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.”

Of course, the Bank of England is doing its part to try to help the economy along: The minutes from its last meeting showed that the BOE “voted unanimously to keep interest rates at a record low of 0.5 percent and maintain its 125 billion pound quantitative easing programme, minutes showed on Wednesday.” Experts reckon that the BOE will probably continue to keep rates low. Unemployment remains high and output will likely remain well below its potential well into any economic recovery. One analyst argues, “Even if the recession is now over, inflation could keep falling until mid-2011. Which means that it should be below its 2 per cent target in late 2011 and early 2012. Because Bank rate is set with regard to where inflation will be in two years time - as it takes that long for monetary policy to significantly affect prices - this points to rates staying low for at least a few more months.”

But the Bank’s rate cuts are being offset by the Pound’s recent 15% rise- its strongest quarterly performance in over 20 years. Based on some models, such a dramatic rise is equivalent in force to a 4% hike in interest rates. The quantitative easing program is also beset with problems, namely that 50% of the newly printed money has been used to purchase assets/bonds from foreign investors, which are more likely to take the money out of the British economy.

The government, meanwhile, is probably out of options, and may have to even unwind some of its fiscal stimulus due to lack of funds. In fact, the “deterioration in the U.K.’s public finances…prompted Standard & Poor’s to warn on May 21 that the country could lose its AAA debt rating. The firm estimated the cost of propping up Britain’s banks at 100 billion pounds ($166 billion) to 145 billion pounds and said government debts could double to almost 100 percent of gross domestic product by 2013.” The budget deficit in 2009 alone could surpass 15%.

In short, there is potentially more downside than upside to these efforts, especially as far as the Pound is concerned. The BOE’s easy money policy makes the Pound an unattractive buy in the short term, while its QE program could stoke inflation in the long-term, without much benefit to the economy. Furthermore, it will be difficult to rein in this program because of the perennial budget deficits of the government, which “must sell about 900 billion pounds of gilts over five years…The Bank of England will buy a third of these gilts.” The recent rise in government bond yields as well as the rising cost of bond insurance (i.e. credit default swap premiums) confirm that investors are growing increasingly nervous. According to a Harvard University historian, “The probability of a real sterling crisis is around one in three.”

Still, there are optimists. Says one analyst, “The U.K. economy’s heavy dependence on the finance sector, recently seen as a big flaw, has also turned into a benefit. ‘Sterling is basically a bet on global financial well-being.’ ” Also, “Foreign demand for gilts rose to an all-time high in the first quarter of this year as concern the world economy would stay mired in a recession drove investors to the relative safety of government securities.” But these notions are somewhat contradictory. When you map these ideas against the backdrop of the Pound, you can see that is benefited primarily from the perception of recovery- not from the safe-haven perception.

These optimists believe the Pound will rise as high as $1.80 against the USD and €1.40 against the Euro. Under the best-case scenario, quantitative easing and government spending will trickle down to the bedrock of the economy, and will be unwound immediately after the economy enters a recovery period so as not to spur inflation. Under the worst-case scenario, though, the government will continue to run large budget deficits and fail to find enough buyers for its debt. The resulting stagflation would cause investors to rush for the exits and for the currency to collapse. In all likelihood, the actual outcome will fall somewhere in between.

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

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

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

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

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.

That was until this week, when the SNB sprung into action, buying Euros on the open market. “The franc slid as much as 2.4 percent versus the euro and 3.3 percent against the dollar, the biggest declines since…March 12.” It’s not clear why the SNB suddenly intervened after months of inaction. The Central Bank didn’t hold a press conference to “celebrate” its intervention, and the only indication was a vague declaration last week that “policy makers will act to curb any ‘irrational appreciation’ of the franc.”

Analysts have speculated that the SNB is (arbitrarily) targeting the exchange rate of $1.50 Francs/Euro, which is plausible given that the intervention occurred very close to that level: “They’re trying to put a line in the sand at 1.50. There’s a big debate as to whether they will continue doing this, and for how long they will remain successful.” After all, the idea of intervention is more effective than intervention itself. The SNB can only buying so many Euros; the real value is in the threat to continue buying, which keeps investors from building up speculative positions.

While the SNB has been criticized as “protectionist” for its actions, its premise for intervention is well-grounded. According to the OECD, “Switzerland should keep interest rates close to zero well into 2010 and mull more fiscal stimulus to fight a deep recession and the risk of deflation.” Modest deflation has already set in, facilitated by a collapse in aggregate demand. Varying forecasts are calling for an economic contraction in 2009 equal to -2.5%-3%, and even a modest contraction to follow in 2010. Q1 GDP growth was negative and the consensus is that Q2 will prove to have been more of the same. If this trend continues, 2009 will be the worst year economically in over 30 years. Still, economic indicators suggest the bottom is soon approaching, and the overall picture is consistent with the rest of Europe.

The real concern is that other Central Banks will imitate the Swiss approach. “In the past couple of weeks we have had five or six central banks, including the Bank of Canada and the Bank of England, talking down their currencies. Like Switzerland, they are fearful that currency appreciation could offset the stimulus to the economy,” noted one analyst. Monetary and economic conditions remain abysmal worldwide, and most banks have already exhausted the tools available to them. Interest rates are universally close to zero; fiscal “stimuli” will push the OECD debt/GDP ratio past 100% in 2009; quantitative easing has given rise to wholesale money printing. Currency devaluation may be the only option left.

Around the peak a couple weeks ago, the Forex Blog reported that emerging market stocks had become quite expensive, relative to historical P/E ratios. It’s hard to say whether investors were/are operating under similar assumptions when the market pulled back, or rather if they have been driven by other factors. This is because emerging market currencies, like many other asset classes, have experienced a disconnect from fundamentals of late, such that the ebb and flow of risk aversion - rather than any substantive developments - now dictates the movement of asset prices.

Analysts looking for clues into why specific currencies were rising against the Dollar ignored the fact that virtually all currencies were rising, albeit some more than others. In other words, it was a Dollar-negative story as much as it was an emerging markets story. Likewise, risky investments are losing value across the board now that risk aversion is back in fashion, not because of a perceived change in emerging markets growth potential.

Still, there is much to be nervous about. Latvia still hasn’t dealt with its currency, which some experts think needs to be devalued by as much as 50%. Turkey has yet to sign a loan agreement with the IMF. Russia’s benchmark stock index fell 20% in one day. One of the best proxies for risk levels are credit default swaps, which function like insurance on bonds. If a company/country were to default on its bonds, a holder of a credit default swap contract would be compensated by the writer of the contract. Suffice it to say that credit default swap premiums, especially on emerging market debt instruments, are once again rising, as investors become more worried about the possibility of default.

Generally, the Yen is viewed as one of the most viable currencies during periods of heightened risk aversion. So is the Dollar for that matter, but the Yen has less baggage, vis-a-vis quantitative easing, etc. Sure enough, the Yen has pulled back tightly of late, rising almost 3% in one day against the Euro alone. [In the current market environment, I think it makes more sense to compare the yen with the Euro, since the two currencies are viewed as fulfilling different purposes for currency traders. The US Dollar, in contrast, is currently being driven by some of the same themes as the Yen, which can make it difficult to use this pair to distill changes in risk appetite.]

In short, as the global economy reaches a critical phase in the recession, investors will be looking for confirmation, either that a recovery is nearby or still far away. Right now, the consensus seems to have swayed towards the “recovery is faraway” side. However, a sudden uptick in a widely-watched economic indicator could send the pendulum swinging right back in the opposite direction.

Generally speaking, there are a few situations in which currency hedging is useful: international equity/bond investing, currency investing/trading, and inflation hedging. The latter typically involves using commodities/metals to hedge against inflation, which is typically proxied by the Dollar. In other words, inflation hawks might buy gold/oil to offset a declining Dollar. This dynamic is currently on display in commodities markets, where “Speculative money has increased oil’s sensitivity to dollar movements, and if the dollar continues to strengthen, this will weigh on prices.” This type of hedging, however, is probably the most nuanced, and I will set it aside it for another post.

Hedging indirect exposure to currencies (from overseas investments) involves the separation of currency risk from credit/equity risk. In other words, if you are an American invested in a European stock, you may wish to hedge against fluctuations in the Euro (which impact you insofar as the stock is priced in and pays dividends in Euros, but your account is denominated in Dollar), so that you are exposed only to fluctuations in the stock, itself. Simply, this would involve selling Euros simultaneously with buying the stock; the amount of Euros that you sell depends on what level of exposure to currency risk you are comfortable with. If you buy $100 worth of stock in a European company and buy $100 USD/EUR, then you are fully hedged.

Hedging direct exposure to currencies is inherently more sophisticated. For example, if you sold $100 EUR/USD, you can’t hedge your position by simply buying EUR/USD, or you will negate any return without changing the level of risk. Instead, you can use financial derivatives (options, forwards, futures, swaps), which if executed properly, are tantamount to buying insurance on your portfolio. For example, if you are long the Dollar, you can buy put options in order to protect yourself from significant downside. Likewise, if you are short the Dollar, you can buy calls to achieve the same end.

The advantage of options is that strategies can be as complex as you want; likewise, they can be as simple as buying calls or selling puts. Other derivatives, however, have another component: carried interest. Since forwards/futures/swaps are all contracts (an option represents a right, other derivatives represent obligations), they are priced to take short-term interest rate differentials into account. Simply put, “For currencies with high short-term interest rates, there is a positive “carry” associated with hedging, while for currencies with low short-term interest rates, the “carry” is negative.”

I pulled that snippet from a study on currency hedging that I read recently. According to this report, “For most base currencies, over most periods, hedging seems to have reduced the volatility of international equity portfolios.” [See chart below]. However, while hedging seems to reduce risk, it doesn’t necessarily boost return. “Again, given one man’s meat is another’s poison, one would expect the results to be distributed evenly around the horizontal axis, and that is in fact the case.” In other words, one currency’s gain is inherently another’s loss. Still, if you could maintain the same returns but limit volatility, why wouldn’t you?