In April, I declared that the dollar would rally when QE2 ended. That date – June 30 – is now only a few weeks away, which means it won’t be long before we know whether I was right. Meanwhile, the dollar is close to pre-credit crisis levels on a composite basis, and has already fallen to record lows against a handful of specific currencies. In other words, it’s now do-or-die for the dollar.

Since my last update, a number of things have happened. Commodity prices have continued to rise, and inflation has ticked up slightly. Meanwhile, GDP growth has moderated, the unemployment rate has stagnated at 9%, and the S&P has fallen slightly as investors brace for the possibility of an economic downturn. Finally, long-term interest rates have fallen, despite concerns that the US will be forced to breach the debt ceiling imposed by Congress.

From the standpoint of fundamentals, there is very little to get excited about when it comes to the dollar. While the US is likely to avoid a double-dip recession (the case for this was most convincingly made by TIME Magazine, of all sources), GDP growth is unlikely to rebound strongly. Exports are growing, but slowly. Businesses are investing (in machines, not people), but they are still holding record amounts of cash. Consumption is strong, but unsustainable. The government will do what it can to keep spending, but given that the deficit is projected at 10% of GDP in 2011 and that Congress is playing hardball with the debt ceiling, it can’t be expected to provide the engine of growth.

Meanwhile, Ben Bernanke, Chairman of the Fed, has implied that QE2 will not be followed by QE3. Still, he warned that “economic conditions are likely to warrant exceptionally low levels for the federal-funds rate for an extended period.” With low growth, high unemployment, and low inflation, there isn’t any impetus to even think about raising interest rates. In fact, Bernanke and his cohorts will continue to do everything in their power to hold down the dollar, if only to provide a boost to exports. Bill Dudley, head of the New York Fed, intimated in a recent speech that the Fed’s current monetary policy is basically a response to emerging market economies’ failure to allow their currencies to rise.

In short, if I was arguing that fundamentals would provide the basis for renewed dollar strength, I would have a pretty weak case. As I wrote a few weeks ago, however, there is a wrinkle to this story, in the form of risk. You see- the dollar continues to derive some significant support from risk-averse investors, as evidenced by the fact that Treasury yields have fallen to record lows.

Ironically, demand for the US dollar is inversely proportional to the strength of US fundamentals. As the US economy has rebounded, investors have become more comfortable about risk, and have responded by unloading safe haven positions in the dollar. With the US recovery faltering, investors are slowly moving back into the dollar, re-establishing safe haven positions. While the dollar faces some competition in this regard from the Franc and the Yen, it still compares favorably with the euro and pound.

In fact, some traders are betting that the dollar’s fortunes may be about to reverse. It has fallen 15% over the last year, en route to a 3-year low. With short positions so high, it would only take a minor crisis to trigger a short squeeze. Said the CEO of the world’s largest forex hedge fund (John Taylor of FX Concepts): “We see a big upside USD catalyst in the next ‘3 or 4 days’ on the grounds that…’Our analysis of the markets has shown that they are very, very dangerous.’ ”

For what it’s worth, I also think the dollar is oversold and expect a correction to take hold at some point over the next month.

Last week, the Wall Street Journal published an article entitled, “Currency Correlations Lose Their Way for Now.” My response: It depends on which currencies you’re looking at. I, too, recently posted about the break-down of multi-year correlations, specifically involving the Australian Dollar and the New Zealand Dollar. However, one has to look no further than the Swiss Franc to see that in fact currency correlations are not only extant, but flourishing!

I stumbled upon this correlation inadvertently, with the intention (call it a twisted hobby…) of refuting the crux of the WSJ article, which is that “Standard relationships between risk appetite and safe havens, and yields and risky assets, are lost as investors appear to scramble in their efforts to adapt to a new direction.” Basically, the author asserted that forex traders are searching for guidance amidst conflicting signals, but this has caused the three traditional safe haven currencies to behave erratically: apparently, the Franc has soared, the Yen has crashed, and the US Dollar has stagnated.

I pulled up a one-year chart of the CHFUSD and the CHFJPY in order to confirm that this was indeed the case. As you can see from the chart above, it most certainly is not. With scant exception, the Swiss Franc’s rise against both the US Dollar and the Japanese Yen has been both consistent and dependable. The only reason that there is any gap between the two pairs is because the Yen has outperformed the dollar over the same time period. If you shorten the time frame to six months or less, the two pairs come very close to complete convergence.

In order to provide more support for this observation, I turned to the currency correlations page of Mataf.net (the founder of which I interviewed only last month). Sure enough, there is a current weekly correlation of 93% [it is displayed as negative below because of the way the currencies are ordered] between the CHFUSD and the CHFJPY, which is to say that the two are almost perfectly correlated. (Incidentally, the correlation coefficient between the USDCHF and the USDJPY is a solid 81%, which shows that relative to the Dollar, the Yen and Franc are highly correlated). Moreover, if Mataf.net offered correlation data based on monthly fluctuations, my guess it that the correlations would be even tighter. In any event, you can see from the chart that even the weekly correlation has been quite strong for most of the weeks over the last year.

The first question most traders will invariably ask is, “Why is this the case?” What is causing this correlation? In a nutshell, the answer is that the WSJ is wrong. As I wrote last month, the safe haven trade is alive and well. Otherwise, why would two currencies as disparate as the Franc and the Yen (whose economic, fiscal, and monetary situations couldn’t be more different) be moving in tandem? The fact that they are highly correlated shows that regardless of whether they are rising or falling is less noteworthy than the fact that they tend to rise and fall together. Generally speaking, when there is aversion to risk, both rise. When there is appetite for risk, they both fall.

The superseding question is, “What should I do with this information?” Here’s an idea: how about using this correlation for diversification purposes? In other words, if you were to make a bet on risk aversion, for example, why not sell both the USDJPY as well as the USDCHF? In this way, you can trade this idea without putting all of your eggs in one basket. If risk aversion picks up, but Japan defaults on its debt (an extreme possibility, but you see my point), you would certainly do better than if you had only sold the USDJPY. The same goes for making a bet on the Franc. Whether you believe it will continue rising or instead suffer a correction, you can limit your exposure to counter currency (i.e. the dollar and yen) risk by trading two (or more) correlated pairs simultaneously.

In the end, just knowing that the correlation exists is often enough because of what it tells you about the mindset of investors.  In this case, it is just more proof that they remain heavily fixated on the idea of risk.

Well over two years have passed since the collapse of Lehman Brothers and the accompanying climax of the credit crisis. Most economies have emerged from recession, stocks have recovered, credit markets are strong, and commodities prices are well on their way to new record highs. And yet, even the most cursory scanning of headlines reveals that all is not well in forex markets. Hardly a week goes by without a report of “risk averse” investors flocking to “safe haven” currencies.

As you can see from the chart below, forex volatility has risen steadily since the Japanese earthquake/tsunami in March. Ignoring the spike of the day (clearly visible in the chart), volatility is nearing a 2011 high.What’s driving this trend? Bank of America Merrill Lynch calls it the “known unknown.” In a word: uncertainty. Fiscal pressures are mounting across the G7. The Eurozone’s woes are certainly the most pressing, but that doesn’t mean the debt situation in the US, UK, and Japan are any less serious. There is also general economic uncertainty, over whether economic recovery can be sustained, or whether it will flag in the absence of government or monetary stimulus. Speaking of which, investors are struggling to get a grip on how the end of quantitative easing will impact exchange rates, and when and to what extent central banks will have to raise interest rates. Commodity prices and too much cash in the system are driving price inflation, and it’s unclear how long the Fed, ECB, etc. will continue to play chicken with monetary policy.

Every time doubt is cast into the system – whether from a natural disaster, monetary press release, surprise economic indicator, ratings downgrade – investors have been quick to flock back into so-called safe haven currencies, showing that appearances aside, they are still relatively on edge. Even the flipside of this phenomenon – risk appetite – is really just another manifestation of risk aversion. In other words, if traders weren’t still so nervous about the prospect of another crisis, they would have no reasons to constantly tweak their risk exposure and reevaluate their appetite for risk.

Over the last few weeks, the US dollar has been reborn as a preeminent safe haven currency, having previously surrendered that role to the Swiss Franc and Japanese Yen. Both of these currencies have already touched record highs against the dollar in 2011. For all of the concern over quantitative easing and runaway inflation and low interest rates and surging national debt and economic stagnation and high unemployment (and the list certainly goes on…), the dollar is still the go-to currency in times of serious risk aversion. Its capital markets are still the deepest and broadest, and the indestructible Treasury security is still the world’s most secure and liquid investment asset. When the Fed ceases its purchases of Treasuries (in June), US long-term rates should rise, further entrenching the dollar’s safe haven status. In fact, the size of US capital markets is a double-edge sword; since the US is able to absorb many times as much risk-averse capital as Japan (and especially Switzerland, sudden jumps in the dollar due to risk aversion will always be understated compared to the franc and yen.

On the other side of this equation stands virtually every other currency: commodity currencies, emerging market currencies, and the British pound and euro. When safe haven currencies go up (because of risk aversion), other currencies will typically fall, though some currencies will certainly be impacted more than others. The highest-yielding currencies, for example, are typically bought on that basis, and not necessarily for fundamental reasons. (The Australian Dollar and Brazilian Real are somewhere in between, featuring good fundamentals and high short-term interest rates). As volatility is the sworn enemy of the carry trade, these currencies are usually the first to fall when the markets are gripped by a bout of risk aversion.

Of course, it’s nearly impossible to anticipate ebbs and flows in risk appetite. Still, just being aware how these fluctuations will manifest themselves in forex markets means that you will be a step ahead when they take place.

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

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

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

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

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

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

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

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

This week’s Bank of International Settlements (BIS) quarterly report came with some interesting revelations (most of which I’ll discuss in a later post). Below, I’d like to focus on one particularly interesting section entitled, “Foreign exchange trading in emerging currencies.” This section carries tremendous implications for the future of reserve currencies and is a must read for fundamental analysts.

According to the BIS, “Foreign exchange turnover evolves in a predictable fashion with increasing income. As income per capita rises, currency trading cuts loose from underlying current account transactions…moreover, currencies with either high or very low yields attract more trading, consistent with their role as target and funding currencies in carry trades.” In other words, the most liquid currencies (and hence, most suitable reserve currencies) are primarily those of advanced economies and secondarily those with abnormal interest rates.

In theory, one would expect a close correlation between forex turnover and trade. In fact, this turns out to be precisely the case for lesser-developed countries. Since the capital markets of such countries are commensurately undeveloped, offering limited opportunities for foreign investment, most of the demand for their currencies stems directly from trade. In fact, the currencies of Malaysia, Indonesia, Saudi Arabia, and (notably) China closely fit this profile, with a 1:1 ratio between forex turnover and trade.

At the same time, the BIS discovered a strong correlation between the ratio of foreign exchange turnover to trade and GDP per capita.  That means that as a country grows economically and enters the realm of industrialized countries, its currency will experience exponential growth in turnover. For example, the British Pound and Japanese Yen are exchanged at a quantity that is 50 times greater than required for trading purposes. The ratio of forex turnover to trade for the US Dollar, meanwhile, exceeds 100!

The BIS was able to fit a regression line to the data that seemed to explain this phenomenon quite well. The majority of economies/currencies that it surveyed fall pretty close to this line, suggesting that forex turnover is exactly where it should be relative to GDP per capita and trade. In fact, the line runs directly through the Euro, Hong Kong Dollar, Canadian Dollar, and Swedish Krona, and Norwegian Krona.

There are also plenty of outliers. Given the size of China’s economy, for instance, the model would predict that turnover in the Chinese  Yuan should be 2-3 times what it currently is. Unsurprisingly, all of the world’s major reserve currencies (except for the Euro) can be found well on the other side of the regression line. Turnover in the US Dollar, Japanese Yen, and Australian Dollar is almost twice as high as the model predicts. Perhaps the most flagrant outlier is the New Zealand Dollar, which seems to be traded at a frequency that is 8-10x higher than it should be. Of course, New Zealand is a unique case; there isn’t another economy that is as small and stable, and yet always has higher-than-average interest rates.

One interpretation of this analysis is that demand for the all of the currencies that fall above the regression line should decline over time, and should experience at least some depreciation. The opposite can be said for currencies that currently fall the regression line, especially if their economies continue to expand at a faster-than average pace.

At the same time, it puts things into perspective. Even if demand for the Chinese Yuan doubled in accordance with the BIS model (which would necessitate looser capital controls, among other things), GDP per capital would need to increase 20x and US GDP per capita would need to remain constant in order for the Yuan to rival the Dollar in importance. Also, I’m beginning to wonder if the New Zealand Dollar isn’t in fact oversubscribed and overvalued…

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

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

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

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

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

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

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

While analysts have been busy dissecting the implications of the natural disasters that ravage(d) Japan for forex markets, the focus has naturally been directed towards the Yen. Given all the rumors about the liquidation of foreign (i.e. Dollar-denominated) assets, it’s also worth examining the potential impact on the Dollar. In a nutshell, Japan’s holdings of US Treasury Securities are extensive, and even a partial unloading could have serious implications for the world’s de facto reserve currency.

As I explained in my previous post, the Yen rose to a record high (against the Dollar) following the earthquake/tsunami/nuclear crisis because of rumors that Japanese insurance companies and other financial institutions would begin repatriating all of their foreign assets in order to pay for rebuilding. (For the record, it’s worth pointing out again that this has yet to take place, and any repatriation is probably related to the approaching fiscal-year end. Thus, the Yen is being propelled by speculation/short squeeze. Period.)

Indeed, Goldman  Sachs has estimated that the rebuilding effort will probably cost around $200 Billion. A significant portion of this will no doubt be covered by the payout of insurance claims. How insurance companies will make their claims is of course, unknown. However, consider that Japanese insurance companies have insisted that they have ample cash reserves. In addition, Japan has what is perhaps the world’s most solid earthquake reinsurance (basically insurance for insurers) program, which means primary insurance companies can basically pass these claims up the chain, perhaps all the way to the government.

As for whether the Bank of Japan will sell some its $900 Billion in Treasury holdings, this, too appears unlikely. First of all, the Bank of Japan is doing everything in its power to soften the upward pressure on the Yen, which would not be consistent with selling any of its Dollar-assets. Second,  the Financial Times has further argued that they will be especially unlikely to sell US Treasury securities, because they would lose money on (US Dollar) currency depreciation. Besides, any assets that are sold now to pay for rebuilding would probably need to be repurchased later in order to restore balance sheet equilibrium.

While I am on the topic, I want to draw attention to a recent Treasury report that documented the overseas holdings of Treasury securities. The major surprise was China, whose holdings were revised upwards to $1.18 Trillion (from $892 Billion), which means it is well-entrenched as the most important creditor to the US. However, this was offset by a 50% drop in the Bank of England’s holdings, caused perhaps by a change from US debt to British debt.

As I have written in the past, it seems unlikely – for political, economic, and financial – reasons that China will move to pare its Treasury holdings in a significant way. Simply, it has no other viable options for investing the foreign exchange reserves that it is forced to accumulate because of the Yuan-Dollar peg. Other doomsdays have speculated that the crisis in the Middle East will end the “petro-Dollar” phenomenon, whereby oil exporters settle their bills almost exclusively in Dollars and use the proceeds to buy Treasuries. While US influence in the Mid East may indeed wane further as a result of the ongoing political turmoil, I don’t think this will force a change to the PetroDollar phenomenon, which is due as much to unavoidable trade surpluses as it is to settling oil transactions in US Dollars.

There is certainly some concern about what will happen when the Fed wraps up QE2 later this year and stops buying Trreasury securities. Two prominent investment companies (PIMCO and Vanguard) have warned that this will cause bond prices to fall and interest rates on debt to rise rapidly. While this is certainly possible, demand for Treasuries will remain strong for as long as the current risk-averse climate remains in place. In addition, given that the US Treasury is not in danger of defaulting anytime soon, yields reflect expectations for inflation and interest rates more than supply/demand for the bonds themselves. Finally, when the Fed stopped buying mortgage backed securities in 2010, mortgage rates fell, contrary to expectations.

In short, the Dollar might continue to fall against the Yen as speculators cover their short positions, but not because of any fundamental reasons. On an aggregate basis, the never-ending string of crises won’t cause the Dollar to collapse. If anything, it might even bring some risk-averse capital back to the US and re-affirm the Dollar’s status as global reserve currency.

Last week, the Obama Administration released its fiscal 2012 budget to much fanfare. Unfortunately, the budget makes only a token effort to address the rising National debt, and forecasts a budget deficit of $1.1 Trillion. While the release of the budget failed to make a splash in currency markets, traders would be wise to understand its implications for the future.

The budget proposes spending of $3.7 Trillion in 2012, and forecasts receipts of only $2.6 Trillion. As usual, entitlements (Social Security, Medicare, and Medicaid: $2 Trillion+), Defense ($760 Billion), and net interest on debt ($250 Billion) are projected to consume the brunt of spending. The Departments of State, Education, Energy, and Veterans Fairs will receive an increased allocation, while almost all other Departments face drastic cuts. (For more comprehensive breakdowns, the WSJ and NY Times offer excellent graphical representations of how the federal budget is funded and disbursed).

The proposed budget allows for a deficit of $1.1 Trillion (7% of GDP), which unbelievably represents a significant decrease from the $1.6 Trillion (11% of GDP) that is projected for fiscal 2011. The Congressional Budget Office (CBO) forecasts the deficit to return to a more “sustainable” level of 3% of GDP beginning in 2014, which should allow the national debt to remain constant in relative terms for the following decade. Beginning in 2021, however, entitlement spending is projected to skyrocket, which would cause debt to rise similarly.

CBO projections are based on a handful of rosy assumptions. First of all, it assumes that the US economy will grow at 3%+ for the indefinite future. Second, it assumes that deficit spending can be financed at reasonable interest rates. Third, it assumes that tax receipts will rise from current lows and revert back to historical levels. Given the ongoing economic uncertainty, high unemployment rates, tax cuts, rising interest rates, the difficulty of cutting spending, etc., there is reason to believe that actual deficits will be even higher.

In fact, net interest payments on national debt will rise 33% over the next year even as Treasury rates remain at record lows. If the economic recovery gathers momentum (something that the budget is counting on), risk appetite and interest rates must rise. In addition, given that the national debt will probably double from 2009 to 2012, it seems likely that investors will demand an increased risk premium for lending to the US. On the other hand, demand for Treasury Securities continues to remain strong: “Net long-term securities transactions showed total buying of $65.9 billion in long-term U.S. securities in December, after purchases of $85.1 billion the month before.” Many Central Banks continue to be net buyers.

In addition, there are some commentators that think the Fed will abet the US government in deflating the real value of its debt. Since the majority of US Treasury Securities are not inflation-protected, 15 years of high inflation (~5%) would be enough to decrease the real debt burden by half. Especially when you account for “contingent obligations,” this might be the only feasible way for the government to deal with its debt burden over the long-term. Then again, higher inflation would probably drive proportional increases in yield, such that the Treasury Department would have a tough time rolling over existing debt (let alone in issuing new debt) at reasonable interest rates.

The main variable in all of this is politics. Specifically, this budget is still only a proposal. The actual budget won’t be ratified for at least another six months, and only after tense negotiations with the Republican Party. (There is also the possibility that it won’t be passed at all, which is what happened with the fiscal 2011 budget). “House Majority Leader Eric Cantor, a Virginia Republican, said his party will propose ‘very bold’ changes to entitlements in their 2012 budget resolution.” Anything short of this wouldn’t dent the projected deficits and would push Social Security / Medicare closer towards the brink of insolvency.

In the end, the deficit merely represents business as usual for the US government. Barring a double-dip recession, it probably won’t be enough to seriously impact the Dollar’s status in the short-term as preeminent global reserve currency. However, that could start to change over the next decade, as the government either takes steps or does nothing to mitigate the looming entitlements crisis. At that time, the long-term viability of the Dollar (and the financial system as we know it) will become clear.

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

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

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

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

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

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

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

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

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

According to Standard Life Investments, the US Dollar will be one of the top currencies in 2011. (The other currency they cited was the British Pound). How can we understand this notion in the context of record high gold prices and commentary pieces with titles such as “Timing the Inevitable Decline of the U.S. Dollar?”

The Dollar finished 2010 on a high note, both on a trade-weighted basis and against its arch-nemesis, the Euro. Speculators are now net long the Dollar, and according to one analyst, it is now fully “entrenched in rally mode.” Never mind that its performance against the Yen, Franc, and a handful of emerging market currencies was less than stellar; given all that happened over the last couple years, the fact that the Dollar Index is trading near its recent historical average means that the bears have some explaining to do.

To be sure, none of the long-term risks have been addressed. US public debt continues to surge, and will not likely abate in 2011 due to recent tax cuts. Short-term interest rates remain grounded at zero, and long-term yields have only just begun to inch up, which means that risk-taking investors still have cause to shun the Dollar. Ironically, signs of economic recovery in the US have reinforced this trend: “The [positive economic] data, which one would ultimately assume is positive for the U.S., looks better for risk, which in turn puts downward pressure on the dollar.” Finally, the the Financial Balance of Terror makes the US vulnerable to a sudden decision by Central Banks to dump the Dollar.

So what’s driving the Dollar in the short-term? The main factor is of course continued uncertainty in the Eurozone over still-unfolding fiscal crisis, which is directly driving a shift of capital from the EU to the US. Next, the budget-busting tax cuts that I mentioned above are predicted to both boost economic growth and make it less likely that the Federal Reserve Bank will have to deploy the entire $600 Billion that it initially set aside for QE2. (To date, it has spent “only” $175 Billion in this follow-up campaign, compared to the $1.75 Trillion that it deployed in QE1). According to The Economist, “JPMorgan raised its growth forecast for the fourth quarter of next year to 3.5% from 3% as a result [of the tax cuts]. Macroeconomic Advisers, a consultancy, says the new package could raise growth to 4.3% next year, up from its current forecast of 3.7%.”

In fact, long-term rates on US debt have started to creep up. They recently surpassed comparable rates in Canada, and even risk-taking investors are taking notice: “U.S. bond yields are attractive and interesting again,” indicated one analyst. Of course, when analyzing the recent increase in bond yields, it’s impossible to disentangle inflation expectations from concerns over default from optimism over economic. Nevertheless, the consensus is that rates/yields can only rise from here: “The CBO [Congressional Budget Office] estimates that interest rates on 3-month bills and 10-year notes will reach 5.0% and 5.9%, respectively, by 2020.”

As if this wasn’t enough, the exodus out of the US Dollar over the last few decades has virtually ceased, with the US Dollar still accounting for a disproportionate 62.7% of global forex reserves. Furthermore, economists are now coming out of the woodwork to defend the Dollar and argue that its supposed demise is overblown. At last week’s annual meeting of the American Economic Association (and in a related research paper), Princeton University economist Peter B. Kenen “argued that neither Europe’s nor China’s currency presents a valid substitute–nor an International Monetary Fund alternative to the dollar that was created some 40 years ago.” Even if the RMB was a viable reserve currency – which it isn’t – Kenen points out that for all its bluster, China has shied away from taking a more active leadership role in solving global economic issues.

In short, as I’ve argued previously, the Dollar is safe, not just for the time being, but probably for a while.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Statisticians love to teach the dictum, Correlation does not imply causation. Nonetheless, I think that in this case, I’d wager to say that the equity and credit/bond markets are driving forex, rather than the other way around. Consider as evidence that, “[Retail] Investors withdrew a staggering $33.12 billion from domestic stock market mutual funds in the first seven months of this year,” and shifted this capital into bonds. While this wouldn’t in itself be enough to drive the Dollar higher, it epitomizes the steady shifts that have been taking place in capital markets for nearly a year, broken only by the S&P/Euro rally in the spring (which now appears to have been an aberration).

In fact, these shifts are once again creating shortages of Dollars: “This week, two banks bid at the European Central Bank’s weekly dollar liquidity providing auction – the first time there have been any bids since May – suggesting that they could not raise dollars in the market.” This suggests that demand for the Dollar could continue to grow.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Rumor has it that the Dollar is about to make a run. As the credit crisis slowly subsides, (currency) investors are once again looking at the long-term, and they like what they see when it comes to the Dollar.

For those that care to remember, 2008 was a great year for the Dollar, as the credit crisis precipitated an increase in risk aversion, and investors realized that despite its pitfalls, the Dollar was (and still is) the most stable and really the only viable global reserve currency. [This reversed a trend which had essentially been in place since the inception of the Euro in 1999]. In 2009, meanwhile, the Dollar resumed its multi-year decline, and many analysts were quick to label the rally of 2008 as an aberration.

Then came the debt crises, first in Dubai, then in Greece. Suddenly, a handful of smaller EU countries appeared vulnerable to fiscal crises. Japan officially became the first of the Aaa economies to receive a downgrade in its credit rating. The British Pound is dealing with crises on both the political and economic fronts. According to Moody’s, “The ratings of the Aaa governments — which also include Britain, France, Spain and the Nordic countries — are currently ‘stable’…But…their ‘distance-to-downgrade’ has in all cases substantially diminished.”  Suddenly, the Greenback doesn’t look so bad.

I want to point out that in forex, everything is relative. (Novice) forex investors are often baffled by how sustained economic and financial crises don’t immediately result in currency depreciation. The explanation is that when the crises are worse in (every) other countries, the base currency still looks attractive.

This is precisely the case when it comes to the US Dollar. To be sure, the economy is still flawed, financial markets have yet to fully to recover, the federal budget deficit topped $1.8 Trillion in 2009, and government finances seem close to the breaking point. Moody’s has also identified the US as a candidate for a ratings downgrade. And yet, when you look at the situation in every other currency that currently rivals the US for reserve currency status, the Dollar still wins hands down.

Its economy is the world’s largest. So are its financial markets, which are also the deepest and most liquid. Its sovereign finances are still manageable from the standpoint of debt-to-GDP and interest-to-revenue ratios. It is the only currency whose circulation can even come close to meeting the needs of global trade. Summarized S&P – when it confirmed the AAA credit rating of the US, “The dollar’s widespread acceptance stems from the U.S. economy’s fundamental strength, which in our view comes from the economy’s size and the flexibility of labor and product markets. We view U.S. banking and capital markets to be dynamic and unfettered relative to their peers.”

That’s why auctions of US Treasury bonds remain heavily oversubscribed (demand exceeds supply), despite the rock-bottom interest coupons. China has reaffirmed its commitment to Treasuries (what other choice does it have), confirmed by some forensic accounting work. Gold might continue to rally. So will other commodities, for all I know. Emerging market currencies are still in good shape as well, but none of these will seriously rival the US Dollar for a long-time, if ever. In short, when it comes to the other majors, the Dollar is still King: “You can say whatever you want, but the dollar is the currency of last resort It’s the currency people want in a crisis.”

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

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

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

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

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

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

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

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

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

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

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

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

In October, I wrote about a “separation” that had taken place in currency markets between the “sick” currencies and the “healthy” currencies. At the time, I argued that the former category was comprised mainly of the Dollar and the Pound, with most other currencies healthy by comparison. While I still stand by this paradigm, I would like to revise it slightly. Specifically, I would like to add the Euro and the Yen to this list.

The recent blow-up surrounding the downgrade of Greece’s debt and subsequent explosion in the price of credit default swaps (which insure against default), have shined a spotlight on the fiscal problems of many of the EU’s member states, including Spain, Italy, Portugal, Ireland, and others. The situation in Japan, meanwhile, has been much more gradual, though equally dangerous: “In 1990, Japan’s total national debt load was 390% of GDP. Now it’s 460%. In the interim, the country has suffered sub-par growth and routine recessions.”

The fiscal problems of the US and UK governments as well as the debts of their citizens and companies have long been famous. For that reason, when the sick/healthy paradigm was first proposed, they were the two most obvious candidates. Having conducted some additional analysis, it’s now patently obvious that the same problems affect the EU and Japan. Given that their economies are also in weak shape, it doesn’t really make sense to group them in with the healthy currencies. Canada (and the Loonie, by extension) is also looking sickly, with its surging national debt and record budget deficits. The only reason it is being spared from the list is because of its richness in natural resources; in other words, it has something tangible that it can use to pay its debts.

Among the so-called majors, then, only the Swiss Franc, Canadian Loonie, Australian Dollar, and New Zealand Dollar get clean bills of health. A re-casting of the paradigm, then, would put the super-majors (Euro, Yen, Pound, and Dollar account for more than 75% of all foreign exchange activity) on one side, and virtually every other currency on the other. Given that national debt ratios and interest rate differentials diverge across the same boundary, it’s not hard to conjure a basis for this partition. “The IMF forecasts that gross government debt among advanced economies will continue to rise until 2014, reaching 114% of GDP, compared to just 35% for developing nations.” Adds another analyst: “If you look at currencies as a proxy for growth, then you can anticipate that emerging-market currencies will appreciate against the dollar.”

There is also a correction that is taking place within the group of sick currencies. Investors have come to realize belatedly that a Dollar sell-off doesn’t make any sense against the Euro and Yen, whose economic and fiscal situations could hardly be characterized as healthy. “Against the majors, we’re pretty close to the end, if we haven’t already reached the end of a bear market in the dollar,” asserted one analyst. Given that the Dollar’s demise had all but been taken for granted, this reconsideration isn’t coming natural. Volatility has surged to a 3-month high, and investors are responding by moving funds back to the US. Among the majors, then, it looks like the Dollar is still the “least worst” currency.

After the impressive rally in the US Dollar at the end of 2009, many market observers predicted that the end was near for the Dollar carry trade. That’s because volatility is the sworn enemy of carry traders; whenever there transpires a sudden change in direction in a funding currency, investors will usually race for the exits, regardless of whether the change was justified by fundamentals.

Alas, 2010 has seen a stabilization – even a modest appreciation – in the Dollar, which means the carry trade is here to stay. For now at least. This is based on two abiding notions. The first is that US short-term interest rates – and, hence, borrowing costs for carry traders – will remain low for the foreseeable future. The second belief is that the most attractive investment opportunities can still be found outside the US, namely in emerging markets. Let’s explore both of these ideas in greater details.

The minutes from its last monetary policy meeting suggest that the Fed is in no hurry to raise rates. On the contrary, it may ease monetary policy even further. According to St. Louis Federal Reserve President James Bullard, U.S. interest rates may remain low for “quite some time.” Added another analyst, “The U.S. economy is chugging along, albeit at a slow pace, and that means the Federal Reserve has no real urgency to raise interest rates.”

In short, investors are rapidly scaling back their expectations for interest rate hikes; futures prices now reflect a mere 20% of a hike by the Fed’s June meeting. If Bullard’s comments carry any weight, investors might turn their attention to the other tools in the Fed’s arsenal- namely quantitative easing. A rise in inflation, portended by many economists, could spur the Fed to draw money out of the markets by selling some of its $1 Trillion in credit securities.  Regardless of what it decides on this front (expand, hold steady, rein in), however, the long and short of it as that interest rates aren’t going anywhere anytime soon. And that means funds will remain cheap and available for carry trading.

On the other side of the equation is an enduring optimism in emerging markets. The last decade has been very kind to investors that bought emerging market stocks, returning a “modest” 100% in some cases and an incredible 1000% in others. The S&P, in contrast, declined slightly over the same period. In some ways, 2009 was a microcosm for this trend, as the MSCI emerging markets index gained 73%, compared to 25% in the S&P. While investors are cautious about bubbles forming in some of these markets (bubbles seem to form and burst with alarming regularity), they continue to pour money in. $75 Billion was added to emerging market equity funds in 2009, to be precise. They are buoyed by predictions that emerging markets will account for the lion’s share of global GDP growth going forward.

This has facilitated a twist on the carry trade, whereby investors are now commonly using Dollar-funded loans to buy stocks, rather than sit back and earn a modest return investing in comparatively low-risk interest-bearing securities. This “traditional” carry trade is perhaps less popular now because interest rates are at all-time lows in many countries. But this is already starting to change as a healthy recovery in emerging markets has paved the way for rate hikes. While this could put a damper on stocks, it would re-open the bread and butter for carry traders, which is to sit back and earn a simple interest rate spread. Moreover, these carry traders can rest assured that if/when the Fed eventually raises rates, Central Banks in Asia and Latin America will almost certainly be in the same position.

The main threat at this point is uncertainty. “Investors plying the carry trade should tread cautiously — economic data will continue to be volatile, as befits a recovery that will proceed in fits and starts,” summarizes one columnist. In short, while fundamentals continue to support a carry trade strategy, it could be undone (rapidly) by an uptick in volatility.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Last week, I opined on the official US forex policy (“Strong Dollar” Policy is a Joke). Most of my analysis was directed towards the lackluster efforts of US policymakers in failing to execute this policy, and I paid short shrift to the policy itself. With this post, then, I would like to address whether a Strong Dollar is, on balance, actually good for the US economy, specifically as it bears on the balance of trade.

Dean Baker, of the American Prospect, in a post germane to this discussion, wrote that “Folks who took econ 101 know that currency fluctuations are the mechanism through which trade imbalances adjust.” Unfortunately, as anyone who follows the forex markets no doubt understands, reality is much more complicated. As the WSJ reported, US exports skyrocketed during the last decade when the Dollar was falling. Case closed, right? However, exports also rose during the 1990’s, when the Dollar was in fact rising. This contradiction should make make anyone think twice before assuming a cut-and-dried relationship between the Dollar and exports think twice.

While exchange rates certainly correlate with export volume, there are a few confounding variables. Fist is the lag time between fluctuations in exchange rates and corresponding changes in exports. That’s because the majority of international trade is conducted by large companies and because global supply chains are not completely fluid. In other words, if the Dollar collapses tomorrow, it will take years before companies can fully modify their sourcing arrangements accordingly.

In addition, it is mainly on non-durable goods that companies have relative flexibility on choosing sourcing locations. In this age of ODM and OEM, it’s not difficult for Nike to shift production to Vietnam if the Chinese Yuan is suddenly revalued. On the other hand, it is significantly more complicated to move an automobile manufacturing plant or oil refinery. Investments in production facilities for durable goods are made on a long-term basis, then, and aren’t responsive to short-term changes in exchange rates. If you look at the breakdown of US exports, it is heavily concentrated in services and high-tech products, many of which it’s not (yet) practical to outsource.

For goods and services that are low-skilled labor-intensive, it’s obviously cost-effective to produce them overseas, because wages are lower. This is not a product of exchange rates, but rather to disparities in standards of living and levels of development. In China (where I am based), factory wages rarely exceed 8RMB per Dollar (about $1.25 at current exchange rates). Conservatively, that’s probably less than 1/20th of US counterpart wages, when you look at salary and benefits. That’s why the weak Dollar hasn’t done much to dent US demand for imports. Personally, I don’t expect to see the RMB rise 1500% in the next few years to erase this discrepancy, which means that’s unrealistic to ever expect the US Dollar to depreciate enough to ever make the US competitive enough in certain export categories.

Obviously, the inverse is true for imports. From the perspective of the US, the shifting of non-durable goods production outside the US represents a permanent structural changes in the US economy. Regardless of how low the Dollar sinks, it’s not reasonable to assume that the US will once again become the hotbed of low-tech manufacturing activity that it once was.

Overall, exports have actually risen steadily over the last decade (and the last 50 years, on average); the problem is that imports have risen even faster. In fact, ebbs and flows in the trade deficit can be better explained by global economic cycle than by short-term fluctuations in exchange rates. Despite the weak Dollar, the US trade deficit has exploded over the last decade because of a comparable explosion in US consumption, which was made possible by cheap credit. When that cycle came to an abrupt end in 2008, the trade deficit narrowed dramatically, despite the rise in the Dollar that took place simultaneously.

Given that the US has basically committed itself to importing certain goods, a Strong Dollar is actually beneficial, because it reduces the cost of those imports. In the short-run, then, a 20% decline in the Dollar might be expected to correlate with a 20% rise in the trade deficit. The hope is that this can be offset over the long-term, with the relocation of production facilities (yes, foreign companies also outsource to the US; it’s a not a one-way exodus) to the US and the creation of new products/services that can fill the void of those that have already been outsourced.

In short, it’s not clear that a weak Dollar will dramatically improve the US trade imbalance. This can best be accomplished not through a weak exchange rate, but through incentives that stimulate innovation and discourage consumption of low-quality, non-durable goods, the majority of which are produced overseas. When you consider the inflation (Strong Dollar keeps prices in check) and financing (Strong Dollar increases the willingness of foreigners to invest in and lend to US entities) perks, the Strong Dollar probably provides a net benefit to the US economy. If Bernanke and Geithner actually believe this, it would be nice if they conducted policy accordingly.

The big story of the week was the announcement by Dubai World, the investment arm of Dubai, that it is having trouble making payments on nearly $60 Billion. The funds were borrowed for various large-scale projects, ranging from man-made islands to massive hotels and skyscrapers, many of which are hemorrhaging money in the wake of the real estate crisis.

This announcement has implications both for the direct stakeholders in Dubai as well as for investors, generally. Dubai World’s bondholders were taken aback by its financial troubles, as well as by the suggestion of the United Arab Emirates that it would not come to the rescue. Apparently, it had always been assumed that oil-poor Dubai would be bailed out by its oil-rich neighbors in the event of insolvency. While it’s possible that this still applies, at the very least, investors will have to squirm/suffer a bit in the short-term. “Moody’s Investors Service and Standard & Poor’s cut the ratings on Dubai state companies yesterday, saying they may consider state-controlled Dubai World’s plan to delay debt payments a default.”

The news rattled forex markets, predictably sending “safe-haven” currencies (is anybody actually still using this term?) like the Dollar and Yen up, while sending everything else down. The reasoning is that the Dubai debt bomb could easily spread to other emerging market economies, triggering a wave of sovereign defaults and even a second credit crisis. Credit default swaps (which function as insurance against default) on emerging market bonds soared on the news, by 60% for Dubai bonds and 16% for Greece, for example. The situation has been likened to the defaults of Russia in 1998 of Argentina in 2002, both of which massively destabilized global capital markets at the time. Despite the recent gains, financial markets remain shaky and a sovereign default would likely reverberate around the financial world. “It will tarnish the reputation of the Gulf region a bit, and it will certainly make investors more bearish again about emerging markets,” explained one analyst.

At the same time, there are reasons to believe that this incident, should it erupt into a full-blown crisis, can easily be contained. For one thing, the situation in Dubai is unique. While many governments and institutions borrowed heavily during the height of the bubble, few came close to matching the scale and audacity of Dubai. In addition, Dubai doesn’t have any natural resources that it can fall back on during the ongoing recession; its pillar industries of tourism and finance were damaged heavily by the credit crisis, and it will be a while before they recover.

At the same time, some investors have been looking for a chance to “take profits” as the end of the year approaches and concerns mount that new bubbles might be forming in certain sectors of the market. “The news seems to have rattled a market already skeptical about the sharp rise in share prices in recent months. Financial instability in Vietnam and widening bond spreads in Greece and Spain have revived concerns that the global financial system is overleveraged.” Added another market observer: “This may be the trigger to allow for the market to take a rest and pull back. I felt that there would be a significant correction in what is an ongoing bull market.”

In the end, it’s hard to assess how significant this Dubai crisis actually is. As one analyst pointed out, the exposure of financial institutions to the UAE “is a negligible 0.4 percent of foreign banks’ total cross-border exposure.” Moreover, there’s not much of a connection between Dubai and China and Brazil, the latter of which largely escaped the economic downturn and have been two of the hottest performing economies over the last year. Still, with the end of the year approaching, investors will probably take this opportunity to book some of their profits so they can make a fresh start in 2010, which means December could see a small rally in the Dollar. For what it’s worth, that’s where my money is.

US economic officials have been busy of late, propagating the “Strong Dollar” farce to anyone who will listen. “I believe deeply that it’s very important for the U.S. and the economic health of the U.S. that we maintain a strong dollar,” said Treasury Secretary Timothy Geithner at last week’s APEC summit in Singapore. Added Ben Bernanke, Chairman of the Federal Reserve, “We are attentive to the implications of changes in the value of the dollar and…will help ensure that the dollar is strong and a source of global financial.”

The markets hardly reacted to Geithner’s assertions, probably because he has parroted this same promise on several occasions since assuming office last January. Investors can be excused for their jadedness, since similar promises were repeatedly made during the Bush administration, during which time the Dollar registered some of its steepest declines in memory.

Still, you’ve got to give Geithner an A for effort, since he  has seemingly taken advantage of nearly every opportunity to pontificate about the Strong Dollar policy. ” ‘The dollar isn’t strengthening in the real world, but I told him [Geithner] I value his stance. The fact that I value his stance means that I believe things will develop that way, and that I believe the U.S. is making efforts to make that happen,’ ” said new Japanese Finance Minister Hirohisa Fuji. By his own admission, Fuji’s remarks were somewhat perfunctory, and it’s obvious to him the Dollar will continue depreciating

Bernanke, meanwhile, has more credibility on this issue, especially since the Fed so rarely discusses forex in public domain, which is why the Dollar initially spiked after he spoke. However, investors quickly registered the contradiction inherent in his remarks, which contained repeated promises about keeping rates low. Not to mention that the wording he used was almost identical to a speech from 2008. It’s no wonder, then, that the Dollar actually finished down on the day.

So if the markets aren’t taking this talk about a Strong Dollar seriously and Bernanke/Geithner know they aren’t being taken seriously, what’s the point of these vain pronouncements? [After all, it’s not even clear that a strong Dollar is in the best interest of the US, which has benefited economically from a narrowing of the trade deficit]. A few explanations have been suggested.

The first is that the rhetoric is intended to re-assure foreign investors and creditors that their assets/loans in the US will be safe from massive devaluation. While foreign Central Banks continue to purchase US Treasury Securities, their have been increasing grumblings that loaning to the US government is a losing proposition. Second, a weak Dollar is inherently inflationary, since it makes imports more expensive. The reverse correlation between oil (and other commodities) and the Dollar means that a weak Dollar could feed back into higher prices double time. Towards that end, Bernanke was actually speaking earnestly about the Fed’s intentions to monitor forex markets, as they bear on inflation.

Finally, while US policymakers seem resigned to the Dollar’s continued decline, they need to make sure that it remains “orderly” (this characterization has cropped up repeatedly in political circles, of late). “We believe Chairman Bernanke’s comments reflect a desire to prevent a disorderly decline in the currency, rather than halt its depreciation altogether.” There is an obvious recognition that a complete collapse in the value of the Dollar would be terrible for everyone, of which Bernanke no doubt also undersds.

Still, the markets are keenly aware that the US (i.e. the Fed) is not prepared to put  its money where its mouth is. The reason for the current bout of Dollar weakness is almost entirely connected to the Fed’s easy monetary policy (and its quantitative easing program) and the never-ending US budget deficit. If the US was seriously committed to a strong Dollar, then the Fed could simply tighten monetary policy. (The federal government could make more of an effort to balance its budget going forward, but this is currently less of a concern to forex markets).

Alas, the Fed is nowhere near ready to hike rates, nor is it willing to contemplate unwinding its quantitative easing program.  Most analysts expect interest rates to remain at the current record lows well into next year. Futures contracts expiring in June 2010 are pricing in a Federal Funds Rate of only .42% at that time. Most telling is that Bernanke, himself, has declared rates will remain low for an “extended period.” In hindsight, using the same speech to talk up the Dollar probably wasn’tthe best idea.

Almost two months ago, I wrote a series of posts (Dollar Down, Everything Else Up and Dollar Down, Gold Up) with self-explanatory titles. Last week, the Wall Street Journal finally got around to covering this story, and were able to quantify the extent of the trend with the use of statistical analysis. Accordingly, they observed an incredible 71% correlation between the Dollar and the S&P 500, compared to an average correlation of 2%. This implies that every 1% rise in the S&P is matched by a .71% fall in the value of the Dollar, and vice versa.

Furthermore, this trend appears to be both strengthening and spreading. The average correlation between the Dollar and stocks since July is 60%; given that it’s now 71%, this suggests that it was closer to 50% over the summer. In addition, the correlation between stocks and oil has touched 75%, the highest level since 1995. By extension, this implies a proportionately high correlation between the Dollar and gold. In short, the notion that as the Dollar is tanking, virtually every other commodity/asset under the sun is rising, now has some weight behind it.

Understanding the basis for this relationship is not complicated. You can think of it in terms of the Fed’s liquidity program or in terms of the carry trade, but regardless of what you call it, the concept is the same. Basically, the Federal Reserve Bank has printed nearly $2 Trillion as part of its quantitative easing program. For better or worse, most of this money found its way into the markets, rather than into the economy. Investors have been faced with the dilemma of either holding the currency in cash or investing it. (Here, I would argue that “speculate” is a more appropriate descriptor than “invest,” but anyway…) The simultaneous rise in stocks, bonds, emerging market currencies, commodities, and even real estate is proof enough about where that money went.

Stepping outside of forex markets a moment, the fact that all asset prices are rising in unison suggests that a new bubble is forming. Normally, one would expect that in a bull market, some assets would outpace others, but in this case, it seems that fundamentals are being pushed to the backburner, and investors are piling into anything and everything that’s liquid. Even traditional relationships, like that which leads bond prices to fall as stock prices rise seems to have broken down.

Getting back to the Dollar, the fact that bubbles are forming in stocks/bonds/commodities probably means that an inverse bubble is forming under the Dollar. One can draw understanding from last year’s partial collapse of the Yen carry trade, which began to deflate after several reliably strong years. The same could very well happen to the Dollar carry trade.

If and when the Fed raises interest rates, and/or begins to draw the excess liquidity out of the markets by offloading its inventory of securities, well, the markets should witness a simultaneous correction. How violent the correction is depends largely on the degree to which the markets anticipated it as well as the finesse of the Fed. If everybody rushes for the exits at the same time, it could create the same kind of panic that ensued after Lehman Brothers went bankrupt, whereby asset prices collapsed and the markets flooded into the Dollar.

History is never far from repeating itself.

The Economist recently published a special report on China and America (“Round and round it goes“). As the title suggests, the article described the increasing interdependency between the economies of the US and China. In a nutshell, China maintains an undervalued currency, in order to stimulate exports. The resulting overseas (American) demand puts upward pressure on the RMB, which China defuses by buying US Treasury securities. This results in artificially low US interest rates, causing American consumers to import more, putting even more pressure on the RMB, which is further defused by buying more US Treasuries. And the cycle continues ad nauseum.

The article focused primarily on the political side of this precarious relationship, at the expense of the financial implications. It got me thinking about the forex forces at work, and how a disruption in the cycle could have tremendous ramifications for currency markets. It’s clear that in its current form, this system keeps the Yuan artificially low, but does that means that the Dollar is also being kept artificially high.

Given the depreciation of the Dollar over the last six months, this seems almost hard to believe. Over the same time period, though, China (as well as many other Central Banks) have vastly increased their Treasury holdings. This would seem to imply that indeed, the Dollar’s fall has been slowed to some extent by the actions of China. It’s kind of a paradox; as US consumers recover their appetite for Chinese goods, the Dollar should decline. But as China responds by plowing all of those Dollars back into the US, then the net effect is zero.

As the Economist article intimated, there are a couple of developments that would seem to upset this equilibrium. The first would be if the Central Bank of China began diversifying its forex reserves into other currencies. By definition, however, it would be impossible for China to continue pegging the RMB to the Dollar without simultaneously buying Dollars. Thus, the day that China stops recycling its export proceeds into the US, the RMB would start to appreciate, almost instantaneously. In addition, the sudden surcease in US Treasury bond purchases would cause interest rates to rise. Both higher rates and a more expensive currency would presumably result in lower demand for Chinese exports, and hence eliminate some of the need to recycle its trade surplus back into the US. In this way, we can see that China’s Treasury purchases are actually self-fulfilling. The sooner it stops purchasing them, the sooner it will no longer need to purchase them.

I’m tempted to elaborate further on this point, but it seems that I’ve already taken it to its logical conclusion. China must recognize the dilemma that it faces, which is why it refuses to break from the status quo. If it allows the Yuan to appreciate, it will naturally face a decline in exports AND the relative value of its US Treasury holdings will decline in RMB terms. Both would be painful in the short-run. However, by refusing to concede the un-sustainability of its forex/economic policy, China is merely forestalling the inevitable. With every passing day, the adjustment will only become more painful.

By all accounts, the decline of the US Dollar has been measured, and without incident. This, despite the fact that most investors reckon the Dollar is doomed, both from a long-term and a short-term perspective. What, then, is preventing an all-out collapse?

Personally, I think the best answer is that Central Banks (and their sponsoring governments) don’t want the Dollar to collapse. In other words, a schism is forming between private investors and public government, whereby investors (on a net basis) are rooting against the Dollar, while Central Banks are rooting for it. That’s not to say that there is a global conspiracy involving Central Banks, designed to prop up the Dollar. Rather, it is that Central Banks are simply trying to protect their short-term financial interests, and long-term economic interests. By this, I mean simply that foreign Central Banks have everything to gain from a strong Dollar, and seemingly everything to lose from its collapse.

From an economic standpoint, foreign Central Banks also benefit from a strong Dollar, especially those whose economies are powered by exports. “A stronger local currency relative to the dollar attracts foreign investment and tempers domestic price pressures by keeping import prices in check, but also cuts into the competitiveness of the country’s export sector.” Given that inflation is currently a moot issue whereas economic growth remains tenuous, Central Banks have made it clear that they currently favor weak currencies. “If (their currencies have) too much strength and the U.S. recovery falters, it’s bad for emerging market growth,” and could even lead to a so-called “double-dip recession.”

In order to alleviate this possibility, many Central Banks have intervened directly in forex markets and depressed their currencies through the purchase of Dollars. During only one trading session earlier this month, “Asian central banks said to be intervening in currency markets overnight by buying dollars included South Korea, Hong Kong, Taiwan, Thailand, the Philippines and possibly, Indonesia, according to analysts.”

Meanwhile, Central Banks in industrialized countries are using increasingly strong rhetoric to try to talk down their currencies. The Banks of Canada and England have achieved modest success in the last few weeks in convincing investors that overvalued currencies would be met with decisive action. The Royal Bank of Switzerland has intervened several times, while the European Central Bank has expressed concerns about “volatility” (code for the rapid appreciation in the Euro) in forex markets. It’s still not clear where the Bank of Japan stands. The newly appointed Finance Minister has already flip-flopped several times, settling finally on a course of action that would prevent the Yen from rising too high and threatening the nascent recovery.

Consider also foreign Central Banks’ collective holdings of US Treasury securities, which increased by nearly $800 Billion over the last year, a large portion of which was accounted for by the Banks of China and Japan. According to the most recent Federal Reserve data, they are collectively adding to their stockpile at a pace of $10 Billion per week. As the WSJ explains, “The inflows highlight the challenges facing nations with large dollar holdings, particularly developing countries. A weaker dollar is, in theory, bad for their investments as it eats into returns when translated back into local currencies.”

In other words, continued foreign Central Bank investment in US Treasury securities is perhaps rooted less in investment strategy, then in the simple desire to prevent their current holdings from depreciating. At the same time, those banks that intervene directly in forex markets often have little choice other than to hold their forex reserves in US Treasuries.

You can see from this that the idea of an alternative reserve currency would actually run counter to the interests of many of these Central Banks. With the exception of a few (i.e. Iran, and to a lesser extent, China) that would like to see the Dollar fail for political reasons, the vast majority of banks have a vested interest in the Dollar remaining where it is. Otherwise, they would witness the value of their Dollar-denominated assets collapse, as well as a collapse in exports to the US.

It looks like, then, there will be a showdown at some point between the Central Banks and investors. If you accept the notion of efficient markets, then it should be obvious who will win in the long-term. On the other hand, you can’t underestimate the determination of some of these banks.

I deliberately concluded my last post (US Dollar: Same Old Story) on a somewhat ambiguous note; even though though the deck is stacked against the Dollar, its 14% decline in 2009 has left it perilously close to record lows, and traders are nervous about pushing the limits further.

On the one hand, everyone believes that the Dollar is fundamentally still in a weak position. The US balance of trade remains deep in deficit. Government spending has exploded, with record-setting deficits and an expansion in the national debt. Interest rates are at rock bottom, and are by some measures, the lowest in the world. Despite signs of life, the economy remains mired in recession. The money supply has also expanding, to the extent that some long-term investors are wondering out loud about the possibility of future inflation.

As a result, the decline in the Dollar since last spring has suffered very few blips, with volatility declining at the same pace as the currency, itself. “There seems to be a paradigm shift underway where more and more foreign investors are becoming concerned that the long-term path of the dollar is downward,” summarized one analyst. The consensus among investors is almost eerie. “Speculators betting that the dollar index will fall outnumber those betting that it will rise by nearly 2 to 1, according to the Commodity Futures Trading Commission.”

Some (mainstream) analysts have even begun to open consider the possibility of a crash in the Dollar, a view that had previously been relegated to conspiracy theorists and doomsday scenarists. “In a run on the dollar, that thinking would create a cascade — fearful global investors would shy away from dollars, expecting further steep declines, creating a self-fulfilling prophesy.” Adds a former Chief Economist of the IMF, “Every time the dollar starts depreciating there is angst and everybody starts raising the question what happens if there is a collapse.” While the majority of Dollar-watchers still believe that a Dollar crash is unlikely, the point is that they are now discussing it actively.

Despite the fact that all of these factors are already in place, the Dollar remains relatively buoyant. Personally, I think this is because investors don’t really want to acknowledge that this is a real possibility. For one thing, the alternatives aren’t any better. While forex investors in recent years have enjoyed ganging up on the Dollar, the fact remains the fundamentals for the other major currencies remain just as weak. For example, a model of purchasing power parity developed by “the Organization for Economic Cooperation and Development finds the dollar is worth roughly 0.85 euro, compared with its market valuation of 0.67 euro, suggesting that the euro is 21% overvalued.” Likewise, the Yen is held to be 22% undervalued.

As a result, the market as a whole is having trouble pushing the boundaries. The Dollar has approached the psychologically important level of $1.50/Euro on several occasions, but has retreated each time. “People are wondering whether we’re going back to $1.46 in euro/dollar or heading toward $1.54. But one thing is for sure, as we head toward $1.50, we’re going to experience a lot of volatility,” summarized one analyst.

“Risk reversals, a measure of currency sentiment in the options market derived by looking at the difference in implied volatility between out of the money calls and out of the money puts, show a bias for euro puts, trading at a mid-market level of 0.2. That means investors are hedging their short dollar positions with bets for a euro downside even though no one expects the euro to fall.” Meanwhile, volatility has edged up slightly, reflecting an increased level of uncertainty surround the near-term direction of the Dollar. It could be the case that if the Euro breaks through $1.50, heartened investors will send the currency up even higher, while a failure to break through means investors just aren’t read to commit. A classic technical crossroads!

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The semiannual meetings of the “G” countries – whether the G7, G8, G20, etc. – are always closely monitored by currency analysts. Especially close attention is paid to the official communique, which often includes an assessment of current exchange rates.

The communique is rarely so straightforward as to indicate if, when, and where the Gs will intervene. Nonetheless, it is often full of intimations, and analysts often spend days parsing its rhetoric for clues. During this period, it’s not uncommon for the forex markets to witness increased volatility, as investors try to come to consensus about what to expect in the months following the meeting. This is because unlike Central Banks, which often face difficulties in unilaterally trying to influence their currencies, the G7 is usually able to achieve its desired goal: “A study last year by ECB economist Marcel Fratzcher found the G7 was successful in moving within a year currencies on 80 per cent of the 29 occasions it tried to do so since 1975.”

However, the current meeting, which is being held in Instanbul, Turkey,may break from this tradition. It’s not clear exactly what motivated the (potential) decision not to release a communique, which has been an important policy tool for the last three decades. Perhaps, policymakers have realized that their are other, better forums to discuss currency issues, namely the G20, which met last week in Pittsburgh, USA.

The timing of the decision is somewhat odd, given that exchange rate and other economic imbalances are proliferating. In fact, in press conferences held before and after the official G7 meetings, policymakers and Central Bankers have been forthcoming about such imbalances. Jim Flaherty, Finance Minister of Canada, sounded off on the RMB, which has stalled in its appreciation for over a year: “They (China) have a position that they are relaxing their currency, relaxing the restrictions on their currency gradually over time,” he said. Meanwhile, ECB Governor Jean-Claude Trichet voiced concerns about the Dollar, which has slide 15% against the Euro so far this year.

Ironically given the G7’s refusal to act, there is actually a strong conensus that the Dollar’s slide is generally bad for the global economy, especially in the context of the nascent recovery. A cheaper Dollar not only affects the export competitiveness of countries in Asia, but is also partially responsible for surging commodity prices. There is also a general belief that volatile (perhaps unstable is a better word) exchange rates are not conducive to economic and financial stability.

At this point, it doesn’t seem likely that either the G7 or the G20 will take the extreme step of intervening on behalf of the Dollar, which remains well below the record lows of 2008. If the Buck continues to slide, however, especially to the point where its role as global reserve currency is in jeopardy…well…that is a different story, and fodder for next year’s meetings, which will be held in Canada. Then again, it may be taken up by the G4, a still-hypothetical group which would consist of the US, China, Japan, and a representative from the EU. It is alos the intended subject of my next post…stay tuned!

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

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

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

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

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

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

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

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

As an unintentional extension to an earlier post (Dollar Down, Everything Else Up), I want to use this post to highlight the appreciation of gold in particular, against the Dollar. After a brief decline following the credit crisis, Gold has resumed its upward path. It has appreciated 15% year-over-year, and recently cracked $1,000/oz for the only the fourth time in history.

The general factors behind the price of gold are too broad and numerous to be captured in this post. In addition, many of these factors have little to do with currencies (including the Dollar), and thus don’t warrant much space on a blog devoted to forex. At the same time, conspiracy theorists, doomsday predictors, and even some mainstream economists have long argued in support of gold as a hedge against inflation (otherwise understood as currency devaluation). In fact, I am only posting about gold now is because that notion has become much more popular over the last few years, to the point where pundits have come to see the current appreciation almost solely in terms of the decline in the Dollar.

That’s because many of the more conventional factors – the same ones that affect prices for other commodities – suggest that gold prices should be declining. Non-speculative demand (i.e. jewelry, industry) remains subdued as a result of the economic recession. Speaking of which; while there is now some evidence of recovery, it is nowhere near robust enough to support a return to bubble prices. In addition, the International Monetary Fund (IMF) just approved a massive sale of its gold reserves, equivalent to 15% of the world’s annual gold production.

Yet the price of gold remains not only stable, but positively buoyant. According to analysts, this is because of an increasing sense of anxiety about the viability of the Dollar as the world’s reserve currency. Euro Pacific Capital’s Peter Schiff, an effusive source of commentary on the markets, believes the price of gold will skyrocket to $5,000 per ounce. “Schiff’s forecast is based on his view the U.S. dollar is going to collapse under the weight of our massive deficit and reckless policies of the Obama administration, which he compares to the massive spending programs of the 1960s, which paved the way for gold’s ascent in the 1970s.”

Other analysts take Schiff’s view one step further by arguing that a shortage of viable alternative reserve currencies (Euro, Yen, Pound, Yuan, etc are plagued by similar fundamental flaws as the Dollar) makes gold the best candidate to replace the Dollar. Some people even hold the extreme view that the entire fiat monetary system will collapse, with the result being a barter system centered around gold. In any event, people are nervous: “That means a growing number of investors, traders — and, most troublingly, foreign governments — don’t believe in the strength of the U.S. dollar, analysts warn. People buy gold when there’s fear.”

On the other hand, it seems reasonable that gold is appreciating for the same reason that everything else is. In this sense, rising gold prices are hardly remarkable. Silver and platinum, for instance, have risen nearly 50% year-after-year, despite similarly weak fundamentals. There is a danger in connecting the Dollar’s decline too closely with the rise in gold, since the former is largely a function of short-term factors such as low interest rates and increasing risk appetite. “With the Fed confirming that interest rates could be steady for a long time, the dollar may continue to be dumped in favor of higher yielding currencies, which may favor the yellow metal.”

While there’s reason to be alarmed or even angry about deficit spending, quantitative easing, money printing, and unsustainable debt, there’s very little to support the notion that inflation is taking hold.  In fact, based on both Treasury bonds and inflation securities, inflation is the last thing on the minds of investors. In addition, while gold represents a conceptual reserve commodity, it’s not very practical. It has very little utility (especially compared to other commodities), and its supply can be easily manipulated by producers and central banks. One analyst explains, “Even a rather wobbly reserve currency is better than gold. Gold is far less liquid than U.S. Treasury securities, costly to store and insure, and above all more volatile in price.”

Still, perception is reality in financial markets. If investors want to see a connection between a weak Dollar and strong gold, they will simply contrive one. But if the Fed raises interest rates and/or the Dollar stabilizes, you can expect gold prices to follow suit. If this happens, it won’t imply that confidence in the Dollar has been restored. Instead, it will only imply that investors can earn a higher return investing in Dollar-denominated assets and no longer need to speculate in gold.

Since March, the financial markets have been characterized by several generalizable trends, which can pretty accurately be distilled into the title of this post: Dollar Down, Everything Else Up. To illustrate just how intertwined these two trends are, consider that on the same day, “U.S. stocks rose, sending the Standard & Poor’s 500 Index to an 11-month high,” and “The dollar slid to an almost one-year low.” Two perfect to be a coincidence. Look at the charts below, which show the performance of the US Dollar and Emerging Market Stocks, respectively. Subtract out the stochastic fluctuations, and you’re left with two mirror images!

In this case, connecting the dots is not difficult. In fact, I don’t know of any analyst that has argued against an airtight inverse correlation between the Dollar and virtually every other commodity/security/currency. A solid explanation can be found in an earlier Forex Blog post “Dollar Under Pressure on All Fronts,” which detailed both the short-term and long-term drags on the Dollar, but I’ll summarize and expand upon it below for those of you who didn’t read the first iteration.

In the short-term, the Fed’s easy monetary policy is one of the most salient factors. It has injected more than $2 Trillion in US capital markets since the start of the credit crisis, and lowered interest rates close to 0%. In fact, the Dollar is now the cheapest funding currency in the world, recently eclipsing Japan, the perennial home of cheap capital. Moreover, US rates are expected to remain low for the near future. According to one analyst, “Congressional elections in November 2010 represent a strong incentive for the Fed to stand pat. That is because going into an election, there often is political pressure to keep rates low and give a boost to the economy.” This belief is reflected clear in US Treasury rates, which remain relatively close to the all-time lows touched in 2008.

In other words, it’s a classic carry trade scenario, with the US footing the bill. Of course, there’s a twist, namely that there’s so much cash floating around the system, that all of it can’t be invested abroad. Hence, the whopping 58% rise in the S&P 500, from trough to present, as well as the recovery in gold, oil, and other commodity prices. You will find plenty of analysts who point to impressive graphs and quote equally impressive statistics to explain these seemingly distinct instances of appreciation. But from where I’m standing, the fact that everything is under the sun (except for real estate, but that’s another story) is rising would lead the proverbial alien watching from outer space to conclude that investors have adopted a bubble mentality, and are once again chasing returns wherever they can be found.

The strongest support for this explanation can be seen in the fact that signs of US recovery have not been accompanied by Dollar strength. By most estimations, the US economy is now stronger (despite the employment picture) than the UK and the EU, at the very least. Yet the Euro and British Pound have far outpaced the Dollar over the last few months, picking up steam once again over the last few weeks.

You don’t need me to tell you that this is a product of risk aversion; that, ironically, signs that the US economy is strengthening/stabilizing causes investors to move capital out of the US economy. If investors were betting on fundamentals, as stock market bulls would have you believe, this would be plain irrational. But the fact is, US economic growth makes investors more confident in global growth, and causes them to turn towards more speculative investments to achieve yield.

In analyzing whether this phenomenon is sustainable, then, it doesn’t make sense to look at the different markets, in isolation. Rather, you must be holistic in your approach, basically by examining whether investors are justified in their overall complacency. If ever it was the case, it certainly is now: perception is reality.

I concluded a recent post with a reference to the X-factor in forex markets: the US National Debt. In fact, the surging debt is only one of several factors that is exerting downward pressure on the Dollar, though it is perhaps the one that receives the most attention, and it probably represents the most pernicious threat to the Dollar’s long-term viability as the world’s reserve currency.

It’s difficult to say for sure how large the federal government debt currently is, and even more difficult to forecast. We can begin by looking at gross debt (Treasury securities) outstanding, which is around $11.4 Trillion. Since half of this represents intra-governmental debt, debt owed to external parties is probably about $6 Trillion. Going forward, meanwhile, the latest government projections indicate a $9 trillion increase over the next decade, touching a whopping $20 Trillion in 2020. In absolute terms, it would smash all previous records, while in real terms (as a percentage of GDP), it would be the largest increase since World War II.

Over the long-long-term, the growth in national debt is projected to be catastrophic, as the baby boomer retirement leads to an explosion in entitlement spending. The resulting strain on the system is summarized by the Government Accountability Office: “Without changes, spending for Social Security, Medicare, and Medicaid would permanently and dramatically increase the Government’s budget deficit and debt, leading eventually to renewed financial and economic instability.”

For simplicity’s sake, let’s ignore the politics of deficit spending and national debt expansion, and focus on the implications for the Dollar. “Major investors like Berkshire Hathaway Inc. Chairman Warren Buffett and bond investment firm Pimco fear the government’s fiscal and monetary stimulus programs could end up fueling inflation in coming years and hammering the dollar.” Buffet’s prognosis is grounded in the beliefs that government will be too timid to raise taxes, and that growth in new Treasury issuance will outpace investor buying capacity. In other words, even if we make the (dubious) assumption that Central Banks remain committed to holding US Treasuries, their needs/finances will constrain their collective ability to absorb more than a fraction of new debt.

The result, predicts Buffet, will be a calculated political preference for inflation: “Legislators will correctly perceive that either raising taxes or cutting expenditures will threaten their re-election. To avoid this fate, they can opt for high rates of inflation, which never require a recorded vote and cannot be attributed to a specific action that any elected official takes.” If this (potential) inflation is not accompanied by higher interest rates, it would erode returns on US investments, and by extension, interest in the Dollar.

Ironically, the Dollar is being driven down in the short-term because inflation (and crucially, interest rates) are too low. In fact, the Dollar is now the cheapest currency in the world to borrow, since the Dollar LIBOR rate fel below than the corresponding Japanese rate for the first time in 16 years. “The historic shift — and the decrease in the three-month dollar Libor — underscores how global financial markets are now awash in liquidity, especially dollars, as central banks have flooded their economies with low rates and cheap financing.”

This pessimism in the Dollar has been accompanied by a search for an alternative, with all parties so far coming up empty-handed. The Euro is a logical choice, but mounting economic and political problems equate to high levels of uncertainty. The Chinese Yuan has also been proposed, but its capital markets and economy remain too opaque for it to be taken seriously as a reserve currency. The final possibility is the Japanese Yen, which is characterized by a perennial stability and transparent capital markets. Unfortunately, Japan’s economy is both too small and too weak for the Yen to be a serious candidate. Not to mention that its national debt already exceeds 170% of GDP and its looming entitlements crisis will make America’s look mild in comparison.

In short, it looks like investors are stuck with the Dollar – for now at least. Actually, a rise in interest rates would alleviate both the short-term and long-term pressures on the Greenback, by making it more expensive to short, and offering a higher risk-adjusted return for investors concerned about the ever-increasing national debt. But, this could create a whole new set of economic pressures, and make US investments just as unattractive in nominal terms. Sounds like a lose-lose currency.

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

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

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

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

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

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

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

Only two weeks ago, analysts were singing about a new day for the Dollar, which had risen on the basis of good news for the first time in months. In hindsight, it looks like such talk was premature, as the Dollar has returned to its old ways. Good news once again causes the Greenback to fall, while bad news causes it to rise.

This development (or lack thereof) suggests that investors may have gotten ahead of themselves, when they sent the Dollar surging after the employment picture brightened slightly. At the time, the news was interpreted as a sign that rate hikes were imminent. On a broader level, it was a sign that investors had dumped the paradigm of risk aversion, in favor of a model based on comparing economic fundamentals. Since then, investors have slowly moved to distance themselves from the notion that the Fed will soon hike rates, and in the process have moved back towards trading based on risk dynamics.

As a result, positive news developments over the last couple weeks have coincided both with a rise in equity prices and a decline in the Dollar. When the Chinese stock market collapsed one day last week, investors responded by dumping high-yield assets, and moving temporarily back into “safe haven” currencies. “Diving Shanghai Helps Dollar” read one headline. “Worries over the continued fragility of the world economy outweighed a firmer tone in overseas equity markets to underpin the U.S. dollar versus major counterparts,” explained another report.

Meanwhile, a divide is forming among fundamental analysts. There is one school of thought which argues that the US will be the first industrialized economy to recover, and hence the first to raise rates. Based on this line of reasoning, then, positive economic news provides a foundation upon which to buy the Dollar. A competing school of thought, meanwhile, has suggested that regardless of if/when a US recovery materializes, it will be overshadowed by out-of-control inflation. In this regard, then, the Dollar is not such an attractive buy.

No less than the venerable Warren Buff has insisted that the Fed’s quantitative easing program and the US economic stimulus plan – while necessary – threaten to create even bigger problems than the ones they purport to solve. “But enormous dosages of monetary medicine continue to be administered and, before long, we will need to deal with their side effects. For now, most of those effects are invisible and could indeed remain latent for a long time. Still, their threat may be as ominous as that posed by the financial crisis itself,” he said.

If this true, then the Dollar is damned either way. Damned in the short-term as a result of a pickup in risk appetite, and damned in the long-term due to inflation.

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

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

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

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

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

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

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

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

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

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

As reported today by the Mortgage Calculator and other sources, the US housing market could be in the early stages of recovery. “Nationwide, home resales in June are up 9 percent from January, on a seasonally adjusted basis. Sales of new homes have climbed 17 percent during the same period. And construction, while still anemic, has risen almost 20 percent since the beginning of the year. Even home prices, down one third from the top, edged up in May, the first monthly increase since June 2006.” While the data is certainly susceptible to overly optimistic interpretation, these represent positive developments by any standard.

Before I lose the forex traders out there who probably think that they logged on to a housing blog by mistake, I’d like to point out that the release of this data coincided with a marked decline in the value of the Dollar, which “hovered near its 2009 low against the euro on Tuesday as a surprisingly strong U.S. housing report suggested the recession was waning.” This sound-byte encapsulates two important relationships: between forex and housing, and between housing and the economy. The former is indirect, while the latter represents a direct connection.

In a vacuum, forex traders probably couldn’t care less about housing data. Between interest rates, economic performance, geopolitics, risk appetite, financial markets, there is enough fodder to overwhelm most amateur analysts. Housing, then, is only important insofar as it bears on one of these “primary” forex factors. However, given the increasing role of housing in the US economy, perhaps it should itself be elevated to the top tier.

Let me explain: when the positive housing data was released last week, financial markets rallied, led by a “4.5% leap in the Dow Jones U.S. Home Construction Total Stock Market Index.” This immediately carried over into forex markets, as investors sold the Dollar en masse. “The market was desperate looking for direction, and a number like this is giving the market a small lift,” offered one analyst.

“The dollar remains vulnerable to good economic news,” summarized another. At face value, it might seem somewhat ironic that the Dollar is now inversely related to US economic performance. From the collective standpoint of investors, the US economic recovery is simultaneously indicative of and less interesting than a global recovery, and an improved environment for risk-taking. This tends to manifest itself in the form of a shift of funds away from safe-haven currencies is riskiery alternatives. In short, pay attention to the US housing market (data); the Dollar hangs in the balance.

There was never much doubt about the underlying causes of the credit crisis. Basically, combination of low interest rates and lax regulation fueled a leveraged credit expansion, which exploded spectacularly last fall. The main issue has always been how to ensure such a crisis doesn’t ever happen again- at least not on the same scale. Towards that end, policymakers around the world have been busy over the last few months conducting hearings and soliciting expert testimony, and are now close to passing sweeping overhauls of their countries’ respective financial systems.

Well, maybe sweeping is too strong of a characterization. In any event, big changes are underway. The US government is leading the way, in attempting to strip the Federal Reserve Bank of its power to regulate consumer finance, but is compensating the Fed by handing it the authority to “oversee large financial institutions…The overhaul would also give the Fed a seat on a new council charged with guarding against financial-market meltdowns like the one that hit the banking system last year.”

Another bill that is currently working its way through Congress would enable the “Government Accountability Office to ‘audit’ the Fed’s decisions on monetary policy.” It’s unclear what exactly that would entail, but at the very least, it would remove some of the Fed’s independence. Already, the Fed is making an effort to increase its transparency, by expanding its interactions with the public beyond the “brief, cryptic statements that analysts busily decode in the days that follow” monetary policy decisions.

The most significant change, especially as far as currency traders and interest rate watchers are concerned, is the potential expansion of the Fed’s mandate, which is currently to “promote ‘full’ employment…while maintaining ‘reasonable’ price stability.” Future monetary policy, however, could be conducted with broader aims: “The Federal Reserve seems to be volunteering to be top bubble burster. In a recent speech, Bill Dudley, the president of the Federal Reserve Bank of New York, overturned more than a decade of Fed orthodoxy by claiming it was the central bank’s duty to defuse asset price bombs before they detonate.” While this declaration has earned plaudits from some economists, it comes with the caveat that asset bubbles could be difficult to identify and even more difficult to defuse. One has proposed that “Regulators develop a small set of measures of irrationality that can be calculated and published at least monthly,” but it seems unlikely that this will be implemented anytime soon.

Changes are also expected across the Atlantic: “Britain’s Conservative Party, likely to form the next government, wants the Bank of England to be in charge not just of interest rates, but also the two big tasks of regulation: guarding the overall system’s stability (‘macro-prudential regulation’, as it is known) and the ‘micro’ supervision of individual firms.” As part of their proposal, the much-maligned Financial Services Authority, would be eliminated.

Of course, no one knows for sure the extent to which the system will reformed, nor whether it will be successful. Conceivably, tighter regulation could be accompanied by equally tight monetary policy. Already, the hawks have begun to grouse “that the Fed might need to raise interest rates in the ‘not-too-distant future’ to fight inflation.” Not-too-distant indeed if the Fed also needs to keep a lid on asset bubbles.

After a brief pause, China’s foreign exchange reserves have resumed their blistering pace of growth: “The reserves rose a record $178 billion in the second quarter to $2.132 trillion, the People’s Bank of China said today on its Web site. That dwarfs a $7.7 billion gain in the previous three months.” Considering that the global economy remains embroiled in the worst recession in decades, this is frankly incredible. [Chart below courtesy of WSJ].

As far as currency traders are concerned, this development has two important implications, the first of which concerns the Chinese Yuan (also known as RenMinBi or RMB). A quick parsing of trade and capital flows data reveals that the majority of the $178 Billion came from unconventional sources. “The trade surplus was $34.8 billion in the second quarter and foreign direct investment was $21.2 billion.” Currency fluctuations (i.e. the depreciation in the Dollar relative to other major currencies) can explain a small portion, “leaving the bulk of the increase in the reserves unaccounted for.”

In short, most of the capital now flowing into China is so-called “hot money,” chasing a piece of the action in China’s surging property and stock markets. The benchmark stock index has risen 75% this year, making it the world’s best performer. In short, China is once again “caught in a squeeze similar to the one that bedevilled policymakers earlier this century, with a flood of hot money trying to force the government’s hand on the currency.” Either it allows the RMB to resume its upward path against the Dollar, or it raises interest rates rapidly to head off inflation. With the money supply now growing at an annualized rate of 30%+, the government is running out of time on this front.

The second implication concerns the composition of China’s reserves. You can recall that in recent months, Chinese officials have become more vocal about ending the Dollar’s role as the world’s reserve currency, and have even taken token steps towards achieving that goal. But the latest analysis suggests that when push comes to shove, China is still firmly behind the Dollar: “Estimates suggest around 65% of China’s official holdings are in U.S. dollar assets, and the remainder are denominated in euro, yen, sterling and other currencies. This mix has been relatively stable as the Chinese government continues to place the bulk of its reserves in U.S. Treasury securities.”

In fact, “stable” is an understatement. While other Central Banks are gradually paring their holdings of US Treasuries, China is adding to its own stockpile. Already the world’s largest holder of Treasuries, China added another $38 billion in May, for a total of $800 Billion. “On the contrary, Japan, Russia and Canada were sellers of US assets in May. Japan, the second-biggest international investor, reduced its total holdings by $8.7 billion to $677.2 billion.” Meanwhile, Zhou XiaoChuan, governor of China’s Central Bank has endorsed the current composition of reserves: “Despite the $800 billion in U.S. Treasuries, it is a diversified portfolio overall.” This certainly represents a step backwards for Mr. Zhou, who only a couple months ago was leading the charge for a global reserve currency.

Perhaps over the longer-term, it can begin to take steps to dislodge the Dollar, but for now, it appears that China has accepted the status quo. As one analyst observed, “We do expect China to increase its purchase of gold and other commodities over time, but these markets are just not big enough to make a meaningful dent in the structure of the overall FX holdings. For example, if China decided to hold 5 percent of its current $2 trillion reserves in gold, it would need to buy …the equivalent to about one year of world production. For other hard commodities, the cost of storage is high and prices fluctuate wildly.”

China did recently appoint a new official (an economist trained in the US) to manage its reserves. “The move isn’t likely to fluster foreign-exchange markets or herald any change in China’s exchange-rate policy and reform.” Still, Chinawatchers are advised to continue to monitor the situation closely for any signs of discontinuity.

There is a pattern in the following smattering of forex soundbites: “It feels like we’re already in the summer doldrums;” “[We] are moving into summer trading;” “We are in a summer period.” From three different analysts, three identical conclusions- summer has arrived.  Granted, summer officially began on June 21, but given all that’s transpired since last summer, I think we can excuse investors from delaying their summer vacations this time around by a few weeks, until the kickoff of second quarter earnings season.

Summer usually means a couple things for the financial markets: less liquidity/volume and less fluctuations. The decline in volume is largely self-explanatory, due to what can best be summarized as more play and less work. The decline in volatility is due to a different, but related cause, which is a delay in important investment decisions until the fall, when traders return to their desks and resume monitoring the markets full-time. Both phenomena tend to cause asset prices to move sideways.

This is especially true for forex markets. “Traders noted major currency pairs remain largely range-bound…Markets for now are hung up by uncertainty over the shape of any future economic recovery, he said. Economic data at this point ‘can be spun either way,’ likely leaving currency markets next week to key off of any earnings surprises from U.S. companies,” observed one analyst. As far as the decline in volume is concerned, “Emerging markets are becoming particularly volatile as liquidity declines over the summer period,” and “Bid-offer spreads are quite wide.”

Kathy Lien, of Forex 360, has observed another summer trend: “Over the past 10 years, the Canadian, Australian and New Zealand dollars have seen their steepest slides in the month of July. In addition, we have seen the U.S. dollar outperform the Canadian and New Zealand dollars 8 out of the past 10 years during this month.” This could be a byproduct of delayed allocation, as investors shift capital out of risky markets/positions/currencies. The lesson might be to stick to the majors.

Based on all current indications, this summer will be no exception to this rule. While investors have certainly grown more complacent about risk over the last few months, there is a lingering uncertainty. “Economic data at this point ‘can be spun either way,’ likely leaving currency markets next week to key off of any earnings surprises from U.S. companies.” Even with across-the-board positive earnings results, investors will likely remain wary and could hold off on taking any risky (overseas) positions until the fall.

Over the last few weeks, the stock market rally has fizzled and commodities prices have cooled off. It’s not clear what triggered this sudden surge in introspection (I would call it reasonableness). Regardless, the markets are now wondering out loud whether the optimism of the second quarter wasn’t a bit naive.

After all, there still isn’t any evidence that global economy has turned a corner. Virtually all of the economic indicators that matter are still trending downwards. In addition, the apparent stabilization in housing prices could prove temporary, as banks move away from loan modifications and back towards foreclosure. Rumors that the Obama administration are considering a second stimulus plan are already circulating

With second quarter corporate earnings season set to kick off next week, investors are once again bracing for the worst: “Given the strong performance of stocks relative to March lows, a reality check from earnings could be detrimental to risk appetite.” Adds another analyst, “It’s renewed risk aversion, triggered by mounting doubts about a near-term economic recovery that’s evident in the sell-off on Wall Street and the subsequent decline in risk assets in general.”

This pickup in risk aversion is also manifesting itself in forex markets, via the upturns in both the US Dollar and Japanese Yen: “The prospect of a slow and bumpy recovery remained the overriding driver of market sentiment and the dollar was soon reasserting itself as the currency of choice – apart from the yen.” Ironically, negative economic data that applies directly to the US is benefiting the Dollar, which goes a long way towards explaining the current market orientation. Currency traders have yet to turn towards comparative growth differentials (despite the predictions of some analysts) and remain firmly focused on risk. Meanwhile, “The yen rally has extended, driven by the liquidation of long-risk asset positions.” In other words, the carry trade has come under pressure as investors move back into low-risk government bonds.

The “uncertainty” narrative will likely continue to drive the markets for the near-term, as neither the optimists nor the pessimists have the data to support their respective positions. In all likelihood, the markets will trend sideways and safe haven currencies will see a slight inflow, until there is confirmation that the economy is firmly on the path to recovery.

The debate over US inflation continues to be waged- in academic circles, among economists, and in the financial markets. There is no still no clear consensus as to the likelihood that the inflation will flare up at some point, as a result of the Fed’s easy monetary policy and the government’s record budget deficits. While the unprecedented nature of this crisis means that such a debate is still a matter of theory, that hasn’t stopped both sides from weighing in, often vehemently.

Admittedly, the risk of inflation in the short-term is still low: “With so much of the world ensnared by the economic downturn, demand for goods and services is weak, which tends to push down prices. Amid high unemployment, workers are in no position to demand wage increases.” Still, the Consumer Price Index (CPI) is already creeping up. The Fed’s “core” measure, which excludes food and energy prices, rose 1.8% from a year ago. If commodity prices continue to rise, the total CPI could soon become positive. (It currently stands at -1.3%).

Among academics and economists, the discussion is being framed relative to the Fed; specifically, can it – and more importantly, will it – move to unwind its quantitative easing program when the time comes? “If it acts prematurely to reduce the money supply, the Fed could stifle the recovery. If it waits too long, it could contribute to a jump in inflation. Its timing is going to have to be perfect,” says a former Fed economist.

This question remains divisive, as evidenced by the ongoing feud between the chief economist at Morgan Stanley and his counterpart over at Goldman Sachs. MS is concerned that the Fed will leave rates too long. According to one of his supporters, “The Fed absolutely has the tools and know-how, but the question is, will they have the guts to use them? I don’t think there is a snowball’s chance in hell they will be willing to tighten to slow inflation down.” Counters the GS camp: ““The Fed will be able to contain inflation pressures through a combination of raising interest rates and unwinding its balance sheets.”

All of this talk seems premature when you consider that the money supply is barely growing, despite the Fed’s QE program: “M2, a gauge that includes savings and checking accounts, is 4.7 times the base cash supply, down from 9.3 times a year ago.”

“Of the $2.1 trillion that the Fed is injecting into the financial system, more than half, or 51 cents per dollar, is being posted back at the central bank by financial institutions in the form of excess reserves, a record high.” In other words, most of the Fed’s cash is not actually finding its way to consumers.

Financial markets are equally ambivalent, although erring on the side of caution. Treasury yields on the long end of the curve have risen over the last few months, though this can be attributable to several causes. More specifically, “The spread been nominal 10-year Treasury yields and comparable-maturity TIPS yields has increased from approximately 0.25% at the start of the year to 1.65% currently, reflecting a 1.4% increase in expected CPI inflation over the next decade.” Based on this, it’s clear that while investors don’t share the doomsday pessimism of inflation hawks, they are nonetheless growing increasingly concerned.

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

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

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