved to unwind their Yen-short carry trades.

Likewise, high volatility should spur demand for so-called safe haven currencies. If only it were clear what constitutes a safe haven currency. Traditionally, that would send the US Dollar, Swiss Franc, and Japanese Yen upwards. In this case, the Franc has benefited most, followed closely by the Yen. The Dollar spiked against emerging market and high-risk currencies, but hardly budged against its G4 counterparts. Could it be that the Dollar’s multi-year positive correlation with volatility has (temporarily?) abated.

With regard to strategy, currency traders have a handful of choices. If you believe that volatility will continue declining or remain stable, you’re probably going to go long emerging market and high-yielding currencies, and short one of the safe-haven currencies, all of which are quite cheap to borrow. The main risk of such a strategy, of course, is that volatility will once again spike, in which these safe have currencies will rally.

If you think that the ebb and volatility isn’t sustainable, then you’re probably going to bet on the Franc, Dollar, or Yen. As I wrote in an earlier post, I think the Yen could theoretically appreciate in the short-term, but actually remains quite risky over the long-term. Despite the best efforts of the Swiss National Bank, the Franc will probably continue appreciation. Economically and monetarily, it is in an excellent shape. Besides, the fact that the supply of Francs is intrinsically small means that even modest capital inflow often translates into a big jump in its its value. As for the Dollar, it is now the most popular currency to short. It remains a safe choice and a good store of value, but probably won’t deliver the returns that safe-haven strategists have come to expect.

From a practical standpoint, you may also want to consider reducing your leverage. As everyone knows, high leverage increases profits but also magnifies losses. In the current environment of heightened volatility, leverage also magnifies risk. Either way, you may also want to consider hedging your exposure, by trading a basket of currencies and/or through the use of options.

In a recent piece published in the WSJ (“Why the Dollar’s Reign Is Near an End“), Berkley Professor Barry Eichengreen declared that the Dollar will soon cease to be the world’s reserve currency. According to Dr. Eichengreen, within 10 years and for various reasons, the Dollar will become one of many reserve currencies, competing for preference with the Euro, Chinese Yuan, Japanese Yen, and Swiss Franc. While Dr. Eichengreen makes some good points, however, I don’t think most of his arguments stand up to scrutiny.

His thesis can be boiled down into a few premises. First of all, he argues that it is fundamentally illogical that oil should be priced in Dollars, and that countries conducting bilateral trade should settle their accounts using Dollars. Dr. Eichengreen is right that this represents the main underpinning of the Dollar. He is wrong to suggest that it will change anytime soon.

That’s because oil ultimately has to be priced in currency. It’s entirely possible that oil exporting countries will band together and decide to price oil in Euros, instead. However, this would mainly be useful as a political tool (albeit a very potent one!) and would serve no economic or risk management purpose whatsoever. If oil were priced in terms of a basket of currencies (such as IMF Special Drawing Rights), it might make oil prices less volatile, but then would require oil exporters to receive 5 (or more!) currencies for their oil instead of one! Finally, the price of oil can and does adjust relative to what happens in forex markets. When the Dollar declined in 2007, oil prices skyrocketed commensurately in order to compensate exporters.

The same largely applies to bilateral trade. While it makes sense for two countries with stable currencies (such as Korea and Japan, for example) to use one of their currencies as the main unit for trade, the same cannot be said for countries with more volatile currencies. For example, if Argentina and Israel are trading, one country would be inherently dissatisfied if trade were denominated either in Shekels of Pesos. When bills are settled in Dollars, however, it is easy and economical for both countries to simply convert those Dollars into currencies which may have more utility for them. As with oil, it’s possible that some countries will decide that it makes more sense to settle trade in Euros instead of Dollars, but again, I don’t see what purpose this would serve and any such decision would probably be politically motivated.

Second, Dr. Eichengreen points out that changes in technology have made it easy to instantly calculate exchange rates and easily convert currency. While I think this point is well-taken, I think people enjoy having a common base currency, if only for psychological reasons. Ultimately, this point is irrelevant because it has very little bearing on the supply and demand for particular currencies.

Third, he argues that the Euro and Chinese Yuan both represent latent threats to the Dollar’s preeminence. Again, he’s both right and wrong. The Euro already represents a viable alternative to the Dollar. It’s economy is reasonably strong, its monetary policy is sensible, its capital markets are deep and liquid. On the other hand, it’s being held back by perennial fears about the a Euro breakup, and the fact that the sum of 20 separate parts is not the same as the whole. Since the EU doesn’t issue sovereign debt, risk-averse investors will be limited to buying German/French/etc. bonds, which are always going to be more less liquid and more risky than US Treasury Securities. Besides, you can see from the chart below that the US economy has actually been growing faster than the Eurozone for the last 30 years.

As for China, I expounded in a recent post about how unlikely it is that the Yuan will seriously rival the Dollar anytime soon. While China certainly has plenty of cachet and expanding vehicles for investment, its capital markets remain much too primitive and opaque for Central Banks and risk-averse investors. Most importantly, the structure of China’s economy is such that foreign institutions simply don’t have the opportunity to accumulate Yuan in massive quantities. Simply, the supply is too small. In fact, the Asian Development Bank forecasts that the Yuan will constitute a mere 3-12% of international reserves by 2035. That doesn’t sound very threatening.

Dr. Eichengreen’s final point is that the Dollar’s safe haven status has been compromised. First of all, this is old news. The Yen is already a – if not the – preeminent safe haven currency, thus headlines like “Safe-Haven Yen Gains As Radiation Concern Mounts” that take irony to a whole new level. The same goes for the Swiss Franc. However, any concerns that investors have about the Dollar must necessarily also be projected onto the Yen, Euro, and Pound. All of these currencies face current or looming fiscal crises and slowing economic growth. While investors might diversify into other countries, they’re not going to suddenly dump the Dollar in favor of the Euro.

In short, it makes sense that a currency that represents 80% (out of a total of 200%) of all forex transactions and more than 60% of global reserves but only accounts for 25% of GDP, should experience a decline of some sort of decline in popularity. Over the next 50 years, the Dollar will gradually cede share to other currencies. But 10 Years? Give me a break.

Over the last two years, the Brazilian Real has appreciated a whopping 37% against the US Dollar, second only to the South African Rand. It hasn’t been this strong since prior to the credit crisis, and it is rapidly closing in on a record high. If only Brazilian policymakers hadn’t made it a high priority to prevent that from happening.

The appreciation of the Real is being driven primarily by high interest rates, which in turn, are being driven by inflation. Brazilian prices are now rising at an annualized pace of 6%, which is well above the Bank of Brazil’s comfort zone. As a result, it has already raised rates several times in this cycle, including a 50 basis point hike at the beginning of this month. Its benchmark Selic rate now stands at a stratospheric 11.75%, which is higher than any other currency in the same tier.

Of course, the Bank of Brazil understands the implications of continuing to hike rates. With inflation as high as it is, however, it doesn’t really have much of a choice. Moreover, investors are betting on additional rate hikes, which means even wider interest rate differentials. When you also factor in a surprising lack of volatility surrounding the Real, it will certainly become an even more popular target currency for yield-hungry carry traders.

The government of Brazil, however, is doing everything in its power to repel this kind of speculation, lest it drive up the Real further and threaten the competitiveness of its export sector. In 2010, it tripled the tax rate on foreign investment in fixed income securities, to 6%. It increase scrutiny on local banks that have sought to borrow abroad. The national government has taken to doing more of its borrowing on the international market, and deposited the proceeds directly into its forex reserves, in order to mitigate the impact on the Real. The government is also contemplating punishing short-term investors by establishing a “lock-up” period for foreign capital.

And yet, Brazil finds itself in a quandary. While its trade balance has remained positive, its current account balance is now entrenched in deficit territory. Just like the US, it remaisn dependent on foreign investors to bridge this gap every month. Perennial budget deficits also mean the government can ill afford to alienate lenders. Finally, the government still wishes to attract legitimate foreign direct investment in infrastructure projects and portfolio investment in the stock market.

If Brazil is successful in limiting speculation – which is difficult, but not impossible given its determination – there is a chance that the Brazilian Real will hold steady. After all, Brazil saves less than it needs to invest, and inflation is high enough that there should be some natural downward pressure on the Real. On the other hand, if volatility remains low and speculators continue to find a way around the new capital controls (tempted by 11.75% short-term deposit rates), it will be difficult for the Central Bank to prevent its rise. It can only sit back, continue to hike rates, and pray that speculators soon lose interest.

Personally, I’m betting that the government of Brazil will achieve some measure of success, at least in the short-term. Of all the emerging-market countries engaged in the currency war, it seems to be the most resolute participant after China. At this point, short of fixing the Real to the Dollar, it has shown that it is willing to do whatever it takes to prevent speculators from winning.

Yesterday, UK Chancellor George Osborne announced that his government was ready to begin rebuilding its foreign exchange reserves. Depending on when, how, (or even if) this program is implemented, it could have serious implications for the Pound.

Forex reserve watchers (myself included) were excited by the updated US Treasury report on foreign holdings of US Treasury securities. As the Dollar is the world’s de-facto reserve currency and the US Treasury securities are the asset of choice, the report is basically a rough sketch of both the Dollar’s global popularity and the interventions of foreign Central Banks. Personally, I thought the biggest shocker was not that China’s Treasury holdings are $300 Billion greater than previously believed (with $3 Trillion in reserves, that’s really just a rounding error), but rather that the UK’s holdings declined by 50% in 2010, to a mere $260 Billion.

Given that the Bank of England (BoE) injected more than $500 Billion into the UK money supply in 2010, I suppose that shouldn’t have been much of a revelation. After all, selling US Treasury Securities and using the proceeds to buy British Gilts (sovereign debt) and other financial instruments would enable the BoE to achieve its objective without having to resort to wholesale money printing. In addition, if not for this sleight of hand, UK inflation would probably be even higher.

Still, this is little more than a mere accounting trick, and those funds will probably still need to be withdrawn from the money supply at some point anyway. Whether the BoE burns the proceeds or reinvests them back into foreign instruments is certainly worth pondering, but insofar as it won’t impact inflation, it is a matter of economic policy, and not monetary policy.

As Chancellor Osborn indicated, the UK will probably send these funds back abroad. In addition to providing support for the Dollar (as well as another reason not to be nervous about the upcoming end of the Fed’s QE2), this would seriously weaken the Pound, at a time  that it is already near a 30-year low on a trade-weighted basis. After falling off a cliff in 2009, the Pound recovered against the Dollar in 2010, largely due to the BoE’s shuffling of its foreign exchange reserves. To undo this would certainly risk sending the Pound back towards these depths.

On the one hand, the UK is certainly conscious of this and would act accordingly, perhaps even delaying any foreign exchange reserve accumulation until the Pound strengthens. On the other hand, the BoE is under pressure to fight inflation. It is reluctant to raise interest rates because of the impact it would have on the fragile economic recovery. The same can be said for unwinding its asset purchases. However, if it offset this with purchases of US Treasury securities and other foreign currency assets, it could weaken the Pound and maintain some form of economic stimulus. Especially since the UK has run a sizable trade/current account deficit for as long as anyone can remember, the BoE has both the flexibility/justification it needs to coax the exchange rate down a little bit.

Ultimately, we’ll need more information before we can determine how this will impact the Pound. Still, this is an indication that the GBP/USD might not have much more room to appreciate.

While I’m fondest of analyzing all currencies relative to the Dollar (after all, it’s what I’m most familiar with and is involved in almost half of all forex trades), sometimes its interesting to look at cross rates.

Take the Pound/Euro, for example, arguably one of the most important crosses, and one of a handful that often moves independently of the Dollar. If you chart the performance of this pair over the last two years, however, you can see the distinct lack of volatility. It has fluctuated around an axis of 1.15 GBP/EUR, never straying more than 5% in either direction. In fact, it’s sitting right at this level as I compose this post.

Yesterday, I read some commentary by Boris Schlossberg (whom I interviewed in 2010), Director of Currency Research at GFT. In the title (“Euro and Pound Go Their Separate Ways”), he seemed to suggest that a big move was imminent. Aside from noting that both currencies stand at crossroads, he declined to offer more concrete guidance on the direction of the potential breakout.

At the moment, the markets are gripped by risk aversion, caused by the Mid East political turmoil and the Japanese natural disasters. Once these events run their course and the accompanying market tension subsides, investors will need something else to latch on to. Perhaps the Bank of England (BoE) and European Central Bank (ECB) can fulfill this function, since both are on the verge of hiking their respective benchmark interest rates . Absent any other developments, the timing and speed of such hikes will probably dictate not only how these currencies perform against each other, but also how they perform against the Dollar.

Despite the numerous indications that both have given to the contrary, I don’t think either Central Bank is in a hurry to raise interest rates. Economic growth remains poor, unemployment is high, and inflation is still moderate. Neither is yet at the stage where it can unwind the monetary easing that it put in place at the height of the financial crisis. Moreover, both are wary about the potential impact of rate hikes on their respective currencies (a concern that I am ironically fomenting with this post).

It looks like the BoE will be the first to act. Combined with high energy prices, the bank’s easy monetary policy is putting extraordinary pressure on prices, and it now appears that inflation could reach 5% in 2011. In addition, the BoE voted 6-3 at its last meeting in favor of tightening, which means that a hike probably isn’t too far off. On the other hand, the ECB is talking tough, but it still doesn’t have much of an impetus to act. Inflation is moderate, and besides, the region’s banks remain too dependent on ECB cash for it to serious contemplate being aggressive.

Either way, the interest rate differential probably won’t be great enough to encourage any short-term speculation between the two currencies. In addition, I think investors will continue to look to the Yen and the Dollar for guidance, and we won’t see any significant movement in either direction. [The chart below is based on benchmark lending rates and isn’t necessarily applicable for retail forex trading].

This would create two opportunities for investors: Options traders should consider a long straddle, which involves selling a put and call at the same strike price (perhaps 1.15), pocketing the premiums, and praying that the rate doesn’t fluctuate much (since they would be exposed to unlimited risk). In the future, carry traders can also profit from the lack of volatility through a carry trading strategy, perhaps amplified by a little leverage. Be careful, however. Since interest rate differentials are currently so small (The current LIBOR rate disparity is a mere .05%!) and probably won’t widen to more than 1% over the next twelve months, any profits from interest could easily be wiped out by even the smallest adverse exchange rate movements.

While analysts have been busy dissecting the implications of the natural disasters that ravage(d) Japan for forex markets, the focus has naturally been directed towards the Yen. Given all the rumors about the liquidation of foreign (i.e. Dollar-denominated) assets, it’s also worth examining the potential impact on the Dollar. In a nutshell, Japan’s holdings of US Treasury Securities are extensive, and even a partial unloading could have serious implications for the world’s de facto reserve currency.

As I explained in my previous post, the Yen rose to a record high (against the Dollar) following the earthquake/tsunami/nuclear crisis because of rumors that Japanese insurance companies and other financial institutions would begin repatriating all of their foreign assets in order to pay for rebuilding. (For the record, it’s worth pointing out again that this has yet to take place, and any repatriation is probably related to the approaching fiscal-year end. Thus, the Yen is being propelled by speculation/short squeeze. Period.)

Indeed, Goldman  Sachs has estimated that the rebuilding effort will probably cost around $200 Billion. A significant portion of this will no doubt be covered by the payout of insurance claims. How insurance companies will make their claims is of course, unknown. However, consider that Japanese insurance companies have insisted that they have ample cash reserves. In addition, Japan has what is perhaps the world’s most solid earthquake reinsurance (basically insurance for insurers) program, which means primary insurance companies can basically pass these claims up the chain, perhaps all the way to the government.

As for whether the Bank of Japan will sell some its $900 Billion in Treasury holdings, this, too appears unlikely. First of all, the Bank of Japan is doing everything in its power to soften the upward pressure on the Yen, which would not be consistent with selling any of its Dollar-assets. Second,  the Financial Times has further argued that they will be especially unlikely to sell US Treasury securities, because they would lose money on (US Dollar) currency depreciation. Besides, any assets that are sold now to pay for rebuilding would probably need to be repurchased later in order to restore balance sheet equilibrium.

While I am on the topic, I want to draw attention to a recent Treasury report that documented the overseas holdings of Treasury securities. The major surprise was China, whose holdings were revised upwards to $1.18 Trillion (from $892 Billion), which means it is well-entrenched as the most important creditor to the US. However, this was offset by a 50% drop in the Bank of England’s holdings, caused perhaps by a change from US debt to British debt.

As I have written in the past, it seems unlikely – for political, economic, and financial – reasons that China will move to pare its Treasury holdings in a significant way. Simply, it has no other viable options for investing the foreign exchange reserves that it is forced to accumulate because of the Yuan-Dollar peg. Other doomsdays have speculated that the crisis in the Middle East will end the “petro-Dollar” phenomenon, whereby oil exporters settle their bills almost exclusively in Dollars and use the proceeds to buy Treasuries. While US influence in the Mid East may indeed wane further as a result of the ongoing political turmoil, I don’t think this will force a change to the PetroDollar phenomenon, which is due as much to unavoidable trade surpluses as it is to settling oil transactions in US Dollars.

There is certainly some concern about what will happen when the Fed wraps up QE2 later this year and stops buying Trreasury securities. Two prominent investment companies (PIMCO and Vanguard) have warned that this will cause bond prices to fall and interest rates on debt to rise rapidly. While this is certainly possible, demand for Treasuries will remain strong for as long as the current risk-averse climate remains in place. In addition, given that the US Treasury is not in danger of defaulting anytime soon, yields reflect expectations for inflation and interest rates more than supply/demand for the bonds themselves. Finally, when the Fed stopped buying mortgage backed securities in 2010, mortgage rates fell, contrary to expectations.

In short, the Dollar might continue to fall against the Yen as speculators cover their short positions, but not because of any fundamental reasons. On an aggregate basis, the never-ending string of crises won’t cause the Dollar to collapse. If anything, it might even bring some risk-averse capital back to the US and re-affirm the Dollar’s status as global reserve currency.

The last week has witnessed unprecedented volatility in the Japanese Yen. Following the earthquake/tsunami and the inception of a nuclear crisis, the Yen defied all logic (and embarrassingly, my own predictions…mea culpa) by rising to a post-World War II high of 76.36 against the Dollar. Then, as rumors of Central Bank intervention began to circulate, it suddenly shot downwards, before resuming a steady upward path. Who knows what next week will bring?!

It’s unclear exactly what’s driving the Yen. Personally, it seems a no-brainer that the string of natural disasters that ravaged Japan would have caused an outflow of foreign capital and a drop in demand (due to a lack of supply) for Japanese imports. In reality, investors began to fear a wholesale selling of Japanese-owned foreign securities widespread repatriation of Japanese Yen by insurance companies and other financial institutions, in order to raise funds for rebuilding and the payout of insurance claims.

While there is still no evidence that such has actually taken place (in fact, the Japanese stock market collapsed as expected, and overseas markets experienced only modest declines), speculators feared the worse, and moved to unload all of their Yen short positions. As hedge funds and domestic Japanese investors tried to exit their Yen carry trades, it caused the market to panic, and the Dollar to fall off a cliff against the Yen, rising 3% in a matter of minutes! As if it wasn’t immediately obvious, “Asset managers, hedge funds, corporates and private clients were all net buyers of the yen for the first time since October,” which means that what we’re basically witnessing is really just a massive short squeeze.

As a result of the highly unusual circumstances, the G7 Finance Ministers held an emergency meeting. The decided not only to offer moral support to the Bank of Japan, but that all G7 Central Banks (Fed, ECB, Bank of Canada, Bank of England) would jointly act to hold down the Yen. Sure enough, the Fed confirmed yesterday that it intervened in the forex markets (probably by selling Yen) for the first time in a decade! This marks a massive about-face from 2010, when Japan was uniformly criticized by the G7 for entering the currency war. Desperate times call for desperate measures…

The Yen has since resumed its appreciation, which has a few implications. First of all, it shows that speculators are still nervous about carry trades that are funded by Yen and continue to think of Japan as a safe haven. This is especially true of domestic Japanese investors, who are naturally bound to become more conservative in the wake of the recent natural disasters. No one knows for certain the size of the Yen carry trade, but 2010 estimates pegged it around $1 Trillion. (Japanese investors purchased $1.25 Trillion in foreign assets between 2005 and 2010 alone!) If that’s the case, there is still quite a bit more unwinding that can be done. In addition, given that Japan is the world’s largest net creditor [the Bank of Japan owns $900 Billion in US Treasury securities, while Japanese sovereign debt is 95% owned by domestic investors], the phenomenon of risk-aversion would be net positive for the Yen.

Second, it shows that investors are skeptical that the Yen’s appreciation can be contained. And if market forces are determined to push the Yen upwards, they are probably right. Simply, the G7 Central Banks (not including Japan) have very limited Yen holdings, which means there is only so much Yen they can sell.

On the flipside, the Bank of Japan has potentially an unlimited supply of Yen at its disposal. In fact, the BOJ already expanded its money printing / quantitative easing program, by “doubling planned purchases of exchange-traded funds, real estate investment trusts, corporate debt, and Japanese government bonds to 10 trillion yen, and launching a program to supply financial institutions with 30 trillion yen in three- and six-month loans at 0.1 percent interest.” This is on top of the 28 trillion yen ($346 billion) that is had already injected into the financial system. While perennial deflation has afforded the BOJ a wide scope, it must still tread cautiously, lest it add inflation (and stagflation) to the country’s list of problems.

Some analyst point to the Kobe earthquake of 1995 as a basis for Yen bullishness. After a one-month lull, the Yen dramatically surged upward, rising 20% in only two months. That disaster also took place towards the end of the Japanese fiscal year (March 31), and seems to suggest that a proportionate Yen rise should take place this time, too.

On the other hand, the Yen proceeded to drop 50% in the two years following the Kobe earthquake, showing the extent to which investors had gotten ahead of themselves. In other words, while there might be significant repatriation of Yen in the short-term, this will more than be outweighed by the decline in GDP, collapse in production/exports, and destruction of stock market value over the long-term.

Until the nuclear crisis is resolved and estimates of the cost (currently pegged at $100-200 Billion) of reconstruction are finalized, the markets will remain jittery. And we all know that volatility will not help the Yen carry trade. Given the BOJ’s determination to hold down the Yen, and the fact that this crisis will only exacerbate Japan’s fiscal issues and its unending economic decline, I’m personally still long-term bearish on the Yen.

The British Pound has risen almost 15% against the Dollar over the last twelve months. It seems that the markets are ignoring the fiscal concerns that sent the Pound tumbling in 2010, and focusing more on inflation and the prospect of interest rate hikes. At this point, the Bank of England (BOE) is now racing with the European Central Bank (ECB) to be the first “G4” Central Bank to hike rates.

You can find cause for optimism towards the Pound in technical factors alone. That’s because while dozens of currencies appreciated against the Dollar in 2010, most were starting from a stronger base. For example, the Canadian and Australian Dollars collapsed during the credit crisis. However, both currencies made speedy recoveries to the extent all losses were erased in only two years. The British Pound, in contrast, still remains 25% below its pre-credit crisis high, more depressed than perhaps any other currency.

On the one hand, this is probably justifiable. The British economy is still in abysmal shape; the latest GDP figures revealed a .6% contraction in the fourth quarter of 2010. Meanwhile, the ECB forecasts only 1.4% growth in 2011, and many analysts think that might even be too optimistic. With the exception of Japan, which suffers from a unique strain of economic malaise (not to mention the 5% hit to GDP caused by the earthquake), the UK is unequivocally the weakest economy in the industrialized world.

On the other hand, this is mostly old news. The reason that investors are starting to get excited is interest rate hikes. According to the minutes from its March meeting, the BOE voted 6-3 to hold its benchmark interest rate at .5%. That means its awfully close to acting. The market consensus is for a 25 basis point rate hike in the next three months, and 2-3 additional hikes over the rest of the year. Depending on how the other G4 Central banks act, that will put the UK rates at the top of the pack.

However, it’s unclear how extensive this tightening will be. According to one analyst, “The probability of a hike in the next three months is significant but the lingering credit crunch, fiscal tightening and bleak outlook for real incomes suggest that if this is the beginning of a tightening cycle, it will be a very shallow one.” Moreover, low bond yields suggest that long-term inflation expectations (and hence, the need for rate hikes) remain low.

At this point, it looks like the UK is looking at a few years of stagflation. That’s certainly going to be bad for UK consumers and probably negative for most UK asset prices. However, short-term currency speculators are less concerned about economic fundamentals, and more concerned about (risk-adjusted) interest rate differentials. That means that if the BOE fulfills expectations, the Pound will probably get a little short-term kick.

Even before today’s devastatingly tragic earthquake, a confluence of negative factors had begun to pile up behind the Yen. Low interest rates. Low GDP growth. Political infighting. Record national debt. Declining current account surplus. Lack of interest in investing in Japan. In short, while the Yen deserves credit for perseverance, I have to believe that the day of reckoning is near.

On the one hand, Japanese exporters appear to be adapting well to the high Yen, and most of the well-known companies are recording healthy profits. On the other hand, Japan recorded its first trade deficit in two years, and the second largest since 1985. Its current account surplus also fell to a modest $5 Billion, on the basis of high oil prices and declining investment inflows. It seems that both foreign and domestic investors are becoming more wary about Japan, which is being reflected in more capital going out and less coming in. Business Week recently reported that “Investment flows into Japanese mutual funds that focus on offshore assets rose 14 percent to 624.6 billion yen ($7.51 billion) in January from a year earlier.”

In fact, this trend is being driven in part by low interest rates. Japan’s benchmark rate is basically nil, and long-term rates are proportionately minuscule. If not for perennial deflation, real interest rates would probably be the lowest in the world. Given that the Bank of Japan probably won’t raise interest rates for another two years (it’s actually quite ridiculous to even broach the possibility at this point, given that it hasn’t even finished unrolling its monetary easing plan), this phenomenon will only further entrench itself.

It seems that the forex markets are finally taking notice, due in part to last week’s rumblings about ECB rate hikes. As a result, the Japanese Yen is set to resume its role as the funding currency of choice for carry trades. According to a Bloomberg News analysis, in 2011, “Carry trades using the yen gained 23.8 percent [on an annualized basis], compared with 2.8 percent in dollar-funded trades.”That represents an about-face from 2010, when the Dollar was the most profitable funding currency. In addition, volatility is slowly returning to pre-credit crisis levels, increasing the stability (and hence, attractiveness) of the carry trade.

As if that wasn’t enough, the government of Japan continues to run massive budget deficits. Wary of the growing national debt (and perhaps of the recent downgrade of Japan’s sovereign credit rating), the legislature appears unwilling to sanction the issuance of more debt. For better or worse, the resultant political standoff could lead to the ousting of Prime Minister Naoto Kan. If recent history is any indication, it seems unlikely that his successor will break through the political stalemate that seems to plague the country.

It’s hard to find a single analyst that is bullish on the Yen. “The yen may weaken to 86 per dollar by the end of the second quarter and 90 by the end of the year, according a Bloomberg News survey of 40 forecasters.” Meanwhile, speculators are net short the Yen for the first time this year, according to the most recent CFTC Commitment of Traders report. It has already weakened 8% (on a trade-weighted basis) from its 2010 peak, and has depreciated against every single major currency in 2011. Perhaps the strongest indication is that the Bank of Japan has announced that it is no longer preoccupied with the Yen, despite the fact that it is still within striking distance of its all-time high against the Dollar.

In short, while I hesitate to broach the earthquake again for fear of sounding callous, I think it might just provide investors with the excuse they need to send the Yen down, down, down.

From trough to peak, the Euro has risen 9% over a period of only two months. You wouldn’t ordinarily expect to see this kind of appreciation from a G4 currency, especially not one whose member states are on the brink of insolvency and which itself faces threats to its very existence. In this case, the Euro is benefiting from expectations that the European Central Bank (ECB) will be among the first and most aggressive in hiking interest rates. As I warned in my previous post, however, those that focus solely on interest rate differentials and ignore the Euro’s lingering Sovereign debt crisis do so at their own peril.

Indications that the ECB will hike interest rates came out of nowhere. Jean-Claude Trichet, President of the ECB, announced last week that it would be particularly aggressive in taking steps to deal with inflation. This caught the markets by surprise, since Eurozone inflation is still below 2% and GDP growth is similarly low. Later, Governing Council members Mario Draghi and Axel Weber (both of whom are potential candidates to replace Trichet when he steps down later this year), issued similar statements, and the question of rate hikes was suddenly changed from If to When/How much.

Futures markets are currently pricing in 3 interest rate hikes, which would bring the Eurozone benchmark rate to 1.75% by year end. According to economist Nouriel Roubini’s (who gained fame by predicting the financial crisis) think tank: “Jean-Claude Trichet has been careful not to commit to a series of hikes, but we believe that is what it will be. The ECB is bluffing. We think the ECB will hike by a total of 75 basis points, probably by August.” Axel Weber, himself, coyly echoed this sentiment: “I see no reason at this stage to signal any dissent with how markets priced future policies.”

On the one hand, the recent rise in oil prices strengthens the case for rate hikes. On the other hand, the EU does not consume energy at the same intensity as the US, which means that its impact on inflation is likely to be muted. In addition, while the ECB’s mandate is indeed titled towards price stability (rather than boosting employment or spurring economic growth), to hike rates now would risk endangering the still-fragile Eurozone economic recovery. Unwinding its quantitative easing would similarly add to the risk of another financial crisis, since banks still make heavy use of its emergency lending facilities.

Speaking of which, it’s still way too early to say that the the EU sovereign debt crisis is behind us. Despite the loans and pledges and bailouts, interest rates for all four PIGS (Portugal, Ireland, Greece, Spain) countries continue to rise, and or nearing unsustainable levels. At the moment, currency investors have chosen to ignore this, since the EU has basically guaranteed them funding until 2013. What will happen then, or as the date draw near, is anyone’s guess.

In the end, one or more defaults seems inevitable. There is only so much that financial engineering can do to conceal and restructure debt which exceeds 100% of GDP in the cases of Greece and Ireland. If that were to happen, significant losses would be incurred by EU banks, which lent heavily to at-risk countries during the boom years. In order to minimize this situation, I think the ECB will probably continue to subsidize the banks via low interest rates.

Even if the ECB does hike rates, it will be extremely gradual. Furthermore, By the time Eurozone interest rates reach attractive levels, the other G4 Central Banks (with the exception of Japan) will probably already have started to close the gap. That means that interest rate differentials probably won’t soon be wide enough to lure more than a modicum of risk-averse investors. (Besides, if you assume a 5% chance of default, risk-adjusted rates are probably still negative).

In short, I think that the ongoing Euro rally is really just a short squeeze in disguise. Basically, speculators are conceding that shorting the Euro is both risky and unprofitable. (According to one hedge fund manager, “It was a very popular trade,” the portfolio manager says. A lot of us stuck with it, and it went wrong in January.”) In anticipating of higher future interest rates, they are preemptively moving to liquidate their short positions. However, not being short is not the same thing as going long. And until the EU sorts through the fiscal issues in a convincing way, I think it would be foolish to start making long-term bets on the Euro.

I was inspired to write this post by a recent article published by Counting Pips, entitled “The Problem with Forex Fundamental Analysis.” While the author, Warren Seah, delivers a stinging critique of fundamental analysis, I think most of his points are pretty hollow. For the sake of debate, I’d like to present my rebuttal.

Seah’s thesis can essentially be boiled down as follows: First, by the time traders have a chance to act on fundamental developments, it is inherently too late as such developments have already been priced into the exchange rates. Second, he argues that fundamental metrics are not automatically trustworthy, since the countries presenting them often have their own agendas. Finally, he asserts that the markets’ response to fundamental news releases is often illogical, and may only serve to confuse traders that would otherwise depend on technical signals to make trading decisions.

I think Seah’s first argument is inherently self-defeating. If one were to concede that all fundamental data has already been priced into currencies, that one would have to make the same concession with regard to price data, which is the backbone of technical analysis. In the end, all traders- regardless of analytical approach – believe that efficient markets theory is flawed, and that exchange rates (and other asset prices, for that matter) are not always correctly valued. The goal of any type of analysis is to identify and exploit such inefficiencies.

I think Seah’s second point, meanwhile, is somewhat irrelevant. Regardless of whether the official economic indicators are actually correct, the market will come to its own (implicit) consensus, and the data will still form the basis for investment decisions. In other words, given that comparative inflation rates can and do drive exchange rates, it’s important to be aware of such rates, be they explicitly provided by a government agency or implicitly priced in by investors. Whether the government agency’s figures are accurate or not doesn’t mean that currency investors shouldn’t worry about inflation.

With regard to the final point, I would agree that news releases can cause exchange rates to move illogically, but as Seah concedes, these inefficiencies will usually smooth themselves out over the following trading periods. A fundamental analyst with a long-term time horizon wouldn’t be swayed by such short-term fluctuations, especially if they are illogical. Thus, I would argue that news releases are more likely to interfere with short-term technical strategies than long-term fundamental strategies.

Ultimately, both fundamental factors AND technical factors drive exchange rates, with the latter primarily dictating short-term movements and the latter bearing more heavily on the medium-term and the long-term. By way of example, consider that all else being equal, a currency backed by low inflation, high economic growth, and high interest rates should outperform a currency with high inflation, low GDP growth, and low interest rates over the long-term. Since exchange rates don’t move up and down in straight lines, there will be plenty of opportunities for technical traders to earn a profit on a minute-by-minute and even week-by-week basis. The fact that very few technical traders will look at 5 year charts and very few fundamental traders will waste their time on 1-day charts largely explains the perceived value of both types of analysis.

Ideally, I would say that all traders should be aware of and make use of both types of analysis. In reality, though, I think this is akin to trying to have one’s cake and eat it too. I think it’s much more practical for traders to decide which type of analysis is better suited to their trading style and even their personality type, and analyze accordingly. For the best analogy, consider that Warren Buffet probably doesn’t know what a stochastic is, while quantitative hedge fund managers probably couldn’t care less about value. And yet it’s possible for both to earn consistent, out-sized returns.

I ended my previous post on the subject by noting that emerging market Central Banks were at a crossroads. Either they would raise interest rates and accept currency appreciation, or they would risk hyperinflation and economic instability. While the jury is still out on a handful of cases, it looks like most of the emerging market countries in Asia have chosen the former.

In February, the Bank of Indonesia raised its benchmark interest rate to 6.75%, from a record low of 6.5%. The People’s Bank of China (PBOC) has now hiked rates three times in the current tightening cycle. After a hike in January, the Bank of Korea inscrutably decided to hold rates in February, but signaled that another rate hike in March is likely. The Central Bank of The Philippines similarly indicated that it is ready to embark on a program of tightening. The same goes for the Reserve Bank of India (RBI). So far the main holdout is the Bank of Thailand, whose interest rates are still the lowest in Asia (ex-Japan) and remains reluctant to raise them too quickly.

Towards the end of January and the beginning of February, most Asian EM currencies sputtered in their appreciation. While there were a number of reasons for this (notably a pickup in risk aversion), Central Banks rejoiced in their perceived victory of foreign currency speculators. Unfortunately, there were a few downsides to this. First of all, capital outflow produced marked declines in Asian stock and bond markets, raising borrowing rates for everyone making it more difficult for domestic firms to raise capital. Meanwhile, inflation continued to rise, with no signs of slowing.

Thus, as I remarked the last time around, it was inevitable that (Asian) Central Banks would inevitably come to their senses. First of all, they realized that there was no free lunch, and that controlling their currencies would disable them from using traditional monetary policy tools to fight inflation. Second, while they could do without currency appreciation, they realized that this would have to be tolerated if they wanted to continue attracting foreign investment. (That’s because, as the Financial Times pointed out, currency appreciation probably accounts for half of all emerging market investment returns).

Third, it is inevitable that emerging market currencies will continue to rise over the long-term, in line with productivity gains. According to the Balassa-Samuelson effect, “countries with above average real income growth should have rising price levels, relative to other economies, and strengthening real exchange rates.” Based on this notion, emerging market currencies are forecast to rise by an average of 1.7% per year for the next 10 years.

Finally, in accordance with the unofficial rules of the currency war, emerging market countries are competing not with industrialized countries, but with each other. If all of their currencies rise in unison, export competitiveness is unaffected, inflation is tamed, and foreign capital remains abundant. It would seem to be a win/win/win.

In fact, it seems like investors are less interested in distinguishing between the different emerging market currencies of Asia, since at this point, all of them offer similar currency appreciation (over the last six months, returns have converged) and similar inflation-adjusted carry. Thus, it stands to reason that as Asian Central Banks continue to tighten interest rates, their currencies will continue to rise together.

I haven’t blogged about oil prices in quite some time. After prices collapsed in the wake of the financial crisis, there really wasn’t much to talk about. However, the price of crude oil has risen more than 50% since June, and it now seems to be at the forefront of investor consciousness. Currency market watchers, in particular, need to brace themselves for the nuanced and sometimes contradictory ways in which oil prices bear on exchange rates.

Under normal conditions, the impact of rising oil prices on the currency markets is somewhat straightforward. First of all, the currencies of oil-exporting countries will typically experience some degree of appreciation. In addition, since oil contracts are still mainly settled in US Dollars, oil prices and a weak Dollar tend to go hand-in-hand. Second, insofar as rising prices drive inflation, the same can be said for Central Banks that are proactive in tightening monetary policy. As real interest rate differentials widen, (risk-averse) capital will naturally gravitate towards the highest returns.

The same logic cannot be applied to the current situation, however. That’s because this time around, oil prices aren’t being driven by economic fundamentals and rising demand, but rather by concerns over supply. You don’t have to be an expert to understand the connection between the continuing Mid East political crisis and oil futures. In the last two weeks alone, prices have risen a whopping 15% and show no sign of abating, as long as tensions linger unresolved.

From that standpoint, you might expect the political tensions to drive safe haven flows to the US Dollar. On the other hand, you would also expect that the resulting high oil prices might crimp the US economic recovery, and cause traders to punish the Dollar. However, you also need to consider that rising oil prices might also cause the Fed to eventually raise interest rates, or at least rein in QE2, which would be Dollar-positive.

Enough with the theory; let’s look at what’s happening in reality! The Canadian Dollar and Australian Dollar are rising, even though oil accounts for only 7% of the  former’s exports, and is a nil factor in the latter’s economy. It looks like forex investors are confusing oil prices with commodity prices, which are also rising, but at a much slower pace. In addition, since higher energy prices will probably erode economic growth in energy importing countries, this could actually hurt some commodity currencies over the long run.

The US Dollar has fallen across-the-board. While Ben Bernanke has insisted that the impact of higher energy prices on the US economy will be minimal, the markets are either taking the opposite view or are punishing the Dollar for the Fed’s dovishness. In other words, if Bernanke isn’t concerned about oil, he probably won’t cap QE2, and certainly won’t steer any interest rate hikes in the near-term.

Meanwhile, the European Central Bank (ECB), whose mandate is tilted towards maintaining price stability, has begun to voice concerns about the impact of rising commodity prices on inflation. Consumer and producer price indexes are rising across the Eurozone, and members of the ECB have suggested that they will take a proactive stance in preventing them from spurring inflation.

In conclusion, while both the EU and the US are net oil importers, the Euro is poised to outperform the Dollar, all else being equal. In addition, as long as the mid east political protests don’t drive further instability and contribute to any major supply shocks (especially in Saudi Arabia and Iran), there won’t be any impetus towards safe-haven capital flows. At the same time, while I don’t pretend to be an expert on oil prices, I would expect prices to stabilize and for a handful of minor corrections to materialize in the fx market. Traders are still looking for an excuse to short the Dollar in favor of, well, everything else, but sooner or later they will have to accept the limits of this trade, high oil prices or not.