After a nearly 20% rise against the Dollar, the British Pound has been rangebound for nearly the entire month of June, with one columnist likening the situation to a “pause for breath.” For him, this amounts to a temporary cessation on the Pound’s inevitable upward path: “Compared to long term levels, the pound was still better value than its peers. He said: ‘It’s still cheap - about 10% below it’s trade-weighted average at present.’ ” For others analysts, however, the picture is not so cut-and-dried.

Forgetting about purchasing power parity for a minute, there are numerous factors which could halt the Pound’s rise. First and foremost is the British economy, which is still struggling to find its feet. “The U.K. economy will recover ‘mildly’ next year, according to the OECD, compared with a previous projection of a 0.2 percent contraction. Gross domestic product will drop 4.3 percent this year, versus a March forecast of 3.7 percent.”

Some economic indicators have begun to stabilize, but the two most important sectors, housing and finance, are still wobbly. Economists warn that “any recovery could be slow and uneven because banks are still unwilling to pump loans into the economy.” In the latest month for which data is available, mortgage lending slowed to a record low, with consumer lending not far behind. With regard to housing,”The annual fall in house prices in England and Wales slowed for a third consecutive month in June, according to property data company Hometrack, but prices were still 8.7 percent lower than a year ago.”

There is the possibility that the BOE’s quantitative easing plan and the government’s fiscal stimulus will provide the economy with the boost it needs. At the same time, both programs will have to be reined at some point, sooner rather than later in the case of government spending. With UK national debt predicted to reach 90% of GDP by 2010, “Most people - the prime minister excepted, apparently - believe that taxes will have to rise and/or public spending fall after the next election. This would at least threaten to hold back economic activity.” Not to mention that both QE and government spending could actually backfire and generate inflation without economic growth (i.e. stagflation). BOE Governor Mervyn King captured this overall sentiment, when he said, “I feel more uncertain now than ever. This is not the pattern of a recession coming into recovery that we’ve seen since the 1930s.”

In short, from a purely economic standpoint, it doesn’t look good for the Pound Sterling. But of course forex is about much more than GDP…stay tuned for Part 2, in which I’ll elaborate on this point, and bring interest rates and inflation into the discussion.

Canada right now seems to typify the contradiction between political posturing and economic reality. GDP dropped by a whopping 5.3% in the first quarter- less than what the Central Bank had predicted but greater than thr 3.7% drop in the previous quarter. “The economy will shrink by 3 percent this year, the central bank predicts. That would be the biggest drop since 1933, according to Statistics Canada. The unemployment rate has also been at a seven-year high of 8 percent the last two months.” The most grim statistic is that “Canadian exports fell an annualized 30.4 percent in the first quarter, led by the automotive industry.” This is particularly problematic for Canada, whose economy is 30% depending on such exports.

Meanwhile, Canada’s Prime Minister, Steven Harper, is bandying the term “green shoots” around, and has declared “The worst is behind us now.” I guess it just depends on which statistics you choose to cite. After all, “April data…showed new jobs were created for the first time in six months and sales of existing homes rose the most in more than five years. Credit markets are also improving, with the Bank of Canada’s composite index of financial market conditions rising to its strongest level last month since September.” Still, a majority of surveyed economists forecast economic contraction for at least another quarter.

At least the Bank of Canada seems to have two feet planted firmly on the ground. It has warned investors not to expect a rate hike (from the current record low of .25%) for about a year, although it admits that could change depending on inflation. The BOC has thus far abstained from unveiling a massive “quantitative easing” plan to match that of the UK and US, which were subtly gibed for not having viable “exit strategies.” In addition, while Canada’s outstanding public debt has surged past $500 Billion, the country’s debt/GDP ratio is still the lowest in the G8 and projected to remain stable (despite projections of deficit for the next five years). In short, inflation inflation is probably not a realistic concern.

What is worrying to the Bank of Canada is the rise in the Loonie, which has surged 14% since March and shows no signs of stopping. In its decision last week to maintain rates at current levels, the BOC referred to “the unprecedentedly rapid rise in the Canadian dollar (which reflects a combination of higher commodity prices and generalized weakness in the U.S. currency).” Given that it can’t cut rates any further and is reluctant to devalue the currency through printing money, the only real option is for the Central Bank to intervene directly in currency markets, last done in 1998. Analysts, though, reckon that this is extremely unlikely.

What would it take for the Loonie to return to a more sustainable level? A decrease in risk appetite, for one thing. If investors got spooked and returned to the Dollar, this would probably crunch the Canadian Dollar. More likely, at least in the short-term, seems to be a retreat in commodity prices. The Loonie has pretty closely tracked the recovery in commodity prices [see chart below], any any pullback in oil and metals would likely be reflected in decreased demand for the currency. A recent report in the NY Times suggested that the surge in Chinese buying activity - which was clearly correlated with rising prices - may soon come to an end. The inevitable fall in commodities prices that would follow will certainly help officials at the BOC to sleep better.

The last week brought a few more developments in China’s quest to turn the Yuan into a viable reserve currency. Don’t get me wrong - I used the term “inches” in the title of this post for a reason - the Yuan will not supplant the Dollar anytime soon, if ever. Still, China deserves credit for their resolve on forcing the issue, as well as for providing an alternative to the Dollar monopoly.

An important boost came from Russia’s Finance Minster, who suggested that, “This could take 10 years but after that the yuan would be in demand and it is the shortest route to the creation of a new world reserve currency,” as long as it was accompanied by economic and exchange rate liberalization. The Head of the World Bank, Robert Zoellick, agreed: “Ultimately, that’s a good thing. And ultimately it’s good if you’ve got, I think, some multipolarity of reserve currencies to create, to make sure that people manage them well.”

These soft endorsements were precipitated by comments from  a top Chinese banker that companies should start to issue bonds denominated in Yuan. “Guo Shuqing, the chairman of state-controlled China Construction Bank (CCB), also said he is exploring the possibility of issuing loans to trading companies in yuan, allowing Chinese and foreign companies to settle their bills in yuan rather than in dollars.” This would serve two ends simultaneously; not only would Chinese capital markets be strengthened, but the Chinese Yuan would benefit from the increased exposure. Already, “HSBC and Standard Chartered have both said they are preparing to issue bonds denominated in yuan” and international monetary institutions might not be far behind.

Conspiracies aside, the Chinese Yuan will become a reserve currency when it is ready to become a reserve currency. I’m sure this seems self-evident, but it’s important for China (and China watchers) not to get ahead of itself. It doesn’t make sense for risk-averse investors to hold a currency that is still essentially pegged to the US Dollar and that isn’t fully convertible. If there’s no pretense that the Yuan fluctuates in accordance with market forces, and if investors aren’t guaranteed the ability to withdraw RMB if need be, what possible reason would they have to hold it in the first place?

Summarizes one columnist, “China would have to gradually make the yuan convertible on the capital account; it needed a more liquid foreign exchange market; its bond markets and banking system needed to be more developed; and there had to be proper monitoring of cross-border capital flows.” The importance of having functioning capital markets cannot be understated. Simply, investors and Central Banks buying Yuan would not want to simply invest in paper currency; instead they would want stocks and bonds that trade transparently.

Currently, foreign investors are limited to savings accounts and investing/lending to firms that record earnings opaquely and are ultimately subject to the whims of the Central government. This system has functioned well in the past, only because investors were betting generally on the Yuan’s appreciation, and not necessarily on specific opportunities within China. If China wants the Yuan to be a serious contender with the Dollar, it needs to give investors more and better options. Ironically, if China had taken these steps in the past, it wouldn’t have found itself with $2 Trillion worth of Dollar assets that it is desperately trying to dispose of.

You may have noticed that the phrase “seven month high” appears quite frequently in recent Forex Blog posts, regardless of the currency being discussed. I offer this preface as context for Pound’s recent rally because it suggests that the factors driving the Pound are hardly unique from the factors driving other currencies. In other words, “It’s a mixture of a dollar-weakness story and a global-growth story.”

Of course, it would it be unfair to so glibly dismiss the Pound, so let’s look at the underlying picture. On the macro-level, the British economy is still anemic: “Gross domestic product dropped 1.9 percent in the latest quarter, the most since 1979, according to the Office for National Statistics. The International Monetary Fund now expects the British economy to shrink by 4.1 percent in 2009.” Without drilling too far into the data, suffice it to say that most of the indicators tell a similar story.

The only relative bright spots are the housing market and financial sector. Mortgage applications are rising, and there is evidence that housing prices are slowing in their descent, perhaps even nearing a bottom. Optimists, naturally, are arguing that this signals the entire economy is turning around. History and common sense, however, suggest that even if the most recent data is not a blip, it’s still unlikely that the UK will able to depend on the housing sector to drive future growth. Besides, there is anecdotal evidence to suggest that foreign buying (due to favorable exchange rates) is propping up real estate prices, rather than a change in market fundamentals.

The stabilization of financial markets is also good for the UK, as 1/3 of its economy is connected to the financial sector. “Sterling is basically a bet on global financial well-being…Now that the banking sector has stepped away from the Armageddon scenario, the prospects for London and the U.K. economy look better.” But as with housing, it’s unlikely that the financial sector will return to the glory days, in which case the UK will have to turn elsewhere in its search for growth.

What about the Bank of England’s heralded attempt at Quantitative easing? While it’s still to early to draw conclusions, the initial data is not good. In fact, the most recent data indicates that half of the bonds that the BOE bought last month (with freshly minted cash) were from foreign buyers, which causes inflation without any of the economic benefits from an increase in the domestic flow of money. Given that S&P recently downgraded the outlook for UK credit ratings, it’s no surprise that foreigners are moving towards the exits. In short, “With underlying weakness in money and credit - plus large gilt sales by overseas investors - we doubt that quantitative easing is playing much direct role in the economy’s possible turnaround,” summarized one analyst.

If you ask me, the Pound rally is grounded in nothing other than naive technical analysis, which relies on indicators that are largely self-fulfilling. In other words, if the Pound seems like it should rise, than it probably will, simply as a result of investor perception. “Citigroup Inc. said in a report last week the pound is ‘among the most undervalued major currencies…’ Barclays Plc predicts it will rise as much as 18 percent against the dollar and 11 percent versus the euro in the coming year. Goldman Sachs Group Inc. sees a 23 percent gain versus the dollar and 15 percent advance against the euro.” Call me skeptical, but it’s hard to understand what kind of analysis underlies these predictions other than simple intuition. Sure the Pound was probably oversold, but is a 20% rise is two months really justified?

The U.S. Commodity Futures Trading Commission data indicated a slight downtick, but “big speculative players continue to hold large net short positions in the pound versus the dollar,” which suggests that the savviest investors are not yet sold on the rally. Emerging markets offer growth and higher yield. Commodity currencies, such as the  Australian and New Zealand dollars, rise in line with energy and commodity prices. Someone please tell me where the Pound fits into this?

Economists generally and Dollar bears specifically both love to harp on the perennial US trade imbalance. Despite the halving of the trade deficit (reported by the Forex Blog last week), the gap between exports and imports remains sizable; it is projected at about a $350 Billion for 2009.

The more important data point, however, concerns capital flows. This is applies mainly currency traders, which are less intrinsically worried about the US trade imbalance than how the rest of the world feels about supporting such a balance. For example, if the entire trade deficit is recycled (i.e. invested) back into the US, than theoretically a trade deficit presents nothing to worry about, at least not in the short run. [Of course, such a trend may not be sustainable for the long-term, but that is outside the purview of this post].

The Dollar’s de facto role as the world’s reserve currency has historically ensured that this has been the case. This phenomena has even been strengthened by the credit crisis, as the initial spike in risk aversion generated a steady demand for Dollar-denominated assets. However, there was concern that this demand was leveling off over the last few months as risk aversion ebbed, and foreigners collectively sold a net $95 Billion worth of American assets. Over this period, the Dollar by no coincidence has declined across the board, against both emerging market currencies as well as the majors.

In March - the most recent month for which data is available - this trend reversed itself. Net capital inflows totalled $23.2 Billion, close to the $27 Billion US trade deficit. Especially surprising is that foreign demand for US Treasury securities remained strong - to the tune of $55 Billion - despite low yields. Moreover, the two most important customers both chipped in: “China, the largest holder of U.S. Treasury securities, increased its holdings of government bonds further in March to $767.9 billion. In February, it held $744.2 billion. Japan’s Treasury holdings stood at $686.7 billion in March, compared with $661.9 billion in the prior month.”

Even demand for equity securities remained strong, as foreigners purchased $12 Billion in March alone. Foreign demand and the rising stock market are probably now reinforcing each other. Meanwhile, US investors collectively continue to pull money from abroad and return it to the US; over $100 Billion has already been returned to the US in this way.

Taken at face value, this is certainly good news. Given all the bad news, the fact that capital is still flowing into the US is worth celebrating. At the same time, the fact that the Dollar continues to fall suggests that this more to the story than meets the eye…

Note: Both Charts courtesy of International Business Times.

Their is no way to sugarcoat it; the EU economy is in poor shape, and is steadily worsening. In the most recent quarter, it contracted by 2.5%, most in at least 13 years. [It very well could have been the worst quarter in 50 years, but Eurozone economic data was only compiled beginning in 1996].

Germany’s economy is leading the pack (downwards), having contracted by 3.8% in the most recent quarter, and by 7% since the recession officially began. Compared to similar declines in other economies, “The 1.2% fall in France, large by any normal standards, almost counts as a boom,” quipped The Economist. It turns out that many of the EU’s headline economies were especially dependent on exports and/or housing to drive growth, both of which have been annihilated by the credit crisis. “One of the ironies of this downturn is that it was caused by global housing and credit busts, and yet the economies that have suffered most, such as Germany and Japan, sat out the credit boom.”

Still, some economists continue to wear rose-tinted glasses: “Hopes rose…that the worst could be over for Germany’s economy as a closely-watched index measuring the confidence of financial market players rose to a near three-year high in May, its seventh consecutive monthly gain.” Added Axel Weber, a member of the ECB’s governing council, “‘There is definitely hope that the euro zone economy will gradually stabilise in the later part of 2009.” A more realistic analyst responds: “That points not to a revival but rather to a slower rate of GDP decline in the present quarter (it could scarcely get worse).” To prove that economists truly create their own reality, another confidence indicator that was released on the same day fell to a six-year low.

Other analysts have found solace in EU labor markets, which remain relatively buoyant due to a lack of flexibility in hiring and firing. In fact, “Unemployment in the United States has risen to European averages, and seems likely to pass them when international data for April is calculated.” While this might be good news for workers, however, it negatively impacts GDP growth by preventing the economy from returning to a stable production base.

The Euro, meanwhile, has never been stronger. It has risen over 10% since touching a low against the Dollar on March 10, and recently broke through an important psychological barrier of $1.40. There are couple of explanations for this “contradiction.” The first is simply an application of the risk-aversion narrative. Simply put, “the euro is generally considered a risky bet on currency markets and therefore gains at times when there is greater perceived economic stability.” Recent trends suggest that financial market stability is more important than economic stability in the eyes of investors, but the idea is the same.

The other explanation concerns inflation, or rather the lack thereof. The European Central Bank’s response to the credit crisis has been much more restrained than its counterparts, most of which are pumping money into credit markets with little concern about the future implications. Sure, the ECB has authorized a program to extend low-interest loans to member banks, and plans to purchase up to $80 Billion in corporate bonds, but these measures pale in comparison to what the Fed and BOE have announced.

The ECB has also opted not to cut rates all the way to 0%, electing instead to hold its benchmark at 1%. Jean-Claude Trichet, head of the ECB, recently underscored that the role of the ECB is primarily to guard against inflation, rather than stimulate economic growth. “We are there to deliver price stability and price stability in the medium term is a crucial element in activating confidence,” he said. While there is certainly room for the debate as to whether this is economically sensible, Euro bulls can rest assured that their currency is being actively protected.

Over the last year, declines in imports and commodity prices have contributed to a veritable collapse in the US trade imbalance. While the deficit increased to $27 Billion last month, the general trend is definitely still downwards.

Since the inception of the credit crisis, US imports have fallen by a record 40%, on an annualized basis. In March, “Imports decreased 1 percent to $151.2 billion, the fewest since September 2004. Demand fell for industrial supplies such as natural gas and steel and for capital goods such as engines and machinery, reflecting the slump in U.S. business investment.” Lower commodity prices have also played a role on the imports side of the equation. In fact, if not for a slight uptick in energy prices, the deficit probably would have declined further this month.

Exports are also falling, but at a slower pace, such than the net effect is a more positive US balance of trade. “The 2.4% monthly fall in exports in March more than reversed the 1.5% rise the month before. But even that 2.4% drop compares well with the monthly declines of 6% plus that had become the norm since last September,” explains one economist. In other words, worldwide demand (as symbolized by US exports), is stabilizing.

Economists remain divided as to whether the trade deficit will continue to decline: “The low-hanging fruit has been achieved, and it will be difficult to narrow the trade deficit by much more going forward, especially if the vicious downturn in the economy seen in the fourth quarter and first quarter has begun to abate…..Once the economy begins to return to health in earnest (mainly a 2010 story), the trade deficit will likely begin to re-widen.” But a competing view expects “drooping consumer demand to weigh on imports and keep the trade deficit on a narrowing trend in the coming months,” in which case the deficit could fall to $350 Billion by the end of the year. Compared this to the record $788 Billion deficit of 2006!

While the balance of trade doesn’t figure directly into GDP (although it confusingly is incorporated into the expenditure method), a declining trade balance is generally reflective of a healthier economy. It implies that either exports are growing relatively faster than imports, and/or consumers are diverting more of their relative spending towards domestic consumption, both of which should contribute positively to GDP. Summarizes one economist, “If the current account did move towards balance, then it would allow the U. S. economy to probably grow at a more sustainable rate in the long term.”

The idea of sustainability (not in the environmental sense, unfortunately) is also connected to the US Dollar. Generally speaking, it is the Dollar’s role as the world’s reserve currency which has enabled the US to run a trade imbalance almost continuously for the last 30 years. In other words, trade surplus economies are willing to accept Dollars because they can be stably and profitably invested in the US. In this regard, one commentator hit the nail right on the head: “When it comes to the U.S. trade gap, how many refrigerators the U.S. sells overseas is far less important than how many dollars the rest of the world wants.”

Note: Both Charts courtesy of International Business Times.

According to a recent Reuters poll, investors are increasingly bullish on emerging market Asian currencies, including the Taiwan dollar, Indonesian rupiah, Singapore dollar, Malaysian ringgit, Philippine peso, South Korean won, and Indian rupee. The Thai Baht wasn’t covered by the poll, but given its strong performance over the last few months, it seems safe to include it in the bunch.

This uptick in sentiment is somewhat unspectacular, since “The Bloomberg-JPMorgan Asia Dollar Index, which tracks the 10 most-active regional currencies,” has now risen for almost three consecutive months [See chart below]. Leading the pack are the Taiwan Dollar and South Korean Won, which recently touched five-month and seven-month highs, respectively. “The Korean currency has climbed 28 percent since reaching an 11-year low of 1,597.45 in March.”

Investors are now pouring money back into Asia at rapid clip. “Asia ex-Japan received $933 million in the week ended May 20, the most among emerging-market stock funds, bringing the total this year to $6.9 billion.” Meanwhile, the “The MSCI Asia Pacific Index of regional stocks climbed 22 percent this quarter” while Chinese stocks are up 45% since the beginning of 2009.

But it’s unclear - doubtful is a better word - whether this rally is supported by economic fundamentals. One commentator summarized this contradiction as follows: “Improved sentiment has led to a massive resurgence in flows to emerging markets, irrespective of the underlying data, which remains weak. Investors are going out of dollars to riskier markets, riskier currencies.”

Let’s drill down into some of the data. Chinese exports fell 15% in April. Japan’s economy contracted 15% in the most recent quarter. Singapore’s exports are down 20% on an annualized basis. The South Korean economy is projected to shrink by 2% this year. The Central Bank of Thailand just cut its benchmark interest rate to an unbelievable 1%. The only bright spot economically is Taiwan, which is benefiting both from improved economic ties with China and a healthy current account surplus. I suppose everything is relative, as “developing Asian economies will grow 4.8 percent in 2009, even as the world economy contracts 1.3 percent” according to the International Monetary Fund.

The notion that the rally is not rooted in fundamentals is shared by the region’s Central Banks, which clearly realize that economic recovery will be much more difficult in the face of currency appreciation. One analyst argues that, “Until the signs of global economic recovery become more convincing, central banks will unlikely tolerate significant currency appreciation.” The Central Banks of South Korea, Taiwan, and Indonesia have already actively intervened to hold their currencies down, while Malaysia and Singapore (discussed in a Forexblog post last week) have also intervened for the sake of stability.

As a result, this rally could soon begin to lose steam. “A ‘correction’ in regional currencies is ‘appropriate’ following recent gains,” said one analyst. Another has called the rally “overdone.” Still, Central Banks and economic data pale in comparison to capital flows and risk/reward analysis. In short, these currencies (and other investments) will continue to find buyers for as long as there are those hungry for risk. Citigroup, whose “Asia-Pacific foreign-exchange volume may rise about 10 percent from the first quarter,” is bullish. A representative of the firm declared: “Fund managers are still ’sitting on lots and lots of cash’ so the pickup in volumes will continue.”

The economic outlook continues to improve for Australia. Most recently, both the government and the Central Bank released five-year growth forecasts, both of which show a modest recovery in 2010. “By 2011-12, the commodity-rich economy will again be firing on all cylinders with growth of 4.5%, well above the long-term growth rate of around 3%.”

This positive development coincided with the release of similarly upbeat economic data: “Retail sales surged 2.2 percent in March from the previous month, four times as much as economists forecast. Home-loan approvals jumped 4.9 percent, the sixth consecutive gain.” Meanwhile, unemployment shrank for the first time in months, and consumer confidence is once again rising. While the economy is forecast to shrink by .75% in the current fiscal year, this compares favorably with other industrialized countries.

The sudden turnaround can be attributed to a couple factors. First of all, the pickup in China’s economy is stimulating demand for natural resources, which had been slack for the last year. If not for simultaneously falling commodity prices, Australia might have even achieved positive economic growth for the year.

The government’s stimulus plan and spending initiatives have also played a role, although the extent cannot be measured accurately for a few months. “The government claims that measures in its budget will inject a further A$8.8 billion into the economy in 2009-10, adding to around A$50 billion in fiscal measures already announced since October 2008.”

The outlook for the Australian Dollar, meanwhile, is not so rosy. The 425 basis points in cumulative rate cuts that the Royal Bank of Australia (RBA) effected over the last year have lowered the interest rate differential with other industrialized countries. While the RBA has indicated that it will pause before cutting rates further, interest rate futures reflect the expectation that rates will be lower twelve months from now. “Economists say the RBA is open to cutting interest rates again if consumer and business confidence appear threatened, but for now it is content to let monetary and fiscal stimulus measures take hold.”

To be sure, the uptick in risk tolerance has been good for the Australian Dollar, igniting a 25% rise since March. The currency now stands at a 7-month high against the US Dollar. But the increasingly modest differential is now causing some analysts to question whether it is a reasonable risk to take, especially against the backdrop of volatility and a high correlation with global stock prices. “What’s the point of picking up a 3 percent interest-rate differential by being long Aussie and short Japan in a world where the exchange rate can move by that much in two days?” Asks One analyst rhetorically.

This same analyst is actually recommending investors to use the Australian Dollar as a funding currency, and go long on higher-yielding currencies, such as the Brazilian Real. This particular trade would have netted a respectable 5.9% return in 2009. How quickly the roles have reversed!

In following up on last week’s post (”Inflation or Stimulus: An In-depth Look At the Fed’s Response to the Credit Crisis“) on the possibility of inflation, I want to focus today’s post on the opposite phenomenon: deflation.

As evidenced by the huge expansion of government borrowing and Fed Quantitative easing, it is deflation which is currently the paramount concern of policymakers. While falling prices would seem to represent an ideal solution to the current economic downturn, deflation is actually quite pernicious if left unchecked. To elaborate: “When prices fall across the board, businesses and consumers postpone purchases because they expect lower prices later, or worry their incomes will decline or don’t want to acquire assets that will fall in value. Shrinking demand forces sellers to cut prices further, triggering a vicious cycle.” Deflation is also detrimental to consumers with liabilities, which remain the same even as incomes are falling.

Now that we understand what deflation looks like, let’s examine its likelihood. In fact, the current economic environment represents a perfect breeding ground for deflation. For example, both consumers and businesses are using stimulus and bailout checks to pay down debt, rather to increase spending. In addition, businesses are selling out of inventory rather than ramping up production, due to uncertainty for the future. Bond yields are rising, making it more expensive - and hence less likely - for companies to borrow and invest.

And what about the data? The Retail Price Index, “RPI - which turned negative for the first time in almost 50 years in March - is expected to fall from minus 0.4% to minus 1% in April.” The Consumer Price Index, meanwhile, “declined by 0.7 percent year-over-year in April, the largest 12-month drop since 1955.” It’s hard to take this data seriously, however, given the “seasonal adjustments” and “stripping of so-called volatile energy prices, and using the dubious ” ‘owners equivalent rent,’ OER, to measure consumer housing expenses” in order to conceal the actual decline in property values. In short, the actual decline is probably much worse, especiall given the steep drop in commodities from 2008.
 
At least Fed Chairman Ben Bernanke is satisfied, and was most recently quoted for his belief that “the risks of deflation were receding.” Bernanke remains committed to pumping money into the economy via its purchases of government bonds. It still has a ways to go in making good on its promise to buy more than $1 Trillion in securities.

While it’s easy to blame the Fed, it’s also hard not to begrudge it some sympathy for having to toe a very thin line between deflation and hyperinflation. In the event that its successful in forestalling a decline in prices, it will have just enough time to catch its breath before drawing all of the new money out of the economy so as to prevent inflation from taking hold and another bubble from forming in asset prices.

Based on the title, you’re probably groaning: ‘Wait, I thought this was supposed to be a forex blog?” Bear with me, however, as this subject is extremely pertinent to forex.

Last week, it was revealed that China has been clandestinely adding to its gold reserves since 2003, to the extent that its holdings increased by 76%, to approximately 1,050 tons. The news initially sent a ripple through forex and commodities markets, which were overwhelmed by the figures involved. After analysts had a chance to gather some perspective, however, the markets relaxed. You see, although the increase seems tremendous in size, it is quite small in relative terms.

It is relatively small compared to other countries: “This places China fifth in the world, ahead of Switzerland’s 1040 tons but behind the U.S. ranked first with 8,133 tons, followed by Germany (3,412 tons), France (2,508 tons) and Italy (2,451 tons).”

It is relatively small given the six-year duration of accumulation: “I think as soon as people realized it’s not a year-on-year increase, or a quarter-on-quarter increase, people realized it should not have that big an impact.”

It is small relative to China’s mammoth $2 Trillion forex reserves: “As a proportion of foreign exchange reserves, which have risen five-fold over the same period, gold now stands at a tiny 1.6 percent, versus 1.7 percent in 2003.”

On some level, the development has at least some symbolic importance, as it demonstrates that it cannot be taken for granted that China will simply continue to plow its (dwindling) trade surplus into Dollar-denominated securities, or even currencies in general. This is underscored by the suspicious timing of the announcement; China essentially waited six years before revealing its buildup in gold, probably in order to coincide with the uproar surrounding the Dollar’s role as global reserve currency. In other words, even though China’s gold purchases in and of themselves don’t amount to much, the Central Bank of China is trying to send a message that it will defend itself against “the depreciation risk of some foreign currencies.”

The announcement also explains the recent buoyancy of gold prices. Historically, there existed an inverse correlation between gold and the Dollar. This correlation has all but broken down as a result of the credit crisis, and for the first time a strong Dollar has been accompanied by high gold prices. Part of the reason may be increased buying activity by Central Banks, including the Bank of China: “The physical market remained well-bid by an unknown buyer despite bullion prices spiking to levels that normally cooled demand…Purchases were made in Shanghai, traders said, in an effort to absorb domestic production and lessen the impact of bullion prices on global markets.”

The stock market rally that has unfolded over the last month is nothing short of incredible; stocks have now risen 25% since bottoming on March 9. Unsurprisingly, the rally has been deeply intertwined with an ebb in volatility. “The VIX, which measures options trading sentiment on the S&P 500 Index has crashed from a high of 80.86 to 38.85 ahead of Thursday’s trading, a 52% decline.” [Chart below courtesy of DailyFX]

This decline in volatility can be witnessed in all corners of the financial markets, including forex. “The lack of volatility in currency markets has been especially mysterious considering the relationship between the dollar and risk adversity since the onset of the credit crisis almost 20 months ago.” The Dollar has been locked in a comparatively tight range, with one analyst even using the word “listless” to describe its recent performance. With the exception of the Japanese Yen- which is declining for economic reasons- most currencies are gradually stabilizing.

Does this lull represent the end of the storm or the metaphorical eye of the hurricane? Naturally, the answer depends on who you ask. Personally, I am inclined to believe that it is only temporary. The last year has already witnessed two “false starts,” and it wouldn’t surprise me if this time around proved to be yet another one in hindsight.

Whether or not the economic picture is “less bad” than before, it remains grim. “The system is bursting with overcapacity. Demand is falling faster than any time since the 1930s. Inventories will have to be trimmed and budgets cut to muddle through the downtimes. Foreign trade has slowed to a crawl, auto sales are down by 40 percent or more, and unemployment is rising at 650,000 per month.” Two economists, meanwhile, have published a widely-circulated piece which uses juxtaposed graphs as a basis for comparing the current downturn to the Great Depression. Of course, this comparison has become hackneyed, but from a purely statistical standpoint, it’s hard to dispute.

The difficulty with forecasting the current recession is that its causes are structural rather than cyclical. Argues one analyst: “It is unwise and foolish to treat this bear market like any other in the post-WW II period because it is totally unique; the scope and depth of the ongoing destruction of consumer and business credit, bank balance sheet compression and insolvency, consumer retrenchment and soaring unemployment should not be underestimated.” As a result, many economic models are out of date. “Economic forecasters have underestimated how bad it is because they have over-estimated the strength of the real economy and failed to take into account the extent of its dependence upon a buildup of debt that relied on asset price bubbles.”

Not only will future growth have to be built on actual wealth (rather than debt), but the mountain of debt that fueled the most recent economic expansion will also have to be resolved. The most recent IMF estimates imply that “Toxic debts racked up by banks and insurers could spiral to $4 trillion.” Until all of this bad debt can be identified and sorted, economic recovery will remain illusory.

Last week marked the beginning of earnings season, as corporations release the results from the first quarter of 2009. The season got off to a strong start with financial heayweights Goldman Sachs and Wells Fargo both smashing analysts’ expectations with large profits. Over the next few weeks, most listed companies will report earnings, which could collectively set the pace for financial markets for the next couple months. “Markets will continue to watch the corporate earnings data very closely in the short term with company comments on prospects also very important for sentiment with any optimism liable to curb defensive dollar demand.”

The last few weeks have witnessed a general decline in risk aversion, as investors have selectively interpreted economic data to support the notion that the economy as bottomed out. Improvements in corporate earnings could reinforce this trend, especially if a majority of companies beat analysts’ expectations. In short, “Forecast-busting first quarter results from Goldman Sachs on Monday encouraged optimism that the worst may be over for financial firms, but investors stayed cautious given that there are many more results to concern.”

It will be interesting to see if and how the strong Dollar will affect corporate earnings. On the one hand,the expensive currency would be expected both to drive a decrease in exports as well as a decrease in earnings from companies that do significant business overseas, since such companies earnings appear relatively smaller in Dollar-terms when exchange rates are more favorable. On the other hand, the decrease in the US trade deficit (to a nine-year low), suggests that the strong Dollar is not exerting a negative impact. “Exports sprang back in February after six months of decline, increasing by 1.6 percent to 126.8 billion dollars and comprising mostly consumer goods, automotive vehicles, foods, feeds and beverages.”

Ironically, an improvement in corporate profitability would further drive risk-taking and would thus have the effect of weakening the Dollar. One would think that an improved economic outlook would strengthen the Dollar. In actuality, financial and psychological factors continue to predominate in financial markets, and investors are looking for an excuse to dump the Dollar in favor of higher-yielding alternatives.

Their is a danger in currency markets taking their cues from stocks, given that the bear-market rally that unfolded over the last month is one of the most dramatic in history. The herd mentality has caused investors to become complacent about risk and pile willy-nilly back into the markets. Writes one analyst, “The growing potential for economic disappointment due to further growth contraction as well as overly confident, economically myopic policy-makers leaves stocks set up for a major wave of selling.”

Only two months ago, the Wall Street Journal published an article under the headline “Slowdown hits Emerging Markets.” Buttressed with economic data and testimony from economists, the piece underscored the notion that “The global downdraft is hitting the world’s emerging economies with a speed and ferocity few imagined possible.” On Monday, the same newspaper published an article entitled “Emerging Markets Go on a Tear,” exploring how emerging markets have outperformed in 2009.

That these stories are built around opposing themes is not surprising, but given that they were published only two months apart, it seems impossible that they could both be meaningful. A deeper analysis, however, reveals some powerful insights, namely that investors seem to be flocking back to emerging markets despite poor fundamentals.

It’s difficult to pinpoint the start of the rally, but it accelerated in earnest in early March for no apparent reason other than investors arbitrarily decided to collectively increase risk-taking. This seems like a classic case of ‘making one’s own reality,’ given that the economic picture continues to deteriorate, and “positive” developments were limited to an increase in government intervention and stimulus plans. But, perception is everything in financial markets, and if investors collectively decide they want a rally, then a rally will indeed obtain.

In the case of emerging markets, the rally has certainly surpassed all expectations. “A Morgan Stanley index tracking emerging-market stocks is up 12% in dollar terms. By contrast, its index following stocks in developed markets outside the U.S. and Canada is down 9%.” Meanwhile, “The extra yield investors demand to own developing nation debt instead of U.S. Treasuries narrowed 10 basis points, or 0.1 percentage point, to 5.68 percentage points.

Emerging market currencies have also enjoyed a nice bounce, led by an across-the-board 7% gain in the Mexican Peso, Brazilian Real, and Russian Ruble over the last five weeks. Analysts at both Citigroup and Goldman Sachs are now encouraging clients to pile back into such currencies, evidently confident that the rally is sustainable: “Valuation has become very attractive in many cases, in particular in historically higher-yielding currencies.”

The concern, however, is that this rally is a product of financial and technical factors, and is not underlied by macroeconomic fundamentals. Exports and confidence have tumbled at a record pace, such that “J.P. Morgan forecasts at least 11 emerging economies — among them South Korea, Taiwan, Russia, Turkey, and Mexico — will shrink in 2009, with another 4 posting no growth.” Instead, investors are using low prices and a lull in bad news - rather than a change in economic tenor - as a basis for buying.

Of course, the bulls will selectively point to data which paint a different picture.  “From monetary easing to joint fiscal policy to capital becoming less constrained at banks, the potential for a recovery in 2010 and 2011 seems more likely.” Some analysts have argued that they believe emerging markets have been, and will continued to be cushioned from the worst of the financial crisis due to their conservative financial sectors, but this argument strikes me as self-justification. Others point to the $500 Billion increase in capital that the IMF (via the G20) will potentially make available to developing countries. As I wrote in a recent post, however, much of the perceived increase is redundant and/or has not yet been guaranteed by rich countries.

Personally, I fall in the “cautiously pessimistic” camp, summarized as follows: “The economic picture is cloudy enough that a number of investors say it is worth adopting a more nimble approach in the short run.” In other words, a wait-and-see approach is probably more prudent than following the crowd, especially since it was the crowd that as originally responsible for the bubble.

This week, the Yen continued its decline against the Dollar and Euro, dipping well below 100 Yen/Dollar en route to a six-month low. Most analysts attribute this trend to a pickup in risk aversion: “Some kind of optimism is returning to the market and that’s putting pressure on the yen,” explained one analyst succinctly.

An ongoing rally in stocks and commodities is reinforcing investor attitudes that the economic recession is under control, and is stimulating risk-taking. In other words, the same forces that contributed to the unwinding of the carry trade during the beginning of the credit crisis, are now working in reverse and causing investors to flee from the Yen en masse. “As long as stocks can retain their buoyancy… risk appetite and risk-based trades will be in vogue and investors will continue to add to and rebuild yen short positions.”

According to the most recent International Monetary Market report, “Short positions on the currency have been building up for three consecutive weeks, and are now at levels last seen in the late summer of 2008,” which means the Yen’s slide has basically become self-fulfilling. From a technical standpoint, “A move above 101.00 yen was technically significant as it was a 38.2 percent Fibonacci retracement of its decline from a peak in 2007 to its 13-year low in January.” Even domestic Japanese investors have signaled their bearishness by taking advantage of last week’s Yen upswing by making “aggressive purchases of foreign bonds.”

From a fundamental standpoint, the decline in the Yen makes sense, given the abysmal economic situation in Japan. In fact, the “Minutes from the Bank of Japan’s March meeting showed members of the central bank were leaning toward cutting the bank’s economic forecast in April, and that they believed the BOJ would need to continue to provide substantial liquidity to financial markets that they see as still under substantial stress.”

The government is finally responding to the economic crisis, having most recently unveiled a $150 Billion plan, to supplement the $100 Billion initiative announced earlier this year. “If implemented competently, these steps could stabilize the domestic economy and stop the bleeding in labor markets.” At the same time, the intertwined tailspin in confidence and spending suggest that the government’s efforts could be in vain.

While equity investors have reacted positively - pushing the stock market into positive territory for the year- bond and currency traders are understandably concerned. Yields on Japanese bonds are already rising in anticipation of $100 Billion in bonds that the government will have to issue in 2009 alone. Naturally, the burden to purchase these bonds will fall on the Bank of Japan, which will be forced to print money and contribute to the further devaluation of the Yen in the process.

Ultimately, the duration of the Yen’s slide depends on the duration of the global stock market rally. If you believe that the global economy has turned a corner, then the Yen is done. If, on the other hand, you are inclined to side with George Soros, who opined recently that “It’s a bear-market rally because we have not yet turned the economy around,” then there is still cause for Yen bullishness.

This week marked a couple milestones for the Japanese Yen. First, the Yen fell below 100 JPY/USD for the first time in five months. Second, the Central Bank of Japan “celebrated” five years of not having intervened in forex markets. Of course, the relationship between these two events is not difficult to ascertain; as the Yen retreats from the stratospheric highs of 2008, intervention is becoming progressively less necessary (and hence less likely).

Risk aversion, or in this case a decline thereof, has been identified as the likely cause of Yen weakness, although as I alluded in an earlier post, there is still a question of causation, as opposed to correlation. Is it higher equity and commodity prices that are driving risk tolerance, or the other way around?

Regardless of whether the chicken or the egg comes first, higher asset prices have recently been accompanied by modest declines in so-called “safe haven currencies,” namely the Dollar and the Yen. In the case of the Yen, there were previously two different narratives, one that underlies the Yen’s performance solely against the Dollar, and another thread seems to govern its fluctuations against virtually all other currencies.

In recent weeks, however, a combination of forces have come together to drive the Yen down against all currencies. First, of course, is the theme of declining risk aversion: ” ‘The euro was bought for the yen on the back of recent firm stock markets and this supported the dollar relative to the yen,’ ” summarized one analyst. The $1 Trillion economic stimulus plan unveiled today by the G20 will also have the effect of “sapping demand for Japan’s currency as a refuge.”

There are also end-of-quarter factors that have played a role in the Yen’s decline. ” ‘The dollar is being buoyed as Japanese investors try to secure currency on the last day of the fiscal year. Investors’ demand for the yen stemming from repatriation flows, on the other hand, appears to have peaked,’ said a trader at a Japanese bank.”

Last but not least, there is the Japanese macroeconomic picture, which shows a country that is headed towards a deep recession. The latest monthly figures show a 49% year-over-year decline in exports, which is contributing to rising pessimism among Japanese businesses. According to a recent survey by the Bank of Japan, “Confidence among Japan’s large manufacturers dropped to minus 55 in March from minus 24 in December, [which]…would be the lowest since 1975 and the biggest drop since the bank started the survey.” Given that Japanese household spending is also falling, “Japanese companies are caught in a double bind, facing markets at home that are shrinking with the population as well as the global downturn.”

If you read analysts’ coverage of the Dollar decline (and consequent Euro rally), there is an even divide over whether it is sustainable. Economic data and technical indicators paint a nuanced picture, such that this kind of uncertainty is understandable.

On the one hand are the the Dollar bears, who point to an economic recession that continues to deepen, and the seeming complacency of the Federal Reserve Bank towards inflation. If there is any doubt as to how the forex markets feel about the Fed’s plan to purchase over $1 Trillion in US government bonds, consider that the the Dollar just recorded its worst weekly performance in 24 years, while the Euro simultaneously recorded its strongest week since its inception in 1999. There’s not much nuance there.

Meanwhile, the economic picture is equally depressing. Summarized by Kathy Lien of GFT Forex:

The Empire state manufacturing survey plunged to a record low in the month of March while Industrial production fell 1.4 percent, driving capacity utilization back to its record lows.  Foreign investors reduced their holdings of U.S. assets by the largest amount since August 2007. Homebuilder confidence held near its record lows in the month of March as the slump in the real estate sector shows no signs of easing.

Unfortunately, there is a contradiction in the argument that the Dollar is being plagued both by economic collapse and by the risk of inflation. Writes Marc Chandler, head of FX strategy at Brown Brothers Harriman, “The pessimist camp wants it both ways. The US is going down the same path as Japan, where the end of a real estate bubble led to a banking crisis and a deep economic contraction. And they want to caution that printing of money will boost interest rates, fuel inflation and debase the currency.” He points out that history, as well as common sense, contradict this line of thinking.
Those that remain bullish on the Dollar argue that the Euro rally is a function of technical, rather than fundamental developments. First of all, we are approaching the end of a fiscal quarter. As evidenced by the Dollar decline which took place at the end of December, these periods are usually marked by portfolio rebalancing and hedging, such that it’s not uncommon to see large swings in forex markets. From a technical standpoint, when the Dollar failed to breach the $1.30 level against the Euro, many short sellers were probably forced to cover their positions, which accelerated the Dollar’s decline.

Bulls are confident that the pickup in risk-taking which catalyzed a 20% stock market rise is here to stay. “The move to the upside came after the government described a plan that will…generate $500 billion, and possibly $1 trillion over time, to buy hard-to-trade and badly deteriorated assets from banks.” The banks will be recapitalized, the financial system is being repaired, and everything will be okay, right?

The markets are certainly prone to false-starts. I can count numerous instances of government officials and market commentators insisting that “the worst is behind us.” Nevertheless, if this time proves to be different, it could be bearish for the Dollar, whose role as ’safe-haven’ currency would likely be eroded by a positive change in market sentiment.

Last week, the Forex Blog concluded a post on the Swiss Franc by suggesting that the Swiss National Bank (SNB) could artificially depress the value of its currency, which had “not just posted strong gains against the euro since late August but has gained 8% on a trade weighted basis.”

The very next day, the SNB followed its widely anticipated rate cut by announcing that it would indeed intervene in forex markets, “implementing” a decision to buy foreign currencies. The Swiss Franc immediately fell into a tailspin, falling 7 units against the Euro, and more than 3 against the Dollar. According to one trader, “the way this was communicated was intended at maximizing its shock value.” By the end of the week, the Franc had posted a record decline, as investors remained alert to the possibility of further invention.

This is the first ’solo’ intervention since 1992 by the SNB, which has “followed a noninterventionist policy when it came to its currency, occasionally hinting at interventions but never following it up. It remained on the sidelines in September 2001 when the euro traded even lower than its present rate, at 1.44 Swiss francs.” It is also the first intervention by any Central Bank since 2003, when Japan intervened unsuccessfully to try to halt the rise of the Yen.

Evidently, the SNB felt justified in its decision not only because of a deteriorating economy, but more importantly because of monetary conditions. Inflation is now projected to dissappear by 2010, and may even “slow to the point where prices broadly fall.” Traders also speculated that the move was designed to relieve downward pressure on Eastern European economies, whose economic woes are being compounded by the fact that much of their debt is denominated in Swiss Francs.

It is doubtful that Switzerland will receive much sympathy from other countries, nearly all of whom have thus far refrained from forex intervention in spite of widespread economic contraction and the risk of deflation. In the words of one analyst, “It is troubling that a country with a current surplus larger than 10% of GDP feels compelled to depreciate its currency.”

The greater concern is that this could ignite some kind of “currency war,” where Central Banks around the world compete with each other to see who can most debase their respective currency. Traders are already speculating that the Bank of Japan could be next: “The BoJ should pay close attention to the SNB’s actions, given that both central banks have expressed a desire to see their currencies weaken.”

A reversal of the yen, from strength to weakness, will have “major global implications…” Perhaps beleaguered Japanese authorities already have begun reacting to the “carnage” the yen’s rise has wrought.

While China remains committed, in rhetoric at least, to a flexible Chinese Yuan that rises and falls in accordance with market forces, its actions suggest otherwise. Beginning in the second half of 2008, China stopped allowing the Yuan to appreciate, for fear that a more expensive currency would exacerbate the domestic effects of the credit crisis by making exports less competitive. What China fails to realize however, is that a more valuable Yuan is not only conducive to global economic stability, but also to its own economic well-being. In fact, the artificially cheap Yuan may have actually worsened the economic downturn in China, because de-incentivized the creation of a domestic economic base. Now that overseas demand has dried up, it is left feeling the consequences of this neglect. The San Francisco Chronicle reports:

Read More: Undervalued currency helps, hurts U.S. economy

Speculation surrounding the Chinese Yuan has been mounting for months, beginning with a sudden halt to the currency's appreciation and continuing with the insinuation of the Obama administration that China is a currency manipulator. In the context of falling exports and a sagging economy, meanwhile, the Chinese Ministry of Finance has issued a research report encouraging the Central Bank to allow the currency to appreciate. Despite the Central Bank's insistence that it wants a "stable" currency, futures prices indicate a mean expectation that in fact, the Yuan will be nudged downward over the next twelve months. On the other side of the equation are financial analysts, who collectively forecast a slightly stronger Yuan, with one bullish analyst projecting a 3.5% appreciation in 2009, on the basis of selectively culled economic data. Bloomberg News reports:

“The consensus around China has been weak growth and falling reserves. The recent data challenges both views. Lending looks good, money supply looks good, and the PMI balanced to slightly bad from very bad levels.”

Read More: Citigroup Is Bullish on Yuan, Bets for 6.60 Year-End

While the year-long surge in the Dollar has been a welcome development for American consumers and the US government (in terms of cheaper imports and easy credit, respectively), American businesses are not smiling. The strong Dollar has resulted in decreased competitiveness in the eyes of foreign consumers, and consequently, lower exports. For this reason, the US trade deficit has not shrunk significantly, despite a slight down-tick in imports. One must also look at the overseas earnings of American multinational corporations, which are frequently repatriated to the US and booked in Dollar-terms. In fact, as much as 50% of S&P 500 member company profits now come from overseas. Simply, lower exchange rates mean lower profits. In short, investing in the stocks of companies as a proxy for the markets in which they do business is not (as) profitable when the Dollar is strong. The Financial Times reports:

As a result of this greater impact of currency swings, companies are starting to put greater emphasis on trying to hedge their foreign exchange exposure, according to a recent survey from JPMorgan.

Read More: US company earnings hit by turbulence in currency markets

The Swiss Franc is in the same boat as the US Dollar and Japanese Yen, benefiting from an increase in risk aversion and an unwinding of carry trade positions. In other words, the currency rising on the back of the sound monetary policy of the National Bank of Switzerland, with its low rate of inflation and proportionately low interest rate. Despite the fact that the Swiss economy is poised to contract in 2009, its economy is in better shape than its rivals, and its current account balance is still in surplus. As a result, the consensus among analysts is that investors will continue to flock to the Franc, as Switzerland is sill perceived as a relatively low-risk place to invest. Especially compared to the Euro, which has risen against the Dollar of late, the Swiss Franc remains undervalued. Bloomberg News reports:

Investors are drawn to the franc in times of international tension and economic upheaval because of the country’s history of neutrality and political stability.

Read More: There's Nothing Swiss Can Do to Stop Franc's Rise

Even the most diligent forex traders would probably have difficulty distinguishing the Swedish Krona from the Norwegian Krone. Given current market conditions, such a distinction may no longer be necessary. Despite important differences in the structure of their respective economies, both currencies have moved in lockstep and fallen drastically, as a result of investor risk aversion associated with the credit crisis. The Norwegian Krona has been singled out especially due to the decline in the price of its most important export: oil. Despite sluggish growth, however, both Sweden and Norway expect to report large current account surpluses in 2009. In addition, inflation in both countries is practically non-existent. It is no surprise, hence, that both fundamental and technical indicators signal that the Krona/Krone are grossly undervalued. Bloomberg News reports:

Based on purchasing-power parity, which measures the relative level of currencies based on the cost of goods in different countries, the krone and krona are the only ones undervalued versus the dollar among their eight most-traded peers, according to data compiled by Bloomberg.

Read More: Nordic Currencies Beaten in Market Slump Lure Goldman

Despite a late 2008 rally on the basis of improved risk tolerance, the prospects for emerging market currencies remain grim. The decline in commodity prices have deprived many such countries, namely Russia and Venezuela, of much-need export revenue. Moreover, the credit crisis and consequent abatement in inflation paved the way for massive interest rate cuts, which made investing in emerging market securities much less attractive. Current-account balances have turned from surplus to deficit in a matter of months, and governments have turned to foreign lenders to make up the difference. Unfortunately, confidence in such currencies is still quite low, forcing governments to issue debt denominated in USD, rather than local currency. Even despite this accommodation, investors remain hesitant. Bloomberg News reports:

Lower levels of foreign investment in these countries will make it harder for policy makers to cut current-account deficits, leaving their currencies “potential flashpoints” for losses.

Read More: Emerging Currencies to Drop, Morgan Stanley Says

While the Australian Dollar and New Zealand Kiwi technically started 2009 in the black, most analysts believe that both currencies will continue their record declines that began in 2008. All economic indicators continue to point downward, due to the adverse conditions created by the worldwide recession. The economies of Australia and New Zealand are extremely dependent on exports of raw materials and dairy products, respectively. Unfortunately, due to a contraction in demand and a decline in speculation, the prices for both types of commodities appears unlikely to erase even a fraction of the losses suffered last year. The death blow into the heart of both currencies will likely be delivered by their respective Central Banks, which are expected to make additional interest rate cuts. This will further erode the rate differential with the US/Japan, that previously signaled the currencies as attractive investments. Bloomberg News reports:

The average forecast is for the currency [AUD] to reach a low of 62 cents in the first quarter before recovering to 66 cents by the end of 2009. New Zealand’s dollar…will bottom at 52 U.S. cents in the second quarter and recover to 55 cents by the end of the year…

Read More: Australian, New Zealand Dollars Complete Worst Year on Record

While the Yen's 30% rise in 2008 is no mystery (a result of the unwinding of carry trades), its performance nonetheless defies economic fundamentals. Exports have fallen and industrial production has collapsed, such that recession now appears inevitable. Japan is not alone in this regard, as a number of economies have suffered unnecessarily as a result of excessive volatility in currency markets. The solution could be the so-called "Tobin tax," which aims to limit forex speculation by levying a nominal tax on short-term currency trades. The proceeds from such a tax would be used to restore some equilibrium in forex markets by providing Central Banks with funds for direct intervention. While the tax itself has never been implemented, countries have previously taken to cooperating on forex matters for the sake of global macroeconomic stability. Seeking Alpha reports:

Exchange rates have to be within a certain range for all economies to prosper. The major economies have to work together to ensure this. If the Group of Five could work together to depreciate the "Super Dollar" in 1985, so the major nations today can and should work together to stem the surge of the super Yen.

Read More: Japanese Yen: An Excessively Strong Currency Spells Recession

The Central Bank of Vietnam finally acceded to reality and devalued its currency, the Vietnam Dong, by 3%. Prior to the change, the Dong (as well as its neighbor, the Chinese Yuan, which has also experienced a decline) was one of the few relative winners of the credit crisis. Perhaps this was because the currency had already depreciated significantly in recent years (35% since 1994), as well as because it remains fixed to the Dollar and hence it is impossible for the markets to short it when it becomes overvalued. Vietnam continues to be plagued by double-digit inflation and a surging current account imbalance, which suggest that the currency will probably have to suffer an additional 'correction' before reaching a sustainable level. In fact, the black market rate remains well below the official rate, reports Bloomberg News:

The devaluation followed five interest-rate cuts by the central bank this quarter to help bolster the economy. Policy makers last lowered the benchmark rate on Dec. 19 by the most ever this year to 8.5 percent, from 10 percent.

Read More: Vietnam Devalues Dong to Fight Slowdown, Help Exports

The last two weeks have proved the old adage, "What goes up must come down." In other words, the year-long Dollar rally has begun to fade, as investors once again embrace economic reality. Previously, Dollar strength could be largely attributed to exit trades out of other currencies, rather than any substantive benefit of investing in the US. Now, risk appetite is slowly recovering, having received a boost from the just-completed government bailout of the US automobile industry. Less concerned about risk/volatility, investors have taken to re-assessing economic fundamentals. In the case of the US, unemployment is rising, the twin deficits continue to expand at a breakneck pace, and the interest rate disparity between the ECB and Fed will remain in place for the near-term. The Wall Street Journal reports:

Whether the dollar will continue to weaken is a matter of debate. Currency strategists caution that the dollar often is weaker toward the end of the year, particularly against the euro, as companies and investors adjust bets.

Read More: Less Panic Puts Pressure on Dollar

In a recent interview, three emerging market fund managers aired a common view: the asset class which comprises emerging markets represents a solid investment. Their reasoning is that the tremendous declines wrought in emerging market equities and currencies over the last six months were caused primarily by technical factors, rather than a substantive change in the long-term economic picture. In other words, this drop was effected by foreign investors that withdrew money en masse from emerging markets in order to meet fund redemptions and repay loans denominated in Dollars. At the same time, economic analysis, as well as common sense, dictate that an increasing portion of future global growth will be realized in the developing world. Many such countries have invested wisely in infrastructure and built up sizable foreign exchange reserves. Consequently, they are well-positioned to survive the current downturn intact. Accordingly, once investors "come to their senses" and recover their collective appetite for riskier investments, it probably won't be long before emerging market assets and currencies are bid up to pre-crisis levels. Forbes reports:

"Current valuation of emerging markets is the lowest it has been since I began investing in this asset class in 1988. Based on trailing 12-month earnings, emerging markets is trading at a price/earnings ratio of only 7.7x, and a price/book of 1.3x (with return on equity at 17%)," [observed one analyst].

Read More: Emerging Markets: What To Buy

Having fallen well below parity with the USD, the Canadian Loonie is now being attacked on two fronts. First, there is the deteriorating economic situation. Prices for virtually all commodities, namely oil, have declined significantly this year, dealing a harsh blow to the natural resource-dependent Canadian economy. In addition, its largest trade partner, the US, is suffering from economic woes of its own and is in no position to support the Canadian export sector. The result is surging unemployment and the most precipitous decline in factory production in 25 years. The most optimistic economists are forecasting GDP growth of 0.0% in 2009. The second prong of the attack against the Loonie is being waged unintentionally by the country's Prime Minister, who recently suspended Parliament in order to avoid a no-confidence vote in his leadership. In short, bulls for the Canadian Dollar (not to mention democracy) don't have much to be excited about these days. Bloomberg News reports:

"The global backdrop is bearish for the Canadian dollar and domestic numbers are merely piling on,"said a senior currency strategist. "No one is looking for reasons to buy the Canadian dollar right now. They want reasons to sell."

Read More: Canada's Dollar Posts Weekly Decline on Jobs, Politics, Oil

The Treasury Department’s most recent attempt to stabilize credit markets involves an injection of $800 Billion into the banking sector. According to one estimate, the total amount of Federal money committed so far (in the form of investments, guarantees, and loans) now exceeds $7 Trillion, and shows no signs of abating. In theory, the possibility exists that such investments could prove profitable, in which case the bailout wouldn’t end up costing taxpayers a cent. In all likelihood however, a significant portion of these investments will have to be written off, causing a net increase of trillions of dollars to the money supply. In the long-term, this is certain to be highly inflationary. It seems currency traders have finally begun to take note of this inevitability, and the Dollar rally has stalled accordingly. The New York Times reports:

The Federal Reserve and the Treasury… [are] sending a message that they would print as much money as needed to revive the nation’s crippled banking system.

Read More: U.S. Details $800 Billion Loan Plans

The British Pound has already fallen 25% against the Dollar, since the credit crisis kicked off earlier this year. On a technical basis, therefore, it would seem that the Pound is due for a rally. From the standpoint of economic fundamentals however, the picture is quite bleak. While the Bank of England’s recent 150 basis point interest rate cut could help restore the UK economy to solid footing, it sent a massive shock to investors. UK interest rates now stand at a 50-year low, and futures prices suggest that the benchmark rate will fall another 1% in the next 12 months. In addition, the Bank of England has not ruled out ruling interest rates all the way to zero. As unlikely as this scenario may be, investors are now fully aware of the scope of Britain’s economic troubles. The next couple weeks could be make-or-break for the Pound, as a series of economic data releases, as well as the minutes from the latest BOE meeting, will help investors craft a more accurate forecast. Daily FX reports:

Housing, industrial trends, consumer spending and public borrowing readings…provide additional confirmation that this evolving recession will be far worse than the slump of 1992.

Read More: British Pound Could Forge New Lows As Rate And Growth Outlook Fail

Regardless of your preference, all economic indicators seem to be heading in the same direction: down. Home sales and home starts, as well as home prices, are way down and projected to fall further. Consumer spending is declining by double-digits (in annualized percentage terms), which is no surprise considering consumer sentiment recently touched an all-time low. The national unemployment rate and unemployment insurance claims are rising nearly every month and week, respectively. Factory production is falling, and inventories are rising. Stock market capitalization is down across the world, especially in export-driven markets like Japan and Korea. The US economy as a whole contracted in the last quarter. The distinct lack of nuance in the economic picture has led most economists to project that the current recession (although not officially a recession) will be the worst in decades. The Wall Street Journal reports:

The current downturn is shaping up to be worse than the recessions of 1990-91 and 2001 and the prolonged downturn that ended in 1982. Banks are cutting back on lending, consumers are spending less, companies are shedding jobs amid sinking profits, and the housing bust that triggered the slide persists.

Read More: Economists Search for End of Woes

Volatility in forex markets has surged to unprecedented levels. In the words of one analyst, "Moves in the currency markets witnessed during just a few hours of trading…’are typically what we see in a quarter.’ " The currencies of both emerging market countries and industrialized nations have been battered indiscriminately, as investors have fled to locations perceived as less risky, namely the US and Japan. On the one hand, a stronger Dollar has almost completely alleviated inflation in the US and will hence make it easier for the Fed to continue cutting interest rates. On the other hand, US exports, previously one of the few bright spots in the sagging economy, will become less competitive. Then there is deflation, long since relegated to history textbooks, but now once again considered a threat. Countries whose currencies have declined, meanwhile, are finding it difficult to convince investors to stay put, and have taken to deploying their forex reserves as a stopgap measure to stabilize their respective economies. The Wall Street Journal reports:

To combat these sharp moves, Brazil, Mexico, Russia, and India collectively have drawn down their reserves by more than $75 billion since the end of September, selling dollars to protect their currencies, according to Win Thin of Brown Brothers Harriman.

Read More: Currency-Price Swings Disrupt Global Markets

Policymakers are once again uttering the dreaded D-word. Not "depression," but rather "deflation." Food and energy prices have retreated from record highs, and the economic downturn is threatening to crimp demand further. In addition, the deleveraging brought about by the credit crisis has sent asset prices (real estate, stocks) tumbling, and it’s not clear when they will stabilize. Economists are also forecasting that a tightening labor market and decreasing demand could force workers to accept pay cuts in return for job security. In short, a sustained period of deflation, such as that which plagued Japan in the 1990’s, is becoming a very real possibility. Last week’s coordinated interest rate cut was motivated by financial and economic factors; it was aimed at providing liquidity to financial markets and stimulating aggregate demand. Future rate cuts, however, may be driven by monetary concerns. One thing to keep in mind is that deflation can be kind to currencies; witness the strength of the Japanese Yen despite its long-term economic malaise. If the entire world experiences falling prices simultaneously, however, its not clear how forex markets would respond. Bloomberg News reports:

The deflation scenario might go like this: Banks worldwide, stung by $588 billion in writedowns related to toxic assets — especially mortgage-related securities — will further reduce the flow of credit, strangling growth. As the credit crisis worsens, businesses will find it almost impossible to raise prices.

Read More: Deflation Threat Returns as Asset Markets Decline

Read the rest of this entry »

That the credit crisis has been kind to the US Dollar is possibly the understatement of the century. In other words, despite the rapid drop in US equity prices and the impending economic recession, the Dollar has gained over 15% against its chief rival, the Euro. The cause of the Dollar bounce is a perception that the US is a safe place to invest during periods of economic uncertainty. This may or not be true. Regardless, some analysts insist that the Dollar remains doomed in the long-term. The US government has already spent $2 Trillion trying to restore confidence in capital markets and/or forestall recession. It seems unlikely that this entire amount can be raised from foreign investors, in which case the Federal Reserve Bank will be forced to print money to make up the difference. Even if the federal government can recover half of this outlay in the form of higher tax receipts and returns on its bailout "investments," the increase in the money supply will nonetheless be tremendously inflationary. The Market Oracle reports:

Americans will soon learn to change their mindset from focusing on their return on capital, to worrying about conserving the capital they have left. We have seen the beginning of this paradigm shift in the run on banks, and the flight to Treasury instruments.

Read More: US Dollar Doomed as Credit Crisis Turning into a Currency Crisis

The rapid and insidious spread of the credit crisis to Europe and even farther afield is catching Central Bankers completely off guard. In fact, they have been forced to rapidly shift gears from fighting inflation to preventing recession. Depending on how you look at it, the Fed was actually ahead of the curve in this regard, having moved to adjust its monetary policy and facilitate greater liquidity in credit markets nearly one year ago, well before other Central Banks. Since such policymaking usually takes about 18 months to trickle down to the grassroots of the economy, the US could conceivably begin the long road to economic recovery well before the rest of the world. As a result, the Dollar is rapidly reversing the multi-year decline it has suffered against the Euro, and analysts are predicting that in a few years the flow of tourists across the Atlantic Ocean will reverse directions. The Times Online reports:

In the longer term, rising productivity and lower domestic inflation, should enable Americans to stomp across the pleasure spots of Europe, paying only $1.25 for each euro.

Read More: A bailout won’t wreck economy

In day 2 of our bailout coverage, let’s look at the potential impact on inflation. On one hand, the government is proposing spending $700 Billion to buy faltering mortgages. Combined with the funds that have already been spent to deal with the credit crisis, this brings the total expenditure $1 Trillion, which amounts to more than 10% of the current liquid money supply. On the other hand, global food and commodity prices have eased over the last few months, causing a similar abatement in record rates of inflation. As a result of the economic recession and consequent depressed demand, prices don’t appear likely to return to the stratospheric levels of early 2008. In the end, the risk of inflation is probably most closely connected to the willingness of foreign institutional investors and Central Banks to continue financing American borrowing. If they hesitate, this would send the government running to the Federal Reserve Bank, which would be forced to print money, thereby stoking inflation. The Wall Street Journal reports:

If the Fed has to print money to pay this debt, "the more dollars put into the system, the more you dilute the value of the dollars out there," said Chuck Butler, at EverBank World Markets.

Read More: Will Bailout Spur Inflation? Hedge That Bet

In case you were asleep, US and global capital markets last week experienced unprecedented turmoil, followed by an unprecedented rebound. US stock market indices, for example, declined nearly 10% over the course of two days as it was revealed that three financial institutions (AIG, Merril Lynch, Lehman Brothers) were in deep trouble. Granted, the three scenarios managed to resolve themselves (government purchase, shotgun merger, bankruptcy), but the unthinkable had transpired. The following day, the markets promptly recouped their losses, as the earliest details of a sprawling US government bailout were announced. However, investors remain wary as they attempt to sort out the details. According to one piece of analysis, the forex implications are as follows:

First, the carry trade has officially fallen out of favor. Look for funding currencies (Japanese yen, Swiss Franc) to benefit and recipient currencies (Australia, New Zealand, etc.) to continue suffering. Next, while the US remains a safe haven because of perceived stability/liquidity, the monetary situation could still ignite a sharp decline in the Dollar, as the Federal Reserve performs an about-face and cuts interest rates in order to avert a complete financial meltdown. Instead, economies that have performed relatively better (less poor, to be more accurate) than the US, will probably witness a rise in their currencies. Think Canada and perhaps, the EU.

Read More: Lehman Fails And AIG Is On The Verge - What Is The Currency Impact?

Over the last couple months, the Dollar has notched some impressive returns against nearly all major currencies, including a 13% gain against its chief rival, the Euro. Nearly is italicized because the pack includes a lone stray-the Japanese Yen-which has managed to maintain most of its value during the Dollar rally. The Yen has benefited from the same trend towards risk aversion that has underlied the Dollar’s strength. Because of the preponderance of carry trades which utilize Yen as a funding currency, spikes in volatility tend to benefit the Yen disproportionately as skittish investors unwind their Yen-short positions. Even excluding volatility, a global easing of monetary policy (including recent cuts in Australia and New Zealand) has lowered yield differentials and made the carry trade far less lucrative. In any event, the Yen now finds itself locked in an epic battle with the Dollar to determine which currency is the least risky in times of crisis. The Wall Street Journal reports:

"As we’ve seen during past episodes of risk aversion and the unwinding of risk trades, some of those were funded with the yen. As those were unwound it involves buying back the yen and it appreciated against a lot of currencies."

Read More: Clash of the Titans: The Dollar and Yen

While not yet in the same league as other popular emerging market currencies, the Brazilian Real and Mexican Peso are sure to join their ranks soon; both currencies have risen markedly over the last few years, and have performed especially well in the year-to-date. They have been propelled by interest rates that are generously high, especially compared to those of the US and EU. Brazil’s benchmark rate currently stands at 13%, while Mexico’s equivelent rate is slightly lower, at 8%. In fact, interest rates are quite high throughout the region, including in Peru and in Chile. Anlaysts expect most of these Central Banks will further tighten their leding rates because of surging inflation, which would provide further impetus to the upward marches of their respective currencies against the Dollar. Reuters reports:

"We see EMEA (European, Middle Eastern and African) central banks as reaching the end of their (monetary) tightening cycles, whereas there is still more to go from Latin America," wrote Barclays Capital.

Read More: Latam inflation eyed for currency impact

The Canadian Dollar continues to lose its luster. Falling natural resource prices and the credit crunch have combined to exact a devastating blow on the Canadian economy, causing it to actually contract in the most recent month for which data is available. Now, the Central Bank is predicting that the economy will expand by only 1% in 2008. Most economists expect that Canadian Monetary Policy will soon lag US policy, especially if the Fed raises interest rates to combat inflation. Based on these developments, the consensus is that the Canadian Loonie is significantly overvalued, and will lose some of its value over the next few years, falling to a more sustainable level against the US Dollar. Bloomberg News reports:

The loonie will slide to C$1.05 by the end of December, and to C$1.09 by the start of 2010, according to the median estimate of 31 strategists surveyed by Bloomberg.

Read More: Loonie Loses Currency Wings as Canada Hurt by U.S.

The parallels between the Australian Dollar and the Canadian Dollar are remarkable! Both currencies are backed by economies highly dependent on natural resources. Both countries’ Central Banks are considering rate cuts in response to slowing growth. Finally, both currencies have slipped well below parity with the US Dollar. Unlike the Canadian Loonie, the AUD had never quite breached the mythical 1:1 level with the USD. Furthermore, given the deteriorating economic picture in Australia, parity is off the table for a long time.

Demand for Australia’s vast natural resources had begun to taper in response to rising prices, and now that prices have softened, exports are off even more. The Central Bank of Australia is indicating that it considers this drop in demand more of a threat than rising inflation. Accordingly, it will attempt to cushion the blow by lowering rates, perhaps as soon as next month. The Australian Dollar’s status as a beneficiary of the carry trade- because of the lofty 7.25% benchmark interest rate- may soon come to an end. Bloomberg News reports:

Investors have increased bets the central bank will cut borrowing costs. [It] will lower the benchmark rate by 91 basis points, or 0.91 percentage point, in the next 12 months, showed [one index].

Read More: Australia Signals First Rate Reduction in Seven Years

2007 was a momentous year for the Canadian Loonie, which rose 17.5% and even reached parity against the US Dollar. 2008 has been somewhat less kind to the Loonie; it has been battered repeatedly from falling commodity prices and the global credit crunch. Actually, even before the price of oil peaked near $140, the link between the Canadian Dollar and natural resources had begun to break down. The rationale among investors had shifted such that expensive commodities were now seen as a drag on global economic growth, and hence, bad for Canada in the long-term. Using this logic, the currency should have received a reprieve from falling prices, but this was interpreted as bad for Canada in the short-term. In other words, a lose-lose situation. Perhaps, the Loonie climbed too high too fast, and a simple technical correction is in order. The Guardian reports:

The Canadian dollar has been stuck in a tight range since the end of last November. If the Canadian currency eventually closes below the low end of that range, it would be considered a sign of U.S. dollar bullishness and likely open the door to further losses.

Read More: Canadian dollar feels heat of economic slowdown

After a brief hiatus, the Australian Dollar has resumed its upward march against the Dollar; its next milestone will be a 25-year high against the Greenback. Of course, its continued strength is due to a combination of high domestic interest rates and high commodity prices. In fact, its performance seems to mirror the price of gold, which is no coincidence since gold may be Australia’s most valuable export. In addition, gold has value as a monetary instrument, which means an appreciation in gold can give the Australian Dollar a double-boost by lifting it while simultaneously punishing the US Dollar. With regard its domestic monetary policy, Australian inflation recently passed the 4% mark, which means interest rates (already at 7.25%) are likely to stay high for a while. The countdown to parity continues, reports Bloomberg News:

The local dollar rose to its highest since 2000 against the New Zealand currency before an inflation report tomorrow that may support the case for the Reserve Bank of Australia keeping interest rates at a 12-year high.

Read More: Australian Dollar Trades Near 25-Year High as Commodities Rally

Who’s familiar with the "song that never ends?" How about the credit crisis that never ends? Only a few months ago, the talking heads were trying to convince us that the worst of the credit crunch had already passed, and that analysts had overestimated the amount of the debt that would ultimately need to be written down. Congress was congratulating itself for its economic stimulus plan, and the Federal Reserve was patting itself on the back for engineering an increase in liquidity to the financial markets. Then, without warning, round two (or three, depending on how you count) was ignited as FANNIE MAE and FREDDIE MAC- which together anchor America’s sprawling mortgage sector- announced financing problems. Commentators are already talking about the possibility of a government bailout. Buckle your seatbelts; it’s going to be a bumpy ride. The International Business Times reports:

Continue to monitor this situation, paying particular attention to whether the bigger investment banks are still lending to customers. Any shutdown in the system would be extremely bearish for the Dollar across the board.

Read More: U.S. Financial Market Turmoil Continues to Beat Down Dollar

The narrative in forex markets had recently become so cut-and-dried, that investors may have forgotten that in the long-term, a variety of factors weigh on currencies. Last week, they were sternly reminded of this fact when tensions in the Middle East boiled over and sent the Dollar racing downwards. An Iranian missile launch sparked the initial uproar, but was quickly followed by unrelated violence in Turkey and Iraq. First, the price of oil skyrocketed, and then the Dollar fell, consistent with the inverse correlation which has been observed between the two commodities. It is unlikely that geopolitical tensions will supercede the macroeconomic situation; investors continue to monitor the credit crisis and interest rate differentials with vigilance. Nonetheless, the events in the Mid East served as a warning against tunnel visions when trading forex. Reuters reports:

Analysts said geopolitics could soon take a back seat again once macroeconomic newsflow picks up after a lack of first tier economic releases from U.S. or euro zone.

Read More: Dollar knocked by geopolitical tensions, oil

When one hears the phrase "housing crisis" uttered, the US immediately comes to mind. Not without reason, of course, since the US housing market is the largest in the world, and the scope of any US housing crisis is sure to dwarf a comparable crisis in any other country, in absolute terms. At the same time, let’s not forget that prices in the UK, for example, began to decline earlier than in the US. In addition, as one columnist points out, the impact of the UK housing crisis may be relatively greater on the UK economy. While some of the statistics he quotes are dubious, housing and consumer debt (on a per capita basis)  may in fact be larger in the UK than in the US. As a result, the ongoing correction in housing prices would be expected to punish the UK more than the US. The story could be the same for the Pound, vis-a-vis the US Dollar. Money & Markets reports:

[One analyst] is…a long-term bear on the British pound and believes any rallies in the currency represent an opportunity to enter short at a better price. Selling the pound against the dollar with a 10-12 month time frame may present one of the best opportunities in the currency markets today.

Read More: UK Housing Bust Spells Trouble for Pound

Global capital markets remain caught in a tug of war between inflation and economic growth. For most of 2008, the economic growth story prevailed as the Federal Reserve Bank cut interest rates aggressively to cushion the blow from the housing crisis. However, the pendulum soon swung to inflation and the Fed began to worry that perhaps it had lowered rates too far and may in fact need to hike them in response to surging food and fuel prices. In fact, the European Central Bank recently hiked its benchmark interest rates. Now, a slew of negative economic data threatens to shift the rhetoric back to the other corner. Securities and currencies have fluctuated wildly over this period, and investors remain unsure about which side the world’s Central Banks will err on. Currency traders need to look no further than credit markets for a snapshot of the current consensus, which often presages changes in currency valuations. A quick and dirty analysis would place American and Euro-zone short-term bonds side by side and compare the yields (or prices), as a proxy for the EUR/USD exchange rate. The Wall Street Journal reports:

Two-year yields in all three markets have been on a wild ride in June, driven up by tough inflation rhetoric from central banks, then down again by renewed worries about the credit crisis and the state of financial markets.

Read More: Inflation and Growth   Compete for Attention

The Indian Rupee has fallen to a 14-month low as a result of the sagging Indian stock market and surging inflation. Foreign investors have withdrawn $5.7 Billion from the Indian stock market in the first half of 2008, reinforcing the 30% drop in stock prices that occurred over the same time period. Meanwhile, the nation’s benchmark inflation rate has risen to the highest level in nearly 13 years, and investors are clamoring for the Royal Bank of India to do more. The RBI has already raised interest rates as well as intervening on the Rupee’s behalf in forex markets, as indicated by data on the RBI’s foreign exchange reserves. Both moves were explicitly aimed at combating inflation, but may also carry the unavoidable consequence of stunted economic growth. The Rupee will likely continue to be caught in the slipstream. Bloomberg News reports:

"The rupee is under pressure to weaken because the losses in the stock market are raising concern about capital outflows. The currency could fall further if not for support from the central bank.”

Read More: India’s Rupee Falls to Near 14-Month Low on Stock Market Losses

Forex analysts reckon the two most powerful forces weighing on the Dollar are commodity prices and European prices, so-to-speak. With regard to commodity prices, it seems plausible that rising commodity prices have contributed to a weaker Dollar, as much as vice versa. Thus, when Saudi Arabia announced recently that it would increase oil production, the Dollar received a nice boost. Conversely, European prices, or inflation, are important for traders to monitor because they represent a proxy for the future of EU monetary policy. Specifically, Eurozone inflation just touched another high, at 3.7%, which analysts point out is now 1.7% higher than the ECB’s stated comfort zone. The likely result is an interest hike in the near-term, which would further widen the differential with US interest rates. Unless, of course, the Fed follows suit with a rate hike if its own. Forbes reports:

"High oil and food prices are already clearly denting any hopes for a pick-up of private consumption but only a severe deterioration of economic confidence indicators might prevent the ECB from pulling the rate trigger at the next rate-setting meeting."

Read More: Euro climbs as inflation figures cement rate hike expectations

In the near future, this day may be looked back on as important in the battle between the Dollar and Euro that is currently being waged. The previous month had been relatively kind to the Dollar, which had gradually clawed its way back from a record low against the Euro. Then came yesterday, when Jean-Claude Trichet, leader of the European Central Bank, surprised investors when he announced that not only will the ECB not be cutting rates, but in fact, it may hike them. If enough members of the Central Bank become convinced that inflation is unlikely to abate, the rate hike could come as soon as next month. Today, the knockout punch was delivered, when the US unemployment rate came in at 5.5%. Not insignificant by itself, what was most shocking was that the crucial indicator had risen .5% from last month, its largest increase in more than a decade. Reuters reports:

That should undermine the dollar’s prospects…"The focus is on the unemployment rate, as it’s obviously starting to catch up with the softening in the payrolls figures…and that’s what the market is reacting to."

Read More: Dollar falls as US jobless rate shoots up

Read the rest of this entry »

According to one index, commodity prices have risen 40% over the last twelve months. One would therefore expect the Canadian economy to be commensurately strong. According to the most current economic data, however, just the opposite is true. Wholesale manufacturing sales are down for the second straight quarter. Non-commodity exports are also trending downwards due to sustained economic weakness in the US, Canada’s most important trade partner. Continued strength in the Canadian Dollar is also to blame. In addition, Canadians are traveling abroad in greater numbers, while international visitors to Canada have dwindled to record lows. As a result, Canadian GDP is expected to fall close to 0% for the second quarter, significantly below the Central Bank’s goal of 1%. The Bank will likely respond with a series of rate cuts, perhaps totaling as much as 1%, intended to reduce buying pressure on the Loonie and ignite the economy. Canada.com reports:

"The loonie is rising, boosted by last week’s energy and resource powered rise in the trade surplus as well as a positive
interest rates spread."

Read More: Deeper rates cuts expected as Cdn. economy slumps

While the credit crisis has ravaged the economies of the US and the UK, the EU has largely been spared. First quarter GDP grew at a healthy annualized rate of 2.8%, helped by a whopping 6% expansion in Germany. However, a number of economic indicators now suggest that all is not well on the European front. Business and consumer confidence indexes are trending downward. Manufacturing output is down. So are retail sales. Spain, which benefited the most during the credit boom, is now reaping the greatest losses during the crunch, and could put a drag on the entire Euro-zone. One prominent economist is predicting that the EU economy won’t expand at all in the second quarter.

Unfortunately, the only data point which is trending upwards is inflation. Even though the EU is much more efficient than the US in terms of its use of oil, record oil prices (as well as food prices) are taking their toll. As a result, the European Central Bank cannot (or will not) lower interest rates until price inflation returns to a more palatable level. Accordingly, EU member states are taking matters into their own hands by unveiling economic stimulus plans and tax cuts. As far as the Euro concerned, the ECB’s focus on price stability (at the expense of growth) is not hurting the common currency, although if the economy really tanks, the story could change depending on concurrent circumstances in the US. The Economist reports:

The ECB has a strict remit to keep inflation in check, so rising commodity prices are likely to keep interest rates high, lending further support to the euro.

Read More: The euro-area economy - Too good to last

Yesterday’s release of the minutes from the Federal Reserve Bank’s April meeting sent shock waves through the investing community. The text revealed that the Fed Board of Governors has become significantly more bearish on the outlook of the US economy, as compared to sentiments expressed at the January meeting. The consensus forecast covering 2008-2009 worsened for all of the major economic indicators, including GDP growth, inflation, and employment. If the low end of the new GDP estimate ultimately obtains, the US economy will expand by only .3% for 2008. Fed officials went so far as to say that even by 2010, they don’t expect rates of inflation and unemployment to return to acceptable levels. To make matters worse, the minutes revealed some opposition to the 25 basis point rate cut that was implemented at the April meeting, on the basis of inflation concerns. The minutes further confirmed that the Fed does not plan to cut rates any further, for fear of stoking price inflation and fomenting another asset bubble. The Wall Street Journal reports:

In a speech Wednesday, Fed Governor Kevin Warsh said the central bank now must look to financial institutions to raise capital and take other actions to improve market functioning.

Read More: Fed’s Forecast Grows Gloomier

Although the first quarter of 2008 ended on March 31, it wasn’t until last week that the Federal Reserve Bank finally finished tallying all of the data and released its obligatory report on the performance of the Dollar. On a trade-weighted basis, the Dollar declined 4%, a figure which accounts for a whopping 11% decline against the Japanese Yen and an 8% decline against the Euro. According to the Fed’s analysis, January was relatively kind to the Dollar, as traders remained uncertain as to how the credit crisis would affect the US economy. An outpouring of negative data in the next 4-6 weeks sent the Dollar spiraling downward, although it recovered at the end of March, as the Fed moved to build liquidity in the financial markets. The Fed also noted that it did not intervene in currency markets during the first quarter, firmly putting to rest rumors to the contrary. Forbes reports:

There had been intermittent discussion in the markets of a coordinated foreign exchange intervention by the G-3 central banks, but the Fed report confirmed officially what markets already realized.

Read More: NY Fed reports trade-weighted dollar down more than 4% in first quarter 

The Federal Reserve Bank recently lowered interest rates for the seventh, and perhaps final, time, bringing its benchmark federal funds rate to 2.0%. Since inflation is still hovering around the 4% mark, the Fed will probably be reluctant to lower rates further. Thus, the markets have been given all of the boost that they are likely to receive, and it is "fate" that will determine whether the economy will find its footing. (GDP growth clocked in at an anemic .6% for the last two quarters). The most recent data (including the just-released jobs data) indicate that the economy may be stabilizing, although consumption and the employment situation are still deteriorating. As a result, the National Bureau of Research has yet to officially declare the current economic downturn a "recession," since the picture remains nuanced. The New York Times reports:

The recession-or-not question is now almost entirely academic, Mr. Bernstein contended, given the steady erosion of American spending power and soaring costs for food and gasoline.

Read More: Low Spending Is Taking Toll on Economy

2007 was a banner year for the Turkish Lira, which appreciated 21% against the US Dollar. However, in the year-to-date, the currency has returned nearly 10% of this gain, making it the third worst performing currency in the world. Turkey generally, and the Lira specifically, are considered by investors as proxies for emerging markets. The global trend towards risk aversion, as well as skyrocketing inflation, are hurting many such currencies. In Turkey, inflation is so problematic (9.4% at last count) that the Central Bank has raised its benchmark interest rate to 15.25%. Ironically, the more the Lira depreciates, the harder it becomes for the Central Bank to control inflation, causing the Lira to slide further as part of a self-perpetuating free-fall. In addition, the country is beset by political uncertainty, as the courts determine whether the nation’s current government can stay in office. Bloomberg News reports:

"The recent political developments are likely to complicate policy-making and the investment climate. The deteriorating political backdrop will in turn undermine the prospects for restoring fiscal discipline and reviving the reform agenda."

Read More: Lira Goes From First to Worst as Politics Whack Bulls

Earlier this week, the Forex Blog speculated that the tide was turning on the Euro, which  had retreated from the $1.60 threshold. Sure enough, the month of April saw the best monthly performance by the Dollar in over two years. The sudden about-face by the Dollar stems from changes in interest rate expectations. Only a couple weeks ago, the consensus among investors was that the Fed would cut rates further at its next meeting; the only point of uncertainty was whether rates would be cut by 25 or 50 basis points.

As of today, however, there is only a 25% chance that the Fed will cut rates at all, if you go by futures prices. Regarding the Euro, investors are no longer so sure that the ECB will hike rates in response to surging inflation. In short, the new consensus is that the US/EU interest rate differential has stabilized. Then there is the economic picture; investors have "chosen" to be pleasantly surprised by the most recent economic data. While the economic downturn still seems inevitable, it may not be as severe as investors had previously feared. Reuters reports:

In contrast to slightly stronger U.S. data, the Ifo German business sentiment index this week showed the biggest monthly fall since September 2001.

Read More: Dollar heads for best month in 2-1/2 years

2008 has witnessed a rapid appreciation in the Euro, which recently breached the psychologically important $1.60 barrier. Last week, however, the Dollar dramatically reversed course, leading many traders to speculate that the Euro’s best days may be temporarily behind it. There are two ideas underlying this theory. First, the Federal Reserve Bank is probably near the end of its tightening cycle, while the ECB has yet to begin. In addition, recent economic data suggests that the Euro-zone economy, which has appeared recession-proof in spite of the credit crisis, may soon falter. The best-case scenario, according to Dollar bulls, would be a loosening of monetary policy in the EU simultaneous with tightening in the US. If such a scenario were to obtain, it would bridge the interest rate differential between the two economies, which many believe is behind the weakness in the Dollar. The Wall Street Journal reports:

If bad news out of Europe starts to accumulate and the Fed stands pat, the dollar’s slide could taper off.

Read More: An Endgame for the Euro?

The Bank of Canada has cut its benchmark lending rate by 50 basis points, to 3.0%.  The move was widely expected by analysts, although some of them had forecast only a .25% cut. Last week, economic data confirmed a mild rate of inflation in Canada, giving the BOC a green light to ease monetary policy without having to worry about the effect on prices.  Despite commodity prices that remain at stratospheric levels, Canada’s economy is sagging, due to the subprime crisis unfolding across the border. Some analysts have analogized Canada’s situation to the dilemma facing the European Central Bank, which is reluctant to cut interest rates for fear of stoking the fires of inflation. As a result, the Euro has surged 8.5% against the Dollar in the year-to-date, while the Canadian Dollar has fallen. If the BOC opts to cut rates further, the Dollar could retake some of the ground it lost last year. Marketwatch reports:

Against the Canadian dollar, the U.S. dollar is likely to hold support around par, gradually firming back toward C$1.03 ahead of the U.S. Federal Open Market Committee meeting on April 30.

Read More: Canada poised to cut after benign inflation data

In a research note, two economists from Morgan Stanley predicted that the Euro will soon come crashing down, failing in its bid to rival the Dollar as a viable reserve currency. They observed that in the beginning of the decade, the Euro was viewed as joke from an economic standpoint. Since long-term economic fundamentals can’t reverse themselves in only a few years, they reasoned that the Euro’s rise must instead be a product of financial (capital flows) trends. Furthermore, as the EU becomes further integrated, a need will develop to diversify capital outside of the EU, thus reversing the trend of the last few years of diversification within the EU. The Globe and Mail reports:

The euro is overvalued because institutional investors…world have been diversifying out of their home markets at the same time as European investors have largely been diversifying within their home market.

Read More: The euro as reserve currency? Hah!

Since the inception of the credit crunch, one of the themes in forex markets has been the surprising strength of the Dollar. Despite growing economic uncertainty, the US is still viewed as a relatively safe place to invest. On the other hand, emerging markets, especially those with current account deficits, have witnessed capital flight and subsequent currency depreciation.  The currencies of South Africa and Iceland, for example, have both experienced declines 20% since the start of this year.  Risk premiums had fallen to historic lows prior to the credit crunch, and neither country experienced great difficulty financing its respecive deficits.  However, investors are growing increasingly nervous and are shifting capital to countries with stable current account balances. The Financial Times reports:

Goldman Sachs says: "We have long argued that in times of global turmoil suppliers of capital are poised to outperform countries in need of capital.  However, it is only since January 2008 that we have seen the current account theme really gain momentum in the FX market."

Read More: Currencies at mercy of deficits

In a recent article published in the Toronto Star, a Canadian columnist outlined five reasons why the Canadian economy is in trouble.  Only a couple factors are unique to Canada, and several can be subsumed under the credit crunch, but the pessimists are sounding broad alarm bells. First on the list is the looming drop in prices for commodities, the cornerstone of Canada’s economy. Oil recently sank below $100/barrel, and gold dropped 5% in one day! In addition, China is threatening to curb demand in order to rein in inflation. 

The second and third causes for concern are a decline in bank credit and loss of confidence, respectively. Neither of these factors are endemic to Canada, as banks around the world have suddenly developed an aversion to risk and have tightened lending accordingly. Next, corporate expansion (namely of American companies) is stalling; Home Depot and Proctor & Gamble have already announced a temporary hold on opening new stores in Canada.  The final factor(s) are American consumers, which collectively spend $9 Trillion per year.  The recent tightening of wallets could spell massive trouble for Canada, since some of its provincial economies are primarily driven by cross-border sales to Americans.

In short, the Canadian economy could actually contract in 2008.  But perhaps the resulting decline in Canada’s currency, the loonie, would make Canadian exports comparatively more attractive and return the economy to firm footing in 2009.

Read More: 5 reasons to start worrying

Recent news reports have painted a downright bleak picture of the US economy. Home prices are now falling. Equity prices are also falling, at an annualized rate of 20%.  Meanwhile, energy and food prices are rising, dipping into what little purchasing power consumers can still claim.  Somehow, as DailyFX, recently reported, the Dollar has held its own. Their reasoning is that there is a struggle being waged in forex markets between yield and growth. On the one hand are investors who are bearish on the Dollar because of interest rates that are headed downwards, despite already being low.  On the other hand are investors who think that yield is comparatively unimportant, since the rate cuts are needed to shore up the economy. While interest rate differentials do not favor the US, the economic growth that they are intended to bring about tell a different story. DailyFX reports:

The only problem with this thesis is that 2 percent interest rates or 100bp is about as low as the market expects the Fed will go. If banks are forced to take more write-offs and the US economy deteriorates further, the Federal Reserve may be forced to go below 1.00 percent.

Read More: What Matters More For the US Dollar:  Yield or Growth?

Remember the expression "Goldilocks economy," used to to characterize the Fed’s perennial aim of simultaneously pursuing economic growth and price stability?  How about "stagflation," a term coined in the 1970s to describe a unique period in US economic history where low growth coincided with inflation.  Now, these two scenarios are being juxtaposed as the Goldilocks economy gives way to stagflation. The Fed is trying to delicately toe the line, as equity and home prices sink while prices rise; one index suggests prices have risen over 7% year-over-year.  The index more often cited, the CPI, reads 4.3%.  Both of these figures exceed current interest rate levels. 

What, then, is the Fed’s proper course of action, especially as far as Dollar bulls are concerned?  If it holds rates or contindfues to lower them, the economy could avert recession but prices would likely continue to climb, eroding the value of the Dollar.  On the other hand, if rates are hiked to mitigate against inflation, a recession would almost become inevitable, and the Dollar would feel the drag of capital being pulled overseas. The New York Times reports:

“February may go down in history as the month that the previously indefatigable U.S. consumer finally threw in the towel, beaten by a combination of deteriorating labor market conditions, surging prices for food and energy and collapsing house prices,”

Read More: As Inflation Rises, Home Values Slump, Data Show

China’s trade surplus grew 22.6% year-over-year for the month of January, on top of export growth of 26.7%.  If there is any silver lining to what many policymakers would consider bad news, it is that growth in imports is slightly outpacing growth in exports.  Unfortunately, that is unlikely to allay the critics, and there are still many of them. The argument remains unchanged- that China is not allowing its currency to rise fast enough.  On paper, however, the Yuan has appreciated by 15% since China officially de-pegged it from the Dollar in July 2005.  In addition, the G7 failed to scold China in its annual meeting, which suggests that economic policymakers are becoming less concerned with China’s forex policy.  Ironically, the revaluation of the Yuan is probably boosting the value of of China’s exports in the short-term, because other countries are now paying more for the same quantity of imports.  AFP reports:

The International Monetary Fund…urged the Chinese government to loosen the reins on the yuan. "We encourage a faster pace of appreciation that would be helpful for addressing China’s key economic challenges and would also contribute to preserving global economic stability."

Read More: China’s trade surplus rises 22.6 percent in January

As talk and evidence of a US economic recession builds, the Dollar has witnessed a slight upswing.  How to explain these seemingly contradictory trends? The rationale is surprisingly simple.  While a US recession would predictably hit the US harder than other countries, it would still hamper growth abroad, especially in emerging markets that have come to depend on exports to the US to drive growth.  Accordingly, investing in such emerging markets becomes relatively more risky than investing in the US, which is still considered to have the world’s most stable investing climate from a long-term perspective.  Thus, as risk aversion rises, so does the Dollar. Thomson Financial reports:

The combination of poor data weighed on stock markets in the US and Asia, while major bourses in Europe have all opened lower today. This meant the dollar gained support as investors shy away from riskier emerging market assets.

Read More: Dollar gains on the back of rising risk aversion

As far as Dollar bulls are concerned, all news is bad news. An economic recession seems inevitable. Interest rates are already negative in real terms, and are now the lowest in the industrialized world, save Japan.  It’s still unclear how much subprime debt will be written down by financial companies before all is said and done.  But analysts from Brown Brothers Harriman, an investment bank, think the Dollar’s multi-year decline is coming to an end.  There are two main reasons underlying their rationale.  The first point is purely technical- that the all of the bad news and in fact, the worst possible scenario, has already been priced into the Dollar.  The second point is fundamental- that the speculative hot money that has poured into the US as foreign investors take advantage of a weak Dollar and that is sustaining the US current account deficit is now transitioning into long-term foreign direct investment.  The Financial Post reports:

In addition, BBH believes that in a weak dollar environment, foreign companies will now start looking to move production and sourcing to the United States, following the successful example of Japanese auto makers.

Read More: Greenback is nearing bottom, currency experts say

So-called ‘Sovereign Wealth Funds’ are the talk of the town, stealing headlines as part of a multi-billion dollar buying spree.  Anecdotally, stories of these funds and other institutional foreign investors have made a big splash, epitomized by a few high-profile investments in struggling American investment banks.  It no longer appears these stories were isolated, as suggested by some pretty compelling economic data.  In 2007, total foreign direct investment into the United States totaled $400 Billion, which represents a 90% increase over 2006.  In addition, the first few weeks of 2008 saw a frenzy of activity, which suggest this trend will continue.  Investment in the US is being driven primarily by a weak Dollar and attractive stock market valuations.  If the bad news on the US economy continues to pour in, analysts warn that foreigners could play an even larger role in mitigating against recession. The New York Times reports:

The weak dollar has made American companies and properties cheaper in global terms. Even as Americans confront the prospect of a recession, economic growth remains strong worldwide, endowing oil producers like Saudi Arabia and Russia and export powers like China and Germany with abundant cash.

Read More: Overseas Investors Buy Aggressively in U.S.

On January 24 last year, the Forex Blog reported with great fanfare that China’s forex reserves had breached the epic milestone of $1 Trillion. [In hindsight, it turns out that the psychologically important barrier was broken several months earlier, but that is beside the point].  Less than one year later, China’s forex reserves reached another important threshold, soaring past $1.5 Trillion. It appears that new reserves are being accumulated at  an exponential rate, having increased $460 Billion last year and over $30 Billion in the month  of December alone. By no coincidence, China’s 2007 trade surplus of $262 Billion shattered the previous record and is expanding at a comparably supersonic pace.

Most analysts reckon that the country is locked in a vicious cycle: when its trade surplus grows, its forex reserves grow proportionately. Moreover, the lopsided trade imbalance th\at China maintains with most of the world ensures that the demand for Chinese Yuan exceeds the supply. In the short run, a more expensive currency equates to higher prices paid for its exports which only increases the trade surplus and forex reserves further, and exerts still more pressure on the currency to appreciate.  Meanwhile, as the Yuan rises, the value of China’s forex reserves, which are denominated predominantly in USD, falls.  What a conundrum indeed! Xinhua News reports:

The value of Chinese RMB against the US dollars has appreciated by over six percent in 2007. The central parity rate of the RMB was 7.2672 to the US dollar on Friday.

Read More: Forex reserve tops $1.53 trillion

The Yen has received a nice boost from Japanese exporters, which moved en masse to exchange Dollars for Yen to meet certain year-end financial obligations.  The logic is that exporters had owed money in arrears to domestic Japanese producers of the goods and services being exported and needed to be paid in Yen. Such logic could theoretically be applied to exporters in ever country, which would provide the same boost to their respective currencies.   However, in addition to being the world’s fourth-largest exporter, Japan’s economy is unusually dependent on exports.  Thus, it is understandable that Japanese exporters could exert such influence on forex markets when entering the market at the same time.

Read More: Yen Rises on Speculation Japanese Exporters Buying the Currency

Most of the world’s emerging economies link their currencies to either the Dollar, the Euro or a basket of currencies, through an outright peg or a so-called "dirty float."  These countries have attracted waves of foreign money, with the intent of buying cheap exports, foreign direct investment, and capital/forex market speculation.  As a result, while the upside of these pegs has been seemingly boundless economic growth, the downside has been inflation, since many of these countries have been forced to print money in exchange for foreign currency.  Countries in the Middle East, Asia, and Eastern Europe, especially, have effected tremendous increases in their respective money supplies with double-digit inflation rates to match.  Many savvy investors, namely hedge funds, have begun to target countries with fixed exchange rates that are suffering high rates of inflation, with the reasoning that it is inevitable such currencies will soon be forced into appreciation. The Telegraph reports:

Further east, Vietnam is throwing in the towel as inflation hits 9pc. It said it will no longer hold down the dong by massive purchases of US bonds. Singapore, Taiwan, and Korea have begun to change tack, slowing dollar accumulation before inflation gets out of control.

Read More: Hedge funds target currency pegs

The UK Pound has been on a tear recently, both against the USD and more surprisingly, against the Euro.  The currency has been given a boost by the
Bank of England’s reluctance to cut its benchmark interest rate, which at 5.75%, remains the highest among the world’s major currencies.  However, many economists feel the case for a rate cut is growing stronger every month, whether or not the Bank of England is willing to acknowledge it.  Inflation is only moderately high, while the fall in housing prices-exacerbated by a prolonged period of tight money-threatens to drag down the entire economy.  The markets are still pricing in a rate cut by year-end, which would surely drag down the Pound should it obtain.  Dow Jones Newswires reports:

“We strongly suspect that market pessimism in this respect will continue to grow, in reverse proportions to its expectations of a further hike in U.K. interest rates,” said…a senior currency strategist.

Read More: Sterling’s Strength Can’t Last Much Longer

Over the last five years, the Canadian Dollar has slowly climbed to parity against the USD, finally reaching the mythical 1:1 exchange rate last week. Canadian shoppers and
American tourists have taken notice, gradually adjusting their behavior in accordance wit their changing purchasing power. For many Canadians, this has translated into more frequent shopping trips across the border, whether for gasoline or for clothing. For Americans, this has resulted in a decline in the number of tourists visiting Canada. It is also slowly redefining the US-Canada trade dynamic. However, as Canada has become the United States’ largest supplier of oil, it is likely Canada that will
benefit most in this relationship. The New York Times reports:

The weakness of the American dollar worries some Canadian investors as well as businesses that rely on American customers.

Read More: Currency Parity Brings Canadian Shoppers South

That the balance of trade between the US and China is becoming more and more lopsided in favor of China should come as no surprise to anyone.  In fact, economists yawned when the August trade data revealed a 33% jump in the Chinese trade surplus.  As a result, many are beginning to argue that China can allow the Yuan to appreciate at a faster pace against the Dollar, since it is obvious that China’s export sector will not be materially affected by a stronger Yuan.  In addition, China now exports more goods and services to the EU than to America, yet another statistic which supports the notion that China can allow its currency to appreciate against the Dollar (the implication here being that the Euro-Yuan exchange rate should be more important to China at this point).  Finally, China’s inflation rate is now hovering around 6.5%, its highest level in over a decade.  A more valuable Yuan would presumably make imports less expensive, thus lowering prices across the board for Chinese consumers. Bloomberg News reports:

The Chinese currency is selling for about 7.51 to the dollar. It has risen almost 6 percent against the U.S. currency in the past year while falling more than 3 percent against the euro, leaving the overall competitiveness of China’s exports little changed.

Read More: Rising Euro Is What China Needs to Dump Dollar

August reports show that the US lost 4000 jobs in one month. The biggest employment slump in several years, it appears that problems with the subprime market are affecting more people than ever. The dollar fell to a 30-day low after these reports went public. According to Reuters:

The euro vaulted to a one-month high of $1.3768 <EUR=> after the report before easing to $1.3751, up 0.5 percent. The dollar was down 0.8 percent at 114.42 yen <JPY=>, near a session low of 114.31 yen.

Read more: Dollar tumbles as August U.S. payrolls contract

Officials from the State Bank of Vietnam have confirmed that the country’s forex reserves have doubled, thanks to a solid investment in US dollars. What was once enough money to pay for 10 weeks of imports now buys 20. This windfall comes with a price, however, as inflation will now increase. Deputy Governor of the State Bank, Nguyen Dong Tien, hopes to keep the adverse effects to a minimum. Reports Daily Times:

Economists say double-digit inflation is a possibility, but Tien told the news conference that the central bank had stepped up its draining of inflation-fueling funds from the economy through open market transactions.

Read more: Vietnam doubles forex reserves

The Euro’s rise against the USD over the last year has been swift and unimpeded.  Many commentators have theorized that it is intense pessimism surrounding the US economy and economic conditions-namely the burgeoning twin deficits-that is responsible for the Dollar’s demise.  Now, a new theory is being batted around, one that is quickly gaining traction with analysts:

perhaps it is optimism directed towards the EU economy rather than pessimism towards the US that is causing the Euro to spike.  After all, the European economy has rebounded nicely and boasts stable monetary and trade statistics. However, this notion of European optimism, if it in fact exists, has some analysts worried that the markets are becoming too optimistic, and that if they are not careful, they will end up wrecking the European economy by driving up the Euro too high. The Times Online reports:

If the euro keeps rising without limit, Europe’s export industries will be decimated, as they were not only in Britain, but also in America in the mid-1980s and also in Japan after 1995.

Read More: The euro’s rise and rise is unsustainable

The story behind the Dollar’s decline contains two threads:
narrowing interest rate differentials and growing concerns surrounding the US economy. With most of the industrialized world’s Central banks not scheduled to meet again for a few weeks, the interest rate story can temporarily be placed on hold in favor of the economic story, which is becoming uglier every day. The centerpiece remains the US housing market, which many analysts believe will soon slide into a major rut. There is a great deal of uncertainty over whether homes can retain their value and if borrowers will be able to pay off their mortgages. Rising rates have squeezed many low-income, high-risk borrowers, causing a crisis of growing proportions in the market for mortgage-backed securities, which is at risk for spreading to other areas of securities markets. Forbes reports:

“Credit concerns, rating reviews, yields tumbling; it has been one-way traffic against the dollar in recent minutes and euro/dollar has rallied up a fresh all-time high.”

Read More: Dollar slump sends euro
to record high

The Economist just released its an updated iteration
of its famous Big Mac Index, underscoring growing disparities in currency valuations. For those of you that aren’t familiar, the Big Mac Index uses the price of a McDonald’s Big Mac sandwich in different countries as a proxy for measuring purchasing power parity (ppp), that perennial staple of economics that theorizes a country’s currency and its inflation rate should move in opposite directions. Thus, where a Big Mac is observed to be more expensive than in the US, it would suggest that country’s currency is overvalued relative to the USD. Of course there are numerous other factors in the local price of a Big Mac, including raw materials and taxes, but the index still packs a pretty profound punch. Unsurprisingly, the most undervalued currencies can be found in Asia - notably the currencies of Japan, China, Thailand, Indonesia, etc. The most comparatively expensive Big Macs (and hence most overvalued currencies) can be found in Europe, especially in Scandinavia and Northern Europe.

Read More: The Big Mac Index

These days, the US economy seems to rise and fall on the wings of the housing sector.  Unfortunately, this sector is in a tailspin as higher interest rates have left many homeowners unable to pay their mortgages, causing a crisis in the oft-cited subprime market.  Already, several hedge funds have nearly collapsed due to subprime mortgage uncertainty, and nearly 600 portfolios of subprime mortgages (representing $12 Billion) have been downgraded as a result of declining creditworthiness.  Investors fear that instability in the subprime market could spread to the rest of the US economy and/or drive the Federal Reserve Bank to lower interest rates, which would narrow the interest rate differential between the US and most of the west. Reuters reports:

Lower U.S. bond yields arising from problems in the subprime sector have diminished the allure of U.S. Treasury debt. The yield on the benchmark 10-year U.S. Treasury note…is at 5.08 percent, down from about 5.29 about a month ago.

Read More: Dollar hits record low vs euro on subprime woes

With the US government doggedly clinging to the notion that China is manipulating its currency and insisting that the communist country be punished accordingly, it bears asking “how can we determine that a currency (in this case the Yuan) is in fact undervalued, and if so, by how much.  One notable economist has laid out three general techniques for “valuing a currency,” which may prove useful to all of you amateur economists.

First, there is the concept known as “purchasing power parity,” which suggests that a pair of currencies should fluctuate in value relative to each other based on changes in their respective interest rates and inflation. Second, there is the notion of a “sustainable” or “fundamental equilibrium” exchange rate which brings a country’s current account into balance- neither deficit nor surplus.  Third, historical exchange rate data can be regressed against various economic indicators (productivity, employment, etc.) in order to distill the select few that had the most direct effect on the currency in the past. The most current economic data can then be plugged into the resulting equation and tested against actual exchange rates.  However, while economists agree that these techniques are the most theoretically sound, they ignore the fact that currencies today seem less tied to the laws of plain economics than they do to financial economics- capital flows.

Read More: Misleading misalignments

Over the last couple months, a raft of positive economic developments has driven the USD steadily to its highest level in months. These developments include GDP data, retail sales data, and housing data have all shown signs of strength after an all-encompassing slump in the first quarter. However, it was not until last week that the markets fully removed the possibility of near-term rate cuts out of the markets, sending US benchmark interest rates to their highest levels in years. As a result, the USD received a second bump, as higher yields sucked in a risk-averse capital from other parts of the world.  The delay between positive economic data and the subsequent rise in yields that took place here is rare, but Dollar bulls were probably happy to ride the wave upwards.  Dow Jones News reports:

Amid soaring rates, the dollar’s rally got a second lease of life, confounding those who had been calling for a reversal in the greenback’s fortunes. Contrast that with late April, when the euro hit a record high of $1.3682 - and analysts were forecasting a run to $1.40.

Read More: Dollar Perhaps Undeserving Of Recent Rally

Since reaching record-highs against the British Pound and Euro in April, the USD has pulled back slightly, due in part to the perception that the US economy is back in track. Last quarter’s round of GDP and housing data revealed that by some measures, the US economy was expanding at the slowest pace in years.  However, that notion was contradicted by last week’s release of employment, retail, and manufacturing data, all of which exceeded analysts’ expectations.  As a result, some economists have reversed their positions on the near-term outlook for US monetary policy, by switching their predictions from rate cut to rate hike.  The Tapei Times reports:

“Against a backdrop of stubborn inflation and tight labor markets, our analysis going forward will be more focused on the timing of rate hikes, not cuts.”

Read More: Expectations of healthy growth boost US currency

While the American economy is sputtering, US corporations are earnings record profits and stock market capitalization is soaring.  These seemingly contradictory trends are being driven by the decline in the USD.  Multinational corporations, especially those based in the US, are conducting a growing portion of their business abroad and subsequently, their foreign sales are booming.  When corporations convert these profits from the currencies they are booked in back to USD, on which their financial statements are based, they are realizing the equivalent of a 5-10% bump from foreign exchange gains.  Many of these companies are web-based, such as Yahoo, Amazon and eBay.  Ironically, as the economy sags, betting on these types of companies may be akin to a bet against the USD.

Today, the US Federal Reserve Bank announced that it would hold the benchmark federal funds rate at 5.25% and will likely wait a few more months before nudging rates upward or downward.  In a press release that accompanied its monthly meeting, the Fed was unusually candid, indicating that it is receiving conflicting signals from economic data.  On the one hand, the economy is now growing at is slowest pace in nearly four years. On the other hand, the unemployment rate is below 5% and jobless claims remain low.  Typically, such an economic deadlock would be broken by inflation data, but in this case, inflation is trending only slightly above the Fed’s stated comfort level. In short, economists are mixed as to what kind of interest rate movements would be most conducive to what has been termed the ‘Goldilocks’ economy [not too hot, not too cold, but just right]. The New York Times reports:

In March, the Federal Reserve gave itself more flexibility to make its next move a rate cut rather than a rate increase. Instead of referring to the possible need for “additional firming,” which is Fed-speak for a rate increase, it simply referred to the possibility of “future policy adjustments.”

Read More: Fed Gives No Signal of Rate Shift

Nearly two months ago, China’s stock market declined 15% in one session, leading capital markets around the world to drop off precipitously. This collapse quickly spread to forex markets, where spooked traders began to unwind their Japanese yen carry trades, fearful that the volatility would trigger a short squeeze, causing the Yen to rapidly appreciate. While the yen has returned to its former low levels, it seems foreign investors have prudently unwound up to 60% of their short positions in the Yen, anyway.

A quandary has plagued analysts, who are attributing the failure of the Yen to appreciate to a surge of carry trade interest by Japanese retail investors. Long term Japanese interest rates remain pathetically low, and Japanese investors have taken to buying securities in American and Australia, where yields are significantly higher. However, if Japan’s Central Bank begins to raise rates- as analysts expect will take place as soon as May- investors could be persuaded to repatriate their capital to Japan. The Economist reports:

Retail investors’ direct share of Japan’s
foreign-currency market may be 20-30%, whereas individuals’ holdings of foreign
currency exceed foreigners’ holdings of Japanese securities. The clue to the
yen’s future, in other words, lies with the little man.

Read More: Out with a whimper

The Euro is currently hovering above its all-time high against the USD, and is flirting with levels never-before-seen in the Euro’s brief, eight-year history.  The Euro had
toyed with the record for the last couple of weeks, before finally breaching it upon last Friday’s release of US GDP data, which indicated the US economy had weakened to its slowest pace of growth in over four years. Investors are now waiting to see how the Fed responds to this latest development, as the bank has found itself in the unenviable position of navigating rising inflation and a slowing economy. Reuters reports:

Benign inflation data and modest growth in Midwest business activity provided more evidence of slowing U.S. economic growth, keeping sentiment bearish for the dollar, traders said.

Read More: Dollar stays near record low vs euro in quiet
trade

This week witnessed a flurry of economic data, capped by tomorrow’s scheduled release of employment and GDP statistics.  At the beginning of the week, the perennially pointless monthly durable goods statistics indicated a rise in durable goods orders, which Dollar bulls interpreted as a good sign.  However, real estate data indicated a lower-than-expected rise in new home sales as well as a dramatic decline in the sale of existing homes.  Polled economists are predicting that tomorrow’s news will likely fall into the dovish category, painting a picture of an economy that has already peaked and making the case for the Fed to hold interest rates at current levels.  However, the bond markets are still pricing in 1-2 rate hikes over the near-term, which currency markets may use to prop up the Dollar.  The Daily Reckoning reports:

Money supply growth has a negative impact on the dollar. Inflation is a currency killer, and looking at the broadest measure (M3), money supply growth is out of control.

Read More: Currency Markets Take a Rollercoaster Ride

Since 1992, two macroeconomic events had not occurred in Britain: price inflation has no exceeded 3% annually and the British Pound has not surpassed the $2 barrier.  Both events were realized today, however, as an early-morning release of economic data indicated inflation in Britain was hovering around 3.1% and the British Pound quickly rose above 2 USD/Pound.  Interest rate futures also witnessed an immediate correction, to the extent that the markets are now pricing in a British benchmark interest rate of 5.75% 6 months from now, .5% above the current rate.  Meanwhile, US inflation statistics were dovish, suggesting the gap between British and US interest rates is set to widen, which should propel the Pound further upwards.  The Financial Times reports:

There is little that is inevitable about currencies moving in line with expected interest rates and nothing in long-term trends that allows people to predict currency movements in connection with inflation and other variables. But on Tuesday, the currencies moved exactly as if they were linked to the inflation figures by an umbilical cord.

Read More: Pound rises on prices and rates fears

Six years ago, Brazil’s economy was in shambles, annual price inflations routinely exceeded 10%, and Brazilian interest rates were hovering around 20%.  Its currency, the Real, traded at roughly 4/USD.  Flash forward to the present: Brazil’s economy is now on solid footing, inflation has been held in check, and Brazilian asset prices are strong.  The result is a much stronger Real, which has doubled in value since 2002. Of course, many analysts have been quick to point out that the Real is benefiting from high commodity prices, which are unlikely to be sustained in the medium-term.  The Financial Times reports:

Brazilian assets suffered during recent nervousness over the troubled US mortgage market. But this seems to have passed and confidence in the global economy and strong commodity prices have caused a return of investment flows.

Read More: Brazilian currency set to hit fresh peak

Most analysts reckon that the USD has resumed its downward path against the world’s major currencies, after a two month hiatus.  The fear is that the mess in the real estate market (via subprime mortgages) will spread to the rest of the economy, with loan defaults and a decline in consumption.  In such a case, the Federal Reserve Bank would be forced to cut interest rates dramatically in order to prevent the US from sinking into a full-fledged recession, which would decrease the relative attractiveness of US assets.  Traders will be eying a couple pieces of economic data this week for any indication as to the direction of the economy. 

The Wall Street Journal reports:
This week’s data parade is bracketed by two key releases: Monday’s national report on U.S. manufacturing activity in March from the Institute for Supply Management and Friday’s payrolls report.

Read More: U.S. Economic Reports Could Ease Dollar’s Woes

While the USD appears to be trending downward these days, commentators note that the currency is actually traveling sideways, as market participants look for cues indirectly from economic data and directly from the Fed. Many pundits feel the economy is resting precariously on the back of the housing market, and are anxiously waiting for the data to provide guidance either way. Already, a spate of bad news surrounding one sector of the mortgage market coupled with disappointing data on new home sales are worrying investors. Ultimately, however, the USD will live or die by the Federal Reserve Bank’s reaction to this news. In fact, the Fed’s Open Market Committee is scheduled to meet today and tomorrow, during which point it is expected that interest rates will be held constant. The Wall Street Journal reports:

Analysts will also be watching for any changes to the Fed’s inflation outlook, particularly after Friday’s stronger-than-expected consumer-price report.

Read More: Dollar Treads Water, Waiting for the Fed

While the figures are still being calculated and confirmed, it looks like 2006 was the worst year ever for the US trade deficit, which is estimated to exceed $800 Billion. Economists have long argued that such an aberration is not sustainable in the long run and that the USD must fall in order to make goods and services relatively less expensive from the standpoint of foreigners. Now, however, economists are beginning to question this logic, by arguing that due to underdeveloped capital markets abroad, foreigners will continue to favor the US as a place to invest their assets. In hindsight, it looks like forex markets were ahead of the curve, since the failure of the USD to fall against other currencies despite its burgeoning deficits signals an utter lack of concern among forex traders that this is an important issue. The Economist reports:

If global imbalances are the result of such frictions, they are unlikely to unwind quickly. Financial systems, after all, do not mature overnight.

Read More: Sustaining the unsustainable

Since reaching a 14-month low earlier this month, the Canadian Dollar has rebounded, thanks to data which indicate the Canadian economy is emerging from a mild recession. The currency was also helped by surging prices for commodities, which account for more than half of the country’s exports. As the summer draws closer, the currency will likely accelerate upwards, helped by predictably strong energy prices. In short, it seems the Canadian Dollar’s recent sluggishness is probably just a seasonal adjustment rather than a long-term correction. Bloomberg News reports:

“The agency didn’t see any need for revising either the growth, or job numbers, which is the Canadian dollar positive development.”

Read More: Canada’s Dollar Rises a for Third Week as Economy Strengthens

One technique for estimating the relative value of the Euro is to aggregate the value of all of the constituent EU currencies, using relative price movements as proxies for currencies. In Spain and Italy, for example, wages have skyrocketed over the past five years while productivity has lagged, which means these countries are relatively more expensive now. Germany, on the other hand, has been the economic leader of the EU, having benefited from declining real wages and surging productivity. When viewed as a sum of its parts rather than as a whole, Europe is plagued by many of the same economic problems that beset America, such as a negative balance of trade. A weighted average of European prices reveals a picture of what the Euro should be worth. Based on these three countries, it looks like the Euro is between fairly valued and overvalued. The Economist reports:

Spain now has the second-largest current-account deficit in the world in dollar terms. Germany’s resurgence has set a challenge for the euro zone’s southern members. Without the option of devaluation, their medium-term outlook looks less than rosy.

Read More: Beggar thy neighbor

The economic law of purchasing power parity (PPP) dictates that price levels and exchange rates should move in opposite directions. Stated another way, when a currency appreciates, its prices should decline proportionately so that the net effect on prices is zero. Methods for measuring PPP-let alone testing it- are imprecise. Recently, an Australian bank has capitalized on the success of The Economist’s Big Mac index and merged it with one of the most popular consumer electronics, the Apple iPOD. The result is the iPOD index, which uses the retail price of an iPOD in different countries as a basis for assessing relative currency valuation. The upshot for forex traders is that the USD inferred to be undervalued, since the US price of an iPOD is among the lowest in the world. The Financial Express reports:

Brazilians pay the most for an iPod, shelling out $327.71, well above second-placed India at $222.27. Canada was the cheapest place to buy a Nano at $144.20, while…the US was fourth cheapest at $149.

Read More: The iPod as currency markets index

Since China revalued the Yuan in July 2005, the currency has appreciated by over 6% against the USD. Having since moved past the Hong Kong Dollar, the currency is showing no signs of slowing down. American politicians and trade representatives could not be happier. Their Chinese counterparts, on the other hand, are peeved. Many Chinese exporters have been forced to lower their prices in order to offset the rising yuan and maintain their competitiveness in overseas markets. Such exporters are complaining to anyone who will listen that a more expensive yuan is already eating into their profits. While China’s government prizes stability, it has not yet given any indication that it will halt the appreciation of the yuan in order to placate such malcontents. The Associated Press reports:

“When they started out on this process, they knew that some people would be hurt,” said Rothman. “If they can see the results are necessary to put the economy on a sounder footing long-term, then they can deal with the pain.”

Read More: China’s exporters suffering as currency rise

Since peaking in July, the Canadian Dollar has declined by over 6% against the USD, finishing the year down for the first time in five years. While movements in currency markets are often difficult to dissect, the reason for the fall of the loonie are not difficult to discern: falling commodity prices. Over the last few years, the Canadian Dollar has moved in near tandem with global commodity prices. Commodities now account for over half of Canadian exports, a figure which may grow further as Canada fine tunes its technique for squeezing valuable oil out of its now famous tar sands. Bloomberg News reports:

“The time to buy the Canadian dollar is nearing.” The currency will gain strength from a fast-recovering U.S. economy and the lack of a benchmark interest rate cut from the Bank of Canada in 2007, Citigroup predicted.

Read More: Canada’s Dollar Touches 11-Month Low as Commodity Prices Drop

As the markets ease into 2007, investors and money managers are beginning to think about how they want to (re)allocate their portfolios. While hedge funds will likely remain a popular investment vehicle, investors would be wise to avoid certain types of funds, namely those that utilize a “global macro” strategy. Technically, such hedge funds examine global economic fundamentals and allocate capital accordingly. In reality, most of these funds make predictions about the global interest rate climate- specifically how interest rates will behave in relation to each other. Since currencies are often seen as proxies for interest rates, many global macro hedge funds are active participants in forex markets. And 2007 was an especially volatile year for forex markets, which translated into a rough year for global macro funds.

Read More: What’s hot and what’s not in hedge funds

While the Yuan is currently rising at an annualized rate of 7% against the USD, China continues to earn the brunt of the ire of US politicians, who point to China’s nearly $200 Billion current account surplus. Meanwhile, the oil-exporting nations of the world have largely escaped detection despite their collective trade surplus of $500 Billion, $300 Billion of which can be attributed to Middle Eastern countries. The countries of Gulf Co-operation Council, or GCC (Saudi Arabia, United Arab Emirates, Kuwait, Bahrain, Oman and Qatar), separately link their currencies to the USD, and as the price of oil soared to record highs in 2006, the coffers of these countries expanded proportionately. Many economists are advocating that these countries abandon the peg to the Dollar in favor of a link to a basket of currencies, which would probably favor the Euro.

This seems to be a sensible approach for several reasons. First, the EU represents the region’s biggest trading partner. Second, the USD-peg has constrained the ability of GCC Central Banks to conduct monetary policy, which has contributed to high inflation and overheating economies. Finally, it is rumored that GCC countries will merge their currencies into a common regional currency in 2010, at which point a peg to the USD will become an economic disaster waiting to happen.

Read More: The Petrodollar Peg

With the USD in a full-fledged tailspin, many economists and analysts are mapping out the implications of a further decline and modeling worst-case scenarios. The release of new economic data is only adding fuel to the fire, and for the first time, many are embracing the possibility of a complete collapse of the USD, as investors rush en masse for the exits. Already, the Dollar is nearing all-time lows against the British Pound and the Euro. Housing data has stabilized slightly, but manufacturing data reveals that many companies are building unhealthy balances of unsold inventory. Meanwhile, GDP growth forecasts have been downgraded to sluggish and the Fed is threatening to further raise interest rates. The Financial Times reports:

“Combined with other soft US data, the ISM data will reinforce fears of a hard landing and will add to the momentum behind the dollar sell-off,” said Martin Slaney at GFT Global Markets.

Read More: Hard landing fears hit dollar

As the British Pound hovers around a 14-year high against the USD, economists have begun to assess the implications. The most obvious consequence is that UK exports will become less attractive to buyers in the US, which is one of Britain’s primary export markets. Along the same lines, British people may begin funneling some of their consumption and investment dollars into the US to take advantage of comparatively lower prices in the US. Many analysts are predicting that this sudden inflow of British capital into the US will halt the decline of the USD against the Pound. The savviest investors have already begun to lock in the current exchange rate to hedge against a reversal. The Finance Daily reports:

“Forward contracts are a great way for people looking to move to the US to take advantage of the favourable exchange rate.” In essence, a ‘forward contract’ means that you can buy the currency now and pay for it later.

Read More: Mixed Benefits to Strong Pound Stateside

Over the last month, the USD has decline precipitously in value, to the extent that the currency is approaching a two-year low against the Euro, a 14-year low against the British Pound and an all-time low against the Chinese Yuan. Most economists had been predicting this decline for quite some time, and felt it was a matter of when it would happen- not if it would happen. With the release of US GDP data indicated that the US economy grew by a healthy clip last quarter, the decline in the Dollar was brought to a sudden halt. However, the news has already begun to dissipate in the markets and will likely soon be offset by dollar-negative news in the coming weeks. The Financial Times reports:

Analysts said that, while it might be something of a surprise that the dollar had failed to derive support from Mr Bernanke’s remarks, he might be in danger of “crying wolf” over US inflationary pressures.

Read More: Dollar relieved by economic growth

At its monthly meeting held his week, the European Central Bank (ECB) left the benchmark Euro-zone lending rate unchanged at 3.25%. However, Jean-Claude Trichet, president of the ECB, announced that the ECB would exercise “strong vigilance” in monitoring economic conditions and weighing future rate hikes. While this kind of language could be confused as rather vague and generic, Trichet’s promise of “vigilance” has been used in the past to preface rate hikes. In addition, Trichet hinted that he would conform to the markets’ prediction that the ECB will raise rates in December. Meanwhile, the US economy is sputtering, and many economists expect the Fed to lower interest rates by a notch in the coming months, which could provide the impetus for the inevitable appreciation of the Euro. The Financial Times reports:

“We have a sneaking suspicion from the tone of the minutes that the ECB feels that it may well have at least a little more work to do in 2007 after December’s interest rate hike.”

Read More: ECB statement boosts the euro

Speculation over whether the Federal Reserve Bank (Fed) would raise interest rates at its monthly policy meeting reached fever-pitch this week, culminating in the Fed’s announcement yesterday to leave rates unchanged. Analysts reckon the calculus of factors that weigh on Fed interest rate decisions is more complex now than ever before. The Fed must not only contend with high inflation, stubborn unemployment, and the need for economic growth, but also asset prices and the balance of trade. Everyone agrees that core inflation, at 3%, is higher than it should be. However, Ben Bernanke, chairman of the Fed, clearly realizes that while a rate hike would certainly stem inflation and limit the possibility of asset bubbles forming, it would also dampen the economic growth which has become so critical to America.

Read More: Why Fed Might Keep Rates on Hold

By now, we all know that in the short run, interest rates and currency valuations are often correlated. In the long term, however, interest rate parity dictates that a country’s currency should move in the opposite direction as its domestic interest rates, in order to guarantee that investors in different countries receive comparable returns. This is consistent with financial economics, in that higher-yielding securities tend to elicit less demand, which means that the corresponding currencies sag due to insufficient capital inflows. Now, let’s apply this theory to the recent downgrade of Italy’s public debt. This downgrade will drive Italian interest rates higher as risk-averse investors flee Italy in search of safer investments. (Bond prices and interest rates move in opposite directions) The resulting capital outflows would cause the Italian currency (if it still existed) to depreciate. Fortunately for Italy, the capital outflows it suffers will be spread across the entire Euro-zone, and the net effect on the Euro will be negligible.

Read More: Euro shrugs off Italy downgrades

Traders bullish on the British Pound have been waiting anxiously for economic data to be released that would provide an impetus for the Central Bank of Britain to raise interest rates. On Tuesday, they got their wish, as a flurry of data revealed British price levels are slowly creeping up. Despite sagging energy prices, core inflation is running at an annualized rate of 2.4%, and retail sales are up nearly 4% in 2006. The new consensus is for the UK Bank to raise interest rates by 25 basis points at its next meeting, which is scheduled for November. The Financial Times reports:

By mid-afternoon in New York, the pound was 0.5 per cent higher at a one-week high of $1.8700 against the dollar and up 0.4 per cent to £0.6707 against the euro.

Read More: Inflation Figures Boost Sterling

The most recent US trade statistics indicate a record trade deficit, at $70 Billion per month and growing. It bears mentioning that $22 Billion of that deficit is with China, alone. At the current rate of growth, the deficit will likely cross the symbolic $1 Trillion dollar barrier in the next few years. Despite this devastating development, the USD hardly budged in forex markets, which suggests that traders remain unfazed in their belief that foreigners will continue to finance the deficit, regardless of how large it grows. However, the current USD valuation runs contrary to the one of the most fundamental laws of classical economics: purchasing power parity. While traders may believe that they can indefinitely forestall the collapse of the USD, they are only making it more likely that a “hard landing” will take place.

Read More: Dollar holds up despite record US trade deficit

When Jean-Claude Trichet, president of the European Central Bank (ECB), threatened “vigilance” against inflation last month, markets braced for what they believed would be several consecutive rate hikes. Recently, however, inflation seems to have largely disappeared, thanks to a leveling off of commodity prices. In the eyes of Euro bulls, this trend has been offset by a spate of positive economic indicators, which suggest the EU economy is as strong as it has been in over five years. Economists are now projecting growth of 2.5% for the EU area this year, with productivity increasing and unemployment declining. The result should be higher interest rates and a proportionately stronger Euro. The Economist reports:

In the long run, theory suggests that higher growth, other things equal, should mean higher interest rates for a given rate of inflation.

Read More: The euro area’s economy

Since reaching a one-year high over the summer, the Euro has been punished in forex markets, due primarily to a less favorable outlook for ECB rate hikes. Previously, analysts were expecting the ECB to raise rates three to four more times, raising the base rate to 4%. Now, however, analysts have revised their models to reflect one to two rate hikes. Forecasts for the Euro have been adjusted proportionately to undo the narrowing of interest rate differentials that Euro appreciation had been predicated on. The Daily News reports:

Steve Pearson at HBOS said the scaling back in rate hike predictions is probably a reaction to the drop in oil prices which should in turn drag euro zone inflation well below the European Central Bank’s 2 pct target rate.

Read More: Euro continues lower as investors rethink ECB rate hike prospects

The US Bureau of Economic Statistics today released its monthly report on America’s trade balance, and the numbers were not pretty. The monthly current account deficit has reached a new high, at $68 Billion, attributed primarily to soaring commodity prices. As the trade balance (exports minus imports) represents one of the components of production, economists are now revising their GDP growth estimates downward to reflect this latest development. The Federal Reserve Bank would love to see the USD depreciate in order to stem the balance, but it may have to wait for interest rates to narrow further before it sees its wish fulfilled.

Read More: Dollar survives knee-jerk selling after record US trade deficit

The UK Pound has stood in virtual lockstep with the Euro, as both currencies have steadily appreciated against the USD. The UK Pound is poised to breakout, however, due to relatively high inflation. Inflation, in and of itself, would theoretically be expected to erode purchasing power and thus lead to currency depreciation. In this case, the opposite will likely obtain, as the byproduct of inflation will likely be a rate hike by the UK Central Bank to keep pace with price levels. The move will bring the short-term UK rate to 5%, just below the US Federal Funds Rate. AFX News reports:

”With consumer price inflation unexpectedly moving back up in August and core inflation rising, another interest rate hike in November remains very much on the cards.”

Read More: Pound gets lift from stubbornly high UK inflation

Speculation has been building in forex markets over whether the European Central Bank (ECB) will raise interest rates at this week’s meeting. Previously, the consensus among traders was that the ECB would continue to tighten through the end of this year in order to keep pace with inflation. Since then, however, new data has been released, indicating that the European economies may have already peaked. Germany’s economy, for example, is now predicted to expand by less than 2% this year. Combined with moderating inflation, these new numbers indicate that another rate hike may not yet be needed. As a result, the narrowing interest rate differentials that USD bulls were fearing will not likely be realized for a few more months. Dow Jones News reports:

“There has been little indication that the central bank is prepared to step up the pace of its interest rate hikes and the likely timing for the next move is the meeting Oct. 5, with a further one in December leaving interest rates at 3.5% by year-end.”

Read More: ECB Unlikely To Hold Surprises For Euro

The last few months have witnessed a spate of bad news surrounding the USD. First, quarterly GDP data indicated the US might already have entered a period of recession, due in part to a slowing housing market. Then, the Federal Reserve Bank announced that it was halting its interest rate hikes, after raising rates 17 consecutive times. Today, monthly inflation data revealed prices are growing faster than most economists had predicted, at an annualized rate of 5.5%. The sudden jump in inflation is being attributed to you guessed it- soaring energy costs. While economists would argue inflation is bad for the USD because it erodes the currency’s real value, many traders reacted positively to the news because they believe it might drive the Fed to hike rates further. AFX News reports:

“The Fed has been focused on the consumers’ perceptions of inflation of late and this may set off some alarm bells among the FOMC hawks.”

Read More: Dollar edges up along with US inflation expectations

For many decades, it was an accepted truth that the fate of the global economy depended largely on the state of the US economy. Over the last few years, however, this link has gradually eroded and many economists now believe the global economy can expand even when the US is in recession. As it becomes more apparent that the US economy is peaking, this belief will soon be put to the test. US housing data, which is closely followed by economists because of the important role it plays in the US economy, indicates that the real estate market is beginning to recede. If emerging markets-which are most dependent on the US as an export market- are able to cushion their economies from the looming US recession, their currencies will be the first to gain. AFX News reports:

Major currencies were stuck in narrow ranges against each other amid concerns about the prospect of a slowdown in the US spilling over to affect growth elsewhere in the world dampening sentiment all around.

Read More: Major currencies rangebound amid worries about slowing growth outlook

Last week, Ben Bernanke, Chairman of America’s Federal Reserve Bank, announced that rates would be left unchanged due to slowing economic growth. USD bulls cringed at the possibility that the Fed was done finished hiking rates. Unfortunately for them, Mr. Bernanke’s assessment was born out by CPI data, released today, which revealed growth in prices is indeed slowing. In fact, the monthly change in inflation was only .2%, the smallest increase in almost half a year. Yields on US debt instruments, including Treasury securities, fell across the board- bad news for traders who are hoping foreigners will continue to finance the US trade deficit. Bloomberg News reports:

The Fed is now done raising rates and will be cutting them next year, said Andrew Balls, a global strategist at Pacific Investment Management Co.

Read More: U.S. Economy: Slowing Inflation Validates Bernanke

A slew of economic data was released yesterday, each with the potential to exert pressure on the USD. Traders and economists were eyeing the data closely, in order to gauge the likelihood of a Fed rate hike next month. The first two pieces of data to be released were new home sales and durable goods orders, both of which came in below analysts’ expectations. Quarterly GDP data was next to be released, indicating the US economy has slowed considerably since last quarter, when GDP grew at an astounding 5.3%. The new consensus is that inflation appears to be easing, and hence, the likelihood of another quick rate hike is waning. It seems traders have been bracing for the end of monetary tightening for quite some time, because the net effect of the economic data on the USD was neutral. The Star Tribune reports:

The uncertainty has caused volatility in the markets, although the dollar has remained in very tight ranges with traders reluctant to push currencies in any one direction without further guidance from the Fed.

Read More: Dollar Little Changed

In a recent white paper, the American Enterprise Institute (AEI), a think-tank with a conservative bend, examined the sustainability of the US current account deficit. The AEI focused its analysis on the net savings and investment side of the account balance equation in its attempt to ascertain the factors that influence capital flows. They concluded that the deficit is ultimately sustainable because of the variety of “wealth storage” opportunities available in the US. In other words, foreigners will continue to park their savings in US-denominated assets because of the inherent liquidity, diversity, and stability afforded by such assets. Further, the AEI argues that while high oil prices have driven vast increases in the value of oil imports, the net effect on the US current account balances may be positive because oil exporters often immediately turn around and reinvest oil profits in US securities. The AEI reports:

Today, the real trade-weighted dollar is virtually at its average level for the past sixteen years and is slightly stronger than it was in 1991, when the U.S. current account deficit stood virtually at zero.

Read More: America’s External Balances

In the days leading up to Ben Bernake’s semi-annual testimony before Congress, financial markets ratcheted up their expectations of an August rate hike to 90%, signaling that it was nearly certain to happen. After Bernanke’s testimony, the expectation of an August rate hike-proxied by interest rate futures-declined sharply. Now, investors have two conflicting sources on which to predicate their interest rate expectations: Bernanke, himself, and actual inflation data. Depending on which products and services are included in the calculation, inflation is hovering between 2.5% and 4%, which is higher than many economists would like to see. Meanwhile, Bernanke has indicated that he is essentially unconcerned with current inflation levels, and is not in any hurry to raise rates, which is bad news for dollar bulls. The Economist reports:

If the economy is slowing only modestly, as his words suggested, his relaxed attitude to inflation seems odd, especially after recent months’ inflation figures.

Read More: Making Sense of Bernanke

The latest Ifo survey released earlier today showed only a slight dip in German business expectations. The index dropped from its 15-year high 105.9 in April to 105.6 in May, much better than most had expected. While the Ifo may slip more in the coming months, a sharp dropoff is unlikely, as most believe the German economy should gain momentum later in the year. Forbes reports:

‘The smaller than expected drop in the index will help the euro to sustain its gains and will do little to dissuade many in the market who look for the ECB to hike by 50 basis points next month,’ said Mitul Kotecha.

Read more: Euro remains firm after strong Ifo data; market awaits US data

One of the most fundamental principles of macroeconomics dictates a nation’s currency should depreciate when its current account balance is negative, in order to induce foreigners to buy its products and services. What happens when foreigners substitute their purchase of goods and services for stocks and bonds? This is precisely the question that economists and currency traders have been asking themselves for years, as the US current account deficit has ballooned while foreigners continued to purchase American assets. According to the most recent data, foreigners are on pace to buy nearly $1 trillion of American debt and equity this year. This number has remained fairly constant and suggests the USD will remain buoyant until demand for US assets declines.

Read More: Foreigners Flock to U.S. Securities

As far as currency traders are concerned, trade data is the most important in the spectrum of economic indicators. Economic theory suggests a nation’s currency should appreciate when its balance of trade is positive, and vice versa. Accordingly, when the monthly report on US trade data revealed a decline in the US current account deficit, dollar bulls rejoiced. In fact, the deficit narrowed by 4.1%, its largest drop in several months. However, pessimists are predicting that next month’s data will reveal a sharp expansion in the deficit, in order to compensate for this month. AFX News Limited reports:

For the long term, many analysts think structural considerations will become more of a concern to currency markets especially as the US Federal Reserve is expected to call a halt to its rate hike cycle by the summer.

Read More: Dollar wins brief respite from better than expected US trade data

This year, the US current account deficit is projected to reach $800 Billion, an astounding 7% of GDP. If current trends continue, the deficit will jump to 13% of GDP by the end of the decade. Moreover, this year will probably mark the first ever that the net US return on foreign investment will be less than the money earned by foreigners on US investments. For this trend to be reversed will require a massive depreciation in the value of the USD. Unfortunately the US is tightening monetary policy at a faster rate than the rest of the developed world, which renders such a reversal unlikely. The Economist reports:

Not only is the yen relatively weak in nominal terms, but falling prices in Japan have made it even more competitive.

Read More: The Yen also Rises

Headlining a recent spate of economic data was the monthly report on EU manufacturing data, which indicated Euro-area manufacturing is growing at the fastest rate in nearly five years. Echoed by other economic indicators, the data suggests that the European economic recovery is slowly feeding into labor markets. On Thursday of this week, the European Central Bank is scheduled to meet to discuss the future of EU economic policy. The consensus is that the bank will leave rates unchanged at this meeting, but will signal the likelihood of a rate hike in May. The Financial Times reports:

The strength of the indices suggested the stronger growth expected to be shown in gross domestic product figures for the first quarter of 2006 would continue into the second quarter.

Read More: EU manufacturing recovery gathers pace

The most recent data on Japanese capital flows paints a picture of increasing repatriation of Japanese capital. In other words, Japanese people and businesses are divesting from overseas assets and parking their money in Japanese securities. Analysts have offered a couple explanations for this trend. First, yields on Japanese bonds have been growing as the Central Bank prepares to lift interest rates, and Japanese equities are approaching valuations left unseen for years. Perhaps, notoriously conservative Japanese investors are growing more confident in the strength of domestic asset markets. Second, and equally plausible, is that Japanese companies are repatriating profits earned overseas for tax purposes. Either way, the Yen will benefit. The Financial Times reports:

Data released on Friday by Japan’s Ministry of Finance revealed that Japanese investors sold a net Y1,480bn of foreign assets in the week to March 17, a six-fold increase on the week before.

Read More: Yen rallies on year-end repatriation flows

According to a variety of economic indicators, Japan is now the fastest growing economy in the G8 Industrialized countries. Further, it seems Japan has definitively succeeded in ending a decade-long deflationary spiral, during which its nominal GDP declined. Japanese economists have hinted that the Bank of Japan may soon end its ultra-loose monetary policy. This move, which will take the form of higher interest rates, has even received the support of Japanese politicians, who previously seemed ambivalent. While the rate hikes will not occur for a couple of months, currency traders are already beginning to buy Yen based on the prospect of a narrowing interest rate differential between Japan and the rest of the developed world.

Read More: Policy hope propels yen’s rally

On paper, the collective economies of the European Union appear stagnant and pathetic, having grown by only 1.6% per year, from 1999-2004. However, it is important to note that when GDP figures are first released, they represent educated guesses, at best. After thorough re-calculation, Euro-area real GDP actually averaged 2.1% in the same time period. Meanwhile, Britain’s economy grew by 2.7% annually during those years, a figure that was revised upwards from 2.1%. As a result, it seems the current performance of the EU economies is being understated, which could provide a case for eventual Euro appreciation. The Economist reports:

On past experience, Europe’s statisticians should add half a percentage point to their first guesses of GDP growth. By also switching to American practices, they could boost growth even further.

Read More: A numbers racket

Over the past few years, the failure of the USD to decline in response to soaring trade deficits has baffled economists, leading some to propose that the only reason the USD has not depreciated is foreigners’ continued willingness to finance the deficits. A new theory, however, is quickly gathering support among economists. It suggests that the common interpretation of current account deficits is unreasonable. Basically, a significant portion of US trade takes place between US companies and their foreign subsidiaries. A change in exchange rates, thus, would not cause much of a change in trade patterns. As a result, a rising current account deficit may not be as large of a problem as has long been argued, as a decline in the USD would not produce a significant drop in the deficit. Reuters reports:

One reason put forward for the growing impotence of currency rates in synching trade accounts is that national trade statistics disguise the real nature of trade flows.

Read More: The gravity-defying dollar

Earlier this week, Japan released a slew of economic data, all of which underscore the likelihood of future rate hikes by the Bank of Japan. First, Japan announced that annualized GDP growth for Q4 exceeded 5.5%, which exceeded growth in both the US and EU. Further, Japanese prices increased by 1.6% on an annualized basis, which indicates Japan seems to have finally escaped from the throes of deflation. If growth and inflation numbers continue to exceed expectations, you can assume Japan will begin raising rates by the end of this year. Currency traders are already beginning to build models around such interest rate hikes, all of which favor the Yen.

Read More: Yen tumbles on fresh deflation fear

As the US twin deficits expanded over the last decade, economists and currency traders have turned a blind eye, pointing to foreigner’s continued willingness to finance the deficit as the reason for their indifference. However, such economists are the first to admit that as soon as foreigners lose their appetite for investing in US assets, the USD will surely suffer. That day may come sooner as later, if viewed from the perspective of the latest release of US capital flows data. In December, foreigners invested 57$ Billion into the US, a sharp drop from the $90 Billion invested in November. This represented the first time in almost a year that the monthly trade deficit exceeded capital inflows, and could serve as a harbinger for a massive USD ‘correction,’ to occur over the next few years. The Financial Times reports:

The drop in net US inflows was almost all the result of a sharp fall in net buying of Treasuries. Foreigners bought a net $18.3bn worth in December – the weakest in six months and down from a record $54.4bn in November.

Read More: Drop in US inflows spooks dollar

Despite the continued lackluster performance of the EU’s largest economy, the European Central Bank (ECB) is still expected to raise interest rates next month, for the second time in over five years. Traders were undeterred by the release of economic data, which indicated Germany’s economy stalled over the last quarter and that investor confidence is sagging. Economists still expect the EU economy, as a whole, to grow by 2.3% this year, and further expect the ECB to move ahead with monetary tightening in order to keep pace with inflation. A narrowing interest rate differential between the EU and US will surely benefit the Euro in the short term. AFX News Limited reports:

One economist noted that the [German] economic sentiment indicator points to significant optimism in Germany, providing further evidence that the outlook is relatively bright. “There is nothing here to stop the ECB from raising rates in March,” she added.

Read More: Euro steady as market continues to price in ECB rate hike

As evidence that Japan has emerged from recession continues to mount, economists and analysts have begun to speculate that the country’s Central Bank will raise rates from their current level of zero. According to the most recent inflation data, Japanese prices have increased for two consecutive months, a feat that had not occurred in nearly a decade. Governors from the Bank of Japan, have themselves hinted that it may be time to stop pumping liquidity into the Japanese economy via an ultra-loose monetary policy. As a result, the consensus is that Japan will begin raising interest rates at the end of this year. Yen bulls have reacted to the prospect of rate hikes with veritable jubilation, arguing that higher interest rates would surely translate into Yen appreciation. The Financial Times reports:

Although the BoJ is not expected to end its zero interest rate policy until next year, any pre-emptive rise in borrowing costs could reduce the use of the yen as a funding currency for the infamous carry trade. This would allow the currency, which most strategists view as undervalued on a fundamental basis, to appreciate.

Read More: Yen climbs on hopes of BOJ policy shift

Last week, the USD surged to one-month highs against both the Euro and the Yen, on the heels of a hike in American interest rates. As this week will not offer much in terms of economic releases, currency traders will likely remain focused on interest rates. A slew of USD-positive economic data has many economists convinced that the Fed will hike interest rates by 25 basis points at its next meeting. Based on credit futures (which serve as a proxy for future interest rates), traders believe there is a 40% probability of such a hike. Traders are expecting the USD to benefit from the building anticipation, and expect a similar surge in the USD to occur if the Fed delivers on expectations. The Wall Street Journal reports:

“The dollar has gotten a lot of strength [last week] alongside a recovery in interest-rate expectations, and we’re likely to see more of that focus on rates and yields,”

Read More: Lack of New Data Is Likely to Crimp Dollar This Week

While the US twin deficits have soared over the past few years, many currency traders have remained bullish on the USD. Their reasoning is that as long as foreigners remain willing to finance this deficit (by purchasing dollar-denominated assets), the USD should remain stable. However, while 2005 was a record year for capital inflows, there was an interesting trend that could spell trouble for the dollar if it continues. It seems a majority of capital inflows are now contributed by private, rather than public entities, leading many analysts to speculate Central Banks are slowing their purchases of USD. However, there is a glitch in the data, in that if a public entity buys USD through a private investment bank, then the transaction is recorded as private. The Business Online reports:

But regardless of how much of the cash is from governments and how much from private sources, one simple fact is clear: in the absence of a major shock, the dollar will continue to be supported by foreign capital.

Read More: Private vs Official Dollar Purchases

On paper, the case for a revaluation of the Chinese Yuan seems rock solid: China’s forex reserves have swollen to $800 Billion, its annual trade surplus exceeds $100 Billion, and its exports have soared. However, delve deeper into the figures, and a vastly different picture emerges. First, the country’s forex reserves are largely the result of ‘hot money,’ inflows of foreign capital hoping to instantaneously capitalize on a Yuan revaluation, rather than long term investment in capital projects. In addition, China’s trade surplus is increasingly a story of slowing imports, rather than growing exports. As investment in fixed capacity has declined, so has the demand for equipment and machinery, much of which is imported. In addition, while China’s trade surplus with the US exceeded $200 Billion in 2005, China runs a deficit with most other countries it trades with. The Economist reports:

So the balancing act, for the [Chinese] authorities, is to keep up the expectation of a revaluation through talk and an exchange rate that crawls up fractionally—by another percent or two here or there.

Read More: Strange happenings along the China coast

According to recent figures, the US current account deficit (the amount by which net investment exceeds US savings) is on pace to surpass $800 Billion. Moreover, the net value of US foreign assets (US ownership foreign assets minus foreign ownership of US assets) is a whopping -$2.5 Trillion. However, a new report released by two economists suggests the situation is not as dire as it appears. According to the report, despite the negative net US ownership of foreign assets, the US still receives positive net income on its foreign assets. Using back-end calculations, the economists figured the US net overseas investment is actually $700 Billion+. However, even if this number is accepted as truth, the economists warn that if current trends continue, net foreign assets will decline $3 Trillion over the next five years, during which point the USD may have to face the music. The Economist reports:

After making $36.2 billion in 2004, America made just $4 billion on its net foreign assets in the first three quarters of 2005. If it continues on its present trajectory, it will shell out about $190 billion in 2010.

Read More: America’s dark materials

Earlier this week, a video tape of Osama Bin Laden was discovered, in which the Muslim leader warned of further terrorist attacks in the US. Originally, the news of the tape was thought to have contributed to the Dollar’s decline. In hindsight, however, it seems the tape merely provided an impetus for the USD to move in the direction that it had already been headed. This week witnessed a few releases of economic data, separately revealing that the housing market is continuing to slow while the labor market is tightening. Overall, the effect on the USD seems to be neutrals, as traders insisted that USD movements this week were related to technical, rather than fundamental factors. The Wall Street Journal reports:

“The bin Laden news helped move the market in the direction it was already going, but the market movements bring back thoughts that we might be in a range between $1.2050 and $1.2150,” said one analyst.

Read More: Dollar Edges Higher Against Rivals

Since 2001, South Africa has been an emerging markets superstar, having seen its currency, the Rand, more than double against the USD. On paper, the Rand’s appreciation seems to be supported by fundamentals. South Africa has narrowed its budget deficit, core inflation is low, and interest rate levels have stabilized around 7%. However, currency traders continue to view the Rand as risky. In most developing countries, high bond premiums are usually attributed to default risk, the likelihood that the government will default on the debt. In South Africa, by contrast, a recent study found 90% of bond premiums could be explained by currency risk. It seems investors are not worried about the government defaulting, but rather they are concerned about the possibility of Rand depreciation. The Economist reports:

Unusually, the Rand is a popular hedging tool for foreigners. The average daily trade in Rand has ballooned since 1998 to nearly $14 billion, most of it by non-residents.

Read More: An Eye on the Rand

As 2006 sets in, economist and analysts are beginning to release their forecasts for the USD in 2006. Their models vary widely, as some place more emphasis on economic indicators (namely the current account balance), while others merely reflect assumptions for interest rate differentials. According to the latter type, the USD is actually undervalued, by as much as 10%. Such models posit that the current discrepancy is merely a premium of uncertainty surrounding current monetary and economic conditions. Models based on the current account balance, in contrast, suggest the USD is heavily overvalued. The economists behind these models believe that 2006 could be a rough year for the USD, as the willingness of foreigners to finance the rising US twin deficit begins to wane. The Economist reports:

According to economic theory, it is the widening of interest-rate differentials that temporarily strengthens the exchange rate. Over time, an international difference in interest rates is offset by a drop in the currency with the higher interest rate.

Read More: The greenback’s sinking feeling

Despite a current account deficit that smashed through the $800 Billion mark last year and continues to expand, many currency traders remain bullish on the USD. Their reasoning is that as long as foreigners remain willing to buy US assets and indirectly finance the US deficit, than the USD will continue to appreciate. However, notes Harvard economist Martin Feldtsein, this line of reasoning is becoming increasingly tenuous. Contrary to data released by the Treasury department, much of the foreign capital the flowed into the US last year was contributed by public/governmental institutions, rather than private investors, as had previously been put forward. Feldstein further argues that as interest rate differentials between the US and other nations narrow over the next year or so, many investors will begin pulling their money out of the US. At which point, the USD should theoretically fall 30% in trade-weighted terms, in order to condense the US trade deficit to a manageable amount.

In the last few weeks, the Euro finally broke through a level of resistance, against the USD, appreciating several cents. Whether the Euro continues to trade outside of its range will depend largely on whether the ECB raises interest rates in the next few months. Accordingly, Euro bulls are anxiously awaiting the release of German investor confidence data. While such data seems trivial and would not normally merit serious consideration, currency traders believe data supporting solid growth in Europe’s largest economy could be enough to tip the ECB in favor of hiking rates in the near-term, which would in turn, support the Euro. Bloomberg News reports:

“Amid the prevailing dollar-bearish sentiment, strong data in Germany could surely push up the euro again. Should the index rise more than expected, it will certainly raise expectations for ECB rate hikes,” said one currency strategist.

Read More: Euro May Advance on Speculation German Investor Confidence Rose

In the last three years, the Canadian Dollar has appreciated over 35% against the USD! Most of those gains, however, took place in 2003 and 2004, as the Loonie only appreciated 3.5% in 2005. Accordingly, many currency strategists believe 2006 will be a flat year for the Canadian currency, due to declining commodity prices and a stagnant economy. In fact, recent economic data suggest that these two variables are closely related, as Canada relies heavily on commodity exports to drive its economy. Nonetheless, 2006 should witness hikes in Canadian interest rates, which could draw inflows of foreign capital. In short, there are competing forces tugging at the Loonie, which could conceivably be pulled in either direction. CBC Business News reports:

The central bank has raised its trend-setting overnight interest rate three times in recent months, to 3.25 per cent, to keep inflation from taking off. Analysts have said the bank could push the key rate as high as four per cent in 2006.

Read More: Canadian dollar falls more than full U.S. cent as commodity prices slip

On the first day of trading in 2006, the USD recorded its largest daily loss since September 11, 2001, falling nearly 2% against the Euro. On the first day of trading in 2005, in contrast, the USD rose significantly, as part of a broader trend of appreciation against the world’s major currencies. That the dollar fell in its first 2006 trading session has led many forex analysts to speculate that the year will not be kind to the USD. Specifically, the dollar fell due to a combination of weak economic data and the ‘minutes’ from the last Fed meeting, which suggest the Fed may slow its planned monetary tightening. Many analysts are pointing to the disappointing manufacturing data and the recent flattening of the Treasury yield curve as evidence that the US economy is faltering and will soon plunge into recession, leading the Fed to stop raising interest rates. Daily FX reports:

The FOMC minutes released today reflected the varying views on the degree of future rate hikes. Additional increases “probably would not be large” and “members thought that the policy outlook was becoming considerably less certain.”

Read More: Dollar Sees Largest One Day Slide in 4 Years

The USD composite index, which measures the value of the USD relative to the world’s major currencies, finished 2005 up 13%, marking the best year for the dollar in almost a decade. The USD might have recorded its best year since 1984 if not for weak housing data, which was released this week.

The data, which indicated sales of new and existing homes both declined in November, could be a harbinger for a downturn in the housing market. Over the last few years, the US economy has remained strong partly due to low interest rates, enabling consumers to borrow against the rising value of their homes. As the Fed has raised interest rates, consumers have predictably borrowed (and spent) less, which could spell trouble for the US economy. The Fed will certainly take this into account when it decides whether to raise interest rates next month. Reuters reports:

“What the market seems to be focusing on are U.S. home sales, which were quite a lot weaker than what people were hoping for. This is definitely weighing on the dollar via what people think that might mean for interest rates.”

Read More: Dollar slips as markets weigh soft US housing data

This year, there have been two issues on the minds of currency traders that employ ‘fundamental analysis:’ global imbalances and interest rate differentials. While the last two posts attempted to bring clarity to the role of interest rates in forex markets, this post will explore the effect of widening global imbalances.

The laws of economics imply that a nation experiencing a current account or trade deficit should witness a depreciation in its currency, so as to cheapen its goods and assets in the eyes of foreign consumers and investors, respectively. While the US twin deficits have soared to record levels, however, the USD has appreciated against a broad basket of currencies. The reason, as I have reported on numerous occasions, is tied to the continued willingness of foreigners to invest in the US. But is this phenomenon sustainable?

Some economists have argued that these deficits are a natural outgrowth of globalization and/or a global savings glut; accordingly, they believe the current value of the USD is economically defensible. Other economists have adopted a more cynical outlook, arguing that foreigners’ current penchant for US assets will eventually wane, at which point the USD will plummet. Unfortunately, this is a debate that will not soon be settled, and it may be years before the sustainability or lack thereof of the current global imbalances can be measured.

Read More: US deficits put cloud over outlook for 2006

Several weeks ago, Chinese officials suddenly announced they had reason to believe China’s economy is much larger than past GDP figures indicate, and they immediately began amassing data and building models to prove their point. Yesterday, the same group of officials released a revised set of GDP figures, which raised the value of China’s economy by 17% and catapulted the country into 6th place in global nominal GDP rankings. Apparently, past GDP calculations had grossly underestimated the size of China’s booming service sector, which represents 41% of China’s economy. In addition, the new GDP figures reveal that fixed asset investment is actually at a sustainable level. In short, China’s economy is both larger and more structurally sound than previously believed. The Financial Times reports:

The new, more rosy picture of economic strength could fuel calls from the US for China to revalue significantly its currency, which critics say is being held at a level that grants an unfair trade advantage.

Read More: China revises size of economy up by 17%