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Euro: Which Investors Know Best?

Jan. 2nd 2011

As the WSJ recently pointed out, there is a bizarre disconnect between equities and currency markets regarding the Euro. On the one hand, the Euro was the world’s worst performing major currency in 2010, and some analysts insist that its breakup is inevitable. On the other hand, stock market investors are increasingly bullish about Europe: “We remain positive on the outlook for [European] stocks in 2011, with a favorable macro backdrop, solid earnings and attractive valuations.” Who’s right?

In fact, both sets of investors are justified. As you would expect, stock market investors are focusing on corporate earnings and the macroeconomic environment. In this regard, the fact that the EU economy expanded in 2010 – buoyed by a cheap currency and loose monetary policy – should certainly be reflected in a stronger stock prices. On the other hand, the sovereign debt crisis in EU has not yet abated, and accordingly, it is still being priced into EUR/ exchange rates.

In the immediate short-term, it’s possible that stock market investors will prevail and that that their collective view will be adopted by currency markets. According to Deutsche Bank, “The euro may rise to $1.45 by the end of the first quarter of next year, as concerns about the single-currency area’s indebted periphery diminish.” Meanwhile, China recently pledged its support for the Euro via a promise to purchase up to €5 Billion in Portuguese Sovereign debt. Over the short-term, then, it’s possible that (currency) investors can be persuaded to temporarily forget about the prospect of default, and focus instead on the Eurozone’s nascent economic recovery.

Over the medium-term, however, the markets will have no choice but to  return their attention to the possibility of default, which is why the same team of analysts from Deutsche Bank “forecasts the euro will fall back to $1.40 by the end of the second quarter and to $1.30 by the year-end.” For example, Eurozone members will need to issue more than €500bn in debt in 2011, including €400bn that needs to be refinanced by Spain and Italy. In this context, China’s purchases will fade to the point of becoming trivial.

Meanwhile, Moody’s has warned that it could follow up on its 5-notch downgrade of Ireland’s sovereign credit rating with further downgrades for Spain and Portugal. Fitch added that it might bump Greece’s rating to junk status, which would deal a significant blow to its solvency. Default is now rapidly on course to becoming a self-fulfilling prophecy, as fleeing investors cause yields to rise and credit ratings to fall, further scaring away more investors.

The EU response has been to “set up a permanent mechanism from mid-2013,” while investors continue to push for an expansion of the European Financial Stability Facility or the joint issuance of European sovereign bonds. As a result, the Center for Economics and Business Research has issued a striking forecast that there is an 80% probability that the European Monetary Union will dissolve over the next decade: “If the euro doesn’t break up, this could be the year when it weakens substantially towards parity with the dollar.” Already, spot market traders are once again increasing their short bets for the Euro, and options trading remains “skewed toward euro puts.”

To be fair, some analysts continue to insist that it is better to think of the sovereign debt problems as a crisis of credit, rather than of currency. In that sense, there is hope that a solution can be engineered (perhaps encompassing a default) that doesn’t endanger the existence of the Euro. In addition, the Euro finished 2010 on a high note, formally welcoming Estonia into the fold. It is 10% above its June trough, including a 2% rise in the month of December. Given all of the bad news in 2010, that might just be cause for optimism.

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Posted by Adam Kritzer | in Euro, News | No Comments »

Brazilian Real Supported By Fundamentals, but Obstacles Remain

Dec. 30th 2010

Despite all of the talk of currency war (a term first introduced by Brazili’s Finance Minister) and volatility in forex markets, the Brazilian Real is on pace to finish 2010 only slightly higher from where it began the year. While fundamentals would seem to support a further rise, Brazil’s government and Central Bank have made it clear that they will do everything in their combined power to prevent such an outcome. In short, the outlook for the Real in 2011 is incredibly uncertain.

There are two (somewhat contradictory) trends that have played a role in driving the Real to its current level. The first is the resurgence of the carry trade, whereby investors shift capital from low-risk, low-yield investments to higher-yield, higher-risk alternatives. With interest rates that are among the highest in the world – and certainly the highest among stable currencies – Brazil has been one of the prime recipients of carry trade funds. Since 2009, when concerns over the credit crisis began to ebb, the Real has risen a whopping 40%!

Moreover, the Central Bank might have no choice but to hike its benchmark Selic rate further over the next couple years. Inflation, at 5.5%, has already breached the Bank’s 4.5% target, and is projected to remain at an elevated level throughout 2011. According to futures prices, investors expect the bank to lift the Selic rate (currently at 10.75%) by 1.5% over the next twelve months, including a 50 basis point hike at its scheduled meeting in January. When you factor in low rates in the rest of the world, this would lift the yield spread between the Brazilian Real and most other comparable currencies to astronomical levels.

Alas, this first trend started to abate in the second half of 2010, due primarily to the EU sovereign debt crisis. Fortunately, the consequent move towards risk aversion hasn’t hurt the Real much. To be sure, Brazil is still an emerging-market economy, and is still perceived as being fraught with risk. However, when you consider that (certain) commodities prices (sugar, cotton) are at record highs and that the Brazilian economy barely dipped during the credit crisis, there are certainly riskier locales to park capital. Besides, many investors have determined that the interest rate premium that they receive from investing in Brazil is more than enough to compensate them for any added risk.

All else being equal, then, the Brazilian Real would probably continue rising at a measured pace in 2011. As I said, however, all else is not equal, since Brazil has pledged to do everything in their power to hold down the Real. According to the WSJ, “Earlier this year Brazil raised the IOF tax on foreign investment in fixed-income securities to 6% from 2% and also raised the tax for guarantees on derivatives investments.” Meanwhile, the Central Bank has intervened regularly in the spot market to purchase Dollars. The Bank’s newly appointed President, Alexandre Tombini, has voiced concerns over the Real’s rise: “We can’t let the economic policies of other countries determine the direction of foreign exchange.” On the day that he testified before the Senate’s Economic Affairs Committee, the Real fell by a substantial margin, suggesting that investors take his warnings seriously.

The Central Bank will also work closely with the new Brazilian administration to combat inflation, in a way that doesn’t cause the Real to appreciate. Rather than raise interest rates – which invites speculative capital inflows – the Bank will probably put pressure on the government to rein in spending and tighten access to credit. Over the long-term, this should allow it to lower rates to more sustainable levels, and prevent an expensive Rea from eroding the competitiveness of its export sector before it is too late.

Over the short-term, however, the immediate focus is to bring down inflation, most likely through rate hikes. That means that the Ministry of Finance will have to resort to more conventional weapons – such as taxes and intervention – to stem the Real’s rise. It managed to hold the Real to a 3% rise in 2010, but it remains to be seen whether it can repeat this feat in 2011.

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

Swiss Franc Surges to Record High(s)

Dec. 29th 2010

In the last two weeks, the Swiss Franc rose to record highs against not one, not two, but three major currencies: the US Dollar, Euro, and British Pound. The Franc is now entrenched well above parity against the Dollar, and is closing in on the magical level of 1:1 against the Euro. With market uncertainty projected to run well into 2011, continued strength in the Franc is all but assured.

usd CHF 2 Year Chart

The Franc’s rise is due entirely to its being perceived as a safe haven currency. Its debt levels are comparable to other industrialized countries, its economy is in mediocre shape, and interest rates are the lowest in the entire world (the overnight lending rate is a paltry .1%). Some analysts have cited the “strong Swiss economic outlook” and “the health of Swiss public finances” as two factors buttressing its strength, but make not mistake: if not for the tide of risk aversion sweeping through the world’s financial markets, the Franc would hardly be attracting any attention.

As I have reported recently, the Dollar and the Yen have also benefited from the spike of risk aversion caused by renewed concerns over the fiscal health of the EU and the prospect of conflict in Korea. Perhaps owning to nothing more than proximity, the Franc has been the primary beneficiary from EU sovereign debt crisis. “It appears that smart money investors are pre-emptively bailing funds out of the eurozone with Switzerland providing a safe port to ride out the eurozone sovereign debt storm that appears to loom on the horizon,” summarized one analyst.

Unfortunately, it looks like the situation in the EU can only become serious. Despite a collective move towards fiscal austerity, all of the problem countries are still running budget deficits. As a result, members of the EU are set to issue no less than €500 Billion of new debt in 2011. To make matters worse, “The onslaught of credit warnings and downgrades of sovereign ratings over the past few days added to worries that borrowing costs in many euro zone nations could rise further.” This could trigger a self-fulfilling descent towards default and further buoy the Franc.

EUR CHF 2 Year Chart
As far as I can tell, the notion that, “Despite the Swiss franc’s recent sharp gains, we still believe there is plenty of room for further upside ahead,” seems to encapsulate current market sentiment. According to the most recent Commitment of Traders Report, investors continue to increase their long positions in the Franc. According to Bloomberg News, “Options traders are more bullish on the franc for the next three months than any major currency except the yen.” Meanwhile, a sample of analysts’ forecasts suggests that the Franc could appreciate another 5% over the next six months.

At this point, the main variable the Swiss National Bank (SNB), which could resume intervention on behalf of the Franc. After spending close to €200 Billion to depress the Franc, the SNB accepted the futility of its efforts and formally renounced intervention in June. However, Swiss National Bank President Philipp Hildebrand recently referred to the Franc’s rise as a “burden,” and warned that the SNB “would take the measures necessary to ensure price stability” in the event of  “renewed financial market tensions.”

As to whether intervention is likely, analysts remain divided. “The timing [for intervention] would certainly be perfect, with liquidity very thin….pre-holiday markets are ideal for springing a surprise,” said one strategist. According to Morgan Stanley, however, the SNB is “unlikely to intervene in the near term to stem the rise in the franc. The previous intervention earlier this year has left a huge overhang of liquidity in the economy and the Swiss National Bank doesn’t want to further boost the money supply.” In addition, the SNB experienced losses of €22 Billion on its forex reserves in the first nine months of this year, and will be reluctant to incur further losses by resuming intervention.

In short, aside from this lone point of uncertainty, all factors point to continued upside.

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Posted by Adam Kritzer | in News, Swiss Franc | 3 Comments »

Forex Volatility Remains Abnormally High

Dec. 26th 2010

If you look at a chart of currency volatility over the last five years, two major spikes immediately jump out. The first took place in the wake of the collapse of Lehman Brothers in late 2008, while the second occurred earlier this year during the height of the EU sovereign debt crisis. While volatility has gradually subsided since then, it is still well above its historical average, and many analysts forecast that it will remain at an elevated level through at least 2011.

G7 Currency Volatility 2006-2010

2010 was a volatile year for the forex markets for good reason. The EU sovereign debt crisis officially emerged, and spread from Greece to Ireland, and potentially to Portugal and Spain as well. There was uncertainty surrounding the impact of the Fed’s second quantitative easing program (QE2), as well as the impact of similar plans announced by the Bank of England and Bank of Japan. A handful of Central Banks ignited what has since been termed the “currency war,” which the G7/G20 are still trying to end. China allowed the Yuan to resume its upward march against the US Dollar, but at a pace that has failed to satisfy most critics. Emerging market currencies in general, and Asian currencies in particular surged, despite the best efforts of their respective Central Banks to contain them.

As a result, investors struggled to figure out what the right levels to buy and sell even the major currency pairs.  The Euro has ranged from $1.1877 to $1.4579 (against the Dollar) so far this year; and the Yen has ranged from 80.22 to 94.99. Amidst this backdrop of volatility, investors once again flocked to the US Dollar. On a trade-weighted basis, it appreciated 5% for the year. Against its arch-rival, the Euro, it gained an impressive 10%. The Japanese Yen and Swiss Franc – the other two major safe-haven currencies – also outperformed, even touching record levels against some other currencies.

US Dollar Index 2010

At this point, the only certainty is that uncertainty will persist well into 2011. Economic and monetary policymakers around the world will continue to struggle to keep (or merely put) their economies on the recovery track, while minimizing the risk of inflation in the medium-term. According to the currency strategy team at UBS, “There is…high risk of policy-maker error in relation to interest rates, quantitative easing and fiscal tightening.” To make matters worse, there is still a lack of coordination among, and in some cases, outright contradiction between countries’ respective policies. “There are doubts about the mutual consistency in economic strategies pursued by major economies…We have seen in recent weeks a tendency by countries to publicly challenge each others’ monetary or exchange rate policies,” said European Central Bank governing council member Christian Noyer.

As a result, it’s more than likely that volatility levels will remain proportionately high. Added UBS, “The euro may range from $1.1 and $1.5…and U.S. dollar may touch as low as 70 yen and high as 100 yen in 2011…Overall investors will have to be more aware of foreign exchange risk in 2011. For at least several more years, volatility will be structurally higher.”

In this kind of environment, the implications are clear. While commodity and emerging market currencies may still be girded by strong fundamentals, a lack of investor risk appetite could trigger another round of capital flight. Meanwhile, the US Dollar (and other safe haven currencies) will benefit, and the Euro will suffer.

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Interview with Boris Schlossberg: “Risk control is EVERYTHING”

Dec. 23rd 2010

Today, we bring you an interview with Boris Schlossberg, director of currency research at GFT Forex, co-founder of BK Forex Advisors, and co-contributor to FX360. He is also a weekly contributor to CNBC’s Squawk Box and a regular commentator for Bloomberg radio and television. His daily currency research is widely quoted and appears in numerous newspapers worldwide. He is the author of Technical Analysis of the Currency Market (2006) and Millionaire Traders (2007). Below, Mr. Schlossberg shares his thoughts on risk management, leverage, currency wars, and other assorted topics.

Read the rest of this entry »

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Posted by Adam Kritzer | in Interviews, News | 3 Comments »

IPOs Raise Questions about the Future of Retail Forex

Dec. 21st 2010

It has been said before, but now I think it’s official: retail forex has entered the mainstream. In the month of December, two retail forex brokerages – Forex Capital Markets (FXCM) and Gain Capital Holdings (GCAP) – went public on the New York stock exchange. Combined with some juicy information revealed in their regulatory filings, I think this event raises some interesting questions about the future of forex.

Some background: both FXCM and Gain Capital operate trading platforms and news/analysis websites (DailyFX.com and Forex.com, respectively). FXCM has a current market capitalization of $850 million, compared to $250 million for Gain Capital. The former earned net income of $98 million last year on revenue of $339 million, and it has 135,000 active clients. The latter earned $36 million net income on $188 million revenue, and its client base totals 52,000. (For the sake of comparison, consider that ETrade has more  than $4 million and its ttm revenues exceeded $2.5 Billion).

If you do some simple arithmetic, you will discover that revenue per account is substantially higher for forex brokers than for stock brokers: $2,500/account for  FXCM versus $100-200 that I’ve been told is standard for retail stock brokers. Of course, some of that disparity is natural, given that the average forex account-holder trades at a higher frequency and higher volume than the average stock investor, who apparently only makes one round-trip trade per month, on average. However, the bulk of that discrepancy is probably due to a lack of transparency/competition.

Although information on average account size was not released, it nonetheless stands to reason that a significant portion of forex account-holder equity is being “transferred” to brokers every year. (Interestingly, FXCM loses money on the majority of its accounts.  Accounts worth more than $10K – which presumably do the most trading – generate the most revenue, and yet more than half of them are still unprofitable for FXCM).

I think this raises some serious questions about transparency in forex commissions. While other brokers make money from the bid/ask spread (which also suffers from a lack of transparency) and by taking offsetting positions, FXCM boasts that it “makes an identical amount of money in the form of pip markups (which are really commissions) regardless of whether the customer made or lost money on the account.” Basically, FXCM matches up buyers/sellers with banks and financial institutions, and takes a cut for facilitating the transaction. While this is somewhat less opaque than filling orders directly for customers, the fact that it doesn’t disclose its commissions should be cause for concern. For the sake of comparison, consider that when you buy/sell stock, the commission that you pay the broker is clearly disclosed.

Someone recently asked me if trading commissions (i.e. spreads) in forex were fair/stable, and in the context of this data, I think it shows that there are is still room for commissions to fall. As the number of retail forex traders grows, you would expect spreads to tighten further, and profit/account to decline from the current level of $700+ per year.

Since both FXCM and Gain Capital are now public companies, they will be subject to increased scrutiny and regulatory oversight, and will henceforth be required to make frequent disclosures. If Oanda and other top-tier brokers accede to competitive pressures and also go public, the result should be increased transparency for the industry and better pricing for traders. In short, daily volume figures ($4 Trillion/day) notwithstanding, retail forex trading still has a ways to go before it can really be compared to retail stock trading.

IPOs Raise Questions about the Future of Retail Forex

It has been said before, but now I think it’s official: retail forex has entered the mainstream. In the month of December, two retail forex brokerages – Forex Capital Markets (FXCM) and Gain Capital Holdings (GCAP) – went public on the New York stock exchange. Combined with some juicy information revealed in their regulatory filings, I think this raises interesting questions about the future of forex.

Some background: both FXCM and Gain Capital operate trading platforms and news/analysis websites (DailyFX.com and Forex.com, respectively). FXCM has a current market capitalization of $850 million, compared to $250 million for Gain Capital. The former earned net income of $98 million last year on revenue of $339 million, and it has 135,000 active clients. The latter earned $36 million net income on $188 million revenue, and its client base totals 52,000. (For the sake of comparison, consider that ETrade has more  than $4 million and its ttm revenues exceeded $2.5 Billion).

If you do some simple arithmetic, you quickly discover that revenue per account is substantially higher for forex brokers than for stock brokers: $2,500 in the case of FXCM compared to $100-200 that I’ve been told is standard for retail stock brokers. Of course, some of that is to be expected, given that the average forex account-holder trades at a higher frequency and higher volume than stock investors, which apparently only make one round-trip trade per month, on average. While information on average account size was
not released, it nonetheless stands to reason that a significant portion of forex account-holder equity is being “transferred” to brokers every year. (Interestingly, FXCM loses money on the majority of its accounts.  Accounts worth more than $10K – which presumably do the most trading – generate the most revenue, and yet more than half of them are still unprofitable for FXCM).

I think this raises some serious questions about transparency in forex commissions. While other brokers make money from the bid/ask spread (which also suffers from a lack of transparency) and by taking offsetting positions, “FXCM makes an identical amount of money in the form of pip markups (which are really commissions) regardless of whether the customer made or lost money on the account.” Basically, FXCM matches up buyers/sellers with banks and financial institutions, and takes a cut for facilitating the transaction. While this is somewhat less opaque than filling orders directly for customers, the fact that it doesn’t disclose its commissions should be cause for concern. For the sake of comparison, consider that when you buy/sell stock, the commission that you pay the broker is clearly disclosed.

Someone recently asked me if trading commissions (i.e. spreads) in forex were fair/stable, and in the context of this data, I think it shows that there are is still room for commissions to fall further. As the number of retail forex traders grows, you would expect spreads to tighten further, and profit/account to decline from the current level of $700+ per year.

Since both FXCM and Gain Capital are now public companies, they will be subject to increased scrutiny and regulatory oversight, and will henceforth be required to make frequent disclosures. If Oanda and other top-tier brokers accede to competitive pressures and also go public, the result should be increased transparency for the industry. As of yet, I think that daily volume figures ($4 Trillion/day) notwithstanding, retail forex trading still has a ways to go before it can really be compared to retail stock trading.IPOs Raise Questions about the Future of Retail Forex

It has been said before, but now I think it’s official: retail forex has entered the mainstream. In the month of December, two retail forex brokerages – Forex Capital Markets (FXCM) and Gain Capital Holdings (GCAP) – went public on the New York stock exchange. Combined with some juicy information revealed in their regulatory filings, I think this raises interesting questions about the future of forex.

Some background: both FXCM and Gain Capital operate trading platforms and news/analysis websites (DailyFX.com and Forex.com, respectively). FXCM has a current market capitalization of $850 million, compared to $250 million for Gain Capital. The former earned net income of $98 million last year on revenue of $339 million, and it has 135,000 active clients. The latter earned $36 million net income on $188 million revenue, and its client base totals 52,000. (For the sake of comparison, consider that ETrade has more  than $4 million and its ttm revenues exceeded $2.5 Billion).

If you do some simple arithmetic, you quickly discover that revenue per account is substantially higher for forex brokers than for stock brokers: $2,500 in the case of FXCM compared to $100-200 that I’ve been told is standard for retail stock brokers. Of course, some of that is to be expected, given that the average forex account-holder trades at a higher frequency and higher volume than stock investors, which apparently only make one round-trip trade per month, on average. While information on average account size was
not released, it nonetheless stands to reason that a significant portion of forex account-holder equity is being “transferred” to brokers every year. (Interestingly, FXCM loses money on the majority of its accounts.  Accounts worth more than $10K – which presumably do the most trading – generate the most revenue, and yet more than half of them are still unprofitable for FXCM).

I think this raises some serious questions about transparency in forex commissions. While other brokers make money from the bid/ask spread (which also suffers from a lack of transparency) and by taking offsetting positions, “FXCM makes an identical amount of money in the form of pip markups (which are really commissions) regardless of whether the customer made or lost money on the account.” Basically, FXCM matches up buyers/sellers with banks and financial institutions, and takes a cut for facilitating the transaction. While this is somewhat less opaque than filling orders directly for customers, the fact that it doesn’t disclose its commissions should be cause for concern. For the sake of comparison, consider that when you buy/sell stock, the commission that you pay the broker is clearly disclosed.

Someone recently asked me if trading commissions (i.e. spreads) in forex were fair/stable, and in the context of this data, I think it shows that there are is still room for commissions to fall further. As the number of retail forex traders grows, you would expect spreads to tighten further, and profit/account to decline from the current level of $700+ per year.

Since both FXCM and Gain Capital are now public companies, they will be subject to increased scrutiny and regulatory oversight, and will henceforth be required to make frequent disclosures. If Oanda and other top-tier brokers accede to competitive pressures and also go public, the result should be increased transparency for the industry. As of yet, I think that daily volume figures ($4 Trillion/day) notwithstanding, retail forex trading still has a ways to go before it can really be compared to retail stock trading.

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

Chinese Yuan: Appreciation or Inflation?

Dec. 19th 2010

Based on nominal exchange rates, the Chinese Yuan has appreciated by a modest 2% against the US Dollar since the month of September (when the People’s Bank of China (PBOC) adjusted the currency peg for the first time in nearly two years). If you take inflation into account, however, the Chinese Yuan has risen by much more. In fact, if current trends persist, the Chinese Yuan exchange rate controversy might resolve itself.

CNY USD 1 year chart
Demands from the international community for China to appreciate its currency hinge on two related arguments. The first is that at its current level, the artificially low exchange has allowed China to build up a massive trade surplus. The second is that Chinese prices seem to be lower than they should be (when quoted in other currencies), and the economic principle of Purchasing Power Parity (PPP) suggests that for this discrepancy to be eliminated, the Chinese Yuan must rise.

As it turns out, both of these claims are more problematic than they would appear. For example, China’s official trade surplus is already massive, and is steadily increasing. For 2010, it will probably near $200 Billion. However, it turns out that majority of that surplus is being captured by foreign-funded companies: “Their 112.5-billion U.S.-dollar surplus accounts for 66 percent of China’s total surplus over the past 11 months.”

In addition, trade statistics are calculated in such a way that the country that assembles the finished product gets credit for the full export value of that product. By looking specifically at Apple’s popular iPhone, researchers calculated that the product officially contributed $2 Billion to the US trade deficit with China. When the nuances of the iPhone’s supply chain are taken into account, that figure swings to a surplus of $48 million. In both of these cases, the fact that these products are manufactured in China doesn’t detract from US GDP (though it probably does cost the US jobs). Hence, the US probably isn’t hurting as much from the weak RMB to the extent that some lobbyists insist.

iPhone US China trade deficit
As for inflation, the official rate is now 5.1% on an annualized basis. Even if we accept this (and living in China, I can tell you that the actual rate is much, much higher), that means that the value of other currencies is eroding at a much faster rate than is implied by official exchange rates. That’s because a currency is only worth its purchasing power; as prices and wages in China rise, the purchasing power of the US Dollar (and other currencies) falls.

The Chinese government is trying to address the problem in the form of price controls and mandated increases in supply, but it is still reluctant to rein in inflation using conventional monetary policy measures. M2 money supply in China is increasing at a rate of 20% a year, the majority of which is being spent on another boom in fixed asset investment. While the PBOC has responded by increasing the required reserve ratio of Chinese banks, it remains reluctant to raise interest rates lest it contribute to further inflows of “hot money” on more upward pressure on the Yuan. As a result, the consensus among economists is that inflation will continue rising unabated: “We see a strong chance of underlying price pressures continuing to build over the medium-term.”

China inflation rate 2004-2010
Unless circumstances change, then, the argument for further RMB appreciation is somewhat weak. Nonetheless, analysts remain optimistic: “A Bloomberg survey based on the median estimates of 20 analysts predicts the yuan to increase 6.1 percent to 6.28 percent by the end of 2011.” Given that Hu Jintao is schedule to visit the US in January – and China’s fondness for symbolic policy gestures – a token move of 1% or so before then wouldn’t be surprising. As for the predicted 6% rise next year, well, that depends on inflation.

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Japanese Yen Down on Risk Aversion

Dec. 15th 2010

It seems the gods of the forex market read my previous post on the Japanese Yen, in which I puzzled over the currency’s appreciation in the face of contradictory economic and financial factors. Since then, the Yen’s 6-month, 15% appreciation (against the US Dollar) has arrested. It has retreated from the brink of record highs, and undergone the most significant correction since March of this year. Have investors come to their senses, or what?!

USD JPY Chart
You certainly can’t give the Bank of Japan (BOJ) any credit. Aside from its single-day $25 Billion intervention in September, it hasn’t entered the forex markets. In fact, it has already repaid the funds lent to it by the Ministry of Finance, which suggests that it doesn’t have any intention to replicate its earlier intervention in the immediate future, regardless of where the Yen moves.

Perhaps the BOJ foresaw the current correction in the Yen, which was probably inevitable in some ways. After all, Japanese interest rates – while gradually rising – still remain at levels that are unattractive to investors. While US short-term rates are low, long-term rates are more than 1.5% higher than their Japanese counterparts. When you factor in that Japan’s fiscal condition is worse than the US, there is really very little reason, in this aspect, to prefer Japan. As one analyst summarized, “The whole interest-rate differential argument is turning out to be dollar supportive, at least in the near term.”

The same is true for risk-averse capital. For reasons of liquidity and psychology, the Japanese Yen will continue to be a safe-haven destination in times of distress. Still, it’s hardly superior to the Dollar, in this sense. Inflation is slowly emerging (or at least, the risk of deflation is slowly abating) in Japan, and it could conceivably reach 1% this year if the Bank of Japan has its way. Its proposed 35 trillion yen ($419 billion) of asset purchases dwarfs the comparable Federal Reserve Bank’s QE2 program (in relative terms) and contradicts the notion that the Yen is the best store of value.

Japan Economic Structure - Dependence on Exports
Finally, the Japanese economy remains weak, and vulnerable to a double-dip recession. On the one hand, “Japan’s economy expanded at an annual 4.5 percent rate in the three months ended Sept. 30.” On the other hand, its economy remains heavily reliant on exports (see chart above, courtesy of Bloomberg News) to drive growth, which is complicated by the expensive Yen and concerns over a drop-off in demand from China and the rest of the world. In fact, “Exports rose 7.8 percent in October, the slowest pace this year, while industrial production fell for a fifth month and the unemployment rate climbed to 5.1 percent.” In addition, the closely watched Tankan survey registered a drop in September, “the first fall in seven quarters.” While Japanese companies are still net optimistic, analysts expect that this to change in the beginning of 2011.

For the rest of the year, how the Yen performs will depend largely on investor risk-appetite. If risk aversion predominates, then the Yen should hold its value. In addition, it’s worth pointing out that even as the Yen has fallen against the Dollar, it has appreciated against the Euro, and remained flat against a handful of other currencies. Against the US Dollar, however, I still don’t see any reason for why the Yen should trade below 85, and I expect the correction will continue to unfold.

JPY comparison chart 2010

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Posted by Adam Kritzer | in Japanese Yen, News | 2 Comments »

Canadian Dollar: Parity Vs Reality

Dec. 13th 2010

After a stellar 2009, the Canadian Dollar (“Loonie”) has had a relatively lackluster 2010 against the Dollar, rising by only 3-4%. As the Loonie has inched (back) towards parity, it has encountered significant resistance. I think there is reason to believe that the currency has reached its limit, and that there are little prospects for further appreciation for at least the first half of 2011.

Canadian Dollar  Oil   Commodity Price Chart 2010
Everyone likes to think of the Canadian Dollar as a commodity currency, but I don’t think this is an accurate representation. Net energy exports account for only a small portion (2.9%) of Canadian GDP, a fraction which is dwarfed by the export of automobiles, for example. In fact, eastern Canada, which is comparatively poor in natural resources, is actually a net energy importer. I think that investors have largely come to the same conclusion, and significant rallies in oil and other commodity prices in the second half of 2010 spurred only a modest appreciation in the Loonie.

The currency has risen so fast over the last couple years that Canada has run a trade deficit for six consecutive months, including a record $2.5 Billion in July. (In some ways, doesn’t this prove that economic imbalances will ultimately self-correct?!). In addition, to say that Canadian export sector is heavily reliant on the US would be an understatement: “The U.S. bought 70 percent of Canada’s exports in October, down from 75 percent in June, and a record of about 85 percent in 2001.” It’s no wonder that Canadian economic officials have defended the Fed’s QE2 monetary easing program; they know that Canada’s economic health is contingent on a strong US economy.

As for how fluctuations in risk affect the Loonie, it’s not clear. On two separate occasions, the WSJ reported first that “With investors more willing to take on riskier assets than they were the day before, the Canadian dollar was able to move sharply higher,” and then that “Canada’s relatively strong fiscal and economic fundamentals attract safe-haven flows when investors are fleeing from risk.” What a blatant contradiction if there ever was one! Personally, I think that Canada’s economic structure and relatively high debt levels disqualify the Loonie from consideration as a safe-haven currency. That being said, it has notched some impressive gains against other non-safe haven currencies.

Canadian Dollar Versus Other Currencies November 2010

If not for its low interest rates, nobody would even mention it in the same breath as the US Dollar or Japanese Yen. Speaking of low rates, the Bank of Canada voted last week to keep its benchmark interest rate on hold at 1% and indicated that it won’t consider raising them for quite some time. Said Central Bank Governor Mark Carney, “There are limits to the divergence that there can be between Canada and the United States.” In other words, the BOC probably won’t hike rates until the Fed does, at which point there will be very little basis for buying the Loonie over the US Dollar.

Analysts tend to agree with this assessment: “The loonie will trade at parity by the end of March and weaken to C$1.01 per dollar through the end of third-quarter 2011, according to…a Bloomberg survey: ‘We still think the Canadian dollar will continue to hover around here and test parity; we don’t think the Canadian dollar is going to back up against the U.S. dollar until the new year.’ Interestingly enough, Canadian investment advisers echo this sentiment: “We’re saying to clients that the Canadian dollar is strong right now, so buying U.S. assets is cheaper than it would be if the dollar were weak.”

It’s a bad sign for the Loonie when even Canadians think it’s overvalued.

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Posted by Amy Cottrell | in Canadian Dollar, News | 2 Comments »

Russian Ruble Undervalued According to Central Bank

Dec. 9th 2010

In the midst of the currency war controversy, there is one emerging market country that continues to insist that its currency is undervalued: Russia. While being a member of the illustrious group of BRIC (Brazil / Russia / India / China) countries would seem to guarantee an appreciating currency, there are strong forces weighing on the Ruble. In other words, that it remains weak is not due to investor oversight.
Ruble Dollar Chart 2006-2010

If you view the performance of the Russian Ruble over the last few years, it’s clear that it never recovered from the rapid depreciation that took place during the height of the credit crisis. Given that nearly every other emerging market currency is either closing in on or has already breached its pre-credit crisis level, there must be something holding down the Ruble.

That something happens to be a sizable current account deficit. Unlike with other emerging markets, capital is actually flowing out of Russia. There are a few reasons for this: first of all, much of Russia’s debt is denominated in foreign currency, as a consequence of its massive default in 1998. Specifically, “The private sector has about $16 billion in foreign debt, including interest-rate payments, due this month [December], double the $8 billion of redemptions in October and November.” This means that every month, Russian companies must scramble to exchange Rubles for Dollars and Euros.

Next, the real returns of investing in Russia are currently negative. Russia’s Central Bank (Bank Rossii) continues to maintain the benchmark refinancing rate at a record-low 7.75%, and the 10-year yield on Russian bonds is even lower, at ~5%. This would seem to compare favorably with the 2.75% yield on comparable US Treasury Securities until you account for inflation, which is projected to top 8% for the year. While Ruble-denominated bonds pay a higher interest rate (7.75%), they also carry higher risk. For that reason, Russian yields and credit default swap spreads (which insure against default) are much higher in Russia than in other BRIC countries.

JPMorgan EMBI Russia Blended Yield Chart 2010

Meanwhile, Russian companies are taking advantage of low borrowing rates to engage in a reverse carry trade and invest in western countries: “Russian companies have announced $27 billion of foreign purchases this quarter, the most since the third quarter of 2008 and triple the amount in the last three-month period.” Finally, the reemergence of the EU fiscal crisis, combined with the skirmish in Korea has spurred a decrease in risk appetite. As one analyst summarized, “The whole of the emerging markets are on the back-foot at the moment and the ruble is no exception…it’s definitely risk off at the moment.”

As a result, Bank Rossii finds itself in a somewhat unique position among Central Banks of having to try to prop up its currency. Technically, the Rouble is pegged to a basket (consisting of 55% Dollars and 45% Euros), but pressure on it has been so intense that the range in which it is permitted to trade has been adjusted downward five times since the middle of October. To prevent it from declining further, Bank Rossii has been dipping into its $450 Billion stock of forex reserves, and selling foreign currency at the rate of $150 million per day. It insists that it will “allow” the Rouble to appreciate in 2011 in order to fight inflation, but that obviously depends on whether the current account shifts back to surplus.

What do investors think? According to a Bloomberg survey of currency analyst, “The Ruble will strengthen 4 percent versus the basket by the end of the first quarter of 2011. On the other hand, “Options traders are still bearish on the ruble with the currency’s one-week risk reversal rate — the premium of put options over calls — at 1.25 percent for the tenth straight day, from 0.5 percent at the end of October.” Non-deliverable forward contracts, meanwhile, reflect a weaker Ruble three months from now.

If the Bank Rosii fulfills analysts’ expectations and hikes rates in March, it will be step towards reinvigorating investor interest in Russia. More importantly, however, is that inflation is brought under control. Until that happens, the Ruble will remain the main standout in a sea of emerging market currencies that otherwise continues to outperform.

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Posted by Linda Goin | in Emerging Currencies, News | 3 Comments »

Risk Aversion (Still) Positive for USD

Dec. 7th 2010

As one strategist recently put it, we seem to be witnessing Deja Vu in the forex markets. The US Dollar in general, and the USD/EUR currency pair in particular, are behaving exactly the same as one year ago: “The greenback rose back then…on a combination of strong U.S. November jobs numbers…and the triple downgrades of Greece later in the month by Fitch, S&P and Moodys.” This time around, a similar combination of US optimism and EU pessimism are once again buoying the Dollar.

Euro Dollar Chart 2009-2010
It all started about a month ago, when the EU sovereign debt crisis flared up again in the EU. Initially, investors were focused on the fiscal plight of Ireland, but quickly became nervous about the possibility that the crisis would spread to Portugal and even Spain, which would tax the finances/ability of the EU and put extreme pressure on the European Monetary Union (EMU). With this in mind, investors have fled the Euro, sending it down more than 7% – from peak to trough – against the Dollar.

The skirmish between North and South Korea further added to the climate of heightened risk, and reinforced the position of the Dollar as the world’s safest currency, ahead of even the Swiss Franc and Japanese Yen: “Recent events just reinforce the underlying message that during times of turmoil, almost no matter what the source, the U.S. dollar is seen as a safe harbor for investors.” Basically, there is still nothing that can compare to US Treasury securities in terms of liquidity and security. In fact, demand for Dollars has become so acute in recent weeks that some analysts are already bracing for the (still-distant) possibility of another Dollar shortage, like the one that plagued the markets following the collapse of Lehman Brothers in 2008. In short, “The strong dollar thirst linked to dollar-funding needs is, as usual, supporting the dollar.”

Meanwhile, the markets are becoming less pessimistic about the impact of the Fed’s $600 Billion expansion of its Quantitative Easing Program (QE2) and consequently more optimistic about US growth prospects. Even before the drama in the EU and Korea, investors had already started to adjust their positions. Since mid-October, “Futures traders have slashed bets for a decline in the dollar against the euro, yen, Australian dollar, and Swiss franc, data from the U.S. Commodity Futures Trading Assn. show…Strategist forecasts for the dollar to weaken have all but disappeared.”

While the employment picture remains a dim spot, the economy is still growing. In a recent televised interview, Ben Bernanke declared that, “Another recession appeared unlikely.” He also added that QE3 is also a possibility if banks continue to hoard capital, eroding the effectiveness of QE2. The positive reaction of forex markets shows that investors are less concerned about inflation and more focused on whether QE2 will facilitate economic growth. It “absolutely can be dollar-positive if the markets decide that [it is] going to be part of the package that brings about a revival in economic growth,” summarized one analyst.

USD EUR CHF JPY Chart
If the markets continue to bet on (as opposed to against) QE2, and uncertainty persists in the EU, the Dollar will continue to rally and finish off the year in positive territory.

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Posted by Adam Kritzer | in News, US Dollar | 1 Comment »

Euro-Watchers Pull About-Face

Dec. 4th 2010

Only last month, the Euro was on top of the forex markets. Especially relative to its “G4” competitors (Dollar, Yen, Pound) – all of which are plagued by economic uncertainty and loose monetary policies – the Euro was seen as a smart bet. In the last few weeks, however, the EU sovereign debt crisis resurfaced, and the Euro has plunged, losing 7.5% of its value against the Dollar. As a result, investors have pulled an about-face: instead of banking on the European Central Bank (ECB) to buoy the Euro through monetary restraint, they are now counting on it to hold the Euro together by adopting the same tactics as its counterparts.

Before I explain what I mean here, I’d like to offer an update on the EU fiscal situation. In the last week, there were a handful of developments. First, Ireland accepted a tentative €85 Billion in aid from the EU/IMF, officially joining the ranks of an infamous club that also includes Greece. Still, it wasn’t clear whether such a bailout would also include Irish banks, which are seen as perhaps in deeper trouble than the Irish government. As a result, investors were unmoved, and S&P moved ahead with a cut to Ireland’s sovereign credit rating.

Ireland Public Deficit of GDP

Naturally, rumors began to circulate that Portugal was also preparing a formal bailout request. Said one trader, “In Portugal the kind of language you’re hearing is similar to what you heard in Ireland a few weeks ago.” Despite promises to the contrary, Portugal’s budget deficit has widened in 2010. Interest in its most recent bond issue was healthy, but at the highest interest rate since the Euro was introduced in 1999 and more than .5% higher than last month.

Ultimately, bailouts of Greece, Ireland, and Portugal can be managed. It is a default and/or preemptive rescue of Spain – the other PIGS member – that worries investors. Its economy represents more than 11% of the EU and any hiccup would seriously shake the foundations of the Euro: “It may well be that we are approaching the endgame of this part of the crisis as Spain is of such importance that one can only imagine that the EU will regard it as the line in the sand that cannot be crossed.” While Spain is working hard to cut its budget deficit to a still-stratospheric 9.3% in 2010, investors have balked. As a result, interest rates in its bonds have surged to a post-Euro high (relative to German bonds), and credit default swap spreads (which insure against the risk of default) have risen substantially.

The problem with the EU sovereign debt crisis – like most credit crises, for that matter – is that they tend to be self-fulfilling. As investors begin to doubt the ability of institutions (governmental and otherwise) to service their debts, they naturally demand greater compensation for the (perceived) increase in risk. This further inhibits that institution’s ability to repay its loans, which only makes funding more difficult to attract, and so on.

It is ironic on multiple levels then that even as investors abandon the debt of EU member countries, they are hoping that the ECB steps in to fill the void they create. As I alluded to the title of this post, this marks a stunning about-face from only a few months ago, when the Euro was rising against the Dollar because of the ECB’s commitment to a responsible monetary policy. Nowadays, the Euro rallies only on news that the ECB is maintaining or expanding its intervention. For example, the Irish banking sector is “increasingly more reliant on the ECB funding,” and as a result, “The euro edged up…as the European Central Bank continued buying Portuguese and Irish government bonds.”

Based on this change in investor mentality, it seems unlikely that the Euro will recover its losses anytime soon. Of course, the ECB has nearly unlimited resources at its disposal. German central bank chief Axel Weber declared confidently that, “An attack on the euro has no chance of succeeding.” However, the ECB can never hope to fully supplant the important role played by private capital, and besides, “What we are experiencing at present is not a speculative attack but a justified depreciation due to unsolved problems.”

Euro Dollar chart December 2010

There are still plenty of optimists who believe that the fear will soon die down and that higher interest rates will attract some of the yield-hungry investors that are currently focused on emerging markets. Goldman Sachs forecast “the euro will rise to $1.50 by year-end 2011 as big economies in the area continue expanding.”

I think the most realistic assessment is somewhere in between. On the one hand, it seems unlikely that the Spain will default on its debt at anytime in the near future or that the Euro will cease to exist. On the other hand, the fact that investors now see the ECB as a savior for following in the footsteps of the Fed implies that there is no reason for investors to buy the Euro against the US Dollar.

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Posted by Adam Kritzer | in Euro, News | 3 Comments »

Asian Currencies Poised to Rise, but for Wrong Reasons

Dec. 2nd 2010

All things considered, Asian currencies have had an okay 2010 (and there’s still another month to go). After a modest first half, they started to rise in unison in June, and several are poised to finish the year 10% higher than where they began. While the last few weeks have seen a slight pullback, there is cause for cautious optimism in 2011.

Asian Currency Chart 2010
At this point, I think the rise in Asian currencies has become somewhat self-fulfilling. Basically, investors expect Asian currencies to rise, and the consequent anticipatory capital inflows cause them to actually rise, thereby reinforcing investor sentiment. For example, the co-head of emerging markets for Pacific Investment Management Company (PIMCO) is “investing in local currency debt and foreign exchange contracts in Asia on the basis that…emerging market currencies are bound to rise for…fundamental reasons.” Upon being asked to elaborate on such fundamentals, he answered lamely that, “One big driver for emerging markets in coming years will come from investors’ relatively low allocations to these fast-growing regions.”

When pressed for actual reasons, investors can glibly rattle off such strengths as high growth and low debt and wax bullish about the emerging market ‘story,’ but ultimately they are chasing yield, asset appreciation, and strengthening exchange rates. It doesn’t matter that P/E ratios for (Asian) emerging market stocks are significantly higher than in industrialized economies, or that bond prices are destined to decline as soon as (Asian) emerging market Central Banks begin lifting interest rates, or that Purchase Power Parity (PPP) already suggests that some of these currencies are already fairly valued. In a nutshell, they continue to pour money into Asia because that’s what everyone else seems to be doing.

Personally, I think that kind of mentality should inspire caution in even the most bullish of investors. It suggests that if bubbles haven’t already formed in emerging markets, they probably will soon, since there’s no way that GDP growth will be large enough to absorb the continuous inflow of capital. According to the Financial Times, “Data suggest that emerging market mutual funds, including those invested in Asian markets, have received about 10 per cent of their assets in additional flows over the past four to five months.” Meanwhile, a not-insignificant portion of the $600 Billion Fed QE2 program could find its way into Asia, exacerbating this trend.

US Dollar Asia Index 2010
In addition, emerging markets in general, and Asia in particular, have always been vulnerable to sudden capital outflow caused by flareups in risk aversion. For example, Asian currencies as a whole (see the US Dollar Asian Currency Index chart above) have declined 2% in the month of November alone, due to interest rate hikes in China and a re-emergence of the EU sovereign debt crisis. The former sparked fears of a worldwide economic slowdown, while the latter precipitated a decline in risk appetite.

As a bona fide fundamental analyst, it pains me to say that emerging market Asian currencies can expect some (modest) appreciation over the next year, barring any serious changes to the EU fiscal and global economic situations. It seems that capital will continue to pour into Asia, which – rather than fundamentals – will continue to dictate performance.

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

War = Good News for South Korea?

Nov. 30th 2010

South Korea was in the midst of figuring out what to do with its appreciating Won when disaster struck, in the form of an unprovoked attack from North Korea. Combined with a worsening of the sovereign debt crisis in Europe, the news was enough to send the Won down 5% over the course of a couple weeks. From the standpoint of managing its currency, it looks like the (distant) prospect of war is actually a blessing in disguise.

Over the last decade, South Korea has been one of the world’s largest serial interveners in currency markets. Over the last two years alone, as evidenced by the growth in its foreign exchange reserves, it has spent more than $100 Billion defending the Won. As the so-called currency war has intensified, so, too has the Bank of Korea intensified its efforts to hold down the Won, having spent more than $20 Billion since July towards this effort.

South Korea Forex Reserves 2005-2010
You could say then that South Korea’s hosting of the G20 Summit on November 15 put it in a slightly awkward position. Still, it was determined to make clear that it would continue to take steps to combat the rise in the Won. According to Shin Hyun-song, the special economic advisor to President Lee Myung-bak, “This means that countries can intervene in the currency market when the market is in disorder and when there is a gap between the market rate and underlying economic fundamentals.” Of course, fundamentals is hardly an objective notion in this case.

While the G20 predictably called on participants to “move toward a market-driven exchange rate system and to refrain from competitive devaluations,” it nonetheless also guided them towards “implementing policy tools for bringing excessive external imbalances down to sustainable levels.” The underlying message is that certain countries should curtail their reliance on exports and try to achieve more balanced growth.

Naturally, South Korea’s interpretation was that while direct intervention is now taboo, taxes and other capital controls are sanctioned. Thus, it has been reported that “the Korean government has been gauging its timing to launch further measures to tighten the financial market and protect it from volatile global capital movement..bank levies on non-deposit liabilities and taxes on foreign purchases of government bonds are both possible options.”

As I said, though, the South Korea now has some breathing room. Its Won depreciated rapidly in the minutes after the shelling of Yeonpyeong island, which killed four and wounded 20, was first reported. The fact that the US government immediately pledged its support and solidarity (by sending over an aircraft carrier) is not instilling confidence. One analyst indicated, “We see a strong chance of further Korean won weakness in the days ahead as more details emerge, particularly if public opinion in South Korea puts pressure on the government there to take a stronger stance.”

Korean Won / US Dollar Chart

Even before this episode, the EU sovereign debt crisis had spread to Ireland, and put Spain and Portugal at risk, too. As a result, the Dollar-as-safe-haven mindset re-emerged, and spurred some capital movement back to the US. In this context, the drama with North Korea only exacerbated the climate of risk aversion.

Ultimately, both the EU fiscal crisis and the tensions with North Korea will subside, which should cause the Won to resume its rise. (In fact, Korean exporters have come to view this as inevitable, and have taken advantage of the relatively favorable exchange rate to repatriate overseas earnings). At this point, you can expect the Bank of Korea to begin implementing capital controls and continue the face-off with currency markets.

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Posted by Adam Kritzer | in News | 3 Comments »

US Dollar is Safe…For Now

Nov. 28th 2010

The Dollar is Crashing! The Dollar is Crashing! Such is the perennial claim of doomsday predictors, conspiracy theorists, gold bugs, etc. Those of you who read my blog regularly know that I often come to the defense of the Dollar. Given that it has risen by more than 5% over the last month and is currently hovering around its average value of the last five years, I think this position is worth reiterating.

US Dollar Index 2006 - 2010
In the months leading up to the expansion of the Fed’s Quantitative Easing Program (QE2), investors took an especially bearish view on the Dollar, precipitating a rapid and steep decline against most currencies. Analysts argued (somewhat contradictorily) that QE2 would be ineffective in the short-run and inflationary in the long-run, and that most of the new cash would be invested abroad – where returns are higher – rather than in the US.

Since the unveiling of QE2, however, the Dollar has rallied strongly. On the one hand, most economists remains skeptical that it will do much to lift GDP and boost employment. However, a parallel thread holds that this was only the ostensible motive for QE2, and that the real motive was to prevent the outbreak of another financial crisis and consequent economic downturn. Given that housing prices are headed downward and banks’ balance sheets are still weak, the Fed’s move reads more like a preemptive move to further shore up the financial system than an economic stimulus program.

At the very least, this probably won’t hurt the Dollar, and certainly not to the extent that the market had priced in prior to QE2. While the stock market rally has stalled, the rise in Treasury Yields has not. The 10-Year rate is close to 3% for the first time in months, making it more attractive (and less costly) to hold capital in Dollar-denominated assets. The Dollar was also helped by the release of GDP data for Q3, during which the US economy beat expectations and grew by 2.5%.

10-Year Treasury Rate Vs. S&P 500 - 2006-2010
As a result, traders are reducing their Dollar-short positions. Analysts have revised their forecasts to reflect a stronger Dollar, based on the notion that “The dollar has found a bottom.” At this point, the main naysayers are “overwhelmingly found in the ranks of the opposition Republican party,” perhaps part of a cynical ploy to hurt both the economy and Barack Obama’s chances of being reelected.

To be sure, there may be other reasons for the Dollar’s rally, namely the growing turmoil in the EU. Evidence is mounting that the EU sovereign debt crisis is spreading, which has spurred both an increase in investor risk aversion and a decline in the Euro. Still, market chatter seems to be focusing less on the Dollar as safe-haven and more on the fact that the Dollar was merely oversold.

On a purchasing power parity (ppp) basis, the Dollar is starting to look cheap. If the opinions of Europeans, Canadian, Australian, and Japanese tourists are to be taken at face value, the US is cheaper than it has been for years. As one commentator summarized, “If the PPP figures are right, the U.S. dollar has more upside than the negative sentiment around it would indicate. If the greenback were to decline further, it would have to do so from an already undervalued situation.”

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

Interview with Kathy Lien: “Trade Defensively and Use a Stop”

Nov. 26th 2010

Today, we bring you an interview with Kathy Lien, the internationally published author, Director of Currency Research of FX360.com and GFT, and co-author of BKForex Advisor, one of the few investment advisory letters focusing strictly on the FX market. She is one of the authors of Investopedia’s Forex Education section and has written for Tradingmarkets.com, the Asia Times Online, Stocks & Commodities Magazine, MarketWatch, ActiveTrader Magazine, Currency Trader, Futures Magazine and SFO. Below, Kathy shares her thoughts on fundamental analysis versus technical analysis, rate hikes in China, forex intervention, and other subjects.

Read the rest of this entry »

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Posted by Adam Kritzer | in Interviews, News | 2 Comments »

Emerging Market Currencies Still Have Room to Rise

Nov. 23rd 2010

Emerging market economies must be whining about their currencies for a good reason. Why else would they spend billions intervening in forex markets and risk provoking a global trade war?

Emerging Market Currencies Chart 2009-2010
As it turns out, however, the rise in emerging market currencies has been greatly exaggerated. Over the last twelve months, the Brazilian Real is flat against the Dollar. The Korean Won has risen a mere 2%. The Indian Rupee has risen 4%, the Mexican Peso has appreciated 5%, and the standout of emerging markets – the Thai Baht – has notched a solid 10%. Impressive, but hardly enough to raise eyebrows, and barely keeping pace with the S&P 500. Not to mention that if you measure their returns against stronger currencies (i.e. not the Dollar) or on a trade-weighted basis, the performance of emerging market currencies in 2010 was actually pretty mediocre.

Perhaps that explains why so many analysts are still pretty bullish. Economic growth in emerging markets is showing no signs of abating: Standard Chartered Bank “expects emerging economies to account for 68 per cent of global growth by 2030 and forecasts China’s economy to expand at an annual average rate of 6.9 per cent over that period, even as the US and Europe grow at a much slower pace of 2.5 per cent.”

MSCI Emerging Markets Index 2007-2010

Stock prices (proxied by the MSCI Emerging Markets Index) and bond prices (proxied by the JP Morgan EMBI+ Index) are still rising. Moreover, as emerging market Central Banks (continue to) hike interest rates, returns on investment (and consequently, the attraction to investors) will rise further. In fact, if credit default swap spreads are any indication, the risk of default is perceived as being lowest in emerging market economies. That means that investors are being compensated for taking less risk with greater returns! It doesn’t hurt that – as Fed Chairman Ben Bernanke recently pointed out – investors are buoyed bu the belief that emerging market currencies will continue appreciating, providing an addition boost to returns.

It doesn’t look like the capital controls and other measures being adopted by emerging market economies will have a significant impact on slowing the inflow of foreign capital. Investors are already devising products to thwart the controls. So-called Global Bonds, for example, allow foreign investors to buy emerging market bonds without having to pay any special taxes, because they are settled in the home currency of the investor. Besides, investors with a long-term horizon can take solace that such taxes will become insignificant when allocated over a number of years.

Credit Default Swap Spreads - Emerging Markets Versus Industrialized Countries 2008-2010There are, however, reasons to be cautious, In the short-term, bad news and flare-ups in risk aversion invariably hit emerging market assets hardest. Regardless of what information can be gleaned from credit default spreads, the majority of investors still associate the US with safety and emerging markets with volatility. That’s why when news of Ireland’s financial troubles broke, emerging market currencies fell across the board, and the Dollar rallied.

In addition, rising interest rates could cause bond prices to fall, and stock-market valuations may not be supported by fundamentals: “Emerging markets on average recorded economic growth of about 4 percent over the past few years while companies only recorded profit growth half of that. In China over the past decade economic growth was about 10 percent, while company earnings growth was only about 2 percent.” There is also evidence that investors and companies from emerging market countries are taking advantage of their strong currencies to invest and buy abroad, reversing the flow of capital.

Personally, I am slightly bullish with regard to emerging market currencies. The figures I quoted at the beginning of this post make it clear that we are not yet in bubble territory. In addition, even if fundamentals in emerging markets are not quite as strong as foreign investors would like to believe, they are certainly a lot stronger than in industrialized economies. Regardless of if/when the currency war is resolved, the short-term prospects for emerging market currencies remain bright.

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

A Return to the Gold Standard?

Nov. 21st 2010

In my last post, I explored the possibility that the role of the Chinese Yuan (CNY) will expand to the point that it could rival – or even overtake – the US Dollar as the world’s preeminent reserve currency. Ultimately, I concluded that the constraints on widespread foreign ownership of CNY assets are too great, and that as a result, the Dollar’s position is safe for the time being. What about the notion that all currencies are doomed? In this case, the biggest threat to the US Dollar won’t come from China, but rather from gold.

This possibility is no longer hypothetical. James Grant (of the eponymous Grant’s Interest Rate Observer) has for many years tried to advance the case for a return to the Gold Standard. In a much-discussed editorial in the NY Times, Grant reiterated the idea that Central Banker are increasingly out of touch with economic reality, and lack any checks on their ability to print money and debase their respective currencies. Grant singles out the Fed for its non-stop quantitative easing programs, which could lead to hyper-inflation and foment additional asset bubbles. At the very least, it will cause the Dollar to lose even more of its value.

Grant’s editorial coincided perfectly (perhaps deliberately) with a proposal by Robert Zoellick, president of the World Bank, to reform the global economic system, with the goal of reducing economic imbalances. While most of Zoellick’s ideas are common-sense, his proposal to “build a co-operative monetary system that reflects emerging economic conditions.” and “consider employing gold as an international reference point of…currency values” stood out. While his comments created a veritable firestorm, they were grounded firmly in the reality that gold prices are rising and faith in the current fiat monetary system is declining.

The theoretical advantages and disadvantages of the gold standard have been mooted ad nauseum, and I don’t want to rehash all of them here. In sum, a gold standard is believed to be promote long-term price stability, eliminate hyper-inflation, a check on government debt issuance, and a transfer monetary power from Central Banks to the people (via the markets). Downsides include short-term price volatility, a heightened possibility of deflation, and the repudiation of modern monetary policy. Given the fact that paper currency in circulation vastly exceeds the supply of gold, a transition to the gold standard would be difficult to implement and would probably cause a substantial rise in the price of gold.

Personally, I’m not convinced that a return to the gold standard would promote economic/financial stability any more than the fiat money system. For example, just as large financial institutions dominate the current system, so they would be likely to dominate any other system, leading to the same lack of transparency and democracy. In addition, gold can also be lent out (with interest), leading to a similar propensity for asset bubbles and economic imbalances of every kind.

Just like currencies have relative value today (in terms of other currencies, commodities, assets, labor, etc.), so does gold. In that sense, saying seven units of gold is enough to buy a house is not really that different from saying it costs 10 units of paper currency to buy that same house. For instance, if Chinese producers charge 1 gold coin for their widgets while American producers charge 2, it will still result in a trade imbalance that will only correct when the Chinese standard of living catches up to the US standard of living.

Finally, gold is arbitrary. Why not a platinum standard or an oil standard? Based on the scarcity of those resources, prices would vary accordingly, much as they do under the paper currency system. Not to mention that gold is incredibly unwieldy, which means that it would be digitalized and used electronically just like paper currencies.

You could argue that this is actually a benefit of the gold standard, since it would be compatible with the current economic system, but at least it would lead to financial stability. Maybe I’m in denial like Ben Bernanke, but I just don’t see gold as the solution.  Asset bubbles inflate, and then they collapse. Economic imbalances will persist for as long as they are allowed to. If emerging market exporters get tired of receiving Dollars for their wares, then they will stop accepting it, the Dollar’s value will crash, and the US economy will have to rebalance itself. In a perfect world, there would be no irrational exuberance. In reality, the current system will persist, and life will go on.

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Posted by Adam Kritzer | in Gold, News | 8 Comments »

Chinese Yuan Will Not Be Reserve Currency?

Nov. 18th 2010

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

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

China Trade Surplus 2009 - 2010
However, as Pettis points out, the structure of China’s economy is such that foreigners don’t have such an opportunity. Basically, China has run a current account/trade surplus, which has grown continuously over the last decade. During that time, its Central Bank has accumulated more than $2.5 Trillion in foreign exchange reserves in order to prevent the RMB from appreciating. Foreign Direct Investment, on the other hand, averages 2% of GDP and is declining, not to mention that “a significant share of those inflows may actually be mainland money round-tripped to take advantage of capital and tax regulations.”

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

China FDI 2009-2010

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

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

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

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

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

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Posted by Adam Kritzer | in Central Banks, Chinese Yuan (RMB), News, US Dollar | 1 Comment »

Euro Correction is Here

Nov. 16th 2010

You can think of this as a follow-up to my last post, entitled “Euro Due for a Correction,” in which I proclaimed that “investors got ahead of themselves when they pushed the Euro down 20% over the first half of 2010, but now they are in danger of making the same mistake, and are pushing the Euro too far in the opposite direction.” Since then, the Euro has indeed fallen 4%. In this case, however, I’m reluctant to toot my own horn, since there were other forces at work.

Euro USD 3 Month ChartNamely, he sovereign debt crisis has officially spread beyond Greece, and “Contagion is definitely back on the table.”  Of chief concern is Ireland, whose banking sector is in serious financial turmoil: “Irish banking losses are estimated at up to 80 billion euros ($109 billion), depending on the forecast used, or 50 percent of the economy. As long as housing prices continue to fall, these losses cannot be capped.” At this point, it’s unlikely that the banks can remain afloat without (additional) government help. The only problem is that the government has already raided its welfare fund, and it is projected that additional support would leave a gaping hole in the budget, equivalent to 32% in GDP. Allowing the banks to fail, meanwhile, would lead to economic losses of 50% of GDP.

Portugal and Spain (rounding out the so-called PIGS countries) are also in trouble, with budget deficits of around 9% of GDP. Given that both countries are struggling economically, it is possible that austerity measures and budget cuts could backfire and worsen their respective fiscal situations. Like their Irish counterparts, Portuguese banks remain heavily reliant on access to cheap ECB credit in order to function. Spanish banks, meanwhile are plagued by distressed loans, which account for “5.6 percent of total Spanish bank loans — the highest level since 1996.”

Currently, their governments insist that they can get by without help from the European Commission. To be fair, they have managed both to issue new debt and refinance existing debt without serious difficulty. In addition, Ireland and Portugal have modest reserve funds which could tide them over for close to a year, if need be. The medium-term, however, looks less rosy.

Ireland Portufal Bond Yields 2010 - Sovereign Debt Crisis
If rising bond yields are any indication, these countries could be in serious trouble. Bond investors are not concerned about an EU bailout, which is seen as inevitable, at least for Ireland. After all, the European Financial Stability Facility that was created in May still has more than $500 Billion left in it. Rather, investors are concerned that they will be asked to take part in the bailout.

Germany, for example, is toughening its stance towards fiscally strained countries, and Angela Merkel has insisted that, “Highly indebted eurozone countries struggling to repay will be forced to restructure their debt in a process of ‘managed insolvency’ and that their creditors will need to take large ‘haircuts.’ ” Up until now, the EU has intimated that will provide a backstop against sovereign default, in order to assuage bond market investors.

This is changing, as German and French politicians insist that they are more beholden to their constituents/taxpayers than they are to their debt-ridden EU brethren.  Given that Germany is fiscally sound, it has pretty much nothing to lose (short of a breakup of the Euro) by playing hardball. In fact, it may actually benefit from scaring away investors, since a weaker Euro will strengthen its export sector.

Going forward, it seems safe to say that the Euro correction will continue, as investors continue to reevaluate their exposure to sovereign credit risk. According to the most recent CFTC Commitments of Traders report, “Investors last week slashed their bets in favor of the euro by 40% to a level not seen since early October.” Of course, given that the Dollar is plagued by its own set of problems, it’s unclear whether the EUR/USD will experience serious fluctuations. Against other currencies, however, the Euro will probably decline: “Those who want to go short euro should consider doing it on the crosses.”

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Posted by Adam Kritzer | in Euro, News | 1 Comment »

Interview with Dollar Daze: Avoid Positions that Entail Currency Risk

Nov. 14th 2010

Today, we bring you an interview with Mike Hewitt of Dollar Daze, whose “belief is that the paper currencies of the world are presently undergoing a devaluation.” Below, Mr. Hewitt shares his thoughts on the US Dollar, Chinese Yuan, inflation, and why you should be paying attention to Gold and other commodities.

Read the rest of this entry »

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Canadian Dollar Reaches Parity…Again

Nov. 12th 2010

Last week, the Canadian Dollar became the second currency – after the Australian Dollar – to reach parity against the US Dollar. While the case for Loonie parity is not quite as strong as the Aussie’s, there is nonetheless reason to believe that it will continue trading at this level for the short-term.

CAD USD 5 Year Chart

It’s not hard to understand what’s driving the Loonie; the weak Dollar. As the Fed embarks on further monetary easing (QE2), investors are nervous that all of these new Dollars will be deployed in a speculative – rather than productive capacity. Emerging market currencies are particularly popular, with commodity currencies, such as the Canadian Dollar, not far behind.

According to Bank of Canada Governor Mark Carney, “The outlook for the Canadian dollar… ultimately reflects the economic fundamentals.” While he has threatened to intervene if currency markets are “disrupted” (i.e. if the Loonie rises to an unreasonable level), past history and the tone of Carney’s remarks suggests that the Bank of Canada will remain on the sidelines for the duration of the currency war.

From where I’m sitting, the Canadian Dollar (as with the New Zealand Dollar, the subject of my previous post), don’t deserve to benefit from the speculative wall of money that is flowing out of the US. The Canadian economy is projected to grow by only 1% in 2010, and after adjusting for the contraction in 2009, it is still the same size as it two years ago. Not to mention that the Canadian government issued a record amount of debt to shepherd the economy through the recession.

Most worrying is that Canada’s trade deficit is nearing a record high, and on an annualized basis is now approaching $30 Billion a year.  In addition, anecdotal stories suggest that Canadians are engaging in cross-border shopping and traveling abroad in great numbers to take advantage of relatively cheap prices. With the Canadian Dollar now at parity, these phen0omena are already becoming entrenched: “We would not anticipate much of an improvement in these trade patterns in the next couple of quarters,” said one economist.

Canada Balance of Trade

There are two observations that can be made here. First of all, while Canada is certainly a natural resource economy, the boom in commodity prices  really isn’t helping Canada in the same way that it is helping Australia, for example. That’s mainly because Canada’s principal market for commodity exports is the US, which remains weak. In contrast, the booming economies of China and Greater Asia ensure an expansive and growing market for Australian natural resources. Moreover, as evidenced by a growing trade deficit, exports of commodities are being offset by an increase in imports: “Economists at Bank of Montreal and Desjardins Financial say weak trade will carve as much as three percentage points from GDP growth in the third quarter.”

The second observation is that currency markets are self-correcting, and that is especially true in the case of the Canada. As the Loonie rises, Canadian exports become less competitive, and consumers (sometimes physically!) start importing more. At some point then, the Loonie will reverse its decline, and the trade deficit will shrink.

However, if you drill deeper into the numbers, you can see that Canada is running a sizable trade surplus with the US. That means that the Canadian Dollar probably has room to rise further (or the Dollar has room to fall further), before the bilateral trade deficit would even close to narrowing. On a trade-weighted basis (perhaps against the Euro), the Loonie has few sources of fundamental support. For what it’s worth, analysts from CIBC World Markets seem to agree: they see the Loonie declining more than 5% over the next six months as the uproar over QE2 gradually fades, and the data shows that only a modicum of the newly printed US Dollars found their way into Canada.

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New Zealand: No Forex Intervention

Nov. 10th 2010

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

USD NZD 5 Year Chart
With most countries, the war cries are coming from the political establishment, who feel compelled to demonstrate to their constituents that they are diligently monitoring the currency war. This is largely the case in New Zealand, as Members of Parliament have argued forcefully in favor of intervention. Prime Minister John Key is a little more pragmatic: He “says his Government is concerned about the strength of our dollar, but is not convinced intervention would work…politicians who think intervention can happen without economic consequences, are fooling themselves.” Showing an astute understanding of economics, he pointed out that trying to limit the Kiwi’s appreciation would manifest itself in the form of higher inflation, higher interest rates, and/or reduced access to capital.

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

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

New Zealand Current Account Balance 2000 - 2014

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

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

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Currency War Will End in Tears

Nov. 8th 2010

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

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

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

Currency War Dollar Depreciation

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

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

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

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

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

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Fed Surprises Markets with Scope of QE2

Nov. 4th 2010

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

Fed Balance Sheet 2010 QE2

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

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

EUR-USD 5 Day Chart 2010

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

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

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

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Currency Wars: Will Everyone Please Stop Whining!

Nov. 2nd 2010

I read a provocative piece the other day by Michael Hudson (“Why the U.S. Has Launched a New Financial World War — and How the Rest of the World Will Fight Back“), in which he argued that the ongoing currency wars are the fault of the US. Below, I’ll explain why he’s both right and wrong, and why he (and everyone else) should shut up and stop complaining.

It has become almost cliche to argue that the US, as the world’s lone hegemonic power, is also the world’s military bully. Hudson takes this argument one step further by accusing the US of using the Dollar as a basis for conducting “financial warfare.” Basically, the US Federal Reserve Bank’s Quantitative Easing and related monetary expansion programs create massive amounts of currency, the majority of which are exported to emerging market countries in the form of loans and investments. This puts upward pressure on their currencies, and rewards foreign speculators at the expense of domestic exporters.

Hudson is right that the majority of newly printed money has indeed been shifted to emerging markets, where the best returns and greatest potential for appreciation lies. Simply, the current economic and investing climate in the US is not as strong as in emerging markets. Indeed, this is why the (first) Quantitative Easing (QE) program was not very successful, and why the Fed has proposed a second round. While there is a bit of a chicken-and-egg conundrum (does economic growth drive investing, or do investors drive economic growth?) here, current capital flow trends suggest that any additional quantitative easing will also be felt primarily in emerging markets, rather than in the US. Not to mention that the US money supply has expanded at the same pace (or even slower) as the US economy over the long-term.

M3 Money Supply 2010

While the point about QE being ineffective is well-taken, Hudson completely ignores the strong case to be made for investing in emerging markets. He dismissively refers to all such investing as “extractive, not productive,” without bothering to contemplate why investors have instinctively started to prefer emerging markets to industrialized markets. As I said, emerging market economies are individually and collectively more robust, with faster growth and lower-debt than their industrialized counterparts. Calling such investing predatory represents a lack of understanding of the forces behind it.

Hudson also overlooks the role that emerging markets play in this system. The fact that speculative capital continues to pour into emerging markets despite the 30% currency appreciation that has already taken place and the asset bubbles that may be forming in their financial markets suggests that their assets and currencies are still undervalued. That’s not to say that the markets are perfect (the financial crisis proved the contrary), but rather that speculators believe that there is still money to be made. On the other side of the table, those that exchange emerging market currency for Dollars (and Euros and Pounds and Yen) must necessarily accept the exchange rate they are offered. In other words, the exchange rate is reasonable because it is palatable to all parties.

You can argue that this system unfairly penalizes emerging market countries, whose economies are dependent on the export sector to drive growth. What this really proves, however, is that these economies actually have no comparative advantage in the production and export of whatever goods they happen to be producing and exporting. If they can offer more than low costs and loose laws, then their export sectors will thrive in spite of currency appreciation. Look at Germany and Japan: both economies have recorded near-continuous trade surpluses for many decades in spite of the rising Euro and Yen.

The problem is that everyone benefits (in the short term) from the fundamental misalignments in currency markets. Traders like to mock purchasing power parity, but over the long-term, this is what drives exchange rates. Adjusting for taxes, laws, and other peculiarities which distinguish one economy from another, prices in countries at comparable stages of development should converge over the long-term. You can see from The Economist’s Big Mac Index that this is largely the case. As emerging market economies develop, their prices will gradually rise both absolutely (due to inflation) and relatively (when measured against other currencies).

Economist-Big-Mac-Index-July-2010
Ultimately, the global economy (of which currency markets and exchange rates represent only one part) always operates in equilibrium. The US imports goods from China, which sterilizes the inflows in order to avoid RMB appreciation by building up a stash of US Dollars, and holding them in US Treasury Bonds. Of course, everything would be easier if China allowed the RMB to appreciate AND the US government stopped running budget deficits, but neither side is willing to make such a change. In reality, the two will probably happen simultaneously: China will gradually let the RMB rise, which will cause US interest rates  to rise, which will make it more expensive and less palatable to add $1 Trillion to the National Debt every year, and will simultaneously make it more attractive to produce in the US.

Until then, politicians from every country and hack economists with their napkin drawings will continue to whine about injustice and impending economic doom.

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China Diversifies Forex Reserves

Oct. 31st 2010

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

China Forex Reserves 2010

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

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

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

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

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

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

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Why is the Japanese Yen Still Rising?

Oct. 29th 2010

Most of today’s headlines regarding the Japanese Yen focus on one thing: Central Bank intervention. Basically, reporters have become focused on the likelihood of additional intervention in the currency markets by the Bank of Japan. However, this obsession has caused them to overlook the larger issue: Why is the Yen still rising?

JPY Versus USD Chart 1970 - 2010

I was prompted to ask this question after coming across the above chart, which tracks the historical performance of the Japanese Yen against the US Dollar. You can see that since 1970, the Yen has risen by a whopping 350% against the Dollar. It has doubled in value since 1990 and risen 14% since the start of the year, en route to a 15-year high. Over the same period (actually since 1980; I couldn’t find data from the 1970), Japan’s economy has expanded by an average annualized growth rate of 2.2%. Over the last 10 years, the average is a paltry .9%. The contradiction between fundamentals and reality could not be more stark!

In addition, investor risk appetite has been reinvigorated. During most of the last decade, carry trading caused the Yen to decline to 120 USD/JPY as investors borrowed Yen in bulk in order to purchase high-yielding assets. The credit crisis spurred a short squeeze (i.e. rapid unwinding of carry trade positions) in early 2007, and caused the Yen to rocket upward. If anything, we would expect the Yen to mirror its performance of a few years ago, as investors take advantage of low Japanese interest rates and rebuild carry trade positions in the Yen.

The recent run-up in emerging market currencies, global equities, commodities, and other risky assets would certainly seem to support a carry trade strategy. For its part, the Bank of Japan is also doing its best to create a healthy environment for carry trading by printing currency, easing monetary policy, and fighting to keep the Yen from rising. And yet, if indeed there are still carry traders (and there certainly are!), the current trend in forex markets suggests that they are very much outnumbered by those betting on the Yen’s rise.

It’s difficult to understand this phenomenon. Those that hold Yen earn a nominal return of near 0%. Long-term interest rates (proxied by 10-year government bonds) are only slightly higher – at 1% – and certainly too low to attract any foreign institutional interest. Besides, it’s well-known that 90% of Japanese government debt is held by domestic savers. Meanwhile, the Japanese stock market has stagnated for more than 2 decades, and the Nikkei average is lower than at any point since 1985 (except for a brief period following the dot-com bust. Japanese real estate is equally unattractive.

As a result, there are only two conceivable reasons for the Yen’s continued upward push. The first is fundamental/structural and is connected to Japan’s trade surplus. In spite of an appreciating currency, the Japanese export sector continues to be the lone bright spot in an economy with otherwise limited sources of growth. Compared to 2009, the trade surplus is up 83%, helped by a rise of 50% in September. It is on pace to top $100 Billion for the year. In this regard, foreigners that buy Japanese Yen do so because they must- for purposes of trade.

Japan inflation rate chart 1970 - 2010

The second source of demand for Japanese Yen is so-called safe haven flows. While the Japanese Yen is not a high-yielding currency, it is actually an excellent store of value. [This is one of the three primary functions that a currency should fulfill. The other two are medium of exchange and unit of account]. That’s because inflation in Japan is the lowest in the world, often to the point of being nil. Since 1970, the inflation rate has averaged only 3%, compared to 4.5% in the US. Over the last 15 years, inflation has been 0%. In other words, even if they are invested in low-yielding savings accounts, Japanese savers can ensure that 1 Yen today will probably still be worth 1 Yen 5 years from now. Foreign investors can take advantage of the same phenomenon, when they bet that the exchange value of the Yen will be equally stable.

On the one hand, it is somewhat surprising that the Yen has been able to thrive in the current “risk-on” investing climate. On the other hand, there is a parallel thread of risk-aversion that will always exist and gravitate towards safe-haven currencies, such as the Yen. In fact, it can be argued that this contingent of investors is as large as the risk-taking contingent, as evidenced by the inexorable appreciation of gold (if not also by the Yen). Insofar as inflation in Japan remains nil and the Japanese export sector proves it can be competitive regardless of exchange rates, demand for Yen will continue to confound the gloomy forecasts and rebuff the best efforts of the Bank of Japan.

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

Much Ado About Debt

Oct. 28th 2010

In addressing the financial/credit/economic crisis, governments around the world have lowered interest rates, bailed-out bankrupt financial insititutions, engaged in wholesale money printing, guaranteed debt, and pumped cash into their economies. However, while such programs may have had some mitigating impact on the crisis, they did little to address the underlying cause. Specifically, debt was merely moved from one institution – one balance sheet – to another. Most of the bad debt that was at the heart of the credit crisis is still outstanding; the only thing that has changed is who is responsible for repaying it.

In many cases, it is governments which have assumed ownership of this debt. Fannie Mae and Freddie Mac remain in a US government conservatorship. The Federal Reserve Bank owns more than $2 Trillion in US Treasuries and Mortgage Backed Securities. The European Union has agreed to collectively back more than $500 Billion in debt belonging to Greece and other unspecified “troubled” member states. The Japanese government has managed to pass off 90% of its sovereign debt onto its own citizens. The UK Treasury has printed money and lent it to the government of the UK. [The graphic below is actually interactive, and is worth a few minutes of perusing].

Global Debt by Country 2010

So what are the possibilities for dealing with this debt? In terms of government debt, the first is to hope that economies can grow faster than the debt, so that it becomes more manageable in relative terms and that one day it can be repaid. Another option is to raise taxes and/or cut spending, and use the extra funds to retire the debt. Given the current economic environment, the former possibility is unlikely. Industrialized economies continue to stall, and much of this growth is being funded with new debt. The latter option would amount to political suicide; any government that is politically naive enough to approve any austerity measures will be voted out of office at the next election. (With the election season about to begin, we won’t have to wait long for confirmation!)

The only alternative then is to reduce the real amount of debt through monetary inflation or currency depreciation. In the US, inflation is at a 50-year low. In Japan, it is non-existent. In the UK and the EU, prices are hardly growing. Monetary policymakers around the world are now actively trying to spur inflation (for reasons unrelated to the reduction of debt), but to no avail. Interest rates are already at rock bottom, and Central Banks have injected Billions of newly minted money into circulation without any impact on prices.

Currency devaluation is already taking place, but the main participants are emerging market economies (which are incidentally more concerned about export competitiveness than reducing the size of the debts). The Japanese Yen is nearing an all-time high, while the Euro has recovered from its spring lows. The British Pound is near its long-term average, while the US Dollar has declined only slightly on a trade-weighted average. In the end, since all of these countries are characterized by high levels of debt, it would be impossible for all of them to devalue their currencies. In addition, the nature of the Euro currency union precludes Eurozone countries from being able to lower their debts through currency devaluation.

The story is the same for private debt. For example, most of the real estate (commercial and residential) debt associated with the collapse of the housing market has yet to be written off. Financial institutions and investors continue to hold onto it with the hope that the real estate market will soon recover, such that the losses will never need to be recognized. While this strategy could vindicate lenders/investors over the long-term, it continues to have a devastating effect in the short-term since it forces the holders of debt to keep more cash on their balance sheets, where it won’t find its way into the global economy.

Euro Franc Dollar Yen 1990-2010 Real Exchange Rates

What are the implications for forex markets? Namely, it would seem to support the notion that emerging market currencies will continue to outperform the G4 currencies over the long-term. Over the near-term, it’s possible that G4 currencies will experience some appreciation, due both to the ebb and flow of risk appetite and the interventions of emerging market Central Banks on behalf of their currencies. Over the long-term, however, the only realistic alternative to default is currency devaluation, and at some point, the forex markets will have to come to terms with the fact that the G4 currencies need to decline. [Chart above courtesy of The Economist].

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Currency War Devalues all Currencies…Except for Gold

Oct. 24th 2010

Have you ever heard currency cheerleaders rave about how unique forex is because there is never a bear market? Since all currencies trade relative to each other (when one falls, another must necessarily rise), it couldn’t be possible for the entire market to drop at once, as happens with other financial markets. The ongoing currency war might be turning this logic on its head, as currencies embark on a collective downward spiral. Profiting in this kind of market might involve exiting it altogether, and turning to Gold.

Gold Versus Global Currencies 2010

For those of you who haven’t been following this story, a handful of the world’s largest Central Banks are now battling with each to see who can devalue their currency the fastest. [Of course, this war is being couched in euphemistic terms, but make no mistake: it is indeed a form of battle]. The principal participants are emerging market economies, which worry about the impact of rising currencies on their export sectors. However, industrialized countries have also intervened directly (namely Japan) and indirectly (US, UK).

Among the major currencies, there are only a few that continue to sit on the side-lines, including the Euro (to a certain extent), Canadian Dollar, and Australian Dollar. For as long as the currency war continues, these currencies and the handful of emerging market currencies that have forsworn intervention will be the winners (at least from the point of view of speculators that deliberately bet on them).

Then there are those that believe all currencies will suffer, and that even the currencies that are still rising are actually depreciating in real terms (due to inflation). Those who harbor such beliefs will often try to short the entire currency market, usually by betting on commodities or heavy metals, of which Gold is probably the most prominent.

The price of Gold has risen more than 20% this year (in USD terms). Its backers claim that it is the ultimate store of value (where this derives from is unclear), and defend its lack of utility and inability to accrue interest by arguing that its appreciation is more than enough of a reason to own it. When you look at the performance of gold over the last five years, you begin to wonder if maybe they have a point.

Gold Prices 10 Year Chart 2000-2010
Interest in Gold as an investment has surged in the last couple years (and especially the last few months), as the currency wars have heated up and the Federal Reserve Bank contemplates an expansion of its Quantitative Easing program (dubbed” QE2″). On the one hand, the notion that the only way to defend against real currency devaluation is to own “alternative” currencies is well-founded. On the other hand, regardless of the fact that the Fed has already minted $2 Trillion in cash and that the US national debt is expanding by $1 Trillion per year, inflation in the US is low. In fact, it’s at a 50-year low, and at an annualized .9%, it’s practically non-existent. You would think that with Gold’s unending appreciation, we would be in the midst of hyperinflation, but that’s simply not the case.

In the short-term, then, there’s really not a strong fundamental basis for investing in gold. That’s not to say that it won’t continue to appreciate and that investors will continue to buy into it merely to benefit from what has become self-fulfilling appreciation. From where I’m sitting, though, there’s really no foundation for this appreciation. Consider, for example, that gold investors still have to convert their gold back into paper currency in order for it to to be “used;” otherwise, it offers no benefit to the owner except that it looks pretty (though most investors wouldn’t know, since they buy gold indirectly). Not to mention that if/when the Dollar stops depreciating, there really isn’t really a justification to buy gold as a short-term store of value.

Over the long-term, the picture is certainly more nuanced. I’m not going to explore the viability of fiat currencies here, but suffice it to say that, “Positioning for significantly higher gold prices over the long run demands a very bold strategic bet: that the global monetary system as we know it will completely break down and be replaced with a gold standard.” Regardless of the merits of this point of view, those that invest in Gold should at least understand that this is really the only justifiable reason to hold it. Those who are buying it because of the ongoing currency war will be disappointed.

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Posted by Linda Goin | in Gold, News, Politics & Policy | 2 Comments »

Euro Due for a Correction

Oct. 21st 2010

Since touching a four-year low in June, the Euro has risen a whopping 19% against the Dollar – a veritable surge! One has to wonder, however, if perhaps the Euro hasn’t gotten ahead of itself in its race back upward.

The Euro’s nonstop rise has perplexed me. During the throes of the Eurozone Sovereign debt crisis, it seemed as if the Euro was headed back towards parity, if it even remained in existence! The European Commission’s $500 Billion bailout plan seemed to assuage the markets, but didn’t do much to mitigate against the risk of sovereign default. Besides, it looks like all of the austerity measures will be undone after the next election cycle. Opposition to further budgets is so vehement, and unemployment is so high (12% in Greece, 20% in Spain) that it will be difficult for leaders to stay in office if they continue to push an agenda that reduces their deficits.

Euro Dollar 1 Year Chart

As evidence that bond investors remain skeptical, consider that Greek debt still trades at a 700 basis point premium to German bonds. EU cheerleaders love to point to the fact that at-risk Eurozone countries are having no trouble tapping the credit markets, but that’s not really surprising when you consider the lofty returns that investors receive for buying bonds that are essentially backed by the good credit of the EU.

Even ignoring the fiscal problems of the EU, the economic picture is not pretty. “The Economist Intelligence Unit, in its just-released report…is forecasting that growth in Western Europe will reach only 1.1% next year, and at or below 1.7% at least through 2015, beyond which it wisely declines to look.” When you subtract out Germany – the engine of the EU economy –  GDP growth will be even more pathetic. And don’t even mention the peripheral economies, many of which are at serious risk for sliding back into recession.

Moreover, the European Central Bank (ECB) monetary policy is just as loose as in other industrialized countries. Through its quantitative easing program, the ECB has injected hundreds of billions of Euros into the banking system and credit markets. Jean Claude Trichet, President of the ECB, bristled at the idea of ending this support: “No! This is not the position of the Governing Council, with an overwhelming majority.This non-standard measure…was designed to help restore a more normal functioning of our monetary policy transmission mechanism.”

On the other hand, the ECB is sterilizing all of its market intervention, which means that most of the funds that it is injected into the economy will remain in the EU. Contrast this with the Fed’s quantitative easing program (which hasn’t been sterilized) and you begin to understand why the Euro has held up well. In addition, Eurozone inflation currently exceeds US inflation (at a 50-year low), which means that the ECB will hesitate before following the Fed in easing monetary policy further.

Still, I don’t think there is a strong foundation for the Euro’s rise. It’s understandable that the expansion of the Fed’s quantitative easing program (“QE2”) is making investors nervous, causing them to send cash out of the US as a preventative measure. However, this seems a little too much like the tail wagging the dog, since until QE2 is officially implemented, all anticipatory shifts in capital flows are purely speculative – not fundamental. And as a fundamental analyst, that concerns me.

I think investors got ahead of themselves when they pushed the Euro down 20% over the first half of 2010, but now they are in danger of making the same mistake, and are pushing the Euro too far in the opposite direction. According to the most recent Commitment of Traders report, investors are building up long positions in the Euro, to the point that trading is becoming lopsided. I’m not much for short-term technical analysis, but when the Relative Strength Index (RSI) and Moving Average Convergence Divergence (MACD) are both approaching 2-year highs, it tells me that a correction is coming.

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Posted by Adam Kritzer | in Euro, News | No Comments »

QE2 Weighs on Dollar

Oct. 18th 2010

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

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

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

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

QE2- US Dollar Trade-Weighted Index 2008-2010
At the very least, we can almost guarantee that QE2 will continue to push the Dollar down. For comparison’s sake, consider that after the Fed announced its first Quantitative Easing plan, the Dollar fell 14% against the Euro in only a couple months. This time around, it has fallen for five weeks in a row, and the Fed hasn’t even formally unveiled QE2! It has fallen 13% on a trade-weighted basis, 14% against the Euro, to parity against the Australian and Canadian Dollars, and recently touched a 15-year low against the Yen, in spite of Japan’s equally loose monetary policy.

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

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Posted by Adam Kritzer | in Central Banks, News, US Dollar | 3 Comments »

Betting on China Via Australia

Oct. 16th 2010

There are plenty of investors that think betting on China is as close to a sure thing as there could possibly be. The only problem is that investing directly in China’s economic freight train is complicated, opaque, and sometimes impossible. The Chinese government maintains strict capital controls, prohibits foreigners from directly owning certain types of investment vehicles, and prevents the Chinese Yuan from appreciating too quickly, if at all. For those that want exposure to China without all of the attendant risks, there is a neat alternative: the Australian Dollar (AUD).

Those of you that regularly read my posts and/or follow the forex markets closely should be aware of the many correlations that exist between currencies and other financial markets, as well as between currencies. In this case, there would appear to be a strong correlation between Chinese economic growth and the Australian Dollar. If the Chinese Yuan were able to float freely, it might rise and fall in line with the AUD. Since the Yuan is fixed to the US Dollar, however, we must look for a more roundabout connection. HSBC research analysts used Chinese electricity consumption as a proxy for Chinese economic activity (why they didn’t just use GDP is still unclear to me), and discovered that it fluctuated in perfect accordance with the Australian Dollar.

Australian Dollar and Chinese electricity consumption 1990-2008
Before I get ahead of myself, I want to explain why one would even posit a connection between China and the Aussie in the first place. There are actually a few reasons. First, Australia is economically part of Asia: “Today, 43 per cent of Australia’s total merchandise trade is with north Asia. A further 15 per cent is with Southeast Asia.” Second, Australia’s economy is driven by the extraction and sale of natural resources, of which China is a major buyer and investor: “In 2008-9, China was the biggest investor in the key resource sector with $26.3bn involvements approved, 30 per cent of the total.” Third, Chinese demand has come to dictate the prices of many such resources, causing them to rise continuously. Thus, Australia’s natural resource exports to countries other than China still draw strength (via high commodity prices) from Chinese demand.

As one analyst summarized, “China is buying raw materials from Australia in leaps and bounds, and that’s what’s driving that currency’s growth.” Sounds like an Open and Shut case. In fact, this presumed correlation has become so entrenched that any indication that China is trying to cool its own economy almost always prompts a reaction in the Aussie. To be sure, warnings that China’s annual legislative conference (scheduled for October 17) would produce a consensus call for a tightening of economic policy have made some forecasters more conservative. Still, as long as the Chinese economy remains strong, the Australian Dollar should follow.

It’s worth pointing out that the correlation between the Aussie and the Chinese economy doesn’t exist in a vacuum. For example, the Australian Dollar has also closely mirrored the S&P 500 over the last decade, which suggests that global economic growth (and higher commodity prices) are as much of a factor in the Aussie’s appreciation as is Chinese economic activity. The Aussie is also vulnerable to a decline in risk appetite, like the kind that took place during the financial crisis and flared up again as a result of the EU Sovereign debt crisis. During such periods, Chinese demand for commodities becomes irrelevant.

AUD USD 2006-2010
On the other hand, part of the reason the Australian Dollar has surged 10% since September and 20% since June is because other countries’ Central Banks (such as China) have increased their interventions on behalf of their respective currencies. Australia is one of a handful of countries whose Central Bank not only hasn’t actively tried to depress its currency, but whose monetary policy (via interest rate hikes) actually invites further appreciation. As the Aussie closes in on parity and Australian exporters and tourism operators become more vocal about the impact on business, however, the Reserve Bank of Australia (RBA) might be forced to act.

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Posted by Adam Kritzer | in Australian Dollar, Chinese Yuan (RMB), News | 3 Comments »

Emerging Market “Wall of Money” Spurs Currency War

Oct. 14th 2010

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

MSCI Emerging Markets Chart 2006 - 2010

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

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

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

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

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

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

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

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Posted by Adam Kritzer | in Central Banks, News | 1 Comment »

Japan Plots Next Yen Intervention

Oct. 13th 2010

Almost one month has passed since the Bank of Japan (BOJ) intervened in forex markets on behalf of the Japanese Yen. In one trading session, it spent a record 2.1249 trillion yen ($25.37 billion) to obtain a 3.5% jump in the Yen. Since then, the Yen has continued to appreciate, and now it seems like it’s only a matter of time before the BOJ intervenes again…and again and again.

USD JPY Forex Intervention

Prior to intervening, Japan’s main concern was that there would be a bitter backlash from the rest of the world. On the one hand, Japan’s fears were validated by accusations that it was engaging in “currency war.” It also received a mild rebuke from US policymakers, who fretted that its intervention would cause China to reconsider allowing the Yuan to appreciate.

Others were more forgiving, however, going so far as to excuse Japan’s actions as a necessary response to Korean and Chinese intervention. After all, given that Japan competes directly with these two countries for export market share, how could it sit by idly as they actively devalued their currencies. US Treasury Secretary Timothy Geithner let Japan completely off the hook by telling reporters that he didn’t think Japan “set the fire”for the current dynamic in forex markets.

Deutsche Bank(which created the chart below) added, “It must be frustrating for Japanese policymakers to see other Asian economics getting away with such persistent intervention to weaken their currencies. Perhaps the final straw was the Chinese purchases of JGBs [Japanese government Bonds] which some Japanese officials argue played a prominent role in the recent JPY appreciation.” In other words, not only was China holding down its currency against the Dollar, but now it had started to target the CNY/JPY exchange rate.

Forex Reserves in Asia, Japan Forex Intervention

At next week’s G7 meeting, Japan will try to achieve a formal permission slip for its program, by arguing that, ” ‘Our intervention isn’t the kind of large-scale operations that aim to achieve certain rate levels over the long term.’ September’s intervention was only ‘aimed at curbing excess fluctuations’ in the yen’s rates.” Depending on how the G7 responds (via its official statement), it may influence the likelihood of further intervention.

From an economic standpoint, Japan also doesn’t have much to fear. The only downside from printing money wholesale and using it to buy US Dollars is the risk of inflation. In Japan, however, this would be seen as a positive development, and is hardly a constraint to further intervention: “With Japan’s economy still in the grip of deflation, the authorities have the ability and the incentive to prevent further gains in the yen.” In fact, the Bank of Japan recently “slashed its overnight ratetarget to virtually zero and pledged to purchase 5 trillion yen ($60 billion) worth of assets in a fresh dose of economic stimulus.” As the Fed prepares to do the same [more on that later this week], the BOJ’s hope is that this time around, “The yen won’t be reflexively favoured by investors turning bearish on the greenback.”

Really, then, the only question is when the BOJ will intervene. The Japanese Yen has already fallen below 82 USD/JPY, disappointing analysts that predicted the point of intervention would take place at 83/84, near the point of last month’s intervention. That it has allowed the Yen to continue to slide is somewhat baffling in that it exposes the futility of its previous efforts. The BOJ claims that it isn’t embarking on a program on continuous intervention, but this is really the only chance it has of being successful for any length of time. The Swiss National Bank (SNB) established a “line in the sand” of 1.50 EUR/SWF and spent $200 Billion defending it. Where is the the BOJ “line in the sand?” 82? 80?

In theory, this should mean that the Japanese Yen appreciation will soon come to an end. Given the fact that every other major currency (with the exception of the Euro) is being either indirectly or competitively devalued, however, this is far from certain. If Japan is serious about holding down the Yen, it may have to formally declare war.

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

Passive Currency Investing Rises in Popularity

Oct. 9th 2010

Those who read the most recent Bank of International Settlements (BIS) Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity know that daily forex turnover rose 20% over the last three years, to $4 Trillion. According to the official data, the vast majority of participants are financial institutions and the like, which would give the impression that overwhelming majority of trading is engaged in for speculative purposes. Anecdotal research, however, suggests that behind the scenes, it is “passive” foreign exchange trading that is making its presence known.

According to Deutsche Bank, ‘passive’ players – such as corporate treasurers who are looking to hedge currency risk or to facilitate their core business, not to make a profit – account for more than 50 per cent of currency flows.” By definition, these passive players are not out to make a profit, and exchange currencies only because it is necessary to simply conduct business.

This is not surprising since the number of confirmed exporters in the US rose 10% during the last year for which data is available. It is almost a given that the number of exporters in emerging markets is increasing an an even faster clip. As a result, corporate banking departments are fighting to keep up with demand for currency exchange/hedging by such businesses, which simply want the ability to know their own profit margins in advance, and can set prices accordingly. Big corporations are among the most reliable hedgers: “Companies lifted the amount of estimated 12-month forward earnings hedged to 34.3 percent on average in September…boosted by a 22 percentage point rise in the U.S. corporations’ hedge ratio to 55.7 percent, the highest on record.” Even Sovereign Wealth funds are reportedly interested in hedging their forex reserves.

If not for the enormous pool of passive participation in forex, it might be difficult for speculators to turn a profit. ” ‘The flows from passive players have only limited direct sensitivity to broader market and macro factors, so they can serve as counterparts to investment theme-driven flows,’ ” reports the Financial Times. Since these participants are disinterested in actual forex fluctuations – so long as they can lock in exchange rates using spot and futures transactions – it creates passive momentum for currency movement, and hence opportunities for speculators (including retail forex traders) to turn a profit.

In some ways, this is a free lunch to speculators. On the one hand, double-digit currency moves have become so common over the last few years as to become almost mundane, with some currencies routinely rising or falling by more than 5% a month. On the other hand, forex volatility has fallen over time (except during the financial crisis) and is lower compared to other asset classes. For example, “Annualised average daily volatility of the euro/dollar pair over the past decade, for example, is 140 per cent lower than the volatility in the EuroStoxx 50 over the same period.” In addition, “JPMorgan’s index of implied volatility on options for Group of Seven currencies dropped 13 percent in the third quarter, after jumping 22 percent in the prior three months.” This is amazing, since it implies that as uncertainty has risen, risk (aka volatility) has fallen.

Interest in forex is also rising among indirect investors, such as pension funds, mutual funds, and retail investors that seek exposure to currency through investment products. “In July, RBC Capital Markets published a survey of 102 asset managers…which revealed that 38 per cent say currency tops the list of asset classes they are most likely to move into over the next 12 months, ahead of equities and commodities.” On a related note, most investment advisers recommend that currencies should comprise 2-7% of every investment portfolio, regardless of objective and tolerance to risk. The number of forex investment “specialists” and related investment products appear to be rising to meet demand variously based on carry, momentum and value strategies.

At this rate, it looks like forex volume will set a fresh record in 2013, when the next round of data is released.

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Posted by Adam Kritzer | in Investing & Trading, News | No Comments »

Korean Won Rises Despite Currency War

Oct. 7th 2010

The Bank of Korea is one of the major participants in the ongoing global currency war, intervening on behalf of the Won to the tune of $1 Billion per day! Meanwhile, the Korean Won has risen 5% in the last month, and 10% over the last three months, the highest in Asia. What a disconnect!

First of all, what’s behind the Korean Won’s rise? In a word, everything. At the moment, things couldn’t be going any better for the Korea Won. The economy is booming. The current account / trade surplus is on pace to surpass forecasts. The Central Bank has hiked its benchmark interest rate once already to 2.25%, and will probably hike again this month. In addition. even though Korean indebtedness is rising, “It is ranked 99th among 129 nations in terms of the ratio of public debt to the gross domestic product (GDP), which means the country’s balance sheet is healthier than most other nations in the world.” Added another analyst, “In this period where there’s a lot of concern about debtor nations, countries that are considered to have higher credit scores will benefit.”

While the Korean stock market has surged (13% this ear and 50% last year), it still remains 25% below its 2007 peak and is trading at valuations well below other Asian countries. It’s no wonder that foreign investors have been net buyers of Korean stocks: “Foreigners have bought more Korean shares than they sold every day for four weeks and net purchases for the year amount to some $13 billion.” It doesn’t hurt investors that the currency is appreciating and that interest rates are rising; at the moment, there really isn’t much downside from investing in Korea.

korea won usd 5 year chart
Meanwhile, the US (Federal Reserve Bank) is contemplating an expansion of its quantitative easing program, and other Central Banks may follow suit. Under the (now fading) paradigm of risk aversion, concerns of economic decline in the industrialized world would have been accompanied by a sell-off in emerging markets and capital flight to safe havens. As evidenced by the spike in the Korean Won and other emerging market currencies, such is no longer the case.

Enter the Bank of Korea (BOK). It is widely known that the South Korean economy is highly dependent on exports, which could be negatively impacted by a rising currency: “For every one percent gain of the won against the U.S. dollar, the nation’s export and gross domestic product decreases by 0.05 percent and 0.07 percent each.” Moreover, South Korea competes directly with Japan, which means the KRW-JPY exchange rate is of crucial importance to the Bank of Korea. Of course, both currencies had been appreciating at a similar clip. Once the Bank of Japan intervened, however, the BOK had no choice bu to double-down on its own efforts.

The Bank of Korea seems to appreciate that there is only so much it can do. Intervention is not cheap, and its foreign exchange reserves have since surged to $290 Billion. It is also not very effective, and the Korean Won has continued to rise. Finally, the currency intervention contradicts the BOK’s efforts to contain rising prices. By not raising interest rates and trying to hold its currency down, it risks stoking inflation. What’s more – South Korea is actually hosting this week’s G20 summit, at which currency intervention is expected to be a major topic of discussion. It would be awkward, to say the least, if Korea’s own currency intervention was broached.

Thus, it seems the Korean Won is destined to keep rising. It, too, is well below its 2007 peak, and there is scope for further appreciation. The BOK will continue to make token attempts at halting its rise, but at this point, the forces that is fighting against – bullish investors and other Central Banks – are too great.

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Currency War: Who are the Winners and Losers?

Oct. 6th 2010

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

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

Unequal Competition- Global Trade and Currency Wars

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

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

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

Emerging Market Capital Inflows 2009-2010

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

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

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Brazilian Real at 2-Year High Despite “Currency War”

Oct. 1st 2010

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

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

Economist Big Mac Index July 2010

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

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

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

Real USD 5-Year Chart

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

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Bullish on the Euro?

Sep. 29th 2010

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

Euro Dollar 5 Year Chart 2006-2010
There are a handful of factors which currently underlie the Euro’s strength, which can all generally be explained by the fact that risk is “on” at the moment, and the markets are moving away from so-called safe haven currencies and back towards growth investments. Of course that could change tomorrow (or even 5 minutes from now!), but at the moment, risk appetite is high and the Euro symbolizes risk. Never mind how ironic it is, that growth in the EU is projected at 1.8% for the year while Rest of World (ROW) GDP will probably top 5%. All that matters is compared to the Dollar (and Yen, Pound, Franc to a lesser extent) the Euro is perceived as the currency of risk.

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

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

Eurozone sovereign debt interest rates graph 2007-2010
In addition, the credit markets in the EU are barely functioning, and large institutions remain dependent on the ECB’s credit facilities for financing. Finally, it shouldn’t be forgotten that the only reason crisis was due to the massive support (€140 Billion) extended to Greece. When this program expires in less than three years, the fiscal problems of Greece (and the other PIGS) will be exposed once again, and a new (stopgap) solution will need to be proposed.

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

Eurozone Budget Deficits, GDP

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

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RMB Appreciation Accelerates, but Dollar Peg Remains in Place

Sep. 27th 2010

The Chinese Yuan has touched a new high, at 6.69 USD/CNY. Given that the Yuan has still only risen about 2% since the peg was officially loosened in June –  with most of that appreciation taking place in the last couple weeks – there still remains intense pressure on China to do more.

Last week’s intervention by the Bank of Japan diverted a tremendous amount of attention towards the Yuan. In fact, many analysts have argued that it is only because of the Yuan-Dollar peg (itself, as well as the Chinese purchases of Yen assets that it engendered) that Japan was forced to act: ” ‘Countries see that getting involved in currency manipulation is a way to give themselves an advantage’…’China, their actions affected Japan, and Japan is affecting us.’ ” The Yen intervention could also force the G20 to re-focus its attention on the Yuan, and at least devote some discussion to it at the next summit.

CNY USD 1 Year Chart 2010

It should be noted that the two soundbites above both emanated from US Congressmen, which is important because the US government is currently mulling action on the Yuan currency peg. Politicians are growing tired by the Treasury Department’s repeated failure to call China a “Currency Manipulator,” which would require diplomatic talks and even trade sanctions. The Treasury will have an opportunity redeem itself in its next report on foreign exchange, due out on October 15, but it is expected that the report will either be delayed or released without adequately addressing the undervalued Yuan.

In fact, Treasury Secretary Geithner testified before Congress last week, and at least admitted that something needed to be done: “The pace of appreciation has been too slow and the extent of appreciation too limited. We have to figure out ways to change behavior.” However, this was only in response to acerbic criticism – (Senator Schumer told him, “I’m increasingly coming to the view that the only person in this room who believes China is not manipulating its currency is you.”) – and he ultimately failed to outline a timetable/blueprint for action. Despite the consensus among politicians (and President Obama) that the currency peg is harmful to the US economy, Geithner made it clear that the Treasury Department continues to favor unilateral action towards dealing with problem, without Congressional intervention. For now, then, politicians are probably relegated to saber-rattling and name-calling.

China’s response to this charade has been predictable. Trade representatives hinted that China wouldn’t bow to external pressure, and that any attempt at “punishment” would be met with countervailing actions. China also questioned the economics between arguments that the Dollar peg contributes to trade imbalance, calling such claims “groundless.” This position is actually supported by the notion that while the Yuan appreciated by 20% against the Dollar from 2005-2008, the US/China trade deficit actually widened.

In practice, China is likely to stick to its policy of gradual Yuan appreciation, or a few reasons. First of all, while Chinese policymakers know that they don’t need to wholly appease US politicians, they at least need to pretend that they are listening. It’s true that the US is dependent on Chinese products and its purchases of Treasury Bonds. However, it is arguably just as dependent on the US to buy its exports, which promotes employment and social stability, and it is keen to avoid a trade war if possible.

Second, a long-term appreciation of the RMB is actually in China’s best interest. If it wants to spur domestic consumption and promote more value-added manufacturing, it will need a more valuable currency. Outbound M&A, especially involving natural resource companies, will also be more economical if the Yuan is worth more. Also, if China has any serious ambitions of turning the Yuan into a global reserve currency, it will need to create capital markets that are deeper and more liquid, which it is currently unmotivated to do, lest it spur demand for Yuan by foreign institutional investors.

Finally, China should let the Yuan appreciate because it is financially gainful to do so. As I mentioned above, its trade surplus with the US has widened over the last few years as prices for its exports grow along with quantity. Meanwhile, prices for imports and prices paid for commodities and other natural resources have declined in Yuan-terms. For that reason, I think China will probably continue to stick its current policy, and allow the RMB to continue to slowly inch up.

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Thai Baht Rises to 13-Year High

Sep. 24th 2010

As I pack my bags and head to Thailand for a vacation (for forex research purposes…yeah right), I thought it would be appropriate to blog about the Thai Baht’s strength. The momentum behind the Baht has been nothing short of incredible, and as often happens in the forex markets, the currency’s rise is becoming self-fulfilling. It has already appreciated 8.5% over the last year en route to a 13-year high, and some analysts predict that this is just the beginning.

THB USD Baht Dollar Chart 2006-2010

The last time I travelled to Thailand, in 2004, the Baht was trading around 40 USD/THB, compared to the current exchange rate of 30.7. That’s pretty incredible when you consider that during the intervening time, Thailand experienced a military coup and related political instability, as well as a financial crisis that dealt an especially heavy blow to the world’s emerging market currencies. And yet, if you chart the Baht’s performance against the Dollar, you would have only the faintest ideas that either of these crises took place.

To be sure, the financial crisis exacted a heavy toll on Thai financial markets and the Thai economy. Stock and bond prices lurched downward, as foreign investors moved cash into so-called safe haven currencies, such as the US Dollar and Japanese Yen. However, the Thai economy was among the first to emerge from recession, expanding in 2009, and surging in 2010. “Compared with a year earlier, GDP rose 9.1%, while the economy grew 10.6% in the first half,” according to the most recent data.  Tourism, one of the country’s pillar industries, has already recovered, along with exports and consumption. Projected export growth of 27% is expected to drive the economy forward at 7-7.5% in 2010, according to both the IMF and Thai government projections. The consensus is that growth would have been even more spectacular (perhaps 1-2% higher) if not for the politcal protests, which were finally quelled in May of this year.

Thailand GDP 2008-2010

Despite concerns about risk and volatility, foreign investors are once again pouring funds in Thailand at a record pace. Over $1.4 Billion has been pumped into the stock market alone in the year-to-date. As a result, “Thailand’s benchmark SET Index has rebounded30 percent since May…helping send the SET to its highest level since November 1996.” Capital inflows are also being spurred by Thai interest rates, which are rising (the benchmark is currently at 1.75%), even while rates in the industrialized world remain flat.  At this point, the cash coming into Thailand well exceeds the cash going out, which remains low due to steady imports and restrictions on capital outflows by Thai individuals and institutions. This imbalance is reflected in the Central Bank of Thailand’s forex reserves, which recently topped $150 Billion, more than 50% of GDP.

Anticipation is building that Thailand will use some its reserves to try to halt, or even reverse the appreciation of the Baht. After last week’s intervention by the Bank of Japan, such intervention is now seen not only as being more acceptable, but also more necessary. Due to pressure from the Prime Minister, the Central Bank has convened at least one emergency meeting to determine the best course of action. So far, members can only agree that restrictions on capital flows and lending standards to exporters should be relaxed.

For what it’s worth, Thailand’s richest man has urged the Central Bank not to act: “The effort is likely fruitless as foreign capital is expected to incessantly flood into Thailand because of the country’s healthy economic recovery and export growth. The baht as a matter of fact should become even stronger should Thailand’s politics remain in normal condition.” He is supported by the facts, which show that the Thai export sector has held up just fine in the face of the rising Baht, though perhaps only because other Asian currencies have risen at a comparable pace.

If other Central Banks were to step up their intervention – (Deutsche Bank has argued, via the chart below, that all “Asian central banks have for many years been more or less persistently in the market “stabilizing” their currencies, but with a clear bias towards preventing USD depreciation in this region”) – the Bank of Thailand would probably have no choice but to follow suit.

Foreign Exchange Reserves, Central Bank Intervention in Asia 2000-2010

Otherwise, it might not be long before the Baht clears 30 USD/THB. My next post on the Baht, in 2015, will probably be in the form of a similar lamentation…

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Interview with Marc Chandler: “You Win Through Discipline.”

Sep. 21st 2010

Today, we bring you an interview with Marc Chandler, the global head of currency strategy for Brown Brothers Harriman. Previously he was the chief currency strategist for HSBC Bank USA and Mellon Bank. Marc is a prolific writer and speaker whose essays have been published in the Financial Times, Barron’s, Euromoney, Corporate Finance, and Foreign Affairs. He is also the contributing economic editor for Active Trader Magazine and to TheStreet.Com. Below, he shares his thoughts on fundamental analysis versus technical analysis, the false Euro rally, Japanese Yen intervention, and other subjects.

Read the rest of this entry »

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Keep an Eye on Central Banks

Sep. 20th 2010

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

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

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

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

Central Bank Credit Crisis Intervention 2007-2008

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

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

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

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Hungarian Forint Touches Record Low

Sep. 19th 2010

Anyone who had bought emerging market currency(s) at the peak of the credit crisis in 2008 would have earned double digit annualized returns in the two years that have passed since then. There are only a handful of exceptions to this rule, and the most prominent one that I can think of is the Hungarian Forint. If you had bought the Hungarian Forint against the Swiss Franc (the base currency that most traders in the Forint look at, for reasons that I will explain below) in the fall of 2008, you would incur a loss of a 63% if you sold today. The Forint is down 11% in the last month alone. These are the kinds of numbers one might associates with mortgage-backed securities and credit default swaps, not currencies!

Swiss Franc CHF Hungarian Forint HUF 2010

So why is the Forint in the doghouse? Ironically, the answer is connected to mortgages. During the inflation of the housing bubble, Hungarians preferred to borrow in Swiss Francs, because interest rates were significantly lower than domestic Hungarian rates. This was not a mere trend; it was a full-blown phenomenon: “About 5.4 trillion forint($24.1 billion), or two-thirds of Hungary’s overall household credit, is denominated in foreign currencies. Of that, 82 percent is in Swiss francs, according to central bank data.” When the housing and credit markets were stable, noone bothered to examine currency risk. Given how much the Forint has fallen against the Franc, you can bet they are now.

As if the decline in housing prices wasn’t bad enough, consider that Hungarians that borrowed in Swiss Francs have now seen their mortgage payments/balances increase by more than 50%, depending on when they took out their loans. It goes without saying that even under the best of circumstances, it would be difficult to find the wherewithal – let alone the motivation – to repay such a loan. When you throw an economic recession into the mix, the prospects for repayment become even more bleak. As the Hungarian Forint has depreciated, loan defaults have risen, further stoking the Forint’s depreciation and loan defaults.

Alas, the Hungarian government’s program for solving this crisis is to punish the banks, both by allowing borrowers to delay repayment and by levying a massive tax – the highest on the EU – on all banks. While this might be helpful for bringing down the country’s budget deficit to the 3% mandated by the EU, it probably won’t do much for the economy. Speaking of the budget deficit, it has prompted S&P to warn of a possible cut in Hungary’s sovereign credit rating to junk-status.

Hungary’s cause hasn’t been helped by the breakdown of talks with the EU and IMF that would have supplied it with emergency funding. As if it wasn’t obvious from the Forint’s decline, investors are beginning to fear the worst and are slowly turning away from Hungary. The country’s benchmark stock market index has fallen 4% over the last six months. Meanwhile, foreign lenders are starting to balk at buying Hungarian debt without some kind of EU/IMF backstop, much like the one that was afforded to Greece: “Auction saleshave been a barometer of investor confidence in the country. On Sept. 2, Hungary sold 35 billion forint of 12-month Treasury bills, 15 billion forint less than planned, after receiving bids for 63.4 billion forint of the bills. Five days later, it sold 60 billion forint of three-month Treasury bills, 10 billion forint more than planned.”

At this point, all eyes are on the Hungarian government to simultaneously boost the economy and repair its budget deficit: “The rating agenciesare taking the same line as the markets and giving the government until local elections in October the benefit of the doubt, but if they don’t see then either a recommitment to the IMF program, or real concrete measures I think they move to cut the rating to junk.” If that were to happen, the self-fulfilling downward spiral in the Forint would probably continue unabated.

It makes you wonder: if the Greek Drachma were still around, how closely would it resemble the Forint?

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Japan Finally Intervenes in Forex Markets

Sep. 15th 2010

After months of speculation, the Bank of Japan (BOJ) has finally intervened in the currency markets. As the plummeted towards a fresh low against the Dollar, the BOJ swiftly entered the market, driving the Yen up 2% instantly. On the day, it finished 3% higher against the Dollar.

Over the last few weeks, Japan had been inching slowly towards intervention. [In fact, I was prepared to write a post yesterday about intervention being imminent, but that is neither here nor there…] The Finance Minister, Governors of the Central Bank, Members of Parliament, and even the Prime Minister himself had started to become increasingly vocal about the Yen’s un-halting rise, and the need to control it. It had already touched a 15-year high, and was only 4% away from it’s all-time low. With rhetorical intervention and its easy monetary policy failing to sway investors, the Bank of Japan sold an estimated $20 Billion worth of Yen on the open market.

BOJ Japanese Yen Intervention September 2010 

By no coincidence, the intervention was carried out only one day after a Parliamentary vote to see whether Naoto Kan would be replaced as Prime Minister. Having defeated Ichiro Ozawa and survived the challenge, Kan evidently was determined to make good on his promise to rescue the economy from the brink of another downturn. (Only a few days earlier, he admitted, “We’re conducting various talks, so other countries won’t say negative things when Japan acts. We’re studying now various scenarios, examining possible responses from markets when we take a decisive measure.”)

Reaction to the intervention has been mixed. On the one hand, the fact that the BOJ waited so long before stepping in is evidence that this measure was taken out of desperation. According to Billionaire investor George Soros, “Japan was right to act to bring down the value of the yen. ‘Certainly, they are hurting because the currency is too strong so I think they are right to intervene.’ ” Politicians and policymakers, on the other hand, were not so kind. One US Senator called the move “disturbing” and Jeane-Claude Trichet, President of the ECB, said it was “not…appropriate.”

From these snippets, then, it’s clear that the intervention is being conducted unilaterally and lacks any support from other Central Banks. Thus, if the BOJ is to continue selling the Yen, it will do so alone and perhaps even under the open contempt of other Central Banks. At the same time, it appears to have some credibility with investors, who may back off the Yen for the time being. That’s because the BOJ is trying to make owning the Yen as unattractive as possible, by driving down interest rates and attempting to spur inflation. Whether investors will take the hint and stop and return to using the Yen as a funding currency for the carry trade is still unclear. (Despite unraveling significantly over the last two years, the Yen carry trade may still exceed $500 Billion). Japan also has to contend with China, which has been putting upward pressure on the Yen by buying Japanese bonds.

For that matter, it’s not even clear whether the BOJ will continue to intervene. Perhaps it just wanted to send a message to investors by showing that it can weaken the Yen any time it wants. Besides, a protracted campaign to hold down the Yen would be expensive and doomed to failure over the long-term, as the BOJ learned the hard way in 2003-2004 and has probably been reminded of by the Swiss National Bank’s recent failure to weaken the Franc. On the other hand, the BOJ needs to show investors that it is serious, and a “shock and awe” intervention campaign is probably the only real way to achieve this.

Either way, I think it’s fair to say that those who bet on the Yen do so at their own peril. While I don’t think the Yen is suddenly going to return to 100 JPY/USD, the fact that my personal reserves are not nearly as vast as those of the Bank of Japan means I’m not inclined to bet on it…

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

The Trend is Your Friend

Sep. 11th 2010

Raise your hand if you’ve ever heard that expression before? Well, now there’s proof that this well-worn phrase is more than just a pointless platitude: “Royal Bank of Scotland Group indexes that track the performance of four of the most popular currency strategies show that the so-called trend style was the best-performing method, returning 7.3 percent this year through August.”

“Trend-Style” trading is also known as trend-following, and is just as it sounds. Traders identify one-way patterns in specific currency pair(s), and attempt to ride them for as long as possible. Given all of the big movements in currency markets this year, it’s no wonder that trend-following is the most popular. If you look at the 52 week trading ranges for the six most popular USD currency pairs, you can see that highs and lows are often as far as 20% apart. The EUR/USD pair, for example, fell 20% over a mere 7 months. Anyone who sold in December 2009 and bought to cover in June 2010 would have earned an annualized return of 35% without leverage! Even if you had captured only a couple months of depreciation would have yielded impressive returns. In addition, you could have traded the Euro back up from June until August and reaped a 60% annualized return. Best of all, both of these trends (down, then up) unfolded very smoothly, with only minor corrections along the way.

The Trend is Your Friend- USD/EURI’m sure serious technical analysts are rolling their eyes at the chart above, but the point stands that trend-following has never been easier and rarely more profitable than it is now. One fund manager summarized, “Trend-following investors are capturing the momentum in several big currency moves. You have so much uncertainty in the world now with regard to inflation or deflation, which typically makes currency markets and interest rates move. That is good for trend followers as it causes volatility, which typically creates good profits.” In other words, there is a tremendous amount happening in forex markets at the moment, and this is reflected in protracted, deep moves in currency pairs, which can change direction without notice and yet continue moving the opposite way for just as long. If you think this sounds obvious, look at historical data (5-10 years) for the majority of currency pairs: while trends have always been abundant, it was only recently that they began to last longer and became more pronounced.

The other three strategies surveyed by the Royal Scotland Group (“RSG”) were the Carry Trade, Value Trade, and Volatility Trade. Unfortunately, data was only offered for the carry trade strategy (confusingly referred to by RSG as the volatility strategy), which is down 5.9% in the year-to-date. The carry trade strategy involves selling a currency with a low yield and favor of one with a high yield, and profiting from the interest rate spread. In order for this strategy to be profitable, however, the long currency must either appreciate or remain constant. Thus, when volatility is high – as it has been over the last 2-3 years – this is a losing strategy.

We can only guess that a true volatility strategy probably would have been the second most profitable strategy. This strategy can be implemented through the use of long and short spot positions, as well as through trading in options and other derivatives. As I said, there is no shortage of volatility at the moment: “Since the collapse of Lehman Brothers in 2008, the dollar has seen record volatility against the euro…including six moves of at least 10%.” For traders that profit from volatility, the current uncertainty has created a windfall situation.

Volatility 2006-2010

However, it has made value trading – based on fundamentals and the notion of Purchasing Power Parity (PPP) – risky and unpopular: “The volatility also has made what would appear to be a straightforward bet against the dollar fraught with risk. Three factors tend to move currencies: the pace of growth, debt levels and interest rates. By those standards, the dollar should be falling against the currencies of emerging-market and commodity-producing nations.” Not only is this not the case (a decline in risk appetite has turned the Dollar into a safe-haven), but even betting on a protracted Dollar decline is itself risky because of surging volatility. One way around this is to trade a Dollar Index (by way of an ETF, for example) which is inherently less volatile (half as volatile, to be exact) than individual currency pairs.

That’s not to say that value trading isn’t profitable over the long-term. “Empirical evidence suggests that currencies…show a tendency to revert back toward PPP in the longer run.” Given current volatility/uncertainty, however, this strategy is unlikely to be profitable in the short run. Fortunately, uncertainty doesn’t negate opportunity, and traders should plot strategy accordingly.

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Posted by Adam Kritzer | in Investing & Trading, News | 2 Comments »

Swiss Franc Touches Record High, Nears Parity

Sep. 9th 2010

In the year-to-date, the Swiss Franc has risen 3% against the Dollar, 15% against the Euro, and more than 5% on a trade-weighted basis. It recently touched a record low against the Euro, and is closing in on parity with the USD. Since the beginning of the summer, the Franc has rallied by an unbelievable 15% against the Greenback. I don’t think I’m alone in scratching my head in bewilderment wondering, What could possibly be behind the Franc’s rise?

CHF USD Chart

By this point, everyone is familiar with the safe-haven phenomenon. Basically, concerns of a double-dip recession have ignited a flare-up in risk aversion and spurred investors to shift capital into locales and investment vehicles that are perceived as less risky. Switzerland and by extension the Swiss Franc, have both benefited from this phenomenon: “Anxious investors searching for a haven from fears about the health of Europe’s banks, which knocked equities and sent peripheral eurozone government bond spreads higher, dumped the single currency. The Swiss franc benefited.” Enough said.

At the same time, the Dollar and Japanese Yen are also considered safe-haven currencies, and as you can see from the chart below, the three have hardly traded in lockstep. In other words, there must be something distinguishing the Franc. Economists point to a strong economy: “Gross domestic product rose 0.9 percent from the first quarter, when it increased 1 percent. ‘The underlying economics of Switzerland are very, very healthy. Concerns about deflation have subsided.’ ” The consensus is that the Swiss economy will expand by close to 2% on the year. However, this is hardly impressive, especially compared to other industrialized countries. In addition, Swiss interest rates remain low, which means the opportunity cost of holding the Franc is high. There must be something else going on.

CHF USD EUR JPY 2010
In fact, it looks like the Swiss Franc’s rise is kind of self-fulfilling. For most of 2009, the Swiss National Bank (SNB) spent nearly $200 Billion to artificially hold down the value of the Franc. During this period, the Franc remained stable against the Euro and depreciated against the Dollar and Yen. Having finally broken through the “line in the sand” of €1.50, however, the Franc is now appreciating rapidly. Why? Because the SNB no longer has any credibility. It lost $15 Billion (due to the Euro depreciation) trying to defend the Franc, and in hindsight, the mission was a complete waste of time. As a result, a fresh round of intervention is out of the question. The currency markets have also dismissed the possibility of new intervention, and it seems they are punishing the SNB (via the Franc) for even trying.

According to analysts, the markets have also come to see the Franc as a reincarnation of the Deutschmark, due to its “strong economy, massive foreign reserves, traditional haven status and close links with the German economy.” Those that fear a Eurozone collapse and/or want to make exclusive bets on Germany are now using the Franc as a proxy. I don’t personally understand the logic behind this strategy, but where perception is reality, it’s more important to understand that other investors see the connection rather than seeing the connection for oneself.

Going forward, there is mixed sentiment surrounding the Franc. One analyst warned clients, “I would be cautious about chasing it too far in the short term. There’s still a huge number of headwinds out there.” According to another analyst, “We expect the franc to remain strong throughout the decade.” Personally, I’m inclined to side with the former point of view. From a fundamental standpoint, there isn’t a whole lot to keep the Franc moving up and its recent surge is probably running on fumes. At the very least, I would expect a correction in the near-term.

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

CFTC Passes New Retail Forex Guidelines

Sep. 7th 2010

I have been covering the US Commodity Future Trading Commission’s (CFTC) efforts to revamp the regulatory structure that governs forex, since it was unveiled earlier this year. On August 30, the CFTC formally published the “final regulations concerning off-exchange retail foreign currency transactions. The rules implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act and the Food, Conservation, and Energy Act of 2008, which, together, provide the CFTC with broad authority to register and regulate entities wishing to serve as counterparties to, or to intermediate, retail foreign exchange (forex) transactions.”

Not only has the CFTC clearly established its authority to be the primary regulator of retail forex, but it has also laid out specific regulations. Chief among them is limiting leverage to 50:1 for major currency pairs, and 20:1 for “other retail forex transactions.” [It’s not presently clear which specific currency pairs will be classified as major].  Remember that the original proposal (which, along with my endorsement, generated vehement protest) called for a decline in leverage to 10:1. Due to negative feedback from traders and brokerages, which ascribed malicious political motives to the changes and argued that it would move the entire industry offshore, the CFTC backed down and implemented only a modest decline in leverage. However, it’s important to note that the National Futures Association (NFA) as well as individual brokers will have discretionary power in setting leverage limits lower than 50:1. There will undoubtedly still be some opposition from traders, but I think we can all agree that the new rule represents a fair compromise.

As for the claim that traders would/will move their accounts offshore, this will become largely moot, since all brokerages, regardless of nationality, will be required to register with the CFTC and subject to its rules/oversight. Of course, those traders that are so inclined will still find a way to circumvent the rules by shifting funds “illegally” to unregistered brokers, but they do so at their own risk and will have no recourse in the event of fraud. As Forbes noted, “It seems these new rules will put a stop to Americans trading retail forex offshore to evade CFTC rules. That trend picked up the pace in recent years and it may need to be reversed quickly.”

Brokerages must register as either futures commission merchants (FCMs) or retail foreign exchange dealers (RFEDs).  These institutions will be required to “maintain net capital of $20 million plus 5 percent of the amount, if any, by which liabilities to retail forex customers exceed $10 million.” While this rule will raise the barriers to entry for potential forex start-up brokerages, it will protect consumers against broker bankruptcy. In addition, “Persons who solicit orders, exercise discretionary trading authority or operate pools with respect to retail forex also will be required to register, either as introducing brokers, commodity trading advisors, commodity pool operators (as appropriate) or as associated persons of such entities.”

One final rule change worth noting is quite interesting: brokerages must “disclose on a quarterly basis the percentage of non-discretionary accounts that realized a profit and to keep and make available records of that calculation.” This calculation will be useful both in and of itself, and also in identifying any significant discrepancies between competing brokers. For the first time, we will be able to see whether forex trading is currently profitable (i.e. whether those that profit are in the majority or minority) and whether/how this profitability metric changes over time, in response to particular market conditions.

The new rules go into effect on October 18.

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Posted by Adam Kritzer | in Commentary, News | 4 Comments »

Australia Dollar Ebbs and Flows with Risk

Sep. 5th 2010

If you chart the course of the Australian Dollar over the last twelve months alongside the S&P 500, the overlap is jarring. You can see from the chart below that the two lines zig and zag in almost perfect unison. It would seem that there was a slight break in the second quarter of 2010, but even this is an illusion, since the Aussie and the S&P continued to rise and fall in the same patterns over that time period, differing only in degree of fluctuation.

Australian Dollar Versus S&P 500: 2009-2010
Since the S&P 500 is a pretty good proxy for risk it can be said that the Australian Dollar is a manifestation of investor risk appetite. When risk aversion was high, the S&P and the Aussie were low. When risk tolerance picked up, they rose. It’s funny how this came to be. It is probably best seen as a vestige from the credit crisis, whereby investors evenly divided assets into two classes: risky and safe. When you look at the performance of the Australian Dollar, it is pretty clear as to which side of the dividing line it was placed.

This is probably fair, since the Australian Dollar is a growth currency. According to the just-released Bank of International Settlements (BIS) Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity, the Australian Dollar is now the world’s fifth most traded currency (behind only the G4: Dollar, Euro, Yen, & Pound), having usurped that position from the Swiss Franc. In 2010, it accounted for 7.6% (out of a total of 200%) of all trading volume, primarily as a result of trading in the USD/AUD currency pair, which was the fourth most popular in forex.

Investors have come to see the Australian Dollar in somewhat contradictory terms. It is both stable and liquid, but its economy is unpredictable and inflation is usually above average. The current economic situation was strong, with GDP growth projected to exceed 3% in 2010. Its benchmark interest rate (4.5%) is the highest in the industrialized world, and may touch 5% before the year is over. On the other hand, its political situation is currently uncertain, thanks to an election that produced a hung Parliament and the recent resignation of its Prime Minster. In addition, while its trade balance is currently in surplus, it fell in July thanks to decreased demand from China. Analysts wonder whether it isn’t entirely dependent on China (directly via exports and indirectly via high commodity prices) to generate positive GDP growth.

Australia Balance of Trade - 2009- July 2010
Ultimately, investors don’t care about any of this. They care only whether the global economy is stable and whether another financial/credit/economic crisis is likely to occur. Even though any such crisis will probably spare Australia, the Aussie is punished by even the whiff of crisis because Australia is perceived as being riskier to invest than the US, for example. “The Australian dollar is going to stay heavy. Markets don’t like uncertainty,” summarized JP Morgan.

Sadly, it’s currently not worth parsing the nuances of trade statistics and monetary policy, because it has no bearing on the Aussie, though at least this makes my job easier. For the time being, the Australian Dollar will tick up if it looks like the global economy (principally the US) will avoid a double-dip recession. Otherwise, it is in for the same rough stretch as the S&P.

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Posted by Adam Kritzer | in Australian Dollar, Economic Indicators, News | 1 Comment »

Trading In Emerging/Exotic Currencies Increases

Sep. 2nd 2010

The long wait is over! The Bank of International Settlements (BIS) has just released the results from its Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity, conducted in April 2010. The report contains a veritable treasure trove of data, perhaps enough to keep analysts busy until the next report is released in 2013. [Chart below courtesy of WSJ].

Daily Turnover in Forex Markets

First, the data confirmed earlier reports that average daily forex volume had surged to a record level in 2010: “Global foreign exchange market turnover was 20% higher in April 2010 than in April 2007, with average daily turnover of $4.0 trillion compared to $3.3 trillion. The increase was driven by the 48% growth in turnover of spot transactions, which represent 37% of foreign exchange market turnover. The increase in turnover of other foreign exchange instruments [consisting mainly of swaps and accounting for the majority of forex trading activity] was more modest at 7%.” In addition, for the first time, investors and financial institutions accounted for a larger share of turnover than banks, whose trading activity has remained roughly unchanged since 2004.

The composition of the turnover actually didn’t change from 2007, interrupting a shift which had been taking place over the previous 10 years. Specifically, the share of overall turnover accounted for by the so-called major currencies actually increased in 2010, from 172% to 175%. [Since there are two currencies in every transaction, total volume sums to 200%]. Growth in the G4 currencies (Dollar, Euro, Pound, Yen) was more modest, however, increasing from 154% to 155%. This reversal is probably attributable to the credit crisis, which drove (and in fact, continues to drive) investors out of emerging market currencies and back into safe haven currencies, namely the Dollar, Yen, and Pound. However, this theory is belied by the significant increase in Euro trading activity, which certainly hasn’t benefited from the recent trend towards risk aversion.

Forex Composition, Major Currencies Versus Emerging Currencies

While emerging currencies as a group accounted for a smaller share of overall activity, certain individual currencies managed to increase their respective shares. The Singapore Dollar, Korean Won, New Turkish Lira, and Brazilian Real all fit into this category. Still other currencies, such as the Indonesian Rupiah and Malaysian Ringgit, also managed impressive gains but account for such a small share of volume as to be insignificant when looking at the overall the picture. Those who were expecting even bigger growth should remember that it’s ultimately a numbers game: the amount of Ringgit it outstanding is dwarfed by the number of Dollars, so any gains that the Ringgit can eke out are impressive. In addition, when you consider that the overall forex pie is also increasing, the nominal increase in volume for these small currencies was actually quite large.

Growth in Emerging Currencies Forex Volume
The ongoing search for yield in all corners of the financial markets is likely to bring some of the more obscure currencies into the fold. “In June, I began getting questions about Uruguay, Vietnam and others,” said Win Thin, senior currency strategist at Brown Brothers Harriman in New York…investors often asked Mr. Thin questions about less-familiar currencies such as the Ukrainian hryvnia and Romanian leu.” In the same article, however, Mr. Thin cautioned that interest in such currencies is still probably lower than in 2007-2008, for a good reason. “It’s not like the Group of 10, or even the more liquid emerging market currencies where, if you decide you’ve made a mistake, you can get out.”

Due to the lack of liquidity and higher spreads, these obscure currencies aren’t really suitable for trading. Of course there will be a handful of institutional and even retail investors that want to make long-term bets on these currencies. They tend to be more aware of the risk and less sensitive to the higher cost and lower convenience. The overwhelming majority of traders, however, churn their portfolios daily, if not hundreds of times per day. A 10pip spread on the USD/MXN (Dollar/Mexican Peso) would be considered too high, let alone a 50 pip spread on any transaction involving the Ukrainian hryvnia.

In short, the majors will account for the majority of trading volume for the foreseeable future, regardless of what happens to the Euro. At the same time, that won’t prevent a handful of selected emerging currencies, such as the Chinese Yuan, Indian Rupee, Brazilian Real, and Russian Ruble from increasing their share. As liquidity rises and spreads decline, volume will increase, and their rising importance will become self-fulfilling.

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Chinese Yuan has Hardly Budged

Aug. 31st 2010

The frequency of my reports on the Chinese Yuan is admittedly much higher than it used to be. Why? Call it disbelief. More than two months have passed since China revalued its currency, and after a rapid 1% appreciation, the RMB has actually fallen back. Today, it stands only .5% higher against the Dollar compared to June 18. On a trade-weighted basis, it is actually 2.3% lower. What is going on?!

Chinese Yuan Revaluation 2010

It can foremost be attributed to a disconnect between Chinese words and Chinese action. While The People’s Bank of China (PBOC) purportedly supports a stronger, flexible Yuan (“Adopting a more flexible exchange-rate regime serves China’s long-term interests as the benefits…far exceed the cost in reorganising industries and removing outdated capacities.”), in practice, it has prevented the currency from budging. On numerous occasions since supposedly allowing the RMB to appreciate, it has intervened in the forex markets through various shadow dealers to prevent this very outcome.

In fact, China has increased its purchases of South Korean and Japanese sovereign debt, ostensibly as part of its diversification strategy, but more likely to put upward pressure on those currencies. “Data from Japan’s Ministry of Finance show that China bought a net 1.73 trillion yen ($20.3 billion) of Japanese government bonds in the first half of this year, compared with a net sale of 5.9 billion yen ($69 million) a year earlier. That strong demand has been a key factor strengthening the yen in recent weeks.” This could have broad implications, since in the last quarter, China accumulated $81 Billion in new forex reserves, and seems intent on further diversifying out of US Dollar-denominated assets.

China Diversifies Forex Reserves
China’s general obstinacy towards in dealing with the Yuan is baffling to market observers, especially given the trade surplus of nearly $30 Billion in June, its largest since January of 2009. In fact, China can be seen moving backwards. It recently inaugurated a pilot program that will allow exporters to hold offshore accounts of foreign currency, which might be expected to relieve some of the upward pressure on both the Yuan and on China’s foreign exchange reserves: “If you don’t force firms to surrender their foreign-exchange proceeds, then they won’t be exchanged for renminbi, which is a source of appreciation pressure.” In this way, China can both limit speculative capital inflows (even by domestic investors) and inflation.

Foreign governments, led by the US, are still threatening action. Senators and Congressmen continue to harp on the issue (it is election season, after all), and are still threatening to slap a tariff on all Chinese imports. However, their efforts are being undermined by both the Department of Treasury (which refuses to label China a “currency manipulator”) and the Department of Commerce, which recently determined that the application of a broad-based tariff on all Chinese imports would violate its mandate.

I have always been cynical about China’s forex policy, on the basis that it is self-interested and disingenuous, and I think the fact that it remains pegged to the USD confirms that sentiment. In the end, China won’t bow to international pressure. It will only allow the Yuan to appreciate after it has determined that its economy won’t be negatively impacted, and even then, the pace will be glacial.

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Posted by Adam Kritzer | in Chinese Yuan (RMB), News | No Comments »

Emerging Market Currencies Flat in 2010

Aug. 29th 2010

The recovery that emerging markets (their economies and financial markets) have staged since the lows of 2008 is impressive. In most corners of the financial markets, all of the losses have been erased, and securities/currencies are trading only slightly below there pre-credit crisis levels. Even compared to twelve months ago, in 2009, the performance of emerging market currencies holds up well. In the year-to-date, however, most of these currencies have appreciated only slightly, thanks to a particularly weak month of August.

Emerging Market Currencies

The MSCI emerging market stock index is currently down 2.5% since the start of the year. You can see from the chart above that most emerging market currencies tend to track this index pretty closely, rising and falling on the same days as the index. Interestingly, emerging market stocks appear to be much more volatile than emerging market currencies. You can also see that while the Malaysian RInggit has started to separate itself from the pack, the others have moved in lockstep with each other and are all about even for the year.

On the other hand, emerging market debt – as proxied by the JP Morgan Emerging Market Bond Index (EMBI+) has been unbelievably strong. Prior to the slight correction in the last couple weeks, the index has risen a whopping 20% over the last twelve months. On the surface, this disconnect between stocks and bonds would seem to be an anomaly, or even a contradiction. After all, if investors are only lukewarm about emerging market currencies and stocks, what reason would there be for them to get so excited about bonds.

jp morgan embi+ 2010

If you drill a little deeper, however, it all starts to make sense. Due to a weak appetite for risk, 2010 has been a favorable year for bonds, at the expense of stocks. I would have assumed that poor risk appetite would also have helped G7 financial markets, at the expense of the emerging markets, but you can see from the chart below (which shows the MSCI emerging markets stock index closely tracking the S&P 500) that this simply isn’t the case. On the contrary, this same dynamic is playing out simultaneously in emerging markets. “Today, we are favoring emerging-market debt over emerging-market equities because the debt provides us with a better risk-adjusted return,” summarized one portfolio manager.

S&P 500 versus MSCI emerging markets 2010

When it comes to debt, emerging markets have actually outperformed G7 debt, in spite of the current risk-averse climate. “Funds investing in emerging-market local-currency debt have attracted $16.9 billion of net inflows so far, more than triple the record annual intake of $5 billion recorded in 2007.” The logical basis for this shift is surprisingly straightforward: “When we look at government debt, we’re always comparing and contrasting the yields versus the fundamentals. I just don’t know why you would want those low yields from a Treasury bond in the developed world when you can get much higher yields — and in our estimation, an improving economic story — in Indonesia, Malaysia or Brazil.”

In other words, why would you want to earn 2.65% from a country (US) whose national debt is close to 100% of GDP, when you could earn double or triple that rate from investing in the sovereign debt of countries whose Debt-to-GDP ratios are sustainable?!  In addition, when it comes to investing in debt, the lack of volatility in emerging market currencies can bee seen as a plus, since it prevents the interest rates from becoming diluted. To be fair, fundamentals don’t represent the whole story: “After 2008, you really have to take liquidity into consideration. Emerging markets are going to be some of the first to freeze up in a crisis.”
Government Bond Yields Inflation 2010
In fact, some analysts are already starting to question whether the markets haven’t gotten ahead of themselves in this regard, and that perhaps we are due for a big correction: “Come September, when trading resumes in earnest, we’ll find out if the cozy emerging markets world we have experienced over the past few months was summer laziness or strong conviction.” With vacations ending and traders set to return to their desks, we won’t have to wait long to find out.

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Posted by Linda Goin | in Emerging Currencies, News | 1 Comment »

“Risk-On, Risk-Off”

Aug. 26th 2010

It sounds like a play on words, based on the Karate Kid refrain, Wax-On Wax Off, and for all I know it was. Still, I rather like this characterization – coined by a research team at HSBC – of the markets current performance. Moreover, you’ll notice from the placement of that apostrophe that I’m not just talking about forex markets, but about the financial markets in general.

What we mean is that when risk appetite is high, credit markets and equities and high-yielding currencies tend to rally together. When risk appetite fades, “those assets fall and government bonds and safe-haven currencies, including the U.S. dollar, the Swiss franc and, in particular, the Japanese yen rally.” Data from Bloomberg News confirms this phenomenon: “The 120-day negative correlation between Intercontinental Exchange Inc.’s Dollar Index and the Standard & Poor’s 500 Index was at 42.4 percent today, and has been mostly above 40 percent since June 2009.”

Skeptics counter that this correlation is tautological. Anyone can point to a stock market rally and declare that “Risk is Back On.” In addition, it’s not wholly unsurprising that there are strong correlations between low-risk currencies and low-risk assets, and between high-risk currencies and high-risk assets. According to HSBC, however, this time is different.

US Dollar Versus S&P

For example, models suggest that the recent decline in volatility should have caused these relationships to break down. That they defied predictions and remained strong suggests that we have witnessed a significant paradigm shift. In the past, “Rising correlations are also tied to weak macroeconomic conditions.” At the moment, this could hardly be more true, with global economic growth flagging.

Statisticians love to teach the dictum, Correlation does not imply causation. Nonetheless, I think that in this case, I’d wager to say that the equity and credit/bond markets are driving forex, rather than the other way around. Consider as evidence that, “[Retail] Investors withdrew a staggering $33.12 billion from domestic stock market mutual funds in the first seven months of this year,” and shifted this capital into bonds. While this wouldn’t in itself be enough to drive the Dollar higher, it epitomizes the steady shifts that have been taking place in capital markets for nearly a year, broken only by the S&P/Euro rally in the spring (which now appears to have been an aberration).
Investors Shift Money from Stocks to Bonds
In fact, these shifts are once again creating shortages of Dollars: “This week, two banks bid at the European Central Bank’s weekly dollar liquidity providing auction – the first time there have been any bids since May – suggesting that they could not raise dollars in the market.” This suggests that demand for the Dollar could continue to grow.

Some analysts have suggested that the low-yielding US Dollar is already on its way to becoming a funding currency for carry traders, but I think this is wishful thinking. The HSBC report supports this conclusion, “A weakening of the ‘risk on-risk off’ paradigm is likely only once macro conditions are improved in a sustainable way…Currency performance will likely be tied to the ebb and flow of the perception of risk for some months to come.” In short, until there is solid proof that the global economy has emerged from recession (even if ironically it is the US which is leading the pack downward), the Dollar will probably remain strong.

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Posted by Adam Kritzer | in Investing & Trading, News, US Dollar | No Comments »

Pound Rally Runs out of Steam

Aug. 24th 2010

The rally in the Pound, which lifted it 10% from trough to peak, appears to be fizzling. The Pound is already down 3% in the last two weeks, and is trending downward. It now stands at a four-week low against the Dollar.

Looking back at the Pound’s two-month rise, it’s not hard to understand why it was unsustainable. You can see from the charts below that there was a strong correlation with the Euro and the S&P 500 over the same period of time. This suggests that the Pound rally was less a product of changing fundamentals and more due to a sudden decrease in risk aversion.

British Pound, Euro, S&P 500 Correlation

By no coincidence the rally in equities, the Euro, and a handful of other proxy vehicles for risk, all came to and end at the same time as the Pound. In a nutshell, the markets are back to focusing on fundamentals. Namely, the risk of a double-dip recession, combined with a lack of resolution in the Eurozone debt crisis is causing investors to think twice about making bets that entail any kind of risk.

In this regard, the Pound is especially vulnerable. On the economic front, the UK economy only grew by 1.1% in the second quarter, with economists predicting only modest growth for the year. According to an economist for the Bank of England, “It would be ‘foolish’ to rule out a renewed downturn.” Evidently, his bosses agree: “The Bank of England last week said growth will be weaker than it forecast in May, citing “continuing fiscal consolidation and the persistence of tight credit conditions.”According to a recent poll, almost half of British households are pessimistic about the country’s economic prospects in the near-term: “The proportion of pessimists is marginally lower than in July, but is higher than in any other month since March last year.”

Ironically, the efforts of the British government to curb spending and cut the deficit are perceived as making matters worse. Since these measures won’t be offset by lowered taxes, they will directly lead to lower economic growth. Given that both the Pound and UK bond prices are rising (implying an increased risk of default), I think this reinforces the point I made last week about the markets not caring at all in this economic climate about increasing national debt.

The icing on the cake is inflation. A British think-tank made headlines by predicting that the UK economy will emerge from recession next year, “But once recovery is under way, he thinks, then the Bank of England’s quantitative easing scheme, which pumped £200 billion into the economy in the wake of the credit crunch, will have terrible consequences.” Specifically, the think-tank is forecasting inflation of 10% and a benchmark interest rate of 10%.

British Pound September 2011 Futures
For now, this remains a distant prospect, and analysts are focusing on the fact that the economy will probably re-enter recession before it can officially exit from it. As for the Pound, forecasts are not optimistic: “Bears in a Bloomberg survey of strategists outnumber bulls 29 to 12, while TD Securities in Toronto, the most-accurate forecaster in the six quarters ended June 30, has the lowest estimate, predicting sterling will depreciate 15 percent versus the dollar by year-end.” According to the most recent Commitments of Traders report, institutional investors were still net long the Pound as of August 10. Futures prices, meanwhile, have moved in lockstep with spot prices, which suggests that futures traders are still waiting for more data before they weigh in on the Pound.

Personally, I’m having a tough time coming up with a prediction. I tend to agree with the characterization of “the foreign exchange markets post-crisis as a beauty parade with ugly contestants.” In other words, all of the major currencies are currently plagued by poor fundamentals. It’s hard to say that the Pound is in better or worse shape than the Dollar or the Euro. Still, given the way that markets have been trading, a return to (global) recession would not be kind to the Pound.

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Posted by Adam Kritzer | in British Pound, News | 1 Comment »

CAD: Steady as She Goes

Aug. 21st 2010

The Canadian Dollar was supposed to be one of the “hot” currencies of 2010. Given that it’s now exactly where it started the year, I think it’s safe to say that this isn’t the case. On the one hand, it would seem that the markets are still confused about how much the CAD should be worth, as Adam recently pointed out. An alternative interpretation is that investors believe the Loonie should trade near parity with the US Dollar; it has hovered just above that mark since breaching it in April.

CAD USD 1 Year
The Canadian Dollar has benefited from strong fundamentals, especially compared to the US. Inflation is low and the economy is stable. “The International Monetary Fund (IMF) recently said that Canada is likely to be the first of the seven major industrialized democracies to return to a budgetary surplus status by 2015.” 2010 GDP growth is projected at 3.3%, compared to around 2.5% in the US.

Canada-GDP-Growth-Rate-Chart-2006-2010

For this reason, “Pacific Investment Management Co. founder Bill Gross said he favors Canada…he’s ‘in awe’ of countries such as Canada that have a low debt-to-gross-domestic- product ratio and solvent financial institutions. ‘North of the border’ has become a ‘preferable destination’ to what he sees in the U.S.” As a result, analysts have started to look beyond commodities, historically seen as the cornerstone of Canada’s economy. When the price of oil collapsed in May, the Loonie hardly budged. Given that Canada’s balance of trade is negative in spite of its commodity exports, maybe in focus is justified.

CAD Versus Oil Prices 2010
The Loonie is also benefiting from a positive interest rate differential with the US. Thanks to two consecutive rate hikes by the Bank of Canada (BOC) – which was the first G7 Central bank to tighten – Canada’s benchmark rate now exceeds the Federal Funds Rate by .5%. If the BOC fulfills expectations and hikes rates again at its meeting on September 8, this differential will widen further. In fact, it could continue expanding well into 2011, since the BOC is well ahead of the Fed in its monetary policy cycle. Here, again, the contrast with the US is self-evident: “The Canadian central bank has been raising interest rates, and has signaled that it will continue to raise interest rates. And with the Fed’s decision today reaffirming its dovish position, the interest rate differential will continue to favor increasingly Canada, and higher interest rates in Canada will continue to favor Canadian dollar strength.”

Bank of Canada 2000-2010 Interest Rate Hike Forecast

Throughout the rest of the summer, the Loonie will likely remain rangebound. Most traders are on vacation and trading volume is low. Besides, risk appetite is currently weak. When the markets return to full swing in September, I expect the Loonie will experience in a surge in volatility. In fact, investors are already starting to adjust their positions, with the most recent Commitment of Traders report showing an increase in Net Longs, bringing the total to $4.2 Billion.

There is certainly a basis for predicting continued strength, but I think much depends on how commodity prices perform. As I pointed out above, the Loonie remains somewhat decoupled from commodities. That it nonetheless got a boost from strong wheat prices and the $40 Billion takeover bid for Potash Corp by mining giant BHP Biliton shows that investors still view Canada as a resource economy. If the global economy avoids a double-dip recession, commodities prices will probably recover and the Loonie will probably rise slowly towards parity. On the flip-side, the Loonie would be one of the big losers of a global slide back into recession.

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Posted by Linda Goin | in Canadian Dollar, News | 2 Comments »

Intervention Looms as Yen Closes in on Record High

Aug. 20th 2010

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

1y Yen Dollar Chart

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

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

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

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

China Passes Japan in GDP, 2005-2010

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

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

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

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Posted by Adam Kritzer | in Central Banks, Japanese Yen, News | 1 Comment »

US National Debt and the US Dollar

Aug. 18th 2010

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

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

US 10-Year Treasury Rate 1960-2010

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

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

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

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

US Dollar and US 10-Year Rate

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

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Posted by Adam Kritzer | in Central Banks, News, US Dollar | 3 Comments »

Safe Haven Trade Returns

Aug. 13th 2010

I shouldn’t have been so complacent in declaring the paradigm shift in forex markets, whereby risk aversion had given way to comparative growth and interest rate differentials. While such a shift might have been present – or even dominant – in forex markets over the last couple months, it appears to have once again been superseded by the so-called safe haven trade.

In hindsight, it wasn’t that the interplay between risk appetite and risk aversion had ceased to guide the forex markets, but rather that they had been deliberately been put on the backburner. In other words, it’s now obvious that investors have remained vigilant towards the possibility of another crisis and/or an increase in risk/volatility.

How do I know this is the case? This week, there was a major correction in the markets, as diminished growth prospects for the global economy led stocks down, and bonds and the Dollar up. If investors were truly focused on growth differentials, the Dollar would have declined, due to a poor prognosis for the US economy. Instead, investors bought the Dollar and the Yen because of their safe-haven appeal.

EUR-USD Versus S&P 500

What exactly was it that produced such a backlash in the markets, sending both the DJIA and the Euro down by 2% apiece in less than one trading session? First, the most recent jobs report confirmed that unemployment is not falling. Then, the Commerce Department released trade data which showed that the recovery in US exports has already leveled off. This sent economists scrambling to adjust their forecasts for 2010 GDP growth: “After downward revisions to other economic data like inventories and the export figures, even that 2.4 percent annual rate is now looking too rosy — and may even be as low as 1 percent.”

To top it all off, the meeting of the Fed Reserve Bank confirmed investors’ worst fears as the Fed warned of continued economic weakness and voted to further entrench its quantitative easing program. According to the official FOMC statement: “The pace of recovery in output and employment has slowed in recent months. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit…Bank lending has continued to contract….the pace of economic recovery is likely to be more modest in the near term than had been anticipated.”

The Fed also indicated slowing inflation, which set off a debate among economists about the once-unthinkable prospect of defaltion. While the consensus is that deflation remains unlikely, investors are no longer automatically inclined to give the Fed the benefit of the doubt: “The Fed’s determined effort to build up its inflation-fighting credibility over the past few decades may be working against it here.”

It was no wonder that the markets reacted the way they did! Cautious optimism has now given way to unbridled pessimism: “Given the uneven rebound in the United States, and now signs that the world’s other economic engines are slowing, economists say Americans may confront high unemployment and lackluster growth for some time to come.” Ironically, if such an outcome were to obtain, it could provide a boost for the Dollar, and even for the Yen.

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Posted by Adam Kritzer | in Economic Indicators, News, US Dollar | 1 Comment »

SNB Leads Downward Pressure on Euro

Aug. 12th 2010

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

euro USD 5 day chart
Earlier this week, Adam reported that China (via the institution that manages its foreign exchange reserves) was at least partially responsible for the Euro rally. If/when China desire to swap Dollars for Euros has been sated, the Euro rally could theoretically lose steam. At this point, it’s too early to call the end of the rally, since its steady appreciation has been marked by a handful of short-lived corrections. However, if this is indeed the start of a U-Turn, hindsight might show that it was inevitable that it would occur at this level.

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

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

EUR CHF 1 Year Chart

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

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

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

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

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Posted by Amy Cottrell | in Central Banks, Euro, News | 1 Comment »

China Currency Revaluation: More Than Just the Yuan at Stake

Aug. 9th 2010

I concluded my last post (Euro Recovery: Paradigm Shift Confirmed) by musing about how interesting it is that nobody has taken credit for predicting/profiting from the sudden reversal in forex markets, whereby the Euro has surged and the Dollar has tanked. Two days later, I think I can offer an explanation: China.

That’s right. The force behind the sudden sea change might not be private investors, which up until the spike entrenched itself as a full-fledged connection, remained firmly behind the declining Euro. Instead, it seems quite reasonable that China – via its sovereign wealth fund, which is charged with investing its foreign exchange reserves – might be the responsible party.

That China is buoying the Euro would make sense on a couple fronts. First of all, it would explain the mysterious silence behind the rally. China is naturally secretive in pretty much everything it does, especially in the way it conducts currency policy and manages its forex reserves. That China hasn’t even formally announced, let alone bragged about, “diversifying” its reserves, makes perfect sense.

More importantly, that China is responsible also makes sense from a strategic standpoint. China has long spoken about its intentions to change the allocation of its forex reserve holdings, and in hindsight, its timing was perfect. In the beginning of June, the Euro stood at a multi-year low, and the price of US Treasury Bonds stood at a multi-year high. Thus, China’s sovereign wealth fund was able to simultaneously lock in some profits from lending to the US and dissipate risk by swapping US assets for those denominated in Euros and Yen. “China has already bought $20 billion worth of yen financial assets this year, almost five times as much as it did in the previous five years combined.” [Analysts have noted that buying Yen also achieves the peripheral end of making Japanese exports less competitive relative to those from China].

Moreover, China can achieve this diversification without influencing the value of the Yuan, since Dollars can be exchanged directly for Yen and Euros. That is important, since the RMB is still effectively pegged to the Dollar. Speaking of which, the Yuan has hardly budged since its 1% revaluation in June. On a trade-weighted basis, it has actually fallen.

China's Current-Account Balance as a Share of GDP 2004-2015
Pressure continues to mount on China to allow the RMB to appreciate. As a result of the 1% nudge in June, speculative hot money is now flowing into China at an increasing rate, because investors are “thematically looking for ways that they can participate in the currency markets in China.” They are supported by the IMF, which most recently called on China to re-balance its economy away from exports and towards trade. Its report included predictions that China’s currency account / trade surplus will continue to rise, seemingly for as long as the RMB remains undervalued. Due to pressure from China, however, it removed precise figures on the recommended extent of said revaluation.

According to a consensus of analysts, China’s exports were probably lower in the month of July, which could give the Central Bank pause in allowing the RMB to rise too much too soon. Instead, it has announced that it will make a more sincere effort to tie the Yuan to a basket of currencies, rather than just the Dollar. ” ‘The yuan should be kept stable at a reasonable and balanced level overall, while it may have two-way moves against particular currencies,’ Hu [XiaoLian, Deputy Governor] said, adding that the composition of the central bank’s currency basket should be mainly based on trade weightings.”

USD CNY 3 Month Chart
Going forward, then, the Yuan will probably remain basically stable against the Dollar. As China moves towards a trade-weighted peg, however, it is conceivable that it will continue to buy Euros (and Yen, for spite) against the Dollar. As this could have a confounding effect on currency markets, traders should plan accordingly.

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Posted by Adam Kritzer | in Chinese Yuan (RMB), Euro, News | 5 Comments »

Euro Recovery: Paradigm Shift Confirmed

Aug. 7th 2010

In early July, when the Euro rally was (in hindsight) just getting under way, I reported on the apparent paradigm shift in forex markets, whereby risk-driven trades that benefited the Dollar were giving way to trades driven by fundamentals, which could conceivably favor the Euro. Since then, the Euro has continued to rally (bringing the total to 12% since the beginning of June), confirming the paradigm shift. Or so it would seem.

Euro fundamentals are indeed improving, with an improvement in the German IFO Index, which measures business sentiment, seen as a harbinger for recovery in the entire Eurozone economy. To be sure, Spain and Italy, two of the weakest members, registered positive growth in the most recent quarter. Contrast that with the situation across the Atlantic, where a growing body of analysts is calling for a double-dip recession with a side of deflation. The Fed has certainly embraced this possibility, and seems set to further entrench – if not expand – its quantitative easing program at its meeting next week.

eur USD 1 year chartAs a result, investors are rushing to reverse their short EUR/USD bets. What started as a minor correction – and inevitable backlash to the record short positions that had built up in April/May – has since turned into a flood. As a result, shorting the Dollar as part of a carry trade strategy is back in vogue. According to Pi Economics, “The dollar carry trade may now be worth more than $750bn, approaching the size of the yen carry trade at its peak in 2004-07.”

Naturally, all of the big banks were completely caught off guard, and are rushing to revise their forecasts, with UBS calling the Euro “exasperating” and HSBC comparing the USD/EUR to a “lunatic asylum.” An analyst at the Bank of New York summarized the frustration of Wall Street: ” ‘I’ll put my hands up on this—I have had a difficult time trying to call the market. The last time I remember it being this hard was in 2001 to 2002.’ ”

In this case, hindsight is 20/20, and if it wasn’t the stress tests that buoyed the Euro, it must be the acceptance that an outright sovereign default is unlikely. Personally, I’m not really sure what to think. There isn’t anyone who has come out to say I told you So, in the context of the Euro rally, which means it’s ultimately not clear who/what is driving it, and who is profting from it. In fact, you can recall that many hedge fund managers referred to shorting the Euro as the trade of the decade. It’s certainly possible that some of these investors took their profits from the Euro’s 20% depreciation in ran. It’s equally possible that investors are once again behaving irrationally.

The latter is supported by volatility levels which are gradually falling. Still, something smells fishy. A rally in the Euro only a few months after analysts were predicting its breakup is hard to fathom, even in these uncertain times. A columnist from the WSJ may have unwittingly hit the nail on the head, when he mused, “So, unless a European bank goes belly up or some other stink bomb explodes in the region’s debt markets, the old-fashioned relationship between [economic] data and currencies looks set to persist.”

To borrow his terminology, a stink bomb is probably inevitable. That’s not to say that investors aren’t focused on fundamentals; on the contrary, any stink bomb would probably directly harm the currency with which it is associated, rather than radiate through forex markets based on some convoluted sorting of risk . The only question is where the stink bomb will explode: the EU or the US?

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Posted by Adam Kritzer | in Euro, Investing & Trading, News, US Dollar | 4 Comments »

Fed Mulls Options for Next Week’s Meeting

Aug. 5th 2010

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

Cleveland Fed August 2010 Meeting Outcomes
In a nutshell, they will be watching for two things. The first is any changes in the statement released at the close of the meeting. According to James Bullard, President of the St. Louis Fed, “If any new ‘negative shocks’ roiled the economy, the Fed should alter its position that interest rates would remain exceptionally low for ‘an extended period.’ ” If the OMC determines that the prospects for continued economic recovery are good, and/or the inflation hawks get their way, we could see subtle – but meaningful – changes to statement.

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

Assets on the Federal Reserve's Balance Sheet

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

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

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

Dollar Index Spot 1-Year Chart 2010

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Interview with Roland Manarin: “Don’t Try to Beat the Market”

Aug. 3rd 2010

Today, we bring you an interview with Roland Manarin, founder of Manarin Investment Counsel and Manarin-On-Money. Below, he shares his thoughts on risk management and the EU Sovereign Debt Crisis, among other topics.

Read the rest of this entry »

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Japanese Yen: Intervention is Imminent?

Aug. 1st 2010

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

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

JPY USD 1 Year Chart 2010

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

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

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

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

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Boom Time for Forex

Jul. 30th 2010

It has been three years since the Bank of International Settlements’ last report on foreign exchange was released. Since then, analysts could only speculate about how the forex market has evolved and changed.

The wait is now over, thanks to a huge data release by the world’s Central Bank, which showed that daily trading volume currently averages $4.1 Trillion, a 28% jump since 2007. Trading in London accounted for 44% of the total, with the US – in a distant second – claiming nearly 19%. Japan and Australia accounted for 7% and 5%, respectively, with an assortment of other financial centers splitting the remainder.

This data is consistent with a recent survey of fund managers, which indicated a growing preference for investing in currencies: “Thirty-eight per cent of fund managers said they were likely to increase their allocations to foreign exchange, while 37 per cent named equities and 35 per cent commodities. Currency was most popular even though this was the asset class where managers felt risks had risen most over the past 12 months.” In short, the zenith of forex has yet to arrive.

There are a few of explanations for this growth. First, there are the inherent draws of trading forex: liquidity, simplicity, and convenience. Second, investors are in the process of diversifying their portfolios away from stocks and bonds, which have underperformed in the last few years (on a comparative historical basis). As investors brace for a long-term bear market in stocks and low yields on bonds for the near future (thanks to low interest rates), they are turning to forex, with its zero-sum nature and the implication of a permanent bull market. Additionally, programmatic trading and risk-based investing strategies are causing correlations in the other financial markets to converge to 1. While there are occasional correlations between certain currencies and other securities/commodities markets, the forex markets tend to trade independently, and hence, represent an excellent vehicle for increasing diversification in one’s portfolio.

There is also a more circumstantial explanation for the rapid growth in forex: the credit crisis. In the last two years, volatility in forex markets reached unprecedented levels, with most currencies falling (and then rising) by 20% or more. As a result, many fund managers were quite active in adjusting their portfolios to reduce their exposure to volatile currencies: “The volume growth was really a result of the volatility and the fact that you had real end users actively hedging their exposures.” Another contingent of “event-driven” investors moved to increase their exposure to forex, as the volatility simultaneously increased opportunities to profit. Moreover, these adjustments were not executed once. With a succession of mini-crises in 2009 and 2010 (Dubai debt crisis, EU sovereign debt crisis) and the possibility of even larger crises in the near future, investors have had to monitor and rejigger their portfolios on a sometimes daily basis: “If you have a big piece of news, such as the Greek debt crisis, there’s more incentive to change your position,” summarized one strategist.

What are the implications of this explosion? It’s difficult to say since there is a chicken-and-egg interplay between the growth in the forex market and volatility in currencies. [In theory, it should be that greater liquidity should reduce volatility, but if we learned anything from 2008, it is that the opposite can also be the case]. As I wrote last week, I think it means that volatility will probably remain high. Investors will continue to adjust their exposure for hedging purposes, and traders will churn their portfolios in the search for quick profits.

It will also make it more difficult for amateur traders to turn profits trading forex. There are now millions of professional eyes and computers, trained on even the most obscure currencies. As if it needed to be said, forex is no longer an alternative asset.

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How About Those Stress Tests…

Jul. 27th 2010

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

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

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

Euro Dollar 3 month chart
On Monday, the tests were finally conducted: “EU regulators scrutinized 91 of the bloc’s banks to assess whether they have enough capital to withstand a recession and sovereign-debt crisis, with a Tier 1 capital ratio of 6 percent as a floor. Regulators tested portfolios of sovereign five-year bonds, assuming a loss of 23.1 percent on Greek debt, 12.3 percent on Spanish bonds, 14 percent on Portuguese bonds and 4.7 percent on German state debt.” Officially, only 7 banks failed the tests – 5 in Spain, 1 in Germany, 1 in Greece – with a combined capital shortfall of €3.5 Billion.

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

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

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

3-month EURO LIBOR 2006-2010
In fact, that test could come quite soon, as the ECB continues to recall the hundreds of Billions of Euros in loans that it made to commercial banks. If LIBOR rates remain steady and the markets remain liquid, then the stress tests can be called a success. If private investors balk and/or the ECB is forced to extend its lending program, however, the tests will be seen in hindsight as a waste of time.

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Forex Volatility to Remain High

Jul. 24th 2010

With the onset of the Eurozone sovereign debt crisis this year, volatility levels in forex (as well as in other financial markets), surged to levels not seen since the height of the credit crisis. While volatility has subsided slightly over the last few months, it still remains above its average for the year, and significantly above levels of the last five years.

The spike in volatility was easy enough to understand. Basically, the possibility of a default by a member of the EU or even worse, a breakup of the Euro created massive uncertainty in the markets, spurring the flow of capital from regions and assets perceived as risky to those perceived as safe havens. As you can see from the chart below, this trend has begun to reverse itself, but still remains prone to sudden spikes.

5 Year Forex Currency Volatility Chart
While the crisis in the EU seems to have (temporarily) settled, investors are attuned to the possibility that it could flare up again at any moment. A failed bond issue, a higher-than-forecast budget deficit, political stalemate, labor strikes – all signal a failure to resolve the crisis, and would surely trigger a renewed upswing in volatility and sell-off in risky assets.

The same goes for (unforeseen) crises in other regions, affecting other currencies. Muses one analyst: “Next week? Who knows. One strong candidate is for flight out of the yen as investors start to fear there won’t be enough domestic demand for mountains of Japanese debt and foreign buyers will insist on much higher yields. Another might be that Swiss banking exposure to insolvent east European households causes another banking crisis.” Don’t forget about the UK and US, both of which have hardly put the recession behind them, and whose Trillions in debt represent powder kegs waiting to explode.

It will be months or years before these latent crises even begin to manifest themselves, let alone achieve some kind of resolution. As a result, many analysts predict that volatility will remain high for the foreseeable future: “Big and sudden currency market moves shouldn’t come as a surprise, whatever the direction…Higher market volatility should follow on from greater macroeconomic volatility. Increased economic fluctuations increase uncertainty. And there’s no question macroeconomic volatility has risen.”

In addition, there is no way for governments for Central Banks to alleviate these crises due to the “Trillema of International Finance.” Greg Mankiw, Harvard Economics Professors, explains that in prioritizing an independent monetary policy and open capital markets have forced many countries to forgo exchange rate stability: “Any American can easily invest abroad…and foreigners are free to buy stocks and bonds on domestic exchanges. Moreover, the Federal Reserve sets monetary policy to try to maintain full employment and price stability. But a result of this decision is volatility in the value of the dollar in foreign exchange markets.” While the Euro has eliminated exchange rate fluctuations between members of the Eurozone, meanwhile, there is nothing that the ECB can (or desires to) do to minimize volatility between the Euro and outside currencies.

From the standpoint of forex strategy, there are a couple of lessons that can be learned. First of all, the carry trade will remain underground until volatility returns to more attractive levels. Until then, the potential gains from earning a positive yield spread will be offset by the possibility of sudden, irascible currency depreciation. Second, growth currencies – despite boasting strong fundamentals – will remain vulnerable to sudden declines. That doesn’t mean that they should be avoided; rather, you should simply be aware that small corrections could easily turn into multi-month weakness.

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Emerging Markets Continue to Shine

Jul. 21st 2010

After a slight respite following the culmination of the Eurozone debt crisis, emerging markets financial markets are back to the their former selves, with stocks, bonds, and currencies all performing well.

The rally is being driven by two principal factors. First, investors came to the gradual realization that the trend towards risk aversion had reached extreme proportions. Given that the crisis in the EU has been fairly limited both in scope and extent (at least so far), it made little sense to punish emerging markets. If anything, emerging markets should have been the financial safe havens: “Debt-to-GDP ratios in the developed world are about double those in emerging markets, and they’re growing. This makes emerging markets interesting because you’re picking up incremental spread and in return you’re actually taking less macroeconomic risk.”

Other analysts see a certain futility in targeting a risk-averse strategy: “It’s not that people suddenly think emerging markets are a lot safer, it’s that they’re realising risk is everywhere and they can’t just assume the developed world is safe.” In other words, some investors are wondering whether it doesn’t make sense to focus less on risk – which  has become increasingly random – and more on return. In this aspect, emerging market investments of all kinds are more attractive than their counterparts in the developed world.

The second source of momentum for the rally is a long-term shift in capital allocation. Thanks to foreign demand, Emerging Market “borrowers, including governments and companies, have raised almost $300bn (£200bn) to date, up 10 per cent on the same period in 2009.” A microcosm of this surge can be seen in US mutual funds: “Emerging market equity funds…posted combined inflows of more than $3 billion for the week ended July 14, while emerging market bond funds took in $745 million, bringing their year-to-date inflows to an all-time high of $18.5 billion.”

Across all sectors, money is pouring into emerging markets at an even faster pace than before the credit crisis. This time around, however, analysts argue that it is justified by fundamentals: “Economies in the developing world are slated to grow 6.3% this year and are expected to maintain a similar growth rate through 2013, according to the International Monetary Fund. Advanced economies are seen expanding around 2.4% annually over the same time period.” The Brazilian economy alone expanded at an annualized rate of 9% in 2010 Q1, the fastest rate in 15 years!

Emerging market investors share the confidence of foreign investors, and it seems the flow of funds will primarily be one-way. According to a recent survey, “Just 19 per cent of Brazilians, 15 per cent of Indians and 11 per cent of Chinese…said they anticipated increasing cross-border investment.”

MSCI Emerging Markets Index 2006-2010
At this point, the only thing that could derail emerging markets is if investors get too ahead of themselves. According to Citigroup, “Developing-nation shares will rally 20 percent to 25 percent by the end of this year as the world economy avoids a double-dip recession and attractive valuations lure investors.” That would bring share prices past the current level and dangerously close to the pre-credit crisis highs of 2008. The JP Morgan Emerging Market Bond Index (EMBI+) has already shattered its previous record, and given the current spread of only 300 basis points to US Treasuries (which themselves are trading near all-time lows), one has to wonder if investors aren’t at risk of re-entering bubble territory.

JP Morgan EMBI+ July 2010
If for whatever reason investors get spooked, it could spark the same capital flight that followed the bankruptcy of Lehman Brothers, in which emerging market and commodity currencies alike fell 30-50% over a duration of mere months. While no one is predicting a similar outcome this time around, I think prudence and caution are nonetheless advisable.

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Reflecting on the Chinese Yuan Revaluation

Jul. 19th 2010

Today marks the one-month anniversary of China’s decision to remove the Yuan’s peg to the Dollar, and allow it to float. Now that the news has had a chance to wend its way through the financial markets, I think it’s time both to reflect and to forecast.

Over the last month, the Chinese RMB has appreciated by slightly less than 1% against the Dollar, although most of that jump took place in the day that followed the June 19 announcement. After the initial excitement faded, a sense of disappointment set in as it became clear that China had no intention of allowing the RMB to appreciate rapidly: “The subsequent appreciation of the yuan against the dollar is likely to be small, perhaps just a few percent over the remainder of the year.” In fact, futures prices reflect only an additional 1.5% appreciation over the next 12 months.

RMB USD June 2011 Futures

Due both to its slow speed and small scope, the revaluation could conceivably benefit the Chinese economy. That’s because in the short-term, a more expensive currency will mean higher prices paid for exports. The quantity of exports is unlikely to decline, such that total export revenues could actually increase. According to one analyst, “With Chinese imports, there are no substitutes in the short term. Maybe in 10 years, importers will have a choice, but right now they will just have to pay more. No other country…can build a manufacturing base and all the infrastructure that you need — transportation, energy, the entire value chain to the final good — takes many years.” As if on cue, China’s trade surplus expanded in June, in spite of the revaluation of the Yuan.

China Trade Balance 2004-2010

As a result, American manufacturers and other vested interests have announced that they will continue to lobbythe US government to pressure China on the currency issue, on the basis that the undervalued RMB is eroding both the US economy and the labor market. Argued the director of the Peterson Institute for International Economics, “The case for a substantial increase in the value of the renminbi is thus clear and overwhelming. An appreciation of 25% to 40% is needed to cut China’s global [account] surplus even to 3% to 4% of its GDP. This realignment would produce a reduction of $100 billion to $150 billion in the annual U.S. current account deficit.” It might also help to restore the estimated 1.4 million jobsthat have been lost due to China’s forex policy. According to analysts, however, political infighting make it unlikely that any new law or punitive tariffs will be imposed anytime soon.

At the very least, China will continue to make the Yuan more flexible, so that one day it can float freely. It has already moved to facilitate trade settlement in Yuan, and analysts expect ” ‘more than half of China’s total trade flows, primarily bilateral trade with emerging markets, to be settled in renminbi in the next three to five years.’ ” China is also making it more attractive for foreign investors to hold Yuan, by loosening controls that govern Chinese capital markets and creating new investment vehicles that will cater directly to foreigners. In the mean time, holding RMB is pretty unattractive given both “the hassle of getting money in and out of China” and the low rates offered by Chinese money market funds.

USD CNY 5 year chart

As for the impact on the rest of the forex market, I think that commodity currencies and growth currencies could come out ahead. The move signals an implicit confidence in the global economic recovery and can perhaps be seen as a harbinger for high commodity prices: In addition, it will “provide a boostto U.S. exports, employment, earnings and growth, reinforcing the case for growth sustainability at a time when investors are more fearful than they were in April.” The US Dollar, on the other hand, could emerge as one of the big losers. Already, China’s forex reserve growth has slowed to the weakest pace in 11 years. This trend will probably continue, since smaller purchases of Dollars will be required to maintain the floating peg. In fact, the Euro’s recovery against the Dollar has coincided mysteriously with the revaluation of the Yuan. While this is probably just a coincidence, it is nonetheless symptomatic of a declining role for the Dollar as the world’s reserve currency. But that is a topic for another day…

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Euro Rally: Temporary or Permanent?

Jul. 17th 2010

Since the beginning of June, the Euro has rallied by an impressive 8% against the US Dollar, and by comparable margins against other currencies. The question on every one’s minds, of course, is whether this represents a temporary pullback or a permanent correction.

EUR USD 3 months 2010
The arguments in favor of the former are pretty strong. Namely, EUR/USD bearish sentiment had expanded to such an extreme level that a pullback – temporary or permanent – was basically inevitable. From this standpoint, what we have seen unfold over the last month-and-a-half is a classic short squeeze. Basically, those who were short the Euro were forced to cover their positions when it started to rally, which in turn triggered more selling, and ultimately, a self-fulfilling rally. As a result, “The difference in the number of wagers by hedge funds and other large speculators on a decline in the euro compared with those on a gain dropped to 38,909 on July 6, compared with record net shorts of 113,890 on May 11.”

Due to its sudden rise, the Euro became a much less attractive funding currency for carry traders. It helps that other Central Banks are delaying interest rate hikes, which means it’s difficult to turn a solid profit (on a risk-adjusted basis) from shorting the Euro. In addition, the markets have started to turn their attention to economic fundamentals in the US, which had been edging out the Euro in one of the perennially important rivalries in currency markets. In short, it suddenly became obvious to traders that the economic and fiscal conditions in the US are at best equal to those in the EU.

Finally, there was an implicit acknowledgement among the EU leadership that the so-called sovereign debt crisis is actually in many ways a banking crisis. This admission came in the form of stress-tests on 91 of the EU’s largest banks, designed to determine their exposure to sovereign debt and placate investors. After all,  “It was German and French banks that led the way in lending to Greece or Spain.” This misjudgement has spurred such banks to set aside Billions in potential losses and vastly curtail their lending activities.

Unfortunately, investors are skeptical that the stress tests will be stringent enough, seeing them as a mere publicity stunt: “While the EU have tried to counter these suspicions by promising to publish the result of stress tests, the market is fearful that stress tests will force some banks into writing down losses on non-performing loans.” By extension, investors are still equally concerned about the possibility of a sovereign debt default, even one that it is only partial.

In other words, the consensus is that despite the EU’s best efforts to tackle the crisis, it still has yet to enact meaningful structural reforms, opting instead for short-term stopgap solutions. According to The Economist, “The debate about how to save Europe’s single currency from disintegration is stuck…because the euro zone’s dominant powers, France and Germany, agree on the need for greater harmonisation within the euro zone, but disagree about what to harmonise.” There remains a lack of agreement over whether the economically and fiscally weaker members of the EU will be allowed to remain members, and if so, what if anything will be done to keep them in line.

EU Public Debt

As you can see from the chart above, time is quickly running out. For the majority of EU countries, debt is now rising faster than GDP. From the standpoint of many investors, default seems like the most likely outcome since such countries lack the political muster to reduce their budget deficits, nor can they devalue their debt  through currency depreciation, due to the common currency.

Thus, the consensus (for now) is that the Euro’s run will soon come to an end. According to Citigroup, “The euro will resume its decline and head toward the $1.10-$1.15 range. ‘The market has digested a lot of the bad news about the euro. There’s no great optimism.’ ” Meanwhile, BNP Paribas “expects the euro to fall to parity by the end of 2010—one euro per dollar—a level it hasn’t seen since December 2002…[and] drift to 97 cents before hitting bottom in the third quarter of 2011.”

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Japanese Yen and the Irony of Debt

Jul. 13th 2010

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

usd-jpy 1 year chart
As to what’s propelling the Yen higher, there is very little mystery. Two words: Safe Haven. “The yen’s attractions lie in its status as a haven from the turmoil that has engulfed financial markets as, first, the eurozone debt crisis unfolded and, then, fears about a double-dip recession have intensified.” To be sure, there are a handful of currencies that are arguably more secure and less risky than the Yen. The problem is that with the exception of the Dollar, none of them can compete with the Yen on the basis of liquidity. In addition, thanks to non-existent inflation in Japan and low interest rates in other countries, there is very little opportunity cost in simply holding Yen and simply taking a wait-and-see approach.

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

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

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

Japan Public Debt 1980 - 2010

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

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

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US Apathetic about Dollar

Jul. 11th 2010

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

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

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

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

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

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

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

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New Zealand Dollar Thriving in Obscurity

Jul. 9th 2010

It’s understandable that forex investors basically ignore New Zealand. Its economy is around 10% the size of its neighbor Australia, its currency is less liquid, and spreads are higher. Given that its performance closely tracks the Australian Dollar, meanwhile, why pay it any attention?

NZD AUD 1 year

To be sure, the new currencies from Down Under trade in virtual lockstep, having strayed by only a few cents in either direction from their trading mean over the last year. Since the beginning of May, however, the Kiwi has staged an impressive rally, rising 8% against the Aussie in a matter of weeks. Perhaps, there is something worth analyzing after all!

According to most analysts, the sudden rise is largely a product of risk-appetite. Specifically, as the EU sovereign debt crisis stalls, investors are relaxing, and gradually moving capital back into growth currencies, like the New Zealand Dollar. In fact, the Kiwi recently rose to a one-month high on the same day that Spain successfully completed a bond auction.

For proof of this phenomenon, one need look no further than the close relationship between the NZD/USD rate and US stocks, as proxied by the S&P 500. You can see from the chart below that they have largely tracked each other over the last 12 months. This relationship seems to have intensified over the last few weeks, as the New Zealand Dollar sometimes takes its cues directly from releases of US economic data.

NZD USD 1 year

However, New Zealand economic fundamentals are also playing a role, perhaps even the dominant role. According to one analyst, “The NZ dollar had now recovered nearly all its losses of late May…Domestic fundamentals had contributed relatively more to the NZ dollar’s recent recovery than had the mild improvement in the global backdrop.” Unlike Australia, which has been racked by political disruptions and concerns over an economic slowdown by its largest trade partner (China), New Zealand continues to coast at a healthy pace.

Moody’s forecasts that New Zealand’s economy will expand by 2.4% in 2010, and “assuming a healthy global economy, New Zealand’s recovery should evolve into a self-sustaining expansion during 2011 and 2012.” This should set the stage for near-term rate hikes, beginning with an expected 25 basis point hike on July 29. Analysts project that the benchmark rate will reach 3.75% by the end of 2010, and 5% in 2011. Widening interest rate differentials, combined with the ongoing recovery in risk appetite, could turn the Kiwi into a popular carry trade currency.

Given that the Central Bank of Australia is also projected to further hike rates, it seems the Aussie will join the Kiwi in its upward march, and that the two currencies will continue to trade in lockstep. Options traders might try to construct a low volatility strategy, such as a short straddle or selling covered calls against the pair. For currency traders that prefer the Aussie, meanwhile, the New Zealand Dollar could serve as an attractive hedge.

Then again, it’s possible that both currencies could fade, especially if the EU debt crisis intensifies, and/or the global economic recovery stalls. In short, “The near-term outlook is…uncertain due to prevailing risk aversion that may weigh on the commodity currency universe.”

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Posted by Adam Kritzer | in Australian Dollar, Emerging Currencies, News | No Comments »

US Dollar Paradigm Shift

Jul. 7th 2010

Since the inception of the financial crisis, the Dollar has been treated as a safe haven currency. Simply, when there was a surge in the level of risk-aversion, the Dollar rose proportionally. When risk aversion gave way to risk appetite, the Dollar fell. It was as simple as that.

Lately, this notion has manifested itself in the EUR/USD exchange rate, with the Euro embodying risk, and the Dollar embodying safety. In fact, a carry trading strategy has unfolded along these lines and made this phenomenon self-fulfilling: traders have taken to reflexively selling the Dollar when news is good and selling the Euro when news is bad.

EUR USD July 2010

In recent weeks, this approach appears to be changing. It started with the US stock market, which began to decline, even as the Dollar was still rising. Investors had started to worry about the housing market stalling, the exhaustion of the government stimulus effect, and worst of all, the possibility of a double-dip recession. The most recent data “showed U.S. gross domestic product in the first quarter grew more slowly than expected…The U.S. GDP numbers came after some weaker-than-expected housing numbers and a dovish Federal Reserve, all of which drove U.S. Treasury yields lower and prompted investors to reassess their dollar positions.”

From my point of view, it is not the possibility of a prolonged recession that is itself noteworthy (though this is surely cause for concern), but rather that the currency markets are paying attention it. To be sure, news of the EU sovereign debt crisis continues to dominate headlines and influence investor psychology. Barring any unforeseen developments, however, this crisis probably won’t evolve much further in the short-term, and it’s logical that investors should turn their attention back to the data.

As a result, “The popular risk-related trade on the euro ‘that was prevalent in the first half of this year appears to have derailed for the time being as market players increasingly focus on comparative fundamentals once again,” summarized one trader. In fact, the Dollar has fallen by 5% over the last month, both against the Euro and on a trade-weighted basis.

DXY 2010

Over the long-term, analysts are divided over which narrative will determine the EUR/USD rate. It would seem that until there is some resolution to the sovereign debt crisis (whether positive or negative), an air of uncertainty will continue to hang over the Euro such that it remains an apt funding currency for a carry trade strategy. US capital markets are the world’s deepest, most liquid, and most stable, and in times of crisis will probably continue to attract risk-averse capital.

On the other side are those who argue that the US will shed its safe-haven status and become a growth currency. According to this line of thinking, the US economy will outperform the EU, Japan, and Britain – its peers/competitors in the Top Tier of currencies.
“The euro zone has been stricken by crisis over the debts of its weaker members. Japan will only emerge slowly from deflation and the U.K. has to deal with its record high budget deficit over the next few years,” argued one analyst.

As a result, “The dollar will return to a pattern seen in the early 1980s and late 1990s, when it appreciated as stocks rose…The likelihood that the dollar performs strongly rather than weakly when investors are risk-seeking will signify a major change in the currency markets.” Under this paradigm, the Japanese Yen and the Swiss Franc would probably become even further entrenched as safe-haven currencies.

Finally, it’s worth pointing out that such a paradigm shift wouldn’t necessarily be good for the Dollar. If the US is indeed able to put the recession behind it, then a renewed focus on growth fundamentals would send the Dollar higher. If the Double-Dip materializes, however, Dollar bulls will probably find themselves hoping that the Dollar can retain its safe haven status.

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Posted by Adam Kritzer | in Commentary, Euro, News, US Dollar | 1 Comment »

Markets Confused about Canadian Dollar

Jul. 2nd 2010

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

CAD USD 1yr

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

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

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

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

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

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

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

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Posted by Adam Kritzer | in Canadian Dollar, Central Banks, News | No Comments »

Emerging Markets Rally, Despite Eurozone Debt Crisis

Jun. 29th 2010

It looks like emerging market investors took my last post (“Investors” Shouldn’t Worry about the Euro) to heart, since emerging markets (EM) have continued to rally in spite of the Euro’s woes. To be sure, EM stocks, bonds, and currencies all dipped slightly in May when the crisis reached fever pitch, but they have since recovered their losses and are once again en route to record highs.

MSCI Stock Index 2010

That’s not to say that that surge in risk-aversion wasn’t justified. In fact, investors are continuing to punish the Eurozone as well as a handful of other risky areas. However, analysts have concluded that in the case of emerging markets as a whole, this mindset doesn’t really make sense.

Simply, the fiscal and economic condition of is stronger than in developing countries. Whereas previously crises were known to originate in developing countries and spread to industrialized countries, this latest series of crisis turned that notion on its head. The credit and housing crises were largely the product of speculation in the West, and the sovereign debt crisis originated in Europe. While it’s possible that investor concern would self-fulfillingly cause the crisis to spread to emerging markets, any impact would probably be muted.

There is recognition that emerging market balance sheets are strong and the debt to GDP ratio is below 40 per cent compared to the western world, where it is over 100 per cent in many countries,” summarized one analyst. “The vast majority of emerging market countries ‘have the tools to tackle inflation and will succeed, having reasonable independence from their central banks,’ ” added another.

Thus, the funds continue to pour in. “Net inflows into emerging market debt totalled $30.6bn (£20.7bn, €25bn) from the beginning of the year to late May compared with $33bn for the whole of 2009.” Here’s another sign of EM confidence: “IPOs in developing countries raised $29.3 billion this quarter, almost three times the amount in industrialised nations.” Meanwhile, the MSCI Emerging Market Stock Index has just finished its strongest rally since 2005, and the JP Morgan Emerging Market Bond Index (EMBI+) is closing in on another record high. This is frankly incredible when you consider that around half of the countries with the largest weightings in the index have experienced debt crises of varying severity over the last decade.

EMBI+ bond index 2010
As far as forex investors are concerned, the confidence in EM capital markets should also extend to currencies. The carry trade is heating up (thanks to the cheap Euro), and will probably only expand as EM Central Banks move to raise interest rates to combat inflation, as alluded to above. If the Eurozone debt crisis intensifies, then you can expect some kind of pull-back. As with recent retracements, however, it will be only temporary.

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Posted by Adam Kritzer | in Emerging Currencies, News | 2 Comments »

“Investors” Shouldn’t Worry about the Euro

Jun. 26th 2010

With today’s post, I want to take off my currency trader hat and put on my investor hat.

You might be tempted to argue: But wait, these two aren’t mutually exclusive. Isn’t it possible to wear both hats? While it’s theoretically plausible for a trader to take a long-term view of the markets based on fundamental analysis, I don’t think it’s likely in practice. In the end, a good investor will always have a longer time horizon than a good currency trader. In short, someone who bought shares in Apple 20 years ago is now probably a millionaire. Someone who went long the USD 20 years ago has probably since lost his investment due to inflation.

But seriously, currency traders must adapt to the zero-sum nature of forex markets by shortening their time horizon. Stock market investors, on the other hand, are not bound by this constraint. In fact, by holding stocks for a long enough time period, investors can actually turn this into an advantage.

As a result of the Eurozone sovereign debt crisis, for example, some analysts are calling for foreign (i.e. not using Euros) investors to dump their European. investments. This recommendation is not necessarily a dismissal of European companies (though an argument could be made on this basis as well), but rather is a reflection of concerns that returns will be negatively impacted by the declining Euro. Since foreigners can only purchase shares using their home currencies indirectly (through ADRs and ETFs), they feel the effects of currency fluctuations every time they enter and exit a position. Those that entered into a position prior to the Euro’s decline, by extension, will naturally be hurt if they try to exit before the Euro has had a chance to recover.

But therein lies the problem with this approach. Those that dump their shares now solely over exchange rate concerns are simply locking in their losses, just like American stock market investors who sold their stocks in March 2009 when the DJIA was below 7,000. By instead waiting a year (or longer!) such investors could have at least partially neutralized the impact of these crises. Of course, if recovery in the Euro was perceived as inevitable, then portfolio investors naturally wouldn’t think about divesting from EU capital markets. The concern is that the Euro will continue to decline, perhaps to the point of breakup.

I don’t want to dig myself into a hole by making a 5-year prediction for the Euro, especially since there is a part of me that is concerned that it will continue to decline. Based on history, however, there is very little reason to believe that will be the case. I’m not talking about economic fundamentals – about how the US fiscal position is equally precarious and how currency markets might recognize this and turn on the Dollar – but rather about the nature of forex markets.

Euro Dollar 5 Year Chart 2005-2010

Simply, currencies fluctuate. Since its introduction 10 years ago, the Euro has fallen, then risen, then fallen, then risen, then fallen again to its current level. If you initially invested in Europe 2 years ago, the exchange rate would erode your returns if you tried to sell now. If you invested 5 years ago, you would break even. If you invested 10 years ago, you would come out ahead. In the end, it’s only a question of perspective. Still, if you maintain your positions for long enough, either you will break-even from the exchange rate or it will only marginally affect your returns (on an annualized basis).

Consider also that you can hedge your exposure to a falling Euro by simply buying Dollars. If you are concerned about exchange rate risk, you can do this every time you open a position. For example, if you were to buy European shares today and simultaneously short an equal quantity of Euros, you would be perfectly hedged against any further decline in the Euro. The cost of the hedge is the sum of any transaction costs, management fees, and negative carry that you incur as part of the currency trade.

In short, unless you deliberately want to speculate on exchange rates, don’t worry about them! If your investing horizon is long enough, their fluctuations will neither help nor hurt you in a meaningful way.

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Posted by Adam Kritzer | in Euro, Investing & Trading, News | 8 Comments »

China Revalues RMB….by .4%

Jun. 24th 2010

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

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

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

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

RMB Revaluation Chart June 2010
Not that it matters. In the US, where it is legal to make long-term bets on the RMB (via futures contracts), investors are still only projecting a 1.8% appreciation (2.2% relative to the RMB’s pre-revaluation level) over the next year, and a 2.9% appreciation by the end of 2011. In the end, there just isn’t a lot of confidence that China will voluntarily act in a way that is contrary to its own short-term economic interests.

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

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SNB Abandons Intervention

Jun. 22nd 2010

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

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

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

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

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

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

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

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Posted by Adam Kritzer | in Central Banks, News, Swiss Franc | 1 Comment »

Euro Rally only Temporary

Jun. 19th 2010

Something incredible has happened: The Euro has reversed is 16.5% decline (from peak to trough), and since bottoming on June 7 at $1.1876, it has risen by an impressive 4%. I guess that means the Euro has been rescued from parity (which I characterized as “inevitable” on June 5)?

EUR USD 3 Month Chart
Not exactly. While financial journalists have interpreted this as a recovery in risk appetite, and mainstream investors dismiss all of it as mundane fluctuations in exchange rates, currency traders – both fundamental and technical – know better. They know that this rally is merely a correction, the product of the Euro falling too much too fast against the Dollar and a consequent short-squeeze. They know that there is nothing underpinning the Euro rally, and that since the bad news continues to emanate from the Eurozone, a further decline is inevitable. ” ‘We could be one or two headlines away from a crisis again. This problem didn’t occur in a couple of days, nor is it going to resolve itself in a couple of days,’ ” summarized one trader.

According to Brown Brothers Harriman, ” ‘The recent euro rally is a corrective phase in a bear market and not a change in trend.’ National Bank Financial added, ” ‘Ultimately, when the market is this short a particular currency and a pullback happens, it results in some price volatility. It doesn’t necessarily reverse the longer-term trend.’ ” Given that so-called net-short bets against the Euro rose to a near record high in the beginning of June, it was inevitable [to borrow my favor word of the moment] that traders would eventually “cut positions when momentum in a currency [the Euro] shifted.”

From a fundamental standpoint, the last two weeks have brought further indications that the crisis is still mounting. The credit rating on Greek sovereign debt was cut to junk (A3) by Moody’s, following a similar move by S&P in the spring. Fitch, while arguing that the Euro has already declined “too far” is simultaneously threatening to do the same.

Meanwhile, Spain managed a successful debt auction, but at interest rates nearly 1.5x what it had to pay the last time around. Still, it’s in a more favorable position than Greece, which is now paying a yield premium of more than 600 basis points on its debt, compared to Germany. The implications for currency markets are clear enough: “There is a little bit of a disjuncture between what the currency is doing and what these bond markets are doing, and that’s a problem for the euro.”

Politicians, for their part, are still struggling to convince investors that they are serious about trimming their budgets and uniting for the sake of the Euro. “I see good news from the current euro-dollar rate, French Prime Minister Francois Fillon told reporters…’and I have been saying for years that the euro-dollar rate didn’t reflect reality and was penalizing our exports.’ ” With comments like that, is there any cause for believing them?!

Even putting politics and economics aside, there is a force that will continue to punish the Euro regardless of what happens: the carry trade. According to the WSJ, there is “some evidence that investors are indeed using euros to finance their bets. That is important because it means there may be structural reasons in the investment world why any lift in the euro will simply be quashed.” Thanks to the promise of continued low interest rates and confidence in its decline, ” ‘The euro is the clear-cut funding currency of choice.’ ”

At this point, then, the only issue is when the Euro will resume its decline. Those with a technical bend think that the Euro will fail to breach a psychologically important level (perhaps $1.25 or $1.27) after exhausting the rest of its momentum, at which point it will resume its precipitous decline. Those who see things in fundamental terms argue that when this happens, it will likely be due to more bad news about the crisis and/or a recovery in risk appetite (the contradiction between the two notwithstanding).

Rest assured, Euro bears. Your friend, the trend, is still intact.

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Posted by Adam Kritzer | in Euro, News | 4 Comments »

Further Delays in RMB Appreciation

Jun. 17th 2010
Throughout 2010, I have continuously reported on the apparent inevitability of the Chinese Yuan appreciation. That the currency still remains firmly fixed in place against the Dollar is a testament not only to the unpredictability of forex, but also to the doggedness of Chinese officials.
 
It seemed that China’s policymakers were all but set in February to allow the currency to resume its upward path (its appreciation was halted in 2008). If anything, the case for appreciation is stronger now than it was then. China’s economy grew by a blistering 11.9% in the first quarter. The bilateral trade surplus with the US has widened on the basis of strong export growth. Inflation has exploded, and there is a property bubble that refuses to cool.
 
Allowing the RMB to appreciate would cool China’s economy and presumably induce a moderation in inflation. In the short-term, it would lead to a slight expansion in the trade surplus (since prices would rise, but quantity would remain unchanged), but this would also moderate over the medium term. Decoupling from the Dollar would also enable China to pursue a more flexible monetary policy; in this case, that means raising interest rates to cool the property bubble as well as the economy at large. As Treasury Secretary Timothy Geithner himself has noted, ” ‘It’s in China’s interest to move.’ “
 
In the same speech, Secretary Geithner conceded that China is still dragging its heels: ” ‘I do not know if we are at the point now where we will see meaningful progress in the short-term.’ ” This inkling was confirmed by the Chinese Foreign Ministry, “China will reform its exchange-rate mechanism based on developments in the global economy and its own economic performance.” Chinese President Hu JinTao, meanwhile, has personally pledged to a visiting delegation from the US State Department to “continue reform of his country’s exchange-rate regime.”
 
This isn’t doing much to assuage American lawmakers, whom are currently being slighted by both sides. While China irks Congress by refusing to adjust the RMB, the Treasury Department is also irritating it by both refusing to label China a currency manipulator and by not establishing a deadline for appreciation. As a result, “There is a broad consensus in Congress for a simple proposition: ‘China is not acting in good faith and is aggressively engaged in a series of troubling and downright protectionist policies that put our economic relationship at risk.’ ” Finally, it seems that rhetoric will become reality, as a bill is currently being mulled that would aim to punish China (via punitive tariffs and WTO action) for failure to revalue.
 
USD RMB Futures - April 2011
Analysts are not optimistic. “The yuan’s 12-month non-deliverable forwards were at 6.7415 per dollar…reflecting bets for a 1.2 percent strengthening over that timeframe.” That’s down from expectations in April of a 3.5% appreciation. Some still believe that China will revalue in the third quarter, but there is no longer any force behind those predictions. Meanwhile, China continues to make long-term plans for its foreign exchange reserves, which indicates that it has no intention of unloading it as part of a controlled RMB appreciation. At this point, it’s essentially a game theory problem: when will China budge?
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Posted by Adam Kritzer | in Chinese Yuan (RMB), News, Politics & Policy | 2 Comments »

No US Rate Hike in 2010

Jun. 15th 2010
In the midst of the Eurozone debt crisis, forex investors have largely stopped paying attention to interest rate differentials and focused the brunt of their attention on risk. Soon enough, however, there will be a resurgence in the carry trade, at which point interest rates will return to the forefront of investors consciousness.
 
From the standpoint of the carry trade, the US Dollar should be one of the least favorite currencies, since it offers investors a negative real return (without taking exchange rate fluctuations into account). If not for the sudden increase and volatility and consequent ebb in risk appetite, the Dollar would probably still be falling, and would continue to fall well into the future. To understand why, one need look no further than the current Fed Funds Rate (FFR), from which most other short-term rates are (indirectly) derived.
 
The FFR currently stands at 0 -.25%. Moreover, the debt crisis could potentially hamper the US economic recovery and the appreciation in the Dollar is causing inflation to moderate, which has removed almost all of the impetus for the Fed to hike rates anytime soon. There is also the problem of high US unemployment and recent stock market declines. There is currently a tremendous amount of uncertainty, as nobody can say definitively whether the US economy has turned the corner or whether it is headed for double-dip recession.
FED 2010 Rate hike monetary policy
 
Most at the Fed think that the US recovery still remains on track. According to Federal Reserve Bank of Chicago President Charles Evans, “As the recovery progresses and businesses become more confident in the future, employment will increase on a more consistently solid basis. My forecast is that real gross domestic product will grow about 3.5%.” In fact, some of the hawks at the Fed see this as a justification for preemptive rate hikes and/or an unwinding of the Fed’s quantitative easing program. The President of the Kansas City Fed argued recently, “Even if the target was increased to 1 percent, policy would remain very accommodative,” while the Philadelphia Fed President added that the Fed should start selling some of $1 Trillion in Mortgage Backed Securities currently on its balance sheet.
 
Still, such voices represent the minority, and besides, most of the hawks don’t current have any voting power. In other words, it will probably be a while before the Fed actually hike rates. Futures contracts currently reflect an infinitesimally low probability of rate hikes at any of the Fed’s summer meetings. “The February 2011 fed-funds futures contract priced in a 48% chance for the FOMC to lift the funds rate to 0.5% at its Jan. 25-26 meeting.” Meanwhile, an internal Fed analysis has concluded that based on previous rate-setting patterns, it is unlikely that the benchmark FFR will be lifted before 2012.
 
Fed FFR Interest Rate Futures September 2010 Implied Probability
In short, US short-term rates will remain low for the indefinite future. For now, the “safe haven” mentality dictates that investors are less focused on yield and more concerned about capital preservation, which means no one is paying attention to the Fed. When risk appetite picks up, however, the Dollar will probably be dumped very quickly in favor of higher-yielding alternatives.
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Risk Aversion Hits Australian Dollar

Jun. 13th 2010
These days, I feel like you could take that title and substitute pretty much any currency for the Australian Dollar. Let’s face it- the EU sovereign debt crisis has hit a number of currencies extremely hard, as investors have fled anything and everything risky, in favor of the US Dollar, Swiss Franc, Japanese Yen, and Gold.
 
Still, the Australian Dollar merits special attention, because in the forex markets, it has come to be a symbol of risk-taking. For veritable years, every credit expansion and economic boom has been accompanied by a surge in the value of the Aussie, and 2009 was no exception. As the global economy recovered and risk aversion ebbed, the Australian Dollar rose by more than 40% against the USD. It has been helped in its upward course by Chinese demand for its natural resources and strong interest rates, especially compared to the rest of the industrialized world.
AUD USD 2 Year Chart
 
That the Australian Dollar has already fallen 14% (from peak to trough) against the US Dollar over the last month is less due to economic and monetary factors, however, and more the result of an ebb in risk-taking. “The Australian dollar is considered a barometer of global risk appetite. Its fall reflects the quick change in mood, as Europe’s debt problems and China’s monetary tightening plans cloud expectations for the global economic growth,” summarized one analyst.
 
Specifically, investors are growing increasingly nervous about the viability of the carry trade, of which the Australian Dollar has been one of the primary beneficiaries. Uncertainty surrounding the fiscal problems of the Eurozone has catalyzed a spike in volatility, and investors have responded by rapidly unwinding their carry trade positions. Ironically, this caused a temporary upswing in the Euro, at the expense of the Aussie: ” ‘The euro rally isn’t that people like the euro. Investors have decided they want out of risk.’ The way to remove that risk from portfolios is to pay back the euro loans by selling the Australian dollar.”
 
From another standpoint, the yield advantage associated with holding Australian Dollars is no longer enough to compensate investors for the added risk. After adjusting for inflation, real interest rates in Australia are only about 2.5% (the nominal benchmark rate is 4.5%). This is still 2.5% higher than the benchmark US Federal Funds Rate, but not very attractive if you consider that the Australian Dollar has fallen by more than 2.5% against the US Dollar in several individual trading sessions in May. Moreover, the Reserve Bank of Australia (RBA) is signalling a pause in its rate hikes. If futures contracts are any indication, the Fed and the ECB will raise their respective interest rates before the RBA moves again.
 
Going forward, the consensus is that a sustainable level for the Australian Dollar based on current fundamentals is probably around .75 AUD/USD. However, the Aussie rallied 5% against the US Dollar last week, which suggests that investors still aren’t ready to give up completely: ” ‘The environment is not yet ripe to get truly bearish on the Australian dollar,’ said Commonwealth Bank Strategist Richard Grace. There are positives on the horizon, namely a better outlook for the U.S. and a calming of the Greek crisis, he said. He’s forecasting a return to $0.87.” Personally, I could see the Aussie going either way. Parity probably isn’t on the table anymore, but virtually everything else still is.
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Interview with Claus Vistesen: “The Eurozone is Shaky”

Jun. 10th 2010
Today we bring you an interview with hedge fund manager Claus Vistesen, of Alpha.Sources and Beta.Sources. Claus is a Danish economist who specialises in macroeconomics. He is currently pursuing post grad studies alongside his commercial endeavors. His primary research interests include demographics, macroeconomics and international finance. Below, Claus discusses his perspective on the forex markets, as well as his approach to macroeconomic analysis.

Read the rest of this entry »

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EU Crisis Punishes Korean Won

Jun. 8th 2010

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

Korean Won USD 1 year
Given all of the economies/currencies from which to choose, it seems bizarre that investors would gang up on the Won. That is, until you consider that South Korea’s fiscal situation is somewhat unique and that funding crises tend to hit the country especially hard. Summarized one analyst: “We are concerned that the negative market view of events in Europe will not dissipate and that the longer the stress continues, the more concerns will arise that the peripheral funding crisis could segue into a more extended funding crisis and into lower growth expectations.”

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

Korean Won Versus Vix Index 2009-2010
The Central Bank is doing its part to relieve the liquidity shortage and stem the Won’s decline. It has already placed modest limits on speculative derivative transactions with the goal of limiting capital flight. It is pressing to renew currency swaps with the Fed and the Bank of Japan in order to increase the supply of alternative currency. In addition, it has taken to intervening directly in currency markets by selling Billions of Dollars on the spot market. Explaining the first market intervention in more than a year, the Central Bank declared,
“The dollar’s surge against the won today was overdone. The authorities will try to prevent one-way currency moves.”

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

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

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

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

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EUR/USD: The Next Benchmark is Parity

Jun. 5th 2010

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

eur usd 1 year chart
That’s right. Parity. We’re not talking about the Canadian Dollar or even the Australian Dollar. We’re talking about the Euro, which only yesterday was trading at a lofty $1.60 against the Dollar. According to CLSA Asia Pacific Markets, “The euro will sooner or later go to parity with the U.S. dollar.” Meanwhile, “The research firm Capital Economics predicts that the euro will reach par with the U.S. dollar by the end of next year.” There wasn’t even a perfunctory attempt by either firm to justify the prediction. Given the way that the Euro has been trading, it probably wasn’t necessary.

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

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

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

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

Recent History of Currency Intervention- Dollar, Euro, Yen

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

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Japanese Yen: 90 or 95?

Jun. 3rd 2010

After a healthy appreciation against the Dollar in 2009, the Yen has backed off slightly in 2010, hovering around the level of 90 USD/JPY. Still, every time the Yen falls, traders quickly push it back up to 90. One has to wonder: Will the Yen ever fall?

JPY USD 1 year chart

Analysts attribute the Yen’s resilience to a series of aberrant developments, rather than to some kind of cohesive trend. Above all, there is the sovereign debt crisis in Europe, which has directed a steady stream of risk-averse capital to Japan. Under the existing paradigm, the US, Japan, Switzerland, a handful of other economies are still thought of as financial safe havens, a notion which serves to explain the Yen’s surge to a 10-year high against the Euro.

This is not exclusively a one-way trend. On the contrary, there is a constant ebb and flow in risk-tolerance as investors weigh the seriousness of the EU debt debacle and other crises. In fact, some believe that the recent uptick in risk aversion is already in decline: “Once investors shift their attention back to the fundamentals, which are still signaling solid improvement, there is no strong reason to buy the yen. Underlying demand for higher-yielding assets outside Japan remains strong.”

Outside of this, there is also some debate as to what constitutes a safe-haven currency, and whether the Yen qualifies. On the one hand, Japanese interest rates are extremely low and monetary policy remains accommodative. It’s capital markets are deep (though not exactly buoyant), and for investors that value capital preservation, Japan would seem like a reasonable choice. On the other hand, this mentality is facing a backlash as a result of prolonged political uncertainty. Since unseating the Liberal Democratic Party in 2009 – an historic achievement – the Democratic Party has been in a dither and implemented no new, meaningful policies. The finance minister was replaced a few months ago, and to top it off, the Prime Minister himself is set to resign.

It is both the uncertainty – the perennial enemy of the carry trade – and the potential replacement which worries investors and currency traders. The current front-runner, Finance Minister Naoto Kan, has not made a secret of his desire for a weak Yen: “Markets in principle should determine foreign exchange rates, but I think we must closely watch [markets] and ensure that there won’t be any excessive yen rises.” As Prime Minister, he would probably be more aggressive than his predecessor in intervening in currency markets, if need be.

Perhaps with Mr. Kan’s support, the Central Bank of Japan recently announced that it would inject $20 Billion into capital markets as part of of an effort to “calm” the financial markets. The Central Bank is apparently committed to “combating deflation,” which in some circles is code for currency devaluation.

In short, the only real question – posed in the title of this post – is the exchange rate that the Japanese leadership is targeting. Currency valuation is always more art than science, so it’s unclear not only the rate that in reality is fair, but also the rate that Japan perceives as fair. My feeling is that it’s north of 95 Yen/Dollar. It seems that anything between 90 and 95 is acceptable, while a drop below 90 is cause for intervention. For now, that intervention has been entirely vocal; if the government’s approval ratings remain in the basement, however, it could turn into actual intervention.

http://www.sfgate.com/cgi-bin/article.cgi?f=/g/a/2010/06/02/bloomberg1376-L3FFDK1A1I4H-1.DTL
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Brazil is Booming, but Real is In Trouble

May. 31st 2010

Generally speaking, investors are bullish about Brazil. The emerging market superstar emerged from the credit crisis essentially unscathed, and some believe that “Brazil will be the world’s fifth-biggest power by the next decade.” This year, the IMF is forecasting GDP growth of 5.5%, while the Central Bank of Brazil is projecting 6%.

Brazil GDP Growth 2000-2015

But this post isn’t about the economy of Brazil. It’s about its currency, the Real. To put it mildly, investor sentiment surrounding the Real is slightly less rosy. The 30% appreciation (from trough to peak) against the Dollar has come to an end. “ ‘Buyers are exhausted. The real has been a pretty crowded trade and what’s happening is a lot of these long-term crowded positions are getting sold,’ ” summarized one money manager.

There are a handful of issues. First is the technical concern that the Real simply rose too far, too fast. “The currency’s weekly TD Sequential indicator suggests an almost yearlong rally against the dollar ended in October, while the moving average convergence/divergence, or MACD, chart shows the real is likely to weaken.  ‘A new trend has started and it’s strongly bearish.’ ” This notion is supported by an explosion in the so-called risk-reversal rate on the Real, in favor of options that give investors the right to sell. In fact, “insurance” on the Real is now the most expensive of any emerging market currency.

Investors are also nervous about the sovereign debt crisis in the EU, and are responding by temporarily moving funds back to safe haven currencies. “ ‘We’re seeing a lot of declines on top of concerns about Greece and Europe. Flows will come back to Brazil when you have signs of stability out there, and it doesn’t look like that will happen in the short term.’ ” Of course, this is also impacting the carry trade, as investors re-examine their models governing the trade-off between risk and return.

To be fair, increased risk could be accompanied by increased returns. Even withstanding a poor performance by the Real, itself, the benchmark Brazilian Selic rate stands at a healthy 9.5%. In all likelihood, it will be hiked past 10% next month, and to 11% by the end of the year. On the flipside, inflation is also surging (5.5% at last count). From the standpoint of investors, this is not really a concern, since there is no intention of using invested capital for consumption purposes. In fact, it could even be seen as positive, insofar as it will force the Central Bank of Brazil to continue to be aggressive in conducting monetary policy.

USD BRL 3 month chart

There seems to be a slight dichotomy between the data and the markets. On the one hand, there is plenty for investors to be excited about when looking at Brazil. On the other hand, the reality is that there just isn’t much excitement at the moment being channeled towards the Real. If interest rates continue to rise, and the debt crisis in Euro can achieve some kind of (stopgap) resolution, perhaps this will change.

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Chinese Yuan as Reserve Currency

May. 22nd 2010

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

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

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

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

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

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

The China Effect

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Failed Euro Bailout Would Buoy Yen

May. 19th 2010

Given that only a week has passed since the bailout of Greece was formally unveiled, it’s still too early to determine whether the plan will be success. Regardless of how it ultimately plays out, though, the bailout (not too mention the concomitant crisis) is shaping up to be THE big market mover of 2009. As investors reposition their chips, some early front-runners are emerging. It might surprise you that one such leader is the Japanese Yen.

On the surface, the Japanese Yen would seem to be an excellent candidate for shorting, especially in the context of the the Greek fiscal crisis. Its fiscal and economic fundamentals are abysmal, and by most measures, it’s debt position is among the least sustainable in the world, behind even Spain, Portugal, and the US. At the same time, the Yen has risen by an unbelievable 8% against the Euro in the last week alone, and many analysts are predicting it will emerge as one of the winners of this episode.

Euro Yen
Why? First of all, with confidence in the Euro flagging, the Yen (and the Dollar) gain luster as the only viable reserve currencies. Regardless of what you think about Japan’s fiscal fundamentals, the longevity at the Yen means that it is inherently safer than the Euro, which may not even exist (in its current form, at least) in a few years time. Second, the current consensus is that the Euro bailout will fail, and as a result, risk tolerance is running low at the moment. With this in mind, it’s no surprise that traders are unwinding their carry trades and that the Yen – “The low-yielding currency of a deflation-prone economy of high savers…entrenched as the world’s funding currency” – has rallied.

Analysts have been quick to point out that the rest of Asia (among other regions) are on the other side of this trend. The concern is that the bailout won’t be enough to prevent a repeat credit crunch and that confidence in investments/currencies that are perceived as risky will remain low.

China could be hit especially hard. Since the Chinese Yuan is pegged to the Dollar (and even it wasn’t), it has risen by a whopping 15% against the EUro over the last six months, severely crimping exports to the EU. In addition, “Chinese exporters rely very heavily on bank letters of credit to finance their shipments…When banks have trouble borrowing money themselves — as has been happening as a result of worries about European banks’ possible losses from the region’s sovereign debt crisis — they tend to cut sharply the issuance of letters of credit for trade finance.” It’s no wonder that the Chinese stock market has tanked 21% so far in 2010, and that the Central Bank continues to delay revaluing the RMB.

Chinese stocks versus S&P
Of course, if the plan turns out to be a success, than the opposite will probably obtain. “In this case…the currency of any emerging market or advanced economy exposed to the Asian region’s impressive, China-led economic growth,” will probably rally. “It could be the South Korean won, the Australian dollar, or the currencies of commodity-producing countries like Brazil.” The Japanese Yen, meanwhile, will probably be hit with a dose of reality, followed by a double dose of the carry trade.

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When Will Attention Shift to the Dollar?

May. 16th 2010

The fiscal crisis ravaging the Euro and the Pound has sent the Dollar skyward. On the one hand, the prospect of continued uncertainty and dissolution of the Euro would seem to be an excellent harbinger for continued appreciation in the Dollar. On the other hand, it should only be a matter of time before investors recognize that the Dollar’s fiscal fundamentals are also quite weak.

chart

Unlike during the last few years, analysts are no longer talking about (forex reserve) diversification. It was once widely predicted that the Euro would rival the Dollar for a place in the portfolios of foreign Central Banks. As expected, preferences are now shifting back in favor of the Dollar and to a lesser extent, the Yen. The Pound and Swiss Franc may have a small role, as will the “New” Euro. Over the short-term, however, Central Banks (and investors) will continue to eschew the Euro, if only due to sheer uncertainty.

Given that everything is relative in forex, investors and Central Banks only have so many options when it comes to choosing which currencies in which to denominate their portfolios. Thus, it’s understandable that a sudden crisis in the EU would buoy the Dollar. At the same time, it’s not exactly a good bet that the US isn’t destined to suffer a similar fate.

Due to extremely low short-term interest rates, most investors have been willing to accept low returns when lending to the US (by buying Treasury Securities, and indirectly by simply holding Dollars). At some point, both short-term interest rates and the rate of inflation will rise, and investors will have to re-examine their risk/reward schemes. My suspicion is that investors will demand higher yields in exchange for lending to the US.

Just like with Greece, a US fiscal crisis would probably emerge suddenly. While the US government pays lip service to the notion of balancing its budget and reducing its sovereign debt, even the most optimistic projections show a budget deficit for the next 10 years. Beyond that, the retirement of the baby boom generation and their “entitlement” payment will make it nearly impossible for the US to operate a budget surplus.

In short, the only hope is for the US economy to grow faster than the national debt. If the US economy grows at 4% per year, for example, it will have to run a budget deficit less than 4% of GDP in order to reduce its relative level of debt. On the surface, this seems like a reasonable possibility, but given trends over the last three decades (covering periods of both recession and economic boom), it doesn’t seem likely.

This is not new information. Doomsday theorists have been predicting the bankruptcy of the US for two centuries. Don’t mistake me for doing the same. Rather, I only wish to point out how ironic it is that the Dollar’s fiscal conditions are comparable (and in some ways worse) than some of the problem countries that investors are currently focusing on.

Then again, forex is relative. Some analysts have suggested that the new reserve currency will be gold, oil, and other commodities. Unfortunately, there isn’t nearly enough (liquid) supply of these materials to occupy more than a small portion of reserves. Under the current system, then, investors are pretty much stuck with the Dollar. At this point, betting to the contrary is tantamount to betting on the complete collapse of the modern financial system. A reasonable bet, perhaps, but you can forgive investors for being hesitant to embrace it.

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Is There Any Hope for the Pound?

May. 14th 2010

Compared to the Euro, the Pound is Gold (figuratively speaking). Compared to everything else, well, the Pound is probably closer to linoleum. Bad geology metaphors notwithstanding, there really isn’t much to get excited about when looking at the Pound.

Let’s take the election, for example. Originally billed as a chance for a fresh start, politically, for the UK, the election has turned out to be nothing short of disastrous. Rather than producing a clear-cut victory, it has resulted in a hung Parliament. The way talks are currently shaping up, it looks like power will be shared by the Liberal Democrats and Conservatives. This is problematic,because neither party has a clear vision for dealing with the skyrocketing UK national debt; with the two parties working together, meanwhile, a compromise seems even more unlikely. “Investors are worried that a hung parliament will result in a weak government that will be unable to force through measures to reduce the UK’s high borrowing levels.”

As a result, many analysts now believe that the UK could lose its coveted AAA credit rating: “We believe that a downgrade…is more than likely since both parties agree that early expenditure cuts could harm the economy. The alternative could be that both parties agree on tax hikes to be implemented with the next budget. Both outcomes would be equally bearish for sterling.’ ”

Even aside from the imminent UK fiscal crisis, there is the fact that its economy continues to stagnate, its capital markets remain languid, and its balance of trade remains perennially mired in deficit. “Figures from the Office for National Statistics (ONS) showed that gap between the UK’s imports and exports hit a massive £7.5bn in March. The deficit — well ahead of an upwardly revised £6.3bn for |February — came as total imports surged £1.4bn over the month compared with a meagre £200m rise in exports.” From a fundamental standpoint, then, there is very little reason to own the Pound.

The picture is slightly more nuanced, when viewed through the lens of technical analysis. The most recent Commitment of Traders report, meanwhile, has showed short interest in the Pound building to record levels. In addition, the ratio of long/short positions is approaching 5:1. Some analysts believe this is inherently unsustainable, and that as net positions become more lopsided, a sharp reversal becomes even more likely. Then again, some analysts had the same theory about the Euro, which was solidly disproved after the short-squeeze rally was soon followed by a steady decline and a re-accumulation of short positions.

Other technical analysts are waiting to see where the Pound moves in the near-term before placing their bets. ” ‘Last week the market eroded the 15-month uptrend from the January 2009 low at $1.3500’…the $1.4255 Fibonacci level is the last defence for the pound ahead of the $1.3500 2009 low. For the downside pressure to be taken off, key resistance at $1.5055, the May 10 high, would need to break.’ ” The Pound is hovering dangerously close to a number of psychologically important levels. If it breaches $1.40, it would signal a 5-year low. Consider also that the Pound last touched $1.38 in 2001 and $1.35 in 1987.

5y chart GBP USD
To be fair, the Pound has hovered around $1.50 for most of the last 20 years, so its current level against the Dollar is not that low, relatively speaking. If investors come to their senses, and realize that the likelihood of UK sovereign default is probably not any higher than the US, and the coalition government is able to produce a convincing plan for reducing the deficit, then the Pound could bounce back. If the safe-haven mentality remains in force, however, the Pound will continue to be one of the big losers.

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Euro Still Doomed, Despite Bailout

May. 12th 2010

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

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

EU IMF Euro Bailout - Two Pronged Approach

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

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

Euro 5 day chart
Indeed, it’s hard to find anyone that has anything positive to say about the bailout, even among the bureaucrats and politicians that contrived it. Here’s a smattering of soundbites:

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

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

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

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

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Posted by Adam Kritzer | in Central Banks, Euro, News, Politics & Policy | 2 Comments »

Greek Debt Crisis Widens

May. 6th 2010

I must confess: I never expected the Greek debt crisis to reach such a dire threshold in such a short time period. Over a matter of mere months, the Euro has fallen 15% against the Dollar. That’s the kind of drop that you would have expected from the Greek Drachma, not from the Euro!

5y Euro

Moreover, it’s not as if this slide is anywhere close to abating. “I don’t think you’d want to bet on a bottom, at this stage, in euro. We’re headed closer to $1.2000 at some point in the game. It’s just a question of when,” said one prominent analyst. Meanwhile, net shorts against the Euro have reached a record 89,000 contracts, according to the weekly Commitments of Traders report. What is producing this swell of bearish sentiment, which is causing the markets to trade in a manner best described as “panic mode?”

The answer, it seems, is a self-fulfilling belief not only that Greece will default on its debt, but also that the credit crisis will spread to the rest of Europe. Greek interest rates recently topped 8%, and the spread with comparable German bonds (this spread has become a crude way of gauging the seriousness of the crisis) is close to an all-time record. Credit default swaps, which insure against the risk of default, surged to 674 bas points, reflecting a 15% probability of default. Meanwhile, credit default swap spreads on Spanish and Portuguese debt is also creeping up.

At this point, there seems to be very little that Greece can do to mitigate the crisis. It has already announced a series of austerity measures, including wage cuts and tax hikes, designed to narrow its budget deficit. In addition, it has successfully obtained an aid package from the EU and IMF, valued at $160 Billion. In April, it successfully refinanced $12 Billion in debt, even though experts insisted that such would be very difficult, given current investor sentiment.

On the other hand, the austerity measures were met with riots, which left 3 people dead, and signaled that the Greek citizenry would sooner vote out the incumbent government than accept their proposals to reduce the budget deficit. Speaking of which, under the best case scenario, the deficit will decline to a still-whopping 8% of GDP in 2010 (from a revised 13% in 2009), and Greece’s budget will remain in the red until at least 2014, by which point its gross national debt is projected to have reached 140% of GDP. Of course, this assumes that GDP growth will turn positive in 2012, and this is no guarantee. Meanwhile, the aid package will probably be enough to tide Greece over for only about 18 months, after which point it will have to return to the capital markets. Even before it can tap the bailout, it must first refinance another $10 Billion in debt in May.

Europe's Web of Debt

In other words, even if Greece can forestall default for 2010 and 2011, who’s to say that it won’t default in 2012? With this possibility in mind, it makes it very unlikely that investors will continue to buy Greek bonds at all, let alone at affordable interest rates. “People are becoming well aware of the fact that the solvency issue for Greece hasn’t been resolved with the aid package. They still have to repay the money. They still have to repay the interest.”

Finally, there is the risk that the crisis will spread to the rest of Europe. Both the IMF and the Spanish government have been busy refuting rumors that Spain is seeking a similar bailout. Regardless of its veracity, the fact that such a rumor even exists will be enough to make investors sweat. When investors get nervous, they stop buying government bonds and/or demanding higher interest rates, which ironically only makes it more likely that the government in question will default. Fortunately, it seems that Spain (and its neighbor, Portugal) are in strong enough shape that they could survive a sudden speculative attack from investors.

Greece, however, is basically a lost cause. “Greece is functionally bankrupt,” and the only solution is for it to leave the Euro and/or default. Until that day comes, uncertainty will persist, and investors will continue to doubt the Euro.

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Posted by Adam Kritzer | in Economic Indicators, Euro, News | 3 Comments »

Emerging Markets Mull Currency Controls

May. 4th 2010

The rally in emerging markets that I wrote about in April is showing no sign of abating. The MSCI emerging market stocks index is back to its pre-crisis level, while the EMBI+ emerging market bond index has surged to a record high. While no such index (that I know of) exists for emerging market currencies, one can be quite certain that at the very least, it too would also have returned to its pre-crisis level.

MSCI Emerging Markets Index 3 Year Chart
The Greek fiscal crisis, far from discouraging risk-averse investors from emerging markets, appears to instead be spurring them closer. From a comparative standpoint, emerging market governments are in much better shape than their industrialized counterparts, to say nothing of Greece. Credit ratings on a handful of emerging market debt issues are gradually being raised, whereas Greece was downgraded to junk status. Summarized one investor: “This is a group of countries with relatively strong balance sheets offering attractive levels of yield.”

It’s no wonder then that capital inflows into emerging market debt has already set an annual record (for 2010), despite the fact that we are only four months into the year! “The World Bank predicts as much as $800 billion in global capital flows this year, compared with about an annualized $450 billion to developing economies in the second half of 2009.” In addition, whereas institutional investors previously insisted on funding only those issues that were denominated in foreign currency (such as Dollars or Euros), now they seem to have a preference for so-called local currency debt. According to one emerging markets fund manager, “We expect local currency to be our biggest theme going forward.”

Net Private Capital Inflows to Developing Countries

The real story here, however, is less the growing investor interest in emerging markets (which is now well established), and more the growing ambivalence of emerging markets. No doubt grateful to be attracting record sums of capital at lower-than-ever interest rates, emerging market governments are nonetheless unhappy about the resulting currency appreciation.

Taiwan has emerged as the unlikely voice of emerging markets on this issue. Its Central Bank recently “asked 65 banks for details of their foreign-currency lending to make sure exporters and importers aren’t using the loans to speculate on the island’s dollar,” and urged its peers to “adjust their monetary policies to address the disorderly movements of exchange rates.”

It doesn’t need to prod too hard, however, since a handful of Central Banks have either already intervened or are seriously considering intervention. Last month, Poland intervened by selling the Zloty against the Dollar. The Central Bank of South Africa cut interest rates by 50 basis points in March, despite surging inflation. Brazil continues to hold auctions to buy Dollars on the spot market, while India mulls implementing some form of a Tobin tax on currency transactions.

Not long ago, such measures would have been criticized as protectionist and against liberal, free-market principles. Not anymore. The International Monetary Funds (IMF), recently “urged developing nations to consider using taxes and regulation to moderate vast inflows of capital so they don’t produce asset bubbles and other financial calamities.” Private-sector economists agree, with Standard Chartered Bank arguing that “Emerging markets need to take ‘urgent action’ on the surge of liquidity and capital flowing into their economies because they could spur inflation and trigger another crisis,” much like “excess liquidity contributed to problems in the Western developed economies ahead of the financial crisis.”

In short, emerging markets have the green light to go ahead and stop their currencies from appreciating. But will they act on it?

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

China’s Forex Reserves Surge to New Record

May. 2nd 2010
There are no words to describe the size of China’s foreign exchange reserves. Massive, Mind-Boggling, and Eye-Popping come to mind, but don’t do the $2.447 Trillion justice. What’s more, this figure represents the end of March; the current total has almost certainly surpassed $2.5 Trillion.

Interesting, the rate of reserve accumulation has slowed markedly from 2009. In the first quarter of 2010, the reserves grew by “only” $45 Billion, compared to growth of $125 Billion in the fourth quarter of 2009. There are a couple key explanations for this slowing. First, China’s trade balance has narrowed considerably over the last twelve months, to the point that it in March, it recorded its first trade deficit in six years. Second, China tallies its reserve growth on a net basis – after accounting for changes in valuation. Given that the majority of China’s reserves are still denominated in US Dollars, then, the Dollar’s appreciation over the last quarter may have shaved $40 Billion from the accumulation of new reserves. With this in fact in mind, the actual slowdown is probably much less pronounced than the numbers would suggest.

Breakdown of China's forex reserve buildup 2003 -2009
Besides, exports and foreign direct investment both continue to grow at healthy clips, which means there is nothing (barring a revaluation of the RMB) which could significantly slow reserve accumulation going forward. Even with a revaluation (that many experts believe is imminent), the need to further accumulate reserves will not be impacted, because the RMB will certainly continue to be pegged to the US Dollar. In order to prevent price inflation (which is already creeping up) from reaching dangerously high levels, then, the government will have no choice but to continue to soak up all capital inflows for as long as the RMB remains pegged.

Speaking of revaluation, the unchecked growth of China’s forex reserves would seem to strengthen the case for it. As the WSJ analysis showed, the value of China’s portfolio of reserves has fluctuated wildly over the last five years due both to gyrations on the capital markets and volatility in forex markets. In fact, China has lost a massive $70 Billion due to such volatility since 2003. In short, this program of accumulating reserves is not only a massive headache, but also a losing proposition.

Experts estimate that more than 2/3 is still denominated in USD. Since the Chinese RMB is also pegged to the Dollar, that means that as the RMB appreciates against the Dollar, the value of its reserves will fall in local currency terms. Rectifying this problem is basically impossible, as the EU sovereign debt crisis has demonstrated. It has looked into the possibility of investing in alternative assets such as Gold, Oil, and other commodities but there is simply not enough global supply to soak up more than a small fraction of China’s $2.5 Trillion. For all of the problems with the Dollar, the alternatives are just as bad, if not worse. At this point, the best China can hope for is to “cut its losses” by revaluing sooner rather than later.

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Posted by Adam Kritzer | in Central Banks, Chinese Yuan (RMB), News | 2 Comments »

Gold Rises as “Alternative Currency”

Apr. 29th 2010

Everything in forex is relative, right? Actually, it turns out this adage is wrong, as there is now a way you can short the entire forex market! I’m not talking about some innovative new financial product that you’ve never heard of, but rather something that everyone already knows about: Gold.

Before you accuse me of sounding like an infomercial, consider that while gold has been an investable commodity for quite some time, its trading pattern has changed recently, especially in the context of forex. Before, the link between gold and forex was inverse and clear: “When the greenback strengthens…this tends to pressure gold since it reduces the need to buy as a hedge against a soft dollar. Also, a strengthening dollar makes commodities generally more expensive in other currencies.” In other words, a rising Dollar is usually accompanied by falling gold prices, and vice versa.

Over the course of 2010, this relationship has steadily grown weaker and weaker, and in the last month, it has almost completely broken down. To understand the rationale for such a change, one needs not to look any further than the sovereign debt crisis currently facing Greece and indirectly, the Eurozone. This crisis has affected the way that investors think about gold; while previously it was primarily viewed as an inflation hedge, now it is seen as a hedge against fiscal/financial crisis. In this regard, it has assumed the characteristics of a “safe haven” currency, much like the US Dollar.

“Gold is going to move higher regardless of what happens in the currency market, as long as there are fears of problems in Europe. People are starting to have more skepticism to a lot of these sovereign entities,” explained one analyst. At the moment, that means that the inverse correlation between the Dollar and Gold (Dollar Up = Gold Down) appears to have reversed itself, such that a rising Dollar is also accompanied by rising gold. In this case, there may be correlation (since investors are buying both gold AND the Dollar as safe haven vehicles) but there is no causation between the two as there was before.

At the moment, the correct interpretation is that anything is preferable to the Euro (whose sovereign debt problems are the most pressing). Thus, gold prices are rising at basically the same rate as the Euro as falling, and gold prices in local currency (EUR, CHF, GBP) terms are already at record levels.

Euro Versus Gold - 2010

As for the future, however, many are betting that gold will distance itself from the Dollar as well, if/when the fiscal “problems” of the US escalate to the level of a Greek-style crisis. At this point, Gold will start to trade as an alternative to the entire forex market! In fact, gold contracts denominated in US Dollars have also been rising, which means that investors already perceive it as more than just an alternative to the Euro. (If this was the case, one would expect gold to appreciate in terms of Euros, but to remain constant or even fall when priced in Dollars. This clearly hasn’t happened).

Admittedly, gold is outside of my expertise, so I’ll refrain from personally making any predictions. According to Deutsche Bank, “If the correlation re-establishes itself before July, either the dollar must continue to decline or investment into bullion-backed funds must pick up in order to avoid erosion in gold prices.”

Regardless of what happens, my intention here is simply to point out the emergence of this trend, for its own sake. While it doesn’t have any serious implications about the internal dynamics of forex markets, it most certainly is important insofar as it reflects what investors (forex and otherwise) are generally thinking about. In this case, it signals that concern over the ongoing sovereign debt crisis isn’t going to abate anytime soon.

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Posted by Adam Kritzer | in Gold, News | 1 Comment »

No Credit Risk in Forex

Apr. 27th 2010

The risks in trading forex are manifold. There is interest rate risk (the possibility that interest rates could change adversely), country risk (that a political, economic, or monetary crisis could adversely affect the dynamics of a country’s currency), and obviously there is exchange rate risk (that exchange rates can and often do fluctuate adversely). However, there is zero or nil credit risk. Why is that?!

First of all, what do I mean by credit risk? Often used interchangeably with the terms settlement risk and counterparty risk (depending on the type of security/investment in question), credit risk refers to the possibility that one party (all financial transactions necessarily involve two parties) will not honor its side of the financial agreement. In the case of forex, this refers to the risk that either the buyer or the seller will not be able to fulfill its promise to deliver currency at the agreed-upon exchange rate. For example, let’s assume that I’ve signed a contract to exchange $100 Dollars for Euros at $1.35. There is a risk that after you hand over the Dollars, the counterparty will not be able to supply the Euros, and even worse, that it won’t be able to return your Dollars.

With regard to transactions involving other types of securities (especially derivatives), this risk is very real, albeit minimal. Anyone who signed a long-term financial contract with Lehman Brothers or Bear Stearns is probably fighting in bankruptcy court to collect pennies on every dollar that they are owed. As I said, however, this is essentially a non-risk in forex. While currency markets fluctuated wildly in the wake of both bankruptcies, these fluctuations were completed unrelated to the possibility that Lehman Brothers and Bear Stearns would not be able to honor their trades, and in fact forex markets continued functioning with very little interruption. In fact, “In the dreadful week following Lehman Brothers’ collapse, more than $150bn of Lehman’s FX trades were settled successfully.” How was this possible?

The answer is CLS, or Continuous Linked Settlement, which is an interconnected system used exclusively for settling foreign exchange transactions, and owned by its member banks. CLS handles 55% of all forex transactions (but a much higher proportion of the volume), amounting to Trillions of dollars in activity per day, and involving 17 of the most popular currencies. Basically, all trades involving major financial institutions (7,000 at last count) pass through CLS, and are netted out at the end of each day such that each participating bank only has to make and receive payment once (for each currency) rather than 10,000 separate times.

As far as retail forex trading is concerned, this doesn’t mean that every trade that you make passes through CLS or even that your broker is itself a member of CLS (chances are that it isn’t). Instead, your broker probably settles all of these trades internally, and then must settle with its market makers at the end of each day, who in turn, settle with each other through CLS. Even though you aren’t directly connected with CLS, its existence still makes seamless forex trading possible for you.

At the same time, CLS doesn’t do anything to limit the possibility that your broker will go bankrupt (like Lehman Brothers), and that you won’t have to line up outside of bankruptcy court to try to reclaim the balance of your account. (Still, this is unlikely if you’ve selected a reputable broker with a healthy capital position). Instead, it means that when you place 100 trades over the course of a day, you can now take for granted the fact that all of them will be settled on time at the correct exchange rate.

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Posted by Adam Kritzer | in Investing & Trading, News | 1 Comment »

Greece Weighs on the Euro…Still

Apr. 23rd 2010

This has really become the story that simply won’t go away. Just when it seemed investors had fully digested the implications of the Greek debt crisis, they once again turned their attention to it and attacked the Euro with renewed vigor. Summarized one analyst, “Fears regarding Greece have been reignited.” As a result, the Euro is already down nearly 10% on the year, and we are barely into the second quarter!

Euro Dollar 1 year
Since I last posted on this issue, there have been a handful of key developments, the most important of which was the approval of an emergency loan packaged. Under the terms of the agreement, the EU will lend €30 Billion to Greece, and the IMF will lend an additional €15 Billion. Both loans will have 3-year terms and 5% coupons. While George Papaconstantinou, Finance Minister of Greece, “insisted that this was ‘not tantamount’ to asking for a bailout,” the markets were of the opposite mindset, which is why the Euro immediately advanced 1.5% when news of the loan package broke on April 12.

Since then, the Euro has cooled, the Greek stock market has dropped, and borrowing costs have surged: “The spread between the government’s 10-year bonds and benchmark German debt [has risen] to 549 basis points, the highest in at least 12 years. Credit- default swaps tied to Greece’s debt jumped 149 basis points to a record 635.” What happened?!

It seems that despite the assurances of Eurozone countries that “parliamentary approval would take ‘one week or two weeks at the maximum’ ” and analysts’ assertions that “Greece is as close to activating the rescue package as one can imagine,” the markets were simply not convinced. Some EU member countries have warned that “new legislation” will be required to lend money to Greece and “a group of German professors are readying a challenge to the rescue plan in Germany’s constitutional court.” In short, until Greece has the money in hand, nothing can be taken for granted. In addition, Greece must refinance €8 Billion in short-term debt that expires on May 19, and investors are skeptical that it can do so at tolerable interest rates, if at all. For example, a US Dollar-denominated bond offering that was projected to bring in $5-10 Billion attracted only $1-4 Billion in institutional interest.

Of course, there is also the concern that even if Greece can raise enough short-term cash to remain solvent, it will once again face trouble in the medium term: “An infusion of cash won’t fix Greece’s long-term problems, and the ‘only choice’ for Greece could be a ‘dramatic economic contraction,’ ” said one expert.Even if default wasn’t previously inevitable, it is quickly becoming self-fulfilling, since investors’ nervousness is leading to higher interest rates (aka borrowing costs), which is making it more difficult for Greece to reduce its budget deficit, which will cause investors to become more nervous, etc etc.

Unsurprisingly, experts have begun to look at alternative scenarios, such as leaving the Euro. The consensus is that it would be mechanically and legally feasible, but economically catastrophic. It would result in massive currency devaluation and economic recession, and wouldn’t even eliminate the sizable chunk of Greek debt that is denominated in foreign currency. In short, it remains a last resort or last resorts, and isn’t even on the table at the moment.

If investors learned anything from the credit/housing crisis, it is that things can quickly go from bad to worse, and they don’t want to have to learn that lesson a second time with Greece and the Euro. In the end, investors will stay away until there is more clarity surrounding Greece’s finances. Until then, betting on the Euro would be an “aggressive call.”

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Posted by Adam Kritzer | in Euro, News | No Comments »

Canadian Dollar and Parity

Apr. 21st 2010

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

CAD USD 5 year chart

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

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

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

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

CAD-USD March 2011 Futures

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

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

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Posted by Adam Kritzer | in Canadian Dollar, Central Banks, News | 1 Comment »

Forex Seasonality: Is it Real?

Apr. 19th 2010

I have always wanted to write a post about seasonality, but whenever push came to shove, I couldn’t see the point. Besides, I was never sure whether seasonality falls into the scope of technical analysis or whether it made sense to consider in fundamental terms, and for fear of overstretching, I stayed away. Recently, I read a column by Kathy Lien about forex seasonality. In fact, this article was merely an updated version of a nearly identical article that she contributed earlier to Investopedia, but nonetheless I found it informative, and I was finally inspired to address the topic on the Forex Blog.

Basically, Lien’s analysis consisted of examining 10 years of data for a handful of major currency pairs, and picking out the month(s) for each pair in which performance tended to be most lopsided. (Since forex is zero-sum, it should be the case that over a long enough time horizon, the average fluctuation for every pair should sink to ~0%. For other types of securities/investments, this type of analysis might be less viable). She discovered that the USD has tended to rise against in the Yen in July, but to fall in August. Meanwhile, the Dollar has tended to rise against the Euro in January, and fall against the Canadian Dollar in May. A similar study by DailyFX found that the US Dollar has also tended to rise against the Dollars of Australian, New Zealand, and Canada in the month of July.

Seasoanlity in EUR-USD from 1999-2008
These numbers are certainly interesting. But, I want to offer a clarification that the authors, themselves, didn’t bother to make. Namely, when making statistical claims about trends, it’s important to perform statistical (and not just visual) analysis. For example, the fact that the authors based all of their conclusions on only 10 years of data means that the case for statistical significance (a mathematical concept which states that a certain result cannot be a product of pure chance) is not as strong as you would think. Given that major currencies have floated since 1973, there is at least 30 years of good data which can and should have been used in the analysis.

For example, Lien observed that the US Dollar rose 80% of the time against the Yen against in the month of July. Given that the sample size (10 years) is only a fraction of the total data (let’s assume 30 years), we can say with 95% confidence (in accordance with statistical theory) that the actual fluctuation is somewhere between 60% and 100%. If you want to be 99% sure, then the interval expands to 53 to 100. To be fair, most traders would be perfectly happy with 95% confidence, and in this case, that means we can be 95% sure that the Dollar will rise against the Yen at least 60% of the time in the month of July. That’s not great, but still better than a coin-toss. If you bet on this trend every July over the next 10 years, then, you can be 95% sure that you will come out ahead. However, the average return over the last 10 years for this particular trend is only .39%, or 4.8% on an annualized basis. That’s not that impressive considering the margin of error and the amount of work that you had to do.

USD-JPY Price Activity in July - Forex Seasonality

As if this were not enough, Lien can’t even proffer an explanation why this is the case. (I’m certainly not blaming her; frankly I would be hard-pressed to come up with anything convincing). Being a fundamental analyst, personally, I like to have some idea (or delude myself into thinking I have some idea) as to why a certain trend exists, and I’m not content to simply take it as face value.  Thus, even if statistical theory tells me that this particular trend probably isn’t a product of pure chance, from where I’m sitting, it might as well be.

Actually, I was much more impressed with a similar piece of analysis that Lien published on FX 360, which looks at how volatility varies for USD/X currency pairs, from month-to-month. For all of the currency pairs that Lien examined, there is a clear pattern: volatility peaks in December/January and reaches a low in the summer. Not only is this trend clearly discernible, but also neatly explicable. In all of the financial markets, trading activity (and volatility, by extension) dries up in the summer as investors go on vacation. It slowly builds during the end of the year as portfolio managers churn their positions to try to meet their annual targets.

Forex Seasonality - EUR-USD Average Monthly Volatility
From a practical standpoint, there are a few takeaways. First, if you’re a carry trader, know that the risk is generally higher in the winter than in the summer. While many traders may complain about the lack of fluctuation in July and consequent difficulty of profitably day trading, you can sit back and earn a low-risk return on the interest rate spread.

With regard to the monthly trends for specific currency pairs that I referenced at the beginning of this post, I would say that they are certainly worth being aware of, especially if you’re a swing trader and tend to hold your positions for only a month. For shorter or longer-term trading, however, I don’t think most of these trends are actionable. Even in the handful of trends that seem to be bullet-proof, the fact that you must enter into the trade on the 1st of the month and exit on the last day of the month (since it’s on that basis that the trends were analyzed) would seem contrived and annoying.

I have to admit- I’m intensely curious as to whether anyone has actually tried to trade on such a strategy. Please share your experiences below!

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Posted by Adam Kritzer | in Investing & Trading, News | 4 Comments »

Inflation: Much Ado about Nothing?

Apr. 16th 2010

One of the cornerstones of exchange rate theory is that currencies rise and fall in accordance with inflation differentials. All else being equal, if US inflation averages 5% per annum and EU inflation averages 0% per annum, then we would expect the Euro to appreciate (or the Dollar to depreciate, depending on how you look at it) by 5% against the Dollar on an annualized basis. If only it were that simple…

You can see from the chart below that since the introduction of the Euro, inflation in the US has slightly outpaced Eurozone inflation (by about 5% on a cumulative basis). Over that same time period, the Euro first appreciated from slightly below parity with the US Dollar to $1.60, and then fell back to the current level of around $1.35. It’s clear (from the current sovereign debt crisis if nothing else) that the EUR/USD exchange rate, then, cannot be explained entirely by the theory of purchasing power parity.

Cumulative Inflation- US versus EU 1999-2009
Still, insofar as inflation bears on interest rates and can be a consequence of economic overheating or excessive government spending, it is something that must be heeded. On that note, after a dis-inflationary 2009, prices in the US are once again rising in 2010, and inflation is projected to finish the year around 2%.

Over the longer term, there is a tremendous amount of uncertainty regarding US inflation, for a couple reasons. The first is related to the Fed’s quantitative easing program, which pumped more than $1 Trillion into credit markets. While the Fed has basically stopped its asset purchases, all of this printed money is still technically in circulation, and some inflation hawks think it represents a ticking inflation time bomb. Doves respond that the Fed will withdraw these funds before they become inflationary, and that besides, most of the funds are actually being held by commercial banks in the form of excess reserves. (This notion is in fact born out by the chart below).

Excess Reserves versus Monetary Base
The second potential driver of inflation is the skyrocketing national debt. While US budget deficits have long been the norm, they have grown alarmingly high in the past few years and are projected to remain high for at least the next decade. Beyond that, the US faces up to $70 Trillion in unfunded entitlement liabilities, which means that net debt will probably grow before it can fall. Hopefully, the US economy will outpace the national debt and/or foreign Central Banks continue to buy Treasury securities in bulk. The alternative would be wholesale money printing (to deflate the debt) and hyperinflation.

Yields on both 10-year and 30-year Treasury securities remain enviably low, which means that buyers aren’t bracing for hyperinflation just yet. In addition, while gold continues to attract buyers despite record high prices, its rise has been closely tied to the performance of the stock market, which means that investors are currently using it to bet on economic recovery, rather than as a hedge against inflation.

gold vs S&P

In short, inflation in the US certainly remains a real possibility. At this point, however, it remains too hazy to be actionable, and the forex markets will probably wait for more information before pricing it into the Dollar.

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Posted by Adam Kritzer | in Economic Indicators, News, US Dollar | No Comments »

Forex Market Inverts as Emerging Markets Soar

Apr. 14th 2010

As I pointed out in last Friday’s post (Volatility, Carry, Risk, and the Forex Markets), volatility has been declining in forex markets since peaking after the collapse of Lehman Brothers. In fact, volatility among emerging market currencies has been falling particularly fast, and recently, something amazing happened: “Three-month implied volatility for the seven biggest developing country currencies fell to 10 percent in March compared with 11.4 percent for industrialized nations.” This inversion could rank as one of this year’s most important developments in terms of its impact on forex. The only runner-up that I can think of is Japanese LIBOR falling below American LIBOR.

Despite its remarkableness, this development isn’t unsurprising, since 8 of the 10 best performers in forex this year are emerging market currencies, led by the Costa Rican Colon, Mexican Peso, and Malaysian Ringgit. Still, we usually assume that with high return, comes high risk. How could it be that what are thought of as risky currencies are now less volatile than the so-called majors. Does it really make sense, for example, that the Turkish Lira is less volatile than the British Pound.

Without exploring this particular pair in detail, in a word, the answer is yes. In 2010, emerging market growth is projected to be higher than in the industrialized world. Inflation is relatively stable, and debt levels are comparatively low. Meanwhile, all of the G4 currencies (US Dollar, Euro, Japanese Yen, and British Pound) are plagued by the possibility of Double-Dip recessions and debt crises of varying seriousness. In sum, “Developing nations reduced their foreign debt to 26 percent of GDP last year from 41 percent in 1999, while advanced nations’ debt may surge to 106.7 percent of GDP this year from 78.2 percent in 2007.” Talk about heading in opposite directions!

EMBI+ 2009-2010

Investors are taking notice. While the JP Morgan Emerging Market Bond Index (EMBI+) is now rising at annualized rate of 22% (implying a decline in emerging market bond yields), rates on comparable EU and US debt is rising. Last week, the 10-Year Treasury Rate topped 4% for the first time in 18 months (though it has since retreated). Meanwhile, credit default swaps are pricing in a .4% chance of default in the US. Granted, this is still infinitesimal, but anything above 0% would have been derided as ridiculous only a few years ago. This year, the US is projected to spend more on servicing its debt than any other country except for the UK. The projected $1.6 Trillion deficit for 2010 certainly won’t help things.

2009-2010 10-Year Treasury Rate
Thus, emerging markets are projected “to lure $722 billion in overseas investment this year, 66 percent more than in 2009…Developing-nation bond funds attracted $7 billion this year, pushing assets under management to a record $74.7 billion.” Many portfolio managers are betting that this will be a long-term trend: “The rally in emerging-markets has barely started yet.”

What are the forex implications? For the first time, we could see the G4 currencies start trading as a bloc. [Previously, it was the US Dollar versus everything else. The introduction of the Euro ten years ago only strengthened this trend, which is ironic considering the EU has also become an establishment currency. But, if you look at the charts, the Dollar/Euro pair has rarely traded sideways, and traders have used it as a basis for making broader claims about the markets]. Now, it looks like this could finally change: “The big trends will be in non-G4 currencies against G4, such as dollar/Norway or euro/Aussie, and in emerging market currencies.”

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Posted by Adam Kritzer | in Emerging Currencies, Major Currencies, News | 1 Comment »

China Inches Toward Revaluation

Apr. 12th 2010

The hoopla surrounding the semi-annual release of the Treasury’s currency report has been awkwardly resolved. As a result of Chinese Prime Minister Hu Jintao’s last minute decision to participate in a US conference on nuclear disarmament, the Treasury has agreed to delay the release of the report for an indeterminate period.

While a handful of commentators saw this as a simple quid pro quo, the consensus among most of us is that a revaluation of the Chinese Yuan is now imminent. Technically, the RMB has been rising steadily for the last few months, and in fact, it recently touched a 9-month high against the USD. However, this appreciation has amounted to a mere .3%, certainly not enough to placate critics, many of whom insist that the RMB is undervalued by 25-40%. Probably within the next couple months (and as soon as tomorrow), the RMB peg will probably be lifted by at least 5% against the Dollar, and allowed to appreciate incrementally from there.

cnyOn the surface, it looks like President Obama deserves much of the credit for the sudden capitulation by China. From tire tariffs to a meeting with the Dalai Lama, he signaled that he was willing to play hard ball. As Senator Charles Schumer, one of the most vocal critics of China’s forex policy, said recently, “Every administration has thought it could get something done by talking to China. But years of experience have shown that the Chinese will not be moved by words; they only respond to tough action.”

While this game of high-stakes International Poker was being played, there was an internal debate taking place within China. On one side was the Central Bank, frustrated by its inability to conduct monetary policy independent of the currency peg. On the other side was the more powerful Commerce Ministry, which is responsible for representing the interests of Chinese exporters, among others. It appears that the Commerce Ministry has lost the debate, although it isn’t going down without a fight. After economic data showed the first monthly trade deficit ($7+ Billion) in 6 years, a press release argued that, “The continued improvement in our country’s balance of trade has created the conditions for the renminbi’s exchange rate to remain basically stable, case received a boost from the March $7 Billion trade deficit, the first monthly deficit in 6 years.”

China monthly balance of trade 2004 - 2010
At this point, analysts have stopped arguing about whether the revaluation is necessary (though this debate has not officially been resolved) and moved on to simply trying to predict the outcome of the internal Chinese negotiations. Some are skeptical:”Based on off-the-record briefing from officials in Beijing, one development that does not appear likely in the short term is any Chinese action to change the currency peg that ties the renminbi to the dollar.” However, this is contradicted by the prevailing view among China-watchers, which is that “Beijing will move on the currency not because they want to placate international pressure on trade flows but because domestic conditions suggest that such a move will be in their own interests.”

This is reflected in futures prices, which are now pricing in a 3% appreciation in the RMB by the end of the year, compared to expectations of a mere 1.5% appreciation in March. What’s harder to gauge (and speculate on) is how other currency pairs will be affected. Some analysts believe that an RMB appreciation will trigger a decline in the Euro, since China’s currency peg had also necessitated tangential purchases of Euros: “The euro will be more vulnerable from the perspective that the People’s Bank of China in the past diversified away from Treasuries to buy euro zone bonds.”

RMB USD December 2010 Futures Prices
Asian currencies should also benefit, since a more expensive Yuan will trigger a marginal shift of (speculative) capital to regional competitors, especially those with undervalued currencies. In fact, the Bank of Korea is already on high alert for any “unusual” (code for sudden appreciation of the Won) activity in the forex markets, and has suggested that intervention is always a possibility.

As for me, well, I’m not taking any chances. I just transferred some of my savings from Dollars into Yuan (of course this wouldn’t really make sense if I didn’t live in China). I like to think of it as a rudimentary form of hedging.

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Posted by Adam Kritzer | in Chinese Yuan (RMB), News | 2 Comments »

Volatility, Carry, Risk, and the Forex Markets

Apr. 8th 2010

Upon reviewing my previous post on the Brazilian Real (BRL), I now realize that it lacked context. In other words, while both the interest rate outlook and economic prospects of Brazil are both incredibly bright, who’s to say that this hasn’t already been priced into the Real? At the very least, more information is needed to determine whether the Real is valued fairly on an historical and/or relative basis. [Alas, the focus of this post isn’t on the Real specifically, but on the forex markets in general. Still, the concepts that will form the backbone of this post – volatility, risk, and carry – can be seen clearly through the prism of the Real.]

This doubt was sparked by an article that I read recently, entitled “Markets ‘Not Pricing’ Potential Risks,” which explored the idea that the renewed appetite for risk and consequent run-up in asset prices and re-allocation of capital is naively optimistic: ” ‘The unique environment we’re in now revolves around unprecedented level of government involvement in markets, which creates this complacency over risk because of this belief that governments will fix everything.’ Markets are under-pricing the risk that nations such as Dubai and Greece may default, and excess borrowing by others could lead to inflation.” From a financial standpoint, the practical implications of this idea is that the markets are underpricing risk.

volatility

In forex markets, complacency towards risk has manifested itself in the form of decreasing volatility. When you look at the 435 most commonly-traded currency pairs (actually most currency pairs involving the 35 most popular currencies), volatility is increasing for only nine of them. In addition, one month-volatility is now below 15% for all (widely-traded) currency pairs, which means that based on the most recent data, the highest, annualized standard deviation percentage change for every currency pair is only 15%. [It’s difficult to translate that concept into plain-English, but the basic idea is that all currencies are (actually, only 68% of the time) currently fluctuating by less than 15% from the mean on an annualized basis. The idea of standard deviation is murky for non-mathematicians, so it’s probably more useful to look at it on a relative and historical basis, rather than in absolute terms. In other words, the 15% figure can not be explained very well in an of itself; one must see how it compares to other currency pairs and to other time periods].

The fact that volatility is currently low suggests that the carry trade, for example, is set to become increasingly viable, especially when you factor in upcoming interest rate hikes. On the other hand, real interest rate differentials are currently modest (from a historical standpoint), and the concern is that rate hikes could be accompanied by rising volatility. The Brazilian Real, for example, “has a risk-adjusted carry of 45 percent, based on Morgan Stanley estimates, which means its carry rates had been better than current levels 55 percent of the time the last five years.” When you look at conditions from a few years ago, when volatility was at record low levels and interest rate differentials were larger than historically average, it’s obvious that the hey-day for the carry trade was in the past. It may come again in the future, but it certainly isn’t now.

From a practical standpoint, if you’re thinking about getting involved in the carry trade, you’ll want to choose a currency pair where the real (after adjusting for inflation) interest rate differential is high and volatility is low. You can cross-reference interest differentials with these charts – which uses recent mean return and volatility as the basis for forecasting confidence intervals – to get an idea about which pairs offer the best value (i.e. higher rate differentials at lower volatility). Just be aware that a sudden upswing in volatility could put a big dent in your risk-adjusted returns.

tock, currency and bond investors are underestimating the risk that government efforts to stabilize markets may fail,
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Brazilian Real Recovers on Rate Hike Hopes

Apr. 6th 2010

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

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

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

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

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

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

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

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

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Japanese Yen: Will We See Intervention?

Apr. 3rd 2010

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

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

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

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

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

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

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

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Posted by Adam Kritzer | in Central Banks, Japanese Yen, News | 1 Comment »

Forget about Greece: What about the US, Japan, and the UK?

Apr. 1st 2010

Forget about Greece: What about the US, Japan, and the UK? Almost 75% of trading in the forex markets involves some combination of the US Dollar, Euro, Japanese Yen, and British Pound. This figure rises to more than 95% when you include trading in which at least one of the currencies (as opposed to both) is one of the aforementioned. In short, these four currencies are by far the most important in forex markets, and most patterns/narratives in forex markets tend to involve them.
FX Most traded currencies
It’s simple supply and demand, really. These currencies are the most heavily traded because their economies are the largest and their capital markets are the deepest and most liquid. [The absence of the Chinese Yuan from this list can be explained by the lack of flexibility in its capital controls and exchange rate regime]. When investors flee one of these major currencies, they tend towards one of the others, and vice versa.

This phenomenon has especial relevance in the realm of sovereign debt. While some investors would love no more than to move their capital from the four debt-ridden currencies above, there just isn’t enough supply of alternative currencies to absorb the outflow. The Swiss Franc, Australian Dollar, and Canadian Dollar (#5, 6, & 7 on the list of most traded currencies), for example, have all surged over the last year as investors have looked for stable and liquid alternatives to what can be dubbed the Big-4 currencies. While these currencies still have some room for appreciation, they can’t continue to rise forever. For better or worse, then, the most useful comparison when it comes to to sovereign debt is not between the Big-4 and everything else (aka the major currencies and the emerging market currencies), but rather between the Big-4 themselves.

Forgive me for this long-winded introduction, but I think it’s important to understand the usefulness of comparing Japan with the US with the EU with the UK when all of these economies have terrible fiscal problems, and why we can’t just compare them to fiscally sound economies. With that being said, let the comparison commence!

Most of the fallout from the sovereign debt crisis has affected the EU and the Euro. This is for good reason, since the focal point of the crisis is a member of the Euro (Greece), and several other Eurozone countries are on the periphery. I addressed the EU in a previous post (EU Debt Crisis: Perception is Reality), so I think it makes sense to focus on the others here.

In terms of debt sustainability, the UK is not far behind Greece. “The flood of British debt is likely to ‘lead to inflationary conditions and a depreciating currency,’ lowering the return on bonds. ‘If that view becomes consensus, then at some point the UK may fail to attain escape velocity from its debt trap,’ ” explained one analyst. With high budget deficits projected for at least the next five years,  the Bank of England no longer buying UK bonds, and the possibility that the ucoming elections could produce political stalemate, the fiscal position of the UK can only deteriorate. On the plus side, the average maturity for UK bonds is 13.7 years, twice the OECD average, which means that it could be more than a decade, before Britain really begins to feel the squeeze.

debt sustainability chart
Japan might not be so lucky. Its net debt already exceeds 100% of GDP and its gross debt is approximately 200% of GDP; both are the highest in the OECD. Meanwhile, the average maturity of its debt is only five years, so there isn’t a lot of time to act. According to analysts, the crisis would most likely assume the following form: “ ‘A surge in yields would lead to a combination of extreme fiscal contraction, through tax increases and welfare cuts’…as well as to even more monetary expansion, perhaps less central bank independence and ‘presumably a much weaker exchange rate.’ ” In the case of Japan, the mitigating factor is that 90% of government debt is held domestically. Therefore, Japan isn’t vulnerable to the whims of foreign creditors, and an outright default is unlikely.

Then, there is the US. Its Trillion Dollar budget deficits, and multi-Trillion Dollar national debt and entitlement obligations are the highest in the world in nominal terms. On the other hand, the US government has not really encountered any difficulty in financing its spending. Political opposition is fierce, but investors have lined up to buy Treasury bonds and record low yields. This will likely change as the Fed curtails its purchases, and the economic recovery gives rise to higher interest rates. Analysts expect that borrowing costs (i.e. Treasury yields) could rise more than 1.5% by the end of 2010.

From the standpoint of markets, its impossible to say which economy’s fiscal problems are the most serious, since sovereign debt yields have declined across-the-board over the last 20 years. One Professor of Finance explains this trend as follows: “Behavioral factors keep many bond traders and investors from recognizing the reality of the situation…since there is no well-defined crisis point.” In other words, the crisis in Greece is only a test run. The real one could come in a few years, and involve a much larger economy. At that point, currency traders will have to decide who to back.

Sovereign Debt Bond Yields 1990-2010 US Japan Germany UK

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Posted by Adam Kritzer | in Major Currencies, News, Politics & Policy | No Comments »

Fed Rate Hike Still Distant

Mar. 31st 2010

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

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

FFR August 2010 Meeting Outcomes Implied Probability Rate Hike
But don’t take my word for it. What do members of the Fed’s Board of Governors have to say about the matter? In his semi-annual testimony before the House of Representatives last week, Chairman Ben Bernanke said that ” ‘the economy continues to require the support of accommodative monetary policies.’ And in response to questions, he reaffirmed that the high level of unemployment and low rate of inflation will continue to justify very low rates ‘for an extended period.’ ”

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

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

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

US Dollar Index Spot Price

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Posted by Adam Kritzer | in Central Banks, Major Currencies, News, US Dollar | 1 Comment »

Swiss Franc Surges to Record High: Where was the SNB?

Mar. 26th 2010
One of the clear victors of the Greek sovereign debt crisis has been the Swiss Franc, which has risen 5% against the Euro over the last quarter en route to a record high. 5% may not sound like much until you consider that the Franc had hovered around the €1.50 for most of 2009. Every time it budged from that mark, the Swiss National Bank (SNB) moved swiftly to return the Franc to its “resting spot.” So where was the SNB this time around?
Swiss Franc Euro chart
 
Beginning last March, the SNB was an active player in forex markets: “Quarterly figures indicate the central bank spent some 4 billion euros worth of francs in March, 12 billion in the second quarter, some 700 million euros in the third quarter, and some 4 billion in the fourth.” In fact, the SNB might still be intervening, and it won’t be until 2010 Q1 data is released that we will be able to say for sure. The Franc’s rise has certainly been steep, but who’s to stay that it couldn’t have been even steeper. For comparative purposes, consider that the US Dollar has risen more than 10% against the Euro over this same time period.
 
But the fact remains that the “line in the sand” was broken and the Swiss Franc touched an all-time high of €1.43. According to SNB Chairman Philipp Hildebrand, “We have a broad range of means to prevent an excessive appreciation and we are going to do this to ensure that the recovery can continue. The instruments are clear: We buy foreign currencies. We can do that in very large quantities.” In other words, he is sticking to the official line, that the SNB forex policy has not yet been abandoned. On the other hand, “SNB directorate member Jean-Pierre Danthine said Swiss companies and households should prepare for a market-driven exchange rate some time in the future.”
 
Actually, I don’t think these two statements are necessarily contradictory. The Franc is rising against the Euro for reasons that have less to do with the Franc and more to do with the Euro. At this point, if the SNB continued to stick to its line in the sand, it would look almost illogical, especially since by some measures, the Swiss Franc is already the world’s most manipulated currency. Besides, by all accounts, the interventionist policy has been a smashing success. The forex markets were cowed into submission for almost a year, which prevented the Swiss economy from contracting more and probably paved the way for recovery. 2009 GDP growth is estimated at -1.5% with 2010 growth projected at 1.5%.
 
By its own admission, the SNB did not target currency intervention as an end in itself. “If you want to assess the success, then you should not only look at a certain exchange rate, but look at the success of the Swiss economy.” Rather, its goal was monetary in nature. Since, it cut rates to nil very early on, the only other way it could tighten is by holding down the value of the Franc. Along these lines, the SNB will continue to use the Franc as a proxy for conducting monetary policy: “An excessive appreciation is if deflation risks were to materialise. We will not allow this to happen.”
 
Going forward then, it seems the Franc will continue to appreciate. “I think the marketwill cautiously continue to sell the euro against the Swiss franc and perhaps see whether the SNB will step in and try and stop the Swiss franc strength,” said one analyst. As long as the Swiss economy continues to expand and deflation remains at bay, there is little reason for the SNB to continue. Besides, intervention is not cheap, as the SNB’s forex reserves grew by more than 100% in 2009. On the other hand, the SNB has probably intervened in forex markets on 100 separate occasions over the last two decades, which means that it won’t be shy about stepping back in if need be.
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A Break-Up of the Euro?

Mar. 24th 2010
Lest you accuse me of doomsday predictions and excessive fear-mongering, consider that I have only broached this topic on one previous occasion. In 2005, it was suggested that the Euro would dissolve since a handful of member countries (France and the Netherlands) rejected the new EU Treaty. [Alas, the tragedy was averted when both countries’ Parliaments ratified the Treaty against the wishes of their respective electorates]. This time around, however, the problems are deeper, and are economic rather than political.
 
Last week [EU Debt Crisis: Perception is Reality], I wrote that Greece only has three possible choices in dealing with its fiscal problems: clean up its finances, pray for a bailout, or (partially) default on its debt. Here I overlooked a fourth possibility: leaving the Euro and devaluing its debt. That this was originally omitted was not an oversight, but proof that this is considered a last resort of last resorts. Most analysts believe that Greece would sooner default on its debt than leave the Euro.
euro dollar 1 year chart march 2010
 
I’m inclined to agree. The Greek economy benefited from inclusion in the Euro zone in the form of lower interest rates and increased credibility. Sure, it took advantage of these perks by running up record budget deficits, but one can hardly blame the Euro since Greece binged voluntarily. The responsible move might be for the EU to kick Greece out, akin to the bartender cutting off the alcoholic; you wouldn’t expect the alcoholic to voluntarily stop drinking.
 
For now, Greece is saying and doing all of the right things to placate both EU officials and its own lenders. On the other hand, it faces increasing pressure from its populace. Fiscal austerity during an economic recession is a recipe for political disaster: “Greek workers disrupted transportation services and tried to storm parliament on March 5 as lawmakers passed 4.8 billion euros ($6.6 billion) of extra deficit reductions, including lower wages for public employees. Such cutbacks will continue to run into resistance as unemployment is propelled above December’s 10.2 percent.” Since both of these extremes (fiscal crisis on the one hand and civil unrest on the other) are equally untenable, some analysts think the only solution will be for Greece to leave the Euro.
 
Given that Greece’s economy only accounts for 2% of EU GDP, it won’t make too many waves regardless of what happens. The bigger problem, looming on the horizon, is Spain. Spain accounts for close to 15% of EU GDP, and the economic slowdown hit the nation hard. Low interest rates fomented a massive property and infrastructure boom, and the subsequent easing of monetary policy (to soften the collapse), succeeded only in stoking inflation. The concerns are twofold: that the economic crisis can’t resolve itself without deflation, and/or that economic crisis will trigger a fiscal crisis. While Spain is still far from fiscal crisis, it’s worth pointing out that fiscal austerity will be difficult (because of the economic downturn) and that an EU bailout would impossible because of its size.
 
The situations in Spain and Greece (Ireland and Portugal could also be included) have underscored concerns harbored by many economists since the creation of the Euro. They argue, namely, that the common currency has allowed poor countries to borrow more than they otherwise would have been able to, and that the common monetary policy has resulted in harmful gaps between countries in inflation and economic growth. “They have a single monetary policy and yet every country can set its own fiscal and tax policy. There’s too much incentive for countries to run up big deficits as there’s no feedback until a crisis,” summarized Harvard economist Martin Feldstein.
 
Feldstein and a chorus of others are now openly predicting the breakup of the Euro. Former U.K. Treasury adviser Roger Bootlehas asserted that, “As countries in the euro area are ‘forced to cut back on fiscal deficits, they’re going to face many years of depression and deflation. It’s doubtful politically they can hold that line.” Naturally, most still dismiss this as an outside possibility, with ECB President Jean-Claude Trichet going so far as to call it “absurd.”
 
Given that the crisis countries (Greece, Spain, etc.) will probably fight the hardest for the Euro’s preservation, Trichet is probably right. “Support for monetary union was highest in Spain, ‘much higher than in Germany, where a lot of people were reluctant because they already had a strong currency…So Spain is very pro-European.’ As a result, the chances of Spain pulling out of the euro are ‘just unthinkable.’ ” Still, even the outside possibility is enough to make investors nervous.
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Chinese Yuan Controversy Heats Up

Mar. 22nd 2010

Over the last couple weeks, rising expectations of a resumed appreciation of the Chinese Yuan (RMB) have brought heightened tension. Politicians, economists, and even newspaper columnists are finding themselves involved in increasingly bitter disputes over the issue. What’s more, the debate has regressed; whereas before it was a foregone conclusion that China would soon lift the peg and the only question was when, now people are once again asking themselves whether an RMB revaluation is even necessary/desirable.

Breaking with his old strategy (on multiple fronts, it should be noted) of soft speech and appeasement, President Obama is now openly calling on China to allow the RMB to appreciate: “Countries with external deficits need to save and export more. Countries with external surpluses need to boost consumption and domestic demand. As I’ve said before, China moving to a more market-oriented exchange rate would make an essential contribution to that global rebalancing effort.” While this would seem like a fairly mundane exhortation, it marks a strong break from Obama’s previous rhetorical approach, in which he generally avoided singling out China.

Meanwhile, the US Treasury Department is busy preparing its semi-annual report on foreign currencies, which will be presented to the US Congress on April 15. As usual, the media is focused on the portion concerning China, specifically with whether it is officially labelled a currency manipulator. Almost by definition, China manipulates the Yuan, but the Treasury Department has heretofore avoided the label because it would allow Congress to impose punitive trade sanctions. Ironically, the most pressure to bestow such a label is coming from Congress, itself.

Aside from the report, Congress is not sitting by idly, as evidenced by a recent letter to the President signed by 130 Representatives calling for action. The Senate is also busy with draft legislation that would place a 25-40% tariff on all imports from China unless the RMB is revalued by a similar percentage. “The senators said the U.S. recession could boost the political prospects for the legislation, which [Charles] Schumer has proposed in various forms since 2003. Schumer said the Senate proposal will be attached ‘very soon’ as an amendment to ‘must-pass legislation. The only way we will change them is by forcing them to change.’ ” Perhaps the economic recession has put things in perspective, and the legislation finally has the impetus needed to pass.

Chinese government officials continue to send conflicting signals. No less than China’s premier (the #2 man behind only the Prime Minister) Wen JiaBao, told reporters with a straight face that China doesn’t manipulate the Yuan and that in fact, it is other countries which are guilty of such a crime. Added another high-ranking official, “We don’t agree with politicising the renminbi [yuan] exchange rate issue.” On the other hand, Zhou XiaoChuan, head of the Central Bank of China “broke new ground by stating that exiting the stimulus would sooner or later spell the end of the ‘special yuan policy’ adopted to counter the financial crisis.” Evidently, the currency peg is interfering with the ability to conduct monetary policy, specifically by raising rates to fight inflation. As if the position of the government wasn’t muddled enough, the Ministry of Commerce is now running “stress-tests” on large exporters to see how they would fare in the event of a large revaluation.

Economists are also getting into the fray, with Nobel Laureate and NY Times columnist Paul Krugman editorializing that China’s Yuan policy “seriously damages the rest of the world. Most of the world’s large economies are stuck in a liquidity trap — deeply depressed, but unable to generate a recovery by cutting interest rates because the relevant rates are already near zero. China, by engineering an unwarranted trade surplus, is in effect imposing an anti-stimulus on these economies, which they can’t offset.” Morgan Stanley’s Chief Asia economist, Stephen Roach, reacted to this accusation by suggesting inexplicably that, “We should take out the baseball bat on Paul Krugman.” This set off a heated back-and-forth (conducted indirectly through other reporters) between the two economists, ultimately accomplishing nothing other than to bring added attention to the issue of the Yuan.

rmb

At this point, everyone – except for Stephen Roach and the WSJ editorial board – seems to agree that a revaluation would benefit everyone. “I basically think that making the yuan flexible would be positive, not only for the world’s economy, but also for China’s. Many of China’s neighbors seem to have questions about the dollar peg,” summarized a vice Finance Minister of Japan. Chinese officials accept and even share that view, and from their point of view, the revaluation is only a matter of being able to do so on their own terms. As with many things in China (coming from someone who lives there), it’s important to save face.

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Why is the Loonie Beating the Aussie?

Mar. 20th 2010

It sounds like the beginning to a bad joke, right? But seriously, why is the Canadian Dollar (aka Loonie) beating the Australian Dollar (AUD) when the two currencies are placed head-to-head?

The currency markets tend to be very Dollar-Centric, in that they tend to view most currencies relative to the US Dollar (and to a lesser extent, the Euro), rather than to each other. When it comes to the Aussie and Loonie, then, traders at the moment seem content to see them as relatively strong, since both are appreciating against the Dollar. After all, the AUD/CAD pair accounts for only a small fraction of overall trading activity, which means that liquidity is lower and spreads are higher. Why bother?

But this ignores the fact that an important battle is currently being waged by the two currencies not only against the Dollar, but also against the other. It’s not as if the AUD/CAD rate is determined solely based on triangular arbitrage (i.e. indirectly from the AUD/USD and USD/CAD). On the contrary, there are unique factors which determine this exchange rate irrespective of others, as well as specific financial instruments.

But enough with the palavering!Let’s try to understand the idea of parity as it exists between the Loonie and Aussie, and not relative to the Greenback. I like to begin any analysis by looking at a chart. But as with any financial chart, a different time period changes the whole picture. In this case, the 1-year chart shows the Australian Dollar gaining in 2009 (in fact it was the highest performer last year among all of the majors) from the lows of the credit crunch, but retreating in 2010 away from parity. It is this latter trend that I want to elucidate here.

CAD AUD 2009-2010

On paper, the Aussie would seem to be the clear favorite. As a result of this month’s interest rate hike by the RBA, the benchmark Australian rate (4%) is now a healthy 3.5% higher than its Canadian counterpart (.5%). This should favor the Aussie among carry traders looking for the highest yield differentials. In addition, the Australian Dollar accounts for a higher portion (6.7% versus 4.2%) of forex turnover than the Canadian Dollar, according to the most recent data, which means that the AUD wins the liquidity battle as well. Meanwhile, Australia’s public debt is near the low end among developed countries, at almost 15% of GDP. After a record 2009 budget deficit, Canada’s public debt is close to 80% of GDP and is among the highest the world. Finally, Australia’s economy was one of the first to emerge from recession (some say it never even officially entered recession), certainly before Canada.

But all of this is in the past. “Canada is on course to be the first Group of Seven nation to erase its budget gap after the global financial crisis.” [Australia should have won this distinction, but alas, it’s not a member of the G7]. In 2009 Q4 (the most recent for which data is available), Canada’s economy grew at 5%, compared to 2.7% in Australia. While the US economy – Canada’s largest trade partner – is accelerating, China – Australia’s most important trade partner – is attempting to slow down.

While both the Aussie and Loonie are thought of as commodity currencies, the Loonie is currently benefiting from higher oil prices while the Aussie could suffer from peaking coal and iron ore prices. Volatility (as implied by options contracts) is lower for the Loonie, and this is just as significant as the interest rate differential, when it comes to the carry trade. When you consider finally that “Canada’s financial system was named the soundest in the world for two consecutive years by the Geneva-based World Economic Forum,” its banks are all financially sound, and the attention garnered by the Vancouver Olympics, it’s no wonder that the Loonie is now edging ahead.

Over the last five years, the two currencies have been pretty stable against each other. [Against a basket of other currencies, the Loonie is ahead, with a 20% total appreciation compared to the Aussie’s 17% rise]. Thus, the current ebb could be a necessary correction. While analysts like to see things in terms of important psychological milestones, there’s no real reason why the two currencies should trade at 1:1 (parity), and the equilibrium value could very well be below the current level.

This is evidently how the markets feel, as the Aussie just slipped below its 200-day moving average against the Loonie for the first time since 2008. In addition, “Investors paid the largest premium in almost a year last month for Australian dollar put options versus the Loonie. The premium of contracts granting the right to sell the Aussie versus the Canadian currency in one week over those for buying increased on February 8 to 1.18 percentage points, the biggest since April 2009.” After all, the Aussie’s appreciation in 2009 was the highest in 15 years. Perhaps it’s only natural that all else being equal, it should fall a bit in 2010.

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EU Debt Crisis: Perception is Reality

Mar. 18th 2010

I wonder if I wasn’t a little glib in my last post (Dollar Returns to Favor as World’s Reserve Currency)when I implied that the Euro would necessarily continue falling because of ongoing sovereign risk crises. In actuality, the situation is much more nuanced, and I want to qualify this idea below.

As I’ve said before, the sudden sovereign debt crisis in Greece is one of many. While its fiscal problems are certainly serious, they are not markedly worse than those of other countries, and it’s somewhat hard to understand why the markets suddenly decided to gang up on Greece. As many analysts have been quick to point out, Portugal, Ireland and Spain are in equally bad shape. Perhaps, it is the unique combination of factors which has led investors to focus on Greece in particular: “Greece stands out for the size of its debt stock, the scale of its budget deficit and the grimness of its growth prospects given high domestic costs and an inability to devalue.” But again, this inability to devalue its debt is shared by every other member of the EU. By virtue of belonging to the Euro, all of these countries must face their debt problems as they are, and cannot attempt to alleviate them through currency depreciation.

It is for this reason that I think that the EU will continue to be the main loser from real (and perceived) debt crises. As you can see from the table below, of the ten countries whose debt positions are least sustainable, seven of them are current members of the EU. This is problematic for the Euro, because as far as currency markets are concerned, one country’s problem is automatically a pan-EU problem.

201007FNC877

 If you look again at the Greek debt crisis specifically, there are really only three possible outcomes: “one of the most excruciating fiscal squeezes in modern European history – reducing the deficit from 13 per cent to 3 per cent of gross domestic product within just three years; outright default on all or part of the Greek government’s debt; or (most likely, as signalled by German officials on Wednesday) some kind of bail-out led by Berlin.” While such a bailout would temporarily stabilize the crisis, it would set a dangerous precedent in terms of dealing with fiscal crises in other EU countries and would do nothing to solve Greece’s underlying structural problems. Only under the first outcome, then, would the Euro not suffer, and unfortunately this one seems least likely.

Of course, the ultimate resolution of the crisis is still many years away. For now, currency traders are perhaps less interested in whether Greece will get its fiscal house in order and/or receive an EU bailout, and more concerned with how perceptions of the crisis will evolve. Recently, many investors have been taking their cues from the market for credit default swaps (CDS), which functions as insurance against and can be used to gauge the likelihood of sovereign default. In the case of Greece, CDS premiums have been rising (now implying a 4%+ chance of default), even though demand for Greek bond issuances remain strong at moderate interest rates. This discrepancy can best be explained by the presence of speculators, which are also working to push the Euro down.

Interestingly, the EU is currently mulling a ban on speculative (naked) CDS purchases, which would theoretically lead to lower CDS premiums and in turn, assuage other investors that the likelihood of a Greek default is low. On the face of things, this would probably – investment and lending in the EU, as sovereign risk would be less of an issue. However, there is still the possibility that speculators would continue to push down the Euro, for lack of a better strategy. In fact, they could even redouble their short bets against the Euro, since the CDS ban would deprive them of a valuable strategy for betting directly against Greece. (In fact, CDS speculation, while leading to higher interest rates and making it more difficult for Greece to finance its deficit, actually has no direct effect on the Euro, since it doesn’t necessitate a cross-border transaction).

Alas, then, it’s actually hard to predict (as always!) the near-term direction of the Euro. Since the crisis is still more perceived than actual, it’s clear that the Euro decline is a product of speculation and uncertainty, neither of which will disappear anytime soon. The best hope, then, for the Euro is probably just that investors will simply get bored with the story – as they eventually always do – and turn their attention to something else.

euro

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Dollar Returns to Favor as World’s Reserve Currency

Mar. 16th 2010

Rumor has it that the Dollar is about to make a run. As the credit crisis slowly subsides, (currency) investors are once again looking at the long-term, and they like what they see when it comes to the Dollar.

For those that care to remember, 2008 was a great year for the Dollar, as the credit crisis precipitated an increase in risk aversion, and investors realized that despite its pitfalls, the Dollar was (and still is) the most stable and really the only viable global reserve currency. [This reversed a trend which had essentially been in place since the inception of the Euro in 1999]. In 2009, meanwhile, the Dollar resumed its multi-year decline, and many analysts were quick to label the rally of 2008 as an aberration.

Then came the debt crises, first in Dubai, then in Greece. Suddenly, a handful of smaller EU countries appeared vulnerable to fiscal crises. Japan officially became the first of the Aaa economies to receive a downgrade in its credit rating. The British Pound is dealing with crises on both the political and economic fronts. According to Moody’s, “The ratings of the Aaa governments — which also include Britain, France, Spain and the Nordic countries — are currently ‘stable’…But…their ‘distance-to-downgrade’ has in all cases substantially diminished.”  Suddenly, the Greenback doesn’t look so bad.

chart

I want to point out that in forex, everything is relative. (Novice) forex investors are often baffled by how sustained economic and financial crises don’t immediately result in currency depreciation. The explanation is that when the crises are worse in (every) other countries, the base currency still looks attractive.

This is precisely the case when it comes to the US Dollar. To be sure, the economy is still flawed, financial markets have yet to fully to recover, the federal budget deficit topped $1.8 Trillion in 2009, and government finances seem close to the breaking point. Moody’s has also identified the US as a candidate for a ratings downgrade. And yet, when you look at the situation in every other currency that currently rivals the US for reserve currency status, the Dollar still wins hands down.

Its economy is the world’s largest. So are its financial markets, which are also the deepest and most liquid. Its sovereign finances are still manageable from the standpoint of debt-to-GDP and interest-to-revenue ratios. It is the only currency whose circulation can even come close to meeting the needs of global trade. Summarized S&P – when it confirmed the AAA credit rating of the US, “The dollar’s widespread acceptance stems from the U.S. economy’s fundamental strength, which in our view comes from the economy’s size and the flexibility of labor and product markets. We view U.S. banking and capital markets to be dynamic and unfettered relative to their peers.”

That’s why auctions of US Treasury bonds remain heavily oversubscribed (demand exceeds supply), despite the rock-bottom interest coupons. China has reaffirmed its commitment to Treasuries (what other choice does it have), confirmed by some forensic accounting work. Gold might continue to rally. So will other commodities, for all I know. Emerging market currencies are still in good shape as well, but none of these will seriously rival the US Dollar for a long-time, if ever. In short, when it comes to the other majors, the Dollar is still King: “You can say whatever you want, but the dollar is the currency of last resort It’s the currency people want in a crisis.”

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Australia Hikes Rates; How about the Carry Trade?

Mar. 14th 2010

Following up on my last post, I want to use this post to write about the long side of the carry trade- specifically the Australian Dollar. The Bank of International Settlements (BIS) observed in a recent report that, “The role of short-term interest rate differentials in both the deprecations and their reversal has grown over time.” When you consider that the benchmark interest rate in Australia is now 4% and that interest rates in every other industrialized country (including Japan) are close to 0%, it’s not hard to connect the dots.

Earlier this month, the Reserve Bank of Australia (RBA) raised the benchmark by .25% for the fourth time since it began tightening. In an accompanying press release, the RBA stated that “The board judges that with growth likely to be close to trend and inflation close to target over the coming year, it is appropriate for interest rates to be closer to average. Today’s decision is a further step in that process. It’s worth noting that the Australian Dollar barely budged, because investors had expected the move. The larger question was, and still is, the ultimate extent of RBA rate hikes and how soon it will get there.

Glen Stevens, Governor of the RBA, has himself indicated that “rates are still 50 to 100 basis points, or hundredths of a percentage point, below normal.” If you do that math, that means that the RBA will hike rates to 4.5-5% before stopping. Other more bullish analysts think 5-6% is a more realistic expectation because it is closer to the long-term average of Australian rate hikes.

As to when the benchmark will reach that point, it’s anyone’s guess. Going forward, analysts have pegged the liklihood of an April rate hike at 40%. Said one analyst, “It’s now a line-ball call; indeed, if you put a gun to my head . . . I’d guess that the RBA is going to hike again by 25 basis points in April.” Still, most think that the RBA won’t hike again until May. Added another analyst, “They are not indicating any urgency. We think they will go again in a couple of months. It could be three months, it could be two, our formal view is two, that may depend on how the inflation numbers look.” It’s too early to project when the next next (after the next one) hike will take place, because it depends on the timing of the first one.

At this point, most Australian economic data is trending steadily in the right direction. “Australia’s economy is starting a new upswing…Unemployment fell to 5.3% in January, not far above levels considered full employment for the economy…A rebound in construction and an investment splurge in the mining sector are expected to restore growth in the economy back to historic averages by the end of 2010. The RBA has indicated it expects inflation to remain within its 2%-3% target band.” Without drilling too deeply into any of the other numbers, there’s very little reason to doubt that the Australian economic recovery is genuine, which reinforces the notion that it is only a question of when – not if – the RBA further hikes rates.

In fact, the picture surrounding the Australian Dollar is almost a mirror image of the Japanese Yen. While the Yen looks destined to fall irrespective of the carry trade, the Australian Dollar looks destined to fall. While further monetary easing in Japan will give the Yen a second life as a funding currency, higher rates in Australia will once again make it a popular long currency. In short, “With commodity prices likely to remain strong and the spread between Australian and US interest rates likely to widen further its only a matter of time before the Australian dollar breaches parity against the US dollar.”

In fact, the Australian Dollar just touched a 13-year high against the Euro – though that is as much due to the Greek debt crisis and Euro problems as it is with Aussie strength. Meanwhile, the Australian Dollar has zig-zagged against the US Dollar, and is now in a rising trend following a recovery in risk sentiment. Whether it sustains this momentum depends largely on whether the RBA hikes rates next month.

 

3m

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Yen Carry Trade is Back!

Mar. 12th 2010

I can’t remember how long it’s been since I was hyping the Yen carry trade (though a browsing of the ForexBlog archives indicates 2 years). Upon the outset of the credit crisis, forex markets went haywire, and one of the main “beneficiaries” was the Yen, which soared as carry trades were unwound. Now, however, a similar set of circumstances that made the Yen carry trade attractive from 2006-2008 have re-appeared, and it looks like the trade could be on the verge of making a big comeback.

2y

Practitioners of the carry trade understand that it has a few pre-conditions. The first is low interest rates. In this case, the benchmark Japanese interest rate is only .1%. While that would have meant something a few years ago, however, it no longer counts for much, since benchmark rates in other industrialized countries are just as low. Where Japan has the edge is in market interest rates. Long-term rates have historically been well below the global average, and short-term rates are finally following suit after a 3-year hiatus. In fact, for the first time since August, the 3-month Japanese LIBOR rate – a lending benchmark – fell below its US counterpart: “On Thursday, the yen Libor JPY3MFSR= was fixed at 0.25063 percent — its lowest level since May 2006 — and the dollar USD3MFSR= rate at 0.25219 percent.” In short, the Japanese Yen is once again the cheapest currency in the world to borrow.

In addition, interest rates in Japan will probably remain low for the immediate future, as the Bank of Japan is actually looking to make its monetary policy even more accommodative (I didn’t think this was possible with a benchmark rate of only .1%!), in order to further stimulate the economy and alleviate the risk of deflation. This contrasts with Central Banks in other countries, which are already contemplating interest rate hikes.

The second condition is low volatility. ” ‘Realized trading vols has not been so low for many years.’ For example, three-month implied vols in the euro have slipped from a 25-plus high at the peak of the subprime crisis to levels around 10.68 currently…’As volatility goes down,’ the FX market tends to move toward a ‘classic carry trade environment.’ ” Low volatility is important because it enables investors to make low-risk bets on interest rate differentials without worrying too much about currency fluctuation. However, it doesn’t hurt that aversion to risk is also trending lower, such that investors can borrow in Yen to make higher-risk bets. According to the Bank of International Settlements, “The carry-to-risk ratios, a measure of the appeal of carry trades, have ‘been steadily rising over the past 14 years, consistent with an increasing attractiveness of the yen-funded carry trades for Australia and New Zealand.’ ”

_vixThe pickup in risk aversion – as a result of the Greek debt crisis – may have delayed the return of the Yen carry trade. In January, volatility rose slightly and the Yen rallied as the safe-haven mentality set in. Personally, I find this somewhat ironic, since Japan’s debt problems are even more pronounced, and unlike Greece, it can’t count on a bailout from Greece if things really get rough. Still, the markets work in strange ways, and the fact that the Yen has benefited from the crisis is probably due to the fact that traders can’t short all currencies simultaneously.

The third condition is really an outgrowth of the first two: belief that the funding currency will remain stable, or even decline. In this regard, the Yen is still hovering near an all-time high against the US Dollar, and given the confluence of bearish economic and political factors, it would seem to ne headed downward irrespective of the carry trade. For those looking for specific reasons to short the Yen, there are plenty from which to choose: low economic growth, dismal performance in finance markets, high public debt, dwindling savings and an upcoming retirement boom. As one analyst argued, “Tokyo is due to announce its medium-term fiscal plans in June. ‘Either this will mark the start of a prolonged period of fiscal restraint, weakening the economy again and requiring further monetary loosening, or the plans will lack credibility, in which case Japan’s financial markets would be hit hard. In either scenario, the yen looks vulnerable.’ ”

I don’t mean to get excited, but it’s hard to state a better case in favor of an imminent return of the Yen carry trade.

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Pound Falls, but may be Oversold

Mar. 10th 2010

One of the pitfalls of forex blogging (or all financial reporting for that matter) is that it’s inherently after-the fact. In other words, any information about the past – while relevant – is inherently useless, since it has theoretically already been priced into the asset (or currency in this case). Before I begin my post on the Pound’s recent decline and the factors that wrought it, then, I wanted to offer the caveat that in analyzing past events, we must simultaneously look to the future.

Anyway, for anyone watching the Pound Sterling over the last month, its performance has been startling. It is down 7.5% for the year already (we’re only in March!), and has fallen 12% from its August peak of 1.70 USD/GBP. This represents an unbelievable about-face, as the Pound spent much of 2009 floating upwards following its lows from the credit crisis.

z
What’s behind the decline? In short, economics and politics, or more precisely, the junction of economics and politics. As the British economy began its recovery from recession, analysts began to turn their attention to UK government finances. Another way of looking at this would be to say that analysts have shifted their gaze from the positive effect of government intervention (i.e. economic recovery) to the many lasting negative effects. Inflation and government solvency, of course, are the two most pernicious of the bunch.

The Bank of England’s quantitative easing program was comparable to the Fed’s program in relative terms, and in the aftermath of all of that money creation, inflation is slowly creeping up. The government’s free spending also contributed, and now, so is the sinking Pound, as prices for commodities and other imports are rising fast in local currency terms. Speaking of government spending, the UK government budget deficit is projected at 12% for 2010, slightly higher than 2009. You can see from the chart below that budget deficits are forecast to remain large for the next few years. Expectations are so low, in fact, that a reduction in the deficit to 3% of GDP by 2014-2015 would be viewed as a victory.

uk-budget-deficit-forecast-2009-2013
Naturally, the UK government feels some pressure to reduce its deficit, both for the sake of financial solvency and to control inflation. The problem is that an election must be called before June, and until then, there is natural pressure to continue operating the money printing presses 24/7 in order to appease the voting public. The same goes for the Bank of England; it can’t be expected to tighten monetary policy and/or reverse quantitative easing until after the election.

I’m not going to pretend that I understand British politics, but from what I’m hearing, it seems the problem is that the election polls are now very close. Previously, a major victory by the Conservative Party was seen as inevitable, and this was viewed positively by financial markets because of the expectation that they would rein in spending. Recently, the incumbent Labour Party has closed the gap, to the extent that a hung Parliament is now a likely outcome. This would be even less desirable than an outright Labour victory, because the sharing of power would make it unlikely that reforms of any kind would be enacted. With regard to forex, some have posited an inverse correlation between the rising popularity of Labour and the falling Pound.

With the crisis in Greece still unresolved, analysts are also making comparisons to the UK. Some have suggested that if Greece were to receive a bailout, then, investors would turn their attention to the UK, whose finances are in equally bad shape. Without the protection of the Euro, the Pound would be open to speculative attack. On the other hand, that the (declining) Pound is independent from the Euro could become in advantage, if it boosts exports.

Going forward, it’s difficult to make any predictions until after the elections and/or the government makes a firm commitment to reduce spending and lower its deficit. Some analysts think that regardless, the Pound is doomed to continue falling, perhaps all the way to the $1.40 mark. Others see the current decline as the “darkness before the dawn.” As I noted in the introduction to this post, the latter could certainly be right. Besides, most of the uncertainty has probably already priced in. While most of the factors currently weighing on the Pound are bearish, some contrarian investors might see this as a good opportunity to buy. And who’s to say they’re wrong?

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Emerging Market Currencies Continue their Run

Mar. 7th 2010

Since most emerging market economies and financial markets are fairly small, their currencies are subject to the whims of international investors, moreso than is the case with major currencies. For that reason, when I research emerging market currencies as a whole, I often like to focus on what investors are saying are saying about their stocks and bonds.

According to one columnist, “For an asset class once considered a snake pit of risk, emerging market sovereign bonds have become remarkably popular among investors. So popular, in fact, that even the most cautious of institutions have developed an appetite. Indeed, US pension funds are poised to pour almost $100bn (£65m, €74m) into emerging market debt in the next five years…potentially helping push yields relative to US Treasuries to a record low.” The popularity of emerging market debt is pretty incredible in the context of the Greek debt crisis and the consequent spike in risk aversion. At the same time, emerging market countries have been lauded for their sound finances and low debt-to-GDP ratios, so perhaps it’s no surprise that investors remain willing to continue lending them money. “More and more investors are looking to emerging market local bonds as an alternative to standard global bond allocations, as the problems in Greece and the European periphery highlight the credit risks of that market that have been long underpriced.”

Picture 3
The same is basically true for emerging market stocks, as “A recovery in economic growth and exports in developing nations is boosting the outlook for…company earnings.” Added another analyst, “When you look at the most recent financial crisis, one of the key features has been that emerging market countries weathered the storm extremely well.” Going forward, the consensus expectation is that emerging markets will soon account for the lion’s share of global growth.

Picture 1
For the most part, investors are still quite bullish on both stocks and bonds, despite – or perhaps because of – their amazing performances in 2009. The MSCI emerging market stock index has doubled over the past year, and the JP Morgan EMBI+ bond index rose 28% in 2009 en route to a record high. Still, there is concern that since emerging market stocks and bonds are basically in line with fundamentals, a further inflow of capital would push them into bubble territory. “Jerome Booth, head of research at Ashmore Investment Management, reckons that currency appreciation will be the main source of return for local emerging market debt portfolios in the medium term. ‘The only questions are when it starts and whether it happens fast or slow: with old world currency crashes or managed adjustment.’ ” This is problematic because it means at this point, investors may be chasing currency appreciation rather than direct asset appreciation.

Some investors have started to talk about bubbles, but these appear to be more regional in nature, and the handful of bears point to specific countries rather than dismiss emerging markets outright. For example, it’s now clear that there is a bubble in China’s property market, but not necessarily in the country’s stock market. The South African Rand, meanwhile appears to be overvalued, but the Central Bank of South Africa has announced that it will allow the Rand to continue appreciating. The Chilean Peso, meanwhile, is also poised to appreciate, ironically because of the recent earthquake, as Billions of Dollars aimed at relief efforts are already pouring into the country.

There’s much else that can be said about emerging market currencies at this point, and the near-term will depend largely on if/when/how the Greek debt crisis is resolved. While emerging market investors like to pretend that this is irrelevant, the fact is that they are still somewhat skittish, and even a minor crisis would send them running towards the exits.

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Chinese Yuan Still Pegged, and US Treasury Purchases Continue

Mar. 3rd 2010

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

Picture 1
What’s behind the change in expectations? The answer is a combination of economics and politics. On the economic side, China’s trade surplus is much smaller than in recent years, as import growth outpaces export growth. “Double-digit annual growth in exports is all but assured in coming months due to a low base of comparison in early 2009, but…sequential growth momentum went into reverse in January, with exports down 16 percent from December.” Moreover, while GDP growth appears strong, it appears tenuously connected to exports and fixed-asset investment. In addition, if the Central Bank of China raises interest rates to counter property speculation, it will have even less room to maneuver in its forex policy if it wishes to maintain high GDP growth. In terms of politics, the CCP doesn’t want to lose a crucial bargaining chip in international relations, and it also doesn’t want to mitigate the threat to its political legitimacy posed by a prolonged economic slowdown.

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

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

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

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Posted by Adam Kritzer | in Central Banks, Chinese Yuan (RMB), News, US Dollar | 3 Comments »

Speculators Pile Up Against Euro

Mar. 1st 2010

The Wall Street Journal’s coverage of the Greek dent crisis has focused less on the crisis itself, and more on the markets’ reaction to it. With headlines like “Hedge Funds Try ‘Career Trade’ Against Euro” and “Speculators Bet Record Amount Against Euro For 4th Week” and “Europe Trouble, U.S. Opportunity” – among others – the WSJ has identified a collapse in the Euro (mainly against the Dollar) as one of the most prominent (and profitable!) strategies for exploiting the crisis.

Euro
As I mentioned in the last post (“Understanding the Greece Situation“), the debt crisis has become self-fulfilling, not only for Greece, but also for the Euro. In other words, as perceptions abound that Greece is insolvent and the Euro is doomed, Greek bonds and the Euro have lost value, which only makes the crisis worse. It seems that speculators are taking advantage of this phenomenon by making large bets against the Euro. In fact, large is an understatement, as the net short positions against the Euro now total a record $12 Billion, according to the closely watched Commitment of Traders report.

Some analysts have taken such information at face value, noting that “The fact that the shorts got even shorter when they were already at extreme levels highlights just how negative the sentiment is toward euro.” On the other hand, there is evidence (and some degree of admission) that large speculators are now acting in concert to bring down the value of the Euro. The WSJ reports mention private meeting between hedge funds managers and investment banks helping their clients bet against the Euro using derivatives. For those that are skeptical that speculators could really influence currency markets, consider that one man – George Soros – single-handedly forced a devaluation of the Pound in 1992, and made $1 Billion in the process. While the Euro is certainly bigger than the Pound ever was, there are more people watching it than ever, and when there is money to be made –  hundreds of billions of dollars in this case – it isn’t inconceivable that the Euro could suffer a similar fate.

Already, there is evidence that this strategy is working, as the Euro has fallen 10% in less than three months, which is unbelievable for a currency whose daily trading volume is estimated at $1.2 Trillion. In fact, one popular options trade is based on the the Euro falling to parity against the Dollar. Once unthinkable, such a possibility now faces odds of “only” 1 in 14 (based on options premiums), compared to 1 in 33 in November. On the one hand, it’s frustrating to accept the market power that these speculators have. But emotion has no place in (forex) trading, and standing in the way of momentum would be costly.

On the other hand, Euro fundamentals remain strong. To be sure, a currency is only as strong as its constituent parts, and the fact that a handful of EU member states have shaky finances certainly cannot be dismissed. At the same time, the fact that such currencies have no direct control over the Euro is just as important. Before the inception of the Euro, currency traders would be justifiably concerned that a country in a similar position to Greece would deliberately devalue its currency (by printing money) in order to devalue its debt and make it more manageable.

Now, this would be impossible, since the Euro is controlled by the European Central Bank, over which Greece has no power. The current crisis in Greece notwithstanding, “The European Central Bank’s (ECB) resolve to maintain sound money is…important. This is especially true for the ECB, which has a single mandate—price stability—unrelated to fiscal problems.” While there is legitimate concern that the ECB will be forced (or voluntarily) print more money to fund bailouts of bankrupt EU member states, this doesn’t seem very likely, given the history of the ECB. Its monetary policy has always been quite conservative, and it’s no wonder that the Euro has come to be seen as a viable alternative to the Dollar.

In my opinion, the decline in the Euro is mostly baseless, and if it were to continue, it wouldn’t represent the prevailing of logic. Then again, logic is not exactly a word that I would apply to the forex markets, now or ever.

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Posted by Adam Kritzer | in Euro, Investing & Trading, News | 4 Comments »

Understanding the Greece Situation

Feb. 26th 2010

With this post, I want to try to clarify the Greek fiscal crisis. The problem is that it’s not clear exactly how serious the problem is, because most of the media coverage of the crisis has been directed towards the financial markets’ perception of it, rather than its underlying fundamentals. In the end, I think it’s important to understand both.

The Financial Times published a great timeline that shows perception and reality side-by-side. While there were certainly other important developments that bear in Greece’s fiscal position (in addition to those listed below), you can see that financial markets are basically making their own reality. For example, there was hardly a response to the October announcement that Greece’s budget deficit would be 12.7%, which was 5% higher than earlier estimates. In fact, the markets only became bearish on Greek debt after it the government announced that it would try to bring the debt down to 9.4% through various measures.

Greece debt timeline
Apologists for the markets would be right to wonder why investors should be inclined to believe the government of Greece when it said it could control the budget deficit. Fair enough. Still, one has to wonder why the markets suddenly started worrying about Greece’s fiscal problems, when only a couple months ago, the possibility of a whopping 12.7% budget deficit barely caused investors to blink. Besides, the credit crisis has been raging since 2008, which means the markets have had plenty of time to digest the implications of recession for Greece’s fiscal position.

These days, where is a financial crisis, chances are derivatives are not far removed. As credit default swap spreads (i.e. the cost of insuring against default by Greece on its loan obligations) have risen, so have concerns that this is a bona fide crisis. “It’s like the tail wagging the dog…There is a knock-on effect, as underlying positions begin to seem riskier, triggering risk models and forcing portfolio managers to sell Greek bonds,” said one portfolio manager. From this perspective, it almost looks like this “crisis” is being completely manufactured by speculators for the sake of profit. Summarized another analyst, “It’s like buying fire insurance on your neighbor’s house — you create an incentive to burn down the house.”

Greece credit default swap spreads
To be fair, Greece also played a role in derivatives speculation, and on some level, it was even more nefarious than the speculators. Assisted by Goldman Sachs (who is now betting on Greek default [how un-ironic that is!]), Greece entered into a series of swap agreements last decade, which it used to conceal its true debt burden. “By using an historical exchange rate that didn’t accurately denote the market value of the euro, Goldman effectively advanced Greece a €2.8 billion loan. Under EU accounting rules—which were tightened in 2008—Greece wasn’t obliged to include the loan in overall public debt on its books.” Now that those transactions have been uncovered and the truth is coming to light, financial markets are rightly re-evaluating the risk of further lending to Greece.

There is no question that Greece’s debt problems are serious. As to whether labeling it a crisis is necessary, that depends on your standards. Greece ranks near the top of the list on a variety of individual “debt sustainability” criteria. At 94.6% of GDP, it’s net debt is among the highest in the world. Its projected 2010 budget deficit is also high, though not the highest. Its cost of borrowing is also significantly higher than projected GDP growth, which means that net debt will continue to grow until a budget surplus can be produced. When you average these measures together, it appears that Greece’s debt problems are the most unsustainable of any country in the world. But this is hardly news.

Debt Sustainability
On the other hand, the weighted average of the maturity of Greek debt is 7.7 years, well above average, and plenty of time (relatively) for Greek to sort through this mess and secure new lenders. Towards the latter end, it has hired a former bond trader to head its debt management agency. In order to improve its fiscal position, it has announced a series of austerity measures, including budget cuts, tax increases, wage cuts for public-sector employees, and stricter laws against tax evasion.

At this point, a ratings downgrade looks inevitable, and some analysts think the crisis has already become self-fulfilling. As borrowing costs rise, it only makes it more likely that Greek will default, which causes rates to rise further, and so on. On the other hand, Greek politicians are being forthright about their position (“Greece’s finance minister, George Papaconstantinou, remarked this week: ‘People think we are in a terrible mess. And we are.’ “) and have a plan for rectifying the situation. There is cause for skepticism here, but also for hope. And that goes not just for Greece, but also for the Euro.

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Fed Rate Hikes a Distant Prospect

Feb. 23rd 2010

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

DXY

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

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

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

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

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

Excess reserves hed at the Fed 2006-2010
Forex traders, however, would be wise to focus on both aspects; inflation erodes the Dollar over the long-term, while higher interest rates make it more attractive in the short-term. For the time being, both remain low. In the not-too-distant future, either inflation and/or interest rates must rise. If/when the markets get over their sudden fixation on the debt crisis (a long-term issue) in Europe, they will return their attention to the Fed, probably just in time for the start of some big changes.

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Posted by Adam Kritzer | in Central Banks, News, US Dollar | 1 Comment »

The R in BRIC Stands for….Romania?

Feb. 19th 2010

By now, most investors are well aware of the acronym BRIC, which stands for the emerging market powerhouses of Brazil / Russia / India / China. When the idea was conceived in 2003, it seemed to make a lot of sense, as these four economies were at the top of the GDP ‘league tables,’ year-after-year. While China, India, and to a lesser-extent, Brazil, all continue to outperform, Russia has begun to lag. Perhaps Russia needs to be replaced as a member of BRIC. If the acronym is to be preserved, the only choices are Romania or Rwanda.

But seriously, last year Russia’s economy declined by 8%, compared to expansions of 6.5% and 8.3% in India and China, respectively. The Ruble fared equally poorly, relatively speaking. Compared to the Brazilian Real, which erased most of its 2008 decline, the Ruble’s rise offset less than half its previous losses. A similar picture can be painted with its. stock market. Not coincidentally, oil/gas prices have followed a similar pattern.

Real versus ruble

That the fortunes of Russia’s economy are too closely tied to energy exports is only half of the problem. The other half is as much cultural as structural. Russia’s economy is still largely oligarchical, and competition is lacking. Corruption is rampant, and the bureaucracy is out of control. In short, there is “a combination of corruption, poor governance, government interference in the private sector, and insufficient investment in the oil and gas sector,” which makes it unlikely that the Russian economy will embark on a stable course of development anytime soon. “What’s more, the warning signs of more economic trouble ahead are growing — for example, the increasing rate of non-performing loans on Russian banks’ balance sheets.” To put it bluntly, Russia’s economic prospects are somewhere between bleak and pathetic.

What about the Ruble, then? In the long-term, the Central Bank has pledged to shift its monetary policy away from micromanaging the Ruble. For the time being however, it remains focused on keeping the Ruble within a carefully prescribed range. Of course, it’s unclear whether the Central Bank sees its charge as defending the Ruble against a decline or against excessive depreciation, so currency traders shouldn’t read too much into it.

On the surface, the Ruble would seem to represent an excellent candidate for the carry trade. Despite being trimmed 10 times in 2009 alone, the Central Bank’s benchmark interest rate still stands at a healthy 8.75%. Moreover, the Central Bank has basically promised not to cut rates any further from the current record low. Remarkably, though, real interest rates are slightly negative, as Russia’s estimated inflation rate is 8.8%. Even more remarkably, this is the lowest level in decades! In other words, there is no interest too be earned from a Ruble carry trade, and the only upside is the appreciation in the Ruble.

And that ignores the downside risks, which are significant. After Russia defaulted on its debt in 1998, the international financial community basically lost confidence in the Ruble. Now, all of Russia’s government debt is denominated in foreign currency, mainly Dollars and Euros. Russian investors seem to harbor the same suspicions about their currency, and in 2008, the Ruble’s fall became self-fulfilling as investors transferred more than $150 Billion out of Russia, in the fourth quarter alone.

In short, I see very little upside from investing in the Ruble. There is no money to be earned from a Ruble carry trade. Betting on the Russian economy seems misguided. Betting on a continued rise in oil and gas prices would be better achieved by buying oil and gas futures directly. Meanwhile, any hiccup in the global economic recovery will certainly be met with an exodus of capital from Russia. Stick to the BIC countries instead.

ruble 5 years

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Pound’s Fate Tied to EU Debt Crisis

Feb. 17th 2010

Since the emergence of the debt crisis in Greece, UK policymakers have been once again patting themselves on the back for not joining the Euro. Otherwise, they would currently be in the same awkward position as France and Germany, whose economic might underpins the entire Eurozone and are wondering about if and how they should lend their support to Greece. Given that the Pound has fallen at an even faster clip than the Euro in recent weeks, however, it seems investors don’t share their sense of complacency. What gives?

One might be inclined to posit that the Pound is falling for reasons unrelated to Greece and the travails of the EU. After all, most of the economic data emanating from the UK these days isn’t exactly positive. GDP grew by an abysmal .4% in the fourth quarter of 2009, and the Bank of England, itself, has revised is 2010 projections down to 1.5%. In addition, inflation is creeping up and short-term rates remain low, such that real interest rates (and by extension, the carry associated with holding Pounds) in the UK are effectively negative.

While this alone would be grounds for selling the Pound, a cursory glance at GBP/USD and EUR/USD cross rates reveals that the Pound and Euro are falling in tandem. In my eyes, this implies that investors have impugned a connection between the situation in the EU (i.e. Greece and the other “PIGS” economies) and in the UK. And no wonder, since UK debt levels are as worrisome as any other country, developing or industrialized. Its budget deficit is 13%, slightly higher than in Greece. Private debt is estimated at £1.5 Trillion, or £60,000 per household, which is the highest (in relative terms) in the world. “Then there’s the trillion-pound bank bail-out, the trillion-pound public-sector pension liability, the trillion-pound public debt and those off-balance-sheet private finance initiatives schemes. If you add up Britain’s real liabilities you find that the UK is heading for a total debt burden of several times its GDP,” summarized one analyst.

NA-BE147_Sterli_NS_20100209193211

Of course, this is nothing new. I, myself, have written about the looming UK debt crisis on previous occasions. While such a crisis is still years away, the turmoil in Greece is causing investors to cast fresh eyes on the similarities and differences with the UK, and they clearly don’t like what they see. On the one hand, Britain’s monetary independence means that it can deflate its debt (by simply printing more money), unlike Greece, whose membership in the European Monetary Union precludes such a possibility. While this means that Britain is ultimately less likely to default on its debt, it makes it more likely that it its currency will have to weaken at some point in the future, so that its liabilities remain manageable. Bond investors, then, are right to prefer UK Bonds, but currency investors are equally right to shun the Pound in favor of the Euro.

It seems that Britain’s conception of itself is somewhat flawed. While it thinks of itself as akin to France or Germany (and hence, is quite happy not to be an EU member at the moment), the markets seem to think of it as a Spain or Portugal. The implication is that the markets currently believe that the UK would do better if it was a member of the EU than on its own. Of course, that proposition is debatable (and still unlikely), but it’s worth bearing in mind because it’s what investors apparently believe.

As usual, the BOE remains (perhaps willfully) oblivious of all of this. It is mulling an extension of its quantitative easing program, which is supposed to end this month. This program is responsible for an expansion of the money supply equal to 14% of GDP in 2009 alone! Most economists consider it a dismal failure, and it seems to have succeeded only in catalyzing growth in prices (aka inflation) rather than output (aka GDP). “The suspicion is that the UK government and Bank of England is not worried that the pound remains weak in this repositioning of currencies. They may indeed welcome it. There is no immediate appetite for raising interest rates to strengthen sterling and no point making exports harder by strengthening the exchange rate.” They would be wise to bear in mind, though, that while currency depreciation is useful for devaluing existing debt, it can have the unintended consequence of scaring off investors, and make it difficult to fund future debt.

Currency investors may be ahead of them on this one.

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CAD/USD Parity: Reality or Illusion?

Feb. 15th 2010

In January, the Canadian Dollar (aka Loonie) registered its worst monthly performance since June. Many analysts pointed to this as proof that its run was over, after coming tantalizingly close to parity. Others insisted that the decline was only a temporary correction, a mere squaring of positions before the Loonie’s next big run. Who’s right? Both!

cad1

There are (at least) two separate narratives presently weighing on the Loonie. The first is causing it to decline against its arch-rival, the US Dollar, for reasons that essentially have nothing to do with the Canadian Dollar and everything to do with the US Dollar. Specifically, the mini-crisis that is playing out in Greece and the EU has caused risk aversion to resurface, such that investors are now returning capital to the US. One analyst explains the impact of this seemingly tangential development on the Loonie as follows: “When you get any sort of ‘risk-off’ type of environment like we’ve had over the past week or so, currencies like the Canadian dollar and the Australian dollar will come under pressure.”

The second narrative explains why the Canadian Dollar continues to hold its own against most other currencies. Specifically, Canada’s economic recovery continues to gain momentum as commodity prices continue their rally. In the latest month for which figures are available, the economy added about 80,000 jobs, more than five times what forecasters were expecting. This turn of events is helping to quash the “view that the Canadian trade sector is incapable of growth with a strong currency,” and making traders less nervous about sending the Loonie up even higher.

Going forward, there is tremendous uncertainty. Both short-term (determined by the Bank of Canada) and long-term (determined by investors) interest rates remain quite low, such that the Loonie is not really a candidate for the carry trade. In addition, the Bank of Canada hasn’t completely ruled out the possibility of intervention on behalf of the Loonie; it may simply leave its benchmark interest rate on hold (at the current record low of .25%) for longer than it otherwise would have. In addition, a series of recent tightening measures by the government in China threatens to crimp demand for commodities and weigh on prices. Finally, the market turmoil in Greece is causing investors to look afresh at the balance sheets (in order to weigh the likelihood of default) of other economies. This probably won’t help Canada, which continues to run large deficits and whose debt level once earned it the dubious distinction of “honorary member of the Third World.”

Still, Canada’s capital markets are among the most liquid and stable in the industrialized world, and if risk-aversion really picks up, it won’t suffer as much as some other economies. “The Canadian economy is not as structurally impaired as the U.S. or the U.K. It creates a sense that Canada is less exposed to the fickleness of foreign investors that are causing uncertainty in other locations.” In fact, the Central Bank of Russia just announced that it will switch some of its foreign exchange reserves into Canadian Dollars, and other Central Banks could follow suit.

cad2

While the Canadian Dollar should continue to hold its own against other currencies, the same cannot necessarily be said for its relationship to the US Dollar. “Options traders are the most bearish on the Canadian dollar in 13 months…The three-month options showed a premium today of as much as 1.34 percentage points in favor of Canadian dollar puts.” In other words, the price of insurance against a sudden decline in the CAD/USD is rising as investors move to cushion their portfolios against such a possibility. While this trend could ease slightly in the coming weeks, I personally don’t expect it to disappear altogether. All else being equal, given a choice between owning Loonies or Greenbacks, I think most investors would choose Greenbacks.

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Posted by Adam Kritzer | in Canadian Dollar, Economic Indicators, News | 2 Comments »

Could Greece’s Fiscal Problems Really Sink the Euro?

Feb. 12th 2010

Currency markets operate in funny ways. Greece’s fiscal problems are hardly a new development. During years of boom and bust alike, it ran unsustainable budget deficits. Why investors have decided to fret now – as opposed to last year or next year, for example – on the distant possibility of default, is somewhat mysterious.

After all, the credit crisis exploded in 2008, and conditions now are inarguably more stable than they were at this time last year, when volatility and credit default spreads (insurance against bond default) – two of the best measures of investor risk sensitivity – were still hovering around record highs. On the other hand, the unveiling of Dubai’s hidden debt problems, has certainly provided impetus to investors to re-evaluate the fiscal situations in other highly leveraged economies. In addition, Greece just estimated that its budget deficit for 2010 at 12.7%, 4% higher than earlier estimates, which were also shockingly high. Regardless of 1, the markets are now focused firmly on Greece – and by extension, the Euro.

euro
How serious are Greece’s fiscal problems? Serious, but not insurmountable. Its sovereign debt recently surpassed 125% of GDP, higher than the US, but lower than Japan, for the sake of comparison. Of course, the Greek economy is hardly a picture of robustness. Neither is the US, these days, for that matter, but its size means that it is pretty much immune from speculative attacks on its credit and capital markets. Greece, on the other hand, remains extremely vulnerable to the whims of international investors.

On the whole, these investors still remain willing to finance Greece’s budget deficits; the last bond issue was five times oversubscribed, which means that demand exceeded supply by a healthy margin. Still, interest rates are rising quickly, and spreads on credit default spreads have risen above 400 basis points, suggesting that nervousness is growing and Greece cannot take for granted that future bond issues will be met with such healthy demand.

In this context, in stepped the European Union. In fact, it isn’t even clear if Greece asked for help. As I pointed out above, the Greek debt “crisis” is largely playing out in capital markets, and doesn’t necessarily reflect a change in the fiscal reality of Greece. Still, leaders of the EU were alarmed enough to convene a meeting between the finance ministers of member states, to discuss their options.

After weeks of denial that any kind of aid to Greece was being considered, EU political leaders announced that they were prepared to step in to help after all, but they were vague on the details. There were no ledges of specifc dollar amounts, only hazy promises of support should conditions warrant it. In the end, what was clearly intended to comfort the markets achieved the opposite effect, as investors took no comfort in the “moral support” and worried about the new uncertainty.

It’s premature to say whether this whole episode will threaten the viability of the Euro. Much depends on whether Greece (Portugal and Spain, too, for that matter) can get its fiscal house in order (Among other things, it has promised to reduce its 2010 budget deficit by 4%). More importantly, it depends how, and to what extent, the EU responds to this crisis as a community. The Euro is already 10 years old, and you would think that it would have been accepted already within the EU, as it has by the rest of the world. On the contrary, it remains deeply divisive and fraught with politics. Many of its critics have seized on this opportunity to challenge to raise fresh calls for its abolishment. If the problems of Greece deteriorate to the point that other EU members are actually required to intervene, you can expect these calls to crescendo.

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Posted by Adam Kritzer | in Euro, News, Politics & Policy | 3 Comments »

Chinese Yuan Expectations Revised Downwards

Feb. 9th 2010

Last month, I reported on how anticipation is (was) building towards a revaluation of the Chinese Yuan (RMB), confidently stating that “The only questions are when, how and to what extent.” While I’m not ready to recant that prediction just yet, I may have to temper it somewhat.

On the one hand, the case for RMB revaluation is stronger than ever. Among large economies, China’s economy is by far the strongest in the world, clocking in GDP of close to 2009% while most other economies were lucky to “break even.” Meanwhile, its export sector – supporting which is the primary purpose of the RMB peg – is once again robust, having recovered almost completely from a drop-off in demand in 2008 and the first half of 2009. In fact, exports grew by 30% in January, on a year-over-year basis. China’s share of global exports is now an impressive 9%, up from only 7% in 2006. From an economic standpoint, then, the case for an artificially cheap currency is no longer easy to make.

China exports inflation 2010
At the same time, the RMB peg is contributing to bubbles in property and other asset markets. That’s because the Central Bank of China has been forced to mirror the monetary policy of the Fed, as a significant interest rate differential would stimulate uncontrollable capital inflows from yield-hungry investors. While the US can still handle interest rates of close to 0%, China’s economy clearly can not. Thus, consumer prices are slowly creeping up, and property prices are soaring. The most effective (and perhaps the only) way for China to contain both consumer price and asset price inflation is to hike interest rates, which which in turn, would necessitate a rise in the RMB.

There is also the notion that the peg is becoming increasingly costly to maintain. China’s forex reserves already total $2.4 Trillion, and each Dollar that it adds will be worth less if/when it ultimately allows the RMB to appreciate further. In addition, China’s economic policymakers continue to fret about its exposure to the fiscal problems of the US, with one pointing out that, “China has effectively been kidnapped by U.S. debt.” Of course, they no doubt realize that there isn’t a better option at this point; its attempt to diversify its reserves into other assets proved disastrous. The solution to both of these problems, of course, would simply be to allow the Yuan to fluctuate based on market forces, or at least for it to resume its upward path of appreciation.

Political pressure on China to revalue, meanwhile, is even stronger than it was last month. While not invoking China by name, President Obama has been increasingly blunt about the need to pressure it on the RMB: “One of the challenges that we’ve got to address internationally is currency rates and how they match up to make sure that our goods are not artificially inflated in price and their goods are artificially deflated in price.” In addition, rumor has it that the Treasury Department could finally label China as a “currency manipulator” in its next report, which would allow Congress to impose punitive trade sanctions.

Developing countries, which now account for a majority of China’s exports, are also increasingly unhappy with the status quo. The peg to the Dollar caused many emerging market currencies to appreciate rapidly against the Yuan in 2009, and there is evidence that many of their trade imbalances with China are rapidly worsening, “with exports to India, Brazil, Indonesia and Mexico growing by 30% to 50% in recent months.” As one analyst pointed out, however, the potential backlash from this development could be massive: “It’s one thing to produce job losses in the U.S., but it’s another to produce job losses in Pakistan,’ with which China has close military ties.”

On the other hand, however, is China’s massive reluctance to allow the Yuan to appreciate. Part of this is related to face; with the US and other countries stepping up pressure on a number of fronts, China’s leaders don’t want to be seen as weak, and could act contrary to their own interests if it thinks it can earn political points in the process. “China is unlikely to make significant concessions to U.S. pressure on the yuan, particularly now when the two countries are involved in a range of disputes, including U.S. arms sales to Taiwan,” explained one analyst. More importantly, the leadership is nervous that the nascent economic recovery is not sufficiently grounded for the peg to be loosened. While 9% growth in most other economies would be cause for celebration, in China, it is being interpreted as evidence of fragility.

There you have it. Reason on one side, and politics on the other. Unfortunately, it seems that politics always triumphs in the end. Despite Treasury Secretary Geithner’s recent assertions that the RMB will rise soon, investors know that China ultimately calls the shots: “When it comes to the exchange rate, China’s main consideration is China’s own stable economic growth and the structural adjustment of its economy. Foreign pressure is only a secondary consideration.” In short, the RMB is now projected to appreciate only 2% in 2010, according to currency futures, compared to 3.5% last month.

rmb

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Posted by Adam Kritzer | in Chinese Yuan (RMB), News, Politics & Policy | No Comments »

Bernanke and the Dollar…Part Two

Feb. 7th 2010

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

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

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

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

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

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

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Posted by Adam Kritzer | in Central Banks, News | 6 Comments »

Juris-my-diction Issues in Forex Regulation

Feb. 5th 2010

Kudos to anyone who correctly identifies that reference. But seriously, in light of the proposed changes in forex regulation that have generated a heated response on this blog and elsewhere, I want to offer some insight into a tangential issue: jurisdiction.

Part of the problem with existing forex regulation is not that it’s insufficiently strict, but rather that it’s essentially optional. That’s because retail forex brokerages do not technically need to be registered in order to operate. Moreover, if they do register, they can choose between several organizations, depending on whose regulations most jive with their business models.

The Commodity Futures Trading Commission (CFTC) is probably the most prominent regulatory organization in retail forex, and of which most retail brokers are registered. [It is also the organization that has proposed the rule changes that everyone in forex is currently talking about]. It was only in 2008 that the CFTC was vested with the power to regulate retail forex, but contrary to popular, only its members (rather than all forex brokers) are subject to the sword of its regulation.

The Financial Industry Regulatory Authority (FINRA), the self-regulatory body for securities brokers,meanwhile, is trying to reach its regulatory powers into the arena of retail forex. In coordination with the SEC, it has proposed enhanced regulation for its own member brokers. Under this proposal, the handful of retail forex brokers that are registered with the SEC would be subject to stricter regulation than their counterparts under the control of the CFTC. Brokers registered only with the CFTC, then, would probably enjoy a competitive advantage (specifically the right to offer 10:1 leverage, instead of 4:1, as proposed by the SEC).

Then, there is the National Futures Association (NFA), which operates in association with the CFTC. Not to mention the exchanges, themselves, which impose their own set of rules on brokers. Make no mistake; all of these organizations are fairly vigilant in pursuing violations and in revoking membership for those brokers that really run afoul. The problem is that such does not nothing to stop a broker from simply registering with another regulatory agency instead, and/or not taking advantage of client apathy/laziness by either not registering at all, or even worse, lying about the registration.

In the end, most forex traders probably don’t care which regulatory organization ultimately wins the turf battle over the right to regulate retail forex. Ideally, though only one such organization would have such power, and all brokers would be subject. Given that this issue isn’t likely to be resolved anytime soon, for now, you would be wise to choose a broker that is registered with the CFTC. You can confirm a broker’s membership here.

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Posted by Adam Kritzer | in Investing & Trading, News | 1 Comment »

Commodity Currencies Remain in the Spotlight

Feb. 3rd 2010

In 2009, so-called commodity currencies – both individually and as a group – registered record-breaking gains. The Brazilian Real and the South African Rand finished up more than 30%, while the Australian and New Zealand Dollars finished up about 25% each, and the Canadian Dollar not far behind. While the outlook for 2010 is slightly less rosy (if only because of the law of averages), investors would still be wise to keep such currencies on their radar screen.

With the appreciations of 2009 canceling out the depreciations of 2008, currency markets are close to “equilibrium.” Going forward, then, investors will to find a rationale other than sheer momentum for making bets. Strong commodity prices represent one such rationale. This is not only the case because currency prices are rising and are underpinning the recoveries in the respective countries that are rich in their production, but also because economic recovery – and “normal” growth as well, for that matter – in many other economies is built precariously on debt and the expansion of sovereign money supplies.

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Commodity currencies – and commodities in general – have always held allure as investment vehicles because of their tangibility and necessity. Simply, modern economies depend on commodities for their functioning. Thus, countries rich in natural resources would seem to represent safe bets, since they can be assured of demand both during periods of expansion and during economic downturns.  The strong performance of commodity currencies in 2009 underscores this point, since despite the fact that prices for many commodities are well below the record highs of 2008, these currencies are very close to their 2008 highs.

More specifically, the Canadian Dollar often tracks the price of oil; this correlation will probably only strengthen when the oil sands of western Canada are developed. While rich in many natural resources, it is gold that both Australia and South Africa are famous for, and to which their currencies are often tethered. Brazil and New Zealand deal in a more diverse array of commodities, and the Kiwi and Real often move in tandem with broad-based commodities indexes. There is also the Mexican Peso (oil), the Russian Ruble (natural gas), the Norwegian Krona (oil), and Chilean Peso (copper), but the correlations between these currencies and the respective commodities for which they are famous tend to be looser.

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Of course, there are many other economies that are rich in natural resources, but for various reasons (lack of liquidity, fixed exchange rates), their currencies aren’t (as) appropriate for investing. Even the currencies I listed above don’t always reflect commodities prices. For example, Canada’s fiscal problems and South Africa’s monetary easing will arguably weigh down the Loonie and Rand, respectively, in 2010.

For commodity pure-plays, your best bet, then, would be to invest in the commodities themselves. Of course, commodities don’t pay interest and their costs associated with holding them (whether directly or indirectly) and they tend to fluctuate with greater volatility than currencies. Another option is the just-announced WisdomTree Commodity Currency Fund, an ETF composed of a basket of commodity currencies, many of which I listed above.

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New “Partition” in Forex Markets

Jan. 29th 2010

In October, I wrote about a “separation” that had taken place in currency markets between the “sick” currencies and the “healthy” currencies. At the time, I argued that the former category was comprised mainly of the Dollar and the Pound, with most other currencies healthy by comparison. While I still stand by this paradigm, I would like to revise it slightly. Specifically, I would like to add the Euro and the Yen to this list.

The recent blow-up surrounding the downgrade of Greece’s debt and subsequent explosion in the price of credit default swaps (which insure against default), have shined a spotlight on the fiscal problems of many of the EU’s member states, including Spain, Italy, Portugal, Ireland, and others. The situation in Japan, meanwhile, has been much more gradual, though equally dangerous: “In 1990, Japan’s total national debt load was 390% of GDP. Now it’s 460%. In the interim, the country has suffered sub-par growth and routine recessions.”

The fiscal problems of the US and UK governments as well as the debts of their citizens and companies have long been famous. For that reason, when the sick/healthy paradigm was first proposed, they were the two most obvious candidates. Having conducted some additional analysis, it’s now patently obvious that the same problems affect the EU and Japan. Given that their economies are also in weak shape, it doesn’t really make sense to group them in with the healthy currencies. Canada (and the Loonie, by extension) is also looking sickly, with its surging national debt and record budget deficits. The only reason it is being spared from the list is because of its richness in natural resources; in other words, it has something tangible that it can use to pay its debts.

Among the so-called majors, then, only the Swiss Franc, Canadian Loonie, Australian Dollar, and New Zealand Dollar get clean bills of health. A re-casting of the paradigm, then, would put the super-majors (Euro, Yen, Pound, and Dollar account for more than 75% of all foreign exchange activity) on one side, and virtually every other currency on the other. Given that national debt ratios and interest rate differentials diverge across the same boundary, it’s not hard to conjure a basis for this partition. “The IMF forecasts that gross government debt among advanced economies will continue to rise until 2014, reaching 114% of GDP, compared to just 35% for developing nations.” Adds another analyst: “If you look at currencies as a proxy for growth, then you can anticipate that emerging-market currencies will appreciate against the dollar.”

P135_G20
There is also a correction that is taking place within the group of sick currencies. Investors have come to realize belatedly that a Dollar sell-off doesn’t make any sense against the Euro and Yen, whose economic and fiscal situations could hardly be characterized as healthy. “Against the majors, we’re pretty close to the end, if we haven’t already reached the end of a bear market in the dollar,” asserted one analyst. Given that the Dollar’s demise had all but been taken for granted, this reconsideration isn’t coming natural. Volatility has surged to a 3-month high, and investors are responding by moving funds back to the US. Among the majors, then, it looks like the Dollar is still the “least worst” currency.

volatility

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South African Rand Loses its Luster

Jan. 28th 2010

In 2009, the South African Rand was the world’s second best performing currency, after only the Brazilian Real. Since September, however, it has stagnated, and over the next year, it is projected to fall 10%. What happened?!

Rand Dollar 2009 - 2010
The Rand represents an interesting case study because it sits at the nexus of several trends. The first is the movement of funds into currencies with high interest rates. (The benchmark rate in South Africa is 7%). The second is the movement of funds into economies that are rich in natural resources. (South Africa is the world’s largest producer of platinum and the third largest producer of gold). The third is the movement of funds generally into emerging market economies. (South Africa’s economy was one of the world’s strongest [perhaps least weak is more apt] economies in 2009).

Thus, we should ask whether then Rand’s stagnation and projected decline is due to unique circumstances, or if instead it represents a reversal of one or more of these trends. Let’s start by looking specifically at South Africa. First of all, natural resource prices (gold and platinum) remain buoyant. Gold, as most of you are probably aware, is still hovering close to its (nominal) all-time high, while the price of platinum has resumed its upward trend, and is arguably closer to is all-time high than oil. In short, the pessimism can’t be explained by commodity prices.

Platinum Prices Historical Chart 2010
How about interest rates? Well, South African rates are among the highest in the world. Despite a handful of cuts totaling 500 basis points over two years, the benchmark rate still stands at a healthy 7%, which is significantly higher than its counterparts in the developed world. Unfortunately, inflation in South Africa is also quite high (6%), which means real interest rates are closer to 1%. In addition, while Central Banks in other countries are contemplating raising rates, South Africa hasn’t ruled out cutting its benchmark further.

What about the fact that South Africa is considered to be one of the world’s vanguard emerging market economies? Well, this too, looks shaky. In contrast to the modest contraction in 2009 that made it a standout, 2010 may not be so kind. Analysts are expecting growth of only 2% in 2010, near the bottom of all economies, emerging market and industrialized. The US economy is projected to grow by 2.6%, in comparison.

2010 consensus gdp growth estimates
With the exception of commodity prices (and perhaps the World Cup), there really isn’t much to be excited about when it comes to the South African Rand these days. For those looking for a growth play, South Africa isn’t it. For those employing a carry trade strategy, the Rand is also not an attractive candidate, since the positive interest rate spread it enjoys (small in real terms and shrinking) is hardly enough to compensate for the risk of currency depreciation. Those looking at Rand technicals (forgive me for not citing specifics here) must be worried that the Rand’s monumental surge in 2008 could only be followed by a correction. Not to mention the fact that various political factions in South Africa are calling for the Rand to be pegged to the Dollar at a rate 33% higher than current levels.

When you consider also that asset prices in emerging markets are now stalling, as investors fret about possible bubbles and contemplate bringing cash “home,” and also that the carry trade is slowly falling out of favor, it’s no wonder that analysts are gloomy about the Rand’s near-term prospects.

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

SNB: Intervention Back on the Table

Jan. 26th 2010

Pull up a 1-year chart of the Euro against the Swiss Franc, and you’ll quickly notice a salient trend: the exchange rate has hovered slightly above €1.50 since last March, with three notable deviations. The first occurred last March, when the Swiss National Bank (SNB) intervened in currency markets on behalf of the Swiss Franc, causing the Franc to shoot up instantly by more than 5%. The second took place in June, when the SNB threatened (it may or may not have actually intervened) intervention again, and the Franc shot up in order to create a buffer zone. The final deviation can be seen at the end of December, when a generalized decline of the Euro also manifested itself against the Swiss Franc, as it fell significantly below the €1.50 threshold.

Euro - Swiss Franc 2009 -2010
It’s not clear whether €1.50 was ever conveyed by the Swiss National Bank explicitly, or whether it was merely accepted implicitly by the forex markets. Regardless, traders certainly respected this boundary, and for most of 2009, dared not challenge it. At the end of December, as I said, there were two important developments, which bore on the EUR/CHF cross. First, credit downgrades and the (far-off) prospect of sovereign default in the EU set loose a wave of panic, after which the Euro has generally fallen. The second development was a subtle change in the wording of the SNB’s forex policy. Previously, it had promised to prevent any “appreciation” in the Swiss Franc, whereas now it is only interested in stopping an “excessive” appreciation.

It’s not clear whether the Swiss Franc suddenly blasted through the €1.50 because investors believe(d) it was undervalued, or if instead it merely got caught up in the Euro’s weakness. Perhaps, investors realized that now they had an excuse to sell the Euro and no longer had to worry about whether actually doing so would risk provoking the SNB. It was probably a combination of both.

For its part, the SNB (through its President and chief mouthpiece Philipp Hildebrand) is already sending subtle clues to the forex markets about the Franc’s prospects. Hildebrand recently told reporters both that “Raising interest rates would be inappropriate,” and “Since the recovery is still fragile, the current expansionary monetary stance will need to be maintained until the recovery strengthens and deflationary pressures recede.” In other words, those that bet on Franc’s appreciation shouldn’t expect any return on their investment, in the form of higher interest rates.

He also reiterated the SNB’s stance on the Franc more explicitly: “Our policy is clear: we will resolutely prevent an excessive appreciation as long as there are deflationary risks.” Given that the markets called his bluff in December, investors are unfazed: “The difference in the number of wagers by hedge funds and other large speculators on an advance in the franc compared with those on a drop, so-called net longs, was 13,926 on Jan. 12 compared with net shorts of 2,780 a week earlier.”

In all likelihood, the Franc will continue to hover around €1.50, only below that barrier, rather than above it. As long as the Franc remains basically stable, either in literally not moving, or in appreciating at a snail’s pace, the SNB probably won’t get involved. After all, the change in wording to its forex policy is a tacit admission that €1.50 is arbitrary and that perhaps the Franc could stand to gain a little bit, especially in the context of the EU fiscal issues. Not to mention that intervention is expensive and ineffective in the long-term.

If traders really get ahead of themselves, though, Hildebrand has already proven that he’s not afraid to act.

http://www.forexblog.org/2009/03/swiss-bank-fulfills-promise-of-forex-intervention-franc-collapses.html
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Posted by Adam Kritzer | in Euro, News, Swiss Franc | No Comments »

Gold and the Euro? I thought it was Gold and the Dollar?!

Jan. 24th 2010

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

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

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

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

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

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

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Posted by Adam Kritzer | in Commentary, Gold, News | 3 Comments »

New CFTC Forex Regulations Unpopular, but Worthwhile

Jan. 22nd 2010

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

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

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

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

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

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

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

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Posted by Adam Kritzer | in Commentary, Investing & Trading, News | 25 Comments »

Dollar Carry Trade: Not Dead Yet

Jan. 20th 2010

After the impressive rally in the US Dollar at the end of 2009, many market observers predicted that the end was near for the Dollar carry trade. That’s because volatility is the sworn enemy of carry traders; whenever there transpires a sudden change in direction in a funding currency, investors will usually race for the exits, regardless of whether the change was justified by fundamentals.

Alas, 2010 has seen a stabilization – even a modest appreciation – in the Dollar, which means the carry trade is here to stay. For now at least. This is based on two abiding notions. The first is that US short-term interest rates – and, hence, borrowing costs for carry traders – will remain low for the foreseeable future. The second belief is that the most attractive investment opportunities can still be found outside the US, namely in emerging markets. Let’s explore both of these ideas in greater details.

dollar index spot

The minutes from its last monetary policy meeting suggest that the Fed is in no hurry to raise rates. On the contrary, it may ease monetary policy even further. According to St. Louis Federal Reserve President James Bullard, U.S. interest rates may remain low for “quite some time.” Added another analyst, “The U.S. economy is chugging along, albeit at a slow pace, and that means the Federal Reserve has no real urgency to raise interest rates.”

In short, investors are rapidly scaling back their expectations for interest rate hikes; futures prices now reflect a mere 20% of a hike by the Fed’s June meeting. If Bullard’s comments carry any weight, investors might turn their attention to the other tools in the Fed’s arsenal- namely quantitative easing. A rise in inflation, portended by many economists, could spur the Fed to draw money out of the markets by selling some of its $1 Trillion in credit securities.  Regardless of what it decides on this front (expand, hold steady, rein in), however, the long and short of it as that interest rates aren’t going anywhere anytime soon. And that means funds will remain cheap and available for carry trading.

On the other side of the equation is an enduring optimism in emerging markets. The last decade has been very kind to investors that bought emerging market stocks, returning a “modest” 100% in some cases and an incredible 1000% in others. The S&P, in contrast, declined slightly over the same period. In some ways, 2009 was a microcosm for this trend, as the MSCI emerging markets index gained 73%, compared to 25% in the S&P. While investors are cautious about bubbles forming in some of these markets (bubbles seem to form and burst with alarming regularity), they continue to pour money in. $75 Billion was added to emerging market equity funds in 2009, to be precise. They are buoyed by predictions that emerging markets will account for the lion’s share of global GDP growth going forward.

Emerging Market Stock Markets - Russia, Brazil, India, China, S&P 2000-2009

This has facilitated a twist on the carry trade, whereby investors are now commonly using Dollar-funded loans to buy stocks, rather than sit back and earn a modest return investing in comparatively low-risk interest-bearing securities. This “traditional” carry trade is perhaps less popular now because interest rates are at all-time lows in many countries. But this is already starting to change as a healthy recovery in emerging markets has paved the way for rate hikes. While this could put a damper on stocks, it would re-open the bread and butter for carry traders, which is to sit back and earn a simple interest rate spread. Moreover, these carry traders can rest assured that if/when the Fed eventually raises rates, Central Banks in Asia and Latin America will almost certainly be in the same position.

The main threat at this point is uncertainty. “Investors plying the carry trade should tread cautiously — economic data will continue to be volatile, as befits a recovery that will proceed in fits and starts,” summarizes one columnist. In short, while fundamentals continue to support a carry trade strategy, it could be undone (rapidly) by an uptick in volatility.

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Posted by Adam Kritzer | in Investing & Trading, News, US Dollar | 2 Comments »

Forex Reserves in Transition: Is the Euro Making a Run?

Jan. 17th 2010

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

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

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

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

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

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

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

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

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Posted by Adam Kritzer | in Central Banks, Euro, News, US Dollar | No Comments »

Canadian Dollar Headed for Parity

Jan. 15th 2010

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

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

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

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

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

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

Canadian Dollar versus commodities

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Posted by Adam Kritzer | in Canadian Dollar, Central Banks, News | 2 Comments »

Making Sense of the Yen: Forex Intervention, Debt and Deflation

Jan. 13th 2010

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

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

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

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

Japan Nikkei stock market and bond market 1989 - 2009

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

Deflation in Japan 2009
As many economists have been quick to diagnose, the problem lies in a tremendous (perhaps the world’s largest) imbalance between savings and investment, as “Japan still has ¥1,500 trillion ($16.3 trillion) of savings.” It’s not clear how long this can last, however, as Japanese demographic changes tax the nation’s pool of savings. “More than a fifth of Japanese are over 65…The nation’s population began shrinking in 2006 from 127.8 million, and will drop by 3.2 percent in the coming decade.”

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

US and Japan budget deficit 2002 - 2009
What is the government doing about all of this? Frankly, not too much. It is spending money like crazy – exacerbating its fiscal state and pushing it closer to insolvency – in a (vain) attempt to prime the economic pump and avoid deflation from further entrenching. The Central Bank, meanwhile, just announced a new round of quantitative easing, also aimed at fighting deflation. At only 2% of GDP, however, the measures are “pretty tame” and unlikely to accomplish much. Considering that its monetary base has only expanded by 5% this year (compared to 71% in the US), it still has plenty of scope to operate. At the present time, however, it is still reluctant to do so.

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

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

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Posted by Adam Kritzer | in Central Banks, Japanese Yen, News | 1 Comment »

Chinese RMB Set to Appreciate in 2010

Jan. 8th 2010

The Chinese Yuan (RMB) spent all of 2009 pegged to the Dollar at 6.83. Since the Dollar depreciated against almost every other currency during that time period, the Yuan has fallen against these currencies, undoing most of its appreciation in 2008. As a result of both international pressure and internal economic conditions, however, the Yuan’s stasis should come to an end soon. The only questions are when, how and to what extent.

Chinese Yuan (RMB) 2000-2010
In hindsight, the Central Bank (i.e. state economic planners) of China were probably justified in holding the Yuan in 2008. At a time when forex markets (and other capital markets, for that matter) were behaving erratically, the Yuan was a baston of stability. China’s premier, Wen Jiabao, recently boasted, “Keeping the yuan’s value basically steady is our contribution to the international community at a time when the world’s major currencies have been devalued.” In fact, there is evidence that the Central Bank went against market forces in the opposite direction during the height of the credit crisis, and successfully prevented the Yuan from depreciating, thus proving that a currency peg can work both ways. The result was price stability, and a boost to exporters that had been damaged by the falloff in foreign demand for Chinese goods.

With the global economy emerging from recession, the argument for maintaining the peg is becoming less tenable. China’s economy, itself, grew at an impressive 8.5% in 2009, and is forecast to grow even faster in 2010, by 9.5%. Thanks to a surge in bank lending and the government’s massive economic stimulus program, inflation is also ticking up. It has been approximated at 2.5%, but is contradicted by spikes of 50%+ in the prices of certain staple goods, and certainly doesn’t take into account the rise in asset prices. China’s benchmark stock market index surged 90% in 2009, and property prices increased by 30% in some areas.

The dual concerns, of course, are that the money supply is expanding too fast and that bubbles are forming in certain asset markets. The weak RMB is certainly not helping either. Thanks to relaxed capital market controls and expectations of further appreciation, speculative “hot money” is once again pouring into China. Holding down the Yuan in the face of such pressure is becoming prohibitivel expensive: “China’s foreign-exchange reserves climbed 17 percent in the first nine months of 2009 to $2.27 trillion, the world’s largest holdings.” Some of the demand is naturally being tempered by bubble concerns, but the trend is still money coming into China.

There is also the argument, much mooted in economics circles, that an appreciation of the RMB would be good for the Chinese economy. Because of a perennially weak currency, its economy has become to addicted to exports to drive growth. “As a report from research firm Euromonitor International notes, in U.S. dollar terms, China’s consumer market lags those of the U.S., Japan and much of Europe, with private consumption just over one third of GDP in 2008.” This is probably a product of social and cultural forces, which still emphasize saving. Skeptics of the usefulnes of RMB appreciation point out that rebalancing the Chinese economy would start with changing the culture of saving, but a stronger currency would certainly provide a powerful incentive. Not to mention that a more valuable RMB would give Chinese companies more leverage in consummating outbound corporate M&A deals and natural resource acquisitions that they have been so keen on in recent years.

China's Outbound  M&A 2000-2009
On the other side of the debate are skeptics of a different sort- those that think RMB appreciation is justified by forward-looking macroeconomic fundamentals. Some fear hyperinflation of the sort that China faced in 2007 and was only brought under control by the global economic recession and concomitant decline in resource prices. “Franklin Allen, a professor of finance at Wharton [University of Pennsylvania], estimates the likelihood of inflation reaching between 10% and 20% to be around one in five.” Any inflation beyond what is experienced in other economies would have to be reflected in the RMB. In a hyperinflation scenario, the Central Bank might even have to deliberately depreciate the currency.

Then there are the skeptics that forecast an economic crash in China. James Chanos, a wealthy hedge fund manager is leading this chorus, “warning that China’s hyperstimulated economy is headed for a crash, rather than the sustained boom that most economists predict. Its surging real estate sector, buoyed by a flood of speculative capital, looks like “Dubai times 1,000 — or worse.’ ”

While this view is gaining some traction, it is still relegated to the minority. Investors and economists are now operating under the firm assumption that China will allow the RMB to resume its appreciation soon. As for when, it could be any day, though probably not for a few months still. As for the questions of how and to what extent, some economists have argued for a one-off appreciation (10% has been suggested) in order to discourage future inflows of speculative capital. Most analysts, though, expect the rise to be gradual. Futures prices currently reflect a 3% rise over the next year, and the consensus among economists is similar. It also depends on how the Dollar performs over the near-term: “If better-than-expected growth in the U.S. helps the greenback recover this year…That would take some of the pressure off Chinese policy makers.”

Personally, I think expectations of a 3-4% rise over the next twelve months are pretty reasonable. The Chinese government doesn’t have much to gain (neither politically nor economically) from a rapid appreciation in the currency, so if/when the RMB rises, it will probably only be in “baby steps.”

RMB USD 2009 Futures

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Posted by Adam Kritzer | in Chinese Yuan (RMB), News | 2 Comments »

The Dollar in 2010

Jan. 7th 2010

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

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

Dollar index 2009

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

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

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

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

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

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

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

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

Forex in 2009: A Year in Review

Jan. 4th 2010

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

Ah, if only it were that simple…

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

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

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

vol

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

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

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

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

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

nybot

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Korean Won Headed Up, Despite Unwinding of Carry Trade

Dec. 31st 2009

The Korean Won is up 32% since March, and 8.2% on the year. At the same time, it is 20% below is 2007 year-end level, as well as 13% weaker than the 2006 average of 955 and 15.5% weaker than the 2007 average.

Korean Won

Focusing only on the Won’s appreciation would probably cause some technical analysts to back off, while comparing it only to the highs of a couple years ago would lead others to pile in, without knowing examining other indicators. In my opinion, this is a situation in which technical analysis – because of the potential to send conflicting signals – falls short. Ergo, let’s turn to the fundamental picture.

The Korea Won has adhered closely to the overarching forex narrative. When the credit crisis struck, investors fled from Korea, and the Won lost 50% of its value practically overnight. With the return of risk-taking in the second quarter of 2009, however, the safe-haven appeal of the Dollar faded, and the Won rebounded strongly. With the potential end of the carry trade in sight, however, the Won has stuttered, and some analysts portend a decline in the near-term.

However, while many currencies will no doubt experience a correction if/when the Fed raises interest rates, the Korean Won probably won’t be one of them. Korean investments have certainly been buoyant of late, but not nearly to the same extent as in other emerging markets, where it could be argued speculative bubbles are now forming. In addition, Korean interest rates are hardly lofty; its benchmark rate is only 2%, hardly enough to justify a carry trade strategy in and of itself.

Instead, investors have been flocking to Korea for the economic fundamentals. Despite an appreciating currency, Korea’s trade surplus is on pace to hit a record $45 Billion this year, with a healthy $15-20 Billion forecast for 2010. In fact, the rising Won has has virtually no effect on exports, as Korean companies had prudently assumed that the Korean Won would be even more expensive (based on 2007 levels). In the automobile industry, for example, “New models being introduced now were designed and engineered two years ago to keep the company in the black even if the won strengthened to 900 to the dollar.” For that reason, analysts expect 2010 will be a banner year for the economy. After a modest expansion in 2009, GDP is projected to grow by 4.5-5% next year, the third highest among large economies, behind only China and India.

South Korea current account surplus
The Central Bank of Korea is also operating as though the Won will keep appreciating, irrespective of what happens to the carry trade. In one session last week, it intervened in forex markets to the tune of $500 million, with the goal of depressing the Won. With the recent expiration of a currency swap with the Fed, this is just as well, as Dollars could soon once again be in short supply. Korean monetary policy remains expansionary, but if the economy takes off in 2010 as expected, the Central Bank will have no choice but to raise rates and keep inflation within its target range.

In addition, there is now talk of turning the Korean Won into an international currency. ” ‘Korea has the opportunity to upgrade the won’s global status as a host country of the G20 2010 Summit.’ International use of the Korean won has been insignificant, although the nation’s share in international trade and finance has increased quickly,” analysts have observed. That the government of Korea is looking to promote the Won as a stable currency implies that it is comfortable with the prospect of further appreciation.

In short, the Won will probably be one of the standouts in 2010. Many currencies will suffer as changes in global monetary policy and the appearance of asset price bubbles cause investors to back off of the carry trade and exit certain emerging markets. South Korea won’t be one of them. With strong fundamentals and a growing profile, it’s no wonder that most analysts expect the Won to appreciate by another 10% in 2010.

Given that tomorrow is the first day of 2010, we won’t have to wait long to find out! On that note, happy new year!

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Pause in Rate Hikes Threatens AUD

Dec. 29th 2009

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

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

aud

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

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

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

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

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Interview with Edward Hugh (Part 2): The Dollar’s Demise is Vastly Overstated

Dec. 28th 2009

Today, we bring you an interview (the second part, and complete transcript) with Edward Hugh, a macro economist, who specializes in growth and productivity theory, demographic processes and their impact on macro performance, and the underlying dynamics of migration flows. Edward is based in Barcelona, and is currently engaged in research into the impact of aging, longevity, fertility and migration on economic growth. He is a regular contributor to a number of economics blogs, including India Economy Blog, A Fistful of Euros, Global Economy Matters and Demography Matters.

Forex Blog: I’d like to begin by asking if there is any significance to the title of your blog (“Fistful of Euros”), or rather, is it only intended to be playful?

Obviously the title is a reference to the Segio Leone film, but you could read other connotations into it if you want. I would say the idea was basically playful with a serious intent. Personally I agree with Ben Bernanke that the Euro is a “great experiment”, and you could see the blog, and the debates which surround it as one tiny part of that experiment. As they say in Spanish, the future’s not ours to see, que sera, sera. Certainly that “fistful of euros” has now been put firmly on the table, and as we are about to discuss, the consequences are far from clear.

Forex Blog: You wrote a recent post outlining the US Dollar carry trade, and how you believe that the Dollar’s decline is cyclical/temporary rather than structural/permanent. Can you elaborate on this idea? Do you think it’s possible that the fervor with which investors have sold off the Dollar suggests that it could be a little of both?

Well, first of all, there is more than one thing happening here, so I would definitely agree from the outset, there are both cyclical and structural elements in play. Structurally, the architecture of Bretton Woods II is creaking round the edges, and in the longer run we are looking at a relative decline in the dollar, but as Keynes reminded us, in the long run we are all dead, while as I noted in the Afoe post, news of the early demise of the dollar is surely vastly overstated.

Put another way, while Bretton Woods II has surely seen its best days, till we have some idea what can replace it it is hard to see a major structural adjustment in the dollar. Europe’s economies are not strong enough for the Euro to simply step into the hole left by the dollar, the Chinese, as we know, are reluctant to see the dollar slide too far due to the losses they would take on dollar denominated instruments, while the Russians seem to constantly talk the USD down, while at the same time borrowing in that very same currency – so read this as you will. Personally, I cannot envisage a long term and durable alternative to the current set-up that doesn’t involve the Rupee and the Real, but these currencies are surely not ready for this kind of role at this point.

So we will stagger on.

On the cyclical side, what I am arguing is that for the time being the US has stepped in where  Japan used to be, as one side of your carry pair of choice, since base money has been pumped up massively while there is little demand from consumers for further indebtedness, so the broader monetary aggregates haven’t risen in tandem, leaving large pools of liquidity which can simply leak out of the back door. That is, it may well be one of the perverse consequences of the Fed monetary easing policy that it finances consumption elsewhere – in Norway, or Australia, or South Africa, or Brazil, or India – but not directly inside the US.

This is something we saw happening during the last Japanese experiment in quantitative easing (from 2002  – 2006) and that it has the consequence, as it did for the Yen from 2005 to 2007, that the USD will have a trading parity which it would be hard to understand if this were not the case. I am also suggesting that this situation will unwind as and when the Federal Reserve start to seriously talk about withdrawing  the emergency measures (both in terms of interest rates and the various forms of quantitative easing), but that this unwinding is unlikely to be extraordinarily violent, since the Japanese Yen can simply step in to plug the gap, as I am sure the Bank of Japan will not be able to raise interest rates anytime soon given the depth of the deflation problem they have. Indeed, investors will once more be able to borrow in Yen to invest in  USD instruments, to the benefit of Japanese exports and the detriment of the US current account deficit, which is why I think we are in a finely balanced situation, with clear limits to movements in one direction or another.

Forex Blog: In the same post, you suggested that the Fed will be the first to raise interest rates. Why do you believe this is the case? How will this affect the Dollar carry trade?

Well, I would want to qualify this a little, becuase things are not that simple. In fact, as Claus Vistesen argues in this post, the ECB has rather “locked itself in” communicationally, and by  talking up the eurozone economies they now have markets expecting clear exit road maps and even pricing in interest rate rises from the third quarter of next year. But if we look at the underlying weaknesses in some of the Eurozone economies – evidently Spain, but Italy is hardly likely to have a strong robust recovery, and the German economy needs exports and hence customers to really return to growth – it is hard to see monetary tightening being applied with any kind of vigour at the ECB, so they may move up somewhat – say  to 2% – and then stop for some time.

I was also suggesting that in the short run they may do this to assist in the process of unwinding the global imbalances, since allowing the Fed to lead the world out of the monetary easing cycle would almost certainly provoke a rebound in USD, and problems for correcting the US current account deficit.

Really none of the developed economies (not even Norway) seem to be looking at the sort of really strong “V” shaped rebound some investors were anticipating, and it is more a question of who is weaker among of the weak. But if we look a little further ahead, at potential growth and inflation dynamics, then it is clear that the deflationary headwinds are stronger in Europe, while headline GDP growth may well turn out to be stronger in the US, and both these factors suggest that the Fed will at sometime be tightening faster than the ECB, in a repetition of what we saw from 2002 to 2005.

Forex Blog: You have pointed out that fiscal problems are not unique to the US. While the UK and Japan are certainly in the same fiscal boat, there seem to be plenty of examples of economies that aren’t, or at least not to the same extent, such as the EU. Do you think, then, that the long-term prospects for the Euro (especially as a global reserve currency) are necessarily brighter than for the Dollar?

Well, actually I wouldn’t say the UK and Japan are in the same fiscal boat. Let me explain. The UK evidently has severe short term problems (as does the US) with its sovereign debt, due to the high cost of resolving the lossses produced by the current crisis. But Japan has still not resolved debt problems which were produced in the crisis of the late 1990s, and indeed both gross and net debt to GDP simply continue to rise there. So I would say – as long as they can weather the present storm – the outlook for US, UK and French sovereign debt is rather more positive than it is for Japan. Indeed in the longer term it is hard to see how Japan can resolve its problems without some kind of sovereign default. This is the problem with deflation, as nominal GDP goes down, debt to GDP simply rises and rises.

But the principal reason I am rather more positive on UK, US and French sovereign debt in the mid term is simply the underlying demographic dynamic. These countries have a lot more young people (proportionately) than the Germany’s, Japan’s and Italy’s of this world, and hence their elderly dependency ratios (which are the important thing when we come to talk about structural deficits into the future) will rise more slowly.

It is also important to realise that the EU – at this point at least – is not a single country in the way the US is, and indeed there is strong resistence among European citizens to the idea that it should be. So it is impossible to talk about the EU as if it were one country. That being said, the lastest forecast from the EU Commission suggests that average sovereign debt to GDP will breach the 100% threshold across  the entire EU by 2014, so I would hardly call the situation promising. Basically some cases are much worse than others. In the East there are countries like Latvia and Hungary which are currently implementing IMF-lead structural transformation programmes, ut it is far from clear that these programmes will work, and sovereign debt to GDP has been rising sharply in both cases. In the South a similar problem exists, with Greek gross sovereign debt to GDP now expected by the Commission to hit 135% by 2011, and Italian debt set to increase significantly over the 110% mark. At the same time the future of government debt in Spain and Portugal is becoming increasingly uncertain. I would also point to the strong gamble Angela Merkel is making in Germany, and indeed ECB President Jean Claude Trichet singled the German case out during the last post rate-decision-meeting press conference for special mention in this regard. The future of German sovereign debt is far from clear, and markets certainly have not taken in this underlying reality.

So basically, and I think I have already explained my thinking on this in earlier questions, we have a structural difficulty, since I am sure the way out of Bretton Woods II will not be found by simply substituting the Euro for the USD. Europe is aging far more rapidly than the US, and the dependency ratio problems are consequently significantly greater.

Forex Blog: Current EU economic policy seems to be favoring government spending and exports, at the expense of investment and domestic consumption. Does this imply that the current EU economic recovery is unsustainable?

I don’t think the current EU expansion is unsustainable as such, but I do think it faces tremendous headwinds. Basically one Eurozone country stands out among the rest, France, since France has a sustainable, internal demand driven, recovery, despite all the longer term issues she faces with the structural fiscal deficit. But the story begins and end there, with France. Most of the rest of the Euro Area 16 have problems, although like Tolstoy’s unhappy families, each is problematic in its own special way. Countries like Germany and Finland are heavily export dependent, and thus have had far deeper recessions than many of the rest, while countries in the South, lead by Spain and Greece, have been running sizeable current account deficits. Since financial markets are now longer willing to fund these, and the ECB isn’t prepared to support the unsupportable forever, these economies too are now being steaily pushed towards dependence on exports for growth (and for paying down their debts), and this raises the issue of where the final end demand is going to come from.  France on its own cannot supply the export surplus needs of the other 15, so external customers are needed, and this makes the value of the Euro more of an issue than it was.

Forex Blog: It seems that the reason that the the the Fed’s liquidity injections have not resulted in price inflation is because much of the funds have been plowed back into capital markets, rather than used for consumption. Given that this liquidity must at some point be pumped out by the Fed, does this imply that a “correction” is inevitable?

Yes, this is true, the global capital markets have acted as a kind of “back door” on US monetary policy, and much of the excess liquidy the Fed has been trying to pump in has simply “leaked out” via that channel. Why this should be is an interesting question in its own right, since while initially the “credit crunch” meant that funds were not available to borrow the money is now there but it is the banks who have difficulty identifying creditworthy customers given the prevailing levels of unemployment, foreclosure and bankruptcy. My feeling is that a sharp correction is not coming, unless there is a large event (Greek sovereign default, for example) in Europe or elsewhere, which leads to a sharp contraction in risk sentiment of the kind we saw after the fall of Lehman Brothers. I wouldn’t like at this point to put a figure on the probability of such an event, but the risk is evidently there.

I don’t think the risk of a correction driven by a rapid withdrawal of US liquidity is that real since I don’t think we are going to see that kind of speedy withdrawal, and even if we did, “ample liquidity” is going to be on offer over at the Bank of Japan until the cows come home. I don’t think we are going to see any precipitate removal of monetary support at the Federal Reserve, since I think exiting this situation is going to be more complicated than many imagine. The tussle which has been going on between the Japanese Ministry of Finance and the Bank of Japan over many years now may well offer a much better guide to exit issues than anything in recent US history, simply because, at least since the 1930s, the US has not been here before. Essentially it will be difficult to withdraw both fiscal and monetary support at one and the same time, but my feeling is that in the US (unlike Japan)  there may well be consensus that the fiscal issue is the most pressing one, and thus this would suggest the Federal Reserve will keep monetary conditions easier for longer, simply to provide an environment in which fiscal consolidation to take place.

Forex Blog: Given the strong economic and fiscal fundamentals of Norway’s economy, do you think currency traders will begin to pay more attention to the Kroner? Do you think it could be taken up as a reserve currency by Central Banks that have become disenchanted with the Dollar?

Well, I think they already are, and evidently the Kroner has become a favoured carry currency. But equally, I doubt the Norwegian authorities would want their country to go the same way as Iceland in the longer term, so I am not sure they would welcome central banks buying Kroner in any large quantity, since this would obviously unrealistically raise the value of the currency, and lead to serious sustainability issues in the domestic manufacturing sector. Basically, as I suggested in the previous interview, I think dollar disenchantment is now likely to be seriously tempered by concerns about Euro weakness.

Forex Blog: It seems that the financial crisis has exposed some of the problems of a common economic/monetary/currency policy for the EU. What are the implications for the future of the ECB and the Euro?

Most definitely. Following Dubai a lot of attention is now focused on sovereign debt, and on who exactly is responsible for what. We should take note of the fact that the  Greek government had to raise 2 billion euros in debt recently via a private placement with banks, against a backdrop of credit downgrades and steadily rising spreads. The ECB undoubtedly agreed to this move given the degree of policy coordination which must now exist behind the scenes, they are, after all,  the ones who are financing the Greek banks, but it does highlight just how things have moved on in recent months. Only last year it was imagined that the being a member of the Eurozone in and of itself gave protection from the kind of financing crisis Greece increasingly now faces, and this was why only eurozone non-members, like Latvia and Hungary, were sent to the IMF. Now it is clear that the ECB could keep protecting Greece from trouble for ever and ever, but they cannot simply keep financing unsustainable external deficits and continue to retain credibility. In this sense the financial crisis has now “leaked” into the Eurozone itself. And this has implications I would have thought, for countries like Estonia, who see Eurozone membership as a “save all”, whatever the price. The difficulty is that the ECB has the capacity to fund troubled countries, but it does not have the power to enforce changes.

The problem of Europe’s institutional structures was highlighted again this week when the Latvian constitutional court ruled that pension cuts included in the recent IMF-EU package are not legal. Personally I find the decision rather significant since pension reform lies at the heart of the whole structural reform programme currently being demanded of “risky” EU states by the IMF, the EU Commission and the Credit Rating Agencies. Indeed the whole credibility of the EU’s ability to manage it’s own affairs could be called into question in this case. As Angela Merkel recently said:

“If, for example, there are problems with the Stability and Growth Pact in one country and it can only be solved by having social reforms carried out in this country, then of course the question arises, what influence does Europe have on national parliaments to see to it that Europe is not stopped…..This is going to be a very difficult task because of course national parliaments certainly don’t wish to be told what to do. We must be aware of such problems in the next few years.”

So obviously, the EU authorities badly need to plug this hole in their armour, or the entire concept of having a common monetary system can be placed at risk, Angela Merkel and Nicolas Sarkozy (who are ultimately the paymaster generals) need to have the power and authority to see to it that national parliaments do what they need to do in the common interest, and they need to get this power and authority in the coming weeks and months, and not simply in the “next few years”. And Europe’s leaders need to be aware that a crisis of sufficient proportions in any one country can very rapidly become a systemic one for the Euro, in much the same way that a problem in a key bank can lead to a crisis of confidence in a whole banking system. I do not feel a sufficient sense of urgency about this in the recent pronouncements of Europe’s leaders.

Forex Blog: So from what you are saying, there is still a risk of a resurgence in the financial crisis on Europe’s periphery. Would you say another round of financial turmoil is now inevitable?

Well the risk is certainly there, and evidently Europe’s institutional structure is in for a very testing time. But no war is ever lost before the battles are fought, although what we can say is that new and imaginative initiatives are certainly going to be needed. Sovereign risk has now spread from non-Eurozone countries like Latvia and Hungary, straight into the heart of the monetary union in cases like Greece and Spain. Mistakes have been made. As I argued in Let The East Into The Eurozone Now! in February 2009, the decision to let the Latvian authorities go ahead with their internal devaluation programme never made sense, and the three Baltic countries and Bulgaria should have been forced to devalue – and the accompanying writedowns swallowed whole – and then immediately admitted into the Eurozone as part of the emergency crisis measures. Perhaps some would feel that this lowering of the entry criteria would have damaged credibility, but as I am stressing here, leaving so many small loose cannon careering around on the lower decks can cause even more issues if matters get out of hand and contagion sets in. So it is a question of pragmatism, and being able to accept the “lesser evil”.

Unfortunately, the situation has simply been allowed to fester, and in addition the much needed change in the EU institutional structure – to allow Angela Merkel the power she is asking for to intervene in Parliaments like the Latvian, Hungarian, Greek and Spanish ones, as and when the need arises – has not been advanced, with the result that we are increasingly in danger of putting the whole future of monetary union at risk. It is never to late to act, but time is, inexorably running out. As the old English saying goes he (or she) who dithers in such situations is irrevocably lost. Caveat emptor!

1. I’d like to begin by asking if there is any significance to the
title of your blog (“Fistful of Euros”), or rather, is it only
intended to be playful?

Obviously the title is a reference to the Segio Leone film, but you
could read other connotations into it if you want. I would say the
idea was basically playful with a serious intent. Personally I agree
with Ben Bernanke that the Euro is a “great experiment”, and you could
see the blog, and the debates which surround it as one tiny part of
that experiment. As they say in Spanish, the future’s not ours to see,
que sera, sera. Certainly that “fistful of euros” has now been put
firmly on the table, and as we are about to discuss the consequences
are far from clear.

2/  You wrote a recent post outlining the US Dollar carry trade, and
how you believe that the Dollar’s decline is cyclical/temporary rather
than structural/permanent. Can you elaborate on this idea? Do you
think it’s possible that the fervor with which investors have sold off
the Dollar suggests that it could be a little of both?

Well, first of all, there is more than one thing happening here, so I
would definitely agree from the outset, there are both cyclical and
structural elements in play. Structurally, the architecture of Bretton
Woods II is creaking round the edges, and in the longer run we are
looking at a relative decline in the dollar, but as Keynes reminded
us, in the long run we are all dead, while as I noted in the Afoe
post, news of the early demise of the dollar is surely vastly
overstated.

Put another way, while Bretton Woods II has surely seen its best days,
till we have some idea what can replace it it is hard to see a major
structural adjustment in the dollar. Europe’s economies are not strong
enough for the Euro to simply step into the hole left by the dollar,
the Chinese, as we know, are reluctant to see the dollar slide too far
due to the losses they would take on dollar denominated instruments,
while the Russians seem to constantly talk the USD down, while at the
same time borrowing in that very same currency – so read this as you
will. Personally, I cannot envisage a long term and durable
alternative to the current set-up that doesn’t involve the Rupee and
the Real, but these currencies are surely not ready for this kind of
role at this point.

So we will stagger on.

On the cyclical side, what I am arguing is that for the time being the
US has stepped in where  Japan used to be, as one side of your carry
pair of choice, since base money has been pumped up massively while
there is little demand from consumers for further indebtedness, so the
broader monetary aggregates haven’t risen in tandem, leaving large
pools of liquidity which can simply leak out of the back door. That
is, it may well be one of the perverse consequences of the Fed
monetary easing policy that it finances consumption elsewhere – in
Norway, or Australia, or South Africa, or Brazil, or India – but not
directly inside the US.

This is something we saw happening during the last Japanese experiment
in quantitative easing (from 2002  – 2006) and that it has the
consequence, as it did for the Yen from 2005 to 2007, that the USD
will have a trading parity which it would be hard to understand if
this were not the case. I am also suggesting that this situation will
unwind as and when the Federal Reserve start to seriously talk about
withdrawing  the emergency measures (both in terms of interest rates
and the various forms of quantitative easing), but that this unwinding
is unlikely to be extraordinarily violent, since the Japanese Yen can
simply step in to plug the gap, as I am sure the Bank of Japan will
not be able to raise interest rates anytime soon given the depth of
the deflation problem they have. Indeed, investors will once more be
able to borrow in Yen to invest in  USD instruments, to the benefit of
Japanese exports and the detriment of the US current account deficit,
which is why I think we are in a finely balanced situation, with clear
limits to movements in one direction or another.

3. In the same post, you suggested that the Fed will be the first to
raise interest rates. Why do you believe this is the case? How will
this affect the Dollar carry trade?

Well, I would want to qualify this a little, becuase things are not
that simple. In fact, as Claus Vistesen argues in this post

http://clausvistesen.squarespace.com/alphasources-blog/2009/11/13/random-shots.html

the ECB has rather “locked itself in” communicationally, and by
talking up the eurozone economies they now have markets expecting
clear exit road maps and even pricing in interest rate rises from the
third quarter of next year. But if we look at the underlying
weaknesses in some of the Eurozone economies – evidently Spain, but
Italy is hardly likely to have a strong robust recovery, and the
German economy needs exports and hence customers to really return to
growth – it is hard to see monetary tightening being applied with any
kind of vigour at the ECB, so they may move up somewhat – say  to 2% –
and then stop for some time.

I was also suggesting that in the short run they may do this to assist
in the process of unwinding the global imbalances, since allowing the
Fed to lead the world out of the monetary easing cycle would almost
certainly provoke a rebound in USD, and problems for correcting the US
current account deficit.

Really none of the developed economies (not even Norway) seem to be
looking at the sort of really strong “V” shaped rebound some investors
were anticipating, and it is more a question of who is weaker among of
the weak. But if we look a little further ahead, at potential growth
and inflation dynamics, then it is clear that the deflationary
headwinds are stronger in Europe, while headline GDP growth may well
turn out to be stronger in the US, and both these factors suggest that
the Fed will at sometime be tightening faster than the ECB, in a
repetition of what we saw from 2002 to 2005.

4. You have pointed out that fiscal problems are not unique to the
US. While the UK and Japan are certainly in the same fiscal boat,
there seem to be plenty of examples of economies that aren’t, or at
least not to the same extent, such as the EU. Do you think, then, that
the long-term prospects for the Euro (especially as a global reserve
currency) are necessarily brighter than for the Dollar?

Well, actually I wouldn’t say the UK and Japan are in the same fiscal
boat. Let me explain. The UK evidently has severe short term problems
(as does the US) with its sovereign debt, due to the high cost of
resolving the lossses produced by the current crisis. But Japan has
still not resolved debt problems which were produced in the crisis of
the late 1990s, and indeed both gross and net debt to GDP simply
continue to rise there. So I would say – as long as they can weather
the present storm – the outlook for US, UK and French sovereign debt
is rather more positive than it is for Japan. Indeed in the longer
term it is hard to see how Japan can resolve its problems without some
kind of sovereign default. This is the problem with deflation, as
nominal GDP goes down, debt to GDP simply rises and rises.

But the principal reason I am rather more positive on UK, US and
French sovereign debt in the mid term is simply the underlying
demographic dynamic. These countries have a lot more young people
(proportionately) than the Germany’s, Japan’s and Italy’s of this
world, and hence their elderly dependency ratios (which are the
important thing when we come to talk about structural deficits into
the future) will rise more slowly.

It is also important to realise that the EU – at this point at least –
is not a single country in the way the US is, and indeed there is
strong resistence among European citizens to the idea that it should
be. So it is impossible to talk about the EU as if it were one
country. That being said, the lastest forecast from the EU Commission
suggests that average sovereign debt to GDP will breach the 100%
threshold across  the entire EU by 2014, so I would hardly call the
situation promising. Basically some cases are much worse than others.
In the East there are countries like Latvia and Hungary which are
currently implementing IMF-lead structural transformation programmes,
but it is far from clear that these programmes will work, and
sovereign debt to GDP has been rising sharply in both cases. In the
South a similar problem exists, with Greek gross sovereign debt to GDP
now expected by the Commission to hit 135% by 2011, and Italian debt
set to increase significantly over the 110% mark. At the same time
the future of government debt in Spain and Portugal is becoming
increasingly uncertain. I would also point to the strong gamble Angela
Merkel is making in Germany, and indeed ECB President Jean Claude
Trichet singled the German case out during the last post
rate-decision-meeting press conference for special mention in this
regard. The future of German sovereign debt is far from clear, and
markets certainly have not taken in this underlying reality.

So basically, and I think I have already explained my thinking on this
in earlier questions, we have a structural difficulty, since I am sure
the way out of Bretton Woods II will not be found by simply
substituting the Euro for the USD. Europe is aging far more rapidly
than the US, and the dependency ratio problems are consequently
significantly greater.

1.  Current EU economic policy seems to be favoring government spending and exports, at the expense of investment and domestic consumption. Does this imply that the current EU economic recovery is unsustainable?

I don’t think the current EU expansion is unsustainable as such, but I do think it faces tremendous headwinds. Basically one Eurozone country stands out among the rest, France, since France has a sustainable, internal demand driven, recovery, despite all the longer term issues she faces with the structural fiscal deficit. But the story begins and end there, with France. Most of the rest of the Euro Area 16 have problems, although like Tolstoy’s unhappy families, each is problematic in its own special way. Countries like Germany and Finland are heavily export dependent, and thus have had far deeper recessions than many of the rest, while countries in the South, lead by Spain and Greece, have been running sizeable current account deficits. Since financial markets are now longer willing to fund these, and the ECB isn’t prepared to support the unsupportable forever, these economies too are now being steaily pushed towards dependence on exports for growth (and for paying down their debts), and this raises the issue of where the final end demand is going to come from.  France on its own cannot supply the export surplus needs of the other 15, so external customers are needed, and this makes the value of the Euro more of an issue than it was.

2. It seems that the reason that the the the Fed’s liquidity injections have not resulted in price inflation is because much of the funds have been plowed back into capital markets, rather than used for consumption. Given that this liquidity must at some point be pumped out by the Fed, does this imply that a “correction” is inevitable?

Yes, this is true, the global capital markets have acted as a kind of “back door” on US monetary policy, and much of the excess liquidy the Fed has been trying to pump in has simply “leaked out” via that channel. Why this should be is an interesting question in its own right, since while initially the “credit crunch” meant that funds were not available to borrow the money is now there but it is the banks who have difficulty identifying creditworthy customers given the prevailing levels of unemployment, foreclosure and bankruptcy. My feeling is that a sharp correction is not coming, unless there is a large event (Greek sovereign default, for example) in Europe or elsewhere, which leads to a sharp contraction in risk sentiment of the kind we saw after the fall of Lehman Brothers. I wouldn’t like at this point to put a figure on the probability of such an event, but the risk is evidently there.

I don’t think the risk of a correction driven by a rapid withdrawal of US liquidity is that real since I don’t think we are going to see that kind of speedy withdrawal, and even if we did, “ample liquidity” is going to be on offer over at the Bank of Japan until the cows come home. I don’t think we are going to see any precipitate removal of monetary support at the Federal Reserve, since I think exiting this situation is going to be more complicated than many imagine. The tussle which has been going on between the Japanese Ministry of Finance and the Bank of Japan over many years now may well offer a much better guide to exit issues than anything in recent US history, simply because, at least since the 1930s, the US has not been here before. Essentially it will be difficult to withdraw both fiscal and monetary support at one and the same time, but my feeling is that in the US (unlike Japan)  there may well be consensus that the fiscal issue is the most pressing one, and thus this would suggest the Federal Reserve will keep monetary conditions easier for longer, simply to provide an environment in which fiscal consolidation to take place.

3. Given the strong economic and fiscal fundamentals of Norway’s economy, do you think currency traders will begin to pay more attention to the Kroner? Do you think it could be taken up as a reserve currency by Central Banks that have become disenchanted with the Dollar?

Well, I think they already are, and evidently the Kroner has become a favoured carry currency. But equally, I doubt the Norwegian authorities would want their country to go the same way as Iceland in the longer term, so I am not sure they would welcome central banks buying Kroner in any large quantity, since this would obviously unrealistically raise the value of the currency, and lead to serious sustainability issues in the domestic manufacturing sector. Basically, as I suggested in the previous interview, I think dollar disenchantment is now likely to be seriously tempered by concerns about Euro weakness.

3. It seems that the financial crisis has exposed some of the problems of a common economic/monetary/currency policy for the EU. What are the implications for the future of the ECB and the Euro?

Most definitely. Following Dubai a lot of attention is now focused on sovereign debt, and on who exactly is responsible for what. We should take note of the fact that the  Greek government had to raise 2 billion euros in debt recently via a private placement with banks, against a backdrop of credit downgrades and steadily rising spreads. The ECB undoubtedly agreed to this move given the degree of policy coordination which must now exist behind the scenes, they are, after all,  the ones who are financing the Greek banks, but it does highlight just how things have moved on in recent months. Only last year it was imagined that the being a member of the Eurozone in and of itself gave protection from the kind of financing crisis Greece increasingly now faces, and this was why only eurozone non-members, like Latvia and Hungary, were sent to the IMF. Now it is clear that the ECB could keep protecting Greece from trouble for ever and ever, but they cannot simply keep financing unsustainable external deficits and continue to retain credibility. In this sense the financial crisis has now “leaked” into the Eurozone itself. And this has implications I would have thought, for countries like Estonia, who see Eurozone membership as a “save all”, whatever the price. The difficulty is that the ECB has the capacity to fund troubled countries, but it does not have the power to enforce changes.

The problem of Europe’s institutional structures was highlighted again this week when the Latvian constitutional court ruled that pension cuts included in the recent IMF-EU package are not legal. Personally I find the decision rather significant since pension reform lies at the heart of the whole structural reform programme currently being demanded of “risky” EU states by the IMF, the EU Commission and the Credit Rating Agencies. Indeed the whole credibility of the EU’s ability to manage it’s own affairs could be called into question in this case. As Angela Merkel recently said:

“If, for example, there are problems with the Stability and Growth Pact in one country and it can onl