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.

In shifting their focus to interest rates, forex traders have perhaps overlooked one very important monetary policy event: the conclusion of the Fed’s quantitative easing program. By the end of June, the Fed will have added $600 Billion (mostly in US Treasury Securities) to its reserves, and must decide how next to proceed. Naturally, everyone seems to have a different opinion, regarding both the Fed’s next move and the accompanying impact on financial markets.

The second installment of quantitative easing (QE2) was initially greeted with skepticism by everyone except for equities investors (who correctly anticipated the continuation of the stock market rally). In November, I reported that QE2 was unfairly labeled a lose-lose by the forex markets: “If QE2 is successful, then hawks will start moaning about inflation and use it as an excuse to sell the Dollar. If QE2 fails, well, then the US economy could become mired in an interminable recession, and bears will sell the Dollar in favor of emerging market currencies.”

The jury is still out on whether QE2 was a success. On the one hand, US GDP growth continues to gather force, and should come in around 3% for the year. A handful of leading indicators are also ticking up, while unemployment may have peaked. On the other hand, actual and forecast inflation are rising (though it’s not clear how much of that is due to QE2 and how much is due to other factors). Stock and commodities prices have risen, while bond prices have fallen. Other countries have been quick to lambaste QE2 (including most recently, Vladimir Putin) for its perceived role in inflating asset bubbles around the world and fomenting the currency wars.

Personally, I think that the Fed deserves some credit- or at least doesn’t deserve so much blame. If you believe that asset price inflation is being driven by the Fed, it doesn’t really make sense to blame it for consumer and producer price inflation. If you believe that price inflation is the Fed’s fault, however, then you must similarly acknowledge its impact on economic growth. In other words, if you accept the notion that QE2 funds have trickled down into the economy (rather than being used entirely for financial speculation), it’s only fair to give the Fed credit for the positive implications of this and not just the negative ones.

But I digress. The more important questions are: what will the Fed do next, and how will the markets respond. The consensus seems to be that QE2 will not be followed by QE3, but that the Fed will not yet take steps to unwind QE2. Ben Bernanke echoed this sentiment during today’s inaugural press conference: “The next step is to stop reinvesting the maturing securities, a move that ‘does constitute a policy tightening.’ ” This is ultimately a much bigger step, and one that Chairman Bernanke will not yet commit.

As for how the markets will react, opinions really start to diverge. Bill Gross, who manages the world’s biggest bond fund, has been an outspoken critic of QE2 and believes that the Treasury market will collapse when the Fed ends its involvement. His firm, PIMCO, has released a widely-read report that accuses the Fed of distracting investors with “donuts” and compares its monetary policy to a giant Ponzi scheme. However, the report is filled with red herring charts and doesn’t ultimately make any attempt to account for the fact that Treasury rates have fallen dramatically (the opposite of what would otherwise be expected) since the Fed first unveiled QE2.

The report also concedes that, “The cost associated with the end of QEII therefore appears to be mostly factored into forward rates.” This is exactly what Bernanke told reporters today: “It’s [the end of QE2] ‘unlikely’ to have significant effects on financial markets or the economy…because you and the markets already know about it.” In other words, financial armmagedon is less likely when the markets have advanced knowledge and the ability to adjust. If anything, some investors who were initially crowded-out of the bond markets might be tempted to return, cushioning the Fed’s exit.

If bond prices do fall and interest rates rise, that might not be so bad for the US dollar. It might lure back overseas investors, grateful both for higher yields and the end of QE2. Despite the howls, foreign central banks never shunned the dollar.  In addition, the end of QE2 only makes a short-term interest rate that much closer. In short, it’s no surprise that the dollar is projected to “appreciate to $1.35 per euro by the end of the year, according to the median estimate of 47 analysts in a Bloomberg News survey. It will gain to 88 per yen, a separate poll shows.”

Over the last year and increasingly over the last few months, Central Banks around the world have taken center stage in currency markets. First, came the ignition of the currency war and the consequent volley of forex interventions. Then came the prospect of monetary tightening and the unwinding of quantitative easing measures. As if that wasn’t enough to keep them busy, Central Banks have been forced to assume more prominent roles in regulating financial markets and drafting economic policy. With so much to do, perhaps it’s no wonder that Jean-Claude Trichet, head of the ECB, will leave his post at the end of this year!

The currency wars may have subsided, but they haven’t ended. On both a paired and trade-weighted basis, the Dollar is declining rapidly. As a result, emerging market Central Banks are still doing everything they can to protect their respective currencies from rapid appreciation. As I’ve written in earlier posts, most Latin American and Asian Central Banks have already announced targeted strategies, and many intervene in forex markets on a daily basis. If the Japanese Yen continues to appreciate, you can bet the Bank of Japan (perhaps aided by the G7) will quickly jump back in.

You can expect the currency wars to continue until the quantitative easing programs instituted by the G4 are withdrawn. The Fed’s $600 Billion Treasury bond buying program officially ends in June, at which point its balance sheet will near $3 Trillion. The European Central Bank has injected an equally large hunk of cash into the Eurozone economy. Despite inflation that may soon exceed 5%, the Bank of England voted not to sell its cache of QE assets, while the Bank of Japan is actually ratcheting up its program as a result of the earthquake-induced catastrophe. Whether or not this manifests itself in higher inflation, investors have signaled their distaste by bidding up the price of gold to a new record high.

Then there are the prospective rate hikes, cascading across the world. Last week, the European Central Bank became the first in the G4 to hike rates (though market rates have hardly budged). The Reserve Bank of Australia, however, was the first of the majors to hike rates. Since October 2009, it has raised its benchmark by 175 basis points; its 4.75% cash rate is easily the highest in the industrialized world. The Bank of Canada started hiking in June 2010, but has kept its benchmark on hold at 1% since September. The Reserve Bank of New Zealand lowered its benchmark to a record low 2.5% as a result of serious earthquakes and economic weakness.

Going forward, expectations are for all Central Banks to continue (or begin) hiking rates at a gradual pace over the next couple years. If forecasts prove to be accurate, the US Federal Funds Rate will stand around .5% at the beginning of 2012, tied with Switzerland, and ahead of only Japan. The UK Rate will stand slightly above 1%, while the Eurozone and Canadian benchmarks will be closer to 2%. The RBA cash rate should exceed 5%. Rates in emerging markets will probably be even higher, as all four BRIC countries (Russia, Brazil, China, India) should be well into the tightening cycles.

On the one hand, there is reason to believe that the pace of rate hikes will be slower than expected. Economic growth remains tepid across the industrialized world, and Central Banks are wary about spooking their economies with premature rate hikes. Besides, Fed watchers may have learned a lesson as a result of a brief bout of over-excitement in 2010 that ultimately led to nothing. The Economist has reported that, “Markets habitually assign too much weight to the hawks, however. The real power at the Fed rests with its leaders…At present they are sanguine about inflation and worried about unemployment, which means a rate rise this year is unlikely.”  Even the ECB disappointed traders by (deliberately) adopting a soft stance in the press release that accompanied its recent rate hike.

On the other hand, a recent paper published by the Bank for International Settlements (BIS) showed that the markets’ track record of forecasting inflation is weak. As you can see from the chart below, they tend to reflect the general trend in inflation, but underestimate when the direction changes suddenly. (This is perhaps similar to the “fat-tail” problem, whereby extreme aberrations in asset price returns are poorly accounted for in financial models). If you apply this to the current economic environment, it suggests that inflation will probably be much higher-than-expected, and Central Banks will be forced to compensate by hiking rates a faster pace.
Finally, in their newfound roles as economic policymakers, Central Banks are increasingly engaged in macroprudential policy. The Economist reports that, “Central banks and regulators in emerging economies have already imposed a host of measures to cool property prices and capital inflows.” These measures are worth watching because their chief aim is to indirectly reduce inflation. If they are successful, it will limit the need for interest rate hikes and reduce upward pressure on their currencies.

In short, given the enhanced ability of Central Banks to dictate exchange rates, traders with long-term outlooks may need to adjust their strategies accordingly. That means not only knowing who is expected to raise interest rates – as well as when and by how much – but also monitoring the use of their other tools, such as balance sheet expansion, efforts to cool asset price bubbles, and deliberate manipulation of exchange rates.

Propelled by economic recovery and the recent Mideast political turmoil, oil prices have firmly shaken off any lingering credit crisis weakness, and are headed towards a record high. Moreover, analysts are warning that due to certain fundamental changes to the global economy, prices will almost certainly remain high for the foreseeable future. The same goes for commodities. Whether directly or indirectly, the implications for forex market will be significant.

First of all, there is a direct impact on trade, and hence on the demand for particular currencies. Norway, Russia, Saudia Arabia, and a dozen other countries are witnessing record capital inflow expanding current account surpluses. If not for the fact that many of these countries peg their currencies to the Dollar and/or seem to suffer from myriad other issues, there currencies would almost surely appreciate. In fact, the Russian Rouble and Norwegian Krona have both begun to rise in recent months. On the other hand, Canada and Australia (and to a lesser extent, New Zealand) are experiencing rising trade deficits, which shows that their is not an automatic relationship between rising commodity prices and commodity currency strength.

Those countries that are net energy importers could experience some weakness in their currencies, as trade balances move against them. In fact, China just recorded its first quarterly trade deficit in seven years. Instead of viewing this in terms of a shift in economic structure, economists need to understand that this is due in no small part to rising raw materials prices. Either way, the People’s Bank of China (PBOC) will probably tighten control over the appreciation of the Chinese Yuan. Meanwhile, the nuclear crisis in Japan is almost certainly going to decrease interest in nuclear power, especially in the short-term. This will cause oil and natural gas prices to rise even further, and magnify the impact on global trade imbalances.

A bigger issue is whether rising commodities prices will spur inflation. With the notable exception of the Fed, all of the world’s Central Banks have now voiced concerns over energy prices. The European Central Bank (ECB), has gone so far as to preemptively raise its benchmark interest rate, even though Eurozone inflation is still quite low. In light of his spectacular failure to anticipate the housing crisis, Fed Chairman Ben Bernanke is being careful not to offer unambiguous views on the impact of high oil prices. Thus, he has warned that it could translate into decreased GDP growth and higher prices for consumers, but he has stopped short of labeling it a serious threat.

On the one hand, the US economy is undergone some significant structural changes since the last energy crisis, which could mitigate the impact of sustained high prices. “The energy intensity of the U.S. economy — that is, the energy required to produce $1 of GDP — has fallen by 50% since then as manufacturing has moved overseas or become more efficient. Also, the price of natural gas today has stayed low; in the past, oil and gas moved in tandem. And finally, ‘we’re closer to alternative sources of energy for our transportation,’ ” summarized Wharton Finance Professor Jeremy Siegal. From this standpoint, it’s understandable that every $10 increase in the price of oil causes GDP to drop by only .25%.

On the other hand, we’re not talking about a $10 increase in the price of oil, but rather a $50 or even $100 spike. In addition, while industry is not sensitive to high commodity prices, American consumers certainly are. From automobile gasoline to home eating oil to agricultural staples (you know things are bad when thieves are targeting produce!), commodities still represent a big portion of consumer spending. Thus, each 1 cent increase in the price of gas sucks $1 Billion from the economy. “If gas prices increased to $4.50 per gallon for more than two months, it would ‘pose a serious strain on households and could put the entire recovery in jeopardy. Once you get above $5, [there is] probably above a 50% chance that the economy could face a downturn.’ ”

Even if stagflation can be avoided, some degree of inflation seems inevitable. In fact, US CPI is now 2.7%, the highest level in 18 months and rising. It is similarly 2.7% in the Eurozone and Australia, where both Central Banks have started to become more aggressive about tightening monetary policy. In the end, no country will be spared from inflation if commodity prices remain high; the only difference will be one of extent.

Over the near-term, much depends on what happens in the Middle East, since an abatement in political tensions would cause energy prices to ease. Over the medium-term, the focus will be on Central Banks, to see if/how they deal with rising inflation. Will they raise interest rates and withdraw liquidity, or will they wait to act for fear of inhibiting economic recovery? Over the long-term, the pivotal issue is whether economies (especially China) can become less energy intensive or more diversified in their energy consumption.

At the moment, most economies are dangerously exposed, with China and the US topping the list. Russia, Norway, Brazil and a select few others will earn a net benefit from a boom in prices, while most others (notably Australia and Canada) are somewhere in the middle.

Forex traders have very suddenly tilted their collective focus towards interest rate differentials. Given that the Dollar is once again in a state of free fall, it seems the consensus is that the Fed will be the last among the majors to hike rates. As I’ll explain below, however, there are a number of reasons why this might not be the case.

First of all, the economic recovery is gathering momentum. According to a Bloomberg News poll, “The US economy is forecast to expand at a 3.4 percent rate this quarter and 3.3 percent rate in the second quarter.” More importantly, the unemployment rate has finally begun to tick down, and recently touched an 18-month low. While it’s not clear whether this represents a bona fide increase in employment or merely job-hunting fatigue among the unemployed, it nonetheless will directly feed into the Fed’s decision-making process.

In fact, the Fed made such an observation in its March 15 FOMC monetary policy statement, though it prefaced this with a warning about the weak housing market. Similarly, it noted that a stronger economy combined with rising commodity prices could feed into inflation, but this too, it tempered with the dovish remark that “measures of underlying inflation continue to be somewhat low.” As such, it warned of “exceptionally low levels for the federal funds rate for an extended period.”

To be sure, interest rate futures reflect a 0% likelihood of any rate hikes in the next 6 months. In fact, there is a 33% chance that the Fed will hike before the end of the year, and only a 75% chance of a 25 basis point rise in January of 2012. On the other hand, some of the Fed Governors are starting to take more hawkish positions in the media about the prospect of rate hikes: “Minneapolis Federal Reserve President Narayana Kocherlakota said rates should rise by up to 75 basis points by year-end if core inflation and economic growth picked up as he expected.” Given that he is a voting member of the FOMC, this should not be written off as idle talk.

Meanwhile, Saint Louis Fed President James Bullard has urged the Fed to end its QE2 program, and he isn’t alone. “Philadelphia Fed President Charles Plosner and Richmond Fed President Jeffrey Lacker have also urged a review of the purchases in light of a strengthening economy and concern over future inflation.” While the FOMC voted in March to “maintain its existing policy of reinvesting principal payments from its securities holdings and…purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011,” it has yet to reiterate this position in light of these recent comments to the contrary, and investors have taken notice.

Assumptions will probably be revised further following tomorrow’s release of the minutes from the March meeting, though investors will probably have to wait until April 27 for any substantive developments. The FOMC statement from that meeting will be scrutinized closely for any subtle tweaks in wording.

Ultimately, the take-away from all of this is that this record period of easy money will soon come to an end. Whether this year or the next, the Fed is finally going to put some monetary muscle behind the Dollar.

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.

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.

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.

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

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

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

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

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

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

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

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

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

In a recent editorial reprinted in The Business Insider (Here’s Why The Yuan Will Never Be The World’s Reserve Currency), China expert Michael Pettis argued forcefully against the notion that the Chinese Yuan will be ever be a global reserve currency on par with the US Dollar. By his own admission, Pettis seeks to counter the claim that China’s rise is inevitable.

The core of Pettis’s argument is that it is arithmetically unlikely – if not impossible – that the Chinese Yuan will become a reserve currency in the next few decades. He explains that in order for this to happen, China would have to either run a large and continuous current account deficit, or foreign capital inflows into China would have to be matched by Chinese capital outflows.” Why is this the case? Simply, a reserve currency must necessarily offer (foreign) institutions ample opportunity to accumulate it.

However, as Pettis points out, the structure of China’s economy is such that foreigners don’t have such an opportunity. Basically, China has run a current account/trade surplus, which has grown continuously over the last decade. During that time, its Central Bank has accumulated more than $2.5 Trillion in foreign exchange reserves in order to prevent the RMB from appreciating. Foreign Direct Investment, on the other hand, averages 2% of GDP and is declining, not to mention that “a significant share of those inflows may actually be mainland money round-tripped to take advantage of capital and tax regulations.”

For this to change, foreigners would need to have both a reason and the opportunity to hold RMB assets. The reason would come from a reversal in China’s balance of trade, and the use of RMB to pay for the excess of imports over exports, which would naturally imply a willingness of foreign entities to accept RMB. The opportunity would come in the form of deeper capital markets, a complete liberalization of the exchange rate regime (full-convertibility of the RMB), and the elimination of laws which dictate how foreigners can invest/lend in China. This would likewise an imply a Chinese government desire for greater foreign ownership.

How likely is this to happen? According to Pettis, not very. China’s financial/economic policy are designed both to favor the export sector and to promote access to cheap capital. In practice, this means that interest rates must remain low, and that there is little impetus behind the expansion of domestic consumption. Given that this has been the case for almost 30 years now, this could prove almost impossible to change. For the sake of comparison, consider that despite two “lost decades,” Japan nonetheless continues to promote its export sector and maintains interest rates near 0%.

Even if the Chinese economy continues to expand and re-balances itself in the process (a dubious possibility), Pettis estimates that it would still need to increase the rate of foreign capital inflows to almost 10% of GDP. If economic growth slows to a more sustainable level and/or it continues to run a sizable trade surplus, this figure would rise to perhaps 20%. In this case, Pettis concedes, “we are also positing…a radical change in the nature of ownership and governance in China, as well as a radical redrawing of the role of the central and local governments in the local economy.”

So there you have it. The political/economic/financial structure of China is such that it would be arithmetically very difficult to increase foreign accumulation of RMB assets to the extent that the RMB would be a contender for THE global reserve currency. For this to change, China would have to embrace the kind of reforms that go way beyond allowing the RMB to fluctuate, and strike at the very core of the CCP’s stranglehold on power in China.

If that’s what it will take for the RMB to become a fully international currency, well, then it’s probably too early to be having this conversation. Perhaps that’s why the Asian Development Bank, in a recent paper, argued in favor of modest RMB growth: “sharing from about 3% to 12% of international reserves by 2035.” This is certainly a far cry from the “10 years” declared by Russia’s finance minister and tacitly supported by Chinese economic policymakers.

The implications for the US Dollar are clear. While it’s possible that a handful of emerging currencies (Brazilian Real, Indian Rupee, Russian Ruble, etc.) will join the ranks of the international currencies, none will have enough force to significantly disrupt the status quo. When you also take into account the economic stagnation in Japan and the UK, as well as the political/fiscal problems in the EU, it’s more clear than ever that the Dollar’s share of global reserves in one (or two or three) decades will probably be only slightly diminished from its current share.

Despite reaching a temporary stalemate, the currency war rages on, and individual countries continue to debate whether they should enter or watch their currencies continue to appreciate. Nowhere is that debate stronger than in New Zealand, whose Kiwi currency has fallen 37% against the US Dollar since its peak in early 2009, and over 15% since June of this year.

With most countries, the war cries are coming from the political establishment, who feel compelled to demonstrate to their constituents that they are diligently monitoring the currency war. This is largely the case in New Zealand, as Members of Parliament have argued forcefully in favor of intervention. Prime Minister John Key is a little more pragmatic: He “says his Government is concerned about the strength of our dollar, but is not convinced intervention would work…politicians who think intervention can happen without economic consequences, are fooling themselves.” Showing an astute understanding of economics, he pointed out that trying to limit the Kiwi’s appreciation would manifest itself in the form of higher inflation, higher interest rates, and/or reduced access to capital.

This is essentially the position of Alan Bollard, Governor of the Central Bank of New Zealand. He has insisted (correctly) that the New Zealand is being driven up, so much as its currency counterparts – namely the US Dollar – are being driven downward, by forces completely disconnected from New Zealand and way beyond its control. Thus, if New Zealand tried to intervene, it would quickly be overpowered (perhaps deliberately!) by speculators. Ultimately, it would end up spending lots of money in vain, and the Kiwi would continue to appreciate.

Mr. Bollard has pointed out that a stronger currency is not without its perks: such as lower (relative) prices for certain natural resources, such as oil. In addition, since New Zealand is largely a commodity economy, its producers are being compensated for an expensive currency in the form of higher prices for milk, wool, and other staple exports. While its other manufacturing operations have been punished by the expensive Kiwi, its economy is still relatively robust. Thanks to a series of tax cuts and the lowest interest rates in New Zealand history, GDP is forecast to return to trend in 2010 and 2011.

New Zealand’s concerns are understandable, and there is an argument to be made for preventing the Dollars that are printed from the Fed’s QE2 from being put to unproductive purposes in New Zealand. At the same time, New Zealand is not such an attractive target for speculators. Its benchmark interest rate, at 3%, is relatively low compared to developing countries. Its current account balance is projected to continue declining, perhaps down to -8%, which means that the net flow of capital is actually out of New Zealand. In addition, while the Kiwi has appreciated against the US Dollar, it has fallen mightily against the Australian Dollar en route to a multi-year low.

Going forward, there is reason to believe that the New Zealand Dollar will continue to appreciate against the US Dollar as a result of QE2 and a general sense of pessimism towards the US. The same is true with regard to currencies that actively intervene to prevent their currencies from appreciating. Still, I don’t think the New Zealand Dollar will reach parity – against any currency – anytime soon, and after the currency fracas subsides, it will probably trend towards its long-term average.

The “currency war” is heating up, and all parties are pinning their hopes on the G20 summit in South Korea. However, this is reason to believe that the meeting will fail to achieve anything in this regard, and that the cycle of “Beggar-thy-Neighbor” currency devaluations will continue.

There have been a handful of developments since the my last analysis of the currency war. First of all, more Central Banks (and hence, more currencies) are now affected. In the last week, Argentina pledged to continue its interventions into 2011, while Taiwan, and India – among other less prominent countries – have hinted towards imminent involvement.

Of greater significance was the official expansion of the Fed’s Quantitative Easing Program (QE2), which at $600 Billion, will dwarf the efforts of all other Central Banks. In fact, it’s somewhat ironic that the Fed is the only Central Bank that doesn’t see its monetary easing as a form of currency intervention when you consider its impact on the Dollar and its (inadvertent?) role in “intensifying the currency war.”  According to Chinese officials, “The continued and drastic U.S. dollar depreciation recently has led countries including Japan, South Korea and Thailand to intervene in the currency market,” while the Japanese Prime Minister recently accused the U.S. of pursuing a “weak-dollar policy.”

As of now, there is no indication that other industrialized countries will follow suit, though given concerns that QE2 “at the end of the day might be dampening the recovery of the euro area,” I think it’s too early to rule anything out. While the Bank of Japan similarly has stayed out of the market since its massive intervention in October, Finance Minister Yoshihiko Noda recently declared that, “I think the [Yen's] moves yesterday were a bit one-sided. I will continue to closely monitor these moves with great interest.”

As the war reaches a climax of sorts, everyone is waiting with baited breath to see what will come out of the G20 Summit. Unfortunately, the G20 failed to achieve anything substantive at last month’s Meeting of Finance Ministers and Central Bank Governors, and there is little reason to believe that this month’s meeting will be any different.

In addition, the G20 is not a rule-making body like the WTO or IMF, and it has no intrinsic authority to stop participating nations from devaluing their currencies. Conference host South Korea has lamely pointed out that while ” ‘There aren’t any legal obligations‘…discussion among G20 countries would produce ‘a peer-pressure kind of effect on these countries’ that violated the deal.” Not to mention that the G20 will have no effect on the weak Dollar nor on the undervalued RMB, both of which are at the root of the currency war.

It’s really just wishful thinking that countries will come to their senses and realize that currency devaluation is self-defeating. In the end, the only thing that will stop them from intervening is to accept the futility of it: “The history of capital controls is that they don’t work in controlling foreign exchange rates.” This time around will prove to be no different, “particularly with banks already said to be offering derivatives products to get around the new taxes.” The only exception is China, which is only able to prevent the rise of the RMB because of strict controls for dealing with the inflow of capital.

In short, the “wall of money” that is pouring into emerging market economies represents a force too great to be countered by individual Central Banks. The returns offered by investing in emerging markets (even ignoring currency appreciation) are so much greater than in industrialized countries that investors will not be deterred and will only work harder to find ways around them. Ironically, to the extent that controls limit the supply of capital and boost returns, they will probably drive additional capital inflows. The more successful they are, the more they will fail. And that’s something that no new currency agreement can change.

For the last few months, and especially over the last few weeks, the financial markets have been obsessed with the rumored expansion of the Fed’s Quantitative Easing program (“QE2″). With the prospect of another $1 Trillion in newly minted money hitting the markets, investors presumptively piled into stocks, commodities, and other high-risk assets, and simultaneously sold the US Dollar in favor of higher-yielding alternatives.

On Wednesday, rumor became reality, as the Fed announced that it would expand its balance sheet by $600 Billion through purchases of long-dated Treasury securities over the next six months. While the announcement (and the accompanying holding of the Federal Funds Rate at 0%) were certainly expected, markets were slightly taken aback by its scope.

Due to conflicting testimony by members of the Fed’s Board of Governors, investors had scaled back their expectations of QE2 to perhaps $300-500 Billion. To be sure, a handful of bulls forecast as much as $1-1.5 Trillion in new money would be printed. The majority of analysts, however, New York Fed chief William Dudley’s words at face value when he warned, “I would put very little weight on what is priced into the market.” It was also rumored that the US Treasury Department was working behind the scenes to limit the size of QE2. Thus, when the news broke, traders instantly sent the Dollar down against the Euro, back below the $1.40 mark.

On the one hand, the (currency) markets can take a step back and focus instead on other issues. For example, yields on Eurozone debt have been rising recently due to continued concerns about the possibility of default, but this is not at all reflected in forex markets. During the frenzy surrounding QE2, the forex markets also completely neglected comparative growth fundamentals, which if priced into currencies, would seem to favor a rally in the Dollar.

On the other hand, I have a feeling that investors will continue to dwell on QE2. While the consensus among analysts is that it will have little impact on the economy, they must nonetheless await confirmation/negation of this belief over the next 6-12 months. In addition, all of the speculation to date over the size of QE2 has been just that – speculation. Going forward, speculators must also take reality into account, depending on how that $600 Billion is invested and the consequent impact on US inflation. If a significant proportion of is simply pumped into domestic and emerging market stocks, then the markets will have been proved right, and the Dollar will probably fall further. If, instead, a large portion of the funds are lent and invested domestically, and end up buoying consumption, then some speculators will be forced to cover their bets, and the Dollar could rally.

Unfortunately, while QE2 is largely seen as a win-win for US stocks (either it stimulates the economy and stocks rally, or it fails to stimulate the economy but some of the funds are used to foment a stock market rally anyway), the same cannot be said for the US Dollar. If QE2 is successful, then hawks will start moaning about inflation and use it as an excuse to sell the Dollar. If QE2 fails, well, then the US economy could become mired in an interminable recession, and bears will sell the Dollar in favor of emerging market currencies.

China’s foreign exchange reserves continue to surge. As of September, the total stood at $2.64 Trillion, an all-time high. However, it’s becoming abundantly clear that China is no longer content for Dollar-denominated assets to represent the cornerstone of its reserves. Instead, it has embarked on a campaign to further diversify its reserves, with important implications for the currency markets.

Despite China’s allowing the Chinese Yuan to appreciate (or perhaps because of it), hot money continues to flow in – nearly $200 Billion in the the third quarter alone. Foreign investors are taking advantage of strong investment prospects, rising interest rates, and the guarantee of a more valuable currency. In order to prevent the inflows from creating inflation and putting even more upward pressure on the RMB, the Central Bank “sterilizes” the inflows by purchasing an offsetting quantity of US Dollars and other foreign currency.

Since the Central Bank does not release precise data on the breakdown of its reserves, analysts can only guess. Estimates range from the world average of 62% to as high as 75%. At least $850 Billion (this is the official tally; due to covert buying through offshore accounts, the actual total is probably higher) of its reserves are held in US Treasury securities. It also controls a $300 Billion Investment Fund, which has made very public investments in natural resource companies around the world. The allocation of the other $1.5 Trillion is a matter of speculation.

Still, China has stated transparently that it wants to diversify its reserves into emerging market currencies, following the global shift among private investors. Investment advisers praise China for its shrewdness, in this regard: “The Chinese authorities are some of the smartest in the world. If you look at the fundamentals of a lot of these emerging markets, they are considerably better than developed markets. Who wants to be holding U.S. dollars at this stage?” However, these investments serve two other very important objectives.

The first is diplomatic/political. When China recently signed an agreement with Turkey to conduct bilateral trade in Yuan and Lira (following similar deals with Brazil and Russia), it was interpreted as an intention snub to the US, since trade is currently conducted in US Dollars. In addition, by funding projects in other emerging markets through a combination of loans investments, China is able to curry favor with host countries, as well as to help its own economy at the same time. The second is financial: by buying the currencies of trade rivals, China is able to make sure that its own currency remains undervalued. This year, it has already purchased more than $5 Billion in South Korean bonds, and perhaps $20 Billion in Japanese sovereign debt, sending the Won and the Yen skywards in the process.

China’s purchases of Greek and (soon) Italian debt serve the same function. It is seen as an ally to financially troubled countries, while its efforts help to keep the Euro buoyant, relative to the RMB. According to Chinese Premier Wen JiaBao, “China firmly supports Greece’s efforts to tackle the sovereign debt crisis and won’t cut its holdings of European bonds.”

For now, China remains deeply dependent on the US Dollar, and is still very vulnerable to a sudden depreciation it its value. For as much as it wants to diversify, the supply of Dollars and the liquidity with which they can be traded means that it will continue to hold the bulk of its reserves in Dollar-denominated assets. In addition, the Central Bank has no choice but to continue buying Dollars for as long as the RMB remains pegged to it. At some point in the distant future, the Yuan will probably float freely, and China won’t have to bother accumulating foreign exchange reserves, but that day is still far away. For as long as the peg remains in place, the Dollar’s status as global reserve currency is safe.

In a few weeks, the US could overtake China as the world’s biggest currency manipulator. Don’t get me wrong: I’m not predicting that the US will officially enter the global currency war. However, I think that the expansion of the Federal Reserve Bank’s quantitative easing program (dubbed QE2 by investors) will exert the same negative impact on the Dollar as if the US had followed China and intervened directly in the forex markets.

For the last month or so, markets have been bracing for QE2. At this point it is seen as a near certainty, with a Reuters poll showing that all 52 analysts that were surveyed believe that is inevitable. On Friday, Ben Bernanke eliminated any remaining doubts, when he declared that, “There would appear — all else being equal — to be a case for further action.” At this point, it is only a question of scope, with markets estimates ranging from $500 Billion to $2 Trillion. That would bring the total Quantitative Easing to perhaps $3 Trillion, exceeding China’s $2.65 Trillion foreign exchange reserves, and earning the distinction of being the largest, sustained currency intervention in the world.

The Fed is faced with the quandary that its initial Quantitative Easing Program did not significantly stimulate the economy. It brought liquidity to the credit and financial markets – spurring higher asset prices – but this didn’t translate into business and consumer spending. Thus, the Fed is planning to double down on its bet, comforted by low inflation (currently at a 50 year low) and a stable balance sheet. In other words, it feels it has nothing to lose.

Unfortunately, it’s hard to find anyone who seriously believes that QE2 will have a positive impact on the economy. Most expect that it will buoy the financial markets (commodities and stocks), but will achieve little if anything else: “The actual problem with the economy is a lack of consumer demand, not the availability of bank loans, mortgage interest rates, or large amounts of cash held by corporations. Providing more liquidity for the financial system through QE2 won’t fix consumer balance sheets or unemployment.” The Fed is hoping that higher expectations for inflation (already reflected in lower bond prices) and low yields will spur consumers and corporations into action. Of course, it is also hopeful that a cheaper Dollar will drive GDP by narrowing the trade imbalance.

At the very least, we can almost guarantee that QE2 will continue to push the Dollar down. For comparison’s sake, consider that after the Fed announced its first Quantitative Easing plan, the Dollar fell 14% against the Euro in only a couple months. This time around, it has fallen for five weeks in a row, and the Fed hasn’t even formally unveiled QE2! It has fallen 13% on a trade-weighted basis, 14% against the Euro, to parity against the Australian and Canadian Dollars, and recently touched a 15-year low against the Yen, in spite of Japan’s equally loose monetary policy.

If the Dollar continues to fall, we could see a coordinated intervention by the rest of the world. Already, many countries’ Central Banks have entered the markets to try to achieve such an outcome. Individually, their efforts will prove fruitless, since the Fed has much deeper pockets. As one commentator summarized, It’s now becoming “awfully hypocritical for American officials to label the Chinese as currency manipulators? They are, but they’re not alone.”

According to Goldman Sachs (which if nothing else, is good at characterizing financial trends. Remember “BRIC?”), there is a “Wall of Money” that is already flooding emerging markets and will continue to do so for the foreseeable future.

“The Institute of International Finance projected 2010 capital flows of $825 billion, up from $581 billion in 2009 and from the $709 billion that the trade group for global financial-services firms had projected for 2010 in April.” In hindsight, the outflow of capital from emerging markets that took place during the financial crisis will probably look like a blip, as risk appetite has already recovered to pre-crisis levels, and then some!

“The move into emerging markets has been led by stock investors, who will pour an estimated $186 billion into these countries this year, — fully three times the annual average of $62 billion generated between 2005 and 2009.” Emerging Market Bond funds, meanwhile, now routinely receive more than $1 Billion per week. Sovereign wealth funds are also starting to shift some of their assets into emerging market assets/currencies as part of their respective diversification strategies. As you can see from the chart below (courtesy of The Economist), Asia is by far the largest recipient of investment, followed by Latin America.

The continued shift of capital from the industrialized world into emerging markets as being driven both by economic fundamentals and the desire to earn a greater return on investment. “The IMF forecast this month that developing nations will expand 6.4 percent next year, outstripping growth of 2.2 percent among advanced economies.” Meanwhile, the ratio of foreign debt to GDP among developing nations has been cut to 26 percent, compared to 41 percent in 1999. And yet, even as analysts predict that emerging markets will account for 85% of global growth going forward, “emerging markets account for $3 trillion, or only 15 percent of market capitalisation of the benchmark MSCI world index.”

While it’s understandable, then, that investors would want to rectify this imbalance as quickly as possible, they need to realize that developing countries’ capital markets simply aren’t deep enough to absorb all of the incoming capital. In other words, an limited pool of capital is chasing a limited stock of accessible investments, and the result is that asset prices and exchange rates are climbing inexorably higher.

Analysts argue, “Some appreciation is due: a rise against rich-world currencies is both a natural consequence of the faster growth of emerging economies and a way to correct global imbalances.” But a 50% rise over five years (notched by a handful of currencies) does not represent some appreciation, but rather an explosion. This is precisely the sentiment echoed by many of the emerging markets, themselves, which have taken to using guerilla tactics to hold down their currencies. Since the latest phase of the “currency war” was ignited by Japan in September, every week has led to increasingly far-flung countries – Peru, Chile, Czech Republic, Poland, South Africa – reputedly contemplating intervention.

According to an interesting economic analysis, which scaled intervention to the size of the given country’s monetary base, South Korea and Taiwan have been among the most active participants in forex markets, while Thailand and Malaysia have been among the most restrained. This is born out by the sizable appreciation of both the Thai Baht and Malaysian Ringit over the last few years. However, I wonder if some economists will take issue with their assessment that Brazil and China have been relatively modest interveners.

Of course, this doesn’t make it any easier to forecast, since how a country behaved in the past isn’t necessarily indicative of how it will behave in the future. For example, Thailand just announced that it will not intervene, but Brazil will double its forex tax from 2% to 4%. Case in Point!

On September 27, Brazilian Finance Minister, Guido Montega, used the term “currency war” to describe the series of recent Central Bank interventions in forex markets. While he may not have intended it, the term stuck, and financial journalists everywhere have run wild with it.

In the current cycle (dating back a couple years), more than a dozen Central Banks have entered the forex markets with the intention of holding down their respective currencies, both against each other and also against the US Dollar. What makes it a war is that the Central Banks are fighting to outspend and outdo each other. It is a War of Attrition, in that Central Banks will fight until they’ve exhausted all of their wherewithal, conceding defeat for their currencies. On the other hand, unlike in a conventional war, there aren’t any alliances, nor is there much in the way of little strategy. Central Banks simply buy large blocks of counter currencies and hope their own currencies will then depreciate on the spot market. In addition, since the counter currencies are almost always Dollars and/or Euros, the participants in this war are not even competing directly against each other, but rather against an enemy that isn’t doing much to fight back. [Chart belowcourtesy of Der Spiegel].

The Swiss National Bank (SNB) was the first to intervene, and staged a one-year campaign over the course of 2009 to hold the Swiss Franc at 1.50 against the Euro. Ultimately, it failed when the sovereign debt crisis caused an exodus of Euro selling. The Bank of Brazil was next, although its interventions havebeen more modest; it seems to have accepted the ultimate futility of its efforts, and will seek to slow the Real’s appreciation rather than halt it. Last month, the Bank of Japan spent $20 Billion in one session in order to show the markets how serious it is about fighting the Yen’s rise. In fact, it was this intervention that sparked Montega’s comments about currency war. (The BOJ hasn’t intervened since). All along, the People’s Bank of China has continued to add to its war chest of reserves – currently $2.5 Trillion – as part of the ongoing Yuan-Dollar peg. And of course, there have been a handful of smaller interventions (South Korea, Singapore, Taiwan) and no shortage of rhetorical (Canada, South Africa) interventions, as well as indirect (US, UK) intervention.

That’s right- don’t forget that the Fed and the Bank of England, through their respective quantitative easing programs, have injected Trillions into the financial markets and caused their currencies to weaken. In a sense, all of the subsequent interventions have been effected in order to restore the equilibrium in the currency markets that was lost when these two Central Banks deflated there currencies through wholesale money printing. Since much of this cash has found its way into emerging markets (See chart below), you can’t blame their Central Banks from trying to soften some of the upward pressure on their currencies.

It’s still too early too early to say how far the currency war will go. The G7/G20 has announced that it will address the issue at its next summit, though it probably won’t lead to much in the way of action. Ultimately, politicians can’t do much more than shake their fingers at countries that try to hold down their currencies. In the case of the Yuan-Dollar peg, American politicians have tried to take this one step further by threatening to slap China with punitive trade sanctions, but this probably won’t come to pass and may disappear as an issue altogether after the November elections. As I reported on Friday, Brazil has taken matters into its own hands by taxing all foreign capital inflows, but this hasn’t had much effect on the Real.

That brings me to my final point, which is that all currency intervention is futile in the long term, because most Central Banks have limited capacity to intervene. If they print too much money to hold down their currencies, they risk stoking inflation. Of course China is the exception to this rule, but this is less because of the size of its war chest and more because of the mechanics of its exchange rate regime. For Central Banks to successfully manipulate their currencies on the spot market, they must fight against the Trillions of Dollars in daily forex turnover. Eventually, every Central Bank must reckon with this truism.

In terms of identifying the winners and losers of the currency war (as I promised to do in the title of this post, the Euro will probably lose (read: appreciate) because the ECB is not willing to participate. The same goes for the Swiss Franc, since the SNB has basically forsaken currency intervention for the time being. The Bank of Japan has deep pockets, and if the markets push the Yen back up above 85 Yen/Dollar, I wouldn’t be surprised to see it intervene again. With the Fed mulling an expansion of its quantitative easing program, meanwhile, the Dollar will probably continue to sink. And as for the countries that are doing the actual intervening, they might succeed in temporarily holding down the valuer of their respective currencies.  As capital shifts to emerging markets over the long-term, however, their currencies will soon resume rising.

Brazil is beating the drumbeat of war. The forex variety, that is. According to the Finance Minister, “We’re in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness.” By its own admission, Brazil will not be sitting on the sidelines of this war. Rather, it will do battle on behalf of its currency, the Real.

Brazil’s concerns are perhaps justified, since the Brazilian Real has surged to a 2-year high, and is amazingly not worth more than prior to the collapse of the Lehman Brothers and the ignition of the global financial crisis. (If anything, this shows just how far we’ve come in returning to stability). According to Goldman Sachs, the Real is now the most overvalued major currency in the world. This is confirmed by The Economist’s Big Mac Index, which shows that in Purchasing Power Parity (PPP) terms, Brazil is now the third most expensive country in the world, behind only Norway and Switzerland.

It’s not hard to understand why the Real is soaring. Its benchmark Selic rate is 10.75%, with government bonds yielding an even higher 12%. Even after controlling inflation, this is the highest among major currencies. Its economy is booming; GDP is projected at 10% in 2010. As a result, capital flow inflows have returned to pre-credit crisis levels: “Net foreign-exchange inflows totaled $11.14 billion in the September 1-17 period, up from $2.11 billion in the first 10 days of the month, according to data released Tuesday by the country’s central bank.” The inflows have been driven by a $70 Billion stock offering by PetroBras, the (formerly) state-owned oil company. It is a record sum, and over 3 times bigger than the eye-popping $23 Billion the Agricultural Bank of China raised only a few months ago. “If the Petrobras deal had never happened, the real might currently be trading somewhere around 1.75 per dollar,” compared to 1.70 today. With other companies rushing to follow suit with debt and equity offerings, cash will probably continue to pour in.

As I said at the beginning of this post, the Bank of Brazil has several tools up its sleeve. It has already resumed “surprise daily auctions to buy excess dollars in the spot market” (suspended in 2006), in which investors can trade Dollars for Brazilian government debt. It is also proposing reverse currency swaps, which would serve a similar purpose. ” ‘The order is to buy, buy and buy,’ ” said a government source. It has purchased nearly $1 Billion in foreign currency in the month of September alone, and has pledged to deploy its $10 Billion Sovereign investment fund if necessary. Finally, there is talk of raising the tax rate (currently 2%) on all foreign capital inflows, though there is no real timetable for such a move.

Alas, while the government of Brazil is certainly sincere in its intentions to hold down the Real, it lacks the wherewithal. Its $1 Billion intervention in September was dwarfed by the $20+ Billion spent by the Bank of Japan in one day to hold down the Yen. Even controlling for the difference in the size of their respective economies, Brazil has still been thoroughly outspent. Its $10 Billion investment fund pales in comparison to the ~$1 Trillion forex reserves of Japan. In short, Brazil would be wise to avoid full-fledged engagement in currency war.

Besides, the Real strength can better be seen in terms of weakness in the US Dollar and other G4 currencies. In this regard, Brazil’s measly purchases of US Dollars on the spot market probably won’t do much to counter the gradual exodus of cash from safe-havens back into growth currencies. Perhaps, it can take solace in the fact that the Real is so overvalued that it would seem to have no place to go but down.

Wouldn’t life just be a little easier if the EUR/USD, the most important forex pair and bellwether of currency markets, could simply pick a direction and stick to it. It dove during the financial crisis, only to surge during the apparent recovery phase, fell during the sovereign debt crisis, and rose during the paradigm shift, then fell as risk appetite waned, only to rise again in September, en route to a 5-month high.

There are a handful of factors which currently underlie the Euro’s strength, which can all generally be explained by the fact that risk is “on” at the moment, and the markets are moving away from so-called safe haven currencies and back towards growth investments. Of course that could change tomorrow (or even 5 minutes from now!), but at the moment, risk appetite is high and the Euro symbolizes risk. Never mind how ironic it is, that growth in the EU is projected at 1.8% for the year while Rest of World (ROW) GDP will probably top 5%. All that matters is compared to the Dollar (and Yen, Pound, Franc to a lesser extent) the Euro is perceived as the currency of risk.

The Euro’s cause is also helped by the ongoing “currency wars,” which heated up last week with Japan’s entry into the game. Basically, Central Banks around the world are now competing with each other to devalue their currencies. In contrast, the European Central Bank (ECB) has decided to remain on the sidelines (in favor of fiscal austerity), which is forcing the Euro up (or rather all other currencies down). To make matters even worse, “The U.S. Federal Reserve indicated this summer that it may ease monetary policy further… often seen as printing money to pump up the economy.” As a result, “The euro looks set to keep on climbing in a trend that looks increasingly entrenched.”

There are certainly those that argue that the Euro’s recent surge reflects renewed confidence in the Eurozone economy and prospects for resolving the EU debt crisis. After all, most Euro members will reduce their budget deficits in 2010 and auctions of new bonds are once again oversubscribed. On the other hand, interest rates for the PIGS (Portugal, Italy, Greece, and Spain) have risen to multi-year highs, as investors are finally trying to make a serious effort at pricing the possibility of default.

In addition, the credit markets in the EU are barely functioning, and large institutions remain dependent on the ECB’s credit facilities for financing. Finally, it shouldn’t be forgotten that the only reason crisis was due to the massive support (€140 Billion) extended to Greece. When this program expires in less than three years, the fiscal problems of Greece (and the other PIGS) will be exposed once again, and a new (stopgap) solution will need to be proposed.

As every analyst has pointed out, none of the EU’s fiscal problems have been solved. EU members have certainly proven adept at resolving acute crises and the ECB certainly deserves credit for keeping credit markets functioning, but none has proposed a viable solution for repairing of member countries’ fiscal and economic health. Currency devaluation is impossible. Sovereign default is being prevented. That leaves wage cuts and increased productivity as the only two paths to equilibrium. The former could be accomplished through inflation, but the ECB seems reluctant to allow this to happen.

For better or worse, the EU seems to have pushed these problems down the road, and if all goes according to plan, they won’t need to be revisited for 2-3 years. For now, then, the Euro is probably safe, and may even thrive. Short positions in the Euro are being unwound with furious speed and data indicate that there is still plenty of scope for further unwinding. Inflation remains subdued, economic growth is stable, and the ECB so far hasn’t voiced any disapproval of the Euro’s rise. While I promote this bullishness with the caveat that “traders have shown a willingness to smack the euro lower from time to time on the slightest news or rumor of downgrades to euro-zone sovereign or bank ratings,” the general Euro trend is now unquestionably UP.

From monetary policy to quantitative easing to forex intervention, the world’s Central Banks are quite busy at the moment. Even though the worst of the credit crisis has past and the global economy has moved cautiously into recovery mode, there is still work to be done. Unemployment remains stubbornly high, inflation is too low, and asset prices are teetering on the edge of decline. In short, Central Banks will continue to hog the spotlight.

On the monetary policy front, Central Banks have begun to divide into two camps. One camp, consisting of the Federal Reserve Bank, European Central Bank, Bank of England, Bank of Japan, and Swiss National Bank (whose currencies, it should be noted, account for the majority of foreign exchange activity), remains frozen in place. Interest rates in all five countries/regions remain at rock bottom, near 0% in most cases. While the ECB’s benchmark interest rate is seemingly set higher than the others, its actual overnight rate is also close to 0%. Meanwhile, none of these Banks has given any indication that it will hike rates before the end of 2011.

In the other camp are the Banks of Canada, Australia, Brazil, and a handful of other emerging market Central Banks, all of which have cautiously moved to hike rates on the basis of economic recovery. Among industrialized countries, Australia (4.5%) is now at the head of the pack, with New Zealand (3%) in a distant second. Brazil’s benchmark Selic rate, at 10.75%, makes it the world leader among (widely-followed) emerging market countries. It is followed by Russia (7.75%), Turkey (7%), and India (6.1%), among others. The lone exception appears to be China, which maintains artificially low rates to influence the Yuan. [More on that below.]

None of the industrialized Central Banks have yet unwound their quantitative easing programs, unveiled at the peak of the credit crisis. The Fed’s balance sheet currently exceeds $2 Trillion; its asset-purchase program has driven Treasury rates and mortgage rates to record lows. The same goes for the Banks of England and Japan, the latter of which has actually moved to expand its program in a bid to hold down the Yen. Meanwhile, many of the credit lines that the ECB extended to beleaguered banks and other businesses remain outstanding, and have even expanded in recent months.

Central Banks have been especially busy in the currency markets. The Swiss National Bank (SNB) was the first to intervene, and as a result of spending €200 Billion, it managed to hold the Franc below €1.50. As a result of the EU sovereign debt crisis, however, the Franc broke through the peg and his since risen to a record high against the Euro. Unsurprisingly, the SNB has abandoned its forex intervention program. Throughout the past year, the Central Banks of Canada, Brazil, Thailand, Korea have threatened to intervene, but only Brazil has taken action so far, in the form of a levy on all foreign capital inflows. Last week, the Bank of Japan broke its 6-year period of inaction by intervening on behalf of the Yen, which instantly rose 3% on the move. The BOJ has pledge to remain involved, but the extent and duration is not clear.

Finally, the Bank of China allowed the Yuan to appreciate for the first time in two years, but its pace has been carefully controlled, to say the least. In the last few weeks, the Yuan has actually picked up speed, but critics insist that it remains undervalued. In addition, China has contradicted the Yuan’s rise against the Dollar through its purchases of Japanese bonds, which has spurred a rise in the Yen. This is both ironic and counter-productive to global economic recovery: “Since China is growing at 10%, it can afford to undermine exports and boost domestic demand by letting the yuan appreciate more rapidly against the dollar. But China doesn’t want to do that. In fact, although China’s State Administration of Foreign Exchange deregulated the currency market overnight, the measures, which allow some exporters to retain their foreign currency holdings for a year, should boost private demand for dollars, not yuan.”

The efforts listed above have undoubtedly moderated the impacts of the financial crisis and consequent economic downturn. However, the banks have found it impossible to engineer a convincing recovery, and at this point, there probably isn’t much more that they do can do. As a result, many analysts are now pinning their hopes on fiscal policy (despite its equally dubious track record). Perhaps, the title of this post should have been: Keep an Eye on Governments and their Stimulus Plans.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What’s the deal with those stress tests? It sounds like the setup for a Jerry Seinfeld joke, and given the way the tests were viewed by the markets, it might as well have been. According to the EU, the tests were a tremendous success. According to investors, the results were irrelevant at best, and patently misleading at worst.

The stress tests were first proposed last month as a way to gauge the health of the EU banking sector; it was hoped that the results would demonstrate the soundness of the banking system and mollify investors. Since then, momentum continued to build in the markets, as investors engaged in meta-speculation about the potential impact of the stress tests.

In the days leading up to the test, there was a mixture of apprehension and uncertainty. One trader warned: “No one seems to want to hold too much risk heading into the release of the European bank stress tests….A great deal of caution should be exercised…as the results of the stress tests are made public. There is definitely the potential for a huge swing in either direction…as there could be a freight train coming down the tracks.” The Euro traded sideways, capping an impressive 8% rally that began in June.

On Monday, the tests were finally conducted: “EU regulators scrutinized 91 of the bloc’s banks to assess whether they have enough capital to withstand a recession and sovereign-debt crisis, with a Tier 1 capital ratio of 6 percent as a floor. Regulators tested portfolios of sovereign five-year bonds, assuming a loss of 23.1 percent on Greek debt, 12.3 percent on Spanish bonds, 14 percent on Portuguese bonds and 4.7 percent on German state debt.” Officially, only 7 banks failed the tests – 5 in Spain, 1 in Germany, 1 in Greece – with a combined capital shortfall of €3.5 Billion.

When the news was initially released, the Euro sea-sawed – first rising, then falling – and analysts rushed to ascribe sometimes-contradicting sentiments. First, there was “concern,” then came “relief.” From where I was sitting, the markets’ reaction was basically somewhere between a shrug and a yawn. First of all, investors saw the tests for the charade that they essentially were. The only reason that EU regulators were willing to conduct them publicly was because they knew that the results would be positive. As I wrote above, it was intended in advance that the tests would “mollify investors.”

On a related note, the tests were not nearly strict enough: “Analysts were instantly dismissive of the tests, saying the bar was too low. ‘The prospect of an outright sovereign default, which is what has worried markets most, has not even been considered.’ “  Instead of examining the possibility of bonds becoming worthless and irredeemable, the tests only assumed modest losses.” By this standard, argue investors, it’s no wonder that virtually every bank was able to pass.

Ultimately, gauging the success of the stress tests will require waiting few weeks. Unlike currency, stock, and bond markets – which can and did offer instant feedback on the news – it will probably take some time before the impact is fully reflected in the money markets. In other words, while an uptick in the Euro, shares of bank stocks, and sovereign bond prices should all be seen as symbols of confidence, the real test is whether investors will be willing to lend directly to banks, at reasonable rates (proxied by 3-month Euro LIBOR, on display below).

In fact, that test could come quite soon, as the ECB continues to recall the hundreds of Billions of Euros in loans that it made to commercial banks. If LIBOR rates remain steady and the markets remain liquid, then the stress tests can be called a success. If private investors balk and/or the ECB is forced to extend its lending program, however, the tests will be seen in hindsight as a waste of time.

Since my last update in June, the Japanese Yen has continued to creep up. It has risen a solid 5% in the year-to-date against the Dollar, 12% against the Pound, and an earth-shattering 20% against the Euro. It is closing in on a 15-year high of 85 Yen/Dollar, and beyond that, the all-time high of 79. According to the Chicago Mercantile Exchange, “Long positions in the yen stand at $5.4bn. This is the highest level since December 2009 and represents the biggest bet against the dollar versus any currency in the market.”

As to what’s propelling the Yen higher, there is very little mystery. Two words: Safe Haven. “The yen’s attractions lie in its status as a haven from the turmoil that has engulfed financial markets as, first, the eurozone debt crisis unfolded and, then, fears about a double-dip recession have intensified.” To be sure, there are a handful of currencies that are arguably more secure and less risky than the Yen. The problem is that with the exception of the Dollar, none of them can compete with the Yen on the basis of liquidity. In addition, thanks to non-existent inflation in Japan and low interest rates in other countries, there is very little opportunity cost in simply holding Yen and simply taking a wait-and-see approach.

According to some analysts, interest rate differentials will probably remain narrow for the foreseeable future: “Global bond yields will fall, reducing the incentive of yen-based investors to place funds abroad.” In fact, thanks to low interest rate differentials, the Yen is not even the target funding currency for carry traders. Suffice it to say that investors are not bothered by the fact that Japanese monetary policy is extraordinarily accommodative and that Japanese long-term interest rates are the lowest in the world. For those who are concerned about rising interest rate differentials, consider that this probably won’t become a factor until the medium-term.

On the fundamental front, there are a couple of risks for the Yen. First of all, there is the stalled Japanese economic recovery and the possibility that the strong Yen could further erode the competitiveness of Japan’s export sector, the mainstay of its economy. Yen bulls respond to this by noting both that Japan’s economic recovery has already stalled for 25 years and that should the Yen’s rise actually crimp economic growth, the Central Bank would probably intervene. By all accounts, “The government will continue to keep a close eye on the yen.”

A greater concern, perhaps, is Japan’s massive debt. Near $10 Trillion, public debt is already 180% of GDP, and is projected to grow to 200% over the next few years. Total public and private debt, meanwhile, is by far the highest in the world, at 380% of GDP. The Japanese government is planning to implement “austerity measures,” but political stalemate and election pressures will make this difficult to achieve.  All three of the rating agencies have issued stern warnings, and downgrades could soon follow. Here, Yen bulls retort that as unsustainable as this debt might appear, the majority (90%) of it is financed domestically, through the massive pool of savings. The remaining 10% is eagerly soaked up by foreign investors, who view the debt as a more attractive alternative to cash and stocks. [This is the great irony that I alluded to in the title of this post - that more debt is viewed positively as "liquidity" and does nothing to hurt the Yen].

Speaking of which, the Japanese stock market has risen by only 5% this year, and some analysts are predicting that a long bull market is inevitable. Adding to the fervor, Central Banks have begun to build their positions in the Yen, for the first time in 10 years. It seems everyone is excited about the Yen, even economists: “Within the developed economy space, Japan looks relatively good as an economy that’s likely to be growing faster than Europe or America, and it’s generally considered to have low risk of capital flight.” In other words, the consensus is that there is a very low chance of a “Greek-like debt crisis.”

At this point, the Yen can only be toppled by Central Banks: either foreign Central Banks will hike interest rates and make the Yen unattractive in contrast, or the Bank of Japan will intervene directly to prevent it from rising further.

Recently, it struck me: the US does not care about the Dollar. If you look at fiscal and monetary policy, there is actually a remarkable degree of consistency. Both reflect a clear disregard for the conditions that are necessary for a strong currency.

This might seem ridiculous, given the Dollar’s amazing performance of late. It has appreciated healthily against almost all of the world’s major currencies, and is also more valuable on a trade-weighted basis. Bear in mind, however, that this rise is entirely a function of the (perceived) crisis in Europe. It speaks not to any strength in the Dollar, but rather to weakness in other currencies. In fact, as I wrote earlier this week (“US Dollar Paradigm Shift“), as investors have returned their gaze to the fundamentals, the Dollar has suffered.

Without drilling into the nuts and bolts of US fiscal policy, consider that the US budget deficit will exceed an unthinkable $1 Trillion for a second year in a row. The national debt is now growing much faster than GDP, and servicing it is consuming an ever-increasing share of the budget. With concerns looming of a double-dip recession, meanwhile, tax revenues will probably stagnate, even regardless of what happens to spending. In short, US budget deficits are going to continue to be a fact of life for the immediate future.

Monetary Policy is equally disastrous. The Fed is pre-occupied with keeping interest rates low and with promoting an economic recovery. $2 Trillion of newly-minted money is still flowing through the system, and it’s unclear when it will be siphoned out. There are a few inflation hawks on the Fed’s Board of Governors, but they lack the power to effect a short-term change in monetary policy.

The Bank for International Settlements (BIS), G20, and a pair of economists, among others, have all sounded alarm bells, calling such policies foolish and unsustainable. According to the BIS, “Keeping interest rates very low comes at a cost—a cost that is growing with time. Experience teaches us that prolonged periods of unusually low rates cloud assessments of financial risks, induce a search for yield and delay balance-sheet adjustments.”

In short, there is a clear consensus that perennial budget deficits and low rates are wrongheaded at best, and disastrous at worst. From the standpoint of currency markets, what matters in the short-term are interest rates, and what matters in the long-term is inflation. The Dollar is in an unfavorable position on both fronts. Interest rates are currently near 0% – the lowest in the world – and easy monetary policy and high government debt increase the likelihood of inflation in the wrong-term.

In light of this notion, the only logical conclusion is that the Dollar simply plays no role in the formulation of government and Central Bank decision-making. Since the inception of the credit crisis, this was a luxury that could be afforded, as safe-haven capital poured into the US. If/when the crisis abates, this capital will probably depart, as investors are forced to consider the fundamentals.

On a trade-weighted basis, the Canadian Dollar (aka Loonie) has appreciated nearly 10% in 2010. At the same time, it has fallen 8% against the Dollar since the beginning of May. This contradiction is reflected in an explosion in volatility: “CAD has been very volatile – the average intraday spread between the high and low in CAD over the last 21-years has been 83 points; over the last month it has been 182 points.” How can we make sense of this uncertainty, and which trend is ultimately more representative?

On the one hand, the Loonie continues to be thought of as a commodity currency whose rise and fall is closely linked to fluctuations in the prices of certain raw materials. “It’s not just about oil any more, but also natural gas – whose price has carved out a bottom – and precious metals, which command a 13-per-cent share of the TSX’s market cap versus less than 1 per cent for the S&P 500,” observed one analyst. From this standpoint, it’s perhaps not surprising that a 7.2% drop in the Raw Materials Index was matched by a proportional drop in the value of the Loonie.

On the other hand, the Loonie is being punished by the Eurozone debt crisis and the consequent flight to safe haven currencies: “The Canadian dollar is following the risk aversion tones of the market.” While the Loonie might have otherwise been “been closer to parity” then, it’s understandable that the so-called “panic trade” is holding it down.

In light of the Eurozone debt crisis, however, one might have predicted that commodity currencies would rally, since they are perceived as being backed by something more tangible than government fiat. In fact, some analysts believe that the comparatively modest decline in the Loonie implies that this is indeed the case: “It was fascinating to see the Canadian dollar only correct down to 92 cents during this most recent round of global financial turbulence and flight-to-safety. That is a far cry from the correction down to 78 cents following the Lehman aftershock, not to mention the move down to 62 cents after the tech wreck a decade ago.”

The same analyst pointed out that the notion of the Canadian Dollar as a safe-haven currency is further justified by Canada’s strong fiscal condition. It is trimming its spending, cutting taxes, and may even reduce its national debt. Meanwhile, it’s financial system remains robust, as evidenced by the fact that none of its banks have required government bailouts. Thus, Canadian sovereign debt has continued to appreciate in spite of the crisis across the Atlantic. In short, “The federal government actually deserves the triple-A credit rating that it receives on its debt.”

Going forward then, the near-term performance of the Loonie will depend both on the EU sovereign debt crisis and commodities prices, which in turn are high sensitive to (perceptions of) the global economy. In this latter aspect, there is tremendous uncertainty. The Canadian economy did grow at 6% last quarter. However, “The fear is that weaker U.S. data is posing a risk to the Canadian economy. And the G-20 is really focused on fiscal restraint as opposed to supporting growth. That probably isn’t good for the growth currencies.”

Furthermore, there are implications for the Bank of Canada, which has already embarked on a tightening of monetary policy. It raised its benchmark interest rate – becoming the first industrialized economy Central Bank to do so – to .5% in June, and there is a 45% chance that it will do so again in July. The futures markets are currently pricing in a benchmark rate of 1.25% by year end. Ultimately, “The extent and timing of any additional withdrawal of monetary stimulus would depend on how the outlook for economic activity and inflation evolves.”

For now, interest rate hikes are largely beside the point as investors remain firmly focused on the EU fiscal crisis: “People are taking risk off heading into the summer, to reassess,” summarized one trader. A resolution of the crisis, would surely send the Loonie back towards parity. In the interim, Canada’s strong fundamentals will ensure that it won’t fall much further, poised to strike when the time comes.

It was only last week that I mused about “Further Delays in RMB Revaluation.” Lo and behold, over the weekend, the Central Bank finally budged, by pledging to the members of the G20 that it would ” ‘proceed further with reform‘ of the exchange rate and ‘enhance’ flexibility.” Upon reading this, I suppose I should have felt stupid.

Still, I wondered whether the move was aimed as a political sop designed to appease Western countries, rather than a meaningful change in China’s forex policy. My suspicions were confirmed on Monday, when the markets opened, and the RMB jumped by a pathetic .4%. All of those who had been hoping for an expecting an instant revaluation a la the 5% jump in 2005 were sadly disappointed.

Most commentators shared my cynicism about the move. According to Goldman Sachs Group Chief Global Economist Jim O’Neill, ” ‘It’s pretty astute timing. The timing of it is clearly aimed at the G-20 meeting, which indirectly links to the whole renewed thrust in Congress with protectionist steps against China.’ ” If this was in fact China’s intention, it backfired, since it only succeeding only in bringing increased attention to the still-undervalued Yuan. Senator Sherrod Brown called the appreciation ” ‘a drop in a huge bucket….We’ve seen China take actions like this before when the spotlight is on, and then revert back to old tricks.” Thus, he and Senator Charles Schumer have announced that they will move forward with a bill to punish China, unless the RMB is allowed to significantly appreciate.

By the Central Bank of China’s own admission, this is unlikely. Instead, it will continue to “keep the renminbi exchange rate at a reasonable and balanced level of basic stability.” In other words, the RMB is still pegged squarely to the US Dollar. It is neither freely floating nor is it pegged to a basket of currencies (in which case it could conceivably appreciate faster against the Dollar, due to the weak Euro). It is technically allowed to rise and fall on a daily basis within a .5% ban, but even this is controlled tightly by the Central Bank, via the so-called Central Parity Rate. If the rate fluctuates too much, state-owned companies often intervene in the markets at the behest of the Central Bank. Legitimate market participants are heavily constrained by a rule that requires them to square all of their positions at the end of every trading session, such that making long-term bets on the RMB’s appreciation would be impossible.

Not that it matters. In the US, where it is legal to make long-term bets on the RMB (via futures contracts), investors are still only projecting a 1.8% appreciation (2.2% relative to the RMB’s pre-revaluation level) over the next year, and a 2.9% appreciation by the end of 2011. In the end, there just isn’t a lot of confidence that China will voluntarily act in a way that is contrary to its own short-term economic interests.

To be sure, there is a possibility that the RMB will be allowed to steadily appreciate, in which case there would be real implications for other financial markets. If the past is any consideration, however, the RMB will rise only modestly against the Dollar, and even more modestly on a trade-weighted basis. Its economy will remain overheated and imbalanced, and if it was headed towards collapse prior to this latest change, it certainly still is.

The Swiss National Bank (SNB) has apparently admitted (temporary) defeat in its battle to hold down the value of the Franc. ” ‘The SNB has reached its limits and if the market wants to see a franc at 1.35 versus the euro, they won’t be able to stop it.’ ” The markets have won. The SNB has lost.

Still, the SNB should be applauded for its efforts. As you can see from the chart above, it managed to keep the Franc from rising above €1.50 (its so-called line in the sand) for the better part of 2009. Furthermore, by most accounts, it managed to slow the Franc’s unavoidable descent against the Euro in 2010. While the Dollar has appreciated more than 15% against the Euro, the Franc has a risen by a more modest 10%. ” ‘Without that €90 billion [intervention], it’s fair to say that the euro would be closer to $1.10,’ ” argued one analyst. In fact, as recently as May 18, the SNB manifested its power in the form of 1-day, 2% decline in the Franc, its sharpest fall in more than a year.

Overall, the SNB has spent more than $200 Billion over the last 12 months, including $73 Billion in the month of May alone. ” ‘To put the figures in perspective, there have been only two months when China, the world’s largest holder of forex reserves with $2,249bn in assets, saw its reserves increase more.’ ” The SNB now claims the world’s 7th largest foreign exchange reserves, ahead of the perennial interveners of Brazil in Hong Kong, the latter of whose currency is pegged against the Dollar.

While the SNB can take some credit for halting the decline in the Franc, it was ultimately done in by factors beyond its control, namely the Eurozone sovereign debt crisis and consequent surge in risk aversion. At this point the forces that the SNB is battling against are too large to be contained: “We’re talking about a massive euro crisis, so no single central bank can prop it up on its own,” summarized one trader. As a result, the Franc is now rising to a fresh record high against the Euro nearly every trading session.

Still, the SNB remains committed to rhetorical intervention. “The central bank has a ‘clear aim‘ to maintain price stability and this is what guides its policy actions, SNB President Philipp Hildebrand said…The bank will act in a ‘decisive manner if needed.’ ” That means that if economic growth slows and/or deflation sets it, it may have to restart the printing presses. Given that its economy is slated to grow at a solid 1.5% this year, unemployment is a meager 3.8%, and the threat of inflation has largely abated. On the other hand, the prospect of a drawn-out crisis in the EU means the Franc will probably continue to appreciate – without help from the Central Bank: ” ‘The SNB may continue to intervene in the currency markets until 2020,’ ” declared the head of forex research for UBS.

The implications for currency markets are interesting. Not only has the SNB prevented the Euro from falling too fast against the Franc, but it may also have prevented it from falling too quickly against other currencies. ” ‘To suggest that the SNB has been the savior of the euro is too much. But one could imagine that if the euro starts to decline again, the market may blame the fact that the SNB isn’t buying,’ ” said a currency strategist from Standard Bank.

This episode is also a testament to the limits of intervention. It has always been clear (to this blogger, at least) that intervention is futile in the long-term. The best that a Central Bank can hope for is to stall a particular outcome long enough in order to achieve a certain short-term policy aim. When enough momentum coalesces behind a (floating) currency, there is nothing that a Central Bank can do to stop it from moving to the rate that investors collectively deem it to be worth.

The South Korean Won has been one of the biggest losers from the EU sovereign debt crisis. After a stellar 2009, the Won is off to a shaky start in 2010, and has lost 12% of its value in the last month alone. According to analysts, The won is “most sensitive to risk aversion” of any currency in Asia – or even the world. Thus, when the President of Hungary likened his country’s fiscal situation to that of Greece and inadvertently ignited fears that the crisis was spreading, the Korean Won immediately fell by 5% – the largest decline in 17 months.

Given all of the economies/currencies from which to choose, it seems bizarre that investors would gang up on the Won. That is, until you consider that South Korea’s fiscal situation is somewhat unique and that funding crises tend to hit the country especially hard. Summarized one analyst: “We are concerned that the negative market view of events in Europe will not dissipate and that the longer the stress continues, the more concerns will arise that the peripheral funding crisis could segue into a more extended funding crisis and into lower growth expectations.”

To elaborate, South Korea’s short-term foreign currency debt is extremely high (60% of foreign exchange reserves). That’s primarily due to Korean exporters’ hedging activities, which for risk management purposes, need to be offset by short-term borrowing by banks in the money market. Since this debt needs to be rolled over frequently, South Korea is especially vulnerable to liquidity crunches. In fact, the Won has been called a “VIX currency,” since it tends to fall when volatility (proxied by the VIX index) rises. Hence, the Won lost 50% of its value during the peak of the credit crisis, and has already declined 10% this time around.

The Central Bank is doing its part to relieve the liquidity shortage and stem the Won’s decline. It has already placed modest limits on speculative derivative transactions with the goal of limiting capital flight. It is pressing to renew currency swaps with the Fed and the Bank of Japan in order to increase the supply of alternative currency. In addition, it has taken to intervening directly in currency markets by selling Billions of Dollars on the spot market. Explaining the first market intervention in more than a year, the Central Bank declared, “The dollar’s surge against the won today was overdone. The authorities will try to prevent one-way currency moves.”

There are also a handful of market analysts who attribute the Won’s fall to the ongoing conflict with North Korea. In response to the sinking of a warship in March, South Korea has responded by imposing trade sanctions on North Korea, which in turn has responded with threats of “all-out war.” From a forex standpoint, “The largest concern is that the cutting off of economic links raises the risk of a sudden regime collapse, resulting in the South facing a huge influx of refugees. This would have a significant — and possibly prolonged — impact on the Korean won.”

How should one proceed? If indeed you believe that the Won is being harmed by the prospect of conflict with North Korea, you might be inclined to agree with the notion that, “The recent sell-off in the won has been overdone and should correct, assuming that the North-South tensions will ease in the months ahead.” In fact, if war is avoided, the current bear market could be an excellent buying opportunity, and the Won could still be on track to rise to 1,100 USD/KRW by year-end, conforming to analysts’ median expectations.

On the other hand, if you believe that the Won’s woes are largely attributable to the EU fiscal crisis, there is very little reason to hold the Won, since that crisis will probably only get worse before it gets better: “The Korean market was precariously positioned, with high multiples, above-trend earnings, heavy positioning towards risk and ominous technicals suggesting little sponsorship for strength.” In this case, the Won could easily fall to 1,300 – or worse – before the year is out.

In any event, South Korea will host a meeting of the G20 this week, which should yield more clarity into what the rest of 2010 has in store for the Won.

The Euro has now declined for six consecutive months against the Dollar. It is down 25% from its 2008 high and 15% in the year-to-date. It declined 8% in the month of May alone. En route to a four year low, the Euro also fell below the 50% retracement level ($1.21) of its rally from 2000-2008. It’s now too clear where the Euro is headed: parity.

That’s right. Parity. We’re not talking about the Canadian Dollar or even the Australian Dollar. We’re talking about the Euro, which only yesterday was trading at a lofty $1.60 against the Dollar. According to CLSA Asia Pacific Markets, “The euro will sooner or later go to parity with the U.S. dollar.” Meanwhile, “The research firm Capital Economics predicts that the euro will reach par with the U.S. dollar by the end of next year.” There wasn’t even a perfunctory attempt by either firm to justify the prediction. Given the way that the Euro has been trading, it probably wasn’t necessary.

Since the last time I reported on the Euro, the bad news has continued to pour in. Spain officially lost its AAA credit rating, and concerns are mounting that the crisis is spreading to Hungary (not even on the radar screen last week) and Italy: “While Italy may not be as structurally vulnerable as Greece or Portugal, the relative underperformance of Italian credit default swaps this month suggests that investor concerns may be rotating away from Greece.” As if it wasn’t bad enough that investors had lost confidence, now banks won’t even lend to each other.

The $1 Trillion bailout, meanwhile, has done nothing to assuage the markets. “The markets are trading in real time, while the politicians are moving in bureaucratic time. We’re promised something maybe in October — that’s a hell of a long time in the financial markets’ eyes,” underscored one economist. Germany appears to be isolating itself from the rest of the EU, thanks to its ban on the short-selling of certain financial movements- a move that was not matched by other member states. “Concerns are also growing because Belgium is unlikely to have a government in place when it takes over the EU presidency on July 1 and markets are worried the EU’s institutions and leaders are ill-equipped to handle a crisis of this magnitude.”

The main issue, which critics of the bailout have been quick to point out all along, is that the fiscal problems that precipitated the crisis are still extant. Spain, for example, currently has the third largest budget deficit in the EU, and yet, it is struggling to make meaningful cuts and pass the necessary “austerity measures.” Germany has tried to unilaterally amend the EU treaty in order to force member states to balance their budgets, but to no avail. If a full-blown crisis is to be avoided, significant structural reforms will have to implemented, and soon.

For many, that the crisis will not be resolved is a foregone conclusion, and they have instead embraced the possibility of ECB intervention to stem the Euro’s decline. The last time the ECB intervened was in 2000, shortly after the Euro was introduced and when it was trading around 87 cents to the Dollar. Experts are divided over whether intervention is likely or even possible. Some have thrown out $1.10 or $1.00 has hypothetical levels at which the intervention would be likely, but the fact of the matter is, no one knows. Any intervention would necessarily involve the Fed and the other important Central Banks of the world. Don’t forget that when the Euro collapsed at the onset of the credit crisis, the Fed quickly underwrote a series of swaps to the ECB, and it could prove to be a willing participant this time around.

The ECB is naturally being coy, with President Jeane-Claud Trichet declaring: “Let us be clear, it is not the euro that is in danger.” Its monetary policy is still extremely accommodative, via low interest rates and a form of quantitative easing. This makes it favorable for investors to bet against the Euro, and is starting to earn the ECB the ire of EU politicians and economic policymakers. Given that the Euro’s decline has become self-fulfilling, pressure on the ECB will continue to mount, until the Euro reaches parity, and/or it has no choice but to intervene to prevent the common currency (and its raison d’etre!) from collapsing entirely.

Even before the sovereign debt crisis in Europe damped confidence in the world’s second most important reserve currency, the Chinese Yuan was on the cusp of being accepted as a global reserve currency.

We’re all familiar with the arguments attacking the Yuan in this context: its currency is pegged, its capital controls are rigid, and its capital markets are shallow and illiquid. Say what you want about the world’s major currencies (volatile, debt-ridden, etc.), but at least none of these factors applies, goes this line of thinking. With the Euro’s future up in the air, however, a potential hole has been created in Central Banks’ respective forex reserves. As replacement(s) for the Euro are sought, such long-held assumptions are being challenged.

The Chinese Yuan is attractive for a number of reasons. First, investors and Central Banks want exposure to China’s economy; its average annual growth rate of 10% over the last 30 years is far-and-away the highest in the world. “China’s economic output will be more than $5 trillion, or around 9% of the world’s economy, according to the International Monetary Fund.” Second, the fact that the RMB is fixed is in some ways a perk: the wild fluctuations that most currencies witnessed as a result of the credit crisis has made some wonder if market-determined exchange rates aren’t overrated. Finally, the widespread consensus is that the RMB will appreciate anyway, so holding it seems like a safe bet.

Therefore, “Central banks or sovereign wealth funds from Malaysia, Norway and Singapore have received special quotas from the Chinese government to allow them to gain a bit of exposure to China’s currency. The bet is that holding yuan-denominated assets is an important feature of a diversified national reserve.” In addition, China has signed Yuan-denominated swap agreements with a handful of its most important trade partners, totaling $100 Billion over the last year.

Still, these are small-scale agreements, and Central Banks are really just testing the waters. According to a recent study by the Reserve Bank of India (RBI), “The Chinese yuan is ‘far from ready’ to gain reserve currency status. Rather, it said China’s yuan was likely first to become a regional currency as trade links with its neighbours expand.” The main issue is not one of stability, but rather of supply. Simply, there are not enough liquid, attractive investments, denominated in RMB. China’s stock and bond markets are filled with unreliable companies, whose primary loyalty is to the State, rather than to investors. Buying Chinese government bonds seems like a safe option, but given, that China finances most of its spending with cash, such bonds are not widely available.

For now, the Chinese Yuan will remain most attractive (from the standpoint of a reserve currency) to regional trade partners, because such countries have a genuine use for RMB. Investors seem to understand this idea, and are using the currencies of such countries to bet indirectly on the RMB. According to one analyst, “On days when trading is especially volatile, the Singapore dollar moves in tandem with the yuan bets. The Malaysian ringgit, Taiwanese dollar and Korean won are also high on the list of currencies affected by the yuan.” In short, the RBI’s assessment of the Yuan seems pretty apt. It will probably be at least a decade before holding the Yuan is as viable (not to say attractive) as the Japanese Yen. For investors who don’t want to wait that long, there are a handful of other regional currencies that they can hold in the interim.

In my last post, I reported that the markets were incredibly bearish on the Euro, due to concerns that the Greek debt crisis could neither be mitigated nor contained. By following up on this report with another incantation of Euro bearishness, I certainly run the risk of belaboring the point. Still, the fact that since then, a $1 Trillion bailout was announced means that at the very least, I need to offer an update!

Anyway, in case you have been living in a cave, the EU finally put its money where its mouth was by forming a €750 Billion Special Purpose Vehicle (SPV) to address the fiscal problems of currently-ailing and potentially-ailing economies. The brunt of financing the SPV will fall on individual Eurozone countries, though the European Commission and the International Monetary Fund (IMF) will also make sizable contributions. In addition, the European Central Bank (ECB) has agreed to purchase an indeterminate amount of government and corporate bonds, while other Central Banks will use currency swaps to ease pressure on the Euro.

The reaction to the news was quite positive, with the Euro reversing its 6-month slump and rallying 2.7% against the Dollar. Equity shares surged on the news: “A a 50-stock mix of European stocks jumped 10.4 percent, Spain’s market soared 14.4 percent, France’s rose 9.7 percent and Germany’s gained 5.3 percent.” Sovereign debt and credit default swap prices also rose as investors moved to price in a decreased likelihood of default.

The celebration was short-lived, and by Tuesday (yesterday), the Euro had already returned to its pre-bailout level against the Dollar. In hindsight, it looks like the rally was the result of a classic short-squeeze. On Sunday, the Financial Times reported that “Positioning data from the Chicago Mercantile Exchange, often used as a proxy for hedge fund activity, showed speculato,rs increased their short positions in the euro to a record 103,400 contracts, or $16.8bn in the week ending May 4.” After the most exposed short positions were covered, however, the rally quickly came to an end: “By the time markets opened in the United States, and American hedge funds entered the market, the euro’s rally began to flag.”

Indeed, it’s hard to find anyone that has anything positive to say about the bailout, even among the bureaucrats and politicians that contrived it. Here’s a smattering of soundbites:

• “Angela Merkel, the Iron Chancellor, has rolled over and we are being taken to the cleaners.”
• “We’ve just kind of kicked the can down the road. Sovereign debt, like all debt, ultimately has to be repaid.”
• “The bailout is ‘another nail in the coffin…This means that they’ve given up on the euro.”
• “Lending more money to already overborrowed governments does not solve their problems.”
• “It was crucial to stop the panic, and this package has done it, but it doesn’t solve the longer-term problems which are slowly undermining the value of the euro.”
• “It’s pretty disappointing that [the] euro only rallied a couple of cents on the back of a trillion dollars.”

There are a few specific concerns about the bailout. First of all, it’s still unclear how it will be paid for and how it will be implemented. How will specific loans be issued, and what will be the accompanying terms? Second, it does nothing to address the underlying fiscal problems that precipitated the crisis, and may in fact exacerbate them since countries have less of an incentive to rein in spending. As one analyst summarized, “Bailing out economies creates moral hazard. Other countries may continue to skirt the kinds of actions that would lower their budget deficits and debt loads…because they too can expect to be rescued.” Finally, the bailout does nothing to mitigate credit risk for private lenders; it merely transfers and expands it, since money that would have been lent to Greece (and other problem countries) anyway, will still be lent to them, after first being funneled through the SPV. In short, “Once market participants look at the actual details of this plan, they are not going to want to buy the euro either.”

As everyone has been quick to point out, the bailout probably makes a (partial) dissolution of the Euro even more likely, because it is tantamount to deflating the currency. As one economist opined, “The euro zone does not look viable in its current form. The basic premise…to unify monetary policy….while keeping fiscal policy completely separate…has completely broken down.” The only solution which will leave the Euro intact is for the weakest members to leave, and for a solid core of economically and fiscally sound economies to remain behind.

To be fair, the EU has certainly bought itself some time. Given that the amount of money pledged to fight the debt crisis well exceeds Greece’s public debt, it won’t be Greece that brings down the Euro. If/when the debt problems of Spain, Portugal, and Ireland become insoluble, however, the futility of the bailout will become abundantly clear.

The Canadian Dollar’s performance of late has been eerily redolent of its sudden rise in 2007, when propelled by nothing more than sheer momentum, it rose 20% against the Dollar and breached the parity mark (1:1) en route to a 30-year high. [Of course, we all remember what happened next: the credit crisis struck, and the Loonie plummeted even faster than it had risen].

Last week, the Canadian Dollar breached parity again, and after a brief retreat, it touched parity again today. On the one hand, this latest rise was simply a matter of making up for the ground lost in 2008, when risk-averse investors shifted capital en masse to the US. On the other hand, Canadian fundamentals are fairly strong, and that the Loonie is once again at parity is deservedly so.

Last week’s jobs report was pretty solid, but the Canadian unemployment rate is still high, at 8.2%, mirroring the “jobless recovery” phenomenon in the US. According to the Bank of Canada’s own estimates, GDP growth is projected at a healthy 3.7% for 2010, thanks to a strong recovery in oil and commodity prices. As a result, the Bank of Canada has finally given the indication that it is ready to hike interest rates, perhaps as soon as July.  After concluding its monthly meeting yesterday, it noted, “With recent improvements in the economic outlook, the need for such extraordinary policy is now passing, and it is appropriate to begin to lessen the degree of monetary stimulus.”

On the other hand, one has to wonder how long the momentum in the Canadian Dollar can continue. While Canada’s economic recovery has indeed been strong, it is no more impressive than the recovery in the US. (In fact, it should be noted that the two economies remain deeply intertwined). In addition, the (Canadian) economy is already expected to slow down slightly in 2011 (3.1%), and slow further in 2012 (1.7%), which makes me wonder whether the Bank of Canada will have to tighten slightly in order to achieve its inflation objectives. Moreover, while the BOC will probably hike rates slightly before the Fed, the arc of monetary policy followed by the two Central Banks will probably be pretty similar for the next few years, regardless of what happens.  This means that interest rate differentials between the two economies should remain pretty close to the current level (near 0%), and won’t expand enough to make a CAD/USD carry trading strategy viable.

It seems the futures markets concur, as the Canadian Dollar is projected to hover around parity with the USD for the bulk of the next 12 months. Granted, futures prices have pretty closely mirrored the Canadian Dollar’s performance in the spot market, but the point is that investors seem to expect the CAD/USD exchange rate to settle down for a while.

Remarked one analyst, “The Canadian dollar parity party is in full swing, however further Canadian gains will be at a much slower pace as the existing long Canadian positions get trimmed on profit taking in the absence of new bullish Canadian catalysts.” Incidentally, this is exactly what the Bank of Canada wants, and spent the better part of 2009 trying to convey to forex markets. If the Loonie were to rise further, it could threaten the economic recovery, and at the very least, the BOC would proba1bly hold off on hiking rates.

In the end, 1:1 does seem like a reasonable exchange rate. I haven’t seen any economic models that argue one way or the other, but it certainly makes sense from the standpoint of convenience and market psychology. Barring any unforeseen developments, I don’t see it fluctuating very much in the short-term, one way or the other.

One of the main themes (even if not always overt) of my posts recently has been the revival of the carry trade, if not the already extant revival than at least the imminent one. In this context, there is no better candidate than the Brazilian Real.

After a stellar 2009, the Brazilian Real opened 2010 in much the same way that most emerging market currencies did: down. In the month of January, alone, it fell almost 10% against the Dollar, as fears of a widespread sovereign debt crisis took hold in currency markets. Its modest recovery since then, is not so much due to a decreased likelihood of such a debt crisis, but rather to a shift in the markets’ perspective away from long-term fiscal problems and back towards short-term economic and monetary conditions.

It is here where Brazil (and the Real) shines. As one analyst summarized, “The Brazilian economy has been transformed over the past few years. The boom-and-bust and hyperinflation of previous decades has been replaced by steady growth. The country was one of the last major economies into recession, but one of the first out.” 2009 Q4 GDP came in at 4.3% on a year-over-year basis, and is projected at 6% for 2010. Moreover, its economy is very well-balanced, and consumer debt levels are relatively low. Unlike in China, for example, infrastructure investment in Brazil still has plenty of room to grow, without crowding out private investment. This is important, given that the 2014 World Cup and 2016 Olympics are right around the corner.

After rebounding from the lows of the 1999 currency crisis, meanwhile, the Brazilian stock market has had an incredible decade, returning an average of 20% annually. For the sake of comparison, consider that emerging markets have averaged 10%, and all stock markets have averaged only .2%. It doesn’t hurt that Brazil just discovered a huge (the fifth largest in the world) coastal oil reserve.

In fact, it might just be the latter that currency traders are most excited about: “Thus far this year, BRL is 68% correlated with crude oil prices…Last year the correlation was 53% and in 2008 the correlation was just shy of 32%.” This is the highest among any currency, even those that derive a much larger portion of GDP from oil exports, such as Canada and Norway. While there are almost certainly lurking variables in this correlation, a continued rise in the price of oil can’t hurt the Real.

Where does the carry trade fit into this? Look no further then Brazil’s benchmark interest rate of 8.5%. Impossibly, this represents a record low, despite the fact that this is nearly 8.5% higher than the current Federal Funds Rate. And the Brazilian rate is only set to rise. At the last meeting of the Bank of Brazil, 3 out of 8 Board members voted to hike the Selic rate by 50 basis points. The main opposition came from the Bank’s President, Henrique Meirelles, who steered a dovish course for political reasons.

Since then, inflation has continued to creep up and Mr. Meirelles has firmly renounced his political ambitions, and the stage is now set for a 75 basis point hike at the next meeting, to be held on April 28. Most analysts are projecting an “increase of between 200 and 300 basis points through mid-2011, [and] some investors are pricing about 450 basis points of hikes in the same period.”

It’s hard to predict if/when the Fed will follow suit, but most certainly won’t be to the same extent. As long as Brazilian interest rates can keep up with inflation, then, it looks like the Real will end 2010 in much the same fashion as 2009.

The Japanese yen has fallen 5% against the Dollar over the last month, and 10% since touching a record high in November. Since this certainly isn’t explainable in the context of the EU debt crisis, what’s going on?!

The primary factor behind the Yen’s decline appears to be seasonal, given the “end of the Japanese fiscal year on March 31, a time when Japanese corporations stop their annual repatriation of foreign profits by converting them into yen, which had kept demand for the currency high.” Analysts add that “A new fiscal year also is a chance for Japanese investors to reset strategies for sending capital abroad and for Japanese companies to set hedging bets for the coming year.” In short, this trend is short-term, and will likely abate in the coming weeks.

Beyond this, it’s difficult to explain the Yen’s decline in terms of financial and economic factors. Japans economy is still lackluster, though its stock market is performing well. I have blogged recently about Japan’s budget deficits and soaring national debt, but given that this debt is financed domestically, fluctuations in the risk of Japanese sovereign default have very little impact on the exchange rate. It’s possible that an increase in risk appetite and consequent revival in the carry trade is behind the Yen’s weakness, but given that US interest rates remain just as low, it makes little sense that the Yen should be falling so precipitously against the Dollar.

Rather, any full explanation must involve the the government of Japan, which appears to have grown increasingly uncomfortable with the persistent strength in the Japanese Yen. Previously, the government (through the Finance Minister) had vehemently denounced the possibility of, intervention on behalf of the Yen and that exchange rates should be determined by market forces, etc. After backtracking, that Minister was replaced (ostensibly for health reasons), and leaders are no longer mincing their words. Japanese Prime Minister Yukio Hatoyama recently declared, “the yen’s strength is out of step with the country’s fragile economic recovery, urging the government to take ‘firm steps’ to counter the growth-limiting effects of a strong currency.”

Even though the Japanese economy grew by a healthy 3.8% in the fourth quarter of 2009, there remain concerns of contraction and deflation. Many experts agree that the Yen is overvalued, which means that exports are less than what they could be. Analysts love to point out that Japan’s economy is so sensitive to changes in exchange rates, that a fall of one “unit” (100 pips) in the Japanese Yen would be enough to cause some companies to swing from profit to loss. Simply, there is too much at stake for the Japanese economy (and the incumbent Japanese government) to simply let the Yen be.

As a result, many analysts believe that intervention is now inevitable, unless the Yen continues to rise. According to Morgan Stanley, “The probability Japan will sell the yen has climbed to 47 percent, the highest since 2004…based on a company model that uses indicators such as market positioning and changes in momentum.” Other analysts believe that the markets will instead preemptively push down the Yen, which would achieve the same result as intervention: “Brown Brothers Harriman analyst Marc Chandler figures if the dollar breaks above 94 yen, because of the way investors place currency bets, the greenback could more easily extend its run as high as 96 or 98 yen.”

For now, the Central Bank of Japan will attempt to use monetary policy to coax down the Yen, perhaps through a combination of liquidity programs and money-printing, but there are a handful of important meeting coming up, during which time it could conceivably decide to join the ranks of a handful of other Central Banks which have already moved to depress their currencies. Let the Beggar Thy Neighbor Currency Devaluation begin.

Analysts and Fed-watchers have been speculating for almost half a year about the possibility of a Federal Funds Rate (FFR) hike. With each prognostication of a rate hike comes a flurry of market activity, followed by an invariable ebb, as investors accept that the Fed will hold the FFR at 0% until at least its next meeting.
Many traders (forex and other) look to interest rate futures for guidance as to when the Fed will ultimately hike. If you “believe” that futures prices are an accurate predictor, then there is currently a 68% chance that the FFR will rise by 25 basis points at the Fed’s December meeting. Until then, markets are pricing in a very low probability of any rate hikes. Besides, there is very little reason to put any stock in interest rate futures more than a few months away, because uncertainty is high and volume is low. Think about it: if you had looked at interest rate futures in the summer of 2008 (right before the onset of the credit crisis), you would have been anticipating a continued tightening of monetary policy, rather than the torrential loosening that followed the collapse of Lehman Brothers.

In fact, “Researchers at the Federal Reserve Bank of Cleveland said, in 2006, the fed funds futures market isn’t terribly good at predicting actual rate moves more than a few months into the future, even when the Fed is actively adjusting its target.” That being the case, there really isn’t any point in scrutinizing futures contracts that mature after May 2010. With regard to contracts that mature during the next two months, well, you don’t need to monitor futures prices to know that there is very little likelihood that the Fed will hike rates any time soon.

But don’t take my word for it. What do members of the Fed’s Board of Governors have to say about the matter? In his semi-annual testimony before the House of Representatives last week, Chairman Ben Bernanke said that ” ‘the economy continues to require the support of accommodative monetary policies.’ And in response to questions, he reaffirmed that the high level of unemployment and low rate of inflation will continue to justify very low rates ‘for an extended period.’ ”

Janet Yellen, President of the San Francisco Fed, has also insisted that “the U.S. economy still needs ‘extraordinarily low’ rates.” That “Yellen is the Fed’s extended-period language personified” is worth noting, since she is reputed to be President Obama’s pick to serve as vice-Chairman of the Fed. If it isn’t enough that Bernanke is a monetary Dove in the extreme, now he may be joined by Yellen, who will certainly echo his belief in the need for low rates.

Without a doing a further role call of the Fed’s power players, suffice it to say that low rates are in the cards for the near future. You’re probably wondering: Who cares?! With so much else to focus on in currency markets these days (namely the still-evolving EU fiscal crisis), is it really worthwhile to pay close attention to the Fed? The answer is Yes. While long-term interest rates (i.e. those that are most impacted by sovereign debt concerns) weigh heavily on all asset prices, currencies are driven largely by short-term interest rate differentials.

The related phenomena of the Carry Trade, Fisher Effect, Purchasing Power Parity, etc. are all based on short-term interest rates. If the Fed leaves rates low for an extended period as it promises, and/or other Central Banks (Australia, Canada, Brazil) nudge their respective rates higher, it probably won’t bode well for the Dollar. It helps that the Dollar is still ahead of the curve compared to the other majors (EU, UK, Japan) both monetarily and fiscally, which means that the Dollar should fare okay against their currencies. When you put the Dollar head-to-head against some of the smaller currencies, its position is much less favorable, due in no small part to the Fed.

It’s still anyone’s guess as to if and when China will allow the Yuan (RMB) to continue appreciating. You can see from the chart below – which shows the trading history for the RMB/USD December 2010 futures contract – that expectations of revaluation have eroded steadily since December 2009. At that time, it was projected that that Yuan would finish 2009 at 6.57 RMB/USD, 4% higher than the current level. Fast forward to the present, and investors now only expect a modest 2% appreciation rise on the year.

What’s behind the change in expectations? The answer is a combination of economics and politics. On the economic side, China’s trade surplus is much smaller than in recent years, as import growth outpaces export growth. “Double-digit annual growth in exports is all but assured in coming months due to a low base of comparison in early 2009, but…sequential growth momentum went into reverse in January, with exports down 16 percent from December.” Moreover, while GDP growth appears strong, it appears tenuously connected to exports and fixed-asset investment. In addition, if the Central Bank of China raises interest rates to counter property speculation, it will have even less room to maneuver in its forex policy if it wishes to maintain high GDP growth. In terms of politics, the CCP doesn’t want to lose a crucial bargaining chip in international relations, and it also doesn’t want to mitigate the threat to its political legitimacy posed by a prolonged economic slowdown.

On the other hand, China still desires to turn the Yuan into a global reserve currency, again both for economic and political reasons. In order to accomplish such a feat, one of the prerequisites would be dual convertibility. Financial institutions and foreign Central Banks are still extremely reluctant to hold RMB currency since it’s difficult to convert into other currencies. “Citing data from the Bank of International Settlements (BIS), it [Citigroup] said the renminbi’s share in the global foreign-exchange market turnovers was only 0.25 percent in 2007, ranked 20th in the world and fifth among Asian emerging-market currencies.” This is pretty incredible considering that China’s economy is the world’s third largest, and will only change when the exchange rate regime is loosened.

While some analysts predict that the Yuan will continue rising as soon as next month – and at least by a slight margin for 2010 – the modest pace of appreciation will ensure that China’s foreign exchange reserves continue to grow. They are currently estimated at $2.4 Trillion, and while their composition is largely a secret, analysts estimate that more than 2/3 is denominated in USD-denominated assets. Recently, there was a perception that China had begun to diversify its reserves out of Dollars, as US Treasury data indicated that its Treasury purchases had all but stopped. As it turned out, China had merely moved to conceal its purchases by conducting them through a UK Bank.

The biggest threat to the USD posed by China is not an end to the RMB peg – for such is unlikely – but rather a change in its structure. Currently, the RMB is pegged directly to the Dollar, which means that the Bank of China MUST stockpile its trade surplus in USD-denominated assets, namely US Treasury securities. If the peg were to shifted to a basket of currencies, however, it would have more flexibility in the denomination of its reserves. Until then, China’s forex policy will continue to favor the Dollar.

Last week, the Fed raised the discount rate by 25 basis points, to .75%. Investors have consistently focused the brunt of their collective monetary attention on the Federal Funds Rate, and the markets (forex included) barely registered a response to the move. Regardless of whether apathy in this particular context was justified, investors who turn a blind eye to changes in Fed monetary policy do so at their own risk

The direct implications for the discount rate (the rate at which depository institutions borrow short-term funds from regional federal reserve banks) hikes are admittedly hazy. Some economists analyzed the move in and of itself as a signal that the Fed wants banks to borrow more from each other, and less from the Fed. Others saw it as a political move, designed to appease both inflation hawks and an angry public that is dismayed over the massive profits that banks have earned from this prolonged period of easy money. If the former are right and the move has an economic basis, then the discount rate will probably have to be hiked at least once or twice more in order to have any kind of measurable impact. If it was indeed political, then another rate hike in the near-term is unlikely.

As I said, investors remain focused on the Federal Funds Rate (the rate at which banks borrow directly from each other) as the crux of the Fed’s monetary power. In this context, the discount rate hike didn’t move the markets because the Fed, itself, cautioned investors from inferring a connection between the discount rate and the federal funds rate. Nonetheless, some analysts posited a connection anyway: “The Fed can talk all day about how the discount rate hike is technical and not a policy move, but the market sees it as a shot across the bow. Not tomorrow, or the next day, but soon, they will be lifting the Fed funds rate target as well as the economy is starting to regain momentum…” Whether this represents the mainstream perception, however, is debatable.

On the one hand, investors have been talking about a (ffr) rate hike for more than six months now. As the above analyst pointed out, the economy is growing (5.7% in the fourth quarter of 2009…not too shabby!), and most other indicators (with the notable exception of housing) are trending upwards. On the other hand, expectations for timing continue to be pushed back (the current consensus – via interest rate futures – is that there is a 70% chance of a 25 bps hike in September).  This is due in no small part to the Fed itself, whose “emissaries” are doing their best to dispel the possibility of a near-term hike.

Some samples: San Francisco Federal Reserve Bank President Janet Yellen said the economy “will continue to need ‘extraordinarily low interest rates.’ ” Dennis Lockhart, the president of the Atlanta Federal Reserve Bank, conveyed that, “If his forecast of slow growth proves accurate, Fed monetary policy will have to hold rates low for longer.” Federal Reserve Bank of St. Louis President James Bullard Thursday said “speculation of an imminent hike in the Fed’s target interest rate was ‘overblown,’ calling an increase in the short-term federal funds rate ‘just as far away as it ever was.’ ” There’s not much ambiguity there.

Analysts also continue to look for clues as to when the Fed will begin to reverse its quantitative easing program. “Bernanke said such steps could be taken ‘when the time comes.’ Given the weakness of the economy, Bernanke signaled that that time was still a long way off.” This kind of procrastination is not being met well, and there is concern that “the Fed will misjudge the situation and wait too long to tighten monetary conditions.” In the end, this is perceived as more of an inflation issue, and it is of secondary importance to interest rate policy for the capital markets.

Forex traders, however, would be wise to focus on both aspects; inflation erodes the Dollar over the long-term, while higher interest rates make it more attractive in the short-term. For the time being, both remain low. In the not-too-distant future, either inflation and/or interest rates must rise. If/when the markets get over their sudden fixation on the debt crisis (a long-term issue) in Europe, they will return their attention to the Fed, probably just in time for the start of some big changes.

In December, I posted about Ben Bernanke (Bernanke’s Background and Near-Term US Monetary Policy), specifically about how a basic understanding of Bernanke’s academic background and philosophical approach to monetary policy could be useful for predicting the general direction of interest rates, irrespective of prevailing economic conditions. This post, is somewhere between a follow-up and a step back.

By this, I mean that when I last wrote about Bernanke, it was already a foregone conclusion that Bernanke would be approved for a second term as Chairman of the Fed. While his confirmation is still pretty much a given (despite the requisite speechifying by a small but vocal opposition), the fact that it has been so bumpy has caused all of us talking heads to seek higher ground and look afresh at the situation. My intention here, however, is not to look at other potential candidates for Bernanke’s position, as such would be a complete waste of time at this point. Nor do I want to discuss the implications of Bernanke’s eventual confirmation, as I have already done that. Rather, I want to discuss the implications of the delay/complications in his being approved. You would think that there wouldn’t be enough meat here for a substantive analysis, but you would be wrong.

That the confirmation process has been anything but smooth tells us much about both public attitudes towards Bernanke and about the attitudes towards the Fed. With regard to Bernanke, there is now a strong amount of criticism being leveled against him – for fomenting the housing bubble via low rates, lowering rates too quickly, not injecting enough new money into the financial markets. That such criticism is often contradictory is not important. What is important, is that such criticism is increasingly being taken seriously by Bernanke et al, such that the Fed is gradually losing its position as an independent stabilizing force and is instead becoming a highly politicized organization, that may soon be subject to the same checks and balances as other branches of government.

Of course, many commentators (and not a small number of politicians, as evidenced by the progress of Ron Paul’s ‘Audit the Fed’ bill), couldn’t be happier with this turn of events. They argue that the Fed has too much power, and for too long has been able to successfully operate in a public gray area with the power of a government institution but the freedom of a private one. Bernanke – and supporters of the status quo – argue that the Fed needs to be independent so that it can continue to shape monetary policy in line with certain economic objectives, rather than the whims of political parties and competing ideologies.

Many of you are probably indifferent to this issue. But consider that the outcome of this battle (whether the Fed remains independent, or its decisions will become subject to Congressional scrutiny)  – of which Bernanke’s confirmation is part of – carries potentially serious implications for currency markets. It is arguable that the Dollar’s safe haven perception at the onset of the credit crisis stemmed in part from actions that the Fed took to stabilize currency markets, in the form of swap lines and liquidity injections. If such decisions could be vetoed by the government, suffice it to say that investors would begin to question whether the Dollar was really the king of currencies that it purports to see.

On the one hand, accountability in any organization is important. On the other hand, skepticism towards the government is currently near an all-time high, and I would venture to guess that most of you wouldn’t want to see the role of auditor filled by the government. While criticism towards the Fed is justified, turning it into a political institution probably isn’t the solution. Abolishing it all together, on the other hand, well, that’s a different story altogether…

With so much to think about these days, I havn’t spent much time poring over foreign exchange reserve statistics. Apparently, this is to my detriment, as there have been a number of important developments on this front, some of which carry far-reaching forex implications.

I’m guessing a lot of you are probably in the same boat as me, wondering why forex reserves are worth paying any attention to. While busy looking at complex charts and GDP/inflation statistics, however, we forget that a currency’s value is fundamentally determined by supply and demand. In other words, while bullish/bearish indicators and interest rates are the proximal factors behind forex, the supply/demand dynamic is the ultimate factor. And Central Banks, collectively, comprise one of the largest contingents behind this supply/demand.

As I was saying, this equilibrium is currently undergoing a seismic shift. Specifically, “The dollar’s share in official foreign exchange reserves in 140 countries has fallen to its lowest level since euro cash was introduced in 2002, according to the IMF.” The Euro, Yen, and “other currencies” (i.e. minor currencies that are collectively important but individually unimportant), meanwhile, have seen increased interest from Central Banks. This is consistent with another report I saw recently, enunciating that,”Global reserves probably gained by about $180 billion in the third quarter with U.S. dollar-denominated reserves accounting for about $50 billion or less than 30 percent.”

This came as a shock to many market observers, who assumed that many economies lacked either the capacity or the impetus to diversify their reserves, especially since many of them peg their currencies to the Dollar. These countries are savvier than they used to be, however: “Emerging market central banks are selling their local currencies and buying U.S. dollars to prevent appreciation of their currencies. They’re avoiding having a bigger concentration of U.S. dollars in their portfolio by turning around and selling dollars against the euro and other currencies.”

Even industrialized countries, whose forex reserves are dwarfed by their emerging market counterparts, are jumping into diversification. After a nearly 10-year hiatus, Canada will jump back into the forex reserve game, by $1 Billion in foreign currency bonds, denominated in Euros. According to one analyst, “This…should be viewed in the context of the entire developed world, which is in the process of generally ramping up the size of its foreign reserves, and subtly shifting away from USD.”

The wild card is China. I use the term wild card both because China’s forex reserves are the world’s largest (recently confirmed at $2.4 Trillion) and hence whatever it decides will have major implications, and because it does not report the specific composition of its reserves to the IMF, so it’s unclear how it’s outlook is changing from month to month. Plus, it offers only vague indications of its intentions, so all we can do is speculate.

But speculate we will! While China has publicly maintained its support for the Dollar, quasi-publicly, there is an abundance of concern. This has most recently manifested itself in the form of internal calls for China to use its hoard of reserves to buy natural resources abroad. This wouldn’t necessary involve large-scale selling of its Dollar-denominated assets – since most oil contracts, for example, are still settled in Dollars – but would certainly involve shedding some of them.

As for why Central Banks are dumping Dollars (or simply choosing not to accumulate more of them), that seems pretty obvious. Even ignoring the Dollar’s problems, a well-balanced portfolio is an exercise in risk management. Especially now that many of the Dollar’s rivals are as liquid and as stable as the Greenback, itself, it makes little sense to put all one’s eggs in one basket.

Only a year ago, who could have conceived of such a possibility? At the time, the Canadian Dollar (aka Loonie) was in the doldrums, as a result of the credit crunch and concomitant collapse in commodity prices. In March, however, the Loonie began an extraordinary rally, and finished the year up 16%, almost perfectly offsetting the record decline that it suffered in 2008. As a result, the Loonie is now only pennies away from returning to parity.

The Loonie’s rise can be ascribed to a combination of fundamentals and speculation. On the fundamental side, a surge in the price of oil and other commodities has driven a recovery in the Canadian economy. Summarized one strategist, “The fundamentals in Canada are strong. Sentiment is bullish Canada, and on a relative basis, Canada should do very well with stronger commodity prices and ongoing U.S. economic recovery.” On the other hand, non-commodity exports remain sluggish, such the current account balance is currently in the red.

It’s obvious then that the gap between reality and expectation is being filled by speculation. Despite the fact that both short-term and long-term Canadian interest rates remain low, investors are pouring money into Canadian assets in the hopes that rates will soon rise. This speculation reached a fever pitch in October of 2009, when the Loonie spiked 6% in less than two weeks, following a modest Australian rate hike.

At that point, Canadian Central Bank governor Mark Carney was forced to firmly step in (previously he had effectively remained on the sidelines) by warning investors that he was in no hurry to lift rates, and that “he had ways of cooling the currency.” While analysts credit Carney’s jawboning with effecting a modest decline in the Loonie, it has since resumed its upward march, breaking through the technical barrier of 97.5 CAD/USD yesterday.

In the short-term, sheer momentum will almost surely carry the Loonie through parity with the Dollar. Analysts are divided on the timing, with some suggesting as soon as this month and others suggesting that later in the year is more likely. They should be careful, as there is an exuberance in the forex markets that I havn’t seen since right before Lehman Brothers collapsed- the event that many say signaled the beginning of the forex markets. In other words, investors are surely getting ahead of themselves, since commodities are well off of their 2008 highs, interest rates are down, Canadian economic growth is mediocre, Canada’s fiscal condition is weak, and it is operating a current account deficit.

For this reason, many analysts are already becoming bearish on the Loonie. “The loonie looks potentially more vulnerable on a number of crosses unless we see renewed upside momentum,” expressed a strategist from RBC Capital Markets. But noticed that she framed a continued rise in terms of momentum, rather than fundamentals. That’s tantamount to saying, Unless the Canadian Dollar continues to appreciate, it won’t continue to appreciate. If that’s not a tautology, I don’t know what is! But seriously, she has a point, which is that the Loonie is being driven purely by speculation at this point, in a trade that could soon come crashing down…after it hits parity.

Last week, Hirohisa Fujii resigned as finance minister of Japan. Since Fujii was an outspoken commentator on the Japanese Yen, the move sent a jolt through forex markets. Those who were expecting that his replacement, Deputy Prime Minister Naoto Kan, would be be more consistent than his predecessor were quickly disappointed, as Mr. Kan managed to contradict himself repeatedly within days of assuming his new post.

On January 6, he said it would be “nice” to see the Yen weaken, going so far as to designate 95 Yen/Dollar as the level he had in mind. One day later, he said that the markets should in fact determine the Yen: “If currency levels deviate sharply from the estimates, that could have various effects on the economy.” After he was rebuked by Prime Minister Yukio Hatoyama, who noted that the government should not talk to reporters about forex, he went on tell US Treasury Secretary that forex levels should be stable. In short, Japan’s official governmental position on the Yen still remains muddled, and it’s no less clear whether it will – or even should – intervene.

Fortunately, they may not have to. Not only because the Yen still remains more than 5% off of the record highs of November, but also because economic and financial forces are coalescing that could send the Yen downward. Despite a recovery in exports, the Japanese economy remains beleaguered, having most recently contracted to the lowest level since 1991, as part of a “tumble [that] is unprecedented among the biggest economies.” Now that we are into 2010, it can be said officially that Japan has now suffered from the “second lost decade in a row.”

When economic growth collapsed in 1990, Japanese consumers became famously frugal, and the domestic market still hasn’t recovered. Neither has the stock market, for that matter: “The Nikkei is 44.3% below where it stood at the end of 1999. It is 72.9% below its peak near the end of 1989.” The performance of the bond market, meanwhile, has been a mirror image, rallying 78% since 1990.

The resulting decline in real interest rates has combined with economic stagnation to produce a perennial state of deflation. In fact, prices are once again falling, this time by an annualized pace of 2%.

As many economists have been quick to diagnose, the problem lies in a tremendous (perhaps the world’s largest) imbalance between savings and investment, as “Japan still has ¥1,500 trillion ($16.3 trillion) of savings.” It’s not clear how long this can last, however, as Japanese demographic changes tax the nation’s pool of savings. “More than a fifth of Japanese are over 65…The nation’s population began shrinking in 2006 from 127.8 million, and will drop by 3.2 percent in the coming decade.”

This brings me to the final component of Japan’s perfect economic storm: debt. Japan’s gross national debt is projected by the IMF to touch 225% of GDP this year, and 250% as early as 2014. As a result of the aging population, the pool of cash available for lending to the government is shrinking at the same rate as the tax base, which is exerting fiscal pressure on the government from both sides. According to one commentator, “Japan’s fiscal conditions are close to a melting point.” Another frets: “I doubt there is any yield that international capital markets can find acceptable that will not bankrupt the Japanese state.”

What is the government doing about all of this? Frankly, not too much. It is spending money like crazy – exacerbating its fiscal state and pushing it closer to insolvency – in a (vain) attempt to prime the economic pump and avoid deflation from further entrenching. The Central Bank, meanwhile, just announced a new round of quantitative easing, also aimed at fighting deflation. At only 2% of GDP, however, the measures are “pretty tame” and unlikely to accomplish much. Considering that its monetary base has only expanded by 5% this year (compared to 71% in the US), it still has plenty of scope to operate. At the present time, however, it is still reluctant to do so.

Ironically, the aging population phenomenon could end up restoring Japan’s economy to equilibrium. The worse Japan’s fiscal problems become, the sooner it will be forced to simply print money, so as to deflate its debt and avoid default. This will stimulate the economy and put upward pressure on prices (solving two problems), and exert strong downward pressure on the Yen. The way I see it, that’s four birds with one stone!

As for the Yen, then, I would expect it to hover over the near-term, since price stability and a strong credit rating don’t signal immediate catastrophe. No, Japan’s economic problems are more long-term, which means it could be a while before they more clearly manifst themselves.

In October, the Reserve Bank of Australia (RBA) became the first industrialized Central Bank to raise interest rates. It followed this up with two additional hikes in November and December, bringing its benchmark rate to the current level of 3.75%, by far the highest among major currencies.

This series of rate hikes caught (forex) markets completely off guard, and investors moved quickly to price the changes into securities and exchange rates. The Australian Dollar initially spiked more than 7% following the first rate hike, bringing its total appreciation in 2009 to 32%- enough to earn it the distinction as the second-best performing currency, after the Brazilian Real. Beginning in November, however, concerns began to build that perhaps traders had gotten ahead of themselves, and the AUD has been in freefall since then.

Investors now fear that the RBA may have acted too hastily in hiking rates so soon and so fast. By its own admission, the RBA raised rates only after much deliberation: “The rate adjustment ‘would not be intended to slow demand compared with the current forecast path, but aimed simply at keeping the stance of policy appropriate for improving economic conditions,’ ” according to its own minutes. Since the recession was ultimately so mild (some would say ‘non-existent’) in Australia, however, the RBA ultimately decided that (pre-emptive) rate hikes were in order.

Now, interest rates are back in the “normal range,” according to a deputy governor from the RBA. In other words, the current rate is perceived as neither promoting nor hindering aggregate demand, which means it may not need to be tweaked much more in the near-term. In addition, there is growing concern that further rate hikes could trigger a cycle of deleveraging, because of the high debt burdens that plague Australian households and businesses. Household debt already exceeds 100% of GDP, which is even higher than in the US.

Besides, financial institutions are raising their own lending rates by wider margins than the benchmark rate hikes, so there is less impetus for the RBA to act further. Investors appear to have come to terms with this, as futures markets now reflect a 45% probability of another interest rate hike at the next RBA meeting, in February. This is down from 67% only last week.

If you’re wondering whether the RBA could be influenced by the lofty Australian Dollar when conducting monetary policy, it’s conceivable but not probable. It has already acknowledged that the carry trade is generally “back in vogue” and specifically targeting its very own Aussie, but that “As on earlier occasions, the economy has proven to be resilient to these [forex] swings.” If it turns out that the markets truly overestimated the pace of recovery (and by extension, interest rate hikes) in Australia, then the RBA won’t even have to worry about whether the economy can withstand further appreciation, since the AUD would probably remain fixed at current levels.

As I outlined in my last two posts, the Dollar could witness a rapid appreciation if/when the Fed finally raises interest rates. Given Chairman Bernanke’s frequent erring on the side of inflation, however, it could be months (at the earliest) before the Fed actually pulls the trigger. With forex markets guided by interest rate differentials, and traders’ uncertainty about the timing of interest rate hikes, its fair to say that the Dollar is at a crossroads.

Currently, the case for an interest rate hike (as the Fed confirmed this week) remains weak: “They will need to see a lot more, better numbers consistently, not just for one or two months, before they would start to genuinely be talking more hawkish…I think the markets may be disappointed if they’re looking for hints of hikes coming soon,” said one strategist. While the data continues to improve – witness last week’s miracle jobs report – it has not yet been demonstrated convincingly and unequivocally that the economy has exited the recession. There are too many contingent possibilities that could send the economy into relapse for the Fed to even consider acting. As I said in my last post, I don’t personally expect a rate hike until next summer.

Still, the markets are alert to the possibility. And where perception is reality, any sniff of rate hikes is enough to send the Dollar soaring; it has risen an impressive 5% against the Euro over the last couple weeks. That investors are acting so early to protect themselves against a possible rate hike shows the precariousness of the foundation on which the Dollar’s rise has been predicated.

What I’m talking about here is the Dollar carry trade, in which investors borrowed in Dollars at record low rates, and invested the proceeds in riskier currencies and assets. It wasn’t so much the interest rate differentials they were chasing (only a few percentage points in most cases, hardly enough to compensate for the risk), but rather outsized returns from currency and asset price appreciation. In other words, while the S&P has risen by an impressive 50% from trough to peak (providing a handsome return to any investor smart enough to have foreseen it), stock markets outside of the the US have performed just as well. Factor in currency appreciation, and in some cases you are talking about gains of around 100%.

But we all know that volatility is the enemy of the carry trade, and volatility is slowly creeping up. First, there was the Dubai debt crisis, then came the downgrading of Greece’s sovereign debt. With talk of interest rate hikes, it’s no wonder that investors are becoming jittery. Bloomberg News reports that, “The so-called 25-delta risk-reversal rate, which was flat as recently as October, hasn’t shown such high relative demand for dollar calls since hitting a record 2.595 percentage points in November 2008….[and] JPMorgan Chase & Co.’s G7 Volatility Index rose to 14.43 last month from the low this year of 12.32 in September.”

The consensus remains that neither the Dubai nor Greece episodes signals broad systemic risk, and that the Fed probably won’t hike rates for a while. Still, investors must brace themselves for the possibility of surprise on one of these fronts, or from a completely unsuspected “bolt from the blue” as one analyst put it, because of what happened to the Dollar after Lehman’s collapse in 2008. As evidenced by the Dollar’s sudden turnaround in the last couple weeks, this kind of uncertainty is self-begetting. As some investors get nervous and begin to unwind their carry trade positions, other investors also begin to move towards the exists, lest they get stuck short the Dollar after the music stops (or when it starts, depending on how you look at it.)

In that sense, the best paradigm for analyzing the Dollar is the end of the carry trade on one hand, weighed against the possibility of interest rate hikes on the other hand. “The dollar will depreciate to $1.55 against the euro by March from $1.49 last week, and to $1.62 by June, according to JPMorgan,” which is betting heavily that investors will remain clear-headed about interest rate differentials. Those that are looking at the Dollar from a risk-aversion/carry trade standpoint have slightly different projections: “I wouldn’t surprised if the euro makes it to $1.40 before the end of the month without much trouble, maybe a little bit lower.”

In short, in forex, it’s never enough to be able to predict the economic future. Instead, you must be able to predict how these predictions will be syncretized into currency valuations by the markets. In this case, that means you need not necessarily be able to accurately predict when the Fed will hike rates; rather you need only be concerned with how other investors view that possibility, and whether that makes them feel more or less confident about holding certain currencies.

The big story of the last month in forex markets has been the possibility that the Fed could soon hike interest rates, which would upend some of most stable (and gainful) strategies currently being employed by traders. As a result, the markets will certainly scrutinize the statement that accompanies today’s conclusion of the monthly rate-setting meeting, for any clues about the likelihood of such rate hikes. As I suggested in the title of this post, I think the best place to start in trying to forecast the near-term direction of US monetary policy is the man with the finger on the button – Ben Bernanke.

Bernanke’s academic background offers valuable insight into his approach to monetary policy- an approach that has been fairly consistent so far and probably will remain that way, barring any unforeseen developments. Specifically, Bernanke is/was a scholar of the Great Depression. He has argued that the fault for prolonging the Depression (though not for Depression itself) lies with the Fed and the US government, whose responses to the crisis he lambasted as conservative. In short, policymakers continued to worry about inflation, when they should have been concerned about deflation, since it was a deflationary spiral – falling prices beget expectations of falling prices, repeated ad nauseum – that prevented the economy from recovering in a timely manner.

Bernanke carried this notion – that falling prices are less desirable than rising prices – into the Federal Reserve Bank. [Though to be fair, it was already in vogue, thanks to the actions of his predecessor, Alan Greenspan]. Summarized James Grant (of the eponymous Grant’s Interest Rate Observer) : “Under the intellectual leadership of Mr. Bernanke, the Fed would tolerate no sagging of the price level. It would insist on a decent minimum of inflation. It staked out this position in the face of the economic opening of China and India and the spread of digital technology. To the common-sense observation that these hundreds of millions of willing new hands, and gadgets, might bring down prices at Wal-Mart, the Fed turned a deaf ear. It would save us from “deflation” by generating a sweet taste of inflation (not too much, just enough).”

Under Bernanke, the Fed’s response to the credit crisis was entirely consistent with this framework. It was the first industrialized Central Bank to cut interest rates, quickly reducing its benchmark Federal Funds Rate to 0%, a record low. The second stage involved literally printing more than $1 Trillion and injecting it directly into US credit markets. The Fed silenced its critics by insisting that the potential for inflation in the future doesn’t compare in seriousness to the possibility of deflation in the present.

Going forward, there’s reason to believe that Bernanke will remain dovish towards inflation. For one thing, Bernanke himself has declared this to be the case: “Mr. Bernanke fears deflation and the effect of tight money and rising interest rates on incipient economic growth.  The Fed Chairman has said so often that rates will stay low for an extended period that the markets have taken it as fact; the Fed will not raise rates.”

The markets have given Bernanke the benefit of the doubt in the short-term, but are pricing in a 50% chance of a rate hike before June 2010. Personally, I think it could be even later. Especially if housing prices experience a “double dip” and unemployment remains high, it seems unlikely that Bernanke would move to tighten. Regardless, he is known for his transparency, which means that when the Fed actually moves to hike rates, chances are investors will know about a month in advance.

I’d like to follow up on my last post (Timing is Everything in Forex, Especially in this Environment) by looking at how to time one specific currency: the Pound. As I noted tongue-in-cheek with the title of this post, timing the Pound will not be difficult, since it is likely headed downward in both the short term and long term.

In the short-term, the Pound will be crippled by the UK’s economic woes: “Britain is the last of the big G20 countries still to be mired in recession. Its GDP has shrunk by 4.75% this year, far more than the 3.5% reckoned likely in April.” There’s no reason to pore through the economic indicators, since all signs suggest that it won’t be until 2010 that Britain returns to positive growth.

Of primary concern to forex markets, however, is not economic growth (or lack thereof, in this case), but rather how this will effect the decision-making of the Bank of England (BOE). To no surprise, the BOE announced yesterday that it would maintain its benchmark interest rate at .5%, and its liquidity program at current levels. It didn’t give any indication, meanwhile, that monetary policy on either of these fronts would change anytime soon.

Thus, Britain could conceivably replace the Dollar as one of the preferred funding currencies for the carry trade. While the Fed is also in no hurry to hike rates, the US economy has already emerged from the recession, which means that regardless of when it tightens, it will almost certainly be before the Bank of England. Unless the BOE pulls an audible then, timing the Pound will be fairly straightforward; the currency should begin to slip as soon as its peers begin to raise rates. Some analysts expect that the Pound will decline to $1.50 per Dollar within the next six months.

Over the long-term, the narrative governing the Pound is naturally more uncertain, but still straightforward. To try to dig itself out of recession, the government has spent itself well into the red, to the extent that this year’s budget deficit is forecast to be a whopping 12.6%, Next year could be even worse. The government has implemented a couple of half-baked measures designed to curb the deficit, but most of these are aimed at increasing tax revenue (which is futile during a recession), rather than trimming spending. While ratings on its sovereign debt were recently affirmed at AAA, Moody’s has warned that a downgrade in the next few years is not inconceivable.

So there you have it. As far as I’m concerned, the only question of timing, vis-a-vis the British Pound, is when the decline will begin. My guess is sometime in the beginning of 2010, when investors start getting serious about projecting near-term interest rate differentials, and pricing them into exchange rates. While most forex traders aren’t thinking this far down the road, it’s also comforting (for bears, not bulls, obviously) that the long-term fundamentals point to a sustained decline in the Pound. Whereas the Dollar could jump up before heading back down – making timing a crucial skill – the Pound will probably just head down.

I just finished reading a Wall Street Journal piece (Central Banks Rattle Markets), which laid out, in fairly broad terms, how the activities of Central Banks have become the main fodder for forex traders, and how this trend will continue as the global economy looks to move beyond the credit crisis. The piece got me thinking about the importance of timing, when it comes to forex.

Let’s face it, timing is important when trading any security. Buying a stock one month earlier and/or selling one month later (as compared to the actual trade dates) could yield drastically different results. This is especially the case in forex, for a couple reasons. The first is that the majority of forex traders have a shorter-time horizon than investors in bread-and-butter securities. We’re talking weeks or months here, compared to years and decades. The second reason is that while long-term trends certainly exist in forex, the average return for all currencies (over a long enough time period) should converge to 0%, since forex is a zero-sum game. In other words, buy $1,000 worth of stock today, and you might be a millionaire by 2050. Buy a $1,000 worth of Euros today, however, and you will probably have about the same, give or take, 40 years later.

This notion has taken on an added significance in the current environment because of its transitional character. As I said, there are certainly long-term trends in forex, but these tend to be anything but smooth. In the short-term, then, it’s conceivable that a currency will move with little correlation to its long-term “destiny.”

We have entered a period of extreme uncertainty, specifically surrounding the actions of Central Banks. Without exception, all of these Central Banks eased monetary policy to aid their respective economies through the credit crisis. This easing varied widely from bank to bank, and ranged from interest rate cuts to “liquidity injections” to wholesale money printing. Just as the performance of many currencies has been guided by the degree of easing exacted by their respective monetary authorities, so will such currencies be guided by the degree and speed of tightening, going forward.

For example, currencies such as the Australian Dollar and Norwegian Krone (as the WSJ article pointed out) have exploded since their respective Central Banks became the world’s first two to raise interest rates. Currencies such as the Dollar and Pound, meanwhile, remain in the doldrums, as it is forecast that the Fed and the Bank of England will be among the last to reverse the spigots of easy money that they unleashed last year.

And this brings me back to the issue of timing. There will be great rewards that inure to those who correctly anticipate interest rate hikes, “liquidity withdrawals,” etc. In this age of instantaneous fund transfers, predicting a move a day before it happens could mean thousands of PIPS in profits, maybe more, if you take leverage into account. Those that think the Fed will raise rates before the ECB but after the BOE can bet on currency crosses accordingly. Moreover, it is not enough to predict who/when will hike rates, but to what extent and how fast. Maybe the Fed will beat the EU out of the starting gate, but the EU will hike faster once it gets going, mirroring what happened (in reverse) when the credit crisis began. This possibility makes you wonder if slow and steady really wins the race…

In short, the next year or two could prove to be extremely choppy (gainful for some, bitter for others) as currencies spike and dive in accordance with the Fisher Effect (the empirical idea that money moves from low-yielding currencies into higher-yielding currencies, as investors chase higher interest rates). For those that think the Dollar is doomed in the long-run, then, be careful about betting all of your marbles in the short-run. That’s not to say that the carry trade will disappear; on the contrary, it could accelerate if interest rate discrepancies widen before they shrink. Instead, consider yourself warned that if the Fed beats other Central Banks to the punch of raising rates, there could be a dramatic pause in the Dollar’s downward slide.

Karl Marx would be pleased…well, maybe not. In any event, the world’s Central Banks are tired of the weak Dollar, and are separately taking matters into their own hands. [Before I continue, I should probably acknowledge the inherent dangers of lumping every Central Bank together under one umbrella. Still, given the current market environment, and the fact that all Central Banks are acting uni-directionally, it seems like a fair categorization].

As I was saying, Central Banks – especially in the developing world – are extremely unhappy with the Dollar’s continued decline, and with the opposing strength in their respective currencies. Over the last year, these Central Banks have waded into the forex markets, one after another, in a non-concerted effort to stem the gains in their currencies. As the Dollar’s decline has gained new momentum, so have they redoubled and intensified their efforts.

In the last couple weeks alone, at least a dozen (and these are only the ones on my radar screen) have issued threats and/or taken action aimed directly at the “speculators,” which are blamed for the across-the-board rise in emerging market currencies and asset prices. Their concerns are twofold: that currency appreciation could choke off economic recovery, and that speculative investment is driving the creation of new asset price bubbles.

While their goals are largely the same, their tactics differ. Some are testing the old approach of simply buying Dollars on the spot market. Thailand, Israel, South Korea, Philipines, and Russia, for example, are now intervening heavily on a regular basis. “Experts estimate that some of the largest emerging economies may have spent as much as $150 billion on currency intervention over the past two months, judging from the growth of their international reserves, according to data from Brown Brothers Harriman.”

Other Central Banks have resorted to policy-making measures; Taiwan and Brazil are perhaps the best examples here. The former has essentially banned foreigners from opening new time deposits in the country, while the latter has just imposed a 1.5% tax on investment in Brazilian ADR shares to match the 2% tax on new FDI. In addition, sources claim that other measures are being considered, including “an overseas sovereign bonds issue denominated in Brazilian reals and a change in rules that would allow foreign equities investors to deposit guarantees overseas.”

South Korea and Sri Lanka have been even more creative in restraining their currencies. Sri Lanka is now making it easier for its citizens to take money out of the country, while South Korea is now placing limits on the hedging activities of exporters, who “have sold large amounts of dollars in the forward market to hedge foreign orders, putting upward pressure on the won.”

Still other Banks are still in the “rhetorical” stage of intervention, whereby they simply convey to investors that they are monitoring forex markets for “instability” and “irregularities.” Such code-words are designed to signal that rapid currency appreciation will not be accepted idly. “People see the central bank looking closely at the dollar and think maybe it’s a good time to unwind some of their positions,” explained one analyst in response to “rhetorical intervention” by the Bank of Chile.

Unfortunately for these Central Banks, their efforts are ultimately unlikely to be successful. They can probably succeed in slowing, or even temporarily halting the rise in their respective currencies, but won’t be able to achieve a permanent cessation. That’s because the forces they are fighting against are simply too large ($3 Trillion per day of forex turnover) and too determined (Russian and Brazilian interest rates are both above 8%, compared to 0% in the US) to be stopped. “It’s [intervention] not working, and it’s a good thing that it’s not working. Emerging-market currencies are appreciating and they’re going to keep on appreciating against currencies from the old world. [Central Banks] has to adapt to that,” declared one trader. Still, you can’t blame them for trying.

The Canadian Dollar fell from parity with the US Dollar in July 2008. For a minute, it looked as though it would return to that mark in October 2009. Alas, it was not to be, as the currency that had risen 20% since March wasn’t able to rise another 3% to close the elusive gap that would once again bring it face-to-face with the Greenback.

The Loonie’s rise was not difficult to understand. Soaring commodity prices and the fact that the economic recession was milder in Canada than in other economies drove the perception that Canada was a good place to invest. Despite a surging budget deficit and weak domestic consumption, investors bought into this notion. The weak Dollar and rising risk aversion reinforced this perception, and as investors accepted that parity was inevitable, hot money poured in and the Loonie’s rise became self-fulfilling.

That was until Mark Carney, head of the Bank of Canada, used the strongest rhetoric to-date in discussing the possibility of intervention. For the first time in this cycle, the markets took the hint, and sent the Canadian Dollar down by the largest single-day margin in months. “Markets should take seriously our determination to set policy to achieve the inflation target. Markets sometimes lose their focus, we don’t lose our focus,” he said firmly, adding that forex intervention is “always an option.”

Intervention is supported both by economic data, and other Canadian institutions. According to one estimate, every 1 cent increase in the Loonie against the Greenback costs the county $2 Billion in export revenue and 25,000 jobs. The chief economist for CIBC, meanwhile, has warned that many companies are in the process of making long-term direct investment decisions, and could be discouraged from locating in Canada because of perceptions that its currency will remain strong for the immediate future: “If the loonie is overvalued for a few years, we may be sacrificing business plant and equipment on the altar of a strong currency.” He also compared the predicament facing the Bank of Canada to that facing the Royal Bank of Switzerland, which ultimately and successfully intervened on behalf of the Franc. Intervention on behalf of the Loonie, he argued, could be undertaken under the umbrella of fighting speculation and irrational movements in currency markets.

In fact, it seems investors still are no convinced that the BOC (via Carney) means what it says. “Mark Carney has raised the prospect of intervening in currency markets, but seems reluctant to actually do so,” argued one analyst. “I don’t think they would really like to intervene at all, and they would prefer avoiding it. If they can intervene by jaw boning, they would much rather do that,” added another.

Why did the Loonie fall suddenly then, if the markets still aren’t concerned about intervention? The answer is that they have seen the concrete impact of the expensive Loonie on the Canadian economy. In the words of one analyst, it has moved from being a threat to a bona fide impediment. Especially given the stall in the commodity price rally, investors apparently are willing to acknowledge that they may have gotten ahead of themselves and that parity with the Dollar is not yet justified by fundamentals. Meanwhile, Canadian interest rates are at a comparable level with US rates, which means foreign investors can’t earn a yield spread from investing in Canada. This is likely to be the case for a while, as the valuable Loonie has kept inflation in check and given the BOC some flexibility in tightening its monetary policy.

Personally, I don’t think the BOC will ultimately intervene. Investors have shown that they aren’t afraid of the BOC, which would make any intervention both expensive and unfruitful. In addition, I think investors have accepted their own accesses, and will hesitate to push the Loonie much higher (or past parity, for that matter) until there is more evidence that such is justified. In the meantime, expect the Loonie to hover in the 90′s and perhaps even test parity, before smashing through when the time is right. And this, I do believe, is inevitable.

In its semi-annual report to Congress, the Treasury Department once again failed to officially label China (or any country for that matter) a currency manipulator. No surprise there. While it’s self-evident that China manipulates the RMB (via the peg with the US Dollar), the political implications of such a label prevent it from being used except in the most extreme cases. Nonetheless, there is mounting pressure on China, both domestic and international, to “adjust” the peg and allow the Yuan to move closer to its fundamental value.

Most of the international pressure has been soft, coming in the form of roundabout pleas for China to allow the Yuan to float “for the sake of global stability.” Said one US Senator weakly, “I hope that with strong leadership from the United States, the G-20 nations and our international institutions will undertake what has been missing — a focused, sustained and meaningful multilateral engagement to address currency manipulation and current imbalances.” At the same time, some of this rhetoric has recently been translated into action. Last month, the Obama Administration enacted a 35% tariff on Chinese tire products. Other countries have also begun to raise concerns about Chinese dumping, and bringing their cases to the WTO for good measure.

Many of these countries are in fact suffering more than the US. Since the Yuan is effectively pegged to the Dollar, the decline of the latter has been mirrored by the former. Since many other currencies of developing countries are also fixed, this leaves only a handful to absorb the shock. For example, the Euro and Yen have both risen about 15% against the RMB over the last year, in line with their appreciation against the Dollar. The handful of floating currencies in the region, such as the Korean Won, Indian Rupee, Malaysian Ringhit, etc. have also faced strong upward pressure. For them, it is not so much the weak Dollar that they fear so much as the weak RMB, since China is a direct competitor to all of them.

More importantly, there are now voices within China’s ruling Communist party that have also begun to press for a stronger Yuan. The Nationalist camp, for example, is pressing for China to make the Yuan a more prominent currency on the international trade scene. While such doesn’t inherently require a floating currency (in fact, all of the trade/swap agreements involving Yuan are based on fixed exchange rates), a loosening of capital controls and liberalizing of financial markets would probably bring about a stronger Yuan.

The other group pushing for a stronger Yuan is doing so on more fundamental, economic grounds. Just-released 2009 Q2 GDP data showed prelimenary growth estimates of a whopping 8.9%! Not bad, especially when you consider that the rest of the world remains mired in recession. Chinese economists largely ignore the political implications of the notion that this growth probably came at the expense of the rest of the world, and focus instead on the economc implications.

First is that the economy remains hopeless dependent on exports to drive growth, which can only be remedid through a stronger Yuan. Second, it heralds the coming of inflation. Many foreigners continue to pour “hot money” into Chinese asset markets hoping to reap the upside from both asset and currency appreciation. In response, “Analysts say China could let the yuan appreciate to help restrain inflation, since a stronger yuan would reduce the cost of imports. But some caution that Beijing tried a similar strategy in early 2008, but didn’t achieve great success in containing inflation or stemming the inflows.”

While analysts don’t expect the Bank of China to allow the RMB to rise until after the Chinese New Year in January, investors are pricing in incremental appreciation every month beginning with the next. In fact, futures prices already reflect the expectation that the RMB will rise 3% over the next twelve-months. My bet is that this will be kicked off by another one-off appreciation, in the same vein as July 2005. Now as was the case then, China needs to make up for lost time.

These days, it’s hard to offer a fresh perspective on the Dollar. The factors driving its short-term momentum – namely low interest rates and its perception as a financial safe haven – have been in place for nearly a year. It’s long-term prognosis, meanwhile, also hasn’t changed much. Since the beginning of the decade, the Greenback has been in a state of perennial decline as a result of its twin deficits and the related notion that it will be soon be replaced as the world’s pre-eminent currency.

Since the last time I posted about the Dollar (October 6: Dollar’s Role as Reserve Currency in Jeopardy), then, there haven’t been many developments. Fears that oil will one day be priced and settled in an alternative currency – such as the Euro – continue to reverberate through the markets. Several ministers from OPEC countries have already officially dismissed such claims as baseless. A parallel debate is now taking place on the sidelines as to whether or not such a shift even matters.

Dean Baker argued in a recent article for Foreign Policy magazine, that pricing oil in Dollars represents a mere “accounting convention,” adopted by most simply by default, since the US is the cornerstone of the world economy. Argues Baker, “World oil production is a bit under 90 million barrels a day. If two-thirds of this oil is sold across national borders, then it implies a daily oil trade of 60 million barrels. If all of this oil is sold in dollars, then it means that oil consumers would have to collectively hold $4.2 billion to cover their daily oil tab.”

Unfortunately, Baker’s “simple arithmetic” is both erroneous and slightly irrelevant. Assuming a price of only $100 per barrel (pretty conservative if you believe the notion of peak oil), current consumption of 85 million barrels per day implies a daily turnover of $8.5 Billion per day, or $3+ Trillion per year. If the price doubles to $200 per barrel….well, you get the point.

Taking this line of reasoning further becomes somewhat problematic, however. First of all, while OPEC members currently hold the majority (70%+) of there reserves in Dollar-denominated assets, it’s unclear how this would change in the event that oil was no longer priced in Dollars. It’s conceivable that just as many of these Central Banks currently diversify their Dollar-denominated proceeds into other currencies, that they would “diversify” Euro-denominated proceeds back into the Dollar. Of course, it’s also conceivable that a combination of inertia and investment strategy would cause them to hold a larger portion of there reserves in Euros.

If OPEC Central banks continue to prefer Dollars, than Baker is right in arguing that the currency in which oil is priced has no implications outside of accounting. If, on the other hand, he is wrong, and a change in pricing causes/coincides with changing preferences, then the implications for the Dollar would be disastrous. [Consider that $3 Trillion/per year which is at stake currently represents more than 15% of total foreign ownership of US assets.] The problem is that we just don’t know.

Regardless, the status quo favors the Dollar, since creating a new reserve currency would take at least a decade, if not more. For that reason, the World’s Central Banks (we’re not just talking about OPEC anymore) continue to prefer Dollars. “In the five weeks through Oct. 7, foreign central banks bought more than $48.55 billion in Treasury securities, an average of $9.71 billion per week, according to the latest data from the Federal Reserve.” In addition, “Finance Minister Hirohisa Fujii said he expects the dollar will remain the key reserve currency for some time to come.” Private foreign investors, meanwhile, are dragging their heals a bit, perhaps waiting for the Dollar to fall further before jumping in. Asks one columnist rhetorically, “Why buy now if the dollar might be even weaker in six months’ time?”

What else is new? The US budget deficit came in at $1.4 Trillion for the fiscal year, the highest level since World War II. On the bright side, the deficit was $200-400 Billion less than earlier estimates. Meanwhile, members of the Federal Reserve’s Board of Governors restated the unlikelihood of higher rates in the immediate future. “Richard Fisher, president of the Dallas Fed and thought to be a rare hawk on the Fed’s Open Market Committee, chimed in that no one at the Fed thinks this is the time to raise interest rates.” Finally, the US trade deficit is once again narrowing, due in no small part to the declining Dollar.

At this point, it seems reasonable to assume that much of the bad news has already been priced into the Dollar. Sure, the Australian rate hikes came as a surprise and forced many to rethink their calculations. Investors have already begun to separate the healthy currencies from the sick (to borrow an analogy from a previous post), but that the Dollar would be grouped with the “sick” currencies has long been anticipated. Given that the currency has already fallen by double digits in 2009 and is nearing the record lows of 2008, some are wondering how long it can continue.

In my report on last month’s Japanese election, I noted that the newly-appointed Japanese finance minister, Hirohisa Fujii, had spoken out against forex intervention. With that, it seemed the matter was closed.

But not so fast! Over the following few weeks, Fujii (as well other members of the new administration) moved to clarify his position, backtracking, sidestepping, contradicting, but never going forward. The following is a summary of selected remarks, beginning with the original statement against intervention and ending in what seems like a promise to intervene:

September 15: “I basically believe that, in principle, it’s not right for the government to intervene in the free-market economy using its money, either in stock or foreign-exchange markets.”
September 27: [The Yen's rise is] “not abnormal…in terms of trends.”
September 28: “That’s not to say I approve of the yen’s rise.”
September 28: “I don’t think it is proper for the government to intervene in the markets arbitrarily.”
September 29: “If the currency market moves abnormally, we may take necessary steps in the national interest.”
October 3: “As I have said in Tokyo, we will take appropriate steps if one-sided movements become excessive.”
October 5: “If currencies show some excessive moves in a biased direction, we will take action.”

Confused? I know I am. Is it possible to glean any semblance of meaning from these remarks? Summarized one columnist, “Hirohisa Fujii has gone through several cycles of remarks that first appeared to favor a strong yen and then seemed to backpedal after markets took him at his word and sent the Japanese currency soaring.”

I think this encapsulates the regret that Minister Fujii must have felt, after his original comments were taken a little too seriously. In hindsight, it appears that Fujii attempted to convey the new administration’s stance on forex, in a nutshell, and certainly didn’t expect that investors would run wild and send the Yen up another 4%, bringing the year-to-date appreciation against the Dollar to 15%. In the words of the same columnist cited above, “Japan’s finance minister has been rudely reminded of the cardinal rule when speaking to markets — less is more.”

So where does Fujii actually stand? I would personally hazard to guess that his original explication is still the most accurate portrayal of how he will tend to the Yen while in office. The former Liberal Democratic Party (LDP) administration intervened several times while in office (once under the direction of Fujii himself!) and most recently in 1994. Despite spending trillions of Yen, the campaign only marginally stemmed the rise of the Yen.

Meanwhile, the Japanese economy has been mired in what could be termed the “world’s longest recession, dating back to the 1980′s. It’s clear that the cheap-Yen policy, designed to promote exports, hasn’t benefited the Japanese economy. The new administration, hence, has indicated a shift in strategy, away from export dependence and towards domestic consumption.

Ironically, the nascent Japanese economic turnaround is once again being driven by exports. Fujii is no doubt cognizant of this, and doesn’t want to jeopardize the recovery for the sake of ideology. For example, Toyota Corporation has indicated that a 1% appreciation in the Yen against the Dollar costs the company $400 million in operating income. In addition, while a strong Yen increases the purchasing power of Japanese consumers, an overly strong Yen can lead to deflation, as consumers forestall spending in anticipation of lower prices down the road.

In other words, Fujii is certainly not a proponent of Japan’s recent runup, but his stance is more nuanced than initially understood. “Fujii is basically saying currencies should reflect economic fundamentals and that it is wrong to manipulate their moves to lower the yen for the sake of exporters,” offered one strategist. This, the markets finally seem to understand, and the Yen has actually reversed course over the last week. After all, “A yen in the 80s is excessive,” given the context of record low interest rates and a economy that is still contracting.

In the near-term, then, it doesn’t even make sense to talk about intervention. It seems the markets were getting ahead of themselves in this regard. It doesn’t make sense to price out the possibility of intervention when interevention shouldn’t be a factor in the first place. If on the other hand, the Yen continues to appreciate, then Fujii may have consider how fixed his principles really are.

A theme in forex markets (as well as on the Forex Blog) is that as the Dollar has declined, virtually every other asset/currency has risen. The rationale for this phenomenon is that the global economic recovery is boosting risk appetite, such that investors are now comfortable looking outside the US for yield. However, this market snapshot may have to be tweaked slightly, in accordance with a recent WSJ article (Sterling Looks Ready to Join the Sick List).

According to the report, “Similar to how investors sorted good banks from bad banks earlier this year, foreign-exchange buyers are starting to sort strong currencies from weaker currencies. The pound appears to be joining the dollar in the weak camp. Both countries have near-zero interest-rate targets, an aggressive policy aimed at boosting the economy, and yawning deficits.” In contrast, the article continues, the Yen and the Euro have risen, as have so-called commodity currencies.

While there’s no question that British economic and forex fundamentals are abysmal, it’s a bit hard to understand why the markets are picking on the Pound now. After all, the Euro, Swiss Franc, and Yen, for example, are plagued by some of the same fundamental problems: growing national debt, sluggish growth, low interest rates, etc. Investors can borrow in Yen nearly as cheaply as they can borrow in Dollars or Pounds, and the Bank of Japan is likely to keep rates low at least as long as the Bank of England (BOE), if not longer. Meanwhile, price inflation remains practically non-existent, which means that any capital that investors stash in the UK should be safe.

Perhaps, then, investors are zeroing in on the BOE’s Quantitative Easing program, which is the point of greatest overlap with the US Dollar. Relative to GDP, both currencies’ Central Banks have spent by far the most of any industrialized countries, in pumping newly printed money into credit markets. The BOE, in particular, is actually thinking about expanding its program. At a recent meeting, Mervyn King, Chairman of the Bank, led the opposition in voting for a 15% expansion, but was voted down by a majority of the bank’s other members. “The ‘next decision point‘ will be the Nov. 5 meeting,” said a former Deputy Governor of the Bank, at which point “Bank of England policy makers will consider expanding their bond purchase plan….on concern the economy’s recovery may be a ‘false dawn.’ ”

The government meanwhile has demonstrated a certain ambivalence when it comes to the program. The head of the UK Debt Management Office indirectly encouraged the BOE to continues its purchases of bonds, for fear that stopping doing so could cause yields to skyrocket and make it difficult for the government to fund its activities. “A rapid sell-off could create a downward spiral of gilt prices which would make life harder for both it and the DMO.” On the other hand, one of the leaders of Britain’s conservative party – which is projected to take office after next year’s elections – has criticized the program on the grounds that it will lead to inflation.

From the BOE’s standpoint, it’s a no-win situation. Continue the policy, and you risk inflation and further invoking the ire of politicians. Wind it down, and you could tip the economy back into recession. For better or worse, it seems the BOE will err on the side of the former: “If we stopped supporting the economy now it would crash. Every country in the world and just about every informed commentator is saying the same thing. The job is not finished.” Given that inflation is projected to hover around 0% for the next two years, the BOE still has some breathing room.

As for the charge that the surfeit of cash flowing into markets is weakening the Pound, ‘So be it,’ seems to be the attitude of Mervn King who suggested that, “The weaker pound was ‘helpful’ to efforts to rebalance the British economy toward exports.” While he backtracked afterward, it still stands that the BOE hasn’t made any efforts to stem the decline of the Pound, and is at best indifferent towards it.

Regardless of where the BOE stands, the Pound is not being helped by the weak financial and housing sectors, which during the bubble years, comprised the biggest contribution to UK growth. Exports are weak, and domestic manufacturing activity has yet to stabilize. As a result, “The British economy will contract 4.4 percent this year before expanding 0.9 percent in 2010, the International Monetary Fund predicts.”

Objectively speaking, then, it makes sense to call the Pound sick. Still, many other currencies are just as sick. I guess the perennial lesson is that in forex, everything is relative.

I concluded my last post by promising to discuss the implications of a change in the status quo, regarding the Dollar’s role as the world’s reserve currency. As it turns out, the last few days have witnessed a few developments on this front.

First of all, the G7 concluded its latest round of talks. Despite previous indications to the contrary, the organization continued its practice of releasing a communique. in which it noted that global economic balances persist and that policymakers should work together to mitigate them. While seemingly benign and desirable, the proposition couldn’t have come at a worse time for the Dollar.

The only reason why the Dollar hasn’t collapsed completely is because economies largely continue to recycle their surplus wealth and trade surpluses back into Dollar-denominated assets. One columnist connects the dots with regard to the forex implications: “Less Chinese intervention to prevent yuan strength would mean China, slowly over time, would build up fewer dollar reserves.” In other words, economies no longer concerned with pegging their currencies would have very little reason to build up large pools of reserves.

In fact, China is fully on board with this notion. Following the G7 talks, Chinese officials announced that it would support a stronger Yuan as soon as the global economic crisis resolved itself. By its own reckoning, this would facilitate a shift in its economy, from one dependent on exports for growth to one focused around domestic consumption. Still, obstacles remain, and “It is far from clear how China can engineer a shift up for the yuan against the dollar, which analysts note would almost certainly translate into a gain against other currencies as well.”

Speaking of China, it is also among the most vocal of nations laboring for alternatives to the Dollar. Towards this end, it has reportedly formed a secret coalition with the other BRIC countries (Brazil, India, and Russia), as well as Japan. The goal is to end the pricing of oil in Dollars by 2018. That the group has given itself nine years to complete this task speaks to its extraordinary ambition.

The implications for the Dollar cannot be understated. A handful of oil-producing nations in the Middle East hold a combined $2.1 Trillion in Dollars, which are solely a product of selling oil in exchange for Dollars. Already, the government of Iran has mandated that in the future, all of its reserves be held in non-Dollar-denominated assets. Thus far, no other countries have followed suit. China is aware that pushing for further developments could roil the US, which would be unlikely to sit on the sidelines and watch its currency be summarily jettisoned. “Sun Bigan, China’s former special envoy to the Middle East, has warned there is a risk of deepening divisions between China and the US over influence and oil in the Middle East.”

Robert Zoellick, president of the World Bank, doesn’t harbor any illusions, and announced during a recent speech that the a decline in the role of the Dollar is inevitable. “He said the United States ‘would be mistaken to take for granted the dollar’s place as the world’s predominant currency. Looking forward there will increasingly be other options to the dollar,’ ” such as the Chinese Yuan and the Euro.

Zoellick’s warnings were prescient, when you consider that the IMF just announced that the share of Dollars in global foreign exchange reserves declined significantly in the most recent quarter, perhaps to its lowest share since the Euro was introduced in 1999. [The latter, however, has yet to be confirmed].  “The dollar’s share in global reserves declined to 62.8% from 65.0%…The euro’s share increased to 27.5% from 25.9%.”

JP Morgan’s research team has discovered a similar trend- that accumulation of US assets accounts for only half of the global increase in global forex reserves. “Quantifying this trend is always imprecise. But the circumstantial evidence — official buying of U.S. assets runs at only half of the pace of global reserve accumulation — suggests that diversification has accelerated since June.”

So, there you have it. The Dollar’s demise (to borrow a characterization by one of the columnists featured in this post) is no longer theoretical. It may have already begun…

The performance of virtually every currency against the Dollar (with the lone, major exception being the British Pound) in the last quarter has been downright impressive. Put another way, the performance of the Dollar has been downright pathetic.

The Dollar’s under-performance is no mystery. While some critics have pointed to long-term weaknesses such as the trade and budget deficits, most of the current impetus continues to come from low US interest rates. As I have reported recently, US short-term rates (based on the 3-month LIBOR rate for Dollars) is already the lowest in the world, and is still moving lower.

As a result, investors have been able to comfortably borrow in Dollars, and invest the proceeds in (comparatively) risky assets, predominantly outside the US. “Low rates have weighed on the dollar as equities have rallied over the summer, leading risk-based traders to buy the higher-yielding euro and commodity-based currencies, such as the Australian dollar, over the safe-haven greenback,” summarized the WSJ.

For most of the last 20 years, such a carry trade strategy would have been most profitable if funded using Yen or Swiss Francs. Since the stock market rally in May, however, buying a basket of emerging market currencies using the Dollar as a funding currency would yield the highest returns, as much as 10% higher than if the same trade had been funded using Yen. Moreover, the Sharpe-ration for such a trade (which seeks to measure the invariability of returns) is the highest when shorting the Dollar, implying that not only is this strategy lucrative, but also comparatively stable.

For a few reasons, however, analysts are beginning to wonder whether the Dollar carry trade has (temporarily) run its course. Technical indicators, for example, suggest that the Dollar may have appreciated too far, too fast. “The U.S. currency rose…after the 14-day relative strength index on the euro- dollar exchange rate climbed yesterday to 74, the highest level since March. A reading of 70 may indicate a rally is approaching an extreme and a reversal is imminent.” Stochastic indicators yield similar interpretations. “Traders have placed an unusually high volume of bearish bets against the U.S. dollar in recent weeks and may want to lock in profits by reversing those trades.” Besides, anecdotal evidence implies that anti-Dollar sentiment may be reaching irrational levels, as every other investors now seems to be betting against the Dollar.

From a rates perspective, the Dollar carry trade may soon become less viable. The markets (as reflected in futures prices) largely expect the Fed to be the first major Central Bank to hike rates, perhaps as soon as 2010 Q2. The ECB, by comparison, is not expected to hike until at least two quarters later, while the Bank of Japan is nowhere even near close to tightening monetary policy. The Fed is also beginning to contemplate possible exit strategies for its quantitative easing programs, which suggests that it is becoming concerned about inflation. One analyst connects this to a decline in the carry trade: “There might be a little bit of nervousness going into the FOMC if they start signaling any potential unwind of quantitative easing. There is a bit of risk over the next couple of days of the dollar starting to recover a little bit of ground.”

Finally, there are concerns that another crisis could trigger a pickup in risk aversion, in which case investors would likely return to the Dollar en masse. Recall that in 2007, when the Japanese Yen carry trade was in vogue, the main concern was volatility. Traders weren’t ever afraid that the BOJ would hike rates. Rather, they feared that some kind of event would inject uncertainty into the markets, making their returns (via the Yen) erratic. If investors suddenly got nervous about the ongoing stock markets rally, then the Dollar could conceivably become more volatile, which would make carry traders think twice.

At the same time, emerging market currencies will continue to offer much higher interest rates than the Dollar. While the Dollar, then, could conceivably become more attractive relative to the Yen, for example, it will remain extremely unattractive compared to high-yielding currencies. The yield differentials are currently so enormous that even if the Fed raised rates tomorrow, it would still be immensely profitable to short the Dollar relative to the Brazilian Real or South African Rand. While the Dollar slump may be reaching an endpoint, a Dollar rally will not necessarily follow. Brace yourself for sideways trading.

After a brief “hiatus,” the Swiss Franc is once again rising, and is now dangerously close to the $1.50 CHF/EUR “line in the sand” that spurred the last two rounds of Central Bank Intervention.

Both from the standpoint of the Swiss National Bank (SNB) the Franc’s appreciation is vexing, while from where ordinary investors are sitting, it’s downright perplexing. That’s because based on the standard litany of factors, the Franc should be falling.

The Swiss economy remains mired in its worst recession in 17 years, and is projected to shrink by at least 2% this year. In addition, deflation has already set in, with prices falling at an annualized rate of .8%. To be fair, signs of recovery are emerging, and a plurality of economists believe that growth will return in 2010, as will inflation.

But downside economic risks remain, namely the worsening labor market. There is also the fact that the Swiss economy remains heavily weighted towards exports, the demand for which remains slack. From a comparative standpoint, though, projections of recovery are not unique to Switzerland. Financial markets have long since stabilized in most industrialized countries, which many have interpreted as a harbinger for better things to come.

On the monetary front, Swiss interest rates remain among the lowest in the world, as the SNB has gradually guided its benchmark lending rate to .25%. It is also in the process of expanding its quantitative easing program, by pumping liquidity directly into the credit markets, in order to mitigate against deflation. In this sense, the SNB is arguably behind the curve. In the US and EU, for example, speculation is already mounting that interest rate hikes will take place as soon as 2010. Economists are less concerned about a shortage of liquidity in those economies, and more nervous about how the potential excess of liquidity can be withdrawn from the financial system before it turns into a problem. Economists in Switzlerland aren’t even close to beginning to have that conversation.

According to the SNB, the problem lies in the Swiss Franc, which has remained oddly buoyant. While capital has flowed out of the US, for example, it actually seems to flowing into Switzerland. Members of the SNB have attributed this to the “safe haven,” notion, whereby investors still view the country as a safe haven from the financial turmoil. Perhaps slightly irrational, but real nonetheless.

Despite strong rhetoric and equally strong action, the Franc has slowly edge back to the 1.50 mark. Policymakers have pledged to defend the currency vigorously, and it now appears as though another intervention is looming. Given that the SNB has intervened to depress the Franc twice in the last six months, you would think that it would have some credibility with some investors. It seems the lesson is that Central Banks are no match for the markets, and investors realize that ultimately, the SNB is no exception.

I toyed with the title of this post for a while, and ultimately settled on the current iteration, because it reflects the battle that is being waged between the Bank of Canada and the forex markets. Simply, the Loonie is moving in one direction (up!), while the BOC would prefer that it moves in the opposite direction.

Let’s start with some context: the Canadian Dollar’s performance this year has been impressive, to say the least. 2009 is far from over, and yet the Loonie has already risen 14% against the Dollar, almost completely undoing the record 18% slide in 2008. Analysts are quick to point to the nascent Canadian economy, fading risk aversion, and the ongoing boom in commodities prices as behind the currency’s rise.

While all of these reasons are certainly valid, they hardly tell the whole story. Consider that Canadian growth remains tepid, deflation is now a reality, its currency is outpacing commodity prices, and its budget deficit will probably set a record this year. Regardless of what the future holds for the Canadian economy, the present remains nebulous. Thus, it seems the best explanation for Loonie strength is not to be found in Canada, but across the border in the US. Specifically, it is US Dollar weakness, and momentum-driven speculation based on the expectation of further weakness, that is driving the Canadian Dollar.

From the Bank of Canada’s standpoint then, the Loonie’s move back towards parity has nothing to do with fundamentals, which is why the BOC maintains that the currency represents a threat to both recovery and price stability. He has a point on the second front, since inflation is currently running at an annualized rate of -.8%, marking three consecutive months of deflation. “The [inflation information] has proved the Bank of Canada’s concerns are justified,” confirmed one analyst.

The Million Dollar Question then, is how far the BOC is willing to go to halt the Loonie’s ascent. Bank of Canada Governor Mark Carnet has already intervened vocally, by repeatedly signaling his displeasure with recent developments in forex markets, and suggesting that all options remain on the table. But rhetoric only goes so far, and after a brief pause, the Canadian Dollar has resumed its rally. “We think [rumors of intervention] it’s 100 percent untrue. I don’t think the bank has the ammunition or the desire to intervene. This is a story about U.S. dollar weakness across the board,” said one trader.

The Bank has already exhausted most of the tools in its monetary arsenal. It recently voted to maintain its benchmark interest rate at the current record low level of .25%, and beyond extending the period of time during which it maintains low rates, there isn’t much more it can do on this front. Besides, conveying an intention to hold rates at .25% beyond June 2010 might not influence investors, who don’t seem too concerned about low yields offered by the Loonie. Moreover, it remains loath to copy the quantitative easing implemented by the Fed and Bank of England, because of the tremendous amount of work required to mop up“that increase in liquidity when the time comes.

In other words, the only thing the BOC can do at this point is to actually intervene, probably by buying US Dollars on the spot market. A couple obstacles are the fact that the BOC hasn’t intervened for over 10 years, and that Prime Minister Stephen Harper is simultaneously trumpeting the importance of “flexible exchange rates” in speeches intended to denigrate China.

In fact, the BOC may not have to get involved, since the consensus among analysts is that the Loonie will trade sideways for the next year. “According to…52 strategists polled by Reuters…In three, six and 12 months, the median estimate of those polled had the domestic currency steady at $1.100 to the U.S. dollar, or 90.91 U.S. cents.” Moreover, polled analysts based their forecasts on a mere 17.5% of intervention, which means that irrespective of the BOC, most forecasters think that the Loonie has reached its potential…for now.

Of course, if the Loonie fulfills estimates at the high end of the poll – especially in the short-term, and if inflation remains negative, the BOC could find itself with no other choice. But for now, investors aren’t holding their breath.

After a brief pause, the world’s Central Banks (or at least those in Asia) have begun to once again accumulate foreign exchange reserves. I’m not one for hyperbole, but the figures are downright eye-popping: “Reserves held by 11 key Asian central banks totaled $2.625 trillion at the end of August, up from $2.569 trillion at the end of July, according to calculations by Dow Jones Newswires.” Most incredible is that this total doesn’t even include China. whose reserves could exceed $2.3 Trillion by now.

The credit crisis was initially marked by a collapse in trade and an exodus of capital from Asia, as western consumers tightened their wallets and investors flocked to so-called safe havens. As developing countries fought off currency depreciation, forex reserve levels plummeted. Less than a year later, trade has already picked back up, investors have returned en masse to emerging markets, and Central Banks are once again sterilizing capital inflows so as to mitigate upward pressure on their respective currencies. [Chart Below courtesy of Council of Foreign Relations.]

“Taiwan and Thailand, the most aggressive in defending the U.S. currency, have logged record-high reserves every month since December.” Japan, whose reserves are the second highest in the world (after China), is the lone holdout. As the Forex Blog reported yesterday, the newly elected Democratic Party of Japan will pursue an economic policy that depends less on exports, and has pledged to stay out of the forex markets.

The prospects for further reserve accumulation remain reasonably bright, as emerging markets lead the global economy towards recovery. “The outlook for key Asian economies is improving faster than that of developed economies. For the time being, this should accelerate flows into these markets, making it harder for central banks to keep their currencies in check.”

While China’s economy is no exception, its nascent recovery is being driven by capital investment, government spending, and (ultimately?) consumer spending. As a result, it is forecast that “China’s current-account surplus will fall to under 6% of GDP this year and 4% in 2010, down from a peak of 11% in 2007. Exports amounted to 35% of GDP in 2007; this year…that ratio will drop to 24.5%.” If such an outcome obtains, it will almost certainly lead to a slower accumulation of reserves.

While this is all well and good, the more important question for most (forex) analysts is how these reserves are being held. The vast majority of these reserves are still denominated in US Dollar assets, and in fact, the proportion may have risen slightly since the beginning of the credit crisis. Asian Central Banks are particularly biased towards the Dollar, which accounts for 70% of their reserves, compared to the worldwide Central Bank average of 64%.

Moreover, it doesn’t look like plans are afoot to change this trend anytime soon. China has maintained its push (though less vocally) to turn the Chinese Yuan into a global reserve currency, declaring that its capital markets and currency controls will open accordingly to facilitate such. It is in preliminary talks with Thailand for yet another currency swap agreement, to supplement the $95 Billion in such deals signed since December. For its part, the Bank of Thailand has insisted that the Yuan is not even close to challenging the supremacy of the Dollar: “You have to accept that the dollar is going to be a reserve currency for quite some time. You don’t have any alternatives.”

Even China, despite its rhetoric, remains committed to the Dollar. The only talk of diversification in Chinese investment circles is in regards to what kinds of US assets they should invest in, not whether they should be invested in the US or somewhere else. Said the manager of China Investment Corp, which has a mandate to invest nearly $300 Billion of China’s FX reserves, “The risk of a decline in the dollar risks was more of a national issue for China than for CIC because its capital is in dollars.”

This last quote inadvertently confirms that the role of the Dollar as the world’s reserve currency is being treated as a political issue, when in fact it is a financial economic issue. In other words, while many countries want to limit the influence of the US by limiting the power of the Dollar, their Central Banks are stuck with it because it remains the most practical, and advantageous option. Dumping it would be akin to punishing themselves.

Earlier this week, President Obama officially nominated Ben Bernanke to a second four-year term as Chairman of the Federal Reserve Bank’s Board of Governors. The reaction was relatively muted, perhaps because most pundits had already anticipated the news. Bernanke himself probably sealed his own re-appointment with the public relations campaign he embarked on last month, ostensibly to offer a rationale for his response to the credit crisis. “In a profound departure from the central bank’s tradition as an aloof and secretive temple of economic policy, Mr. Bernanke has plunged into the public spotlight to an extent that none of his predecessors would have contemplated.”

Most of the sound-byte reactions came from politicians, and focused on whether he deserved another term, rather than the potential ramifications of his re-nomination. Heavyweights Barney Frank and Christopher Dodd both offered tepid support. Ron Paul referred to the news as irrelevant. Meanwhile, “European Central Bank President Jean-Claude Trichet on Tuesday said he was ‘extremely pleased’ by President Barack Obama’s decision.”

The reactions from investors, likewise, ranged from ambivalent to moderately supportive. Equity markets rose to a 2009 high the day after  the story broke, while the Dollar fell slightly. The re-appointment was deliberately awarded five months ahead of schedule in order to help the president’s credibility with investors. Fortunately (or unfortunately, depending on how you look it), the fact that the markets didn’t react much, shows that they don’t really care. In other words, “President Obama overstated matters when he said that Mr. Bernanke had kept us out of a Great Depression” not only because “this remains to be seen,” but also because the ebbs and flows of GDP are contingent on more than just monetary policy.

Regardless of how much credit Bernanke actually deserves, he will certainly have his work cut out for him in his second term. “Bernanke’s Next Tasks Will Be Undoing His First,” encapsulated one headline. At some point, the Fed must raise interest rates, return credit markets to normal functioning, and remove hundreds of billion of dollars from the money supply.

But this is easier said than done: “If the Fed shifts too quickly from the role of savior to that of strict disciplinarian, it risks aborting the recovery and tipping the nation back into a recession, essentially repeating mistakes made in 1937 after the economy had begun to rebound. If the Fed moves too slowly, it risks the kind of intractable inflation it experienced in the 1970s and fueling another bubble.”

The consensus is that, for better or worse, he will err on the side of price stability, perhaps at the expense of economic growth. “A Fed chaired by Ben Bernanke will follow a policy uncomfortably tight as the 2012 election looms into sight. Bernanke has espoused a commitment to low inflation over his entire career,” argued one economist. Meanwhile, the markets aren’t expecting rate hikes at least until 2010, although Bernanke, himself, has conveyed a sense of optimism – and hence hawkishness – about a quick exit from recession.

What does all of this mean for the Dollar? It’s impossible to say exactly, and depends largely on whether Bernanke can unwind the easy money policy of the last year just as deftly as he deployed it.And of course, there is the wild card of the US National debt, and the potential for a loss of confidence to induce a run on the Dollar, which even Bernanke would be powerless to solve.

It’s safe to say that the inverse correlation observed between the Dollar (and also the Yen) and global equities is largely a product of the carry trade. “The U.S. stock market bottomed and the U.S. Dollar Index peaked almost simultaneously in March. While U.S. stocks are up more than 50% in that time, the Dollar Index (which measures the greenback’s value against the euro, the yen, the British pound, the Canadian dollar, the Swedish kroner and the Swiss franc) is down nearly 12%,” observed one analyst.

On one level, this represents a return to 2008, prior to the explosion of the credit crisis, when carry trading was THE dominant theme in forex markets. However, there is one important difference. While the Dollar and Yen were the funding currencies then and now (due to their low interest rates), there has been a slight shift in the currencies selected for the opposing/long end of the trade.

Traditionally, the most popular long currencies were those of industrialized countries, rich in commodities and backed by high interest rates and often rich in commodities. To be sure, these currencies have shined in recent months, certainly due in part to speculative (carry) trading. “Strategists at Wells Fargo Bank in New York ‘believe that the gains in the dollar-bloc currencies (Australia, New Zealand, Canada) have run ahead of the gains in commodity prices.’ ” The Bank of Canada also noticed that “At the time of its last statement, oil prices were about $75 a barrel, but now they are in the $60-to-$65 range. That suggests the currency’s appreciation has outpaced the demand for its commodity exports.”

But the run-ups in the Kiwi, Aussie, and Loonie have been overshadowed by even more rapid appreciation in emerging market currencies. This shift is largely a product of changes in interest rate differentials, which are now gapingly large between developed countries and developing countries. Compare the 2.75%+ spread between the US and Australia, with the 8.5% spread between the US and Brazil or 12.75% between the US and Russia. For investors once again becoming complacent about risk, the choice is a no-brainer.

Still, some analysts are nervous about this change in dynamic: “While the new carry trade may be less leveraged, it’s an inherently riskier bet. As such, it’s more vulnerable to the kind of swift unraveling of risk appetite observed across all nations and sectors in 2008, but which occurs with far more frequency in emerging markets.” Meanwhile, emerging market stocks have behaved volatilely over the last few weeks (with Chinese stocks even entering bear market territory), and some investors are concerned that they may be temporarily peaking. There are also signs that bubbles may be forming in carry trade currencies, with bullish sentiment at high levels. Accordingly, one strategist suggests waiting out a 5% pullback in the Australian dollar, and a 10% pullback in the New Zealand dollar before going back in.

There is also the outside possibility that the Fed will raise interest rates, which would crimp the viability of the US Dollar as a funding currency. Granted, it seems unlikely that the Fed will tighten within the next six months, but investors with a longer time horizon could begin to adjust their positions now, rather than wait until the 11th hour, at which point everyone will be rushing for the exits.

From trough to peak (March 10 – August 5), the British Pound appreciated by a whopping 25%, its strongest performance in such a short time period since 1985. The Pound has fallen mightily since then, and most factors point to a continued decline.

On almost every front, the Pound is being buried under a mound of bad news. Its economy is currently one of the weakest in the world, especially compared to other industrialized countries; on a quarterly basis, its economy is contracting at the fastest rate in over 60 years. Forecasts for UK economic growth are commensurately dismal: “Median estimates in Bloomberg economist surveys see the U.S. shrinking 2.6 percent in 2009 and expanding 2.2 percent in 2010, compared with a 4.1 percent contraction followed by 0.9 percent growth in the U.K.”

In addition, the only signs of growth appear to be a direct result of government spending, a notion that is evidenced by the latest retail sales and housing market data, both of which remain at depressed levels. “People are worried that the global recovery is based on unsustainable government spending and numbers like this from the U.K. only encourage those fears,” said one analyst in response.

While government spending, meanwhile, is arguably a valuable tool for stimulating economic growth, analysts worry that it might be reaching the limits of feasibility. “The Office for National Statistics said the budget shortfall was 8 billion pounds ($13.2 billion), the largest for July since records began in 1993.” On an annual basis, the government is planning to issue 220 Billion Pounds in new debt, to fund a budget deficit currently projected at 12.4% of GDP, easily the largest since World War II.

The Bank of England’s prescription for the country’s economic woes are also provoking a backlash. When the Bank announced at its last monetary policy meeting that it would expand its quantitative easing program by 50 Billion Pounds, the markets were aghast. Imagine investor shock, when the minutes from that meeting were released last week, revealing that 3 dissenting governors were agitating for an even bigger outlay! No less than Mervyn King, the head of the bank, “push[ed] to expand the central bank’s bond-purchase program to 200 billion pounds ($329 billion).

Given the dovishness that this implies, combined with an inflation rate that is rapidly approaching 0%, investors have rightfully concluded that the Bank is nowhere near ready to raise interest rates. “The market was expecting the BOE to be one of the first to hike rates. It’s becoming clear that’s unlikely, undermining the pound,” conceded one economist. Interest rate futures reflect an expectation that the Bank will hold rates at least until next spring. LIBOR rates, meanwhile, just touched a record low.

As a result, forecasts and bets on the Pound’s decline now seem to be the rule. “BNP Paribas…predicted another 9.3 percent decline to $1.50 in 12 months…After the Bank of England decision, pound futures and options speculators became more pessimistic as weekly bets favoring sterling fell more than 32 percent, the most since November.” In short, “Sterling is over-priced at current levels.”

While Central Banks have always featured heavily in the minds of forex traders, their actions have taken on a whole new significance of late. Financial reporters have also been generous in doling out space to stories about Central Banks, writing stories with headlines like “Central bankers add to equities’ momentum” and “Currency Traders Hold Fire, Await Central Banks.”

Traditionally, forex traders eyed Central Banks for one reason: interest rates. The theory was simple: currencies with higher interest rates tended to outperform in the short term. This trend was especially reliable in the years leading up to the housing bubble, as carry traders ensured that high-yielding currencies rose while low-yielding currencies stagnated or fell.

Even in the context of the credit crisis, traders have continued to monitor the rate setting activities of Central Banks. Interest rates in every industrialized country are currently locked at record low levels, but anticipation is already starting to build that the beginning of a tightening cycle is just around the corner. Current expectations are for the US to lead the way (first to lower, first to rise), followed by Australia, New Zealand, and Canada. The Bank of England and European Central Bank are further away on the curve, while rate hikes are a remote possibility in Japan, a perennial favorite of carry traders.

Interest rates are now only a small part of the equation, however. Most Central Banks have implemented additional strategies, known variously as quantitative easing, asset purchases, liquidity programs, etc. The goal of all of these programs is to stimulate the money supply and stabilize financial markets, by injecting newly-minted money directly into capital markets. Traders initially focused on which Central Banks were involved in quantitative easing. After nearly every bank introduced some version, it quickly became a question of scope. In this respect, the Fed and the Bank of England are in first and second place, respectively. Now, traders are waiting to see not only when these programs will end, but also when they will be unwound. If there is a perception (and even worse, a reality) that some Central Banks are waiting too long to draw funds out of the market, this could foster (concerns of) inflation, and consequently, currency depreciation.

Finally, there is the issue of direct currency intervention. The Swiss National Bank became the first western bank to intervene on behalf of its currency. Its actions are directly responsible for holding the Swiss Franc down. The Bank of England meanwhile has used its quantitative easing program to influence the Pound, while the Banks of Korea and Brazil are buying Dollars on the spot market to depress their respective currencies. Paranoia is clearly running high, and some traders are apparently concerned that the Fed could be next. Just when you thought the surprises were over.

The Brazilian Real has been one of the world’s best performers in 2009, having risen by a solid 25%. The currency is now close to pre-credit crisis levels, and is even closing in on an 11-year high. When you consider that only six months ago, most analysts were painting doomsday scenarios and predicting currency devaluations and bond defaults for the entire continent, this is pretty incredible!

The currency’s rise has been supported by a variety of factors, few of which are grounded in fundamentals. To begin with, while Brazil has staved off depression, it’s not as if the economy is firmly back on solid footing. The economy contracted by 5% in the first quarter, and forecasts for 2009 GDP growth still vary widely, from a slight contraction to modest expansion. Meanwhile, the economy is importing more than it exports, despite the rebound in commodity prices. “The central bank said the net trade result was based on $9.89 billion in receipts for exports and $12.72 billion in import payments overseas.”

“Investment inflows, meanwhile, totaled $33.88 billion, while outflows totaled $29.78 billion.” The disparity between investment and trade data goes a long way towards explaining the Real’s rise. Thanks to a recovery in risk appetite, foreigners have poured cash into Brazil at an even faster rate than they once removed it. As a result, Brazil’s “Bovespa stock index has risen 51 percent this year, the world’s 12th-best performer among 89 measures tracked by Bloomberg, as foreign investors moved 13.7 billion reais into the market through July, the most since the exchange began tracking data in 1993. Brazilian local bonds returned 37 percent in dollar terms after falling 13.8 percent in 2008.” The country’s foreign exchange reserves also just set a new record, surging past the $200 Billion mark.

Brazilian interest rates tell the rest of the story. Despite a gradual decline over the last decade (made possible by a moderation in inflation), Brazil’s benchmark SELIC rate stands at a healthy 8.65%, which is the highest in South America, after Argentina. Unlike Argentina – and the dozen or so other economies around the world that boast equally lofty interest rates – Brazil is perceived as relatively safe place to invest. Given interest rate levels in the western world, combined with the expectation that Brazil’s currency will appreciate further, investors are more than happy to accept a little bit of risk in order to earn an out-sized return.

Just like the Bank of Korea, Bank of England (both profiled by the Forex Blog in the last week), the Bank of Brazil is not happy with the resilience in its currency. “Brazil’s central bank said on Wednesday it bought $779 million on the spot foreign exchange market this month to Aug. 7 as dollar inflows to the country surged because of growing demand for local stocks and bonds.” This brings the total intervention expenditure to $9 Billion.

Unfortunately for the Bank of Brazil, the forces in the forex market are way beyond its control. “Dollar inflows to the country totaled $2.26 billion this month to Aug. 7, compared with inflows of $1.27 billion in all of July.” Analysts are also unconvinced, and are racing to revise their Real forecasts upward. One economist, caught completely off guard, just “changed his year-end real forecast to 1.8 from 2.5 at the start of the year. ‘The resilience of the Brazilian economy to weather this crisis has been spectacular,’ ” he explained.

Last year the Korean Won was one of the world’s weakest currencies- and that’s saying a lot when you you consider how many currencies tanked at the onset of the credit crisis. The Won lost nearly half of its value, driven by concerns that Korean creditors would be unable to pay their foreign debts. Since March, however, the currency has rebounded by an impressive 25%, as the government took action: “To avert a crisis, South Korea forged a dollar-swap agreement with the U.S., pumped money into the banking system, boosted fiscal spending, set up funds to replenish bank capital and cut rates.”

In the last quarter, South Korea’s economy grew 2.3%, the fastest pace in nearly six years, marking a significant turnaround from the 5% contraction recorded in the fourth quarter of 2008. Still, “South Korea’s economy will shrink 1.8 percent this year, the IMF said yesterday, revising a July prediction for a 3 percent contraction.” Exports, which account for 50% of GDP, have also recovered, and are now rising by nearly 20% on an annualized basis. Retail sales are climbing, and bank lending to households has risen for six straight months. Finally, “Stimulus measures at home and abroad are fueling South Korea’s revival. The government has pledged more than 67 trillion won ($53 billion) in extra spending, helping consumer confidence climb to the highest in almost two years in June.”

However, an inflow of speculative hot money – which has buttressed a rally in Korean stocks – threatens to undo the recovery. “With an anticipated increase in risk appetite, foreign investors may invest further in emerging-market equities, leading to more dollar supply,” said one analyst. The first half 2009 current account surplus set a record, with forecasts for the second half not far behind. Korea’s foreign exchange reserves, meanwhile, have recovered, and could touch $300 Billion within the next year.

Of course, the Central bank is not simply standing by idly. It has already lowered its benchmark rate to a record low 2%, and at yesterday’s monthly monetary policy meeting, it firmly refused to consider raising it for at least six months. Commented one analyst, “There is no urgent need to raise rates. The most likely course of action is that the Bank of Korea will wait until the economy fully recovers, and in particular, they will wait until the unemployment rate stops increasing.” Still, given both that interest rates remain above levels in the west (see chart below) and that the Korean Won is considered undervalued, funds could continue to flow in.

The Central Bank’s other tool is direct intervention in the forex markets, in order to depress the strengthening Won. But this, it is loathe to do: ” ‘It would be better to have a larger foreign exchange reserve in order to better deal with economic crises, but attempts to buy dollars to artificially boost the reserve volume could lead to accusations of currency manipulation, while excess won in the markets could stoke inflation,’ a high-ranking ministry official said.” Still, investors are growing increasingly nervous about this possibility:”A state-run bank that usually doesn’t participate much in the market bought some dollars at the day’s low, prompting speculation about a possible intervention, a local bank trader said.” Sure enough, after hitting the psychologically important level of 1,220 at the end of July, the Won dived. It has yet to bounce back.

Over the last week, the markets have been abuzz with chatter about how the US recession will soon come to and end, followed by a quick and healthy recovery. According to investor logic, the result would be a rise in inflation and interest rates. This optimism was partially deflated today, as the Federal Reserve bank conducted its annual monetary policy meeting.

Excluding a brief uptick in June (see chart below courtesy of the Cleveland Fed), investors had long come to expect that the Fed would leave its benchmark Federal Funds rate unchanged, at 0-.25%. At the same time, there was a strong belief that the Fed would begin to hike rates at the end of 2009, and comment accordingly in the press release that accompanied its monetary policy decision. Barron’s predicted yesterday: “The statement will acknowledge some improvement in the U.S. economy, though it will imply that this nascent growth reflected in recent gross domestic product reports is fragile and will be monitored closely. This will leave open the specter that interest rates could be increased at some point in the future.”

Sure enough, the Fed left rates unchanged, and its press release conveyed a restrained sense of hope that the worst of the recession is now behind us: “Information received since the Federal Open Market Committee met in June suggests that economic activity is leveling out. Conditions in financial markets have improved further in recent weeks…Although economic activity is likely to remain weak for a time, the Committee continues to anticipate…a gradual resumption of sustainable economic growth in a context of price stability.” The Fed also announced that its Treasury buying activities would soon come to an end, although it may continue to buy mortgage securities as part of its quantitative easing program.

Perhaps the tone of the press release was slightly less positive than investors would have liked, since interest rate futures dived immediately on the news. Especially compared to last week, investors are now assuming that it will be a while before the Fed actually hike rates: “At Wednesday’s settlement price of 99.655, the February fed-funds futures contract priced in about a 38% chance for a 0.5% funds rate after the late-January meeting. That’s down sharply from about a 60% chance at Tuesday’s settlement, about a 76% chance at Monday’s settlement, and about a 96% chance at last Friday’s settlement.” Analysis of options trading activity reveals that the large brokerage houses believe similarly.

As for the Dollar, it now seems possible that last week’s rally was premature. If the Fed isn’t prepared to hike rates anytime soon, then the current interest rate differentials between the US and the rest of the world will remain intact. More importantly, the Dollar will remain a viable funding currency for carry trades, and the shift of funds into higher-yielding alternatives will probably continue for the time being.

The British Pound’s rise since the beginning of March has been nothing short of spectacular: “Improving economic data have helped the pound advance 14 percent against the dollar this year and 12 percent against the euro.” Due primarily to a recovery in risk appetite and the concomitant belief that the Pound had been oversold following the onset of the credit crisis, investors began pouring hot money back into the UK. As recently as two weeks ago, one analyst intoned that, “Longer term, we are in part of an uptrend for the pound. I don’t think this is over.”

Since then, however, a series of negative developments have cast doubt on such optimism. The first was the release of economic data, which indicated an unexpected widening in Britain’s trade deficit. While exports rose, imports rose even faster, causing analysts to wonder whether it would be realistic to expect the British economic recovery would be led by exports: “We remain skeptical that the U.K. is about to become an export-driven economy any time soon. A return to sustained growth continues to look unlikely in the near term,” said one economist.

The second development was the decision by the Bank of England to expand its quantitative easing program: “The central bank spent 125 billion pounds since March as part of the asset-purchase program and had permission to use as much as 150 billion pounds, about 10 percent of Britain’s gross domestic product. Chancellor of the Exchequer Alistair Darling has now authorized an extra 25 billion pounds.” This came as a huge shock to investors, which had collectively assumed that the program had already been concluded.

Upon closer analysis, it appears that the rise of the Pound and the expanding trade deficit might have contributed to the BOE’s decision: “According to the Bank’s rule of thumb, this [the Pound's rise] is equivalent to interest rate increases of 1.5 percentage points.” However, interest rates are already close to zero. The BOE has already conveyed its intention to maintain an easy monetary policy for the near-term (March 2010 interest rate futures reflect an expectation for a 75 basis point rate hike); otherwise, there is nothing else it could do on the interest rate front. “Unless the UK is ready to deflate its production costs heavily, it can only achieve required competitiveness by reducing the value of sterling…The BoE knows this and its decision to increase its quantitative easing efforts may well have to be seen in the context of summer sterling strength.”

The final factor has been the Dollar’s sudden reversal. Previously, the Pound had been helped as much by UK optimism as by Dollar pessimism. This changed last week, when positive US economic data triggered expectations of a near-term economic recovery and consequent Fed rate hikes. In short, the Pound must now rest on its own two feet, and can no longer count on Dollar pessimism for a boost: “The current gloomy sentiment, which has chipped some 3% off sterling’s value against the dollar in the past four trading days, represents a sharp turnaround.”

The prognosis for UK economic recovery should receive some clarity tomorrow, when the Bank of England releases a report on inflation and GDP. At this point, we will have a better idea as to what to expect from the Pound going forward.

A recent WSJ headline reads, Good Economic News Threatens the Dollar, and summarizes the Dollar’s trading pattern as follows: “Demand for the U.S. currency continues to erode amid a tide of more encouraging economic data and corporate earnings that have fed a thirst for riskier assets such as stocks, commodities, and growth-sensitive currencies.”

Less than two weeks after that article was published, the Dollar rose by a healthy 2% against the Euro in only one trading session, as US labor market conditions improved slightly: “The U.S. unemployment rate fell in July for the first time in 15 months as employers cut far fewer jobs than expected, giving the clearest indication yet that the economy was turning around from a deep recession.” While technically another 250,000 jobs were lost and economists forecast that the employment rate will rise past 10% before peaking, investor sentiment is still at a high.

Unsurprisingly, the news triggered a stock market rally. More noteworthy, though, is that the Dollar also rallied. Since the beginning of 2009 and especially since the beginning of March, there has been a clear negative correlation between stocks and the Dollar, as a result of risk appetite. “At one point this year, the correlation between the euro-dollar rate and the S&P 500 index hit 50 percent, according to BNP Paribas calculations. That is, the euro and S&P 500 rose or fell in tandem half the time.”

This latest development suggests that this relationship has broken down, at least temporarily. Argues one analyst, “The dollar’s going to turn. The U.S. economy is more able to withstand shocks than other economies, especially Europe.” Perhaps going forward, the markets will be driven less by risk appetite and more by comparative growth trajectories and economic fundamentals.

Not so fast, though. Much of the Dollar’s recent slide has been a product carry trading patterns, as investors borrow in low-yielding Dollars and invest in higher-yielding alternatives. An improvement in economic conditions could compel the Fed to hike rates, which would seriously dent the attractiveness of the carry trade. “Indeed, long-dated U.S. interest rates have been quietly moving in the dollar’s favor while U.S. interest rate futures on Friday started pricing in a federal funds rate of 1.25 percent by the mid-2010, the highest since June.” Based on this paradigm, then, it’s still risk appetite that’s driving the Dollar, whether up or down.

Over the last year, Israel has quietly amassed one of the world’s largest repositories of foreign exchange reserves. On average, the Central Bank of Israel has purchased $100 million worth of Dollars every day since July 2008, bringing its total reserves to $52 Billion. The Bank’s goals are twofold: to sterilize the inflow of speculative money pouring into Israel in order to mitigate inflation, and to stem the appreciation of the Shekel.

Towards this latter, the Bank received a boost by the credit crisis, which caused an outbreak of risk aversion and sent investors rushing to shift funds into so-called safe haven countries/currencies. As a result, the Israeli stock market tanked, and the Shekel plummeted 30% in a matter of months.

Thanks to the recent upswing in risk appetite, however, the Shekel has bounced back, having risen 10% since April. While the Shekel still remains well off its its 2008 highs, the sudden rise still elicited the attention of the Bank of Israel, which announced that it would respond to the, “Unusual movements in the exchange rate that are inconsistent with underlying economic conditions, or when conditions in the foreign exchange market are disorderly,” by intervening heavily in the open market. It “is believed to have purchased between $1.5-1.7 billion this week so far.”

The Bank has also taken steps to inadvertently degrade its currency by lowering its benchmark interest rate to .5%, and buying bonds on the open market. “The central bank will have bought a total of 18 billion shekels ($4.7 billion) of bonds when it completes the program….The bank said in its statement that it does not intend to sell the securities it purchased and will continue buying foreign currency.” While its unclear whether the program has succeeded in stimulating the economy – which contracted by 3.7% last quarter – it has provoked inflation, which is still running in excess of 3% per year.

The forex markets have taken notice of both developments, sending the Shekel down 4% since Monday. Still, it’s not clear whether the Bank of Israel has any real credibility with traders. By its own admission, its intervention program is temporary: “It is clear that we won’t carry on buying foreign currency forever. Everybody understands that the central bank can’t beat the market, but sometimes the market does things that are not justified.”

Analysts, meanwhile, insist that the Shekel’s appreciation is not unusual, and that the intervention runs counter to fundamentals. “[The] market pressures strengthening the shekel against the dollar, are, in fact, consistent with underlying economic conditions. Fundamental economic conditions favoring the revaluation of the shekel include the accumulation of a balance of payments credit of $4.3 billion over the past thee quarters.” These analysts, then, are more concerned about rising inflation then about the competitiveness of Israeli exports.

Barclays, an investment bank, evidently subscribes to this school of though, and predicts the Shekel “will increase 2% after breaching their so-called resistance levels.” Merrill Lynch, meanwhile, sees the Shekel appreciating an additional 10% over the next year.

Since the Forex Blog last covered the Canadian Dollar – on July 29 – the Canadian Dollar appreciated another 2% against the US Dollar, reinforcing the perception that the currency is both too volatile and appreciating too rapidly. This concern is harbored by the Central Bank officials and policymakers, which fear that the rising currency represents the proverbial wrench in the Canadian economic recovery.

From a volatility standpoint, it looks like their concerns are justified. “For years it was traditional for the cost of a one-week option on the Canadian dollar to be 20 to 25 basis points…The cost is now commonly in the 50-point to 75-point range and in the last six months it has been as high as 100 points.” On a relative basis, the currency is also more volatile than the commodities with which it is commonly associated. In the last two months alone, it recorded both a 7.4% plunge and a 10% rise. To be fair, short-term volatility is lower than it was one year ago, but this isn’t going to placate those who insist that it’s still too high.

Looking at the charge that the Canadian Dollar has risen too rapidly, this too appears valid. One could argue that the thundering 20%+ rise since March was simply a retracement (in FX terminology), necessary to offset the even bigger decline that took place following the onset of the credit crisis. This argument, however, ignores the notion that the Loonie was probably overvalued before it fell. At that time, commodity prices were sky-high, and expectations were that they would remain high, if not soar even higher. Since then, they have fallen precipitously, to less than half of the record highs recorded during the peak of the bubble.

Speaking of commodity prices, “At the time of its [the Bank of Canada's] last statement, oil prices were about $75 a barrel, but now they are in the $60-to-$65 range. That suggests the currency’s appreciation has outpaced the demand for its commodity exports.” In other words, the Loonie’s recent rise can be attributed more to speculation, than to a change in fundamentals. “The rise in the dollar reflects ‘hot money seeking alternatives to the greenback,’ not the underlying economic strength,” agrees one analyst.

The Bank of Canada, naturally, views this as a problem, and “Bank of Canada Governor