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Archive for May, 2011

Aussie is Breaking Away from Kiwi

May. 31st 2011

The correlation between the Australian Dollar and New Zealand Dollar is among the strongest that exists between two currencies. Given their regional bond and similar dependence on commodities to drive economic growth, perhaps this is no wonder. Over the last year, however, the Aussie has slowly broken away from the Kiwi. While the correlation between the two remains strong, the emergence of distinct narratives has given rise to a clear chasm, which can be seen in the chart below. Given that the NZD is evidently among the most overvalued currencies in the world, does that mean the same can be said about the AUD?

Alas, geographic proximity aside, the two economies have very little in common. Australia is rich in coal, precious metals and other natural resources , while New Zealand produces and export primarily agricultural products. Granted, the prices for both types of commodities have exploded over the last decade (and especially the last year), but let’s be clear about the distinction. This has enabled both economies to achieve trade surpluses, but oddly current account deficits. Australia’s economy is projected to grow by more than 4% in 2011, compared to 2% in New Zealand. Australia’s benchmark interest rate is also higher, its capital markets are deeper, and the supply of its currency necessarily exceeds that of New Zealand.

Taken at face value, then, it would seem commonsensical that the Aussie should rise both against the Kiwi and the US Dollar. Indeed, it recently touched an all-time high against the latter, and is now firmly entrenched above parity. On a trade-weighted basis, it has been among the world’s best performers over the last two years.

In fact, some are wondering (myself included), whether the Australian Dollar might have risen too much for its own good. According to OECD valuations based on purchasing power parity (ppp), the Aussie is now 38% overvalued against the dollar, behind only the Swiss Franc and Norwegian Krone. In fact, exporters of non-commodity products (i.e. those whose customers are actually price-sensitive) have warned of mounting competitive pressures, declining sales, and inevitable price cuts. In other words, the portion of the Australian economy that doesn’t deal in commodities is actually in quite fragile shape. Given that China’s economy is projected to slow over the next two years and that booming investment in Australia’s mining sector should boost output, the commodity sector of the economy might soon face similar pressures.

For that reason, the Reserve Bank of Australia (RBA) has avoided raising its benchmark interest rate is fast as some analysts had expected, and inflation hawks had hoped. There is a chance for a 25 basis point hike as soon as June – bring the base rate to an even 5% – but the RBA’s own statements indicate that it probably won’t be until June and July. Regardless of when the RBA tightens, Australian interest rate differentials will remain strong for the foreseeable future, and likely continue to attract speculative inflows for as long as risk appetite remains strong.

So why does the Australian dollar continue to rise? It might have something to do with gold. As you can see from the chart above, the correlation between the Aussie and gold prices is almost just as strong as the relationship between the Aussie and the Kiwi. Given that Australia is the world’s second largest gold exporter, it is perhaps unsurprising that investors would see rising gold prices as a reason for buying the Australian dollar. However, it seems equally possible that demand for both is being driven by the pickup in risk appetite. While some gold buyers might counter that gold is best suited for those who are averse to risk (i.e. afraid that the financial system will collapse), the performance of gold over the last five years suggests that in fact the opposite is true. When risk appetite is high, speculators have bought gold and the Australian dollar (among other assets).

It’s unclear whether this will remain the case going forward. The Wall Street Journal recently reported that gold is increasing attracting risk-averse investment, as buyers fret about the eurozone sovereign debt crisis and other threats to the system. However, the same cannot be said about the Australian Dollar. For as long as risk is “on,” demand for the Aussie will remain intact. And if the Aussie Dollar Barometer survey – which found that “exporters expect the Australian dollar to reach a post-float record of $US1.16 by September and to remain above parity well into next year” – is any indication, risk appetite will indeed remain strong for the foreseeable future.

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Posted by Adam Kritzer | in Australian Dollar | 2 Comments »

New Zealand Dollar: Come Back to Earth!

May. 30th 2011

In March, I wondered aloud about whether the New Zealand Dollar might be the most overvalued currency in the world. Since then, it has continued its unlikely ascent, rising 10% on a correlation-weighted basis and 3% against the US Dollar, hitting a 26-year high in the process. While there are signs that the New Zealand economy might be able to withstand an expensive currency, at some point, the chickens must come back to roost.


Surely the expensive kiwi must be wreaking havoc on the New Zealand dollar? “How is New Zealand supposed to rebalance its economy away from consumption, importing, borrowing and asset selling towards investment, production, exporting and asset buying when our currency is headed for record highs?” Wonders one commentator. In fact, exporters are coping just fine, and New Zealand just recorded its highest quarterly trade surplus on record. Never mind that this is due almost entirely to soaring prices for commodities and unflagging demand. In spite of two earthquakes and other related downside factors, the New Zealand economy is nonetheless forecast to grow by 2.3% in 2011.

On the other hand, New Zealand’s current account deficit continues to rise, as foreign investors pour in to New Zealand to make acquisitions, portfolio investment, and loans to the government. New Zealand’s largest dairy conglomerate could soon be sold to Chinese investors, while China’s sovereign wealth fund (which manages a portion of the country’s sprawling forex reserves) has announced plans to purchase a big chunk of New Zealand government debt. This is just as well, since a record 2011 budget deficit will require a significant issuance of new debt.

Meanwhile, New Zealand price inflation is currently 4.5%, which means that the country’s real interest rate is -2%, certainly among the lowest in the world. Moreover, even as two-year inflation expectations tick up, rate hike expectations remain unchanged. The consensus is that the Reserve Bank of New Zealand will avoid hiking its benchmark until the first quarter of 2012. Regardless of what happens in the interim, it seems unlikely that Bank president Alan Bollard will give in, for fear of stoking further speculative interest in a currency that is already “undesirably high.”

Let’s review: record low interest rates and record low real interest rates. Record budget deficit. Large current account deficit. Declining expectations for GDP growth. Record high New Zealand Dollar. Does anyone see a contradiction here? It’s no wonder that the IMF recently speculated that the Kiwi might be overvalued by as much as 20%, echoing the sentiments of yours truly.

At the same time, commentators concede that “The New Zealand dollar or any currency can deviate for a long period of time from academic measures of valuation.” And that is why making fundamental bets on currencies is so difficult. Even if all signs point to down (as is basically the case here), a currency can continue rising for many more months, before suffering a massive correction. For what it’s worth, this is the fate that the New Zealand Dollar is resigned to. Whether it will happen tomorrow or next year, alas, will depend more on global macroeconomic factors (such as the ebb and flow of risk aversion) than on what happens in New Zealand.

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Posted by Adam Kritzer | in New Zealand Dollar | 3 Comments »

High-Frequency Traders Descend onto Forex Markets

May. 28th 2011

According to a recent report by the Wall Street Journal, high-speed traders are quickly establishing themselves as the main force in forex markets. Just like in other financial markets, a significant portion of trading volume is dominated by computerized trading, in which huge blocks of currency can change hands multiple times in mere milliseconds. While this is certainly old news for hedge funds and other institutional traders, it may come as a slight surprise to retail traders, many of whom still see forex as the neglected stepsister of stocks, bonds, and other assets. Nonetheless, there are a number of implications for the forex markets, and retail traders would be wise to heed them.

Here are the facts: “High-frequency trading accounted for roughly 30% of all foreign-exchange flows, as of 2010, compared with 13% in 2004, according to Boston-based consulting firm Aite Group. (By contrast, 66% of global stocks trading is high frequency.” According to Aite Group, it will jump to 42% by the end 2011 and to 60% in 2012. “About 85% of the currency market’s growth in volume from 2007 to 2010 came from financial institutions like hedge funds [represented as other financial institutions in the chart below] rather than Wall Street’s traditional bank currency dealers, thanks partly to high-frequency traders.”

According to the Wall Street Journal, this is changing the way in which currencies are traded. Previously, for big blocks of currency, traders would have to manually request a quote from Wall Street brokerages, which still dominate forex trading through the interbank market. The brokerage would match up buyer and seller (or step in and fulfill one of the roles itself) and take a cut, in the form of the spread. Retail traders, on the other hand, have never known such a troublesome process, having always been afforded electronic quotes and instant execution. However, the price paid for this convenience comes in the form of wide spreads, since both your retail broker and its representative on the interbank markets must both earn a profit.

In fact, wide spreads recently came under attack by Karl Deninger and sparked a fierce debate about whether it is still possible for retail traders to turn a profit using high-frequency (albeit non-computerized) trading methods. Fortunately, the Wall Street Journal is reporting that spreads have already fallen to one pip (though it didn’t specify the currency pair) thanks to new systems that have been set up to cater to high-frequency traders. It seems only a matter of time before these systems are either adapted to the retail market and/or replace the interbank market as the market-maker for retail brokerages. (Given that a handful of banks are currently under investigation by the SEC for deceptive quoting practices, a changing of the guard probably isn’t such a bad thing!)

In addition, while high-frequency trading has increased liquidity and lowered spreads, it has probably increased volatility. Sudden spikes quickly becomes exacerbated as automatic stop orders flood the market. You can see from the chart below the abundance of such spikes, the most recent one on March 11 caused by the Japanese natural disasters. Overall volatility is also at elevated levels, though it’s impossible to know how much of this is due to an increase in high-frequency trading and how much is simply due to post-financial crisis uncertainty. In any event, retail traders with ultra-short time horizons have no choice but to play the same game, by maintaining active stop-loss orders. Traders should also consider reducing leverage, since sudden spikes can trigger margin calls and wipe out entire accounts. (For the record, of the dozens of interviews I have conducted over the last couple years, I have yet to find one expert that condones the use of leverage greater than 5:1.In my opinion, leverage is still nothing more than a cynical marketing tool), but I digress…)

Ultimately, I think this is just further evidence that day-trading forex is only going to become more difficult. According to a research paper (that I spotlighted in an earlier post), algorithmic trading has already caused a decline in the power of technical analysis. Presumably, this is because computerized trading systems are better than humans at identifying trends and faster at executing trades designed to profit from them. In the end, outsmarting computers is unlikely, since both human traders and their electronic counterparts use the same forms of deductive reasons to spot potential trading opportunities. At the same time, the algorithms are still “stupid.” They are designed by humans and can only consider the variables that have been inputted them, which are inherently technical in nature. To beat them, you merely have to beat their human designers. In practice, this probably means designing more creative strategies based on more complex analytical tools and/or considering fundamental factors in addition to technical ones.

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Posted by Adam Kritzer | in Investing & Trading | 3 Comments »

Swiss Franc at Record Highs

May. 27th 2011

This month, the Swiss Franc touched a record high against not one, but two currencies: the US dollar and the Euro. Having risen by more than 30% against the former and 20% against the latter, the franc might just be the world’s best performing currency over the last twelve months. Let’s look at the prospects for continued appreciation.


As I wrote on Monday, the Swiss Franc has been one of the primary beneficiaries of the safe haven trade. With each spike in volatility, the Swiss Franc has ticked upward. Due to monetary and fiscal stability as well as political conservatism, investors have flocked to the Franc in times of crisis. Of course, the Japanese Yen (and the US dollar, of late) has also received a boost from this phenomenon, but to a lesser extent than the franc, as you can see from the chart above.

Personally, I wonder if this isn’t because the Swiss economy is significantly smaller than that of Japan and the US. In other words, its capacity to absorb risk-averse capital inflows is much smaller than that of Japan and the US. For example, the impact of one million people suddenly rushing out to buy shares in IBM stock would have a much smaller impact on its share price compared to a sudden speculative flood into FXCM. The same can be said about the franc, relative to the dollar and yen.

Ironically, the franc is also rising because of regional proximity to the eurozone. I use the term ironic to denote in order to signify that the franc is not being buoyed by positive association with the euro but rather because of contradistinction. In other words, each time there is another flareup in the eurozone sovereign debt crisis, the franc typically experiences the biggest bounce because it is the easiest currency to compare with the euro. In some ways, it is basically just a more secure version of the euro. This phenomenon has intensified over the last month, as the euro faces perhaps its most uncertain test yet.

It is curious that even as investors have gradually become more inclined to take risk, that not only has the franc held its value, but it has actually surged! Perhaps this is because it is expected that the Swiss National Bank (SNB) will soon hike interest rates, making the franc both high-yielding and secure. To be sure, some analysts think that the SNB will hike as soon as June. The fact the the economy has continued to expand and exports have surged in spite of the strong franc only seems to support this notion.


On the other hand, inflation is still basically nil. And just because the Swiss economy can withstand an interest rate hike hardly provides adequate justification for implementing one. Besides, the SNB hardly wants to give the markets further cause to buy the franc. If anything, it may even need to intervene verbally to make sure that it doesn’t rise any higher. Thus, “The median forecast among economists is for a rate increase in September.”

In short, I think the franc is overbought against the dollar. In fact, you can see from the most recent Commitment of Traders data that speculators have been net long the franc for almost an entire year, and it seems inevitable that this will need to reverse itself. On the other hand, the franc probably has more room to rise against the euro. The takeaway here is that it is less important to know where you stand on the franc in general and more important to understand the cross currency.

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Posted by Adam Kritzer | in Swiss Franc | No Comments »

Risk Still Dominates Forex. The Dollar as “Safe Haven” is Back!

May. 23rd 2011

Well over two years have passed since the collapse of Lehman Brothers and the accompanying climax of the credit crisis. Most economies have emerged from recession, stocks have recovered, credit markets are strong, and commodities prices are well on their way to new record highs. And yet, even the most cursory scanning of headlines reveals that all is not well in forex markets. Hardly a week goes by without a report of “risk averse” investors flocking to “safe haven” currencies.

As you can see from the chart below, forex volatility has risen steadily since the Japanese earthquake/tsunami in March. Ignoring the spike of the day (clearly visible in the chart), volatility is nearing a 2011 high.What’s driving this trend? Bank of America Merrill Lynch calls it the “known unknown.” In a word: uncertainty. Fiscal pressures are mounting across the G7. The Eurozone’s woes are certainly the most pressing, but that doesn’t mean the debt situation in the US, UK, and Japan are any less serious. There is also general economic uncertainty, over whether economic recovery can be sustained, or whether it will flag in the absence of government or monetary stimulus. Speaking of which, investors are struggling to get a grip on how the end of quantitative easing will impact exchange rates, and when and to what extent central banks will have to raise interest rates. Commodity prices and too much cash in the system are driving price inflation, and it’s unclear how long the Fed, ECB, etc. will continue to play chicken with monetary policy.


Every time doubt is cast into the system – whether from a natural disaster, monetary press release, surprise economic indicator, ratings downgrade – investors have been quick to flock back into so-called safe haven currencies, showing that appearances aside, they are still relatively on edge. Even the flipside of this phenomenon – risk appetite – is really just another manifestation of risk aversion. In other words, if traders weren’t still so nervous about the prospect of another crisis, they would have no reasons to constantly tweak their risk exposure and reevaluate their appetite for risk.

Over the last few weeks, the US dollar has been reborn as a preeminent safe haven currency, having previously surrendered that role to the Swiss Franc and Japanese Yen. Both of these currencies have already touched record highs against the dollar in 2011. For all of the concern over quantitative easing and runaway inflation and low interest rates and surging national debt and economic stagnation and high unemployment (and the list certainly goes on…), the dollar is still the go-to currency in times of serious risk aversion. Its capital markets are still the deepest and broadest, and the indestructible Treasury security is still the world’s most secure and liquid investment asset. When the Fed ceases its purchases of Treasuries (in June), US long-term rates should rise, further entrenching the dollar’s safe haven status. In fact, the size of US capital markets is a double-edge sword; since the US is able to absorb many times as much risk-averse capital as Japan (and especially Switzerland, sudden jumps in the dollar due to risk aversion will always be understated compared to the franc and yen.

On the other side of this equation stands virtually every other currency: commodity currencies, emerging market currencies, and the British pound and euro. When safe haven currencies go up (because of risk aversion), other currencies will typically fall, though some currencies will certainly be impacted more than others. The highest-yielding currencies, for example, are typically bought on that basis, and not necessarily for fundamental reasons. (The Australian Dollar and Brazilian Real are somewhere in between, featuring good fundamentals and high short-term interest rates). As volatility is the sworn enemy of the carry trade, these currencies are usually the first to fall when the markets are gripped by a bout of risk aversion.

Of course, it’s nearly impossible to anticipate ebbs and flows in risk appetite. Still, just being aware how these fluctuations will manifest themselves in forex markets means that you will be a step ahead when they take place.

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Posted by Adam Kritzer | in Commentary, US Dollar | 2 Comments »

Japanese Yen Strength is Illogical, but Does it Matter?

May. 21st 2011

On a correlation-weighted basis, the Japanese Yen has been one of the world’s weakest performing currencies in 2011. Alas, while this information is interesting for theoretical purposes, it is of little concern to traders, who focus instead on individual pairs. Against the dollar (USDJPY), the Japanese yen is still quite strong, having recovered most of the losses inflicted upon it by the coordinated G7 intervention in March. Does the yen deserve such a lofty valuation? No. Will it continue to remain strong as the dollar? Well, that is a different question altogether.

As a fundamental analyst, I am inclined to look at the data before making a determination on whether a particular currency will rise or fall. In this case, the fundamentals underlying the yen are beyond abysmal. The recent release of Q1 GDP showed a 3.7% contraction in GDP. Thanks to an interminable streak of weak growth combined with deflation, Japan’s nominal GDP is incredibly the same as it was in 1996! Based on industrial production, consumption, and other economic indicators – all of which were negatively impacted by the earthquake/tsunami – this trend will undoubtedly continue.

The only force that is keeping Japan’s economy afloat is government spending. While this was a necessary response to anemic growth and natural disaster, it is clearly a double-edged sword. The government’s own (inherently optimistic) forecasts show a budget deficit of 5% in 2015, which doesn’t even include the costs of rebuilding the earthquake region. This will necessitate tax hikes, which will further erode growth, requiring ever more government spending. It seems self-evident that Japan’s national debt will remain the highest in the G7 for the foreseeable future.

From a macro standpoint, there is very little to be gained from investing in Japan. The stock market continues to tank, and bond yields are the lowest in the world. To be fair, years of deflation have made the yen an excellent store of value, but this is hardly of interest to speculator, whose time horizons are usually measured in weeks and months, rather than years and decades.

If not for the yen’s safe haven status, it would and does make an excellent funding currency for the carry trade. Short-term rates are around 0%, and the Bank of Japan (BOJ) has made it clear that this will remain the case at least into 2013. As you can see from the chart above (which mimics a strategy designed to take advantage of interest rate differentials), the carry trade is alive and well. Granted, it has suffered a bit since 2010, due to increased fiscal and financial uncertainty. However, given that the rate gap between high-yielding emerging market currencies and low-yield G7 currencies continues to widen, this strategy should remain viable.

And yet, the Yen continues to rise against the US dollar. It has receded in the last couple weeks, but remains close to the magic level of 80, and it’s not hard to find bullish analysts that expect it to keep rising. They argue that Japanese investors are eschewing risky asset, and that the yen remains an attractive safe haven currency. Not to mention that volatility (aka uncertainty) serves as an effective deterrent to those thinking about shorting it and/or using it as a funding currency for carry trades.

Personally, I’m not so sure that this is the case. If you look at the way the yen has performed against the Swiss Franc, for example, the picture is completely reversed. The Franc has risen 20% against the Yen over the last twelve months, which shows that heads-up, the Yen is hardly the world’s go-to safe haven currency. In addition, you can see from the chart below that on a composite basis, the yen peaked during the height of the financial crisis in 2009, and has since fallen by more than 10%. This shows that its performance in 2011 should be seen as much as dollar weakness as yen strength. Since I’ve spent countless previous posts explaining why I think dollar bearishness is overblown, I won’t revisit that topic here.

In the end, the majority of traders don’t care about this nuance – that the Yen has conformed to fundamental logic and depreciated in the wake of the natural disasters against a basket of currencies – and want to know only whether the yen will rise or fall against the dollar. Even though, I think that shorting the Yen remains an attractive (and as I argued yesterday, comparatively riskless) proposition. Given that the dollar also remains weak, however, traders would be wise to short it against other currencies.

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Posted by Adam Kritzer | in Japanese Yen | 1 Comment »

G7 Leads Shift in Forex Reserves

May. 20th 2011

As you can see from the chart below, the world’s foreign exchange reserves (held by central banks) have undergone a veritable explosion over the last decade. While emerging markets (especially China!) have accounted for the majority of this growth, there are indications that this could soon change. China’s reserve accumulation is set to slow, while advanced economies’ reserves are set to increase.


In the past, central banks from advanced economies have accumulated reserves only sparingly, and in fact, much of this growth can be claimed by Japan. This is no mystery. While held by emerging economy central banks, most of the reserves are denominated in advanced economy currencies. This has ensured a plentiful supply of cheap capital, to support both economic expansion and perennial current account deficits (namely in the US!). In addition, advanced economy central bankers tend to hew towards economic orthodoxy, which precludes them from intervening in forex markets, and obviates the need to accumulate forex reserves. Emerging economies, on the other hand, depend principally on exports to drive growth. As a result, many are driven towards holding down their currencies in order to maintain competitiveness. China has taken this to an extreme, by exercising rigid control over the value of the Yuan, and necessitating the accumulation of $3 trillion in foreign exchange reserves.

This trend accelerated in 2010 with the inception of the so-called currency wars (which have not yet abated). Competing primarily with each other, emerging economies bought vast sums of foreign currency in order to promote economic recovery. Many countries from South America and Asia which don’t normally intervene were also drawn in. The result was a tremendous accumulation of foreign exchange reserves, which is reflected in the chart above.

There is already evidence that this phenomenon is starting to reverse itself. Consider first that advanced economies have participated in the currency wars as well. Japan’s reserves have swelled to more than $1.1 Trillion. Switzerland spent $200 Billion defending the Franc, and South Korea has spent more than $300 Billion over the last five years trying to hold down the Won. The Bank of England (BOE) recently announced plans to rebuild its reserves (the majority of which were redeployed towards gilt purchases). The European Central Bank (ECB) has announced similar plans, and may be joined by the Bank of Canada and US Federal Reserve Bank.

Advanced economies need currency reserves for a couple reasons. First of all, they can no longer rely on monetary easing to reduce their exchange rates because of the inflationary side-effects. Second, the recent coordinated intervention on Japan’s behalf showed that the G7 will move to protect its members when need be. Finally, political forces are compelling advanced economies to slow the outflow of jobs and production, and this requires more competitive exchange rates.

Emerging economies, meanwhile, are starting to recognize that unchecked reserve accumulation is neither sustainable nor desirable. First of all, managing those reserves can be tricky. Intervention is not free, and exchange rate and investment losses must be accounted for somewhere. Second, continued intervention has several detrimental byproducts, namely inflation and the handicapping of domestic industry. Finally, emerging economy currency appreciation is inevitable. Constant intervention merely forestalls the inevitable and invites unending speculation and inflows of hot-money.

There are a few of ways that currency investors can position themselves for this change. As emerging market economies stop the accumulation of (or worse, sell off) their reserves, a major source of demand for advanced economy currency will be curtailed. This will accelerate the broad-based appreciation of emerging market currencies against their advanced economy counterparts. At the same time, I’m not sure how much reshuffling we will say in the composition of reserves. The euro is plagued by existential uncertainty, while the yen and pound have serious fiscal problems. In the short-term, the Chinese Yuan is prevented by several factors from becoming a legitimate reserve currency, namely that it is too difficult to obtain. (As soon as this changes, you can bet that emerging economy central banks will begin accumulating it. After all, they are competing with China – not with the US). The dollar is certainly also an “ugly” currency, but given the size of the US economy, the depth of its capital markets, and the liquidity with which the dollar can be traded, it will remain the go-to choice for the immediate future.

In the short-term, traders that wish to short advanced economy currencies (namely the Japanese yen) can do so in the secure knowledge that they are backstopped by the G7 central banks. It’s like you have an automatic put option that limits downside losses. If the Yen falls, you win! If the yen rises, the BOJ & G7 should step in, and at least you won’t lose!

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Posted by Adam Kritzer | in Emerging Currencies, Japanese Yen | No Comments »

The Euro (Still) has a Greek Problem

May. 18th 2011

Since the beginning of May, the euro has fallen by a whopping 7% against the dollar on the basis of renewed fiscal uncertainty in the peripheral eurozone. The optimists would have you believe that the markets will soon forget about the so-called sovereign debt crisis and just as quickly return their focus to monetary policy and other euro drivers. Personally, I think investors to follow such a course, as forex markets must eventually reckon with the seriousness of the eurozone’s fiscal troubles.

First, I want to at least acknowledge the primary sources of euro support. Namely, the European Central Bank (ECB) recently became the first “G4” central bank to raise its benchmark interest rate; at 1.25%, it is now the highest among major currencies, save only the Australian dollar. Moreover, there is reason to believe that the ECB will hike further over the coming six – twelve months. First of all, eurozone price inflation continues to rise, and the ECB is notoriously hawkish when it comes to ensuring price stability. Second, Q1 GDP growth for the eurozone was a solid .8%, thanks to especially strong performances from France and Germany. While the ECB will likely follow the lead of the Bank of England and wait until Q2 data is released before making a decision, the strong Q1 performance is nonetheless an indication that the eurozone can withstand further rate hikes. Finally, Mario Draghi, who has been confirmed to replace Jean-Claude Trichet in June as head of the ECB, will need to effect an immediate rate hike if he is to establish credibility with the markets.

As I wrote in my last euro update (“Time to Short the Euro“), however, such a modest ECB interest rate – regardless of how it compares to other G4 rates – should hardly be enough to compensate yield-seekers for the risks associated with holding the euro for an extended period of time. Of course, the primary risk I am talking about is the possibility first of a full-fledged sovereign debt crisis, and secondarily of a eurozone banking crisis.

At this point, it is painfully obvious to everyone except for EU officials that the status quo cannot continue. Bailout funds cannot be expanded and rolled over indefinitely, especially since 3 countries (Greece, Ireland, and Portugal) are now involved. Greece, which is certainly the most pressing case, faces skyrocketing interest rates and declining interest from creditors, even as its budget deficit and national debt rise and its economy shrinks. Under these conditions, there is no way that it can re-enter private bond markets in 2012 (as was originally expected), if at all.

Thus, the only question is, what will happen instead? If Greece were to leave the eurozone, it could inflate away its debt, devalue its currency, and decrease interest rates. Regardless of its merit, this possibility has been vehemently dismissed because of concerns that it would lead to the implosion of the euro, and it seems very unlikely. What if Greece were to restructure its debt, by demanding concessions from bondholders? Based on the bond covenants, it apparently has wide latitude to do so, and might not even face legal repercussions. This possibility is also opposed by the ECB and EU officials because it would force banks to take massive [see chart below] write-downs on their debt holdings.

Greece could similarly elect to “re-profile”- basically lengthening the bond maturities (no “haircut” on interest and principal), ostensibly to give it more time to retool economically and fiscally. While this is a popular option, it probably would only succeed in forestalling the inevitable. Finally, the EU (with help from the IMF) could continue to loan money to Greece, in exchange for more additional austerity measures and collateralized by sales of state assets. Alas, this would be met with stiff political resistance from Greece. Not to mention that the recent indictment of Dominique Strauss-Khan – head of the IMF- on rape charges has jeopardized what has been the highest-profile advocate for continued support of Greece.

It seems inevitable that Greece will default on all or part of its debt. That’s not to say that this would cause its economy to collapse, nor that it would precipitate the end of the euro. In fact, recent history is full of cases of countries that successfully declared bankruptcy and emerged several years later unscathed. In this way, Greece could probably eliminate half of its debt, and significantly ease the burden that it poses.

Of course, this would not only set a dangerous precedent for Ireland, Portugal (and perhaps even Spain and Italy), but it would also reverberate throughout Europe’s banking sector, and would probably necessitate multiple bailouts. But what’s the alternative? Dragging out the crisis with secret meanings and feckless proposals will only add to the uncertainty. If Greece and the rest of the eurozone can come to grips with its collective fiscal problem, it will certainly cause chaos in the short-term and a further decline in the euro. By removing uncertainty, however, it will buttress the euro over the long-term and allow it to remain in existence.

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Posted by Adam Kritzer | in Euro | 1 Comment »

Pound Correction is Already Underway

May. 17th 2011

Last week, I was preparing to write a post about how the British pound was overvalued and due for a correction, but was sidetracked by a series of interviews (the second of which – with Caxton FX – incidentally also hinted at this notion). Alas, the markets beat me to the bunch, and the pound has since fallen more than 3% against the dollar- the sharpest decline in more than six months. Moreover, I think there is a distinct possibility that the pound will continue to fall.

Not much has changed since the last time I wrote about the pound. If anything, the fundamentals have deteriorated. Fortunately, the latest GDP data showed that the UK avoided recession in the latest quarter, but this is offset by the fact that overall GDP remains the same as six months ago and still 4% below pre-recession levels. Despite a slight kick from the royal wedding in April, the UK will almost certainly finish 2011 towards the low end of OECD countries, perhaps above only Japan. Ed Balls, shadow chancellor of the UK, has conceded, “We’ve gone from the top end of the economic growth league table to being stuck at the bottom just above Greece and Portugal.”

Of course, the question on the minds of traders is whether the Bank of England (BOE) will raise interest rates. Initially, it was presumed (by me as well) that the BOE would be the first G4 central bank to hike, if only to contain high inflation. In fact, at the March monetary policy meeting, three members (out of nine) voted to do just that. However, there stance softened at the April meeting, and they have since been beaten to the bunch by the European Central Bank (ECB) which is notoriously more hawkish.

Now, it seems reasonable to wonder whether the BOE might also fall behind the Fed. While still high (4%), the British CPI rate has slowed in recent months. “The bank’s Governor Mervyn King said on Jan. 26 that rising prices would be temporary.” Moderating commodity prices have reduced the need for a rate hike, and bolstered the case for keeping the pound week. Unemployment is high, construction spending is falling, and the current account deficit remains wide. Moreover, budget cuts (declined to contain a national debt that has almost doubled in the last three years) and a a hike in the VAT rate have dampened the economy further, to the point that it might not be able to withstand even a slight rate hike.

Furthermore, record low Gilt (the British equivalent of the US Treasury bond) rates reflect expectations for continued low rates for the immediate future. If Q2 GDP growth – which won’t be released for another 3 months -is strong, the BOE might conceivably vote to tighten. Still, we probably won’t see more than one 25 basis point before 2012.

It seems that the only thing that kept the pound afloat so long was its correlation with the euro, which recently rose above $1.50. It has since fallen dramatically and dragged the pound down with it. In fact, the pound probably needs to fall another 3% just to stay on track with the euro. If this correlation were to break down, it would almost certainly fall much further.

It has become cliched to suggest that the forex markets have become a reverse beauty pageant, whereby investors vote not on the most attractive currencies, but rather on the least ugly. At this point, it is safe to say that among G4 currencies, the pound is the ugliest.

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Posted by Adam Kritzer | in British Pound | 3 Comments »

Interview with Caxton FX: “The Most Successful Traders are also the Most Knowledgeable”

May. 13th 2011

Today’s interview is with Richard Driver, currency analyst of Caxton FX, an oft-quoted expert on currency issues. [Caxton FX offer three main services foreign exchange service, where they deal in large foreign exchange deals, and offer advice and hedging strategies to clients. Its Fastpay system allows clients to change up to £20,000 online at any time of the day or night (we don’t charge any fees for this service). This service is often used for mortgage payments and SME stock purchases. Finally Caxton FX offer a range of currency cards (euro, dollar and global) – the cards are available for individuals and for businesses. The main advantage of the card is the lack of ATM fees]. Below, Mr. Driver explains his firm’s approach to analyzing currencies and offers some insights on specific currency pairs, among other things.

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Are Forex Markets Underpricing Volatility?

May. 12th 2011
This question has been raised by several market commentators, including The Wall Street Journal. Its recent analysis, entitled “Currency Investors: What, Me Worry?” wondered whether the forex markets might not have become too complacent about risk and have seriously underestimated the possibility of another shock.
First, some basics. There are two principal volatility measurements: implied
volatility and realized volatility. The former is so-called because it must be deduced indirectly. In the Black-Scholes model for pricing options, volatility is the only unknown variable and thus is implied by current market prices. It serves as a proxy for investor expectations for volatility over the period for which the option is valid. Realized volatility is of course the actual volatility that is observed in currency markets, calculated based on the size of fluctuations over a given period of time. When fluctuations are greater (whether upward or downward), volatility is said to be high.
 
For short time frames, implied volatility tends to be very close to realized volatility. For longer time-frames, however, this is not necessarily the case: “The long-dated implied volatilities are often driven to extreme values by one-sided demand or supply – the difference between implied and realised volatilities this causes is particularly large during periods of risk aversion in the market…making implied volatility a particularly poor proxy for realised volatility during periods of market unrest.” In practice, this is reflected by higher prices for long-dated put or call options (depending on the direction of the move that investors are trying to hedge against).
 
Indeed, most volatility metrics are well below their historical averages and are rapidly closing in on pre-credit crisis levels. This is true for the JP Morgan G7 3-month forex volatility index, the S&P VIX, as well as for specific currencies. Mataf.net (whose content manager I interviewed yesterday) contains replete short-term and long-term data for a few dozen currency pairs, and you can see that almost all of them feature the same downward trend. According to the WSJ, “Investors believe there is a 66% chance each day for the next month that the euro and pound will move no more than 0.6% and 0.5%, respectively—both limited moves.” In addition, “A gauge of the euro’s ‘realized’ volatility, which measures how much daily changes deviate from their recent average, is only 8.6%, lower than its 11% rolling one-year average.”
Of course, some commentators don’t see any problem here. They see it both as a positive indication that the markets have returned to normal following the financial crisis, and as a reflection of the correlation that has developed between stock prices and forex markets. (You can see from the chart below the strong inverse correlation between the S&P and the US dollar). According to Deutsche Bank, “Most news that should have shocked the market this year has not managed to do so for sufficiently long to make volatility rise sustainably. Our analytical models tell us that we are indeed moving to a low volatility environment again.”
 
On the other side of the debate is a growing consensus of investors that sees a pendulum that has swung too far. “I just don’t see how volatility will not increase quite substantially,” said one money manager. “There is significant potential for shocks to the system that currency volatility levels suggest the market is not prepared for,” added another, citing higher commodities prices and inflation, growing public debt, and the imminent end of the Fed’s QE2 monetary stimulus.
 
To be sure, volatility has started to tick up over the last month. This trend has also been reflected in options prices: “Many investors have avoided buying short-dated currency options this year, instead focusing on longer-dated protection, a phenomenon called a ‘steep volatility curve’…that trend has slowed a bit, with investors moving to hedge against near-term yen, euro and dollar swings.”
 
Currency traders should start to think about making a few adjustments. Those that think that volatility will continue to rise and/or that the markets are currently underpricing risk can employ a volatility strangle strategy, buying way out-of-the-money puts and calls. The options will pay off if there is a big move in either direction, with no downside risk. Those that think that volatility will continue declining or at least remain at current low levels can make use of the carry trade. Those pairs where interest rate differentials are highest and volatility levels are lowest represent the best candidates. BNP Paribas is also reportedly developing a product that will make it easier for traders to make volatility bets without having to rely on indirect means.
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Interview with Arnaud Jeulin of Mataf.net: “Try a Lot of Strategies!”

May. 11th 2011

Today, we bring you an interview with Arnaud Jeulin of Mataf.net. Below, Arnaud discusses his background and reveals his favorite currency pairs.

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What the Forex Markets Tell Us about Gold & Silver

May. 10th 2011

All investors, regardless of stripe, must now be aware both of the bull market for gold/silver and the bear market in the US dollar. Despite all of the rhetoric, however, it seems that little is actually understood about how these two phenomena are actually connected. Ultimately, this connection (or lack thereof) has serious implications for both markets.

Many gold investors insist they are buying gold as a proxy for shorting the dollar. Commentary on gold prices is full of apocalyptic warnings about the current financial system and criticism of fiat currencies, which are backed by nothing except for good faith. They argue that buying gold is the best (or even the only) hedge against the eventual collapse of the dollar.

Unfortunately, I don’t think this argument holds up to close scrutiny. First of all, gold and silver [I am including silver in this analysis not because of any deep relationship to gold, but only because of the association ascribed by other commentators and an observable market correlation] prices have risen much faster over the last year (and decade, for that matter) than even the strongest currencies. Furthermore, gold is rising faster than the dollar is falling. In terms of the Swiss Franc – which is to forex markets as gold is to commodities markets – gold has risen more than 17% since the start of 2010.

Second, the putative correlation between gold and forex markets asserts itself sparingly (as you can see from the chart below, which plots gold against an index that shows dollar bearishness), and in difficult-to-understand ways. For example, gold stalled during the financial crisis, while the price of silver suffered a veritable collapse. Does it make sense that when financial anxiety was highest, interest in gold and silver ebbed? Along similar lines, the recent rally in the dollar followed the recent correction in gold and silver – NOT the other way around. If anything, this shows that gold investors are taking their cues from the broader commodity markets, and not from forex markets.

Third, the macroeconomic case for gold is flimsy. While I don’t think it’s fair to attack gold on political grounds, I still think it’s reasonable to try to ascertain what forces are supposedly being hedged against. If it is inflation that gold buyers are worried about, why aren’t other all investors equally concerned? Based on futures markets – whose credibility is just as solid as gold markets – inflation expectations are around 2-4% across the G7. If instead it is sovereign debt default that gold investors are concerned about, again, I have to ask why other markets don’t share their concerns. Credit default swap rates are higher for Japanese and European debt than for US Treasury securities, but the yen and euro remain positively buoyant against the dollar. Again, how do gold investors explain this contradiction?

To me, it seems obvious that gold and silver are rising for reasons that have very little to do with fundamentals. Monetary expansion has driven a wave of money into financial markets, and a significant portion of this has no doubt found its way into gold, silver, and other metals. In fact, it seems that last week’s correction was driven partly by higher margin requirements for speculators. Finally, their cause is being helped by low interest rates, since the opportunity cost of holding gold (which doesn’t pay interest) in lieu of dollars (which does) is currently close to zero. When interest rates rise, it will certainly be interesting to see if there is any impact on gold.

In the end, I don’t have a strong understanding of gold and silver markets. For all I know, their rise is genuinely rooted in supply/demand, as it should be. My only wish is that investors will stop pretending that it has anything to do with the dollar.

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Posted by Adam Kritzer | in Commodities | 9 Comments »

Introduction to Technical Analysis: “Morning Fake-out”

May. 8th 2011
As regular readers of this blog are probably aware, I rarely post about technical analysis. Simply, I’m not well-acquainted with its nuances, and I would probably sound like a dilettante if I tried to offer some serious advice on the subject. That being said, I read an interesting overview of a particular technical strategy (in the San Francisco Gate, of all places…please hold your laughter), that appealed to me on a number of levels, and that I would like to to share below.
 
Contrary to popular belief, the forex market is not a 24-hour market. Given time differences and market overlap, it’s true that it’s possible to trade forex 24 hours a day, six days a week. In practice, however, the markets are observably more active/liquid at certain regular hours. Anecdotally, it seems that many traders focus their trading at these hours, since the opportunities for profit (and losses, to be fair) are greatest at these times.
 
The author of the article (Investopedia contributor Cory Mitchell) has specifically identified the opening of certain key markets (typically 9AM local time; actual time will vary based on your location). Prior to opening, the markets may appear calm before a sudden onslaught of trading activity, as banks move to establish new positions for the day, stop orders are cleared, and the market struggles to find direction. In every major market, there are a handful of currency pairs that dominate trading in that market, and that traders should pay special attention to at the open. Tokyo has the Yen; London has the Pound, Euro, and Franc; New York has the US Dollar.
 
This confusion may create an opportunity if a so-called “fake-out” occurs. Basically, the market will suddenly lurch in one direction, and trading desks might latch (mistakenly) onto this pattern with the goal of reaping early morning profits. In some cases, this break-out will just as quickly reverse course, and a dominant trend will re-establish itself. Those who have correctly anticipated this can enter the market in the direction of the dominant trend and ride the wave in that direction as it entrenches.
 
I like this strategy because I think it is grounded in human psychology. Basically, it speaks to early-morning overzealousness by poor traders that is quickly overcome by broader market forces, which will re-assert themselves when opportunity resurfaces. Of course, the market is zero-sum, which means that all profits are necessarily earned at the expense of those caught trading what in hindsight was a false breakout.
 
Of course, trading the morning fake-out is hardly this simplistic, and those that are curious to learn more would be wise to read the original article. Still, I think it offers a few convenient lessons for aspiring technical traders, and even for fundamental traders with shorter time horizons. First, understand that the market is inherently busier at some times of the day than others. Second, understand that while the trend is still your friend, there are micro-trends which may be moving in the opposite direction from the macro-trend. Third, make sure to establish stops, so that if you are unlucky enough to get caught trading in the direction of the fake-out, your losses are limited. Finally, it’s worth remembering that the forex market is inherently zero-sum. While an overall bear market is categorically impossible, so is an overall bull market. That means that any profits you earn must be at the expense of unskilled/unlucky traders. The only way you will come out ahead is if you are not one of them! 
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SA Rand in Bubble Territory

May. 7th 2011
The story of the South African Rand (ZAR) is nearly identical to that of other leading emerging market currencies: multi-year gains were completely undone by the 2008 credit crisis, only to be restored in 2009 and 2010. From trough to peak, the Rand has now risen 64%, including 15% over the last twelve months and 10% over the last six weeks. While the reasons for its renewal are understandable, they are far from justifiable. Based on a number of metrics, the Rand now appears to be somewhat overvalued.
 
Just like its BRIC (which it was recently invited to join) peers, the Rand’s appeal lies in high growth prospects and even higher nominal interest rates. It has also been bought amidst the general pickup in risk appetite (complacency) that has spurred investors back into emerging markets. Given the relatively small size of its economy and proportionately small money supply, it’s no surprise that demand for Rand – made worse by the difficulty of betting directly on China – has overwhelmed the supply.
Despite repeated cuts, South Africa’s benchmark interest rate still stands at a lofty 5.5%. Relative price stability also means that interest rates are positive in real terms, a claim which few countries can make nowadays. Thanks to bond yields hovering around 8% and a comparatively modest government debt, lending to South Africa still carries a significant risk-adjusted return advantage over other emerging markets. The Bank of South Africa is trying to hold off on hiking rates for as long as possible, partly to avoid stimulating the Rand. Its decision to tighten will essentially be determined by the battle between unemployment and inflation. With more than 25% of South Africans out of work, the Bank is understandably reluctant to take any steps that would ameliorate that problem.
 
Perhaps above all else, the Rand’s rise has been closely correlated with the ongoing commodities boom. South Africa is the world’s largest producer of platinum and palladium, second largest of gold, and at the top of the rankings for a handful of other precious metals and minerals. Thus, you can see from the chart below that the Rand/Dollar rate has very closely tracked platinum and gold prices for the last twelve months. Aside from a modest correction (induced by a temporary ebb in risk aversion) at the end of 2010, the three assets appear to have moved in lockstep!
 
While rising commodities prices have certainly been a boon to South Africa’s foreign exchange reserves, it hasn’t done much for its economy. In fact, mining comprises only 3% of South Africa’s economy (down from 14% two decades ago), and analysts expect that this proportion will decline further as deposits are mined to exhaustion. Its balance of trade fluctuates between surplus and deficit, as revenues from increased commodities exports are turned around and spent on imports. (China is now South Africa’s largest trading partner). Still, given the record current account deficits of the last few years, foreign investors evidently are undeterred from bridging the South African shortfall in domestic investment, even (or especially!) at current exchange rates.
 
Going forward, there are plenty of analysts that believe the Rand will continue rising, at a healthy rate of around 10% per year. This notion is based as much on the depreciation of major currencies – which were punished for their respective Central Banks’ expansionary monetary policies – as it is in the appreciation of the Rand. In fact, the Rand’s performance against a basket of emerging market currencies has been more modest; on a trade-weighted basis, it has still risen an estimated 15% since 1995. Regardless, this suggests that any bubble underlying the Rand is no different from that which may affect any number of other currencies.
 
Still, it’s hard to argue with fundamentals. According to one back-of-the-envelope analysis based on purchasing power parity (ppp) differentials, the Rand will need to depreciate significantly if it is to return to more normalized valuation levels. “Since 2000, South African inflation has exceeded that of the US by 44 percent, while the rand has depreciated by just over 10 percent, which means that goods in South Africa are now over 30 percent more expensive for Americans than they were a decade ago… it is impossible to know when this difference will unwind, but…it is reasonable to assume that it will unwind in every five-year period, and this would entail a depreciation in the rand-US dollar exchange rate of six percent a year.” Reasonable indeed.
 
Ultimately, it is going to be tough to sell this argument to carry traders, who care more about interest rate differentials than inflation differentials, which means the Rand could continue to rise over the short-term. Over the medium-term, however, the Bank of South Africa may see to it that this trend does not continue.
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Interview with InnerFX: “JPY and CHF will Continue to Strengthen”

May. 4th 2011

Today, I bring you an interview with Liviu Flesar, an independent trader and blogger. His portal is InnerFX, which is billed as a “useful resource for traders from all over the world and a trading blog where novice traders can learn how to trade better.” Below, Mr. Flesar discusses his background and shares his thoughts on the major currencies, setting up trades, and how to reform the rating agency system.

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The Diminished Case for Chinese Yuan Appreciation

May. 3rd 2011

The Chinese yuan has appreciated by more than 27.5% since 2005, when the People’s Bank of China (“PBOC”) formally acceded to international pressure and began to relax the yuan-dollar peg. For China-watchers and economists, that the Yuan will continue to appreciate is thus a given. There is no question of if, but rather of when and to what extent. But what if the prevailing wisdom is wrong? What if the yuan is now fairly valued, and economic fundamentals no longer necessitate a further rise?


Prior to the 2005 revaluation, economists had argued that the yuan (also known as the Chinese RMB) was undervalued by 15% – 40%, and American politicians had used this as a basis for proposing a 27.5% across-the-board tariff on all Chinese imports. Given that the yuan has now appreciated by this exact margin (and by even more when inflation is taken into account), shouldn’t this alone be enough to silence the critics, without even having to look at the picture on the ground? How can Senator Charles Schumer continue to press for further appreciation when the yuan’s rise exceeds his initial demands? Alas, election season is upon us, and we can’t hope to make political sense out of this issue. We can, however, attempt to analyze the economic sense of it.

China manipulates the value of the yuan in order to give a competitive advantage to Chinese exporters, goes the conventional line of thinking. Look no further than the Chinese trade surplus for evidence of this, right? As it turns out, China’s trade surplus is shrinking rapidly. In 2006, it was a whopping 11% of GDP. Last year, it had fallen to 5%, and it is projected by the World Bank to settle below 3% for each of the next two years. Thanks to a first quarter trade deficit – the first in over seven years – China’s trade surplus may account for a negligible portion (~.2%) of GDP growth in 2010.


With this in mind, why would the PBOC even think about allowing the RMB to appreciate further? According to one perspective, the narrowing trade imbalance is only temporary. When commodities prices settle and global demand fully recovers, a wider trade surplus will follow. In fact, the IMF forecasts China’s current surplus will rise to 8% by 2016. As you can see from the chart below (courtesy of The Economist), however, the IMF’s forecasts have proven to be too pessimistic for at least the last three years, and it now has very little credibility. Besides, China’s economy is gradually reorienting itself away from exports and towards domestic spending. As a resident of China, I can certainly attest to this phenomenon, and the last few years has seen an explosion in the number of cars on the road, domestic tourism, and conspicuous consumption.


A better argument for further RMB appreciation comes in the form of inflation. At 5.4%, inflation is officially nearing a 3-year high, and there is evidence that the PBOC already recognizes that allowing the RMB to keep rising represents its best tool for containing this problem. It has already raised banks’ required reserve ratio several times, but there is a limit to what this can accomplish. Meanwhile, the PBOC remains reluctant to raise interest rates because it will invite further “hot-money” inflows (estimated at more than $100 Billion per year, if not much higher) and potentially destabilize the banking sector. By raising the value of the yuan, the PBOC can blunt the impact of rising commodities prices and other inflationary forces.

In fact, some think that the PBOC will quicken the pace of appreciation, a view that as supported by last month’s .9% rise. Others think that a once-off appreciation would be more effective, and is hence more likely. This would not only remove the motivation for further hot-money inflows, but would also reduce the PBOC’s need to continue accumulating foreign exchange reserves. At $3 trillion+ ($1.15 trillion of which are held in US Treasury Securities), these reserves are already a massive headache for policymakers. Merely stating the obvious, PBOC Governor Zhou Xiaochuan has officially called the reserves “really too much.” (It’s worth pointing out that the promotion of the yuan as an international currency is backfiring in some ways, causing the reserves to balloon even faster).

For the record, I think that the Chinese yuan is pretty close to being fairly valued. That might seem like a ridiculous claim to make when Chinese wages and prices are still well below the global average. Consider, however, that the same is true for the majority of emerging market economies, including those that don’t peg their currencies to the dollar. That doesn’t mean that the yuan won’t – or that it shouldn’t – continue to rise. In fact, the PBOC needs to do more to ensure that the Yuan appreciates evenly against all currencies, since most of the yuan’s rise to-date has taken place relative to the US Dollar. It’s merely a commentary that the PBOC is close to fulfilling the promises it has made regarding the yuan, and going forward, I think that observers should expect that its forex policy will be reconfigured to promote domestic macroeconomic policy objectives.

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Korean Won Poised for Further Gains

May. 1st 2011

It was in November 2010 that I last blogged about the South Korean Won. As a result of the standoff with North Korea and a recent flareup in the Eurozone sovereign debt crisis, the Won had plummeted. Still, I viewed these as temporary problems and concluded that, “Ultimately, both the EU fiscal crisis and the tensions with North Korea will subside, which should cause the Won to resume its rise.” Since then, the Won has indeed risen by more than 8% against the US dollar. Rather than call for a correction, however, I’m ignoring my best instincts and arguing in favor of a further rise.


In a nutshell, the Korean Won has almost everything going for it at the moment. In the words of one columnist, “South Korea is today the 15th largest global economic power [and] is also the leading global nation in shipbuilding, production of LCD screens and in the distribution of broadband per capita. It is the third leading nation in the production of semi-conductors, the fifth in automobile manufacturing and in scientific research.” GDP is growing at a healthy clip of 4.2%. After recording real GDP growth in excess of 6% in 2010, South Korea’s economy is projected to grow by a further 4.5% in 2011, which means that it has more than made up for the recession that it suffered alongside the rest of the word in 2008-2009.  Exports reached a record level in 2010, propelling Korea’s current account balance well into surplus. “It seems that a target of $1 trillion of trade this year will be achieved, in spite of unfavorable conditions from the massive quake in Japan and the Middle East unrest,” declared Korea’s commerce minister. On balance then, money coming into Korea well exceeds money flowing out.

Moreover, unlike Japan and China – both of whose currencies are hovering around record levels – the Korean Won remains about 20% below its 2008 pre-credit crisis high. That means that the Won has plenty of scope for further appreciation before its exporters will be squeezed to the same extent as its Asian competitors. If the Bank of Korea (BOK) has its way, it will be a long time before this even happens. The BOK continues to intervene on behalf of the Won on a daily basis, and as a result, its foreign exchange reserves have risen to $300 billion, a record high.

Granted, Korean inflation is also rising, and most recently touched 4.7%, which is at or above the level in neighboring economies. The Bank of Korea has taken steps to counter this, but it is understandably wary about inadvertently stoking speculative interest in the Won. Thus, it has raised its benchmark interest rate only four times since last summer, and the rate is still at a historically low level. According to the Wall Street Journal, “That’s still well below the 4% to 4.5% level where economists estimate the neutral policy rate to be.”

When you consider both that the carry trade is back in vogue and that most other emerging market currencies have recovered most of their credit crisis losses and then some, it’s downright surprising that the Won hasn’t risen more. Perhaps, lamented one commentator, South Korea still lacks cachet among investors and is known more as the political counterbalance to North Korea than as the economic juggernaut that it has become. Even though its economy is larger than that of Australia, the Won doesn’t have nearly as much appeal as the Aussie.

Since it’s the weekend, I’ll keep this post short and sweet! Suffice it to say that the Won still has plenty of scope for further appreciation, and unless the BOK completely avoids hiking rates, I don’t see real downside pressures. At this rate, it will probably be one of the big success stories of 2011.

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