Let me preface this post, by noting that I try to avoid writing about gold, since there are some many other excellent analysts out there writing about the subject. But when there is a such a strong overlap between gold and forex markets, well, I just can’t resist!

Recently, gold prices have collapsed at virtually the same rate as the Euro, with the result being a near-record high short-term correlation between EUR/USD and gold prices. This has caused no shortage of confusion among gold-watchers, which are accustomed to seeing the strongest (inverse) correlation with the US Dollar. This change is causing everyone to rethink some classically held assumptions about gold prices.

The foremost of which is that gold is chiefly a hedge against the Dollar, which is a symbol for inflation and erosion of value. [In fact, analysts argue that gold has little real purpose (besides a handful of trivial practical uses, such as jewelry), especially since holders of gold don't receive interest, there is little reason to own it other than as a store of value].  Thus, as the Dollar has declined over the last five years, gold has soared. Investors who are nervous about perennial budget deficits in the US and the skyrocketing national debt, have turned to Gold because of the belief  it will continue to hold its value even (or especially) if the US government is forced to devalue its debt by devaluing the Dollar. While this tenet underlies the gold/Dollar inverse relationship, the long and short of it is that investors typically buy gold when the Dollar falls, and vice versa. Thus, when the credit crisis struck and the Dollar rallied, gold prices fell, despite the fact that the US was now more likely to default on its debt.

In the last month, however, the Euro has taken center stage in dictating the price of gold. This is most likely because of the sovereign debt problems of certain EU countries. A not insignificant number of which well exceed the budget (not to exceed 3% of GDP per year) and debt (not to exceed 60% of GDP) limitations imposed on them by their membership in the EU. Recent credit rating downgrades have underscored an increasing likelihood of default, which has been duly noted both by the forex and gold markets. As the Euro has dropped (quite dramatically in fact), so has gold.

According to the current paradigm, this is not wholly unsurprising, since the Euro’s fall has naturally been mirrored by a rise in the Dollar. Thus, if you continue to look at gold prices in terms of the Dollar, it seems naturally that a rising Dollar is being accompanied by falling gold. On the other hand, the fact that the Dollar is suddenly rising has little to do with a change in US fundamentals, and instead reflects the fact that in forex, it’s impossible to short all currencies simultaneously, even if sometimes fundamentals would justify such an approach.

In other words, that certain EU member states are more likely to default on their respective debt obligations has limited bearing on whether the US will also default. [If anything, it increases the likelihood, since a default in the EU would likely send sovereign borrowing costs higher around the world, straining the ability of the US to continue borrowing]. By extension, the current drop in the price of gold is fundamentally irrational, especially when viewed relative to currency markets.  To borrow a hackneyed expression, perhaps it’s time for a paradigm shift.

I try not to editorialize much when writing this blog. There are too many talking heads as it is, which is why I try not to interject own opinions into the facts. Admittedly, the notion of facts in forex is obviously a bit murky, but I stand by my approach, nonetheless. Today, I would like your permission to stray from the facts (well, not entirely) and offer my opinion on the recently proposed regulatory overhaul for trading forex.

For those of you who haven’t been following this story, let me give you an overview. On January, the U.S. Commodities Futures Trading Commission (CFTC) proposed a set of sweeping changes to the rules that currently govern forex trading in the US. Among the changes are beefed-up requirements for forex dealers which would be legally required to register with the CFTC as “retail foreign exchange dealers”, and satisfy certain capital adequacy requirements, aimed at mitigating counter-party risk (i.e. dealer bankruptcy.) In addition, “introducing brokers,” (i.e. those that act as intermediaries between customers and dealers) would be required to sign exclusivity agreements with dealers, who would in turn be required to vouch for their brokers. Last, but not least, would be a bombshell change that would shrink leverage (i.e. raise margin requirements) to a maximum of 10:1.

We have are now partially through a 60-day “comment period,” during which the CFTC is soliciting feedback from stakeholders to determine if and in what form it should ratify these changes. And feedback is indeed reverberating around the blogosphere (more so than traditional media, based on my observation). Most industry insiders are predictably opposed to the regulation, on the grounds that it will make them less competitive with their (lightly regulated) foreign counterparts. Based on an online poll, it seems the majority of forex traders are as well. On forums, many have promised to shift their accounts overseas (or are gloating about already having done so) as soon as the measures pass. Meanwhile, the blogger to come out most prominently in favor of the regulation, is none other than Karl Denninger, who champions the the potential increase in transparency in decrease as leverage, but notes that it will probably bring about the “Death of Retail Forex.”

Personally, I am inclined to agree with Denninger (though not his flawed math, nor his erroneous tirade against rollover fees), on the grounds that transparency – especially with regard to commissions, which are dissimulated and ultimately buried in spreads – can only benefit customers. In addition, requiring all brokers and dealers to register, while strengthening the CFTC’s jurisdiction over forex will surely go a long way towards minimizing fraud, which remains rampant and in disguise, even among major brokers. Interestingly, industry lobbyists have come out in tepid support of this measure, but only because it will also raise the barriers of the entry.

As for the clause that aims to limit margin – and is really the only one that anyone is seriously protesting – this is also a step in the right direction. While libertarians and the 1% of traders that have turned a profit employing 100:1 leverage (the current U.S industry standard) will surely disagree, I think that sometimes, people need to be protected from themselves. I don’t want to frame this debate in political terms, however, since at the end of the day, such high leverage is both de-stabilizing to the market, and unnecessary. It’s destabilizing, because of the massive speculation it invites, and its resulting contribution to volatility and systemic risk, and unnecessary because it’s impossible to produce a viable trading strategy that’s built on borrowing 100 times as much money as you are able to commit. For the sake of comparison, consider that the average hedge fund, its reputation for excessive risk-taking not withstanding, will rarely employ leverage greater than 2:1. How about another comparison: Has 100:1 leverage (i.e. 1% down-payment) been good for the housing market, from both the standpoint of individual and society?

As for the argument that retail traders will instead send their money off-shore to gamble (cough, I mean trade), well I suppose that’s possible. But given that a related piece of  recent regulation has been very successful at preventing Americans from patronizing offshore casinos, I’m sure the government can ensure a high rate of adherence with this piece as well. But obviously, this too, is a highly charged political issue, and it’s probably not practical to examine forex from this angle.

In the end, I think the government has (rightly) identified retail forex as the casino it is, and is finally taking steps to make it legitimate. For regular readers of the Forex Blog and those that follow its implicit approach (i.e. not churning your portfolio on a daily, or even weekly basis), I am confident that this regulation, if approved, will NOT adversely affect you. As for everyone else, maybe it’s time to either re-think your strategy, or ask yourself whether trading forex is still right for you.

I thought it would be fitting to follow up my last post (Forex in 2009: A Year in Review), with one that looked forward. And what better way to do that then by squarely examining the US Dollar, which is still the undisputed heavyweight champion of forex markets, and from which most other forex trends can be ascertained and comprehended.

December (I know I said I wouldn’t look backwards, but come on, a little context is necessary here…) was the best month for the Dollar in 2009. From December 1 to December 31, it rose 4.7% against the Euro and 7% against the Yen, as part of an overall 4.8% appreciation against a basket of the world’s six other major currencies. “The dollar rally which has taken place in December is significant in that it has brought an end to the powerful downtrend which had been in place since March following the Fed’s decision to begin quantitative easing,” summarizes one analyst. As a result of the Dollar’s strong turnaround in December (and the forgotten fact that it actually appreciated in the beginning of last year), the broadly weighted Dollar Index finished 2009 down a modest 4%.

Analysts summarized this turnaround using a few main paradigms. The first was that logic had returned to the forex markets, such that the negative correlation between equities (which serve as a broad proxy for risk sensitivity) and the Dollar had broken down [See earlier post: “Logic” Returns to the Forex Markets, Benefiting the Dollar]. As a result, good economic news was once again good for the Dollar. The second interpretation was a direct contradiction of the first, and argued that the Dubai debt bomb, coupled with credit scares in Europe, had in fact increased risk aversion, and reinforced the notion that the Dollar is still a safe haven [Edward Hugh mentioned this in my interview of him]. The third theory represents a slight twist on the first one- that concern over Fed interest rate hikes will shift interest rate differentials and cause the Dollar carry trade to break down. Technical analysts, meanwhile, argue that the Dollar had been oversold, and that the year-end rally was merely a product of the closing of short positions and profit-taking.

The key to predicting how the Dollar will perform in 2010, then, largely rests in correctly discerning which paradigm currently underlies the forex markets. Let’s begin by comparing the first possibility – that good economic news will be good for the Dollar – to its antithesis – that the Dollar remains the safe havens. I think two WSJ headlines can shed some light on which interpretation is more accurate: Dollar Rises On Lower Demand For Riskier Assets and Dollar Slumps As Investors Snap Up Risky Assets. In other words, the market logic is that the Dollar is still a safe-haven currency, to the chagrin of market fundamentalists.

While there are certainly “naysayer” analysts that think the US stocks will soon outpace their counterparts abroad (namely in emerging markets), such a view can best be ascribed to the minority. The majority, then, believes that good economic news (from the US, or anywhere else from that matter) is a sign that risk-taking is relatively less risky, and will lead to capital flight from the US. In short, “It’s too early to dismiss the negative correlation between equities markets and the dollar, i.e., when risk appetite declines, that still seems to favor the dollar even though we’ve seen a slight decoupling from that in early December.”

With regard to the notion that the Dollar is being driven by expectations that the Fed will tighten monetary policy at some point in 2010, that seems to have some traction. The markets have priced in a 60% possibility of a Fed rate hike by June, and a majority of economists (9 out of 15 surveyed) think that the Federal Funds rate will be higher at the end of the year. This optimism is a product of the last month, which saw strong improvements in non-farm payrolls, housing sales, durable goods orders, ISM supply index, and more. Some of these indicators are now at their highest levels since 2006; “That speaks better about the health of the U.S. economy and that could help move up the timetable for the Fed to boost interest rates,” goes the accompanying logic.

That investors believe the Fed will hike interest rates and that it will be good for the Dollar is not so much in dispute. Whether investors are right about rate hikes, on the other hand, is less certain. To be sure, momentum is growing in the US as the economy shifts from recession to growth. While current data is unambiguous in this regard, the future is less certain. A vocal minority of analysts argues that the apparent stabilization is largely due to government incentives. When these expire, then, the result could be a double dip in housing prices, and a second act in the economic downturn.

The result, of course, would be a delay and/or slowing in the pace of Fed rate hikes. Some economists predict that that Fed will indeed hike rates in 2010, but only incrementally. Others have argued that it won’t be until 2012 that the Fed lifts its benchmark FFR from the current level of approximately 0%. Instead, the Fed will first move to withdraw some of the liquidity that it unleashed over the last two years, of which an estimated $1.1 Trillion still remains “in play.” Such would be directed primarily at heading off inflation, and wouldn’t do much for the Dollar.

Regardless, the implication is clear: “The fate of the dollar is in the hands of Ben Bernanke. If he begins the exit process and starts to raise interest rates, the dollar will perform okay this year.” If he stalls, and investors accept that they may have gotten ahead of themselves, well, 2010 – especially the second half – could be a sorry year for the Dollar.

In some ways, 2009 was a wild year in forex markets. Compared to 2008, however, it was relatively tame. And that is all I have to say about forex in 2009.

Ah, if only it were that simple…

The year began as a continuation of 2008. Global capital markets were still in the throes of the credit crisis, and risk aversion was in vogue. Investors continued to remove funds en masse from virtually every economy – with an emphasis on emerging markets – and parked the proceeds in the US. More specifically, they put the proceeds in US Treasury securities. US corporate bonds and equities declined, as did interest rates, to such an extent that short-term rates briefly dipped below zero.

As this trend gathered momentum, the Dollar continued its rally against virtually every currency, with the notable exceptions of the Swiss Franc and Japanese Yen. For reasons related both to the unwinding of the Japanese Yen carry trade and the bizarre perception that Japan was also a safe haven against the storm of the financial recession, despite the fact that its economy contracted by the largest amount of perhaps any economy due to its reliance on exports. Against other currencies, the Dollar was nothing short of brilliant, surging 30% against many emerging market currencies, and 50% against the Korean Won, from trough to peak. Some analysts predicted that it was only a matter of time before the Dollar reached parity with the Euro.

But it wasn’t to be, as the Dollar never topped $1.25 against its chief rival. The markets pulled an abrupt about-face in March, and began a rally that would last 8 months (and might still be in progress, depending on who you talk to). The S&P 500 rose by more than 50%, impressive, but still paling in comparison to emerging market equity prices. As investors grew more and more comfortable with risk, they reversed the flow of funds, and bond spreads between the US and the rest of the world gradually declined. More importantly, so did volatility. For the forex markets, that meant a rapid appreciation in every single currency against the Dollar.

Around the same time, the Swiss National Bank (SNB) intervened for the first time (it would intervene again in June) in forex markets, ostensibly to guard against deflation. As a result, the Swiss Franc has largely been exempted from the forex rally which sent the Euro up 15%, the Brazilian Real up 35%, and the Australian and Canadian Dollars back towards parity with the the US Dollar.

After a modest rally, the British Pound stabilized around pre-bubble levels, due to concerns about the UK’s quantitative easing program (i.e. wholesale money printing), and consequent impact on inflation and the British national debt. Similar concerns have plagued the US Dollar, but interestingly have spared the Euro and Canadian Dollar, despite the fact that their respective Central Banks’ response to the credit crisis have largely mirrored that of the Fed. As a result, the Pound was quickly segregated with the Dollar as a fellow “sick” currency.

By the summer, currencies and asset prices had risen by such an extent that investors began to fear the formation of bubbles. Governments and Central Banks, meanwhile, grew concerned about the potential impact of expensive currencies on their nascent economic recoveries. A handful of Central Banks – many in Asia – intervened successfully to thwart the appreciation of their respective currencies, while Brazil resorted to taxes to try to stem the appreciation of the Real. The Bank of Canada threatened intervention, while the Bank of Japan was more ambiguous; investors ultimately shrugged off both, and the Japanese Yen touched an all-time high against the Dollar in November.

Towards the end of the year, the rally began to lose steam as investors began to fret that they had gotten ahead of themselves. In addition, the prospect of interest rate hikes was moved to the fore, thanks to early action by the Bank of Australia. While it’s clear that the Fed won’t be moving to tighten monetary policy anytime soon, investors have been forced to re-evaluate their short-Dollar carry trade positions within this context.

Meanwhile, a handful of credit market scares, first involving Dubai, and later, a handful of EU member countries, reminded investors that the recovery was both fragile and unequal. As a result of the renewed focus on fundamentals, commodity currencies and currencies backed by strong economic growth projections, continued to appreciate. The Dollar, despite comparatively weak fundamentals, also appreciated, due to its safe-haven appeal and perceptions that the Fed would be among the earliest Central Banks in the industrialized world to hike rates. Ironically, forex markets ended the year ironically just as they began (though for different reasons), with the Dollar in the ascendancy.

Many analysts are pointing to Friday, December 4, as the day that logic returned to the forex markets. On that day, the scheduled release of US non-farm payrolls indicated a drop in the unemployment rate and shocked investors. This was noteworthy in and of itself (because it suggests that the recession is already fading), but also because of the way it was digested by investors; for the first time in perhaps over a year, positive news was accompanied by a rise in the Dollar. Perhaps the word explosion would be a more apt characterization, as the Dollar registered a 200 basis point increase against the Euro, and the best single session performance against the Yen since 1999.

Previously, the markets had been dominated by the unwinding of risk-aversion, whereby investors flocked back into risky assets that they had owned prior to the inception of the credit crisis. During that period, then, all positive economic news emanating from the US was interpreted to indicate a stabilizing of the global economy, and ironically spurred a steady decline in the value of the Dollar. On December 4, however, investors abandoned this line of thinking, and used the positive news as a basis for buying the Dollar and selling risky currencies/assets.

If you look at this another way, it reinforces the notion that investors are paying closer attention to the possibility of changes in interest rate differentials. The fact that the recession seems to have ended suggests that the Fed must now start to consider tightening monetary policy. This threatens the viability of the US carry trade – which has veritably dominated forex markets – because it literally increases the cost of borrowing (carry): “If the market thinks that Fed rates are about to move higher, the dollar will cease to be a funding currency and the inverse correlation between the dollar and risky assets will break.”

To be fair, it will probably be a while before the Fed hikes rates: “It’s a prerequisite to have a continuing decline in the unemployment rate for at least three months before the Fed considers tightening,” asserted one analyst. At the same time, investors must start thinking ahead, and can no longer afford to be so complacent about shorting the Dollar. As a result, emerging market currencies probably don’t have much more room to appreciate, since the advantage of holding them will become relatively less attractive as yield spreads narrow with comparable Dollar-denominated assets.

To be more specific, investors will have to separate risky assets into those whose risk profiles justifies further speculation with those whose risk profiles do not. For example, currencies that offer higher yield but also higher risk will face depressed interest from investors, whereas high yield/low risk currencies will naturally greater demand. You’re probably thinking ‘Well Duh!’ but frankly, this was neither obvious nor evident in forex markets for the last year, as investors poured cash indiscriminately into high-yield currencies, regardless of their risk profiles.

To be more specific still, currencies such as the Euro and Pound face a difficult road ahead of them (as does the US stock market, for that matter), mainly due to concerns over sovereign solvency. (Try saying that three times fast!) On the other hand, “Commodity-linked currencies such as the New Zealand, Australian and Canadian dollars [have] rallied sharply, and will probably continue to outperform as their economies strengthen and their respective Central Banks (further) hike interest rates.

It remains to be seen whether investors will remain logical in 2010, since part of the recent rally in the US Dollar is certainly connected to year-end portfolio re-balancing and profit-taking, and not exclusively tied to a definitive change in perceived Dollar fundamentals. Especially since they remain skittish about the possibility of a double-dip recession, investors could very easily slip back into their old mindsets. For now, at least, it looks like reason is in the front seat, making my job much less complicated.

By now, the notion that the nascent global economic recovery is being and will continue to be led by China has become cliche. The NY Times summarized: “In past global slowdowns, the United States invariably led the way out, followed by Europe and the rest of the world. But for the first time, the catalyst is coming from China and the rest of Asia, where resurgent economies are helping the still-shaky West recover from the deepest recession since World War II.”

The statistics are certainly compelling. After a brief dip in the first quarter, GDP grew by an impressive 7.9% in the second quarter. In hindsight, the downturn in Chinese economic output was so slight as to hardly warrant use of the term recession to describe it; any other country would have rejoiced after achieving 6.1% (2009 Q1) growth, especially in the context of the current economic climate.

While stock market investors are evidently optimistic that the economy will continue to gather momentum, China-watchers and policymakers are more cautious. Wen Jiabao, premier of China, insisted that, “We must clearly see that the foundations of the recovery are not stable, not solidified and not balanced. We cannot be blindly optimistic.”

Wen’s downbeat prognosis should be seen in the context of China’s massive stimulus plan, which delivered an immediate jolt to the economy, but is already winding down. “The flood of bank lending in the first half of this year — equivalent to more than half of gross domestic product in the period…is ebbing. Net new lending in July was 355.9 billion yuan ($52.13 billion), the lowest figure so far this year and well below the first half’s monthly average of 1.2 trillion yuan.” Some analysts believe that this sudden decrease is due to seasonal factors, but others argue that it is a sign that the boost in lending (and spending) from the stimulus may have already exhausted itself.

In addition, the stimulus itself was not necessarily geared towards sustainable growth (in the economic, not the environmental sense). Over the last two decades, China embraced an economic model focused around exports and capital investments, at the expense of domestic consumption. While it will certainly be years before economists can determine whether the recession changed the structure of China’s economy, the earliest indications point to business as usual. “This year the bulk of the government’s stimulus is going into infrastructure, further swelling investment’s share. Chinese capital spending could exceed that in America for the first time, while its consumer spending will be only one-sixth as large.”

To be sure, the government has rolled out incentives and subsidies designed to reduce savings and increase consumption. However, Chinese cultural mores and the government’s lack of social services represent a formidable obstacle to any opening-up of the mentality of Chinese consumers- and their wallets. In fact, while China’s government is still nominally Communist, spending on public services is among the lowest in the developed world. Despite doubling to 6% of GDP, such spending is still well below the OECD average of 25%. The widening rich-poor gap, meanwhile, suggests that most of the windfall from China’s economic boon has been bestowed upon a relative handful of businesses and people, such that the majority of China’s 1.3 Billion populace simply doesn’t have the means to increase consumption.

For better or worse, the global economic downturn has severely crimped demand for Chinese exports, and this component of GDP could remain depressed for quite some time. After a record $400 Billion in 2008, the trade surplus plummeted in 2009, “to $35 billion in the same [second] quarter, 40% down on a year earlier…the decline is even more impressive in real terms (adjusting for changes in export and import prices), with the surplus shrinking to less than one-third of its level a year ago.” In fact, some analysts project that China could soon experience a trade deficit, if current trends continue.

All of this suggests that the Chinese RMB is not likely to return to its path of rapid appreciation (28% in real terms), observed from 2005-2008. (The currency has essentially been fixed at 6.83 RMB/USD since December 2008, leading to an 8% decline in real terms to match the decline of the Dollar.) China’s foreign exchange reserves, which have come to mirror the appreciation of its currency, are once again expanding. ($2.13 Trillion at last count). Given the decline in the trade balance and the explosion in the budget deficit, however, much of this increase must be attributed to the inflow of speculative capital, which will not necessarily translate into currency appreciation.

Some economists insist that the Yuan is still undervalued by as much as 25%, but investors don’t believe that it will bridge this gap anytime soon. While the spot exchange rate has risen to the strongest level since May, futures prices indicate a modest 1.5% appreciation against the Dollar over the next twelve months. This is an improvement from expectations of a flat exchange rate, but still a long way away from what some economists think is reasonable.

Yesterday, both the European Central Bank (ECB) and the Bank of the UK cut their benchmark interest rates to record lows. This is especially incredible in the case of the UK, whose Central Bank over 300 years old! You can see from the following chart that both Central Banks have more than made up for their respectively slow starts in easing monetary policy by effecting several dramatic rate cuts, following the example of the Federal Reserve. The baseline UK rate now stands at .5%, only slightly higher than the Federal Funds rate, and slightly lower than the 1.5% ECB rate.

Given that they have essentially reached the terminus of their monetary policy options, all three Central Banks are exploring further options aimed at pumping money into their respective economies. The Fed has already “announced a program to buy $100 billion in the direct obligations of housing related government sponsored enterprises (GSEs) — Fannie Mae, Freddie Mac and the Federal Home Loan banks — and $500 billion in mortgage-based securities backed by Fannie Mae, Freddie Mac and Ginnie Mae.” As I wrote in a related article, “this was quickly followed by repurchase programs, lending facilities, investments in money market funds, and option agreements, all of which were designed to supplement its ‘traditional open market operations and securities lending to primary dealers.’ The Fed’s efforts also worked to ease the liquidity shortage in credit markets abroad by entering into swap agreements with several foreign Central Banks suffering from acute Dollar shortages.”

In conjunction with the rate cut, the Bank of the UK, meanwhile, will pump £150bn directly into UK credit markets through liquidity support, buying public and private debt, and asset purchases. “The main purpose of quantitative easing is not to send the money supply into orbit but to stop it from crashing…the broad money held by households has risen at a worryingly slow rate over the past year, and holdings by private non-financial firms have actually been dropping.” In contrast to the monetary programs of the UK and US, the ECB has thus far refrained from the kind of liquidity support that would necessitate printing new money. Instead, “the central bank will continue offering euro-zone banks unlimited loans at the central bank’s policy rate until at least the end of this year.”

The interest rate cuts were announced simultaneously with a spate of macroeconomic data, which collectively paint a bleak picture. Eurozone growth is projected at -2.7% for 2009 and 0% for 2010. The current unemployment rate at 8.2% and climbing. The thorn in the side of the EU is represented by eastern Europe, where growth is falling at an alarming pace, dragging the EU down with it. While EU member states have pledged to intervene if one of their own falls into bankruptcy, it’s unlikely that they would intervene similarly if a non-EU member state went bust. The UK economy is similarly desperate, having contracted at an annualized rate of 5.8% in the most recent quarter. The wild cards are the real estate and financial sectors, the fortunes of which are increasingly intertwined.

So what do the forex markets have to say about all this? Economists have used the dual phenomena of risk aversion and deflation to explain the interminable weakness in the the Pound and Euro. Everyone is surely familiar with the notion of the US as “safe haven” during periods of global financial instability. The deflation hypothesis, meanwhile, suggests that the ECB (and to a lesser extent, the Bank of UK), fell behind the curve when easing liquidity. The ECB, especially has harped on inflation as a reason for cutting rates more quickly. Given that investors are now more concerned with capital preservation than price inflation, it follows that they would prefer to invest where Central Banks were more vigilant about deflation (i.e. the US).

Personally, I think that the continued declines in both currencies, in spite of steep interest rate cuts, indicates that the deflation hypothesis is bunk, and investors remain fixated on risk aversion. By no coincidence, the temporary rebound in US stocks that took place in January was also accompanied by a bump in the Euro. (See chart below).

I think this mindset is reasonable, but only in the short-term. Given the current economic environment, I don’t think investors (and currency traders) can be faulted for ignoring the possibility that quantitative easing and liquidity programs will have to be funded with the printing of new money, which would be inherently inflationary. Many comparisons are being made with Japan, whose ill-fated quantitative-easing program succeeded only in inflating a bond-market bubble and vastly increasing Japanese public debt. According to one columnist, “it’s hard to argue that quantitative easing ended deflation; high oil prices did that. Meanwhile, the economy cured on its own most of the structural problems such as excess capacity and too much debt associated with the deflationary environment.”

In short, with a medium and long-term investing horizon in mind, I think the ECB’s approach to dealing with the credit crisis is more conducive to monetary stability. Thus, when investors grow weary of the idea of US as safe haven, they will no doubt focus instead on fundamentals. At which point, the ECB will likely be rewarded for fulfilling its anti-inflation mandate, in the form of a stronger Euro.

Over the last month, the Dollar has rallied tremendously, rising over 7% against its main adversary, the Euro. The price of gold, which serves as an inverse proxy for investor confidence in the USD, has fallen dramatically. As a result, many analysts have proclaimed that the Dollar has (permanently) bottomed out, and are busying themselves preparing projections for how high the Dollar will rise. But is the Dollar rally sustainable?

In the short-term, I would argue the answer is yes. The bubbles in the various sectors of commodity markets seem to have partially deflated, with oil and certain food staples well below the record highs they touched earlier in the year. As a result, inflation may soon begin to abate, and return to a comfortable level as early as 2009. More importantly, the US economy was among the first to be affected by the credit and real estate crises. Some analysts have argued that the worst developments have already come to pass. The crisis has since spread to the global economy, with other countries sharing in some of the burden. The result is that the US economic and monetary cycle is probably ahead of most of its peers. Accordingly, by the time the full impact of the crisis is felt by the rest of the world, the US should firmly be on the path to recovery. As other Central Banks move to ease their respective monetary policies, the Fed should be in a position to hike rates, providing further support for the Dollar.

As a result of this belief, US capital markets have received a sudden inflow of capital. This trend has been further buoyed by the notion that the US is the safest place to invest in times of crisis is gaining traction among investors. If the credit crisis continues to spread, this notion will no doubt be reinforced.

The long-term picture is of course more nuanced. The US will hardly emerge from the current crisis unscathed, and the ultimate cost of the credit crisis could exceed $1 Trillion. In addition, the US is unlikely to be shamed into changing its nasty habit of spending more than it saves. Accordingly, the twin deficits, those permanent thorns in the side of the Dollar, will probably persist. In addition, recent history suggests that investors are slow to absorb the lesson that There is No Such Thing as a Free Lunch. Despite the horrible collapse of the dot-com bubble, investors piled willy-nilly into the real estate market, with the result speaking for itself. Analysts are already speculating where the next bubble will occur; perhaps in alternative energy?

In conclusion, while the near-term prospects of the Dollar are surprisingly bright, the long-term prognosis is less so. There is no indication that the structural weaknesses in the US economy that led to the credit crisis and the multi-year decline in the USD that preceded it, will abate following its resolution. The future is inherently unpredictable, but I would expect the Dollar to continue declining once the global economy is back on track, perhaps in 2010.

In the context of fundamental currency analysis, we usually talk about inflation, interest rates, economic growth, politics, etc. But perhaps these variables mask some deeper "truth" in forex, specifically that there is some ultimate "force" guiding the decision-making processes of forex traders. What we are really talking about here is comfort with risk. Especially in the medium-term (the short-term consisting of hours and defined by randomness and the long-term consisting of years and defined by relative changes in the money supply), investors are constantly re-evaluating the level of risk that they want to assume.

To make this idea more concrete, let’s look at how the credit crisis has impacted forex markets. In general, it has favored major currencies, such as the Dollar and the Euro, although sometimes one more than the other. This is to be expected since the capital markets of the US and the EU are the most stable and in times of uncertainty, investors seek out stability. Likewise, the Japanese Yen has fared well. Despite a continuation of its easy money policy, investors have unwound their Yen carry trade positions, ever-fearful that a spike in volatility could cost them dearly. On the other end of the equation are emerging market currencies and beneficiaries of the carry trade, which have faltered as investors pare their exposure to risk. The underlying narrative is the same; only now, investors are willing to accept lower returns in exchange for proportionately lower risk. 

The Dollar is currently teetering on the edge of a precipice.  Many analysts are predicting that, having recently retreated from a record low against the Euro, the Dollar’s best days are still in front of it. On the other hand, the economic data and interest rate pictures remain nuanced, and still favor the Euro on paper. In this article, we aim to sort through this morass, and produce a clear summation of the factors which bear on the Dollar in the short term.

Let’s begin with the bullish side of the equation, which is supported by the Dollar’s recent upside swing. First of all, while interest rate differentials are currently hurting the Dollar, the Fed is probably near the end of its loosening cycle, while the ECB has yet to begin. The best-case scenario would be a tightening of US monetary policy simultaneous with a loosening of EU policy. Next, there is the economic picture. The most recent GDP data indicates an economy that is still growing, albeit slowly. In addition, the unemployment rate declined in the most recent month for which data is available. The US stock market has regained half the value it lost in the first three months of 2008, and the overall P/E ratio is close to its long-term average, which suggests the markets could appreciate further. Finally, the economic stimulus package that was approved by Congress in March will go into effect this month, as tax rebates worth $150 Billion are distributed to consumers and businesses.

On the bearish side, let’s return to the interest rate story. While the future certainly bodes well for the US, the present still favors the EU. US interest rates are currently negative in real terms, and investors have already turned the Dollar into a funding currency for carry trades. Moreover, negative real interest rates implies high inflation. US CPI is hovering around 4.0%, and could continue to climb in proportion with surging food and energy prices. In fact, inflation is now viewed by economists as more problematic than the economy, itself. While US exporters have benefited from the resulting cheap Dollar, US consumers- which account for 75% of the US economy- have not. The economic downturn still has not officially been labeled a recession by the Bureau of Economic Research, but the situation remains tenuous, and the scales could easily be tipped by a few pieces of negative economic data.

The wild card in this mess is housing. In certain regional markets, real estate prices have tumbled by 30%.  In other markets, they have hardly budged. While an estimated $350 Billion in subprime debt has already been written down, analysts disagree over the eventual total.  Estimates vary from $1 Trillion to less than $350 Billion, which would imply "write-ups" on debt that was erroneously declared worthless. The difference represented here amounts to 6% of GDP, which could mean the difference between growth and contraction, a strong Dollar and a weak Dollar, respectively.

For at least the duration of the current administration, the official US stance towards its currency has been a "strong dollar" policy.  In hindsight, it appears that this policy was entirely baseless, since its was directly undermined by the simultaneous easy monetary policy, and thus it stands to reason that US policymakers did not actually believe that a strong Dollar policy was necessary to pursue.  In a recent op-ed piece published in the Wall Street Journal, one analyst outlines the case for a strong dollar, and by extension, why the depreciating Dollar is bad for the US economy. 

First, since oil contracts are settled in Dollars, a weak Dollar has directly contributed to high oil prices, which has several negative economic and geopolitical consequences. Second, a cheap Dollar is eroding the purchasing power of US consumers directly by making imports more expensive and indirectly through inflation. Third, the weak Dollar shifts the balance of economic power in favor of US competitors, which don’t need to grow as fast to keep pace with the US, in Dollar terms.  Finally, the recent weakness threatens the long term reserve status of the Dollar, which has important implications for economic growth and jobs creation.

On the other hand, argues the analyst, the conventional wisdom that a declining Dollar is necessary to correct the current account and trade deficit is bunk, since much of the trade deficit is accounted for by intra-company trade and since the current account deficit is generally overstated and not connected to currency valuations. In short, he argues, it is in the best interest of the US to align its rhetoric with its economic and monetary policies such that the long term luster of the Dollar is restored.

Read More: The Dollar and the Market Mess

Last week, the Forex Blog recounted what happened across forex markets in 2007, in all of its drama. Now, we would like to offer a nice counterpoint, in the form of the major themes expected to dominate forex headlines in 2008, courtesy of Dow Jones. The list includes eight distinct themes, though there is some overlap.  Three of the themes pertain directly to the USD, which is the currency most worth watching in the upcoming year.  The fundamentals bode well for the Dollar; the economy has not suffered from the credit crunch nearly as much as economists feared; the cheaper currency has boosted exports; foreigners have proven surprisingly willing to finance the twin deficits.

Then, there is inflation, which has reared its ugly head in the US as well as abroad. Foreign Central Banks, especially in Asia, may have to tighten monetary policy in order to maintain price stability. Those countries with already-high interest rates, such as Australia and New Zealand, are expected to keep rates high.  The next theme, accordingly, is the carry trade, which should continue its run due to the aforementioned high interest rates.  Next is China, which will be watched on two fronts: its economy and its currency, both of which are expected to continue rising. 

The final two themes pertain especially to the Middle East: currency pegs and Sovereign Wealth Funds. As the Dollar declined in 2007, several nations in the Mid East mulled the possibility of de-linking their respective currencies from the Dollar, but thus far, the status quo has obtained.  Sovereign Wealth Funds also made a big splash in 2007 with several high-profile investments in the US, implicitly underscoring their their commitment to the Dollar.  They represent a growing force in global capital markets, and will be watched vigilantly in 2008.

View the Complete List Here

As 2007 draws to a close, the Forex Blog would like to formally deliver its second annual ’state of the markets’ address. While the picture in most capital markets was blurry and nuanced, the story for forex markets was relatively straightforward. Simply speaking, the story was all about the US Dollar, which followed up its worst year in recent memory in 2006 with an equally abysmal performance in 2007. In fact, over the last two years, the Dollar has fallen over 20% against the Euro, and even further against most of the world’s other important currencies.

During the early part of the year, evidence mounted that the current US economic cycle had peaked, and analysts began to speculate that the US Federal Reserve Bank would cut interest rates. Nonetheless, the Dollar traded sideways for the next nine months, until the housing bubble burst and the ensuing credit crisis quickly metastasized to the rest of the economy.  The Fed responded by cutting interest rates by 50 basis points, and the Dollar began to unravel, losing 10% of its value in a matter of weeks.  After that point, the bad news began to pour in.

The oil-exporting countries delivered a one-two punch to the Dollar, first by announcing that the possibility of accepting payment for oil in other currencies, than hinting towards a collective dissolution of their respective Dollar pegs. The Canadian Dollar reached parity with its counterpart to the south shortly thereafter.  Countries in the developing world, including Brazil, Russia, and India, also witnessed surges in their respective currencies. The Chinese Yuan continued its slow climb, rising over 6% for the year, though this figure is probably closer to 2-3% in real terms. Even the Japanese Yen, previously held in place by the carry trade, notched an impressive performance as the credit crunch touched off a cascade of risk aversion.  Then, of course, there was the interest rate story: by the end of the year, US interest rates were only 25 basis points above EU rates, and Dollar bears were licking their lips.

The news was not all bad, however.  Foreign investors proved that they were willing to continue to finance the US twin deficits, though perhaps to a lesser extent than before.  There were even several high-profile investments in US financial institutions, led by Sovereign Investment Funds, which collectively claim hundreds of billions of dollars at their disposal.  In addition, the world’s Central Banks announced plans to pump over $500 Billion into global capital markets, which should especially benefit the Dollar since the US bore the brunt of the credit crunch.  Finally, economic data now indicate that US exports have been helped by the declining dollar. 

All things considered, it could have been worse.  Tune in later this week, as we unveil our forecast for 2008.

Despite its multi-year decline, the US Dollar remains the world’s undisputed reserve currency, claiming a 65% share of total Central Bank reserves. However, the chorus of soothsayers proclaiming the apocalypse for the Greenback is growing louder by the day. Every week seems to offer a new piece of news confirming that the Dollar’s reign is coming to an end. Analysts are drawing parallels between the British Pound of 50 years ago and the Dollar today. China is threatening to diversify its reserves into Euros. Iran and Venezuela are leading calls to price oil in terms of a basket of currencies, rather than in USD. The other members of OPEC are considering de-pegging their respective currencies from the Dollar. What does all of this mean? Is the Dollar truly in danger of being replaced as the world’s reserve currency?

The short answer is ‘no.’ The US twin deficits have expanded every year for the past decade and economic theory suggests that in order for a nation’s current account to rebalance itself, a decline in the value of its currency is required. At the same time, these deficits are sustainable for as long as foreign investors, sovereign and private, are willing to sustain them. And despite the looming threat of recession, economic data and anecdotal stories suggests that such investors remain willing to lend their financial support. For example, the announcement of record-breaking losses by American financial institutions has been met with solid commitments to invest by international investors.

In addition, while foreign exchange reserve diversification is certainly justifiable from a risk management standpoint, it hardly makes sense from a financial standpoint. The case could have been made for foreign Central Banks to exchange their Dollars for Euros and/or Pounds several years ago when both currencies were trading at relative bargains to the USD. Now that these currencies are more expensive, it seems harder for to justify buying assets and securities denominated in them. Furthermore, Central Banks must recognize that diversifying now would be counter-productive, by sending a wave of panic through the markets and undermining their efforts. As one analyst pointed out, Japan and China, the two largest holders of USD, both have a vested interest in an expensive Dollar.

However, the long answer to the question posed at the beginning of this article is closer to ‘maybe’ than ‘no.’  In the long-term, Central Banks will certainly move towards a more diversified portfolio of currencies.  For countries like China and Japan, this will help minimize risk.  For countries in the Middle East that peg their currencies to the Dollar, this will enable them to conduct monetary policy independent of the US.  Ultimately, US capital markets are the most stable and liquid in the world, and regardless of the value of the USD, it will serve the interests of Central Banks to denominate a large portion of their portfolios in Dollars.  Besides, analysts can be extremely fickle. It was only five years ago that the Euro was trading below parity with the USD and analysts were predicting its collapse.  The fundamentals underlying both currencies have not changed much since then, yet commentators have reversed their positions. Who knows what such analysts will be preaching five years from now…

Now that the furor over the US housing crisis/credit crunch has begun to subside in forex markets, investors have turned their attention to what is perhaps the second biggest threat to the Dollar’s long term health: the PetroDollar phenomenon.  In short, the price oil is denominated in Dollars and many oil-exporting nations peg their currencies to the USD. Having found themselves awash in cash, such nations are beginning to ponder greater financial independence from the declining Dollar.

The anecdotal evidence for the declining importance of the Dollar among oil-exporting countries could not be stronger. Last week, the Forex Blog reported two developments. First, OPEC is considering altering the way oil contracts are settled, by pricing oil in a basket of currencies rather than in USD.  Next, the members of the Gulf Coast Council are considering de-pegging their currencies from the Dollar, due to rising inflation and the increasing opportunity cost of owning Dollar-denominated assets.

Actual data, on the other hand, suggests that OPEC may be moving in the opposite direction, towards a greater dependence on the Dollar.  The US remains the most popular destination for petrodollar investments, attracting 55% of all such investment capital. Europe comes in at a distant second, attracting just 18%. Plus, in the last year, oil money has been used to make several widely-publicized investments in American investment groups, including a recent $7.5 Billion investment in Citigroup by the Abu Dhabi Investment Authority.

The evidence is certainly nuanced. In all likelihood, OPEC will make good on Iran’s failed attempt to sell oil denominated in Euros by linking oil to a basket of currencies.  In their own words, “oil is being sold in a currency whose value was eroding by the day.”  At the same time, the US is still the home of the world’s best capital markets, from the standpoint of stability and risk. Thus, while it’s possible that some or all of the members of the GCC will de-peg their currencies from the Dollar, any relative decrease in Dollar-denominated investments is likely to be passive, rather than active. 

At last week’s G8 meeting in Washington, it was expected that currencies would be a hot topic of discussion.  With the Dollar retreating to record lows on a daily basis, the failure of China to allow the Yuan to appreciate, the Japanese Yen’s continued weakness despite its strong economy, and the recent parity of the Canadian Dollar and USD, there are certainly plenty of forex phenomena that deserve attention.  However, it is the Euro/USD relationship that probably received the most scrutiny, as the biggest contingent of the G8 uses the Euro.

European politicians and bureaucrats have spent the last few months arguing with America-as well as amongst themselves-over the declining Dollar.  The consensus is certainly that the Dollar is harming the European economies; as one German Minister phrased it, the “pain threshold” has been crossed.  At the same time, it is clear that a relatively weak Dollar is probably in the best interest of global economic stability, since the US current account and financial account imbalances can only be solved by changes in exchange rates.  Thus, there is a growing divide between European politicians, who tend to think in provincial terms, and the European Central Bank, which is more focused on the Big Picture.  The new President of France, for example, has been quite vocal in lamenting the appreciation of the Euro, even going so far as to demand the ECB step in.  Jean Claude Trichet, president of the ECB, responded by calling on European politicians to be circumspect in their comments on the Euro.

However, since Central Banks do not participate in G8 conferences, you can bet that politicians hounded Hank Paulson, US Secretary of the Treasury, on the declining Dollar.  Some analysts have even speculated that ‘intervention’ would enter into the discussions. In fact, the US has not intervened in forex markets since 1994, when Europe and American worked in tandem to prop up a then-ailing Dollar.  After a couple months, however, the plan was abandoned due to mixed results.  Is it possible that the US, confronted with the same situation, will once again attempt intervention?

The answer is “not likely.”  First, the Europeans are not even united in their position on the USD/Euro exchange rate.  Secretly, they would probably all prefer a stronger Dollar, but in public, only a handful have called for intervention.  Second, short of fixing the exchange rate (which would require the US to borrow money), it is very difficult for a government/central bank to control its currency.  Recent intervention by South Korea and Japan, as well as America’s efforts in 1994, ended in failure. Finally, there is the issue of China, which does control its currency.  The US would surely appear hypocritical if it intervened on behalf of the Dollar while simultaneously encouraging China to float the Yuan.  Thus, while certain US economic concessions may result of the G8 conference, a controlled appreciation of the Dollar will not likely be one of them.

When the US Dollar eclipsed its previous record low against the Euro last week, commentators immediately began painting doomsday scenarios for the beleaguered currency. On paper, the argument for a continued decline in the Dollar is quite strong, due to a sagging economy, surging current account deficit, the prospect of lower interest rates and turmoil in US capital markets. But, in practice, the Dollar remains the world’s de facto reserve currency, which begs the question: “how much-if at all-will the Dollar decline?”

Let’s begin by examining the state of the US economy.  At this point, economists have clearly identified the housing/real estate sector as a major weakness in the US economy.  Instability and an overall lack of demand have contributed to falling prices for real estate, which is eating into consumers’ disposable income, and hence threatens to bring down the rest of the economy.  In fact, the most recent employment data, which has become the most-watched piece of economic data in recent years, signaled that for the last 3 months, no new jobs were created in America, which is a tremendous cause for concern.

As a result, it is all but certain that the Federal Reserve Bank will lower its benchmark interest rate at its next meeting, perhaps by as much as 50 basis points.  While this may soften the impact of the sagging housing market on the rest of the economy, it
will also decrease the EU-US interest rate differential to only 75 basis points. In addition, the European Central Bank will likely raise rates at its next meeting, which means the differential will be further reduced.  Combined with general instability in US capital markets, brought on by weakness in mortgage-backed securities, foreigners are beginning to grow wary of investing in the US.

While a US economic recession would decrease imports and perhaps stem the growing trade imbalance, foreigners may still decide that it is too risky to continue financing the US trade deficit.

On the other hand, many Dollar bulls insist (correctly) that the Dollar remains the world’s reserve currency, and serves as a safe haven in times of global economic instability.  And in fact, the Dollar initially appreciated in value despite the turmoil in its securities markets. However, this upward trend seems to have been the result of a temporary shunning of risk, and since then, the Dollar has resumed its fall.  In short, both in theory and in practice, the evidence suggests that the Greenback can still fall much further against the world’s major currencies.

Most commentators assume that the only thing currently keeping the USD afloat is high interest rates. While attractive rates have certainly encouraged an inflow of (risk-averse) foreign capital in the short term, they may ultimately be harming the currency in the long-term. In fact, the economic law of interest rate parity dictates that currencies and interest rates should move away from each other in the long term. Stated differently, high interest rates should imply a less valuable currency. Since US rates are among the highest in the world, the USD should decline in the long term in order to compensate US investors in foreign securities for the lower risk-free returns they are implicitly accepting.

The reasoning is simple enough: since the advent of currency futures, traders have been able to speculate on future exchange rates. In order for futures to be priced fairly (such that arbitrage is impossible) the difference between a currency’s current value and its implied future value should perfectly equal the difference between domestic interest rate levels and international interest rate levels. In the case of the US, bets on the USD made during the recent period that US interest rates have exceeded European and British interest rates, must have been predicated on a declining USD in the future, which is now the present.

The Chinese Yuan refuses to die as a topic of conversation among forex speculators. In theory, the currency is among the world’s most prosaic; since its famous “revaluation” by the Chinese government nearly two years ago, the Yuan aka RMB has appreciated at a leisurely pace, roughly equivalent to 3% per year. Last week, the CCP took a step further in liberalizing its currency system by widening the band in which the Yuan is permitted to fluctuate, to .5% daily.

However, this did little to appease foreign diplomats and American politicians, who contend that the Yuan remains vastly undervalued, and that the Chinese government is guilty of currency manipulation. Two American Senators, Lindsey Graham and Charles Schumer, are still threatening to introduce a latent piece of legislation into Congress, which would slap a 27.5% tariff on all Chinese imports, unless the CCP promptly increases the value of the Yuan. (The 27.5% represents an average of the high and low estimates, 40% and 15%, respectively, of the extent of the Yuan’s undervaluation relative to the USD.) For its part, China maintains that not only is the currency fairly valued, but also that it will not be pressured into hastening the Yuan’s rate of appreciation. So, two questions need to be answered: Is the Yuan undervalued and if so, should China allow it to appreciate at a more rapid pace?

The first question is probably the trickier of the two to answer. Economists use admittedly crude techniques to value currencies. One method involves a calculation of purchasing power parity (PPP), which dictates that currencies should adjust in value relative to each other in inverse proportion to their respective price levels. In the case of the Yuan, PPP analysis suggests that the Yuan may be undervalued by as much 50%. However, this is to be expected; since income levels in China are vastly lower than in the US, one would expect prices to be lower, irrespective of exchange rates. Other methods used to estimate the fundamental value of the Yuan involve sophisticated statistical analysis, producing estimates of undervaluation ranging from 0% to 50%. In short, it appears as though the Yuan remains marginally undervalued, but the extent of which remains guesswork.

Upon concluding that the Yuan is undervalued, should China be expected to allow the currency to fluctuate more freely (i.e. appreciate)? It depends on who you ask.  American officials argue that the revaluation of the Yuan represents a crucial piece of the drive to reduce the burgeoning US trade deficit. However, upon closer examination, this notion is revealed to be false since most of China’s exports to the US are themselves repackaged products from other parts of Asia. Further, a sudden revaluation of the Yuan would likely result in the relocation of Chinese production to facilities to other low-wage countries, thus doing little to stem the US trade deficit. From China’s point of view, its economy is helped by an artificially cheap currency in that its export sector receives an indirect subsidy. However, it is constrained in its ability to conduct monetary policy as well as in its need to accumulate massive forex reserves, both of which would be relaxed in the event of a revaluation.

Not withstanding that China’s stubbornness mean it will not be bullied into appreciating its currency, it is probably in everyone’s best interest if it capitulates. My prediction, for what it’s worth, is that China will ultimately allow the RMB to appreciate at a slightly faster pace against the USD, probably somewhere in the neighborhood of 5% a year.

Technical analysts use a myriad of indicators and indices to
try to gauge where currencies are headed. Many seek insight in the prices of derivatives, where forwards, futures,
options, and swaps are used to make bets on the future movements of
commodities, securities, and even currencies. Let’s ignore swaps, which are more complicated and virtually
inaccessible to retail investors.  Currency
futures, forwards, and options are based on the same premise: one party agrees
to buy/sell a specific unit of a specific currency at a fixed price on or
before a fixed date in the future.  In
the case of forwards and futures, the contract represents an obligation.  In the case of options, it is a choice. 

As is probably self-evident, there are only a few variables
which determine the price of a currency option: the underlying exchange rate,
strike/purchase price, time to maturity, risk-free rate, and volatility of the
underlying currency. The first four variables are known: the fifth, volatility,
can be induced from the price of the option. You will often here of traders quoting “implied volatility” prices,
which, given the other four variables and the price of the option, can be
calculated easily enough. Based on the
price of the option, the volatility figures implicitly represent how investors
collectively view a currency’s prospects.

Volatility is worth paying especial attention to because it
can help you sort through the layers of analysis and guidance that pundits,
like myself, proffer with regard to forex markets. Implied volatility offers an instant snapshot
of how much investors believe a currency will fluctuate over the term of the
option.

Implied volatility is currently drawing the attention and scrutiny
of forex analysts because it is much lower than would be expected given the
Dollar’s recent collapse.  The USD has
fallen to a record low against the Euro and a 26-year low against the British
Pound, and many analysts, including myself, expect the Dollar to fall
further. However, implied volatility of
USD/Euro and USD/GPB options indicate that investors believe the worst of the
Dollar’s travails are behind us.  The
markets can be wrong, and in the case of currencies, which are among the most
difficult to forecast, they are frequently wrong.  But, prices do not lie: in this case, they are
telling us unequivocally that traders are not expecting further Dollar
volatility.

In recent years, the performance of the USD has been dismal. The currency is near historic lows against most of the world’s major currencies (with the notable exception of the Japanese Yen), and in fact, just yesterday, the USD dropped to a 15-year low against the British Pound.  And yet, it is my belief that when all is said and done, the USD will have fallen much further in value.  You are probably wondering, ‘If the USD has already depreciated significantly, how could it still be overvalued.’

The answer is simple: the USD is currently suffering a correction relative to other currencies. Simply put, economic fundamentals and monetary benchmarks are becoming stronger in other countries, which is putting downward pressure on the USD, relative to other currencies.  The decline that I am presaging is a decline in the absolute value of the USD, which is more of a structural change in the USD than a financial or economic change. 

The primary driver of the decline of the Dollar is inflation. On the surface, inflation has been stable over the last decade, averaging about 3% per year.  There are a few things worth noting here. First, this statistics does not services for which prices are rising much faster than the general rate of inflation, such as taxes, education, and health insurance. Second, and perhaps more importantly, this statistic is net of the deflation that is wrought by inexpensive foreign-produced goods. In other words, if cheaper imports save us 3% annually, then domestic inflation is probably closer to 6%. When outsourcing the production of key goods and services no longer produces savings, then consumers can expect a rise in overall rate of inflation.

It should also be noted that since the stock market crash of 1929, the Dollar has lost 95% of its value, whereas in the previous 125 years, the purchasing power of the USD had hardly changed.  Meanwhile, the twin deficits (trade deficit and budget deficit) have ballooned, to the extent that the national debt now measures approximately $9 Trillion and the annual US trade deficit is fast approaching $1 Trillion!  The result is that the government has been forced to print tremendous amounts of new paper money.
This phenomenon is evident in US capital markets, where yields are anomalously low, credit spreads are non-existent, corporate earnings are at record levels, and there is a general excess of liquidity. 

The bright side is that this trend could be reversed if the government was able to balance its budget.  However, this is probably impossible since some estimates of the government’s future liabilities exceed $50 Billion, which would be required to plug the holes in social security and other government entitlement programs. Some sectors of the market have already sprung into motion: the price of gold, which is normally used to hedge inflation, has doubled over the last decade. Central Banks are formulating plans to diversify their foreign exchange reserves (i.e. get rid of USD assets as fast as possible before the currency depreciates further).

Even if you’re an active trader in stocks, you may not be prepared to invest in forex, or the foreign exchange market. Forex trades 24 hours a day from 5:00 p.m. ET on Sunday until 4:00 p.m. ET Friday, so you won’t hear those opening or closing bells. And, there’s no central market like the New York Stock Exchange or Nasdaq. Instead, trade is conducted between participants through electronic communication networks (ECNs) and phone networks in various markets around the world. So, when you hear that the US dollar closed at a certain rate, it simply means that was the rate at market close in New York. But currency continues to be traded around the world long after New York’s close.

But, like securities, traders can go long or short and they can make a profit or lose money. As with stocks, it’s best to conduct some research into how the forex market works before you begin to trade. After you understand how the forex market works, you can begin to build a trading strategy.

The following list contains 37 tutorials, tools, and resources that will help you get started with investments in forex. If you’ve traded on any stock exchange in the past, some of these tools might feel or appear familiar, but they may have a new twist. The resources listed below were chosen for their clarity and simplicity as well as for their reputation.

Getting Started

The following information is for the forex beginner, but even intermediate-level forex traders might pick up a tip or two from these sites:

1. Baby Pips:
   A pip is the smallest unit of price for any foreign currency, so "baby pips" is a bit redundant. But you won’t find any redunancy on this site. Skip the news on the front page for now and go straight to the School of Pipsology that holds a complete course for beginners. If you walk through all the lessons contained on this site, you’ll have a solid basic forex education under your belt.
2. Forex Glossary: Although the previous tutorial might help you to understand some forex terms, this glossary is a great tool to have on hand for future reference. You’ll see some familiar terms here, like "selling short" and "limit order," and you’ll learn that they mean the same as they do when you use them for trading securities. But, you’ll also find new terms like "big figure" and "two-way price," terms that will set you apart as a forex trader.
3. Investopedia: This online financial encyclopedia contains an extensive 10-part article on forex investing, from an introduction to a recap that covers everything from benefits and risks to technical analysis. If you can’t get enough of Investopedia’s information, head to their Forex index, where you can find a list of articles and an opportunity to download their free e-Book entitled, "High Probability Trading Setups for the Currency Market."
4. National Futures Association(NFA): Now that you have a basic understanding about forex markets, visit the NFA to learn how to build a sound forex strategy. The NFA is "the premier independent provider of efficient and innovative regulatory programs that safeguard the integrity of the derivatives markets," which basically means that this organization regulates any market that depends upon future cash flows. The "investor information" section contains materials about how to find a broker and basic lessons in forex trading. Plus, they publish forex warnings, news, and they offer a place for investor disputes and complaints.
5. Commodities Futures Trading Commission(CFTC): The CFTC operates along the same lines as the SEC (Securities and Exchange Commission), except this government organization focuses on protecting market users and the public from fraud in the futures and option markets. So keep this site handy to stay on top of any forex scams through their Consumer Advisory on Forex Fraud. You can learn quickly what to avoid in your learning curve through a detailed forex advisory that offers information about other resources as well.
6. Martket Traders Insitute (MTI): You don’t need to spend a lot of money to train in forex markets. Even MTI offers free resources such as videos and lesson plans that will help you get off the ground. If you like what you hear and see, you can invest in materials for the advanced trader down the road.

Learn about Currency

If you’re going to trade something, you better know what it is you’re trading. These currency sites will help you get up to speed on foreign currency exchange and markets.

7. Exchange Rate: Skip the top link box, as those links will take you to FXCM (Forex Capital Markets — see #13 and #33). Instead, try out the "hot" and "currency info" links that provide information about everything you’d want to know about worldwide currencies for 170 countries. Includes calculators, fun facts, serious facts, and more.
8. Oanda: With a free registration you can access customizable currency tools, including calculators and foreign exchange data. If you don’t register you can still access currency exchange tools that are great items for instant information, especially for travelers, let alone forex investors. The Traveler’s Cheat Sheet is indispensable for money-conscious globetrotters.
9. GoCurrency: This site offers a powerful and accurate currency converter, but don’t stop there. Learn about currencies by country, currency forecasts, and gather insights on foreign investments.
10. The Euro: Confused about the Euro? Over 13 European Union countries now use the Euro, and this Web site, brought to you by the European Commission, will teach you everything you want to know about this currency. But the Euro represents just one currency among hundreds. Which leads me to my next point…
11. List of Currencies: This is an extensive list provided by Wikipedia that covers everything from ancient coinage to the current Yen. As with most Wikipedia lists, you might run across a link or two that doesn’t contain information. But, you can use that information to search elsewhere if needed.

Get the News

Once you’ve learned the basics, the next best thing you can do before you begin to trade is to read up on forex information via traditional financial news sites and blogs. Use the tutorials listed above during this process so that you can grasp the language and learn the strategies involved in any reporting. Take advantage of forums or chats offered by these resources to ask questions:

12. Action Forex: This site offers an easy-to-read layout that includes news, insights, fundamentals reports, calculators, and tons of other forex resources.
13. Daily FX: An easy-on-the-eyes news source that offers a calendar, charts, and a forum. Sponsored by FXCM, this site offers a free weekly trading lesson and free quarterly outlook reports. You must be an FXCM client to access the market commentary, but the other "free" news offers a great resource for learning and for staying
    on top of forex news.
14. Forex Reader: The Forex Reader is a popular blog that offers updates on financial headlines relegated by currency. It also serves as a resource for individuals seeking a Houston trucking accident attorney along with other legal and financial information.
15. Forex News: Like most of the sites listed here, Forex News offers more than news. Check
    out their forums, their technical news, and their educational and research materials while you’re there. Register for free to take full advantage of the site’s resources, including a chat feature.
16. FXStreet: Global Forex Trading (GFX) sponsors this forex news site. Use the forums, chats, strategies, techniques, and trading tools to get a feel for forex. Additionally, several bloggers share their insights, including Wayne McDonell’s FX Boot Camp Training Videos (visit his FX Bootcamp
    site).
17. Profiting with Forex Blog: You might discover that this newsworthy blog is part of the network, "Profiting with Forex."
    The blog is interesting, but the backend reports, podcasts, and commentary at the "Profiting" site might appeal to you more.
18. The Forex Project: Lessons learned first-hand from a forex trader. This site has an unbelievably long list of topics, along with news about the blogger’s personal trading experiences, calculators, charts, news, and a perspective on forex psychology.

Participate in Forums

Speaking of forums, here are a few specific resources where you can tap into information from around the world that may help to answer your questions about forex trading and markets. Be aware that individuals who want to sell their ideas visit these forums, just like any other forums. But, you’ll find a wealth of valid information here as well.

19. MoneyTec: With over
    33,000 members, this traders’ forum offers a format to discuss trading ideas, share, learn, and build new trading techniques and strategies.
20. Global View Forums: Another free forum that’s been around since 1996. This one focuses solely on forex. You must register to participate.
21. Forex Factory Forum: You’ll find a Forex Beginner Q&A section as well as topics that focus on specific strategies and techniques. Free to register.

Learn Strategies

You’ll discover that some forex traders use Fibonacci (Fib) methods, and that others rely on current financial news to divine futures. There are as many strategies as personalities in the forex market, but — like the stock market — they rely either on fundamental or technical analysis. The following contains a mix of the two:

22. Fibonacci Lesson: Don’t know much ’bout arithmetic, Fibonacci numbers, or the Golden Section? This tutorial, offered by Dr Ron Knott from the Mathematics Department of the University of Surrey, UK will provide results. Simple to use, easy to understand, and filled with illustrations to help you learn why some numbers are so important to nature. Interstingly, these numbers are also of vast interest to many forex investors.
23. Fibonacci Forex Indicators: Forex Planet will begin to show you how to apply Fibs to forex in this easy-to-understand lesson. But, the lesson is short, so you might try the next resource as well:
24. Mini-Lesson on Fibonnaci: This lesson also applies to forex, and it offers a short tutorial on applications along with a downloadable Fib calculator.
25. Intro to Japanese Candlestick Charting: Altavest provides a short and succinct introduction to Japanese candlestick charting, another method that forex traders use to graph charts.
26. Candlestick Patterns: If you like the Japanese candlestick methodology, this site will thrill you. Extensive patterns are illustrated graphically from basic to single patterns and reversal to continuation formations. This entire site offers some great information on techniques and strategies beyond the candlestick information, so take some time to look around while you’re here. Basically, this site has it all as far as technical analysis goes.
27. Fundamentals of Forex: Forex TV brings you the lowdown on what type of news would affect forex from a fundamental standpoint. You can use the information on this list to conduct further research, but I’ll bring a few of those topics to you now…
28. Consumer Price Index (CPI): The US Department of Labor offers a ton of information just on this page alone through their links. But, the CPI is often influenced by many other factors. If you’re a fundamentalist, you might want to tag this next link for further research as well…
29. Bureau of Economic Analysis (BEA): Don’t play around with someone else’s opinions. Get the straight stuff from the US Department of Commerce like the pros. Everyone from the White House staff to US Trade Commission employees to trade policy officials who want to negotiate international trade agreements uses the measurements contained on the BEA Web site. Why should you be left out of this information resource?

Use Charts

Charts offer visual validation for technical strategies, but they also reflect fundamental behaviors in the market. Even if you’re a seasoned securities trader, you might want to learn more about the psychology behind forex trading. If you can read all sorts of charts inside and out, you’ll have the forex advantage.

30. The Law of Charts: Joe Ross offers advice for traders across the board, but the information contained in his "Law of Charts" offer speaks to forex as well as any other trading strategy. He identifies chart patterns that result from human behaviors and points to entry and exit targets on those charts. You can take advantage of Ross’s other tools as well, including the forum.
31. Forex
    Charting 101: A brief and basic overview of forex charts from Pip Trader. You’ll discover that the charts are very similar to those that you might use for securities trading. But, some of the charts may seem more complicated if you’re not a seasoned trader.
32. Free Forex Charts: There’s no reason for me to push you into using a specific chart. Instead, I’ll point you to a short list of free forex charts that you can use for practice. When you’re ready to begin trading, take a look at their lists of premium and system trading charts for professional use. The lists contain ratings and reviews, visuals, features, and tips and tricks for individual charts.
33. FXCM: Although I don’t advocate specific brokers in this article, when you visit brokerage sites make sure that you take advantage of any free information offered by those businesses. In this instance, Forex Capital Markets offers tons of information about forex trading, and you can sign up for a risk-free 30-day practice account to get your feet wet. Forex.com and several other brokerage sites also offer this free account service. Be aware that when you sign up for these services that you’ll be added to a mailing list. You can opt out of these lists, but read any other pertinent information to make sure that you’re not obligated to purchase anything from any brokerage that you use for services such as this one.

Other tools

The tools listed below are "sidebars" to all the information listed above. I’ll cut you loose on the last two sites, as they contain just about every site you’d might want to access for more forex information:

34. Live Forex Rates: You might recognize the GFT logo behind the rates, but don’t let that distract you from the constantly changing figures. If you’re addicted to live feeds, you’ll be mesmerized by the constantly changing currency
    rates on this chart.
35. A
    Free Book about Forex: This book is truly free, as you don’t need to register to access the PDF file. A forex trader offers information about all the mistakes he made as he learned how to develop his own forex strategy. Short and easy to read, this little book will bring some insights into how to avoid some pitfalls in the forex markets.
36. Top 100 Forex Sites:
    Although these sites are rated by popularity and, therefore, subject to rating scams, you can learn much from the sites that are listed simply from the variety of information that’s offered here. Many sites are brokerage firms, but as I mentioned previously you can find free information on many of these sites such as news, calculators, techniques, and more.
37. Earn Forex: A link exchange/directory for other forex sites. Unlike the "Top 100" site listed previously, Earn Forex doesn’t rate their links. But, you will also find much different information here than at the previous site. Additionally, the links are sorted by categories, which makes it easier to find what you need. In addition, you’ll find other tools here like calculators, articles, and a forex FAQ and glossary.

There are many other sites that I could list for your forex training, but my next suggestion is to head to your local library and read some books about forex trading. If you find an author or two who are to your liking, begin to study their techniques and strategies both through their books and on the Internet. If you share your information and questions on forums, you might find a mentor who will help you learn how to strategize and to use charts and fundamentals to your advantage as well.

Forex trading isn’t learned overnight; so don’t feel inadequate if you can’t grasp the fine points immediately. You can’t lose by learning more about how world economies work. The information that you gather in your search for forex training will make you a better trader no matter which markets you prefer to use.

Did you enjoy this article?

Before I attempt to answer the following question, let’s examine where the Japanese Yen is today and more importantly, how it got there. The story begins around the establishment of the second Bretton-Woods agreement, which de-linked the USD from gold, and ushered in the modern era of freely floating currencies. In the 30 years that have elapsed since this period began, the Yen has never been less valuable. In fact, in trade-weighted terms, the Japanese Yen is at an all-time low!

The decline began in 1995, touched off by a nagging recession and the accompanying easy monetary policy, in which Japanese real interest rates were effectively negative. The decline seems to have accelerated over the past five years, due to the proliferation of the carry trade. In this type of trade, investors borrow Japanese Yen at a low interest rate, and sell the Yen for a currency which is supported by higher interest rates. The profit, known as carry, is the spread between the two rates. Hedge funds have piled into the carry trade, driving the Yen to lower and lower depths.

Politicians, relying on economists, have begun to clamor for reform. For a while, trade representatives and politicians insisted Japan was intervening on behalf of the Yen, which was ostensibly keeping the Yen grounded. They have since retreated from this position and embraced the carry trade theory as being responsible. Regardless of the causes, everyone agrees that the Yen’s undervaluation is not only destabilizing, but is economically inefficient. After all, Japan is home to the world’s largest trade surplus, and its economy is growing at an annualized rate of almost 5%!

So why doesn’t Japan give in and raise rates? The answer, it turns out, may not even matter. Traders have speculated that it require a rise of 200 basis points in Japanese interest rates for the carry trade to lose its appeal, an event which is extremely unlikely to occur by the end of 2007. Instead, a little bit of volatility in forex markets might go a long way in coaxing the currency upward. The Economist has drawn an analogy of the current situation to 1998, when the Russian default made hedge funds nervous, and they unwound their carry positions in the Yen. The result was a rapid 15% appreciation in the Yen.

The books have been closed on 2006 for more than a week, which means it is time for the forex blogger to give his first-ever ‘state of the markets’ address. After a dull and static 2005, forex markets roared back into action in 2006, with several notable developments. On everyone’s radar screens, the world’s most important currency, the USD, declined by over 13% against the Euro and the British Pound. Analysts attributed the decline to narrowing interest rate differentials between the US and the rest of the developed world, as the US monetary cycle peaked while the rest of the world continues to raise rates.

In addition, several countries, notably China, Russia and several OPEC nations announced that they had already begun to diversify their foreign exchange holdings. This process is becoming auto-catalytic, which means that as the USD declines, it makes less financial sense for Central Banks to hold USD-denominated assets, which causes the USD to decline further, and so on. Meanwhile, the US economy is sputtering, and a majority of economists believe the Federal Reserves Bank will lower interest rates in 2007.

The Yen initially joined the ranks of the Pound and the Euro in their upward march, before retreating back to earlier levels, due to a couple reasons. First, low interest rates continue to make the carry trade a viable trading strategy, as investors borrow in Yen and invest in higher-yielding currencies, which effectively keeps the Yen grounded. Second, Japan’s Central Bank has repeatedly threatened to intervene in forex markets on behalf of the Yen, which has made investors wary about betting too much on its appreciation.

The Chinese Yuan accelerated upward, due primarily to American political pressure and the threat of trade sanctions. Meanwhile, the Thai Baht appreciated almost 20% against the USD, prompting Thailand’s Central Bank to step in and impose draconian capital controls intended to curb speculation. Emerging market currencies fared equally well on the heels of strong economic fundamentals and intelligent monetary policy that kept inflation on check. If these trends continue, expect 2007 to be a repeat of 2006.

For years, economists have been arguing that the USD was vastly overvalued, and a fundamental correction was in order. Last month, their claims were born out, as the bottom fell out beneath the USD, and the currency declined by over 10% against most of the world’s major currencies, including the British Pound and Euro. But, was this only the beginning and is there more to come?

In trade-weighted terms, the USD is hovering around its 30-year average, and is just above a 20-year low against the Japanese Yen. Meanwhile, the Yuan is appreciating at a snail’s pace. In real terms, therefore, the correction that has taken place thus far is trivial. The decline against the Euro is unlikely to fix the trans-Atlantic balance of trade. It will certainly make risk-averse investors think twice about investing in the US, especially since Europe and Great Britain now offer comparable returns, but will not cause Americans and Europeans to adjust their patterns of consumption enough to narrow the trade imbalance.

However, further USD appreciation would be inflationary in America by raising the prices of imports. This would therefore deter the Federal Reserve Bank from lowering interest rates, since according to Ben Bernanke, inflation is already “uncomfortably high.” Meanwhile, America’s economy is starting to sputter with productivity lagging and the housing market in tatters. The Fed is in the unenviable position with reconciling the looming recession with the specter of inflation, both of which are to be avoided if possible.

In the long term, the USD must decline, against the currencies of Asia at the very least. At some point, foreigners will either become unwilling to finance the American twin deficits are will run out of assets to purchase and loans to underwrite. This is already happening, as American interest rates are at disconcertingly low levels while equity prices continue to touch record highs. As if this were not enough, Asia already owns over $2 Trillion in USD-denominated assets, and is in the process of shifting its reserves out of US capital markets. In short, it is still a question of when-not if-the USD will decline drastically (by 20% or more) so that the global imbalances can be permanently ironed out.

Every month, almost like clockwork, when China announces its new total of foreign exchange reserves, a cloud of paranoia descends on currency markets, as traders weigh the likelihood of China diversifying its reserves. This month was different, however, as this paranoia seems to have been born out by Zhou XiaoChuan, chairman of China’s Central Bank. He stated explicitly that China would *continue* to diversify its reserves, but did not specify particular currencies or investments that would be targeted. However, the consensus is that any diversification by China, regardless of the scope, would surely benefit the Euro.

“Plainly, there’s a lot of sensitivity on this issue, and as an investor, one has to respect the market’s reaction.”

Read More: China’s reserve plans keep forex market on edge

In 1998, the Euro and the Britsh Pound began rallying against the USD, appreciating over 30% in the following years. Then, last year, the USD staged a miraculous comeback, retracing 10% of its losses against the world’s major currencies, and costing bearish US investors (such as Warren Buffet) billions of dollars in losses. This year, the Euro and the Pound resumed their upward path against the USD, but have been stuck in a narrow range for many months. And against the major currencies of Asia, the USD has performed equally (well), prevented from depreciating by what is believed to be deliberate intervention in forex markets.

This begs the question, that if so many fundamental economic indicators seem to favor rival currencies, why has the USD remained so resilient? The answers, of course, are complicated, and not readily apparent. The key to this puzzle lies in reconciling economic theory with financial reality. In theory, the laws of purchasing power parity and interest rate parity dictate that a country’s currency should move inversely with its interest rate and price levels. However, any financial economist will tell you that these laws will only obtain in the long run, if at all. In the short term, risk-averse investors flock to the countries that offer the highest real return on investment, which ensures countries with high interest rates will rarely see their currencies depreciate, as in the current case of the US.

In addition, the laws of economics are being artificially undermined by some of the policies of Asia, namely China, South Korea, and Japan. The economies of these countries are heavily reliant on exports, rather than domestic consumption. Thus, it is in their interests to implement any measures necessary to prevent their respective currencies from appreciating. These measures include issuing forex stabilization bonds, building up massive forex reserves, threatening markets with intervention, and maintaining unnaturally low interest rates to deter speculative capital inflows.

Purchasing power parity is being undermined further by the continued willingness of foreigners to finance the American twin deficits. The globalization of capital markets enables investors, worldwide, to seek out the highest returns on invested capital. This is directly preventing the USD from appreciating and the trade deficit from narrowing, since foreigners still prefer to invest in US capital markets, which are well-established, stable, and perennially strong. Unfortunately, the Federal Reserve Bank must contend with inflation and potential asset bubbles when conducting monetary policy; lowering interest rates would push the USD downward, but it might also drive core prices and asset prices up, which the Fed seems intent on avoiding at all costs.

Last week, The Economist published a survey of the world economy, confirming what many economists have been arguing for years- that emerging markets will provide most of the world’s economic growth going forward. Led by the BRIC nations (Brazil, Russia, India, and China), emerging markets are projected to grow by 6.8% this year. These nations already consume half of the world’s energy, produce half of all exports, and contain 2/3 of the world’s population. Now, you might be wondering: what are the implications of this phenomenon for forex markets.

A few weeks ago, I argued that emerging market currencies are currently undervalued and represent attractive alternatives to the world’s major currencies. This week, I would like to explore a different effect of the rise of emerging markets: surging forex reserves. The world’s developing countries currently hold $2.7 trillion in foreign exchange reserves, the majority of which is held in USD-denominated assets. The ultimate cause of this surge is clearly strong economic fundamentals. The proximate causes, however, are more complicated.

First, the members of OPEC and other nations rich in natural resources have found themselves inundated with cash due to soaring commodity prices. However, the capital markets in these countries provide few opportunities to invest these proceeds, so countries have turned around and reinvested their windfall into American assets, notably equities and government securities. Second, since developing countries run a combined $500 Billion current account surplus, they have found themselves awash in foreign currency. In order to prevent their currencies from appreciating, they prevent this currency from circulating by holding it in reserve.

Now that we understand why the global stock of forex reserves is expanding, let’s explore why it matters. One of the only reasons that the USD has not plummeted in value as its current account deficit has ballooned is that foreigners largely remain willing to finance the deficit. If countries suddenly decide that they either want to inject their foreign currency into their economies (which would deplete their reserves) or if they decided to diversify their reserves by holding a larger fraction of them in non-USD-denominated assets, the USD would certainly suffer.

A couple weeks ago, I posted on this very subject- that the value of the Chinese Yuan is largely tied to inflation and interest rate differentials. With this week’s commentary piece, I wish to further expound upon this theory, because it appears to really carry weight. Most traders who have an opinion on the Chinese Yuan base their forecasts for the Yuan’s appreciation on political developments: how much diplomatic pressure the world will apply to China and how much China will capitulate on this most delicate of economic issues. A Stanford economist, however, has demonstrated that political guesswork might not be necessary, by connecting the Yuan’s appreciation to several important economic indicators.

Let me explain. There are two closely related theories in classical economics which attempt to account for changes in the relative value of currencies: interest-rate parity and purchasing power parity. The theories hold that the relative value of a nation’s currency should move inversely with price levels and interest rates, respectively. The reasoning is straightforward enough: the return on risk-free investments denominated in two different currencies should be equal in order for the markets to clear. However, as in many areas of economics, the gap between theory and reality in currency markets is significant, for high interest rates often attract risk-averse foreign investors instead of repelling them, which ultimately leads to the currency increasing in value.

In contrast, the Stanford economist seems to have established that the laws of parity seem to be holding in the case of the Chinese Yuan. It turns out the China-US inflation and interest rate differentials have almost perfectly mirrored the movement of the Yuan in the past year. As growth in the US began to drive inflation, the Fed raised interest rates to the extent that they currently exceed Chinese rates by over 3.5%- the precise amount by which the Chinese Yuan has appreciated against the USD this year! This phenomenon indicates that the Central Bank has allowed the Yuan to appreciate only so much as to offset the value by which the USD has been eroded by inflation. Coincidence? Probably Not. In short, we should expect the Yuan to appreciate only by the amount that American price and interest rate levels exceed those of China.

One of the most popular trading techniques used by forex traders is known as the carry trade. The goal of the carry trade is to find two countries with vastly different interest rates, and profit by buying the currency of one and selling the currency of the other. This trade is popular precisely because it is safe and somewhat predictable. By borrowing in denominations of the lower-yielding currency and lending in denominations of the higher-yielding currency, a savvy investor can capture a spread equal to the interest rate differential, as long as the values of the currencies themselves do not change. Towards this end, most of the talk in forex markets over the last year has focused around interest rate differentials.

However, the prominence of the carry trade is coming to an end for the time being, since Japan and the EU have begun to raise interest rates and erode the profits of carry traders. If forex traders are to survive this period of narrowing interest rate differentials, they must become more creative. In short, it means they must stop focusing on interest rates, and begin focusing on currency fundamentals, such as economic indicators and the actual supply & demand relationship for particular currencies.

The currencies of many emerging markets represent strong candidates on both fronts. Brazil, Mexico, Eastern Europe, India, SE Asia, have all witnessed rapid appreciation in the values of their currencies on the heels of a global economic boom. Many of these nations have implemented important structural changes to their economies and have begun to see prolonged periods of political stability. This has resulted in an improved investment climate, and foreign companies have been quick to capitalize through portfolio and direct investment. This, in turn, has driven increases in productivity and exports, spurring economic growth, which only makes foreigners even more eager to invest. Since the respective money supplies of each of these countries are quite small, all it takes is a slight uptick in foreign capital inflows to drive significant appreciation in the value of their currencies.

Over the past 6 months, the Euro and Pound Sterling have risen steadily in value against the USD. Labor and market reforms are forcing European companies to become more competitive. Hence, the economies of Britain and the EU are finally beginning to show signs of life. While economic fundamentals have certainly contributed to currency appreciation, they must take a back seat to interest rate differentials in any analysis of currency markets. Economists reason that interest rate differentials represent a leading indicator for foreigner’s willingness to continue financing the US current account deficit. That is, if US capital markets can continue to offer foreigners attractive returns, then they will continue to park their savings in the US.

Ben Bernanke, Chairman of the US Federal Reserve Bank, recently announced that the Fed is approaching the peak in the current interest rate cycle. It has raised interest rates more than a dozen consecutive times over the last two years, and may finally have achieved a point of balance, whereby growth is neither restrained nor excessive. Inflation has reared its ugly ahead, driven by rising food and commodity prices, but American consumers have learned to adapt.

Meanwhile, the Central Banks of Britain and Europe have independently begun to tighten money supply in order to preempt inflation. Most economists expect them to hike rates several times over the next 6 months, which will narrow the gap between American and European interest rates. This could be bad news for the US. For many years, OPEC nations and the Asian exporting nations have ‘threatened’ to diversify their forex reserves out of USD-denominates assets. They may finally have the impetus they need, because now they can earn attractive returns in Europe, whereas before they were limited to American securities. In short, foreigners may soon become far less willing to lend to and invest in the US if they can earn comparable returns (without sacrificing stability) in Europe. In such a scenario were to be realized, the result would surely be a weaker USD.

With my first commentary piece, I would like to address several issues concerning the Chinese Yuan. Let me begin by saying there is a tremendous amount of information and a wide array of often-conflicting opinions surrounding the Chinese Yuan. The problem with most financial analysts is that they often fail to grasp the big picture: in this case, the determinants of the Chinese Yuan’s value are multifarious, and take in financial, economic, and political factors, which most analysts fail to consider.

As most of you are probably aware, the Chinese Yuan has appreciated over 3.5% in the last year, including the 2.1% revaluation that the Chinese government effected last July. Many economists insist the Yuan is still undervalued by 35%, a figure that politicians love to quote. Analysts have also backed this estimate and incorporated it into their models that predict the Yuan will appreciate by 5% this year. You can look at RMB currency futures for proof that this is indeed the consensus forecast.

Both of these figures are ill-conceived and downright misleading. First of all, while the Yuan could clearly stand to appreciate, the extent to which it’s undervalued is probably closer to 10-15%. A true estimate of the Yuan’s fair value must make adjustments for inflation in order to account for differences in purchasing power. As China’s economy has expanded, inflation has grown at a proportional rate, eroding the value of the Yuan. At this point, China’s ability to produce cheap goods is probably more closely related to a surplus of unskilled labor and free capital, than to an undervalued currency.

Secondly, and just as important, is the fact that China will likely continue to appreciate the Yuan at its own pace. On several occasions, Chinese political leaders have invoked an ancient Chinese proverb when discussing the revaluation of the Yuan. The proverb states that one should take small steps in this type of situation. Whether China is genuinely nervous about revaluing or whether it simply wants to keep benefiting from an undervalued currency is anyone’s guess. What is not debatable is China’s stubbornness, reflected in its refusal to bow to western pressure when shaping its economic policy. In short, when an analyst tells you that the Yuan will appreciate by more than 3% this year, you should react with skepticism.