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.

source

Forex Blog: I’d like to begin by asking if there is any significance to the title of your blog (”Fistful of Euros”), or rather, is it only intended to be playful?

Obviously the title is a reference to the Segio Leone film, but you could read other connotations into it if you want. I would say the idea was basically playful with a serious intent. Personally I agree with Ben Bernanke that the Euro is a “great experiment”, and you could see the blog, and the debates which surround it as one tiny part of that experiment. As they say in Spanish, the future’s not ours to see, que sera, sera. Certainly that “fistful of euros” has now been put firmly on the table, and as we are about to discuss, the consequences are far from clear.

Well, first of all, there is more than one thing happening here, so I would definitely agree from the outset, there are both cyclical and structural elements in play. Structurally, the architecture of Bretton Woods II is creaking round the edges, and in the longer run we are looking at a relative decline in the dollar, but as Keynes reminded us, in the long run we are all dead, while as I noted in the Afoe post, news of the early demise of the dollar is surely vastly overstated.

Put another way, while Bretton Woods II has surely seen its best days, till we have some idea what can replace it it is hard to see a major structural adjustment in the dollar. Europe’s economies are not strong enough for the Euro to simply step into the hole left by the dollar, the Chinese, as we know, are reluctant to see the dollar slide too far due to the losses they would take on dollar denominated instruments, while the Russians seem to constantly talk the USD down, while at the same time borrowing in that very same currency – so read this as you will. Personally, I cannot envisage a long term and durable alternative to the current set-up that doesn’t involve the Rupee and the Real, but these currencies are surely not ready for this kind of role at this point.

So we will stagger on.

On the cyclical side, what I am arguing is that for the time being the US has stepped in where  Japan used to be, as one side of your carry pair of choice, since base money has been pumped up massively while there is little demand from consumers for further indebtedness, so the broader monetary aggregates haven’t risen in tandem, leaving large pools of liquidity which can simply leak out of the back door. That is, it may well be one of the perverse consequences of the Fed monetary easing policy that it finances consumption elsewhere – in Norway, or Australia, or South Africa, or Brazil, or India – but not directly inside the US.

This is something we saw happening during the last Japanese experiment in quantitative easing (from 2002  - 2006) and that it has the consequence, as it did for the Yen from 2005 to 2007, that the USD will have a trading parity which it would be hard to understand if this were not the case. I am also suggesting that this situation will unwind as and when the Federal Reserve start to seriously talk about withdrawing  the emergency measures (both in terms of interest rates and the various forms of quantitative easing), but that this unwinding is unlikely to be extraordinarily violent, since the Japanese Yen can simply step in to plug the gap, as I am sure the Bank of Japan will not be able to raise interest rates anytime soon given the depth of the deflation problem they have. Indeed, investors will once more be able to borrow in Yen to invest in  USD instruments, to the benefit of Japanese exports and the detriment of the US current account deficit, which is why I think we are in a finely balanced situation, with clear limits to movements in one direction or another.

Well, I would want to qualify this a little, becuase things are not that simple. In fact, as Claus Vistesen argues in this post, the ECB has rather “locked itself in” communicationally, and by  talking up the eurozone economies they now have markets expecting clear exit road maps and even pricing in interest rate rises from the third quarter of next year. But if we look at the underlying weaknesses in some of the Eurozone economies – evidently Spain, but Italy is hardly likely to have a strong robust recovery, and the German economy needs exports and hence customers to really return to growth – it is hard to see monetary tightening being applied with any kind of vigour at the ECB, so they may move up somewhat – say  to 2% – and then stop for some time.

I was also suggesting that in the short run they may do this to assist in the process of unwinding the global imbalances, since allowing the Fed to lead the world out of the monetary easing cycle would almost certainly provoke a rebound in USD, and problems for correcting the US current account deficit.

Really none of the developed economies (not even Norway) seem to be looking at the sort of really strong “V” shaped rebound some investors were anticipating, and it is more a question of who is weaker among of the weak. But if we look a little further ahead, at potential growth and inflation dynamics, then it is clear that the deflationary headwinds are stronger in Europe, while headline GDP growth may well turn out to be stronger in the US, and both these factors suggest that the Fed will at sometime be tightening faster than the ECB, in a repetition of what we saw from 2002 to 2005.

Well, actually I wouldn’t say the UK and Japan are in the same fiscal boat. Let me explain. The UK evidently has severe short term problems (as does the US) with its sovereign debt, due to the high cost of resolving the lossses produced by the current crisis. But Japan has still not resolved debt problems which were produced in the crisis of the late 1990s, and indeed both gross and net debt to GDP simply continue to rise there. So I would say – as long as they can weather the present storm – the outlook for US, UK and French sovereign debt is rather more positive than it is for Japan. Indeed in the longer term it is hard to see how Japan can resolve its problems without some kind of sovereign default. This is the problem with deflation, as nominal GDP goes down, debt to GDP simply rises and rises.

But the principal reason I am rather more positive on UK, US and French sovereign debt in the mid term is simply the underlying demographic dynamic. These countries have a lot more young people (proportionately) than the Germany’s, Japan’s and Italy’s of this world, and hence their elderly dependency ratios (which are the important thing when we come to talk about structural deficits into the future) will rise more slowly.

It is also important to realise that the EU – at this point at least – is not a single country in the way the US is, and indeed there is strong resistence among European citizens to the idea that it should be. So it is impossible to talk about the EU as if it were one country. That being said, the lastest forecast from the EU Commission suggests that average sovereign debt to GDP will breach the 100% threshold across  the entire EU by 2014, so I would hardly call the situation promising. Basically some cases are much worse than others. In the East there are countries like Latvia and Hungary which are currently implementing IMF-lead structural transformation programmes, ut it is far from clear that these programmes will work, and sovereign debt to GDP has been rising sharply in both cases. In the South a similar problem exists, with Greek gross sovereign debt to GDP now expected by the Commission to hit 135% by 2011, and Italian debt set to increase significantly over the 110% mark. At the same time the future of government debt in Spain and Portugal is becoming increasingly uncertain. I would also point to the strong gamble Angela Merkel is making in Germany, and indeed ECB President Jean Claude Trichet singled the German case out during the last post rate-decision-meeting press conference for special mention in this regard. The future of German sovereign debt is far from clear, and markets certainly have not taken in this underlying reality.

So basically, and I think I have already explained my thinking on this in earlier questions, we have a structural difficulty, since I am sure the way out of Bretton Woods II will not be found by simply substituting the Euro for the USD. Europe is aging far more rapidly than the US, and the dependency ratio problems are consequently significantly greater.

Forex Blog: Current EU economic policy seems to be favoring government spending and exports, at the expense of investment and domestic consumption. Does this imply that the current EU economic recovery is unsustainable?

I don’t think the current EU expansion is unsustainable as such, but I do think it faces tremendous headwinds. Basically one Eurozone country stands out among the rest, France, since France has a sustainable, internal demand driven, recovery, despite all the longer term issues she faces with the structural fiscal deficit. But the story begins and end there, with France. Most of the rest of the Euro Area 16 have problems, although like Tolstoy’s unhappy families, each is problematic in its own special way. Countries like Germany and Finland are heavily export dependent, and thus have had far deeper recessions than many of the rest, while countries in the South, lead by Spain and Greece, have been running sizeable current account deficits. Since financial markets are now longer willing to fund these, and the ECB isn’t prepared to support the unsupportable forever, these economies too are now being steaily pushed towards dependence on exports for growth (and for paying down their debts), and this raises the issue of where the final end demand is going to come from.  France on its own cannot supply the export surplus needs of the other 15, so external customers are needed, and this makes the value of the Euro more of an issue than it was.

Forex Blog: It seems that the reason that the the the Fed’s liquidity injections have not resulted in price inflation is because much of the funds have been plowed back into capital markets, rather than used for consumption. Given that this liquidity must at some point be pumped out by the Fed, does this imply that a “correction” is inevitable?

Yes, this is true, the global capital markets have acted as a kind of “back door” on US monetary policy, and much of the excess liquidy the Fed has been trying to pump in has simply “leaked out” via that channel. Why this should be is an interesting question in its own right, since while initially the “credit crunch” meant that funds were not available to borrow the money is now there but it is the banks who have difficulty identifying creditworthy customers given the prevailing levels of unemployment, foreclosure and bankruptcy. My feeling is that a sharp correction is not coming, unless there is a large event (Greek sovereign default, for example) in Europe or elsewhere, which leads to a sharp contraction in risk sentiment of the kind we saw after the fall of Lehman Brothers. I wouldn’t like at this point to put a figure on the probability of such an event, but the risk is evidently there.

I don’t think the risk of a correction driven by a rapid withdrawal of US liquidity is that real since I don’t think we are going to see that kind of speedy withdrawal, and even if we did, “ample liquidity” is going to be on offer over at the Bank of Japan until the cows come home. I don’t think we are going to see any precipitate removal of monetary support at the Federal Reserve, since I think exiting this situation is going to be more complicated than many imagine. The tussle which has been going on between the Japanese Ministry of Finance and the Bank of Japan over many years now may well offer a much better guide to exit issues than anything in recent US history, simply because, at least since the 1930s, the US has not been here before. Essentially it will be difficult to withdraw both fiscal and monetary support at one and the same time, but my feeling is that in the US (unlike Japan)  there may well be consensus that the fiscal issue is the most pressing one, and thus this would suggest the Federal Reserve will keep monetary conditions easier for longer, simply to provide an environment in which fiscal consolidation to take place.

Forex Blog: Given the strong economic and fiscal fundamentals of Norway’s economy, do you think currency traders will begin to pay more attention to the Kroner? Do you think it could be taken up as a reserve currency by Central Banks that have become disenchanted with the Dollar?

Well, I think they already are, and evidently the Kroner has become a favoured carry currency. But equally, I doubt the Norwegian authorities would want their country to go the same way as Iceland in the longer term, so I am not sure they would welcome central banks buying Kroner in any large quantity, since this would obviously unrealistically raise the value of the currency, and lead to serious sustainability issues in the domestic manufacturing sector. Basically, as I suggested in the previous interview, I think dollar disenchantment is now likely to be seriously tempered by concerns about Euro weakness.

Forex Blog: It seems that the financial crisis has exposed some of the problems of a common economic/monetary/currency policy for the EU. What are the implications for the future of the ECB and the Euro?

Most definitely. Following Dubai a lot of attention is now focused on sovereign debt, and on who exactly is responsible for what. We should take note of the fact that the  Greek government had to raise 2 billion euros in debt recently via a private placement with banks, against a backdrop of credit downgrades and steadily rising spreads. The ECB undoubtedly agreed to this move given the degree of policy coordination which must now exist behind the scenes, they are, after all,  the ones who are financing the Greek banks, but it does highlight just how things have moved on in recent months. Only last year it was imagined that the being a member of the Eurozone in and of itself gave protection from the kind of financing crisis Greece increasingly now faces, and this was why only eurozone non-members, like Latvia and Hungary, were sent to the IMF. Now it is clear that the ECB could keep protecting Greece from trouble for ever and ever, but they cannot simply keep financing unsustainable external deficits and continue to retain credibility. In this sense the financial crisis has now “leaked” into the Eurozone itself. And this has implications I would have thought, for countries like Estonia, who see Eurozone membership as a “save all”, whatever the price. The difficulty is that the ECB has the capacity to fund troubled countries, but it does not have the power to enforce changes.

The problem of Europe’s institutional structures was highlighted again this week when the Latvian constitutional court ruled that pension cuts included in the recent IMF-EU package are not legal. Personally I find the decision rather significant since pension reform lies at the heart of the whole structural reform programme currently being demanded of “risky” EU states by the IMF, the EU Commission and the Credit Rating Agencies. Indeed the whole credibility of the EU’s ability to manage it’s own affairs could be called into question in this case. As Angela Merkel recently said:

“If, for example, there are problems with the Stability and Growth Pact in one country and it can only be solved by having social reforms carried out in this country, then of course the question arises, what influence does Europe have on national parliaments to see to it that Europe is not stopped…..This is going to be a very difficult task because of course national parliaments certainly don’t wish to be told what to do. We must be aware of such problems in the next few years.”

So obviously, the EU authorities badly need to plug this hole in their armour, or the entire concept of having a common monetary system can be placed at risk, Angela Merkel and Nicolas Sarkozy (who are ultimately the paymaster generals) need to have the power and authority to see to it that national parliaments do what they need to do in the common interest, and they need to get this power and authority in the coming weeks and months, and not simply in the “next few years”. And Europe’s leaders need to be aware that a crisis of sufficient proportions in any one country can very rapidly become a systemic one for the Euro, in much the same way that a problem in a key bank can lead to a crisis of confidence in a whole banking system. I do not feel a sufficient sense of urgency about this in the recent pronouncements of Europe’s leaders.

Forex Blog: So from what you are saying, there is still a risk of a resurgence in the financial crisis on Europe’s periphery. Would you say another round of financial turmoil is now inevitable?

Well the risk is certainly there, and evidently Europe’s institutional structure is in for a very testing time. But no war is ever lost before the battles are fought, although what we can say is that new and imaginative initiatives are certainly going to be needed. Sovereign risk has now spread from non-Eurozone countries like Latvia and Hungary, straight into the heart of the monetary union in cases like Greece and Spain. Mistakes have been made. As I argued in Let The East Into The Eurozone Now! in February 2009, the decision to let the Latvian authorities go ahead with their internal devaluation programme never made sense, and the three Baltic countries and Bulgaria should have been forced to devalue – and the accompanying writedowns swallowed whole – and then immediately admitted into the Eurozone as part of the emergency crisis measures. Perhaps some would feel that this lowering of the entry criteria would have damaged credibility, but as I am stressing here, leaving so many small loose cannon careering around on the lower decks can cause even more issues if matters get out of hand and contagion sets in. So it is a question of pragmatism, and being able to accept the “lesser evil”.

Unfortunately, the situation has simply been allowed to fester, and in addition the much needed change in the EU institutional structure – to allow Angela Merkel the power she is asking for to intervene in Parliaments like the Latvian, Hungarian, Greek and Spanish ones, as and when the need arises – has not been advanced, with the result that we are increasingly in danger of putting the whole future of monetary union at risk. It is never to late to act, but time is, inexorably running out. As the old English saying goes he (or she) who dithers in such situations is irrevocably lost. Caveat emptor!

1. I’d like to begin by asking if there is any significance to the
title of your blog (”Fistful of Euros”), or rather, is it only
intended to be playful?

Obviously the title is a reference to the Segio Leone film, but you
could read other connotations into it if you want. I would say the
idea was basically playful with a serious intent. Personally I agree
with Ben Bernanke that the Euro is a “great experiment”, and you could
see the blog, and the debates which surround it as one tiny part of
that experiment. As they say in Spanish, the future’s not ours to see,
que sera, sera. Certainly that “fistful of euros” has now been put
firmly on the table, and as we are about to discuss the consequences
are far from clear.

2/  You wrote a recent post outlining the US Dollar carry trade, and
how you believe that the Dollar’s decline is cyclical/temporary rather
than structural/permanent. Can you elaborate on this idea? Do you
think it’s possible that the fervor with which investors have sold off
the Dollar suggests that it could be a little of both?

Well, first of all, there is more than one thing happening here, so I
would definitely agree from the outset, there are both cyclical and
structural elements in play. Structurally, the architecture of Bretton
Woods II is creaking round the edges, and in the longer run we are
looking at a relative decline in the dollar, but as Keynes reminded
us, in the long run we are all dead, while as I noted in the Afoe
post, news of the early demise of the dollar is surely vastly
overstated.

Put another way, while Bretton Woods II has surely seen its best days,
till we have some idea what can replace it it is hard to see a major
structural adjustment in the dollar. Europe’s economies are not strong
enough for the Euro to simply step into the hole left by the dollar,
the Chinese, as we know, are reluctant to see the dollar slide too far
due to the losses they would take on dollar denominated instruments,
while the Russians seem to constantly talk the USD down, while at the
same time borrowing in that very same currency – so read this as you
will. Personally, I cannot envisage a long term and durable
alternative to the current set-up that doesn’t involve the Rupee and
the Real, but these currencies are surely not ready for this kind of
role at this point.

So we will stagger on.

On the cyclical side, what I am arguing is that for the time being the
US has stepped in where  Japan used to be, as one side of your carry
pair of choice, since base money has been pumped up massively while
there is little demand from consumers for further indebtedness, so the
broader monetary aggregates haven’t risen in tandem, leaving large
pools of liquidity which can simply leak out of the back door. That
is, it may well be one of the perverse consequences of the Fed
monetary easing policy that it finances consumption elsewhere – in
Norway, or Australia, or South Africa, or Brazil, or India – but not
directly inside the US.

This is something we saw happening during the last Japanese experiment
in quantitative easing (from 2002  - 2006) and that it has the
consequence, as it did for the Yen from 2005 to 2007, that the USD
will have a trading parity which it would be hard to understand if
this were not the case. I am also suggesting that this situation will
unwind as and when the Federal Reserve start to seriously talk about
withdrawing  the emergency measures (both in terms of interest rates
and the various forms of quantitative easing), but that this unwinding
is unlikely to be extraordinarily violent, since the Japanese Yen can
simply step in to plug the gap, as I am sure the Bank of Japan will
not be able to raise interest rates anytime soon given the depth of
the deflation problem they have. Indeed, investors will once more be
able to borrow in Yen to invest in  USD instruments, to the benefit of
Japanese exports and the detriment of the US current account deficit,
which is why I think we are in a finely balanced situation, with clear
limits to movements in one direction or another.

3. In the same post, you suggested that the Fed will be the first to
raise interest rates. Why do you believe this is the case? How will
this affect the Dollar carry trade?

Well, I would want to qualify this a little, becuase things are not
that simple. In fact, as Claus Vistesen argues in this post

http://clausvistesen.squarespace.com/alphasources-blog/2009/11/13/random-shots.html

the ECB has rather “locked itself in” communicationally, and by
talking up the eurozone economies they now have markets expecting
clear exit road maps and even pricing in interest rate rises from the
third quarter of next year. But if we look at the underlying
weaknesses in some of the Eurozone economies – evidently Spain, but
Italy is hardly likely to have a strong robust recovery, and the
German economy needs exports and hence customers to really return to
growth – it is hard to see monetary tightening being applied with any
kind of vigour at the ECB, so they may move up somewhat – say  to 2% -
and then stop for some time.

I was also suggesting that in the short run they may do this to assist
in the process of unwinding the global imbalances, since allowing the
Fed to lead the world out of the monetary easing cycle would almost
certainly provoke a rebound in USD, and problems for correcting the US
current account deficit.

Really none of the developed economies (not even Norway) seem to be
looking at the sort of really strong “V” shaped rebound some investors
were anticipating, and it is more a question of who is weaker among of
the weak. But if we look a little further ahead, at potential growth
and inflation dynamics, then it is clear that the deflationary
headwinds are stronger in Europe, while headline GDP growth may well
turn out to be stronger in the US, and both these factors suggest that
the Fed will at sometime be tightening faster than the ECB, in a
repetition of what we saw from 2002 to 2005.

4. You have pointed out that fiscal problems are not unique to the
US. While the UK and Japan are certainly in the same fiscal boat,
there seem to be plenty of examples of economies that aren’t, or at
least not to the same extent, such as the EU. Do you think, then, that
the long-term prospects for the Euro (especially as a global reserve
currency) are necessarily brighter than for the Dollar?

Well, actually I wouldn’t say the UK and Japan are in the same fiscal
boat. Let me explain. The UK evidently has severe short term problems
(as does the US) with its sovereign debt, due to the high cost of
resolving the lossses produced by the current crisis. But Japan has
still not resolved debt problems which were produced in the crisis of
the late 1990s, and indeed both gross and net debt to GDP simply
continue to rise there. So I would say – as long as they can weather
the present storm – the outlook for US, UK and French sovereign debt
is rather more positive than it is for Japan. Indeed in the longer
term it is hard to see how Japan can resolve its problems without some
kind of sovereign default. This is the problem with deflation, as
nominal GDP goes down, debt to GDP simply rises and rises.

But the principal reason I am rather more positive on UK, US and
French sovereign debt in the mid term is simply the underlying
demographic dynamic. These countries have a lot more young people
(proportionately) than the Germany’s, Japan’s and Italy’s of this
world, and hence their elderly dependency ratios (which are the
important thing when we come to talk about structural deficits into
the future) will rise more slowly.

It is also important to realise that the EU – at this point at least -
is not a single country in the way the US is, and indeed there is
strong resistence among European citizens to the idea that it should
be. So it is impossible to talk about the EU as if it were one
country. That being said, the lastest forecast from the EU Commission
suggests that average sovereign debt to GDP will breach the 100%
threshold across  the entire EU by 2014, so I would hardly call the
situation promising. Basically some cases are much worse than others.
In the East there are countries like Latvia and Hungary which are
currently implementing IMF-lead structural transformation programmes,
but it is far from clear that these programmes will work, and
sovereign debt to GDP has been rising sharply in both cases. In the
South a similar problem exists, with Greek gross sovereign debt to GDP
now expected by the Commission to hit 135% by 2011, and Italian debt
set to increase significantly over the 110% mark. At the same time
the future of government debt in Spain and Portugal is becoming
increasingly uncertain. I would also point to the strong gamble Angela
Merkel is making in Germany, and indeed ECB President Jean Claude
Trichet singled the German case out during the last post
rate-decision-meeting press conference for special mention in this
regard. The future of German sovereign debt is far from clear, and
markets certainly have not taken in this underlying reality.

So basically, and I think I have already explained my thinking on this
in earlier questions, we have a structural difficulty, since I am sure
the way out of Bretton Woods II will not be found by simply
substituting the Euro for the USD. Europe is aging far more rapidly
than the US, and the dependency ratio problems are consequently
significantly greater.

source

This series of rate hikes caught (forex) markets completely off guard, and investors moved quickly to price the changes into securities and exchange rates. The Australian Dollar initially spiked more than 7% following the first rate hike, bringing its total appreciation in 2009 to 32%- enough to earn it the distinction as the second-best performing currency, after the Brazilian Real. Beginning in November, however, concerns began to build that perhaps traders had gotten ahead of themselves, and the AUD has been in freefall since then.

Investors now fear that the RBA may have acted too hastily in hiking rates so soon and so fast. By its own admission, the RBA raised rates only after much deliberation: “The rate adjustment ‘would not be intended to slow demand compared with the current forecast path, but aimed simply at keeping the stance of policy appropriate for improving economic conditions,’ ” according to its own minutes. Since the recession was ultimately so mild (some would say ‘non-existent’) in Australia, however, the RBA ultimately decided that (pre-emptive) rate hikes were in order.

Now, interest rates are back in the “normal range,” according to a deputy governor from the RBA. In other words, the current rate is perceived as neither promoting nor hindering aggregate demand, which means it may not need to be tweaked much more in the near-term. In addition, there is growing concern that further rate hikes could trigger a cycle of deleveraging, because of the high debt burdens that plague Australian households and businesses. Household debt already exceeds 100% of GDP, which is even higher than in the US.

Besides, financial institutions are raising their own lending rates by wider margins than the benchmark rate hikes, so there is less impetus for the RBA to act further. Investors appear to have come to terms with this, as futures markets now reflect a 45% probability of another interest rate hike at the next RBA meeting, in February. This is down from 67% only last week.

If you’re wondering whether the RBA could be influenced by the lofty Australian Dollar when conducting monetary policy, it’s conceivable but not probable. It has already acknowledged that the carry trade is generally “back in vogue” and specifically targeting its very own Aussie, but that “As on earlier occasions, the economy has proven to be resilient to these [forex] swings.” If it turns out that the markets truly overestimated the pace of recovery (and by extension, interest rate hikes) in Australia, then the RBA won’t even have to worry about whether the economy can withstand further appreciation, since the AUD would probably remain fixed at current levels.

source

Focusing only on the Won’s appreciation would probably cause some technical analysts to back off, while comparing it only to the highs of a couple years ago would lead others to pile in, without knowing examining other indicators. In my opinion, this is a situation in which technical analysis – because of the potential to send conflicting signals – falls short. Ergo, let’s turn to the fundamental picture.

The Korea Won has adhered closely to the overarching forex narrative. When the credit crisis struck, investors fled from Korea, and the Won lost 50% of its value practically overnight. With the return of risk-taking in the second quarter of 2009, however, the safe-haven appeal of the Dollar faded, and the Won rebounded strongly. With the potential end of the carry trade in sight, however, the Won has stuttered, and some analysts portend a decline in the near-term.

However, while many currencies will no doubt experience a correction if/when the Fed raises interest rates, the Korean Won probably won’t be one of them. Korean investments have certainly been buoyant of late, but not nearly to the same extent as in other emerging markets, where it could be argued speculative bubbles are now forming. In addition, Korean interest rates are hardly lofty; its benchmark rate is only 2%, hardly enough to justify a carry trade strategy in and of itself.

Instead, investors have been flocking to Korea for the economic fundamentals. Despite an appreciating currency, Korea’s trade surplus is on pace to hit a record Billion this year, with a healthy -20 Billion forecast for 2010. In fact, the rising Won has has virtually no effect on exports, as Korean companies had prudently assumed that the Korean Won would be even more expensive (based on 2007 levels). In the automobile industry, for example, “New models being introduced now were designed and engineered two years ago to keep the company in the black even if the won strengthened to 900 to the dollar.” For that reason, analysts expect 2010 will be a banner year for the economy. After a modest expansion in 2009, GDP is projected to grow by 4.5-5% next year, the third highest among large economies, behind only China and India.

The Central Bank of Korea is also operating as though the Won will keep appreciating, irrespective of what happens to the carry trade. In one session last week, it intervened in forex markets to the tune of 0 million, with the goal of depressing the Won. With the recent expiration of a currency swap with the Fed, this is just as well, as Dollars could soon once again be in short supply. Korean monetary policy remains expansionary, but if the economy takes off in 2010 as expected, the Central Bank will have no choice but to raise rates and keep inflation within its target range.

In addition, there is now talk of turning the Korean Won into an international currency. ” ‘Korea has the opportunity to upgrade the won’s global status as a host country of the G20 2010 Summit.’ International use of the Korean won has been insignificant, although the nation’s share in international trade and finance has increased quickly,” analysts have observed. That the government of Korea is looking to promote the Won as a stable currency implies that it is comfortable with the prospect of further appreciation.

In short, the Won will probably be one of the standouts in 2010. Many currencies will suffer as changes in global monetary policy and the appearance of asset price bubbles cause investors to back off of the carry trade and exit certain emerging markets. South Korea won’t be one of them. With strong fundamentals and a growing profile, it’s no wonder that most analysts expect the Won to appreciate by another 10% in 2010.

Given that tomorrow is the first day of 2010, we won’t have to wait long to find out! On that note, happy new year!

source

Ah, if only it were that simple…

The year began as a continuation of 2008. Global capital markets were still in the throes of the credit crisis, and risk aversion was in vogue. Investors continued to remove funds en masse from virtually every economy – with an emphasis on emerging markets – and parked the proceeds in the US. More specifically, they put the proceeds in US Treasury securities. US corporate bonds and equities declined, as did interest rates, to such an extent that short-term rates briefly dipped below zero.

As this trend gathered momentum, the Dollar continued its rally against virtually every currency, with the notable exceptions of the Swiss Franc and Japanese Yen. For reasons related both to the unwinding of the Japanese Yen carry trade and the bizarre perception that Japan was also a safe haven against the storm of the financial recession, despite the fact that its economy contracted by the largest amount of perhaps any economy due to its reliance on exports. Against other currencies, the Dollar was nothing short of brilliant, surging 30% against many emerging market currencies, and 50% against the Korean Won, from trough to peak. Some analysts predicted that it was only a matter of time before the Dollar reached parity with the Euro.

But it wasn’t to be, as the Dollar never topped .25 against its chief rival. The markets pulled an abrupt about-face in March, and began a rally that would last 8 months (and might still be in progress, depending on who you talk to). The S&P 500 rose by more than 50%, impressive, but still paling in comparison to emerging market equity prices. As investors grew more and more comfortable with risk, they reversed the flow of funds, and bond spreads between the US and the rest of the world gradually declined. More importantly, so did volatility. For the forex markets, that meant a rapid appreciation in every single currency against the Dollar.

Around the same time, the Swiss National Bank (SNB) intervened for the first time (it would intervene again in June) in forex markets, ostensibly to guard against deflation. As a result, the Swiss Franc has largely been exempted from the forex rally which sent the Euro up 15%, the Brazilian Real up 35%, and the Australian and Canadian Dollars back towards parity with the the US Dollar.

After a modest rally, the British Pound stabilized around pre-bubble levels, due to concerns about the UK’s quantitative easing program (i.e. wholesale money printing), and consequent impact on inflation and the British national debt. Similar concerns have plagued the US Dollar, but interestingly have spared the Euro and Canadian Dollar, despite the fact that their respective Central Banks’ response to the credit crisis have largely mirrored that of the Fed. As a result, the Pound was quickly segregated with the Dollar as a fellow “sick” currency.

By the summer, currencies and asset prices had risen by such an extent that investors began to fear the formation of bubbles. Governments and Central Banks, meanwhile, grew concerned about the potential impact of expensive currencies on their nascent economic recoveries. A handful of Central Banks – many in Asia – intervened successfully to thwart the appreciation of their respective currencies, while Brazil resorted to taxes to try to stem the appreciation of the Real. The Bank of Canada threatened intervention, while the Bank of Japan was more ambiguous; investors ultimately shrugged off both, and the Japanese Yen touched an all-time high against the Dollar in November.

Towards the end of the year, the rally began to lose steam as investors began to fret that they had gotten ahead of themselves. In addition, the prospect of interest rate hikes was moved to the fore, thanks to early action by the Bank of Australia. While it’s clear that the Fed won’t be moving to tighten monetary policy anytime soon, investors have been forced to re-evaluate their short-Dollar carry trade positions within this context.

Meanwhile, a handful of credit market scares, first involving Dubai, and later, a handful of EU member countries, reminded investors that the recovery was both fragile and unequal. As a result of the renewed focus on fundamentals, commodity currencies and currencies backed by strong economic growth projections, continued to appreciate. The Dollar, despite comparatively weak fundamentals, also appreciated, due to its safe-haven appeal and perceptions that the Fed would be among the earliest Central Banks in the industrialized world to hike rates. Ironically, forex markets ended the year ironically just as they began (though for different reasons), with the Dollar in the ascendancy.

source

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 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.

source

In hindsight, the Central Bank (i.e. state economic planners) of China were probably justified in holding the Yuan in 2008. At a time when forex markets (and other capital markets, for that matter) were behaving erratically, the Yuan was a baston of stability. China’s premier, Wen Jiabao, recently boasted, “Keeping the yuan’s value basically steady is our contribution to the international community at a time when the world’s major currencies have been devalued.” In fact, there is evidence that the Central Bank went against market forces in the opposite direction during the height of the credit crisis, and successfully prevented the Yuan from depreciating, thus proving that a currency peg can work both ways. The result was price stability, and a boost to exporters that had been damaged by the falloff in foreign demand for Chinese goods.

With the global economy emerging from recession, the argument for maintaining the peg is becoming less tenable. China’s economy, itself, grew at an impressive 8.5% in 2009, and is forecast to grow even faster in 2010, by 9.5%. Thanks to a surge in bank lending and the government’s massive economic stimulus program, inflation is also ticking up. It has been approximated at 2.5%, but is contradicted by spikes of 50%+ in the prices of certain staple goods, and certainly doesn’t take into account the rise in asset prices. China’s benchmark stock market index surged 90% in 2009, and property prices increased by 30% in some areas.

The dual concerns, of course, are that the money supply is expanding too fast and that bubbles are forming in certain asset markets. The weak RMB is certainly not helping either. Thanks to relaxed capital market controls and expectations of further appreciation, speculative “hot money” is once again pouring into China. Holding down the Yuan in the face of such pressure is becoming prohibitivel expensive: “China’s foreign-exchange reserves climbed 17 percent in the first nine months of 2009 to .27 trillion, the world’s largest holdings.” Some of the demand is naturally being tempered by bubble concerns, but the trend is still money coming into China.

There is also the argument, much mooted in economics circles, that an appreciation of the RMB would be good for the Chinese economy. Because of a perennially weak currency, its economy has become to addicted to exports to drive growth. “As a report from research firm Euromonitor International notes, in U.S. dollar terms, China’s consumer market lags those of the U.S., Japan and much of Europe, with private consumption just over one third of GDP in 2008.” This is probably a product of social and cultural forces, which still emphasize saving. Skeptics of the usefulnes of RMB appreciation point out that rebalancing the Chinese economy would start with changing the culture of saving, but a stronger currency would certainly provide a powerful incentive. Not to mention that a more valuable RMB would give Chinese companies more leverage in consummating outbound corporate M&A deals and natural resource acquisitions that they have been so keen on in recent years.

On the other side of the debate are skeptics of a different sort- those that think RMB appreciation is justified by forward-looking macroeconomic fundamentals. Some fear hyperinflation of the sort that China faced in 2007 and was only brought under control by the global economic recession and concomitant decline in resource prices. “Franklin Allen, a professor of finance at Wharton [University of Pennsylvania], estimates the likelihood of inflation reaching between 10% and 20% to be around one in five.” Any inflation beyond what is experienced in other economies would have to be reflected in the RMB. In a hyperinflation scenario, the Central Bank might even have to deliberately depreciate the currency.

Then there are the skeptics that forecast an economic crash in China. James Chanos, a wealthy hedge fund manager is leading this chorus, “warning that China’s hyperstimulated economy is headed for a crash, rather than the sustained boom that most economists predict. Its surging real estate sector, buoyed by a flood of speculative capital, looks like “Dubai times 1,000 — or worse.’ ”

While this view is gaining some traction, it is still relegated to the minority. Investors and economists are now operating under the firm assumption that China will allow the RMB to resume its appreciation soon. As for when, it could be any day, though probably not for a few months still. As for the questions of how and to what extent, some economists have argued for a one-off appreciation (10% has been suggested) in order to discourage future inflows of speculative capital. Most analysts, though, expect the rise to be gradual. Futures prices currently reflect a 3% rise over the next year, and the consensus among economists is similar. It also depends on how the Dollar performs over the near-term: “If better-than-expected growth in the U.S. helps the greenback recover this year…That would take some of the pressure off Chinese policy makers.”

Personally, I think expectations of a 3-4% rise over the next twelve months are pretty reasonable. The Chinese government doesn’t have much to gain (neither politically nor economically) from a rapid appreciation in the currency, so if/when the RMB rises, it will probably only be in “baby steps.”

source

On January 6, he said it would be “nice” to see the Yen weaken, going so far as to designate 95 Yen/Dollar as the level he had in mind. One day later, he said that the markets should in fact determine the Yen: “If currency levels deviate sharply from the estimates, that could have various effects on the economy.” After he was rebuked by Prime Minister Yukio Hatoyama, who noted that the government should not talk to reporters about forex, he went on tell US Treasury Secretary that forex levels should be stable. In short, Japan’s official governmental position on the Yen still remains muddled, and it’s no less clear whether it will – or even should – intervene.

Fortunately, they may not have to. Not only because the Yen still remains more than 5% off of the record highs of November, but also because economic and financial forces are coalescing that could send the Yen downward. Despite a recovery in exports, the Japanese economy remains beleaguered, having most recently contracted to the lowest level since 1991, as part of a “tumble [that] is unprecedented among the biggest economies.” Now that we are into 2010, it can be said officially that Japan has now suffered from the “second lost decade in a row.”

When economic growth collapsed in 1990, Japanese consumers became famously frugal, and the domestic market still hasn’t recovered. Neither has the stock market, for that matter: “The Nikkei is 44.3% below where it stood at the end of 1999. It is 72.9% below its peak near the end of 1989.” The performance of the bond market, meanwhile, has been a mirror image, rallying 78% since 1990.

The resulting decline in real interest rates has combined with economic stagnation to produce a perennial state of deflation. In fact, prices are once again falling, this time by an annualized pace of 2%.

As many economists have been quick to diagnose, the problem lies in a tremendous (perhaps the world’s largest) imbalance between savings and investment, as “Japan still has ?1,500 trillion (.3 trillion) of savings.” It’s not clear how long this can last, however, as Japanese demographic changes tax the nation’s pool of savings. “More than a fifth of Japanese are over 65…The nation’s population began shrinking in 2006 from 127.8 million, and will drop by 3.2 percent in the coming decade.”

This brings me to the final component of Japan’s perfect economic storm: debt. Japan’s gross national debt is projected by the IMF to touch 225% of GDP this year, and 250% as early as 2014. As a result of the aging population, the pool of cash available for lending to the government is shrinking at the same rate as the tax base, which is exerting fiscal pressure on the government from both sides. According to one commentator, “Japan’s fiscal conditions are close to a melting point.” Another frets: “I doubt there is any yield that international capital markets can find acceptable that will not bankrupt the Japanese state.”

What is the government doing about all of this? Frankly, not too much. It is spending money like crazy – exacerbating its fiscal state and pushing it closer to insolvency – in a (vain) attempt to prime the economic pump and avoid deflation from further entrenching. The Central Bank, meanwhile, just announced a new round of quantitative easing, also aimed at fighting deflation. At only 2% of GDP, however, the measures are “pretty tame” and unlikely to accomplish much. Considering that its monetary base has only expanded by 5% this year (compared to 71% in the US), it still has plenty of scope to operate. At the present time, however, it is still reluctant to do so.

Ironically, the aging population phenomenon could end up restoring Japan’s economy to equilibrium. The worse Japan’s fiscal problems become, the sooner it will be forced to simply print money, so as to deflate its debt and avoid default. This will stimulate the economy and put upward pressure on prices (solving two problems), and exert strong downward pressure on the Yen. The way I see it, that’s four birds with one stone!

As for the Yen, then, I would expect it to hover over the near-term, since price stability and a strong credit rating don’t signal immediate catastrophe. No, Japan’s economic problems are more long-term, which means it could be a while before they more clearly manifst themselves.

source

The Loonie’s rise can be ascribed to a combination of fundamentals and speculation. On the fundamental side, a surge in the price of oil and other commodities has driven a recovery in the Canadian economy. Summarized one strategist, “The fundamentals in Canada are strong. Sentiment is bullish Canada, and on a relative basis, Canada should do very well with stronger commodity prices and ongoing U.S. economic recovery.” On the other hand, non-commodity exports remain sluggish, such the current account balance is currently in the red.

It’s obvious then that the gap between reality and expectation is being filled by speculation. Despite the fact that both short-term and long-term Canadian interest rates remain low, investors are pouring money into Canadian assets in the hopes that rates will soon rise. This speculation reached a fever pitch in October of 2009, when the Loonie spiked 6% in less than two weeks, following a modest Australian rate hike.

At that point, Canadian Central Bank governor Mark Carney was forced to firmly step in (previously he had effectively remained on the sidelines) by warning investors that he was in no hurry to lift rates, and that “he had ways of cooling the currency.” While analysts credit Carney’s jawboning with effecting a modest decline in the Loonie, it has since resumed its upward march, breaking through the technical barrier of 97.5 CAD/USD yesterday.

In the short-term, sheer momentum will almost surely carry the Loonie through parity with the Dollar. Analysts are divided on the timing, with some suggesting as soon as this month and others suggesting that later in the year is more likely. They should be careful, as there is an exuberance in the forex markets that I havn’t seen since right before Lehman Brothers collapsed- the event that many say signaled the beginning of the forex markets. In other words, investors are surely getting ahead of themselves, since commodities are well off of their 2008 highs, interest rates are down, Canadian economic growth is mediocre, Canada’s fiscal condition is weak, and it is operating a current account deficit.

For this reason, many analysts are already becoming bearish on the Loonie. “The loonie looks potentially more vulnerable on a number of crosses unless we see renewed upside momentum,” expressed a strategist from RBC Capital Markets. But noticed that she framed a continued rise in terms of momentum, rather than fundamentals. That’s tantamount to saying, Unless the Canadian Dollar continues to appreciate, it won’t continue to appreciate. If that’s not a tautology, I don’t know what is! But seriously, she has a point, which is that the Loonie is being driven purely by speculation at this point, in a trade that could soon come crashing down…after it hits parity.

source

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 0 billion in the third quarter with U.S. dollar-denominated reserves accounting for about 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 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 .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.

source