With this week slow for news and other economic developments, some forex traders are taking a step back to look at the long-term picture. The US Dollar, in particular has come into focus, because of the uncertain consequences of its current economic policy and the related talk of central bank diversification away from the Dollar. “The United States’ expansionist fiscal and monetary policies, which are raising fears of inflation down the road that could erode the value of the dollar, is surely driving diversification out of dollar-denominated asset…The dollar has weakened whenever talk about an alternative reserve currency makes the headlines.”

This week brought a couple small developments on this front. First, China released its annual report on the economy, in which it renewed calls for a “supra-national” currency, to be administered by the IMF: “To avoid the inherent deficiencies of using sovereign currencies for reserves, there’s a need to create an international reserve currency that’s de-linked from sovereign nations.” Analysts caution however that the move is politically motivated, and it could be a while before it’s squared with economic reality: “There may be signs here of tensions mounting between the PBOC’s economic concerns over China’s holdings of dollars and the Chinese government’s diplomatic reasons for doing so.”

Still, China is walking the walk. Having already entered into swap agreements with Argentina and several other developing countries, it is moving to conduct as much of its trade in Chinese Yuan as possible. This week, it inked a deal with Brazil, “for the gradual elimination of the US dollar in bilateral trade operations which in 2009 are estimated to reach US$ 40 billion.” Previously, such trade had been settled primarily in Dollars, a bane for Brazilian companies, which collectively “have lost hundreds of millions over the last two years due to dollar weakness.”

There is also activity closer to home. “The government said on April 8 that it will allow Shanghai and four cities in the southern Guangdong province, including Shenzhen and Guangzhou, to settle international trade in yuan.” An agreement with Hong Kong, meanwhile, aims to settle at least half of bilateral trade in Yuan. “Hong Kong Financial Secretary John Tsang said the city will be a ‘testing ground’ for use of the yuan outside mainland China.” If successful, this program could quickly expand to encompass the rest of East Asia ex-Japan.

In the short-term, these baby steps won’t have much of an impact on the Dollar. Besides, most Central Banks remain committed to the Dollar, if only for lack of a viable alternative. “The Fed’s holdings of Treasuries on behalf of central banks and institutions from China to Norway rose by $257.2 billion this year, or 15 percent, according to data compiled by Bloomberg. That compares with an increase of $127.3 billion, or 10 percent, in the first half of 2008.”

Even China has stated that its reserve policy will not feature any sudden changes. In sum, “It seems safe to say that the Chinese are pursuing a rather logical path. They will continue to accumulate dollar reserves, as doing so fits their three-adjective criteria [liquidity, safety and returns], while also pushing for international acceptance of an alternative to the dollar in a new global currency.”

For those of you that make a living (i.e. trade forex) from interest rate differentials, consider that the US Treasury yield curve is now steeper than at any point in recent memory. Short-term rates are still close to zero, while long-term rates just passed 4% and are still rising. The theoretical implication is that one can borrow at a low short-term rate and reinvest at a higher long-term yield. The question is: would you want to?

The meeting this week of the Federal Reserve Bank yielded few surprises, as the Fed voted to hold its benchmark Federal Funds Rate at the current level of nil, and indicated that they would stay “unusually low” for the near-term. According to one analyst, “It was totally as expected. The market doesn’t seem to have reacted that much. Everybody pretty much knew that for sure they wouldn’t raise rates anytime soon and they wouldn’t do anything to withdraw liquidity.”

At the same time, the Fed voted to maintain (though not to increase) its $1.75 Trillion asset price program, in order to prevent long-term rates from rising. This was probably directed at mortgage rates, which had begun to move higher in recent weeks, leading some analysts to fear that the nascent economic recovery would be stillborn. However, “Part of the rise in rates may be caused by fears that the Fed will allow inflation to get out of control down the road and that it will print money to finance government deficits. To the degree that those fears are out there, expansion of the Fed programs could be counterproductive, sending rates up rather than down.” In other words, the Fed is naive in its assumption that it can buy rates down, since its very act of buying is actually sending rates up!

This could be very bad for the US Dollar, which loses on both ends of the curve. Low short-term rates make it cheap to use the Dollar as a funding currency, while high long-term rates imply the expectation of inflation, and thus capital erosion. Current market conditions are unique, however: “The enthusiasm of the past three months has led many to believe that the Fed has actually provided more than adequate liquidity…It is critically important to remember that the dollar is the funding currency whose availability, or lack of … will drive all the markets in the world,” said one analyst.

This, the lack of liquidity in credit markets (the very problem that the Fed is trying to counter) is actually good for the Dollar, since it implies an under-supply. On the other hand, if the Fed is “successful” in its asset purchase program, then the supply of Dollars must necessarily increase relative to the demand, in which case the Dollar will fall. It’s not as cut-and-dried as it was prior to the credit crisis, but interest rate differentials (both short and long-term) still hold represent one of the crucial determinants of exchange rates.

The Dollar’s status as global reserve currency was a subject of discussion at two multilateral meetings this week: G8/G20 and BRIC. At the first ever BRIC meeting of the four largest developing economies (Brazil, India, Russia, China) the result was a consensus decision to explore reserve diversification further, while “developments at the Group of Eight meeting of finance ministers helped reinforce the currency’s status as global reserve currency. The statement that emerged from the meeting in Lecce, Italy did not specifically mention currency markets.”

One of the motivations for convening the meeting between the BRIC companies may have been to convey the growing opposition to the Dollar. “The June 16 gathering of the BRICs is the biggest show of unity yet in their bid to win more financial influence — while they take jabs at the U.S. Russian President Dmitry Medvedev said on June 5 that using a mix of regional currencies as a global reserve rather than the dollar would help stabilize the world economy.”

While much of this represents posturing as part of the global power game, there is a certain amount of pragmatism reflected in this attitude. After all, the U.S. is projected to run a $1.85 trillion deficit in 2009, bringing the total debt held by the public close to $10 Trillion. Meanwhile, the Fed - through its quantitative easing plan - is both facilitating this debt and potentially stoking inflation.

As a result, “The BRICs are putting the U.S. on notice that there has to be a cutback on spending and get their house in order.” The BRIC meeting yielded $70 Billion in commitments to enhanced IMF bonds- commitments that would presumable be funded/collateralized with sales of US Treasury bonds. “The debt will pay a yield similar to Treasuries and will be denominated in the fund’s basket of currencies, known as Special Drawing Rights…The IMF calculates the value of SDRs daily, with 44 percent weighted toward the dollar, 34 percent to the euro and the remainder split between the yen and the pound.”

At the G8, however, participating countries were practically competing with each other to voice their support for the Dollar. “Japanese Finance Minister Kaoru Yosano said his nation’s confidence in U.S. debt is ‘unshakable‘ and that the currency’s global status is safe.” Then, “Officials at Asia’s richest central banks said they would shrug off a U.S. sovereign credit rating downgrade — a topic of speculation recently in markets — and continue to buy Treasuries to keep markets stable.” Even Russia, which was simultaneously denigrating the Dollar to its fellow BRIC members, “said the dollar’s role as the world’s main reserve currency is unlikely to change in the near future.”

For several reasons then, many analysts view the diversification talk as a distraction, especially as it bears on the forex markets: “The raging debate about the future of the U.S. dollar’s reserve currency status may be masking the real drivers of its near-term direction.” First of all, contradictory and ambiguous statements reveal a complete lack of consensus, not only about whether the current system should be abandoned but also with regard to what form an alternative system would assume. For example, neither the Euro nor the Chinese Yuan represent viable alternatives, since the former is too new and the latter is still not fully exchangeable.

Thus, their threats to dump the Dollar have actually been accompanied by an increase in Dollar purchasing, which is required to maintain their currency pegs. “Periods of dollar weakness are therefore met with official dollar purchases…global reserve accumulation, which peaked about $7 trillion last summer, has resumed as the dollar has weakened since March.”

Second, even if Central banks and governments decided to make change, it would take years to implement. “The evolution of a reserve currency would be exactly that, an evolution, not an overnight change,” said one analyst. Another added, “The choice of a reserve currency is not made by central bankers; it chooses itself.” In other words, investors will flock towards currencies that are characterized by liquidity and openness and backed by strong capital markets, not on the basis of politics.

This leads to the third and perhaps most important point, which is that capital flows by private investors dwarf movements by Central Banks, especially in the short-term. While Central Banks are and should be taken seriously by forex markets because of their size, they still account for only one portion of global (Dollar-denominated) foreign exchange holdings. In the short term, investors will continue to move capital around in accordance with their risk/reward profiles. Barring a sudden shift by Central Banks away from the Dollar (which would be counter-productive and a losing proposition), then, it is these private capital flows which will shape the Dollar’s future in the near-term.

This is a question that many investors found themselves asking last week, following the release of labor market data that showed employers are now shedding jobs at a slower pace than before. Short-term yields immediately jumped, as investors suddenly considered the possibility that the US economy would return to ‘normalcy’ sooner than expected. Two year Treasuries jumped to 1.3%, while “Eurodollar futures on Monday priced in a rise in U.S. interest rates of almost 1 percentage point within a year.”

There are two components that mandate the Fed’s approach to monetary policy in the US: inflation and economic growth. While both indicators are currently at dismal levels, economists are forecasting upticks in 2010. Commodities prices have already started to rebound. Combined with the Fed’s quantitative easing program and consequent explosion in liquidity, this could easily lead to inflation if not “mopped up” as soon as the economy begins to recover.

Still, concern over interest rate hikes represents a dramatic about-face from the last few months. During this time, investors grew comfortable with the seemingly contradictory notions that the US economy was already recovering and that the US Dollar represented a viable funding currency. In light of the most recent economic revelations, the former proposition seems even more tenable, which means that the inevitable rate hikes would make the latter less tenable. If indeed interest rate differentials shift, it would cause a huge change in current trading dynamics. “In a certain way the dollar has become a risky currency…You need your funding currency for carry trades to be stable, with very low-interest rates for a long time and it has also to be weak. Think about what’s going on in the U.S. and the conclusion is that the dollar may not qualify.”

Long-term rates have already begun to rise, due both to an oversupply in long-dated bonds and a decline in demand, as investors turn away from low-yielding assets. But currency traders (especially those that rely on carry trades) tend to favor short-term rates, which means that the Federal Funds Rate (and accompanying interest rates) supersede. While even the most hawkish Fed watchers don’t anticipate a rate hike for many months to come, the shift in forex markets indicates that investors are already calculating their exposure to such a hike.

Skeptics, meanwhile, insist that such hawkishness is way overblown and that “investors who bought the dollar recently betting on higher borrowing costs were at a ‘risk. Interest rates are not going to go up in this country anytime soon.’ ” Another analysts chimes in that, “It seems highly unlikely that the Fed will raise rates this year which…suggests that the dollar could come under renewed pressure in the event of a dovish shift in US interest rate markets.” I guess it just depends on what time horizon you look at.

On June 1, the Forex Blog reported that Brazil is considering a forex tax on capital inflows as a way of discourage the inflow of speculative capital that is causing the Real to appreciate. It turns out that Brazil is not alone; England and France, among others, are also mulling taxes on forex transactions. Their goal is not necessarily to discourage capital inflows, but rather to raise money to fund projects that would otherwise not be viable under current budgetary conditions. The UK “levy would raise $30bn-$50bn a year - enough to double spending on health in low-income countries.” The French plan, meanwhile, would “involve taking 0.005% of the proceeds of currency transactions, perhaps on a voluntary basis, to benefit global aid projects.”

While Brazil and England/France appear to be pursuing different ends, together their plans capture the idea behind the “Tobin Tax.” Originally proposed by Nobel Laureate James Tobin after President Nixon declared the end of the gold standard, the tax would be levied on all forex transactions with the proceeds deposited in forex stability funds. One of the most popular versions would only impose the tax during periods of volatility (i.e. speculation) so as not to punish those exchanging currency for “mundane” reasons.

While still a fringe idea, the tax initially gained momentum following the 1997 Southeast Asian economic crisis, and has found new followers in the wake of the ongoing credit crisis. Consider the unprecedented volatility in currency markets of late, manifested in wild daily fluctuations.

Even the US Dollar, the world’s reserve currency, has been on a veritable roller coaster of late, rising and falling by 10% in a matter of months. Prior to the rise of forex speculation (already a $1 Quadrillion/year market!), it was rare for a currency to move that much in a year. Given that such speculation probably accounts for 90% of daily turnover, it seems obvious as to who is causing this volatility.

Don’t get me wrong; there’s a role for speculation in the forex markets, just like there’s a role for speculation in all securities markets. When markets function efficiently and players act rationally, currences should and will reflect economic fundamentals and act to minimize global imbalances. Due to the rise of the carry trade and the herd mentality, however, the oppose often obtains in practice. This can cause currency runs and or artificially inflated currencies that compel Central Banks to act counter to the way they otherwise would (i.e. by raising interest rates rapidly to deter capital flight, crimping economic growth.)

A Tobin tax would work both to minimize speculation in the short-term (by taxing trades) and promote stability in the long-term (by providing Central Banks with funds that they can use to fight speculative “attacks.” Besides, given that forex traders already enjoy favorable tax treatment - i.e. taxed below the short-term speculative rate - it wouldn’t be the end of forex trading as we know it.

The only thing predictable about currencies these days is that they will remain unpredictable. Forgive me for speaking in cliches, but when you consider that the last twelve months have seen both record rises and record falls, I think a cliche might be justified in this case. We’ve seen the Dollar soar, only to collapse again. On the other side, we’ve seen the bottom fall out from emerging market currencies, before rising 20-30% in a matter of weeks.

Volatility levels have certainly declined (see Chart below) from the record highs of October 2008, when Lehman Brothers collapsed. At the same time, the oft-cited VIX index remains well above its average over the last decade. This suggests that while investors may have been lulled into a relative sense of security, serious doubts remain.
If the current rally is to be seen as “legitimate,” then perhaps the worst of the 2008-2009 recession is truly behind us, and the global financial system has been given a reprieve from a meltdown. The concern going forward then will naturally shift past the steps that governments and Central Banks are taking to fight the crisis, towards the long-term economic impact of those measures.

Jim Rogers, a famous and perennially outspoken investor, is now sounding alarm bells over the possibility of “meltdown” in currency markets, due to inflation and currency debasement that he views as an inherent byproduct of quantitative easing and deficit spending.

Most of the attention is being focused on the US, whose stimulus and monetary programs are probably larger than all other economies in the world, combined. Offers one analyst, “We keep very low U.S. Dollar exposures because we think a further devaluation of the greenback is imminent, and we see a structural weakness for at least a number of years.” Meanwhile, there is speculation that the US could soon receive a ratings downgrade, following a similar threat by S&P directed towards Britain. But this remains highly unlikely.

The problem that Rogers (and all other investors who are worried about currency debasement) faces is how to construct a viable strategy to protect yourself and/or exploit such an outcome. Rogers himself has admitted, “At the moment I have virtually no hedges…I’m trying to figure out what to do there.” The difficulty can be found in the inherent nature of currencies, whose values are derived relative to other currencies. While you can short the entire stock market or the entire bond market (via market indexes), you can’t short all currencies simultaneously- at least not yet.

Instead, you can pick one currency or a basket of currencies, that you believed is best protected from currency collapse and buy it against threatened currencies. But how do you deal with an environment when all currencies appears equally questionable- when all governments all loosening monetary policy and risking inflation? Really, the only answer is to invest in commodities that you think represent good stores of value, such as oil or gold, or the currencies that benefit when prices of such commodities are high. Naturally, the relationship between commodities and currencies is not cut-and-dried, and if the currency system were indeed beset by meltdown, it’s not clear to me that commodities would hold their value. But that’s fodder for another post…

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

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

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

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

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

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

Note: Both Charts courtesy of International Business Times.

During the global economic boom and concomitant run-up in energy prices, Russia’s foreign exchange reserves exploded. The subsequent bursting of the bubble, however, proved the maxim, what goes up must come down. “After reaching a record high of $597.5 billion in early August, reserves have declined dramatically as the central bank spent more than $200 billion on propping up a depreciating ruble.”

Excluding the European Union, Russia’s foreign exchange reserves are still the world’s third largest, behind only China and Japan. By Russia’s own admission, this will not remain the case for long. If current economic conditions continue to prevail, its entire stock of reserves will be depleted within two to three years. Moreover, as its reserves have declined, the share of Euros have risen (perhaps due to the selling of Dollars) to 47.5%, surpassing the Dollar for the first time. Despite the insistence of Russian authorities that the change was inadvertent, the fact remains that the Euro currently predominates in Russia’s forex portfolio.

These two trends - declining reserves and shifting allocation - are becoming entrenched, and may in fact accelerate. A cursory skim of the most recent IMF Data on International Reserves reveals that the reported reserves of most countries have fallen over the last year, or at the very least, are not growing at the same pace. The WSJ reports that “Foreign-exchange reserves of about 30 low-income countries have already fallen below the critical value equivalent to three months of imports.”

Meanwhile, it has been highlighted elsewhere that China - which does not report its reserves and is hence not included on this list - has seen its reserves stagnate, and has hinted publicly that it is nervous about the preponderance of Dollars it holds. And suffice it to say that when China talks, people listen.

The clear implication is that the US Dollar may not hold sway as the world’s unchallenged reserve currency for much longer. It is certainly not as if this is a new possibility. After all, “The United States possesses around one-fifth of the world’s GDP, but its own paper provides around 75% of world’s exchangeable currency reserves. This is a worrying imbalance,” argues one economist.

The impetus can be found in changed economic circumstances, which previously reinforced the Dollar’s role as reserve currency, but now suggest the opposite. Declining world trade and lower current account imbalances result directly in lower reserves, as do government stimulus plans funded with foreign exchange. The pickup in risk appetite meanwhile, combined with inflationary US monetary and fiscal policy, will make Central Banks increasingly reluctant to hold Dollar-denominated assets. Finally, the locus of the global economy is slowly shifting to East Asia. This trend will probably gather momentum if and when the global economy recovers, as the rest of the world has now learned the hard way that their collective reliance on US consumers is not sustainable.

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

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

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

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

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

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

Note: Both Charts courtesy of International Business Times.

Over the last couple months, the Euro has thoroughly outperformed the Dollar, which recently fell to a five-month low on a trade-weighted basis. Over the same period, global stock and commodity prices have also risen quickly, which is not a coincidence.
In other words, investors are allocating capital on the basis of risk, rather than in accordance with (economic) fundamentals. For example, “ICE’s Dollar Index and crude oil have a correlation of minus 0.61 in the past two months, compared with minus 0.26 since the start of the year,” as rising oil prices and the declining Dollar feed back into each other.

Meanwhile, “Implied volatility on major currencies, which reflects investors’ expectations of currency swings, fell to 13.96 percent yesterday, from…17.22 percent at the end of March. A drop in volatility tends to signal less demand for options to protect investors from currency swings.” This indicator is now at its lowest level since the days preceding the Lehman Brothers bankruptcy and subsequent stock market collapse. One would normally expect a correlation between risk and return, but in this case, rising returns have been accompanied by lower risk.

Even more unbelievable is that this decline in risk is taking place against the backdrop of declining economic fundamentals. “Risk appetite in the currency market is nothing short of impressive considering the fact that the Fed reduced their growth forecasts,” said one analyst. However, “The euro-area economy will contract 4.2 percent this year, according to the International Monetary Fund, more than the projected 2.8 percent contraction in the U.S. and 4.1 percent slump in the U.K.” If investors were focusing on this divergence in economic growth, one would expect the Euro would be falling.

One hypothesis is that inflation-conscious traders are flocking to the Euro, since the ECB remains vigilant about fighting inflation, even in the face of declining prices and aggregate demand. After cutting rates to a record low 1% earlier this month, the ECB unveiled its own version of a quantitative easing plan, involving the purchase of 60 billion euros worth of low risk securities. But this is a pittance, both relative to the size of the EU economy (it represents a mere .6% of GDP) and compared to the Trillion Dollar Fed program. This led one analyst to call the ECB’s plan “chicken feed.” While all of this is noteworthy, it’s unlikely that this is having a meaningful effect on forex markets, which still remain focused on (avoiding) deflation.

If the Euro is to continue rising, it must overcome some technical obstacles. “The euro could hit a ceiling if the recent resilience of U.S. stock markets faces headwinds. ‘At some point…stronger nongovernment growth has to show up to sustain and justify these moves in equities.’ ” It’s interesting that the fear of Euro bulls is not that the EU economy won’t recover, but rather that US stock prices are overvalued. Given recent market movements, however, their concerns are reasonable, and “any disappointment [in corporate fundamentals] could provide an excuse to take profit [this] week — benefiting the dollar.”

“The Dow Jones Industrial Average has bounced an astounding 30% from its March 9 low of 6547. Is this the dawn of a new era? Are we off to the races again?” Asks Andy Kessler provocatively in a recent Op-Ed for the Wall Street Journal.

This is an important question not only for stock market investors, but also for forex traders. By no coincidence, the stock market rally has coincided with a steady decline in the Dollar, which recently broke through a key level of resistance and touched a four-month low against a basket of currencies, and is similarly nearing a four-month low against its chief rival, the Euro. ”

Experts” point to a decline in risk aversion as the chief driver of the rally; when investors become more comfortable with risk, they buy stocks, which in turn causes investors to become even more complacent with risk. Hence, a 30% rally only six months after stocks recorded their worst day and worst week ever.

In this case, however, the experts are not in complete agreement. Economic fundamentals, for example, remain relatively weak, and corporate profits are still anemic. Andy Kessler blames the Fed for distorting “asset allocation formulas” by dropping yields to zero and for its quantitative easing program, which “gets money into the economy the fastest — basically by cranking the handle of the printing press and flooding the market with dollars (in reality, with additional bank credit). Since these dollars are not going into home building, coal-fired electric plants or auto factories, they end up in the stock market.”

Sure enough, trading data suggests that in fact this rally is being driven by retail investors, as opposed to institutions. Says Lou Ritholz, ” ‘The ‘dumb’ retail money is leading the gains. ‘In this type of environment, the market is guilty until proven innocent. We have to assume this remains a bear market until we see a more normalized economy.’ ” In short, it looks like analysts have confused the chicken with egg, by emphasizing the decline in risk aversion, rather than the self-fulfilling nature of the rally.

If the rally does end, it will almost certainly be good news for the Dollar, at least in the short-term. There has emerged a strong correlation between global stock prices and emerging market currencies, for example, which virtually ensures an outflow of capital from emerging markets. One professional idiot- err investor- Jim Rogers has prognosticated an end both to the stock market rally and the Dollar rally. Credit Rogers for his long-term thinking, but he seems to have impugned a direct relationship, when recent trends suggest it is actually inverse.

I agree with Kessler, and abide by the same maxim “Only a fool predicts the stock market…” My point here is not to convince you that the market rally is unsustainable, but rather to emphasize the importance of knowing where you stand. I’m personally quite bearish on the Dollar in the long-term (food for a future post), but a damper in the stock rally would almost certainly be positive for the Dollar.

These days, The Federal Reserve Bank seems to have very few supporters. A recent poll showed that “Twenty-six percent of Americans said they were ‘a lot less’ confident in the Fed…now than five years ago.” Some people think the Fed is doing too much in responding to the economic downturn, others accuse it of doing too little, and everyone agrees the Fed is culpable for lax regulatory efforts under Alan Greenspan. One of the biggest criticisms being levied at the Fed is that its current policies are sure to generate massive inflation in the medium-term, as a result of the massive liquidity being pumped into the financial system now. In this post, I will attempt to provide some clarity on this aspect.

Sure enough, the US monetary base (represented by M1) has exploded since the inception of the credit crisis, rising more than 15% to more than $1.5 Trillion. Plus, given that there is a slight lag in the release of data, these figures don’t necessarily include the effects of the Fed’s expansion in its quantitative easing program, announced on March 18. One commentator explains that, “Of all the Fed’s moves, this ‘quantitative easing’ gets money into the economy the fastest — basically by cranking the handle of the printing press and flooding the market with dollars (in reality, with additional bank credit). Since these dollars are not going into home building, coal-fired electric plants or auto factories, they end up in the stock market.” In the short-term, then, QE has probably contributed only to asset-price inflation, rather than the more serious consumer price inflation.

What about the charge that the Fed is dangerously reaching its tentacles into every corner of the financial markets? As you can see from the chart below, there is certainly a huge degree of truth to this claim. Since January 2008, the Fed has “diversified” its portfolio away from relatively benign Treasury securities, into at least 20 different types of securities and loans. In the process, its balance sheet exploded from approximately $800 Billion to $2.2 Trillion, and could expand further as the next phase of quantitative easing is implemented.

This portfolio’s makeup is indeed becoming increasingly risky. For example, “The Federal Reserve took on more than $74 billion in subprime mortgages, depreciating commercial leases and other assets after Bear Stearns Cos. and American International Group Inc. collapsed.” Despite writing down almost $10 Billion from this portion alone, however, the Fed continues to turn consistent profits. “Last year the central bank reported a whopping $43 billion in operating income. That was more or less the same level as in 2007, but meanwhile short-term interest rates had plummeted, ending the year near zero.” The assertions of conspiracy theorists, notwithstanding, the majority of this profit was transferred to the US Treasury. [Chart courtesy of The Economist].

Fortunately, most of the (non-esoteric) securities are highly liquid, and can theoretically be sold to investors if and when it becomes appropriate to do so. “The Fed, for example, is required by law to end some when the need is no longer urgent. It charges a penalty for some programmes so that borrowers will return to private markets once these have healed.” The Commercial Paper Funding Facility (CPFF) and Term Auction Facility (TAF) programs, which together account for over $650 Billion of the Fed’s portfolio, moreover, can be quickly undone. “The maturity of the outstanding [TAF] loans is 84 days at a maximum, ” while CPPF “deals in short-term money market instruments and can also be phased out, if desired, in a short period of time.”

The $400 Billion in swap lines, on the other hand, are slightly more problematic, both because of the longer time frame and because foreign banks “are now heavily dependent on the Fed for dollars.” Then there is the Term Asset-Backed Securities Loan Facility (TALF), which is not yet operational. While this program is also designed to be temporary, “the multi-year maturities of the loans and the potential size of the program—up to $1 trillion—make the impact on the monetary base more persistent than for some of the other liquidity programs.”

In short, inflation isn’t yet on the radar screen, as economists and bankers must first combat disinflation, and perhaps even deflation. Of course, there is always the (very serious) risk that the Fed either won’t be able to, or simply won’t be diligent enough in removing this cash from the money supply when the time comes. There is also a moral hazard component of the Fed’s QE, whereby “governments could come to rely on such purchases to finance budget deficits.” In my opinion, this kind of scenario would be much more likely to engender inflation, but it would be primarily the fault of the government (as opposed to the Fed), and hence beyond the scope of this post.

Last week, the Fed opted to maintain its benchmark Federal Funds Rate close to zero, and indicated in its press release that it “anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” [Chart courtesy of CNN].
Nonetheless, the Fed made a point of emphasizing that the economy seems to be stabilizing: “Information received since the Federal Open Market Committee met in March indicates that the economy has continued to contract, though the pace of contraction appears to be somewhat slower.” I suppose everything is relative, but it’s a bit perplexing as to where the Fed is getting its data from, given that “Gross domestic product, the broadest measure of economic activity, fell at an annual rate of 6.1% in the first quarter of 2009 after a 6.3% drop in the last three months of 2008.” This exceeded analysts’ expectations for a 4.7% decline, and if anything, would seem to suggest that the economy is worsening. Granted, consumer spending rose slightly and inventories declined, but the aggregate picture paints an unequivocal picture of an economy in deep recession.

Bernanke, apparently, is unconvinced. ” ‘We continue to expect economic activity to bottom out, then to turn up later this year,’ Mr. Bernanke told the congressional Joint Economic Committee.” Meanwhile, the unemployment rate is currently 8.5% and falling. Business investment is still abysmal, as companies implement hiring freezes and hold off on all non-essential capital purchases.

Bernanke is especially optimistic about the state of the US financial system, noting that “conditions in credit markets have revived slightly in recent weeks. Homeowners are refinancing mortgages at a rapid clip, and financial institutions have stepped up their sale of securities backed by of credit card loans, automobile debt and student loans.” However, mortgage refinancing is a red herring, and frees up very little cash for consumption. Meanwhile, debt securitization is well below 2007 levels, and some experts predict that credit card loans represent the next catastrophe. “Fitch’s Prime Credit Card Delinquency Index measures credit card debt more than 60 days late. Through January 2009 that index surged to a record 4.04 percent.”

Bernanke also hinted that the results from the bank stress-tests, scheduled to be released today, are largely positive. As part of this program, “The government plans to divide banks into three categories, based on the adequacy of their capital reserves to absorb projected losses,” if the recession were to worsen. If Bernanke’s assertions are to be believed, then the tests will show that their capital reserves are sufficient, and they will not need additional capital infusions.

Bernanke’s testimony and the Fed Statement have been greeted positively by investors, “contributed to improving sentiment and boosted risk appetite, easing demand for then yen and greenback as safehavens.” Nonetheless, everything he says should be taken with a grain of salt. Even with the best rose-tinted glasses money can buy, it’s hard to draw such optimistic conclusions from an objective interpretation of the data. Either Bernanke is basing his assessment off of the stock market rally (which is circularly based on such economic optimism), or he is trying to deliberately distort reality in order to try to make a recovery self-fulfilling by disingenuously telling people that everything is okay. Personally, I don’t think he’s worth taking seriously.

By no coincidence, the Dollar’s best day in April was a mirror image of its worst day in March. Recall what happened when the Fed initially announced its quantitative easing program: “The dollar plunged a record 3.4 percent against the euro on March 18 as traders speculated the Fed’s purchase Treasuries would debase the currency.” On April 29, meanwhile, “The dollar rose the most against the yen this month after the Federal Reserve refrained from increasing purchases of Treasuries and mortgage securities.”

The implication is that as risk aversion has dropped, investors have turned their gaze towards interest rates. Previously, this phenomenon would have worked against the Dollar, as both short-term and long-term interest rates are generally lower in the the US than they are abroad. On the short end of the curve, this is a product of a low Federal Funds Rate, as guided by the Fed. On the long end, this is a function of high demand for US Treasury securities, which keeps prices high and rates proportionately low.

However, this trend is very quickly reversing itself. Aside from a few hiccups (including a big one on March 18!), Treasury yields have risen continuously since touching an all-time low in January. Since then, the yield on the 10-year note, for example, has risen from 2.2% to nearly 3.2%. The impetus for higher rates is coming both from a decline in risk aversion (which is leading investors to seek alternatives to Treasuries) as well as a concern that the Fed will not be as active in buying US bonds as it had initially intimated.

A decline in demand for Treasury securities is making some investors understandably nervous that the government will not be able to fund its deficits (projected at 10% of GDP in 2009). Writes one columnist, “We cannot take it for granted that the global bond markets will prove deep enough to fund the $6 trillion or so needed for the Obama fiscal package, US-European bank bailouts, and ballooning deficits almost everywhere.” The fear is that the government will turn to the Fed, which will stoke inflation by printing money, and induce a devaluation of the Dollar.

If the Fed limits its purchase of Treasuries, by extension, not only will this limit inflation, but also it will lead to higher interest rates on US government bonds, which should help prop up investor demand. One currency strategist observed that “The dollar-yen is very closely correlated with the back end of the yield spread.” In other words, as US long-term yields rise, so may the Dollar.

Of course, the key is to strike a balance between too much demand and not enough. If investors got really spooked by the fact that “The Congressional Budget Office expects interest payments to more than quadruple in the next decade as Washington borrows and spends, to $806 billion by 2019 from $172 billion next year,” then it could lead to a skyrocketing of interest rates as investors beat a mass retreat away from Treasuries, which would certainly entail a devaluation of the Dollar. To apply Alan Greenspan’s famous analogy, has anyone coined the term “Goldilocks Treasury Yields” yet?

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

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

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

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

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

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

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

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

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

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

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

Until the Fed announced an expansion of its quantitative easing program two weeks ago, gold had begun to fade into relative obscurity. Sure, gold had risen in value from a low of $710/ounce back up to $900/ounce, but prices were still off 10% from the highs reached in 2008. Meanwhile, risk aversion had begun to decline and the stock market had begun to rise, such that pundits were talking more about stocks and less about gold.

Since the Fed’s announcement, however, gold has been thrust back into the spotlight. The same trading session that saw a record fall in the Dollar and a record rise in Treasury prices, also witnessed a 7% spike in gold futures prices. ” ‘Money is being pushed into the system and that’s creating the inflationary threats that the markets are contemplating…Commodities are a decent way to hedge against that potential threat,’ ” observed one trader.

Other analysts, however, caution that rising gold prices are a sign of the fear/crisis mentality, not inflation. “There are just not a lot of alternatives for global investors. You will see more and more investors moving into gold as a safe haven, and you will see more institutions putting money into commodities indexes.” In other words, gold is being driven by the safe-haven trade, which is evidenced by an increasing correlation with Treasury bonds. One commentator calls it a hedge against uncertainty: “The demand for gold is for gold coins, a massive flurry of bullion buying by ETF’s (and investors), and the institutions and traders buying the hell out of it.  The reason is simple… pure fear.”

With the exception of the perennial gold bulls and conspiracy theorists, the short-term consensus is that due to “massive spare capacity now opening up in the global economy, soaring unemployment and a dysfunctional banking system – it would be very hard for central banks to generate a surge in inflation even if they wanted to.” This analyst further argues that the Fed is undertaking the expansionary program under the implicit assumption that it will have to siphon this money out of the financial system, if and when the economy recovers.

Of course, there is not even a consensus that gold is a good hedge against inflation. Mike Mish points out that the correlation between the US money supply and the price of gold is not very robust. When examined relative to a basket of currencies (rather than the Dollar), however, the relationship suddenly becomes much stronger. Especially when you filter out fluctuations in the value of the Dollar (which is affected by many factors unrelated to inflation), “gold is doing a reasonably good job of maintaining purchasing power parity on a worldwide basis.” This can be seen in the following chart:

Ascertaining a relationship ultimately depends on the time period of analysis, and the currency(s) in which prices are being tracked. Given also gold’s notorious volatility, it probably makes sense to use special inflation protected securities, rather than gold, as an inflation hedge.

On Thursday, the European Central Bank will conduct its monthly monetary policy meeting. The consensus among analysts is that the meeting will lead to a 50 basis point cut, leaving the EU’s benchmark lending rate at 1%, a record low. Investors are also bracing for the ECB to announce certain unconventional steps, similar to the Fed’s program of quantitative easing, although not to such an extent. Analysts have speculated that the ECB “could intervene in bond markets to help ease companies’ financing problems.”

This marks an about-face from current policy and recent rhetoric, in which the ECB insisted that guarding against inflation was more important than providing economic stimulus. In fact, Jean-Claude Trichet, President of the ECB, has recently found himself on the defensive: “I don’t think it is justified to say we are doing less on this side of the Atlantic. We have automatic stabilizers,” he said during his quarterly testimony in front of European Parliament. In fact, the ECB had become an outcast among Central Banks for waiting a long time before finally agreeing to cut interest rates. Since embarking on a program of monetary easing, it has been playing catch-up by cutting rates at breakneck speed.

It appears that the ECB’s arm was twisted by the most recent economic data; a sudden drop in German manufacturing suggests that the recession is both spreading and deepening. Combined with a record drop in the EU economic sentiment, this “suggests that the euro zone economy will have contracted by roughly 2 percent quarter on quarter in the first three months of the year.” In addition, both producer and consumer prices have eased, such that inflation has fallen well below the 2% target level, and the ECB lost its last excuse for not dropping rates.

As a result both of the worsening economic situation, as well as the projected decline in yields, currency traders are once again questioning the Euro. The last couple weeks have been rife with commentary that the Dollar rally had come to an end as a result of the intensification of the Fed’s plan to use newly printed money to as a source of liquidity in the credit markets. “The dollar’s traditional trading patterns have been altered in the wake of new U.S. quantitative-easing measures. Risk appetite, stocks and funding currencies appear to hold lesser influence lately.”

This week, the narrative in forex markets favors the Dollar. It could be that the safe-haven trade has returned to lift the Greenback, but more likely is that investors are comparing economic fundamentals when making bets on currencies. One analyst summarized his firm’s position as follows: “We have argued that the leveraging-de-leveraging axis has been the key driver in the foreign exchange market. We expect a new driver, anticipated growth trajectories, to emerge…[and] for the dollar’s uptrend to resume in the second quarter.”

“China is a hostage. China is America’s bank and America basically says there’s nothing you can do to me. If I go down you don’t get paid.”

While the Obama administration has pledged the kind of fiscal responsibility that would secure its government obligations, its actions haven’t been so responsible. The Fed recently announced purchases of $1 Trillion in government debt, while the government is set to rack up Trillion-Dollar deficits over the next decade, even by the most conservative estimates.

In other words, China is in a quandary; stop lending to the US, and you might see the value of your existing reserves plummet. Continue lending, and you risk the same result. Tired of participating in this apparent no-win situation, China is finally taking action.

First, it will petition the G20 at its upcoming meeting for some level of protection on its $1 Trillion+ “investment” in the US. Meanwhile, Zhou XiaoChuan, governor of the Central Bank of China, has authored a paper calling for a decline in the role that individual currencies play in international trade and finance. According to Mr. Zhou, “Most nations concentrate their assets in those reserve currencies [Dollar, Euro, Yen], which exaggerates the size of flows and makes financial systems overall more volatile.” His point is well-taken, since of the $4.5 Trillion in global foreign exchange reserves that can be identified, perhaps 85% are accounted for by Euros and Dollars alone. When crises occur, everyone flocks to these currencies.

Mr. Zhou’s proposal is not without precedent. “His idea is to expand the use of ’special drawing rights,’ or SDRs — a kind of synthetic currency created by the IMF in the 1960s. Its value is determined by a basket of major currencies. Originally, the SDR was intended to serve as a shared currency for international reserves, though that aspect never really got off the ground.” It’s not clear exactly how such a system would work, but the idea is straightforward enough; instead of holding individual currencies, which are inherently volatile, Central Banks would be able to denominate reserves in a sort of universal currency. Instead of parking money in US Treasury securities, they would hold IMF bonds, or some equivalent.

Even before China starting becoming more vocal about its concerns, analysts had begun questioning the role of the US as reserve currency. I’m not just talking about the perennial pessimists. Within the context of the current credit crisis, a bubble may be forming in the market for Treasury bonds. “Foreign buying of American financial assets by both private investors and governments averaged $141 billion from September to December, Treasury data show…Demand was so strong that, for the first time, investors accepted rates below 0 percent on three-month Treasury bills to safeguard their capital.”

There is concern that a slight recovery in risk appetite (of which there is already evidence) could ignite a massive sell-off: “People are sitting there holding massive amounts of zero- yielding dollar assets. If there is any sort of good news, demand for dollars can drop off very, very quickly.”

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

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

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

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

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

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

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

Since Chinese Premier Wen Jiabao (as the ForexBlog reported here) expressed doubts about China’s US loans and investments two weeks ago, the markets have been awash in speculation. In hindsight, it seems that the announcement was a political ploy, rather than a harbinger for a policy change. With a few qualifications, therefore, it seems to safe to conclude that China’s foreign exchange reserves will not undergo any serious changes in the near-term.

Motivated both by politics and pragmatism, “China’s top foreign-exchange official said the nation will keep buying Treasuries and endorsed the dollar’s global role. Treasuries form ‘an important element of China’s investment strategy for its foreign-currency reserves,’ she said at a briefing in Beijing today. ‘We will continue this practice.’ ” The economic fortunes of China and the US have become increasingly intertwined over the last decade, such that China has come to depend on exports to the US to drive economic growth, while the US simultaneously depends on China to fund its fiscal and current account deficits. As a result, “about two-thirds of China’s nearly $2 trillion in reserves is parked in dollar assets, primarily U.S. government and other bonds.”

Even ignoring the potential political fallout from forex reserve diversification, such a move doesn’t really make practical sense. First of all, there isn’t a buyer sufficiently capitalized to relieve China of its US Treasury burden. “If China decided to sell off some of its U.S. Treasury holdings, it would scarcely be able to dump that in large blocks. And a partial selloff would surely lead to a slump in the Treasury market, eroding the remaining value of China’s portfolio.”

In addition, there doesn’t currently exist a viable alternative to US Treasury securities, nor to investing in the US, for that matter. China’s attempt at diversifying into corporate bonds and equities was extremely ill-timed, having been implemented just prior to the puncture of the real estate and stock market bubbles. Including the collapse in the value of its high-profile investments in the Blackstone Group and Morgan Stanley, total paper losses are estimated at a whopping $80 Billion. Investments in other currencies and markets, meanwhile, probably would have yielded similarly poor returns. The market for gold- mulled by some as a theoretical alternative- is even more volatile and “not large enough to absorb more than a small proportion of China’s reserves.”

As a result, China’s forex reserve diversification strategy is likely to proceed along two lines: change in duration of loans, and investments in natural resources. “The risk of short-term national debt is comparatively more controllable. China increased its holding of short-term US bonds by $40.4 billion, $56 billion, and $38 billion in September, October and November, respectively. At that time, China began to sell long-term government debt.” Through its affiliates meanwhile, China’s Central Bank is cautiously making stealthy forays into natural resources; see its recently-acquired a $20 Billion stake in Rio Tinto, an aluminum company, as evidence of this strategy.

Of course, China has announced tentative support for loaning money to the IMF and backing an ‘international’ reserve currency that would serve as an alternative to the Dollar. Given that this is probably many years away, however, it has little choice but to continue to hold Treasuries and the like. In the words of a high-ranking Chinese official: “We are in the middle of a crisis right now, and the priority for foreign exchange reserves is to minimize losses.”

Having already lowered interest rates essentially to zero, the Fed has announced that it will now focus on ‘quantitative easing,’ a fancy way of saying that it intends to turn on the printing presses. It will purchase over $1 Trillion in credit instruments, split between Treasury securities and Mortgage-backed debt, expanding its balance sheet to $3 Trillion. This should (temporarily) put an end to speculation over whether foreign Central Banks are still willing to finance the US debt, as this question is now moot, since the Fed has demonstrated its willingness to fulfill that role. “The Fed is basically financing our deficit by buying the debt issued by the Treasury. If the Obama administration pushes through another stimulus package, the dollar is done.”

When the news was announced, the Dollar plummeted by 2.7%, the highest daily margin since 1971, as traders mulled the inflationary implications of printing over $1 Trillion and injecting it directly into the money supply, with the potential of more to come. Wrote one analyst, “Interest rates now are effectively negative across the board. The dollar is selling off because this may contribute to long-term weakness in the currency.”

Unfortunately for the Fed and the Dollar, the last few weeks have witnessed a slight pickup in risk tolerance, as investors began to focus more on fundamentals. If this development took place in the deepest chasm of the credit crisis, investors might have been willing to look the other way, but now they are very concerned that a huge expansion of the US monetary supply could trigger long-term inflation. A less pessimistic way of looking at the Dollar sell-off would be to attribute it to investor confidence that the Fed plan will help revive the global economy, decreasing the appeal of the US as a safe haven for investing.

Whether this will push the Dollar down further towards the $1.40 range depends on a couple factors. First of all, will other Central Banks follow suit? “All the major central banks may end up in the same position. The way we look to play it is to see which goes the first and which one lags, and try to explore the timing difference between the two,” explained one analyst. If this proves to be the case, investors will once again focus on the “least worst” currency, in which case the Dollar could once again come out on top.

It also depends on whether this action is intended as a quick fix, or as part of a series of purchases by the Fed. “Sell the dollar!” said…a portfolio manager. “This is huge, huge. It’s equivalent to the Plaza accord. This is the last thing theyhave in the closet, and they used it a bit early.”

The Korean Won is among the biggest losers of the credit crisis, excluding Iceland of course. The currency has fallen 40% against the Dollar over the last year, even adjusting for a 10% rise in the last week. South Korean Finance Minister Yoon Jeung-hyun blames currency speculators, pledging that “The government will not sit idle when the foreign exchange rate is excessively tilted toward one direction or when there are speculative forces.”

Perhaps understanding that it cannot possibly hope to defend its currency against such a broad tide of determined speculators, the Central Bank of Korea has all but given up on intervening in forex markets. “South Korea was the catalyst for the shift away from defensive intervention. After spending 22 percent of foreign reserves from August to November to stem won losses, Yoon…said Feb. 25 that its weakness may be an ‘engine for export growth.’ ”

There is some plausibility to this argument, since South Korean economic fundamentals (as bleak as they are) probably don’t support such a precipitous decline in the Won. In fact some South Korean exporters have benefited from the weak currency, with companies such as Hyundai and Samsung growing revenues and increasing market share. Still, the global recession has impelled foreign consumers to cut back on spending, with the end result that “A double-digit fall in exports in the last three months of 2008 seriously undermined industrial production, [and] a 16% plunge in facility investment was an equally important factor in the 5.6% contraction in Korea’s GDP from the previous quarter.”

Ultimately, the Won’s decline is being driven by an acute shortage of Dollars. A relatively large portion of Korean public and private debt is denominated in foreign currency. The collapse in liquidity spurred by the credit crisis and consequent decline in bank lending have made it very difficult for South Korean borrowers to procure the requisite Dollars to repay their loans, causing a large imbalance in the supply and demand for the Dollar within Korea. Even more alarming is that $150 Billion of such debt will come due in the immediate future. “The government stresses that foreign debt maturing within a year amounts to 77% of its foreign exchange holdings, meaning Korea can cover its obligations. However, no other Asian nation that investors care about has such a high ratio of short-term external debt (on a remaining maturity basis) to foreign exchange reserves.”

South Korea recently extended a swap agreement with the US, which enables it to exchange up to $30 Billion in Won for Dollars. Investors are evidently hopeful that this represents a step towards easing the Dollar shortage, as the news caused the Won to appreciate by the largest margin in months. Borrowing costs for Korean firms remain high, and the odds remain tilted against them. Unless the US financial system stabilizes and/or Korea is able to run a current account surplus (as a result of increased foreign investment), liquidity will remain a problem.

Yesterday, Chinese Premier Wen Jiabao aired his country’s growing concerns about continuing to lend money to the US. Within the context of the US economic stimulus plan and other related US spending initiatives, Mr. Wen is understandably anxious about China’s vast holdings of US Treasury securities:

President Obama and his new government have adopted a series of measures to deal with the financial crisis. We have expectations as to the effects of these measures. We have lent a huge amount of money to the U.S. Of course we are concerned about the safety of our assets. To be honest, I am definitely a little worried.

While the announcement represented political posturing (to an increasingly restless, domestic Chinese audience), it should nonetheless be heeded as a warning, that the US cannot expect China (and other foreign Central Banks) to fund US budget deficits indefinitely.

Let’s put aside the rhetoric for a moment, and examine the data. This week witnessed strong demand for Treasury securities, which were auctioned by the Treasury Department on consecutive days. Despite historically low yields (see chart), investors continue to snap up Treasury Bonds, mainly for the sake of risk aversion. The newly-revived issuance of 30-year bonds also went off without a hitch, and were more than 2x oversubscribed. Most relevant to this discussion is the fact the foreign Central Banks accounted for as much as 46% of demand!

The most recent Federal Reserve Statistical Release paints a similar picture. While foreign Central Banks and other international institutions reduced their holdings of US government securities slightly from the previous week, the decrease was essentially negligible. Overall, such entities have increased their holdings by at least $440 Billion over the previous year, bringing the total to approximately $3 Trillion (depending on the data source). China’s contribution remains substantial. Of its $2 Trillion in foreign exchange reserves, “Economists say half of that money has been invested in United States Treasury notes and other government-backed debt.”

However, there are a few reasons why I don’t think this trend will continue. First of all, the buildup in foreign Treasury holdings that transpired over the last decade was largely a product of unsustainable global economic imbalances, as net exporters to the US invested their perennial trade surpluses in what they perceived to be the world’s most secure investment. Temporarily putting aside whether Treasuries are actually secure, economic indicators suggest that Central Banks simply do not have the capacity to increase their holdings by much more. China’s trade surplus plummeted to $4.8 Billion last month; one economist projects a surplus of only $155 Billion in 2009, compared to nearly $300 Billion in 2008.

You can also remove from the list Japan- the second-largest holder of US Treasury securities- which is now running a trade deficit. Instead, both countries have publicly announced plans to use some of their forex reserves to fund domestic economic initiatives.

Then there is the equally unsustainable short-term buildup in US Treasuries, which is largely a product of technical factors. As I mentioned above- and which should be clear to all investors- the current theme underlying securities markets is one of risk aversion. In fact, it now appears that a bubble is forming in the bond market, and “any exodus now could spark selling across the board. Foreign debt holders would likely repatriate their funds immediately to reduce the risk of being last to convert.” As soon as markets recover- of which there are already nascent indications- investors will probably reduce their holdings of government bonds, or at least not increase their holdings.

Even the most conservative projections indicate a cumulative budget deficit for the next few years measuring in the the Trillions. Unless the risk-aversion theme obtains for the next decade, it seems unlikely that foreigners can be tapped to fund more than a small portion, leaving the Federal Reserve (with the help of its printing press) to make up the shortfall.

The Japanese Yen is increasingly resembling a patient with split personality disorder, moving in one direction (down) against the Dollar while behaving quite differently against other currencies.

For most of the duration of the credit crisis, the Yen had mirrored the performance of the Dollar, both of which had performed well as so-called “safe-haven” currencies. For a while, the Yen even outpaced the Dollar, rising to a 13-year+ high. Over the last five weeks, however, the Yen has fallen off against the Greenback, while maintaining its value against other rivals. It’s unclear exactly what’s driving this split, but careful analysis suggests it is a product of changed investor psychology.

To elaborate, the Yen’s precipitous rise was due to financial- as opposed to economic- factors. As investors fled emerging markets en masse and unwound carry trades, it spurred a flood of capital back into Japan. This was not because the Yen was anything special; far from it, in fact. Rather, it was because the alternatives were perceived to be substantially more risky. This began to change in earnest when it was revealed that the Japanese economy shunk by over 12% (on an annualized basis) in the recent quarter. Given that Japan’s economy is famously dependent on exports, it didn’t take long for investors to connect Japan’s sagging GDP with its strong currency.

This prompted speculation that Japan would intervene in forex markets in order to prevent the Yen from rising further. In the end, Japan didn’t spend a dime. Fortunately, it didn’t have to, as investors took the hint, and sent the Yen tumbling against the Dollar. Technically, Japan hasn’t intervened since 2004 (see chart), but the threat of intervention combined with low interest rates ensured that in this case, words spoke just as loud as actions. It should be noted that Japan will use a small portion of its reserves to fund domestic economic initatives, but for now at least, none of it will be used to purchase Dollars in the spot market.

So why hasn’t the Yen reversed course against other currencies? Its stock market is sagging, and its economy is in equally bad, if not worse-than-average shape. The answer lies in interest rate differentials and investor risk tolerance. The rate gap between the Yen and the highest-yielding currency (New Zealand), has shrunk to less than 3.5%. Excluding Australia, and to a lesser extent the Euro, interest rate differentials are effectively negligible. Accordingly, investors have decided that the gains from an additional couple hundred basis points in yield are not offset by the perceived increase in risk associated with currency volatility. That this theory holds water is evidenced by the fall in the Japanese Yen that immediately registered when the Bank of Australia opted to hold rates steady at its most recent meeting.

US Treasury yields have been held low across the short-term and long-term due in part to a lack of appealing investment opportunities in a deflationary period, while the Federal Reserve announced in January the possibility of buying long-term US government Treasury bonds to help hold down long-term interest rates (and thus mortgage rates), hoping for a slow controlled decent in housing prices.

At the other end of the spectrum, the US government has been bailing out every large financial institution willing to accept a few billion here or there, and running the printing presses in overdrive.

Eventually this will lead to inflation, as explained by John Williams last August:

Excess supply of a commodity or product usually is reflected in downside pressure on its price, and the same is true for money. Excessive supply of money leads to its debasement, to a decline in its value that otherwise is known as inflation. Where money supply generally is an underpinning of economic activity, it also is the ultimate determinant of prices and inflation. At present, near-record high annual growth in the broadest U.S. money measure M3 is suggesting a significant inflation problem in the year ahead.

The Chinese have nearly 2 trillion Dollars in their reserves, with roughly 2/3 of them being denominated in US Dollars. Seeing their own economy slow, and the coming risk of inflation, the Chinese government is looking to shift some of their reserves away from US Dollars to hard commodities, particularly oil. Marketwatch reports:

China is considering plans to tap its foreign reserves to buy crude oil as part of a push to diversify holdings from U.S. Treasurys, according to a published report.

With the U.S. issuing massive amounts of government bonds to finance economic stimulus measures, Chinese officials are looking to hedge against the risk of Treasury prices dropping.

China, which has been building up a national oil stockpile since 2004, aims to amass 100 million barrels by next year as a first step, the Japanese business daily Nikkei reported.

This may just be jawboning to try to slow down the US printing presses, but if it is more than that, it could have a significant effect on the perceived value of the US Dollar, especially in light of the current $1.75 trillion US deficit - a full 12.3% of the projected 2009 GDP. If foreigners lose confidence in the US Dollar, inflation and interest rates will certainly move sharply off their historic lows as the risk of “risk free” US treasuries is revealed and repriced.

The ForexBlog recently reported that investors were cautiously wading back into emerging market currencies. In hindsight, it looks like this report was delivered prematurely, as this week marked a return to the notion of the Dollar as save haven currency, having displaced even the Japanese Yen. While President Obama did his best to assure taxpayers and investors that the economic stimulus would bring the economy out of its slump, the markets were unconvinced. Economic data, especially as it pertains to the housing market, has become increasingly grim, and even Chairman Bernanke of the Federal Reserve conceded that a recovery is unlikely before 2010. Given that the government will have to issue a tremendous quantity of Treasury Bonds in order to fund its ambitious spending plans, however, it’s possible that foreign investors will soon lose their appetite for low-yielding American securities. Reuters reports:

Any optimism that the global economy could be recovering, however, should prompt investors to sell the dollar and buy riskier assets and currencies.”When panic and risk aversion abate, money will start flowing into other regions such as Europe,” said a portfolio manager.

Read More: Dollar gains broadly as safe-haven demand rises

While continuing to deny the possibility of direct forex intervention, Japan is nonetheless desperate to halt the rise in the Yen. The primary concern of the US government, meanwhile, is not that the Dollar is becoming too valuable, but rather that it will face great difficulty in funding its economic stimulus plan. Perhaps there exists a golden opportunity to simultaneously alleviate both of these quandaries; Japan should be solicited to buy US government bonds. A large-scale purchase of US Treasury securities by the Central Bank of Japan would be tantamount to intervention, and would probably lead to a decline in the Yen, at least against the Dollar. Of course the US would benefit not only by the direct purchase of its bonds, but also by the positive signal that this would send to other institutional investors. Besides, given that China is in no position to increase its holdings of US Treasury securities, Japan represents the best candidate for partnership. The Washington Post reports:

Achieving such a currency adjustment may seem farfetched, but the yen-dollar exchange rate historically has been heavily influenced by the market's perception of the U.S. and Japanese governments' comfort level for the currency relationship.

Read More: America's New Rescuer: Japan

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

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

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

In accordance with yesterday's post, it appears that this February is set to continue the trend of low volatility observed in previous years. With the US government on the verge of passing a record economic stimulus package, investors are becoming increasingly confident about the prospects of the global economy to avoid recession. On the surface, it would seem that the stimulus should benefit the economy, and by extension the Dollar. However, this ignores the fact that the Dollar is currently being driven by fear- the idea that the US remains a safe haven for investing- rather than by economic fundamentals. The same holds true for the Japanese Yen. Accordingly, regardless of how the stimulus ultimately impacts the economy, it will certainly increase risk tolerance in capital markets, potentially leading investors to shift capital out of the US and Japan into higher-yielding sectors. Bloomberg News reports:

"A lot of money that sat on the sideline is now being put back to work," said [one analyst]. "People are starting to move to make risky bets."

Read More: Yen, Dollar Fall as U.S. Stimulus Prospects Reduce Haven Demand

Efficient markets theory would suggest that the inherent randomness of commodity prices should be preserved from month to month, such that on average, prices are equally likely to go up as they are to fall. In practice, we know that earnings and tax calenders are such that stocks consistently perform better in some months, than they do in others. Such patterns can also be observed in forex markets.The Dollar, for example, typically rises in January, probably as a result of the US stock market to rise likewise. In February, meanwhile, one analyst has observed a consistent decline in volatility between the Yen and the Dollar. The implication is that with lower volatility will follow a sell-off in the Yen, due to renewed interest in the carry trade. Of course, this may not hold in the current market environment, as both currencies are now being used to fund carry trades and are being punished accordingly when risk tolerance increases.

Read More: What Is Unique About Forex in February?

Investing wisdom has long held that gold is used to hedge (Dollar) inflation; historically, the two commodities have tended to trade inversely with one another. In the last month, this relationship appears to have broken down. As the credit crisis has entered a new critical stage, investors have come to view both the Dollar and the gold as safe havens in a sea of uncertainty. To elaborate, the Dollar is being purchased primarily to pay down debt, with the proceeds invested in low-risk, low-return vehicles. Gold, in turn, is being used as a form of insurance, as a "deflationary backstop" in case the bets on the Dollar miss the mark. In short, the Euro and Gold are no longer friends. BullionVault reports:

"The new dynamic in risk aversion now means that when the EUR/USD goes up then traders must sell their gold – since a higher Euro implies lower risk in the overall markets and hence less need to hoard the yellow stuff."

Read More: Gold and the Dollar Running Together: Why?

During his confirmation hearings, Treasury Secretary Geithner indicated that the Obama administration consensus is that China is manipulating the Yuan. China predictably refuted the charges, and indicated that it will not be bullied into submission by the US when managing its currency. Thus began a heated back-and-forth between US and Chinese economic officials, with the forex markets caught awkwardly in the middle. Geithner apparently doesn't realize that his position also carries important diplomatic responsibilities, namely helping the US government to pay its bills by ensuring a steady demand for US Treasury securities abroad. Offending the most reliable foreign lender, accordingly, is probably not the best strategy to fulfilling this role. Moreover, Geithner's testimony couldn't have occurred at a worse time, given the planned expansion of US debt and the simultaneous leveling off of China's forex reserves. The implications for the Dollar couldn't be clearer. Forbes reports:

China has been a major purchaser of America's official debt in recent years. If it were to stop…Geithner would likely find his Treasury paper having to offer higher yields to draw investors, putting new pressure on the American budget.

Read More: China Speaks, U.S. Debt Market Listens

US government bond issuance in 2008-2009 will shatter all previous records. Fortunately, risk tolerance remains low as a result of the ongoing uncertainty surrounding the credit crisis,and demand for US Treasuries remains proportionally high. However, analysts are beginning to wonder just how much more the market can support, as it appears that a bubble has begun to inflate. A slight recovery in risk appetite, and/or institutional investor concern that the bubble is on the verge of popping could trigger a mass exodus from US Treasuries. Moreover, foreign holders would likely rush to repatriate the proceeds in order to minimize currency conversion risk. The result would be a self-reinforcing downward spiral between the Dollar and bond markets. Reuters reports:

A tanking U.S. dollar on the back of a decline in the U.S. bond market would signify the global economy may not be recovering anytime soon, however, which could leave very few places to hide.

Read More: Dollar investors wary of bond market bubble

The Fed is officially in panic mode, having lowered its benchmark federal funds rate close to zero and exhausted all of the tools in its monetary arsenal, with one notable exception: its printing press. In other words, the Fed is trying to jumpstart credit markets by acting as a market participant- investing funds to compensate for the reticence of private investors. Capital markets are naturally enthusiastic about this policy, since some of the new cash will probably be used to make leveraged bets on asset prices and erase some of the losses of the last year. Forex markets are palpably less excited that the Fed has essentially eroded much of the impetus for foreigners to hold their ash in the US, with paltry short-term yields and long-term gains that will likely be offset by inflation. Unless foreign Central Banks follow suit

and eliminate the current interest rate disparity with the US, it could be a bumpy 2009 for the Dollar. Forbes reports:

Citi Analyst Steven Wieting opined: "If you want yield, you'll have to take some risk." With borrowing rates suddenly close to zero and the Fed saying it will keep them at “exceptionally low levels … for some time, you'll get as little of it from government-issued debt as possible."

Read More: After the Fed Panic 

As 2008 comes to a violent end, forex analysts are releasing their predictions for 2009. Most believe that risk aversion and interest rate discrepancies will cease to weigh on forex markets, especially compared to 2008, when investors unwound carry trades and parked their money in low-yielding (but apparently less risky) US and Japanese securities. Instead, investors will probably begin to focus more on economic fundamentals. With regard to the Dollar, this approach could work either way. On the one hand, it is conceivable that the US will outperform (this could translate into a milder recession) the EU and Japan, since the Fed's interest rate cuts were implemented at such an early stage. On the other hand, the US twin deficits continue to expand, which suggests the possibility of long-term inflation as well as a potential reluctance in foreigners to continue to lend to the US. Marketwatch reports:

To be sure, the dollar's 2009 trajectory depends a lot on what the U.S. and global economies do, and when they do it. The U.S. recovery could begin midyear, or the clouds could linger until the fourth quarter or even longer.

Read More: Dollar faces correction, but could head up in 2009

More than a week after America's Federal Reserve Bank slashed its benchmark interest rate to the historic (low) level of .25%, investors are still struggling to assess the implications. The immediate reaction was mostly positive, as Central Banks around the world (namely Hong Kong and Japan) quickly followed suit, and stocks rallied. In other words, investors were buoyed by the belief that Central Banks can and will employ all available financial tools to maintain acceptable liquidity in financial markets and to prevent the economic downturn from turning into a depression. On the other hand, forex traders were understandably dismayed by the growing gap between US and foreign interest rates, as well as the inflationary implications of the Fed's plan to essentially print money and inject it directly into the economy. The Associated Press reports:

"While there was applause for the (Fed) cuts…investors are now standing back and reflecting further on what that means," said…an analyst. "Some nervousness has been expressed in the currency markets. We have seen a weakened dollar, which has probably had an effect on the markets across the board."

Read More: World markets mixed after Fed's historic rate cut

Several years ago, Ben Bernanke earned the nickname "Helicopter Ben" by joking that the Fed would drop Dollars from helicopters if the American economic situation ever became desperate enough to warrant it. In hindsight, the bestowers of this nickname could not have been more prescient, as the Federal Reserve Bank has now officially pledged to do everything in its power to stimulate the flow of money, short of literally dropping currency from the sky. Capital markets naturally reacted to this policy prescription with delight, as some of the surplus dollars will certainly be used to bid up and stock and bond prices. Currency markets, on the other hand, were not so complacent, sending the Dollar back down from the depths from which it only recently emerged. In other words, zero-interest rates and a surfeit of dollars hot off the printing press has analysts and forex traders wondering aloud about who will be foolish enough to want to own Dollars in the future. The Wall Street Journal reports:

If the Fed is going to create boatloads of depreciating, non-yielding dollar bills, who will absorb them? Who will finance the Obama administration's looming titanic fiscal deficits? Who will finance America's annual surplus of consumption over production (after 25 more or less continuous years, almost a national trait)?

Read More: Is the Medicine Worse Than the Illness?

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

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

Read More: Less Panic Puts Pressure on Dollar

When all is said and done, the US government will have injected trillions of dollars into the economy, in the form of bailouts, guarantees, economic stimuli, etc. Whether it will have the desired effect is debatable. The question that no one seems to be asking is, "How is the government going to finance such exorbitant spending?" It appears that China, which has become of of the largest holders of US government debt, will continue to participate- not necessarily because it wants to, but because it doesn't have a choice. China's economy remains heavily reliant on the export sector to drive growth. Because its exchange rate regime does notpermit the RMB to fluctuate freely, the proceeds from the consequent trade surplus must be invested abroad, rather than domestically. For both symbolic and economic reasons, it seems the bulk of the surplus will continue to be invested in the US, probably in safer assets like US Treasury Securities. This is certainly good news for deficit hawks and Dollar bulls. The Wall Street Journal reports:

Even if China wanted to invest outside the U.S., it couldn't. If China recycled its foreign currency into, for instance, the European Union or Japan, it would effectively force those trading partners to run large trade deficits with China, which neither can absorb.

Read More: China Will Keep Buying U.S. Government Debt

At this point, it should be clear to everyone that the ongoing Dollar Rally is due more to technical factors than US economic strength. In short, the Greenback is benefiting from the intertwined trends of risk aversion, capital flight from emerging markets, unwinding of carry trade positions, and the perception that the US is a safe haven to invest during periods of global economic uncertainty.

If this is indeed the case, shouldn’t the Dollar rally eventually come to an end? Based on economic fundamentals, the answer is a resounding ‘yes.’ The twin deficits of trade and government spending are unlikely to abate as a result of the credit crisis. In fact, the trillions of dollars in fresh government spending, combined with a decline in exports wrought by the suddenly strong Dollar, will probably exacerbate these dual trends. Based on almost every measure, the US economy remains dangerously over-leveraged. Fueled by cheap credit, household debt, government debt, and financial sector debt have exploded over the last couple decades, such that total US debt is estimated at a whopping %350 of GDP. Given that both China and the Middle East are facing domestic economic crises brought on by a drop in exports and a decline in the price of oil, respectively, it seems unlikely that they will have the resources, let alone the inclination, to continue to fund this debt. Seeking Alpha reports:

Chinese have recently lowered interest rates considerably, have started large domestic stimulus packages and have even tried to depreciate their currency. Again, one should anticipate a much lower appetite for U.S. assets going forward.

Read More: Will the Dollar Rally Survive?

What does the appointment of New York Federal Reserve President Timothy Geithner as Treasury Secretary mean to forex traders? To answer this question, it depends on which side of the Dollar you fall in. Geithner worked in the Treasury Department under Bill Clinton, which means he is well versed in the Strong Dollar policy. It is not clear whether such a policy will be implemented under the Obama administration, which may be counting on the export sector to fill the gap created by a decline in domestic consumption. Regardless, the consensus among analysts is that Geithner understands currency markets, and is not likely to take steps that will rattle them. This would mark a sharp break from his predecessor Henry Paulson, whose bungling of the economic bailout has given rise to record levels of volatility (read: uncertainty) in forex and financial markets. The Australian reports:

"For all the currency traders out there, this means he was in charge of US dollar policy and is steeped in the nuance of the currency markets…Unlike during rookies Paul O’Neill or John Snow’s tenure, we won’t get many mistakes to make easy money," said [one analyst].

Read More: ‘Safe pair of hands’ Timothy Geithner tipped for US Treasury

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

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

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

Having endured years of abuse from free-market advocates and the International Monetary Fund, fixed exchange rate regimes are officially back in vogue. This is because the sole currencies not to have been affected by the recent surge in forex volatility are those that are pegged to the US Dollar, namely the Chinese Yuan and Hong Kong Dollar. Both countries have stood by calmly as other emerging market economies have witnessed speculators lay waste to their currencies, driving them down by 5% or more per day. Fortunately, both HK and China have significant stockpiles of foreign exchange reserves, which virtually eliminates any possibility of a speculative attack. Iceland, meanwhile, was forced to abandon a half-hearted attempt at a currency peg when it ran out of cash to defend it. Of course, a fixed currency can also be a disadvantage, as exports may become expensive relative to competitors that experience declines in their currencies. Given the current economic climate, however, it seems HK is happy to give up this potential upside in favor of stability. The Wall Street Journal reports:

Like Japan, Hong Kong was a source of funds for the carry-trade. Turbulent markets have taken that strategy apart, and investors who borrowed in Hong Kong are pulling money back into the territory at a rapid clip.

Read More: Hong Kong Loves Its Currency Peg

The consensus among economists is now that the US Federal Reserve Bank will lower its benchmark interest rate all the way to 0%. The Fed Funds Rate currently stands at 1%, and two projected 50 basis point cuts within the next two months would bring the rate to its lowest level ever, where it could remain for as long as one year. Apparently, the concern among economic policymakers is that the sagging economy and falling asset prices will ignite a protracted period of deflation. Given the extent to which the Federal Reserve Bank as well as the Federal Government have already moved to stimulate the economy, it’s unclear whether any further loosening will have an effect. Currency investors remain unfazed about this prospect, perhaps because the rest of the world is in equally dire straits, and foreign central banks are mulling proportionately drastic measures. Marketwatch reports:

"This [interest rate cut] move confirms a highly pro-active and aggressive central banking community and there will be more to come" from the Bank of England and European Central Bank, said one currency strategist.

Read More: High-yielding currencies under pressure

After rising nearly 20% over the last three years, the RMB has virtually stopped appreciating against the US Dollar, perhaps as a result of the credit crisis. At the same time, the US exports sector- previously one of the few bright spots of the sagging economy- has begun to stall. US Politicians have taken note, and are now renewing their efforts to persuade China to allow its currency to rise further. They are also agitated about China’s perpetually growing forex reserves (currently estimated at $2 Trillion), which are increasingly being deployed in sensitive areas. Meanwhile, the Chinese economy is growing at the slowest pace in years, and the Chinese government is resorting to desperate measures to prop it up. In short, allowing the RMB to rise, while placating US policymakers, is tantamount to economic suicide, and hence unlikely.

While other sovereign wealth funds have existed for nearly 50 years without controversy, "China appears far less likely than other nations to manage its sovereign wealth funds without regard to political influence that it can gain by offering such sizable investments."

Read More: US panel urges action on China currency, investing

Since the credit crisis heated up several months ago, the theme of risk aversion has predominated in equity markets. This is also true in forex markets, where deleveraging and a shift to perceived investing "safe havens" has led to a collapse in the carry trade, leading to a sharp rally in both the Dollar and Yen. In fact, the recent rise of these two currencies has coincided remarkably with stiff declines in the prices of virtually every class of risky asset.

Read More: Currency Trading Markets Remain Highly Correlated to Dow Jones, Crude Oil Prices

It’s a little-known fact that the US Federal Reserve Bank does not actually set interest rates. As a result, there is often a discrepancy between the "suggested" Fed rate and the actual rate. Since the onset of the credit crisis, this gap has widened considerably, such that the "effective" benchmark interest rate is nearing 0%. Some commentators are beginning to draw parallels with Japan, where interest rates have remained close to 0% for several years. If/when the global economy finds its footing, the Dollar could follow the lead of the Yen, and once again find itself a funding currency for the carry trade. The Economist reports:

If the effective rate remains near zero, the Fed will have to turn to more unconventional means of stimulating growth.

Read More: The Federal Reserve - Turning Japanese

While the Bush Administration nominally embraced a strong Dollar policy, the currency’s 20% decline over the last eight years suggests it was actually a low priority. The Obama administration, in contrast, is much more likely to maintain such a policy, a circumstance which could help the Dollar to continue its year-long rally. Obama will assume the office of the presidency at a time when US finances are looking particularly tenuous, with a projected 2009 budget deficit of $1 Trillion. In order to finance the government bailout, as well as an additional economic stimulus plan and a host of other initiatives (let’s not forget the two ongoing wars), Obama will need to spearhead an effort to attract more foreign capital. For this to happen, the Dollar’s status as the world’s reserve currency must be cemented and confidence in the Greenback must be restored. Ironically, Obama may receive a boost in this aspect from the credit crisis. The Guardian reports:

The dollar [rally] is likely to persist as market participants looked to snap up more U.S. assets after the decisive election of a candidate that promised to bring sweeping changes to a country mired in the worst economic crisis since the Great Depression.

Read More: Obama win cements need for strong dollar policy

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

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

Read More: Economists Search for End of Woes

These days, the Dollar and the Yen are veritable proxies for investor confidence/risk tolerance. As a result, on days when US stocks rise, the Dollar (somewhat ironically) will typically experience a decline. Over the last couple weeks, it should therefore come as no surprise that the tremendous rise in US stock prices was matched by a proportional fall in both the Dollar and the Yen. If only for technical reasons (i.e. that the scale tipped too much in the other direction), it seems investors have regained some of their comfort with investing in emerging markets, leading some of the hardest-hit currencies (Korean Won, Brazilian Real, Mexican Peso) to recover some of their gains. Call it wishful thinking, but some investors now believe that the US recession will be milder than originally forecast, which would certainly exert a positive impact on such emerging market economies. In addition, there were monetary factors underlying the currency reversal, reports The Washington Post:

There were more specific reasons for some of the fluctuations. A news report that the Bank of Japan might cut rates in the near future was a factor in driving down the yen.

Read More: Currency Swings Reverse Course

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

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

Read More: Currency-Price Swings Disrupt Global Markets

While the Dollar rally may ultimately prove beneficial to US consumers (due to cheaper imports), it is certainly not helping US-based multinational corporations. Companies that earn a significant portion of their revenue abroad would normally be considered stable investments during times of economic uncertainty, since their exposure to individual economies is minimal. In the context of the current crisis, however, such companies have struggled; since they must report earnings in terms of USD, a strong Dollar is equivalent to lower earnings on foreign sales. Some companies have turned to hedging their exposure, while others have opted to either ride out the fluctuations and/or hope that they cancel each other out, banking on the notion that forex is ultimately a zero-sum game. Dow Jones reports:

To be sure, such global currency fluctuations are hard to manage and even those companies that do have hedges in place may only be able to limit and not completely offset the pressures of a strengthening greenback and oscillating exchange rates.

Read More: Multinationals Turn To Hedging To Manage Rising Dollar

One can usually assume that any talk of the carry trade is in reference to the Japanese Yen. In this case, however, it is the Dollar that is being driven by a shift away from the popular strategy of borrowing in one currency and investing the proceeds in assets dominated in another. In explaining the recent Dollar rally, analysts have tended to focus on the pall of risk aversion that has descended upon global capital markets, coupled with the spread of the credit crisis from the US to the rest of the world. While these are certainly contributing factors, perhaps they should also look at the repatriation of Dollars that were initially sent abroad over the last decade in search of loftier returns. Hedge funds and other institutions, including those based outside of the US, took advantage of record-low interest rates to borrow Trillions of Dollars and invest them abroad. Due to a combination of margin calls and client "withdrawals," however, such investors have been forced to not only unwind such positions, but return the proceeds of the US. The Guardian UK reports:

Data collected by the Bank for International Settlements shows that European and UK banks have five times as much exposure to emerging markets as US and Japans banks, with surprisingly big bets in Latin America and emerging Asia - where they rely on dollar funding rather than euros.

Read More: Dollar roars back as global debts are called in

Last week, China revealed that in the most recent quarter, its economy grew at the slowest pace in nearly five years. It also revealed that its foreign exchange reserves crossed $1.9 Trillion, due to a record monthly trade surplus. How can this seeming contradiction in economic peformance be reconciled? In my opinion, the Chinese economy will continue to slow as a result of a generalized post-olympics slowdown and falling export demand brought on by the global economic crisis. The consequent collapse in risk appetite will bear negatively on investing in Chinese assets. Its stock market has already lost 50% of its value this year, and foreign direct investment (which is more difficult to monitor) is certainly sliding. In other words, there will be less foreign capital for the Central Bank to soak up, and less pressure on the RMB to appreciate. AFP reports:

The various factors at play could actually be causing some capital outflows as troubled foreign firms and investors may need the money overseas.

Read More: China’s forex reserves pass 1.9 trillion dlrs: central bank

The word "confidence" has become ubiquitous when talking about the credit crisis. Policymakers talk casually about the lack of confidence and offer solutions for its restoration. But wasn’t it a surplus of confidence that was responsible for the credit crisis? Banks confidently extended loans to less-than-credit-worthy borrowers, who confidently took on more debt than they could repay, which was then confidently repackaged and underwritten by Wall Street, and sold to unassuming Central Banks abroad, who confidently believed that the Dollar was tantamount to gold. Ironically, their confidence has been (falsely) confirmed by the recent Dollar rally, as investors flocked to the eye of the global financial storm because of the perceived safety of investing in the US. If confidence is indeed restored, it will not be cheap, as the US government bailout will probably be highly inflationary. Central Banks may soon catch on and realize that if they are to continue financing an annualized current account imbalance of $700 Billion, they will need to be compensated accordingly. The Wall Street Journal reports:

Our foreign creditors accepted dollars in payment for their goods and services — and then obligingly invested the same dollars in America’s own securities. It’s as if the money never left the 50 states.

Read More: The Confidence Game

Forex traders, and by extension, forex analysts, tend to focus on the Euro-Dollar currency pair because the two currencies are the most highly-traded and perceived as the most stable. As the financial crisis swirls with renewed vigor, however, the Pound and the Yen have been thrust into the spotlight, although for opposite reasons. The Pound has been Pounded (for lack of a better word) by dismal economic data emanating from the UK; investors remain pessimistic that the UK will recover since housing prices are tanking and the Central Bank has been slow to react. In the case of the Yen, the picture is more financial than economic. Japan’s economy and its capital markets have been pummeled by the credit crisis, but ironically, its currency is considered one of the safest. The reason is that investors have dramatically reduced their short-Yen positions which had been built up as part of carry trade strategy. Now, the name of the game is risk avoidance, which is good for the Yen but bad for the Pound. Seeking Alpha reports:

Out of the currency majors, USD/CHF and EUR/USD are the tamer pairs whereas GBP/USD and USD/JPY are pairs which are seeing the most volatile moves in forex trading, reflecting the strong bias of the underlying sentiment.

Read More: Amidst Chaos, Some Clarity on the Forex Markets

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

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

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

As Karl Marx once proclaimed, "Central Banks of the world: Unite!" Well, not exactly….

In any event, six of the world’s largest Central Banks have come together in an unprecedented display of force, simultaneously lowering their benchmark interest rates. The Federal Reserve bank and European Central Bank appear to have spearheaded the effort, and were joined by the Banks of China, Switzerland, Britain, and Canada. The Bank of Japan remained on the sidelines, but it probably wouldn’t have made a difference given its already record-low rates. Obviously, the global rate cut was designed to be as much symbolic as economic. However, it’s not clear whether investors will take the hint, given that they have already ignored the Trillions of Dollars that have been spent by Central Banks and governments around the world. As far as currencies are concerned, if the global ship continues to sink, the two proxies for risk aversion- Dollar and Yen- will continue to lead the pack. In other words, fear is proving itself a much more powerful force than economic reality. The New York Times reports:

“The move is to be applauded but there is more to come. The playbook to avoid depressions says rates need to be as close to zero as possible.”

Read More: Central Banks Coordinate Cut in Rates

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

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

Read More: A bailout won’t wreck economy

At the end of each quarter, banks usually make an effort to balance their books. As a result of the ongoing credit crisis, however, completing this task at the end of the 3rd quarter fiscal 2008 was nearly impossible for most banks. Fortunately, the Federal Reserve Bank intervened to relieve the situation. In conjunction with the world’s major Central Banks, the Fed moved to make hundreds of Billions of Dollars in short-term capital available to financial institutions. The Fed will utilize swap agreements, which involve the exchange of blocks of currencies at agreed-upon exchange rates on agreed-upon dates. These particular swaps should help both to mitigate the shortage of Dollars on the open market and to further buttress the Greenback. AFP reports:

These expanded facilities will now support the provision of US dollar liquidity in amounts of up to 120 billion dollars by the ECB and up to 30 billion dollars by the Swiss National Bank.

Read More: Global central banks offer more dollars to markets

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As the US Congress puts the finishing touches on a $700 Billion plan intended to resuscitate the ailing financial sector, analysts remain hard at work assessing the potential implications. The consensus- unchanged from when the plan was first unveiled- is strongly negative, especially as far as the Dollar is concerned. When combined with the government’s other initiatives, the bailout will add nearly $1 Trillion to America’s national debt. Additionally, the Federal Reserve Bank would have to print money to bridge a shortfall in the government’s borrowings, thereby stoking the fires of inflation. Ironically, the Dollar’s best chance to avoid a continued decline is if the bailout plan fails in its stated aim, and the American economy implodes, pulling the global economy down with it. The Wall Street Journal reports:

Investors have already begun to cut their exposure to emerging-market and other higher-yielding currencies, and this trend could continue even if the dollar is no longer the bedrock of safety it once was.

Read More: Outlook for Dollar Dims

US political and economic officials are now operating in panic mode, as the credit crisis enters a new stage of direness. Politicians are hard at work trying to hammer out a bill that would funnel as much as $700 Billion into mortgage securities in a last-ditch effort to raise investor confidence. Ben Bernanke, Chairman of the Fed, has warned that failure to pass the bill could send the US economy into a prolonged recession and asset prices into a deflationary tailspin. Accordingly, the Fed may continue to act unilaterally if the US government can’t be persuaded to come on board.

Contrast this frenzy with the relative air of calm across the Atlantic: although the European Central Bank has toned down its hawkish rhetoric, its focus remains on inflation, instead than the state of the economy. Accordingly, a change in the current monetary environment (whether rate hikes or rate cuts) still seems somewhat unlikely. However, a moderation in inflation combined with an economic contraction could force them to re-think their strategy, especially if EU member states step up their rhetorical attacks. In short, as the Fed ponders yet another interest rate cut, it looks like the EU-US interest rate gap could conceivably widen before it narrows, reports the The Wall Street Journal:

Interest-rate futures suggest investors believe the Fed is likely to cut its key rate soon, perhaps even before its next meeting on Oct. 28 and 29.

Read More: ECB Leans Toward Keeping Rates Steady Despite Market Turmoil

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

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

Read More: Will Bailout Spur Inflation? Hedge That Bet

Congress remains deadlocked over the proposed $700 Billion plan to bail-out the American mortgage industry and alleviate the financial crisis, but that hasn’t stopped forex traders from weighing the implications. Suffice it to say that the Dollar fell 2.5% against the Euro-its worst-ever single session performance- in the first day of trading since a loose outline of the proposal was made available to the public. The consensus, thus, is that the plan is unambiguously bad for the Dollar. Investors expect the US national debt will balloon, and it isn’t clear whether foreign institutions and Central Banks are willing to play along, as they have in the past. In fact, treasury bond prices mirrored the performance of the Dollar, recording the sharpest fall in nearly two decades. Ironically, the potentiality that is more disconcerting for Dollar bulls is that the proposal won’t be passed at all, and the global financial system will collapse as a result. Damned if you do, damned if you don’t. Marketwatch reports:

"Investors [will] favor currencies where the central banks retain an anti-inflationary stance and where there is a well-developed government bond market where they can leave their capital. The euro would seem the most likely home for such investment flows."

Read More: Dollar buckles under bailout’s fiscal weight

The Treasury Department has officially dipped into the Exchange Stabilization Fund (ESF), the obscure and rarely utilized pool of foreign exchange whose ostensible purpose is to stabilize forex markets in times of uncertainty. The Treasury surely skirted this mandate by using a portion of the reserves to provide insurance to money market funds, which are facing a sudden collapse of confidence in the latest chapter of the credit crisis. Although, the move was not without precedent, since the ESF was used as a source of capital for a loan to Mexico as recently as 1995. Ironically, the Treasury’s actions this time around will surely provide a boost to capital markets, thereby reinforcing the notion that the US remains the safest place to invest in crisis situations, which in turn, supports the Dollar. The Wall Street Journal reports:

The Fund, which now amounts to $50 billion, was created in 1934 to conduct interventions in foreign exchange markets. The enabling statute gives the president and Treasury secretary enormous latitude to act without prior consent of Congress.

Read More: The Exchange Stabilization Fund to the Rescue — Again?

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

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

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

While the factors affecting gold are no doubt nuanced, its popularity is primarily vested in the belief that it represents a stable alternative to the Dollar. Accordingly, as the Dollar fell over the last five years, gold prices soared. Likewise, the ongoing Dollar rally has been matched by a proportional decline in gold prices. However, at least one analyst believes this link could soon break down. While gold is traditionally viewed as a specific protection against US inflation (and the concomitant Dollar depreciation), perhaps its role could expand to offer protection against worldwide inflation.

For example, analysts largely agree that the Dollar rally is as much a product of global economic weakness as of US economic recovery. In fact, the monetary and economic situation in the US continues to deteriorate. But, the global economic situation is deteriorating even faster. By this standard, it is conceivable that the Dollar could continue to outperform its rivals. Meanwhile, it is also conceivable that gold would continue to rise, since the long-term economic picture of the US remains bleak.

Read More: Will gold now move separately from the US dollar and euro?

A (deliberately) leaked report has revealed what investors and analysts have suspected all along: the "Committee to Save the Dollar" is real. Evidently, back in March, when the credit crisis was threatening to spiral out of control, the world’s leading bankers were busying themselves preparing a plan to prop up the ailing the Dollar. Their rationale is/was that a more valuable Dollar would do more to relieve inflation (via lower food and commodity prices) and ultimately be easier to implement than a worldwide hike in interest rates. Under the plan, the Central Banks of Europe and Japan would join the Federal Reserve Board to coordinate the large-scale sale of Yen and Euro assets, in exchange for Dollars. While the Dollar’s impressive rally has thus far eliminated the need for intervention, the long-term prognosis remains questionable. Regardless of economic fundamentals, however, currency traders may be reluctant to bet too heavily against the Dollar, lest the Central banks move forward with their plan. Bloomberg News reports:

None of this means the dollar won’t plunge anew if the global credit crunch worsens. For the moment, though, the need for some kind of Plaza Accord-like currency deal has been reduced.

Read More: `Committee to Save the Dollar’ May Not Be Needed

Everyone has a theory to explain the Dollar’s explosive rally, which has yet to run out of steam. A recent one identifies a shift in China’s forex reserve policy as a driving force. Apparently, in an ostensible effort to clamp down on inflation, the Central Bank of China is resorting to draconian measures. One rule change, which was executed with both speed and lack of media coverage, requires commercial banks to hold a larger portion of their reserves in Dollars, rather than Chinese Yuan. In addition, such banks face new restrictions on foreign debt, which is designed to turn them into net buyers of Dollars. Analysts suggest that this policy represents a roundabout attempt to slow the appreciation of the Chinese Yuan. If they are correct, than surely the Central Bank of China has succeeded, for the currency has virtually ceased in its interminable upward march against the Dollar. This upshot suggests that the goal of the Central Bank was not to fight inflation, but rather to avoid a post-Olympic economic slowdown. The Telegraph reports:

They are now more worried about growth than overheating, and you are seeing that play out in the currency markets. There has been a remarkable change of view."

Read More: Beijing swells dollar reserves through stealth

John Taylor is head of the world’s largest currency hedge fund, International Foreign Exchange Concepts. Accordingly, when he speaks about currencies, people tend to listen. In an extended interview with Bloomberg News, Taylor noted that volatility has surged in the forex markets. On average, the Dollar is fluctuating 46% more against so-called major currencies and 23% more than emerging currencies, compared to 2007. However, this volatility is largely random- perhaps as a result of increased liquidity- which means inefficiencies in the markets are becoming harder to exploit and profit from. One of the fund’s largest bets is against the US Dollar, specifically against the Euro. Taylor’s rationale for this bet is nuanced, and is more fundamental than technical, which is surprising given his fund’s primary trading strategy. Bloomberg News reports:

The prediction is partly based on his charts of the U.S. real estate cycle, which he says has a major impact on the dollar and will continue to point south for the next couple of years, dragging down the currency with it. He also says the price of a barrel of crude oil might reach $250 in 2011, further eroding the strength of the U.S. economy and the dollar.

Read More: Taylor Rules Currencies, Not to Be Confused With the Other Guy

I won’t lie; the Forex Blog is admittedly Dollar-centric, in that developments in forex markets are usually assessed relative to their projected impact on the US Dollar. Sometimes, we forget that their are other currency pairs that move irrespective of the Dollar. Take the Australian Dollar and New Zealand Kiwi, for example. As both currencies are backed by high interest rates, they have benefited equally from the carry trade and as a result, they behave quite similarly. Combined with the fact that they are practically neighbors, it’s easy to forget that there are unique circumstances that weigh separately on them.

Over the next 12 months, both countries’ Central Banks are expected to significantly lower their benchmark interest rates as a result of slowing economic growth. However, as New Zealand does not have a large stock of natural resources to depend on in times of economic turmoil, it is projected to lower rates quite sharply, compared to Australia. Accordingly, the Australian Dollar may represent a buying opportunity against the Kiwi in the near-term. Bloomberg News reports:

New Zealand’s dollar is likely to fall 8.7 percent to NZ$1.33 versus Australia’s by year-end as the nation’s economic slowdown accelerates, boosting prospects the RBNZ will lower borrowing costs…according to RBC Capital Markets.

Read More: Buy Australian Dollar Calls Versus New Zealand Dollar, RBC Says

When the credit crisis kicked off in 2007, many online forex traders and economic analysts quietly began to circulate the theory of "decoupling," which asserted the global economy was strong enough to weather a downturn in the US economy. In other words, it was expected that the credit crisis would be contained within the US, and the rest of the world would plod along, unaffected. This notion now appears to be completely without merit, except in a few isolated cases.

Instead, economies from Europe to Asia are sinking, and sinking fast. Some economies, namely Japan and Germany, have even begun to contract! Canada and Australia may slide into recession, regardless of what happens in commodity markets. Within this context, the Dollar’s 10% rally is not much of a mystery. In other words, this rally is probably more a function of economic weakness in other countries than of US economic strength. In addition, the end of de-coupling works both ways; a global economic downturn could further harm the US. A wave of negative economic data and/or the next round of debt write-downs could send the Dollar spiraling downwards. The Telegraph reports:

We are not witnessing a dollar rally so much as a collapse in European and commodity currencies. The race to the bottom has begun in earnest.

Read More: Dollar surge will not stop America feeling the effects of a global crunch

Over the last few years, the inverse relationship between the price of oil and the value of the US Dollar has been remarkable. As the Dollar has fallen to record lows, oil has risen to record highs. Now, with a massive Dollar rally underway, the price of oil has virtually collapsed. This relationship is understandable, since expensive oil contributes to the US trade deficit and crimps the economy, while the weaker Dollar, in turn, drives oil-producing countries to charge more in Dollar terms for their oil so that the price remains constant in absolute terms.

However, there are signs that this link may be coming to an end. Hedge funds, which are famous for spotting such trends and riding them to profitability, are winding down their long/short positions in currency and commodity prices because such strategies have evidently become unprofitable. Apparently, analysts and traders expect other fundamental factors to assume control over the price of oil and the Dollar. Namely, the still-unfolding credit crisis and the projected long-term supply/demand imbalance in energy markets will become more relevant. In short, don’t expect a further drop in the price of oil to necessarily help the Dollar, and vice versa.

Read More: Dollar-Oil Relationship In Doubt As Market Drivers Diverge

Yesterday, the Forex Blog published a commentary piece exploring the rally in the Dollar that is currently under way. While the rally is strongly grounded in fundamentals (falling commodity prices, the spread of the credit crisis to the rest of the world), some traders are nonetheless crying foul. They claim that the European Central Bank (with or without the assistance of the US) furtively intervened in forex markets to the tune of 10 Billion Euros. Even if their claim is true, it is unlikely to have meaningfully contributed to the Dollar rally, since the amount in question is quite small. Central Bank intervention would require an expenditure of at least $100 Billion to be even partially successful. Japan, for example, has spent nearly $1 Trillion (if its foreign exchange reserves are any indication) holding down the Yen over the last decade. Besides, the Dollar rally is unsurprising, given certain recent economic developments and the benefit of hindsight. Minyanville.com reports:

Whenever global liquidity tightens relatively speaking, it is very US$ supportive. Obviously, there are always time lags between economic events until the the market perceives them. So as a result of weak demand in the US, lower imports, the demand for oil declines, and that led to a tightening of global liquidity which led to the strong dollar

Read More: Currency Intervention and Other Conspiracies

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

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

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

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

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

The USD is officially trending upwards, having appreciated over 7% against the Euro in only a few weeks. Of course, hindsight is 20/20, and some analysts now claim that support for the Dollar had been building for several months. They point out that the first break for the Greenback came in March when the Fed stopped lowering interest rates. Then, at a meeting of the G8 nations, several high-ranking officials indicated that they were unhappy with the recent decline of the Dollar and suggested that coordinated intervention should be effected in order to prevent a further collapse of confidence. While this "verbal intervention" was ultimately not backed by any kind of substantive action, investors apparently took the hint.

Further comments by America’s Federal Reserve Bank and the Secretary of the Treasury made clear that the US remained committed to the Strong Dollar Policy. A reprieve in the rise of commodity prices, followed by the proposed bailout of the two cornerstones of American’s sprawling mortgage industry, convinced currency traders that the world’s economic policymakers simply would now allow the Dollar to fall further. Lo and behold, the Dollar failed to break through a resistance level at $1.60/Euro (near a record low), and has since rallied sharply. The International Business Times reports:

It seems that that the big money had committed to a long Dollar, and was waiting for the economic slowdown to spread to the Euro Zone. Once the Euro Zone began to experience a slowdown, it just became a matter of time before the short positions that had been built for several months would pay off.

Read More: U.S. Dollar Takes Control of Forex Markets

In historical periods of financial crisis, where did investors turn? The answer: the US. Some analysts thought that this logic would be turned on its head during the current credit crisis, since the reputation of the US as investing safe haven would surely be undermined by its role in the global economic slowdown. Over the last couple weeks, however, investors have returned en masse to US capital markets, sending US equities as well as the US Dollar to new highs. This has created a self-fulfilling cycle whereby a more valuable Dollar is driving commodity prices lower, which in turn, will benefit the US economy and drive the Dollar even higher. Perhaps the new logic is not so different from the old: that although it was the US that is primarily responsible for the credit crunch, it is also the US which is most likely to lead the global economy out of it. The Los Angeles Times reports:

Whether we come out of this first remains to be seen. But some grim economic data from Europe and Japan in recent weeks at least confirm that the slowdown has gone global. In that sense, the U.S. is the devil you know.

Read More: Homecoming time: Money pours back into U.S. markets

By one measure, the US Dollar has lost 33.8% of its value under President George Bush, its worst performance by far under any one administration. The burgeoning twin deficits, lackluster economic performance, as well as the current environment of stagflation have all contributed to a dramatic and unprecedented loss of confidence in the Dollar. While investors are understandably optimistic about the prospect of a new President, come January, they are ambivalent as to whether it is Barack Obama or instead John McCain that is ultimately elected. Since the Dollar seems to have bottomed out anyway, the new President stands to preside over a recovery of the Dollar. Reuters reports:

"We look at the dollar as a brand and any change from Bush will help benefit the dollar."

Read More: Forex investors see new president helping dollar

In a recent report on the state of the Dollar, the International Monetary Fund (IMF) declared that the Dollar’s unprecedented period of dominance will not likely come to an end anytime soon. This assertion seems to sharply contradict the 25% depreciation (in trade-weighted terms) that has taken place since 2002. Moreover, many countries have liberalized their exchange rate regimes, such that they no longer need to maintain large stores of Dollar assets. The report’s conclusion draws strength from another period of sustained Dollar depreciation (which took place from 1985 and 1991), which was likewise not able to shake the currency loose from its moorings. The IMF does concede that Central Banks will probably continue to diversify their reserves in Euros, especially as EU capital markets continue to be seen as a stable alternative to those in the US. In the end, however, they see the Greenback is King. The Daily Monitor reports:

“Notwithstanding the dramatic claims by some, there is no doubt that the dollar will retain the central role, even though it may gradually share the stage with other currencies to a greater degree than at present."

Read More: US dollar to remain global currency

At the Fed’s most recent monetary policy meeting, two Governors disagreed with the decision to hold rates constant, voting instead to hike rates by .25%. The most noteworthy aspect of the meeting was not the presence of dissent, but rather its irrelevance; it underscored that the Fed has been reduced to playing a largely symbolic role in the determination of American monetary policy. As the Fed cut rates aggressively over the last year, credit markets simultaneously witnessed a tightening of credit conditions. In other words, investors deliberately ignored the actions of the Fed, and market-clearing interest rates remained well above the rates "suggested" by the Fed. Some commentators have connected this to the recent rally in the Dollar, which would have been expected to plummet given such low interest rates. Barron’s reports:

The credit cycle will progress with or without central bankers. If their rhetoric convinces investors of the Fed’s probity, it’s all to the good. But market forces are far stronger, and they’re what should be watched.

Read More: Raise Rates, If It Makes You Feel Better

Yesterday, the Forex Blog reported that Central Banks and Sovereign Wealth Funds appear to be losing confidence in the Dollar. To follow up with a specific example, a high-ranking Chinese policymaker recently suggested that China should move spend some of its reserves since they are rapidly losing value in RMB terms. The official offered that a portion be used to purchase foreign energy assets, in order to mitigate against both the falling Dollar and rising oil. There is clearly a trend among institutional holders of Dollars to use the currency to purchase US assets. Witness the recent (separate) sales of the Chrysler and GM Buildings to Middle Eastern buyers. With nearly $2 Trillion in foreign exchange reserves, however, China is in a class by itself, and any indication of its frustration with the Dollar should be taken very seriously.

Read More: China Considering Using Forex Reserves

Earlier in the week, the Forex Blog reported that the potential for intervention in the forex markets seemed to have declined, due to a brief Dollar rally and toned-down rhetoric at the most recent G8 conference. However, we would be remiss if we didn’t point out that the intellectual justification for intervention remains. While statistics have not been forthcoming, it appears that Sovereign Wealth Funds and Central Banks are paring their exposure to Dollar assets, which is both a cause and effect of Dollar weakness. In addition, the falling Dollar and rising oil prices have reinforced each other, and contributed to surging inflation around the world. Investment Banks are advising clients now would be a perfect time for the world’s economic policymakers to take coordinated action. GoldSeek.com reports:

In his testimony yesterday, Ben Bernanke, stated that “dollar Intervention should be done rarely” but that it “may be justified in disorderly times.”[In addition,] Treasury Secretary Paulson said last month that he would never rule out currency intervention as a potential policy tool.

Read More: U.S. Government To Intervene in Markets to Prevent Run on the Dollar

Typically, only the savviest (or the most foolish) of forex traders dabble in currency options. Leverage is already so high (often exceeding 100:1) when trading forex directly, that the additional leverage gained from trading options can seem unnecessary. However, even if not trading options, you would be wise to at least pay heed to options prices. The reason is that movements in the options market often precedes movements in the forex markets.

To explain further, the premiums built into options contracts serve as a proxy for demand for those particular currencies. When premiums on call contracts, which give the holder the right to buy a particular currency at a fixed price, are unusually high, it signals a "risk reversal;" the currency may be overbought. To offer a practical example, call premiums on EUR/USD contracts are approaching a one-year high, which has led some analyst to speculate that a Dollar rally is just around the corner. MarketWatch reports:

"Whenever risk reversals hit critical levels, it indicates that everyone who wants to be long euros are already long and as a result, sentiment has hit an extreme." The last time euro/dollar risk reversals were that high….a U.S. dollar "relief rally" followed.

Read More: Forex options market held clues to dollar’s moves

Over the last few months, the Dollar has bounced up and down against the Euro, but never breaking out of a range defined by $1.53 and $1.60. Analysts remain divided not only over if the Dollar will soon break-out, but also over whether its next major move will be upwards or downwards. The recent Dollar upswing has led some to speculate that more permanent strength is inevitable, but naysayers note that this rebound was a product of lowered oil prices, caused by global economic weakness, which is actually Dollar-negative. According to a recent poll, though, the bulls outnumber the bears; the consensus forecast for the Dollar 12 months from now is $1.50. The Wall Street Journal reports:

A Dow Jones Newswires survey last week of 23 analysts forecast the dollar would
begin to recover on longer-term basis.

Read More: Dollar Likely to Extend   Downward Euro Spiral

Some analysts are surprised by the evident unwillingness of Central Bankers to intervene on behalf of the Dollar, especially considering how common such "rescue plans" are becoming in other corners of the financial markets. Over the last couple months, all of the momentum that was previously behind intervention has gradually evaporated, such that at the recent G8 Summit, currencies were hardly even discussed. This is somewhat ironic considering the Dollar has resumed its downward trend, and even touched an all-time low against the Euro. Treasury Secretary Henry Paulson and Fed Chief Ben Bernanke aren’t willing to completely write off intervention, however. Both have commented explicitly that it is still being mooted as an option. Nonetheless, the current consensus among analysts is that unless the Dollar completely collapses, it’s not likely. The Associated Press reports:

"It would take a rare set of circumstances to get the U.S. right now to intervene," said David Gilmore, a managing partner in Foreign Exchange Analytics in Essex, Conn.

Read More: Don’t count on ailing-dollar bailout

Without exception, every time there is a period of sustained volatility in forex markets, a flood of new forex accounts are opened as new traders try to capitalize on the action.  Also, without fail, a concerned journalist inevitably takes it upon himself to warn these would-be profiteers that trading forex is risky, as if that were not abundantly obvious. This past week is a perfect example, as the Dollar touched a record low against the Euro on the basis of credit concerns. One columnist pointed out the significant upside potential of purchasing a CD denominated in foreign currency, but also implored investors to hedge their exposure and limit leverage. His advice: diversify by buying multiple currencies and/or equities for foreign companies and/or exchange traded funds based on hard-to-mimic strategies. Marketwatch reports:

[He] recommends…hedging your bets in you think the dollar will continue to weaken…[through] specialized mutual funds or exchange-traded funds that move inversely to the dollar. He holds the Pro Funds Falling U.S. Dollar Fund

Read More: Foreign currency trading is as risky as it gets

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

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

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

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

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

Read More: Dollar knocked by geopolitical tensions, oil

In a bid designed to placate skittish investors, America’s Federal Reserve Bank announced that it will extend the duration of its liquidity facilities at least through 2008 and possible into 2009. It is hoped that the continued enabling (which began several months ago) of certain Wall Street firms to borrow on especially favorable terms will prop up faltering credit markets. Given that both credit conditions and the economy at large continue to flounder, this move seems more symbolic than anything. Analysts are divided about whether this increased liquidity will serve as a complement or a substitute for a near-term interest rate hike. Futures prices had previously reflected a 65% chance that the Fed would hike rates in September, but the bet is now closer to even money. Reuters reports:

Others…think liquidity problems and inflation concerns are two separate issues. [One analyst] believes that the Fed is still on track to raise rates in
September.

Read More: Dollar rises as Bernanke calms financial markets

At its most recent meeting, the Fed voted to hold rates steady at 2%. Only one week ago, 90% of investors (based on interest rate futures) had expected the Fed to lower rates.  What changed? In the words of one columnist, Randall Forsyth, the Fed opted to take a "fork in the road," upon reaching the conclusion that price stability is now just as important as economic growth. Forsyth would be pleased with the Fed’s decision, having argued that the institution is largely responsible for the inflation that it is currently trying to rein in. The record low interest rates following the burst of the dot-com bubble, not helped by the recent loosening of monetary policy, have created a surplus of liquidity. The Fed was abetted by the Central Banks of emerging markets, who by linking their respective currencies to the Dollar have stoked the fires of domestic inflation. In trying to reverse the "liquidity pump" the Fed may likewise be aided by these same Central Banks. Tumbling prices for "economically sensitive" commodities serve as evidence of their respective efforts to clamp down on inflation. Barron’s reports:

"As the liquidity fueled food and energy price bubbles burst, who will believe when headline inflation collapses? It really could happen. Poof!"

Read More: Will The FOMC Take The Fork In The Road?

The looming possibility of forex intervention in response to the Dollar’s continued weakness is causing an uproar in forex circles. Some analysts don’t feel intervention is a real possibility because it is so inconsistent with the ideology espoused by the current US presidential administration. In a piece published in the AsiaTimes, however, one expert noted that the history of the Dollar is also a history of intervention. Even when the Dollar was still linked to the Gold Standard, the Fed intervened by buying or selling gold depending on the result it wanted to achieve. Preceding the stock market crash of 1987, by which point the Dollar was already freely floating, the Fed acted in concert with foreign Central Banks to drive down the value of the Dollar in order to stem a burgeoning trade imbalance. Then, there was the bailout of the Mexican Peso in 1994 which set a precedent for intervention on behalf of the currencies of developing countries. The current situation is somewhat dicey because the Fed is technically obliged to back up the Treasury’s Strong Dollar Policy, but it must balance  this with its other objectives of economic growth and price stability.

Read More: The Fed and the strong dollar policy

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

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

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

G8 finance ministers met last week to discuss the detrimental effects of rising (commodity) prices on the global economy. Oil prices and commodity prices have in some cases doubled over the last year, contributing  to a nasty surge in worldwide inflation rates. While the Dollar was not technically a topic of the discussion at these particular meetings, it was broached tangentially because of the perceived relationship between the weak Dollar and high commodity prices. Accordingly, Central Bank intervention on the Dollar’s behalf could theoretically be justified on the basis of both mitigating inflation and facilitating global macroeconomic stability. The "I" word hasn’t been mentioned explicitly, but its likelihood increases with every up-tick of inflation and every down-tick of GDP. It is no surprise that in the weeks leading up the actual G8 conference, the Dollar has sustained its strongest rally against the Euro in nearly 3 years. Forbes reports:

Last week Federal Reserve Chairman Ben Bernanke flagged a change in Washington by linking the weaker dollar to inflation and saying he was watching the currency closely with the Treasury. Then U.S. Treasury Secretary Henry Paulson refused last week to rule out direct intervention in currency markets.

Read More: Oil, dollar dominate runup to G8 inflation talks

George Soros, one of the most well-respected investors who sits in the same echelon as Warren Buffet, just released his book on the current state of the world’s financial markets. His conclusion is that a "super-bubble" is forming. Connecting to all of the major financial markets, namely property, commodities, and equities, Soros outlines how the expansion in credit that has unfolded over the last 30 years has caused an unsustainable run-up in the prices of most investable assets. Due to the resulting inflation, investors are now fleeing en masse from mainstream securities and parking their money in commodities, triggering a super-bubble therein. With regard to the Dollar, Soros expects the currency to fall as the credit crisis runs its course and Central Banks gradually replace it with more stable currencies. CBC reports:

I think that the dollar is probably still, will emerge as the most widely used currency but the United State will have to abide by the limitations that are imposed on it by the willingness of the rest of the world to hold dollar reserves.

Read More: Bubbles building in financial markets

When it comes to forex, the old adage actions speak louder than words doesn’t always hold. In fact, words can be quite effective on their own in holding down or propping up a currency. For a while, the threat of intervention by the Central Bank of Japan was enough to hold down the Yen, despite a lack of supporting action. With regard to the Dollar, several high-ranking economic officials have recently made unsolicited comments implying that traders should think twice about shorting the Dollar. First, Ben Bernanke worried publicly about the effect of the sinking Dollar on inflation. Then, President Bush suggested that the Dollar was undervalued relative to economic fundamentals. Treasury Secretary Hank Paulson capped the effort by refusing to dismiss the possibility of coordinated intervention on behalf of the Dollar. While it has been eight years since the US last intervened in forex markets, it looks like investors are taking these threats seriously. The Wall Street Journal reports:

Traders seized on the comments as a signal that the administration — which has never intervened in the markets before — could do so if a dollar rout gets bad enough.

Read More: Intervention, Other Tools On Table for Dollar

Kurt Brouwer offers his take on the falling USD over at Fundmastery Blog:

Let’s start with how far the dollar has fallen. One problem with our media is that the news of the day is often one-sided and it seldom comes with any historical perspective. For example, do you rememberhearing that the Euro fell to historic lows versus the dollar? Well, as you will see from the chart below, it happened not too long ago. In fact, the Euro fell steadily versus the dollar for the first five years of its existence, beginning in January 1999. It did not get back to even until mid-November, 2003. At the low point for the Euro you could have bought one for 84 cents. Now, it takes a $1.56.

Read more: How Far Has the Dollar Fallen? And Why? — What’s Next?

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

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

Read More: Dollar falls as US jobless rate shoots up

Read the rest of this entry »

After sinking to a record low of $1.60 against the Euro in April, the Dollar has rallied to a 3-month high. According to analysts, the interest rate story appears to have driven the sudden reversal. In short, expectations surrounding the EU-US interest rate differential are changing, such that investors now believe the ECB will begin lowering rates just as the Fed begins hiking them. This story is also consistent with the broader economic picture, whereby the Fed is shifting its attention from the economy to inflation, while the ECB is doing the opposite. Meanwhile, the Treasury yield curve has gradually expanded in order to reflect expectations for higher medium-term interest rates. It doesn’t look like the Dollar will be a funding currency for carry trades for much longer. Thomson Financial reports:

John Noonan, a senior foreign exchange analyst at Thomson IFR, said the hawkish turn in Fed expectations is coinciding with a growing view that the euro zone economy will suffer more from the U.S. economic fallout than previously thought.

Read More: Dollar near 3-month highs vs euro on U.S. GDP revision

Over the last few weeks, the focal point of discussion surrounding the current US economic crisis has shifted from economic growth to inflation, and commentators are now invoking the stagflation of the 1970’s. Moreover, the Fed is experiencing mounting pressure to show that it is serious about preventing inflation from spiraling out of control. In a move clearly intended to silence critics, Ben Bernanke announced today that the Fed is finished cutting rates, which stand at a four-year low of 2%. No one had seriously expected the Fed to continue loosening its monetary policy. Thus, analysts are debating whether Bernanke was merely stating the obvious or if instead, he is laying the groundwork for rate hikes, perhaps later this year. In his speech, Bernanke also acknoweldged the sagging Dollar, for its role in stoking inflation. The New York Times reports:

The Fed is continuing to ”carefully monitor developments in foreign exchange markets,” he said. After Bernanke’s remarks, the dollar — which has fallen sharply against the euro in the past year — gained some muscle.

Read More: Bernanke Signals More Rate Cuts Are UnlikelyRead More:

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

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

Read More: Fed’s Forecast Grows Gloomier

After the G7 meeting, during which officials finally commented on the "volatility" in forex markets, the Dollar rapidly appreciated over 5%. Analysts had previously ascribed this rally to a variety of factors, both technical and fundamental. For example, the Dollar was oversold. The EU economy is faring worse than the US economy. The interest rate differential has stabilized and may favor the US in the medium-term. The Dollar will remain the world’s reserve currency through the duration of the credit crisis.

Recently, a new theory has begun to circulate- that US officials are prodding large holders of USD assets to support the Dollar, because a strong Dollar is conducive to global price and economic stability. The rumor was sparked by comments made by high-ranking officials in the EU and US governments, suggesting that the Bush administration is finally putting some force behind its "Strong Dollar" policy. Specifically, it has been speculated that the BRIC countries (Brazil, Russia, India, China) have been requested to stop diversifying their forex reserves away from Dollars. Some have speculated further that the Fed may directly intervene in forex markets, a move which would be supported by the Dollar’s upward momentum. Marketwatch reports:

"The G-7 would be smart to consider a strong intervention effort geared at pushing speculators toward their pain threshold."

Read More: Dollar rally, leaks put fresh focus on G7 meetings

The Australian Dollar is rapidly approaching parity with the USD, having risen 12.8% in the year-to-date. In fact, it recently notched a 24-year high against the Dollar. The currency’s strength is connected closely with the US-Australia interest rate differential, which currently measures a whopping 5%. While the Australian Dollar has always been a favorite target of carry traders, it has received a special boost from the easing of US monetary policy, which has turned the Dollar into a funding currency. The New Zealand Kiwi has also performed well, thanks to a benchmark interest rate of 8.25%. However, New Zealand rates are probably headed downwards, whereas the consensus for Australia is for rates to remain at current levels, or even to rise, depending on inflation. Bloomberg News reports:

Board members decided to leave the rate at 7.25 percent because of "the substantial tightening" in financial conditions since mid-2007 and "uncertainty surrounding" the outlook for economic growth and inflation.

Read More: Australian Dollar Rises to 24-Year High on RBA Meeting Minutes

The slight recovery of the USD has been accompanied by a couple of other interesting trends: falling gold and oil prices, and rising equity and bond prices. What is the connection here? With regard to gold and commodity prices, the prevailing theory was previously that high prices were caused not by supply issues, but rather by the Fed’s easy monetary policy, which was stoking the embers of inflation. The recent rise of the Dollar has poked a broad hole in this theory, because of the simultaneous fall in prices for certain commodities, namely gold. This has led some analysts to conclude that commodity prices are fluctuating irrespective of the Dollar.

With regard to oil, there does exist a 95% correlation between the price of oil and the EUR/USD exchange rate. However, it now appears that strong oil had been driving the weak Dollar, and not vice versa. The Dollar is also deriving some impetus from a rally in equity and bond markets, which have outperformed their European rivals.  Bond yields remain lower in the US, but with the stabilization of the Dollar, perhaps foreign investors will be convinced that the US is the least risky place to invest during the global economic downturn.

Read More: The dollar rallies at last

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

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

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

The anecdotal evidence that China is diversifying its forex exposure away from the Dollar continues to mount. To date, most of the focus has centered around the Central Bank of China, which is passively diversifying its reserves into European and higher-risk assets. Apparently, Chinese exporters are also getting nervous about the impact of a falling Dollar on their respective bottom lines. The RMB has risen 11% since the beginning of 2007, which means Chinese companies now receive 11% less on sales to destinations abroad than they did for equal-priced goods in 2007. As a result, some companies have taken to quoting prices in Euros or to adjusting Dollar-denominated prices every few months. Other companies are building assumptions of a more valuable RMB into their profit models, and setting prices accordingly. The New York Times reports:

“We are gradually increasing our emphasis on the domestic market until we can forget about the export market, because the profit margins on exports are so thin,” [said one exporter].

Read More: Some Chinese Exporters Prefer Euros to Dollars

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

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

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

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

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

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

Read More: Low Spending Is Taking Toll on Economy

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

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

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

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

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

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

Read More: An Endgame for the Euro?

The word "parity" is becoming a mainstay of traders in the forex markets.  In 2007, it applied to the Canadian Dollar, which had rallied 70% over the course of five years to reach the mythical 1:1 level against the USD.  This year, it is the Australian Dollar that is threatening to surpass the Dollar in value. The AUD has always benefited from general USD weakness, but now the focus is shifting to the AUD, itself. The most recent Australian price data suggests that inflation in Australia remains problematic, which could force its Central Bank to raise the benchmark lending rate to 7.5%.  In addition, high commodity prices and consequently strong exports should provide demand for the currency. As always, analysts are divided over the likelihood of parity, but that hasn’t stopped them from bandying the term about. The Australian Age reports:

Parity was never a "ridiculous suggestion." "But it’s probably a bit tougher going because the Australian economy is slowing," says one analyst. "Then again, if you saw a reacceleration in growth, that might be a different story."

Read More: Our dollar on a roll…

When asked to discuss the official position of the USA with regard to its currency, Treasury Secretary Henry Paulson typically invokes the "Strong Dollar Policy."  According to former Treasury Secretary Paul O’Neill, however, this policy is a "vacuous notion."  Mr. O’Neill served as Secretary from 2001-2002, during which time he echoed the strong dollar sentiments of his forebears, without apparently ever believing that the US had any ability or intention to influence the value of the Dollar in forex markets.  The implications of Mr. O’Neill’s comments are such that the rhetoric of Secretary Paulson, as well as a recent warning by the G7 nations, are both wholly empty, and the Dollar’s value will continue to rise and fall as determined by the markets.  Bloomberg News reports:

O’Neill roiled currency markets when he was in office from 2001 to 2002, at one point with comments in an interview with a German newspaper that the U.S. pursued a policy of a strong economy, rather than currency.

Read More: O’Neill Says U.S. `Strong Dollar’ Policy Is `Vacuous Notion’

Forex Capital Markets (FXCM) recently unveiled a product that represents a viable alternative to currency exchange trade funds. A currency ETF is "index-passive" because it is linked to an index and rises and falls in line with the value of the currency with which it is associated.  FXCM’s Enhanced Dollar Index programs, however, are "actively managed" and  aim to capture all of the upside of currency movements with only some of the downside. This is achieved through sophisticated trading algorithms that combine a leveraged index approach with market timing and directional investing. To explain in more concrete terms, a leveraged investment in a Dollar ETF would yield an above-market return if the ETF appreciates, but a proportionately below-market return if the ETF loses value.  The Enhanced Dollar Index Program, in contrast, would yield the same above-market return in the first scenario but a smaller loss in the second scenario.

Read More about FXCM Enhanced Index Programs

For the last few months, EU politicians have whined about the appreciating Euro.  Aside from some token comments by the European Central Bank, however, the world failed to pay heed.  That changed last week, when the G7 formally and harshly warned that volatility in forex markets risks harming the global economy. But talk is cheap, and the real question is whether it will be backed up by action. Most analysts reckon that it will be difficult and would take time for the governments of the EU, US, and Japan, at the very least, to put together a coordinated plan of intervention.  Besides, the window has probably closed on action by Central Banks, which have conducted monetary policy irrespective of currency valuations. Reuters reports:

The U.S. Federal Reserve Board [is] nearing the end of its interest rate-cutting cycle, the European Central Bank [is] likely to reduce rates before the end of the year, and things might not get much worse for the U.S. economy. That suggests the dollar may recover in the coming months, with or without official intervention.

Read More: G-7 leaders talk tough on currency markets

The USD continues to dominate conversation in forex circles, as investors ponder whether the currency will fall further or whether it has already sunk as low as it can go. One commentator recently encapsulated the debate into six factors, three bullish on the Dollar and three bearish.  Number one on the side of bearishness is the interest rate situation. Short term US rates are negative in real terms, and savvy investors are using the Dollar to fund carry trades in order to take advantage of higher yields outside the US. The second and third factors are technical: based on one measure, the Dollar is not nearly as "oversold" as it was in 1992, the last time the Dollar suddenly reversed a multi-year decline.  In addition, the "open interest" on the Euro is not as large as it should be if traders were preparing to dump it.

First on the list of factors supporting a bullish outlook is the US recession. This is somewhat counter-intuitive, but history shows that US economic weakness typically coincides with Dollar strength.  Perhaps this is because many countries depend on the US to drive the global economy.  In fact, the Dollar is already rising against certain emerging market currencies that rely on the US as an export market. In addition, overseas investors tend to park their capital in the US during periods of global economic instability because of its continued reputation as a safe haven.  Second, the economies of the UK and the EU are already weak and growing weaker every day.  The only reason their respective Central Banks have not eased monetary policy is because they are also focused on combating inflation. However, they may soon have to sacrifice price stability in favor of economic growth, at which point interest rate differentials will begin to reverse themselves in favor of the US.  The final reason for bullishness is technical; based on a series of indicators different from those listed above, the Dollar IS oversold  and the recent slip downward may presage an upward shift.

Read More: Has the U.S. Dollar Bottomed?

For a recent article, EuroMoney Magazine pulled together some of the top currency analysts on Wall Street for a comprehensive discussion on the state of forex.  The conversation zigs and zags, covering such varied topics as volatility, interest rates, trading strategies, emerging markets, central banks and market infrastructure.  Among other things, it was noted that volatility has surged by 50% since the inception of the credit crunch, returning to levels last seen at the beginning of the decade.  One of the participants broached the possibility of deflation, but that was quickly dismissed by the others due to surging food and energy prices. It was also noted how Central Banks are caught between fighting inflation and facilitating growth, in deciding whether to raise or lower rates, respectively. The main theme in the markets is the sagging Dollar, which is being punished for both economic and strategic reasons as investors sell it in response to the economic downturn and to fund carry trades. Finally, one participant commented that despite growth in liquidity, forex strategy hasn’t evolved much, and the markets remain vulnerable to a huge sell-off due to the "mob mentality."

Read the Discussion in its Entirety

The last week has seen a spate of positive developments in the financial markets, including reassurances by several bulge bracket investment banks that their respective capital positions are in strong and in no need of shoring up. As a result, some analysts are speculating that the worst of the credit crunch has already been priced into securities and the USD, and that actual write-downs on subprime mortgage obligations won’t match the "Himalaya-like guesstimates." At the same time, job losses are mounting and the unemployment rate recently crossed 5% for the first time in two years. Interest rate futures contracts suggest a 20% chance that the Fed will cut rates by 50 basis points at its meeting on April 30. Then, there is the ECB, which has been vocal about fighting inflation and European financial markets, which have benefited from "domestic" investors diversifying within the EU rather than to the US.  Thus, there is no definitive answer regarding where the Dollar is headed in the near-term: everyone seems to have their own opinion.  Bloomberg News reports:

The Dollar Index traded on ICE Futures in New York, which tracks the currency against those of six trading partners, dropped 0.2 percent to 72.049, its third straight decline. It was at a record low of 70.698 on March 17.

Read More: Dollar Falls Against Euro; Report May Show Payrolls Declined

In the first three months of 2008, the USD notched its worst quarterly performance since 2004, falling over 8%. During the same period, the Dollar lost 10% of its value against the Japanese Yen and 6.4% against a broad basket of currencies. Forex analysts reckon the slide was so steep because investors have taken stock of the US economic situation and have concluded that recession is inevitable. The story is also being driven by interest rates. The Fed has already cut rates by 300 bps in the current cycle of easing, making the benchmark federal funds rate the lowest in the industrialized world, in real terms. Meanwhile, the European Central Bank is giving every indication that it will maintain rates at current levels in order to keep a lid on inflation. As a result, the Dollar could fall further, especially if the Fed continues to hike rates and investors use the currency to fund carry trades. Reuters reports:

[According to one analyst], "And to call a bottom now is still a very risky call. It’s too early to say the worst is behind us and the dollar’s in for a sharp rebound."

Read More: Dollar logs weakest quarter vs euro since 2004

Since 2002, the Dollar has lost 70% of its value, relative to the Euro.  Meanwhile, the same factors that signaled bearishness in 2002 persist in 2008, or even worsened in some aspects.  The twin deficits are still growing, though the current account deficit may be leveling off.  The US economy is headed towards recession.  Inflation is set to rise due to soaring commodity prices and a loosening of monetary policy.  As a result, many investors are betting that the Dollar’s slide will continue well into the near future.

However, prudent investors would be wise to "handle with care." While not entirely applicable to forex markets, efficient markets theory dictates that inherent in a security’s current valuation is all relevant, publicly available information. Thus, all of the bad news listed above has already been priced into the Dollar, to some degree at least. The rule of diversification is in full effect when betting on forex. Thus, rather then putting all of one’s chips directly behind one currency, an investors could buy foreign securities (stocks and bonds) instead, which also capture any currency appreciation (and depreciation).  Investors can also purchase Treasury Inflation Protected Securities (TIPS), whose yield is linked to inflation and, thus, acts as a hedge against a declining Dollar. The Wall Street Journal reports:

While some market watchers believe the six-year dollar bear market isn’t over yet, investors should recognize that trends in the currency markets are typically marked by volatile ups and downs along the way.

Read More: Don’t Bet the Farm on Dollar’s Skid

Two American economists recently conducted a computer simulation to determine how the role of the US Dollar as the world’s reserve currency will evolve over the next decade.  Their hypothesis- that the Dollar’s preeminence would be maintained- was contradicted by the simulation leading them to conclude that the Euro will overtake the Dollar within the next 10-15 years. This may be hard for many analysts to stomach, since the Dollar’s share in global currency reserves is 66%, compared to the Euro’s 25%. In addition, the Dollar has held its title for nearly 150 years, and it’s difficult to fathom its being replaced.

However, two factors have emerged within the last 10 years, lending support to the argument.  First, the US twin deficits have exploded; the current account deficit approximates $800 Billion and the national debt is estimated at $9.4 Trillion. Second, prior to the inception of the Euro, there didn’t exist a credible alternative to the Dollar. The Deutsch Mark and Japanese Yen initially seemed like potential candidates, but the German currency was folded into the Euro, and the Japanese economy has soured and taken over by deflation. Then there are peripheral factors, like US monetary policy, which is facilitating inflation and eroding the Dollar.  There are also signs that a neo-imperialist foreign policy has overstretched the US, and foreign Central Banks are becoming nervous.  The Financial Times reports:

Many developing countries will find it harder to maintain their dollar pegs. They may be reluctant to drop them now but there will come a point when the rise in inflationary pressures becomes unbearable.

Read More: This crisis could bring the euro centre-stage

Last week, the Euro retreated from the record high of $1.60 that it achieved earlier in the week. Policymakers are still concerned, however, and are perhaps using this lull to come up with a plan of action should the Dollar resume its slide. In fact, the consensus among analysts is that coordinated intervention is likely if the Euro crosses a certain threshold- perhaps $1.65. In order to be successful, the intervention would need to involve the Federal Reserve Bank and the European Central Bank principally, as well as the peripheral participation of the Central Banks of Switzerland, Japan and England.  The situation is complicated by the monetary policy of the ECB, the tightness of which is causing the interest rate differential with the US to widen dramatically. Already, volatility levels in forex markets are slowly climbing, suggesting that investors are bracing themselves for a big move.  The Guardian UK reports:

ECB Executive Board member Lorenzo Bini Smaghi said in a speech on Tuesday markets sometimes overshot, with possible negative implications for the world economy. Since his speech, the dollar has strengthened by almost 2 cents against the euro.

Read More: Euro intervention edging nearer, but still distant

In a recent commentary piece, the Market Oracle used the analogy of baseball to outline why this will be an "off year" for the Dollar, listing three reasons to support its claim. Consumer spending was listed first because it represents the largest component of US GDP.  Since much consumption is financed through borrowing and since the credit crunch has forced banks to rein in lending, the Oracle reasoned that consumer spending will be especially hard hit. Next, there is the worsening employment picture. As its moniker implies, the "jobless recovery" that has characterized the US economy over the last few years did not add many jobs, and due to the economic downturn, jobs are now being shed.  Finally, the Market Oracle has identified the Federal Reserve as a primary contributor to the decline of the Dollar. While the Fed is trying to shore up the economy, it is simultaneously enabling inflation.  Thus, even if the battle is won and recession is averted, the Fed may still find that it has lost the war- on prices.

Read More: Three Strikes Against the U.S. Dollar

On Tuesday, the Federal Reserve Bank lowered its benchmark federal funds rate by 75 basis points, its sharpest cut in decades. The markets initially reacted positively to the move, which was intended to shore up sagging confidence in the economy and financial markets.

But the next day, most of the gains had been lost, as investors feared both that the recession has already begun and that the Fed is giving up on fighting inflation to battle the lost cause of the economy. In fact, as many analysts feel a recession is a foregone conclusion, the focus may soon turn to inflation, especially given exploding commodity prices and the sagging dollar. The New York Times reports:

"I’m disappointed," said an economist at Citigroup. "It’s not as if we’re trying to gauge policy priorities on a sunny day. I’d like to know how you’re going to get inflation in an environment with suffocating financial restraint and pervasive slowing in demand."

Read More: Fed Trims Rates Sharply, Sending the Markets Up

Over the weekend, Bear Stearns, a prestigious American investment bank, hurriedly scrambled to find a buyer in order to avoid having to file for bankruptcy. While a buyer (JP Morgan) was ultimately secured, investors remained jittery, as the collapse of this magnitude is virtually unprecedented.  When forex markets re-opened on Monday, the Dollar crashed against all of the world’s major currencies, namely the Euro and the Yen. Furthermore, analysts are now beginning to view forex intervention as increasingly likely. It’s still unclear whether the Bank of Japan or the European Central Bank (with or without support from the Fed) would spearhead any such intervention.  At the breakneck speed at which events are unfolding, however, no one will be surprised if a plan is quickly cobbled together. The Wall Street Journal reports:

"Were such intervention to be seen, (the euro) could briefly trade down to $1.55, yet unless the (ECB) is prepared to back up such intervention with a rate cut, intervention will be futile," said [one analyst].

Read More: Dollar’s Slide Keeps Pace

On January 31, 2006, Ben Bernanke officially replaced Alan Greenspan as Chairman of America’s Federal Reserve Bank. At that time, the EUR/USD and USD/JPY exchange rates hovered around 1.20 and 118, respectively. For the first year of his tenure, Bernanke lived up to investor expectations and burnished his credentials as an inflation fighter by continuing a string of interest rate hikes begun by Greenspan. Fast forward to today, where the US economy is in tatters, inflation is raging, home and equity prices are slumping, and the Dollar has declined to $1.55 against the Euro and 100 against the Japanese Yen. Meanwhile, forex volatility levels are climbing rapidly, suggesting that the Dollar’s troubles still havn’t reached their climax.

Needless to say, currency traders- and a whole host of other investors and analysts- are furious with Bernanke. Many insist that he misled them, by downplaying the seriousness of housing jitters and insisiting stubbornly that inflation isn’t a problem.  Even now, he is lowering interest rates in order to spur the economy, but at the expense of price stability.  As any experienced currency trader can attest, low interest rates and high inflation are a recipe for a weak currency. Reuters reports:

Bernanke "has sacrificed the dollar in an attempt to save jobs and U.S. business," said one analyst. "He had to do something, but at the same time he is only putting off the crisis. We will face tight credit for a decade and we will have stagflation."

Read More: Bernanke rapidly loses fans in the forex world

Over the last couple weeks, the Dollar has plummeted against all of the major currencies, falling below the $1.50 mark against the Euro for the first time ever.  It seems investors are reacting to a spate of negative economic data which are painting an increasingly bearish picture for the US economy.  In addition, the Fed seems likely to lower rates further while the ECB will maintain rates at current levels. For a brief period, talk of recession was actually helping the Dollar, as investors predicted that the global economy would be harmed more than the US economy, but it looks like that period has passed. As a result, the EU is growing increasingly alarmed, and the pressure is building for some kind of intervention.   AFX News Limited reports:

Euro group president Jean-Claude Juncker said currency markets are overreacting to the short-term outlook for the US economy. " We don’t like excessive volatility in exchange rates," Juncker said.

Read More: Euro group’s Juncker says currency markets reacting too hastily to US outlook

Based on several indexes, volatility in forex markets is nearing historic lows.  How can this be explained, given the enormous daily swings in equity and bond markets? The first explanation is that business cycles, and by extension, monetary policies, are gradually synchronizing across the industrialized world, especially among the USA, EU, and Japan. When inflation rates and interest rates are similar across different countries, this mitigates any theoretical need for changes in exchange rates. The second explanation is that the tremendous growth in forex volume ($3 Trillion per day and rising) is increasing liquidity and lowering volatility.

More importantly, is it possible to profit in a climate where volatility is lacking? The answer is "of course."  It simply involves a shift in strategy.  When volatility is high, trading is usually the most profitable strategy: using technical analysis and churning your "portfolio" on a daily basis.  On the other hand, when volatility is low, then trending is probably the best bet. Don’t forget: volatility is not the same as directional movement.  If a currency appreciates every day by only a small increment and without any wild swings, volatility is low but the profit potential is high.

Read More: Making the Most of a Benign Environment

Read the rest of this entry »

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

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

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

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

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

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

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

In testifying before the Senate Budget Committee, Ben Bernanke, Chairman of America’s Federal Reserve Bank, hinted strongly that further rate cuts would be necessary to stabilize the US economy.  Last week, the Forex Blog covered an editorial which suggested that Bernanke knew something about the state of the economy that the American public did not, which his testimony seemed to confirm.  Bernanke testified that the Fed is also committed to fighting inflation, but the emphasis was clearly on spurring economic growth. As a result, futures markets are pricing in a rate cut of 50 basis points, projected for the next month.  The forex markets were unambiguous about the implications of this development for the Dollar.  Thomson Financial reports:

‘By highlighting the downside risks to growth, Bernanke confirmed prevailing aggressive rate cut speculation, which currently keeps the dollar under broad pressure,’ said Antje Praefcke, currency strategist at Commerzbank.

Read More: Dollar remains under pressure following Bernanke’s testimony

In its annual meeting, the G7 virtually ignored the situation in forex markets.  In previous years, the G7 used the so-called "communique," which essentially functions as a summary of the meeting, to rebuke China for not allowing the Yuan to appreciate at a satisfactory pace. This year, the RMB has appreciated markedly- by 9% on a trade-weighted basis- and thus, the G7 opted not to apply further rhetorical pressure.  In addition, several of the most prominent EU member states had hoped to work a discussion of the Dollar into the communique, but alas, any mention was notoriously absent. Analysts have speculated that this is due both to America’s political indifference towards the valuation of the Dollar as well to a disagreement over what the correct valuation should be, if indeed it is undervalued. Thomson Financial
reports:

"It was clear a few days ago that there was going to be no change in the (currency section) of the communique and that really spoke of a lack of consensus about mainstream currencies."

Read More: China spared ritual lambasting as yuan slips down G7 agenda

Last week, the USD recorded its best weekly performance since 2006, rising 3 cents against its chief rival, the Euro.  Apparently, analysts are becoming increasingly pessimistic about the effect of the America recession on the global economy.  The consensus is now that a dampened global economy will induce a trend towards risk aversion, which favors the world’s #1 and #2 reserve currencies, the Dollar and the Euro, respectively.  However, it also appears the near-term economic prospects for Europe are less rosy than originally forecast,.  Thus, if last week is any indication, the Dollar should receive a larger proportion of risk-averse capital. Reuters reports:

"Despite a torrent of bad economic news the dollar has been
on a tear this week, as the currency market recognized the fact that the slowdown in U.S. economic activity is likely to drag down growth in the rest of the G10 universe…"

Read More: Dollar set for biggest weekly rise since June 2006

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

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

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

China’s foreign exchange reserves currently approximate $1.5 Trillion, the majority of which is denominated in USD.  Moreover, the Central Bank of China earns interest on every Dollar it adds to its reserves but must also pay interest on every RMB note that it must issue to offset the Dollars. Since the Fed began easing monetary policy, the amount of carry (the difference between what the Central Bank receives on Dollars and pays on RMB) earned by the Central Bank has completely inverted, such that it now loses 250 basis points on average for each Dollar exchanged for RMB. 

Based on the rate at which China is currently accumulating reserves, this amounts to between $5 Billion and $10 Billion per month, depending on which method of accounting is utilized. Furthermore, this trend has been exacerbated because China is accumulating reserves at a faster rate than its economy is growing. Some analysts have speculated that this could turn into a major political issue, with important implications for the RMB/Dollar exchange rate. The Financial Times reports:

The renminbi has started to appreciate more rapidly in recent months, rising at an annualised rate of about 20 per cent, compared with 6-7 per cent over the whole of 2007.  In the longer-term, say economists, China will have no choice but to allow its currency to appreciate faster, even in the face of entrenched domestic resistance.

Read More: Beijing starts to pay for forex ‘sterilisation’

It seems self-evident that the Fed is easing monetary policy because it is trying to stimulate the economy and shore up confidence in capital markets by making credit less expensive.  Dig a little deeper, however, and a more nuanced picture begins to emerge.  Conspiracy theorists believe that the Fed knows something that investors don’t, perhaps that the subprime mortgage situation is more serious than the public is being led to believe. Accordingly, the theory goes, it is trying to prevent a complete collapse of the financial system.  Another theory holds that the Fed is cutting rates because it has nothing to lose by doing so. Inflation is still low, from a historical standpoint, and the Fed may be trying to inject liquidity into the financial markets before it is too late.  Yet another theory holds that the Fed is deliberately targeting a weak Dollar and high commodity prices, as the former benefits the US directly by narrowing the trade imbalance, and the latter benefits the US indirectly by helping emerging market economies, which are relatively more dependent on commodities.  The Chicago Tribune reports:

An increase in exports was one of the
positive features of Wednesday’s disappointing fourth-quarter report on U.S. gross domestic product. The cheaper dollar is a major factor in export growth, both in terms of current sales and expansion of overseas market share by U.S. manufacturers.

Read More: Fed rate cut conspiracy or power play?

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

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

Read More: Greenback is nearing bottom, currency experts say

Today, the Federal Reserve Bank lowered interest rates for the second time in as many weeks, bringing its benchmark federal funds rate down to 3.00%.  The Fed has now lowered rates by 2.25% since August. The move came as a relief to investors, who now see that the Fed is serious about preventing the economy from slipping into a full-scale recession. However, it remains to be seen whether the rate cuts will provide the necessary boost to the economy or instead prove too little too late. As far as the Dollar is concerned, the rate cuts carry two (conflicting