The Diminished Case for Chinese Yuan Appreciation

The Chinese yuan has appreciated by more than 27.5% since 2005, when the People’s Bank of China (“PBOC”) formally acceded to international pressure and began to relax the yuan-dollar peg. For China-watchers and economists, that the Yuan will continue to appreciate is thus a given. There is no question of <em>if</em>, but rather of <em>when</em> and <em>to what extent</em>. But what if the prevailing wisdom is wrong? What if the yuan is now fairly valued, and economic fundamentals no longer necessitate a further rise?<br /><a name="more"></a><br /> <div style="text-align: left;"><img alt="" class="aligncenter" height="340" src="http://www.forexblog.org/wp-content/uploads/2011/05/US-Dollar-Chinese-Yuan-10-year-chart.png" title="US Dollar Chinese Yuan 10-year chart" width="567" /><br />Prior to the 2005 revaluation, economists had argued that the yuan (also known as the Chinese RMB) was <a href="http://www.forexblog.org/2005/06/is-the-yuan-really-undervalued.html">undervalued by 15% – 40%</a>, and American politicians had used this as a basis for proposing a 27.5% across-the-board tariff on all Chinese imports. Given that the yuan has now appreciated by this exact margin (and by even more when inflation is taken into account), shouldn’t this alone be enough to silence the critics, without even having to look at the picture on the ground? How can Senator Charles Schumer <a href="http://online.wsj.com/article/SB10001424052748703856704576285380858477662.html">continue to press for further appreciation</a> when the yuan’s rise exceeds his initial demands? Alas, election season is upon us, and we can’t hope to make political sense out of this issue. We can, however, attempt to analyze the economic sense of it.</div>China manipulates the value of the yuan in order to give a competitive advantage to Chinese exporters, goes the conventional line of thinking. Look no further than the Chinese trade surplus for evidence of this, right? As it turns out, China’s trade surplus is shrinking rapidly. In 2006, it was a whopping 11% of GDP. Last year, it had fallen to 5%, and it is <a href="http://online.wsj.com/article/SB10001424052748704463804576290293851753066.html?mod=googlenews_wsj">projected by the World Bank</a> to settle below 3% for each of the next two years. Thanks to a first quarter trade deficit – the first in over seven years – China’s trade surplus may account for a negligible portion (~.2%) of GDP growth in 2010.<br /> <div style="text-align: left;"><img alt="" class="aligncenter" height="270" src="http://www.forexblog.org/wp-content/uploads/2011/05/China-Balance-of-Trade.png" title="China Balance of Trade" width="630" /><br />With this in mind, why would the PBOC even think about allowing the RMB to appreciate further? According to one perspective, the narrowing trade imbalance is only temporary. When commodities prices settle and global demand fully recovers, a wider trade surplus will follow. In fact, the IMF forecasts China’s current surplus will rise to 8% by 2016. As you can see from the chart below (courtesy of <a href="http://www.economist.com/node/18620934?story_id=18620934"><em>The Economist</em></a>), however, the IMF’s forecasts have proven to be too pessimistic for at least the last three years, and it now has very little credibility. Besides, China’s economy is gradually reorienting itself away from exports and towards domestic spending. As a resident of China, I can certainly attest to this phenomenon, and the last few years has seen an explosion in the number of cars on the road, domestic tourism, and conspicuous consumption.</div><div style="text-align: left;"><img alt="" class="aligncenter" height="299" src="http://www.forexblog.org/wp-content/uploads/2011/05/Chinas-Current-Account-Surplus-Actual-and-Predicted.gif" title="China's Current Account Surplus - Actual and Predicted" width="290" /><br />A better argument for further RMB appreciation comes in the form of inflation. At 5.4%, inflation is officially nearing a 3-year high, and there is evidence that the <a href="http://www.bloomberg.com/news/2011-04-12/former-china-central-bank-adviser-yu-calls-for-stronger-yuan.html">PBOC already recognizes</a> that allowing the RMB to keep rising represents its best tool for containing this problem. It has <a href="http://online.wsj.com/article/BT-CO-20110418-706258.html">already raised</a> banks’ <em>required reserve ratio</em> several times, but there is a limit to what this can accomplish. Meanwhile, the PBOC remains reluctant to raise interest rates because it will invite further <a href="http://online.wsj.com/article/BT-CO-20110330-706084.html">“hot-money” inflows</a> (estimated at more than $100 Billion per year, if not much higher) and potentially <a href="http://www.bloomberg.com/news/2011-04-13/china-banks-said-to-need-131-billion-of-equity-over-six-years.html">destabilize the banking sector</a>. By raising the value of the yuan, the PBOC can blunt the impact of <a href="http://online.wsj.com/article/SB10001424052748704366104576254310964824864.html">rising commodities prices</a> and other inflationary forces.</div>In fact, some think that the PBOC will quicken the pace of appreciation, a view that as supported by last month’s .9% rise. Others think that a once-off appreciation would be more effective, and is hence more likely. This would not only remove the motivation for further hot-money inflows, but would also reduce the PBOC’s need to continue accumulating foreign exchange reserves. At $3 trillion+ ($1.15 trillion of which are held in US Treasury Securities), these reserves are already a massive headache for policymakers. Merely stating the obvious, PBOC Governor Zhou Xiaochuan has officially called the reserves “<a href="http://www.marketwatch.com/story/chinas-forex-cache-too-much-of-a-good-thing-2011-05-02?reflink=MW_news_stmp">really too much</a>.” (It’s worth pointing out that the promotion of the yuan as an international currency is <a href="http://online.wsj.com/article/SB10001424052748704821704576270682839679232.html">backfiring in some ways</a>, causing the reserves to balloon even faster).<br /> <div style="text-align: left;"><img alt="" class="aligncenter" height="426" src="http://www.forexblog.org/wp-content/uploads/2011/05/Chinese-Yuan-denominated-trade.png" title="Chinese Yuan-denominated trade" width="233" /> For the record, I think that the Chinese yuan is pretty close to being fairly valued. That might seem like a ridiculous claim to make when Chinese wages and prices are still well below the global average. Consider, however, that the same is true for the majority of emerging market economies, including those that don’t peg their currencies to the dollar. That doesn’t mean that the yuan won’t – or that it shouldn’t – continue to rise. In fact, the PBOC needs to do more to ensure that the Yuan appreciates evenly against all currencies, since most of the yuan’s rise to-date has taken place relative to the US Dollar. It’s merely a commentary that the PBOC is close to fulfilling the promises it has made regarding the yuan, and going forward, I think that observers should expect that its forex policy will be reconfigured to promote domestic macroeconomic policy objectives.</div>

The Diminished Case for Chinese Yuan Appreciation

The Chinese yuan has appreciated by more than 27.5% since 2005, when the People’s Bank of China (“PBOC”) formally acceded to internationa...

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Dollar will Rally when QE2 Ends

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.<br /><a name="more"></a><br /> <div style="text-align: center;"><a href="http://www.forexblog.org/wp-content/uploads/2011/04/QE2-USD-Vs.-SP-Vs.-Treasury-Yield-2010-2011.jpg"><img alt="" class="aligncenter size-full wp-image-3948" height="293" src="http://www.forexblog.org/wp-content/uploads/2011/04/QE2-USD-Vs.-SP-Vs.-Treasury-Yield-2010-2011.jpg" title="QE2- USD Vs. S&P Vs. Treasury Yield 2010-2011" width="552" /></a></div>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 <a href="http://www.forexblog.org/2010/11/fed-surprises-markets-with-scope-of-qe2.html">reported</a> that QE2 was unfairly labeled a <em>lose-lose</em> 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.”<br /> 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, <a href="http://blogs.wsj.com/economics/2011/04/20/putin-u-s-monetary-policy-is-hooliganism/">Vladimir Putin</a>) for its perceived role in inflating asset bubbles around the world and fomenting the currency wars.<br /> <div style="text-align: center;"><a href="http://www.forexblog.org/wp-content/uploads/2011/04/Fed-Monetary-Base-1980-2011.png"><img alt="" class="aligncenter" height="302" src="http://www.forexblog.org/wp-content/uploads/2011/04/Fed-Monetary-Base-1980-2011.png" title="Fed Monetary Base 1980 - 2011" width="504" /></a></div>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.<br /> 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 <a href="http://blogs.wsj.com/economics/2011/04/27/live-blog-bernanke-holds-first-postmeeting-press-conference/">today’s inaugural press conference</a>: “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.<br /> 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 <a href="http://www.pimco.com/EN/Insights/Pages/The-End-of-QEII-It%E2%80%99s-Time-to-Make-the-Donuts.aspx">widely-read report</a> 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.<br /> 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.<br /> <a href="http://www.forexblog.org/wp-content/uploads/2011/04/Portfolio-Balance-Effect-and-Impact-on-Inflation-Expectations.jpg"><img alt="" class="aligncenter size-full wp-image-3946" height="385" src="http://www.forexblog.org/wp-content/uploads/2011/04/Portfolio-Balance-Effect-and-Impact-on-Inflation-Expectations.jpg" title="Portfolio Balance Effect and Impact on Inflation Expectations" width="525" /></a><br /> 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 <a href="http://www.businessweek.com/news/2011-04-04/fed-qeii-answers-brazil-china-germany-axis-with-u-s-growth.html">Bloomberg News survey</a>. It will gain to 88 per yen, a separate poll shows.”

Dollar will Rally when QE2 Ends

In shifting their focus to interest rates, forex traders have perhaps overlooked one very important monetary policy event: the conclusion ...

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Forex Markets Focus on Central Banks

Over the last year and increasingly over the last few months, Central Banks around the world have taken center stage in currency markets. First, came the ignition of the currency war and the consequent volley of forex interventions. Then came the prospect of monetary tightening and the unwinding of quantitative easing measures. As if that wasn’t enough to keep them busy, Central Banks have been forced to assume more prominent roles in regulating financial markets and drafting economic policy. With so much to do, perhaps it’s no wonder that Jean-Claude Trichet, head of the ECB, will leave his post at the end of this year!<br /><a name="more"></a><br /> <div style="text-align: center;"><a href="http://www.forexblog.org/wp-content/uploads/2011/04/US-Dollar-Index-5-Year-Chart.png"><img alt="" class="aligncenter size-full wp-image-3913" height="410" src="http://www.forexblog.org/wp-content/uploads/2011/04/US-Dollar-Index-5-Year-Chart.png" title="US Dollar Index 5 Year Chart" width="576" /></a><br /></div><div style="text-align: left;">The currency wars may have subsided, but they haven’t ended. On both a paired and trade-weighted basis, the Dollar is declining rapidly. As a result, emerging market Central Banks are still doing everything they can to protect their respective currencies from rapid appreciation. As I’ve written in earlier posts, most Latin American and Asian Central Banks have already announced targeted strategies, and many intervene in forex markets on a daily basis. If the Japanese Yen continues to appreciate, you can bet the Bank of Japan (perhaps aided by the G7) will quickly jump back in.</div>You can expect the currency wars to continue until the quantitative easing programs instituted by the G4 are withdrawn. The Fed’s $600 Billion Treasury bond buying program officially ends in June, at which point its balance sheet will near $3 Trillion. The European Central Bank has injected an equally large hunk of cash into the Eurozone economy. Despite inflation that may soon exceed 5%, the Bank of England voted not to sell its cache of QE assets, while the Bank of Japan is actually ratcheting up its program as a result of the earthquake-induced catastrophe. Whether or not this manifests itself in higher inflation, investors have signaled their distaste by bidding up the price of gold to a new record high.<br /> <a href="http://www.forexblog.org/wp-content/uploads/2011/04/Central-Bank-Fed-ECB-BoE-Balance-Sheet-Assets-Quantitative-Easing.jpg"><img alt="" class="aligncenter size-full wp-image-3908" height="305" src="http://www.forexblog.org/wp-content/uploads/2011/04/Central-Bank-Fed-ECB-BoE-Balance-Sheet-Assets-Quantitative-Easing.jpg" title="Central Bank Fed ECB BoE Balance Sheet Assets Quantitative Easing" width="276" /></a><br />Then there are the prospective rate hikes, cascading across the world. Last week, the European Central Bank became the first in the G4 to hike rates (though market rates have hardly budged). The Reserve Bank of Australia, however, was the first of the majors to hike rates. Since October 2009, it has raised its benchmark by 175 basis points; its 4.75% cash rate is easily the highest in the industrialized world. The Bank of Canada started hiking in June 2010, but has kept its benchmark on hold at 1% since September. The Reserve Bank of New Zealand lowered its benchmark to a record low 2.5% as a result of serious earthquakes and economic weakness.<br /> Going forward, expectations are for all Central Banks to continue (or begin) hiking rates at a gradual pace over the next couple years. If forecasts prove to be accurate, the US Federal Funds Rate will stand around .5% at the beginning of 2012, tied with Switzerland, and ahead of only Japan. The UK Rate will stand slightly above 1%, while the Eurozone and Canadian benchmarks will be closer to 2%. The RBA cash rate should exceed 5%. Rates in emerging markets will probably be even higher, as all four BRIC countries (Russia, Brazil, China, India) should be well into the tightening cycles.<br /> <a href="http://www.forexblog.org/wp-content/uploads/2011/04/G7-2011-Interest-Rates-Current-and-Forecast.jpg"><img alt="" class="aligncenter size-full wp-image-3910" height="200" src="http://www.forexblog.org/wp-content/uploads/2011/04/G7-2011-Interest-Rates-Current-and-Forecast.jpg" title="G7 2011 Interest Rates - Current and Forecast" width="502" /></a><br />On the one hand, there is reason to believe that the pace of rate hikes will be slower than expected. Economic growth remains tepid across the industrialized world, and Central Banks are wary about spooking their economies with premature rate hikes. Besides, Fed watchers may have learned a lesson as a result of a brief bout of over-excitement in 2010 that ultimately led to nothing. <a href="http://www.economist.com/node/18529677?story_id=18529677">The Economist has reported that</a>, “Markets habitually assign too much weight to the hawks, however. The real power at the Fed rests with its leaders…At present they are sanguine about inflation and worried about unemployment, which means a rate rise this year is unlikely.”  Even the ECB disappointed traders by (deliberately) adopting a <a href="http://online.wsj.com/article/BT-CO-20110407-714978.html">soft stance</a> in the press release that accompanied its recent rate hike.<br /> On the other hand, a <a href="http://www.bis.org/publ/qtrpdf/r_qt1103.pdf">recent paper published by the Bank for International Settlements (BIS)</a> showed that the markets’ track record of forecasting inflation is weak. As you can see from the chart below, they tend to reflect the general trend in inflation, but underestimate when the direction changes suddenly. (This is perhaps similar to the <a href="http://en.wikipedia.org/wiki/Fat_tail">“fat-tail” problem</a>, whereby extreme aberrations in asset price returns are poorly accounted for in financial models). If you apply this to the current economic environment, it suggests that inflation will probably be much higher-than-expected, and Central Banks will be forced to compensate by hiking rates a faster pace.<br /><a href="http://www.forexblog.org/wp-content/uploads/2011/04/Actual-and-Expected-Inflation-in-Advanced-Economies.jpg"><img alt="" class="aligncenter size-full wp-image-3909" height="486" src="http://www.forexblog.org/wp-content/uploads/2011/04/Actual-and-Expected-Inflation-in-Advanced-Economies.jpg" title="Actual and Expected Inflation in Advanced Economies" width="536" /></a>Finally, in their newfound roles as economic policymakers, Central Banks are increasingly engaged in <em>macroprudential policy</em>. <a href="http://www.economist.com/node/18178251?story_id=18178251">The Economist reports</a> that, “Central banks and regulators in emerging economies have already imposed a host of measures to cool property prices and capital inflows.” These measures are worth watching because their chief aim is to indirectly reduce inflation. If they are successful, it will limit the need for interest rate hikes and reduce upward pressure on their currencies.<br /> In short, given the enhanced ability of Central Banks to dictate exchange rates, traders with long-term outlooks may need to adjust their strategies accordingly. That means not only knowing who is expected to raise interest rates – as well as when and by how much – but also monitoring the use of their other tools, such as balance sheet expansion, efforts to cool asset price bubbles, and deliberate manipulation of exchange rates.

Forex Markets Focus on Central Banks

Over the last year and increasingly over the last few months, Central Banks around the world have taken center stage in currency markets...

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Record Commodities Prices and the Forex Markets

Propelled by economic recovery and the recent Mideast political turmoil, oil prices have firmly shaken off any lingering credit crisis weakness, and are headed towards a record high. Moreover, analysts are warning that due to certain fundamental changes to the global economy, prices will almost certainly remain high for the foreseeable future. The same goes for commodities. Whether directly or indirectly, the implications for forex market will be significant.<br /><a name="more"></a><br /> <a href="http://www.forexblog.org/wp-content/uploads/2011/04/Commodity-Price-Index-1996-2011.jpg"><img alt="" class="aligncenter size-full wp-image-3853" height="291" src="http://www.forexblog.org/wp-content/uploads/2011/04/Commodity-Price-Index-1996-2011.jpg" title="Commodity Price Index 1996 - 2011" width="561" /></a><br />First of all, there is a direct impact on trade, and hence on the demand for particular currencies. Norway, Russia, Saudia Arabia, and a dozen other countries are witnessing record capital inflow expanding current account surpluses. If not for the fact that many of these countries peg their currencies to the Dollar and/or seem to suffer from myriad other issues, there currencies would almost surely appreciate. In fact, the Russian Rouble and Norwegian Krona have both begun to rise in recent months. On the other hand, Canada and Australia (and to a lesser extent, New Zealand) are experiencing rising trade deficits, which shows that their is not an automatic relationship between rising commodity prices and commodity currency strength.<br /> <div style="text-align: center;"><a href="http://www.forexblog.org/wp-content/uploads/2011/04/Rouble-Krona-Dollar-5-Year-Chart.jpg"><img alt="" class="aligncenter size-full wp-image-3855" height="307" src="http://www.forexblog.org/wp-content/uploads/2011/04/Rouble-Krona-Dollar-5-Year-Chart.jpg" title="Rouble Krona Dollar 5 Year Chart" width="554" /></a></div>Those countries that are net energy importers could experience some weakness in their currencies, as trade balances move against them. In fact, China just recorded its first quarterly trade deficit in seven years. Instead of viewing this in terms of a shift in economic structure, economists need to understand that this is due in no small part to rising raw materials prices. Either way, the People’s Bank of China (PBOC) will probably tighten control over the appreciation of the Chinese Yuan. Meanwhile, the nuclear crisis in Japan is almost certainly going to decrease interest in nuclear power, especially in the short-term. This will cause oil and natural gas prices to rise even further, and magnify the impact on global trade imbalances.<br /> <div style="text-align: center;"><a href="http://www.forexblog.org/wp-content/uploads/2011/04/China-Balance-of-Trade-2000-2011.jpg"><img alt="" class="aligncenter size-full wp-image-3857" height="240" src="http://www.forexblog.org/wp-content/uploads/2011/04/China-Balance-of-Trade-2000-2011.jpg" title="China Balance of Trade 2000 - 2011" width="578" /></a></div>A bigger issue is whether rising commodities prices will spur inflation. With the notable exception of the Fed, all of the world’s Central Banks have now voiced concerns over energy prices. The European Central Bank (ECB), has gone so far as to preemptively raise its benchmark interest rate, even though Eurozone inflation is still quite low. In light of his spectacular failure to anticipate the housing crisis, Fed Chairman Ben Bernanke is being careful not to offer unambiguous views on the impact of high oil prices. Thus, he has warned that it could translate into decreased GDP growth and higher prices for consumers, but he has stopped short of labeling it a serious threat.<br /> On the one hand, the US economy is undergone some significant structural changes since the last energy crisis, which could mitigate the impact of sustained high prices. “<a href="http://knowledge.wharton.upenn.edu/article.cfm?articleid=2732">The energy intensity of the U.S. economy</a> — that is, the energy required to produce $1 of GDP — has fallen by 50% since then as manufacturing has moved overseas or become more efficient. Also, the price of natural gas today has stayed low; in the past, oil and gas moved in tandem. And finally, ‘we’re closer to alternative sources of energy for our transportation,’ ” summarized Wharton Finance Professor Jeremy Siegal. From this standpoint, it’s understandable that every $10 increase in the price of oil causes GDP to drop by only .25%.<br /> On the other hand, we’re not talking about a $10 increase in the price of oil, but rather a $50 or even $100 spike. In addition, while industry is not sensitive to high commodity prices, American consumers certainly are. From automobile gasoline to home eating oil to agricultural staples (you know things are bad when <a href="http://www.nytimes.com/2011/04/15/business/15bandits.html?_r=1&hp">thieves are targeting produce</a>!), commodities still represent a big portion of consumer spending. Thus, each 1 cent increase in the price of gas sucks $1 Billion from the economy. “If gas prices increased to $4.50 per gallon for more than two months, it would ‘pose a serious strain on households and could put the entire recovery in jeopardy. Once you get above $5, [there is] probably above a 50% chance that the economy could face a downturn.’ ”<br /> Even if stagflation can be avoided, some degree of inflation seems inevitable. In fact, US CPI is now 2.7%, the highest level in 18 months and rising. It is similarly 2.7% in the Eurozone and Australia, where both Central Banks have started to become more aggressive about tightening monetary policy. In the end, no country will be spared from inflation if commodity prices remain high; the only difference will be one of extent.<br /> <div style="text-align: center;"><a href="http://www.forexblog.org/wp-content/uploads/2011/04/US-inflation-rate-2008-2011.jpg"><img alt="" class="aligncenter size-full wp-image-3859" height="243" src="http://www.forexblog.org/wp-content/uploads/2011/04/US-inflation-rate-2008-2011.jpg" title="US inflation rate 2008 - 2011" width="579" /></a></div>Over the near-term, much depends on what happens in the Middle East, since an abatement in political tensions would cause energy prices to ease. Over the medium-term, the focus will be on Central Banks, to see if/how they deal with rising inflation. Will they raise interest rates and withdraw liquidity, or will they wait to act for fear of inhibiting economic recovery? Over the long-term, the pivotal issue is whether economies (especially China) can become less energy intensive or more diversified in their energy consumption.<br /> At the moment, most economies are dangerously exposed, with China and the US topping the list. Russia, Norway, Brazil and a select few others will earn a net benefit from a boom in prices, while most others (notably Australia and Canada) are somewhere in the middle.

Record Commodities Prices and the Forex Markets

Propelled by economic recovery and the recent Mideast political turmoil, oil prices have firmly shaken off any lingering credit crisis wea...

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Fed Mulls End to Easy Money

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.<br /><a name="more"></a><br /> First of all, the economic recovery is gathering momentum. According to a <a href="http://www.bloomberg.com/news/2011-03-26/bullard-says-federal-reserve-s-qe-program-has-been-successful-.html">Bloomberg News poll</a>, “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.<br /> <div style="text-align: center;"><a href="http://www.forexblog.org/wp-content/uploads/2011/04/US-Unemployment-rate-2006-2011.jpg"><img alt="" class="aligncenter size-full wp-image-3817" height="266" src="http://www.forexblog.org/wp-content/uploads/2011/04/US-Unemployment-rate-2006-2011.jpg" title="US Unemployment rate 2006 - 2011" width="558" /></a></div>In fact, the Fed made such an observation in its <a href="http://www.federalreserve.gov/newsevents/press/monetary/20110315a.htm">March 15 FOMC monetary policy statement</a>, 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.”<br /> To be sure, interest rate futures reflect a <a href="http://www.clevelandfed.org/research/data/fedfunds/index.cfm">0% likelihood</a> 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: “<a href="http://www.reuters.com/article/2011/03/31/markets-forex-idUSL3E7EV46A20110331">Minneapolis Federal Reserve President Narayana Kocherlakota</a> 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.<br /> <div style="text-align: center;"><a href="http://www.forexblog.org/wp-content/uploads/2011/04/August-2011-FOMC-Federal-Funds-Rate-Forecast.jpg"><img alt="" class="aligncenter size-full wp-image-3818" height="361" src="http://www.forexblog.org/wp-content/uploads/2011/04/August-2011-FOMC-Federal-Funds-Rate-Forecast.jpg" title="August 2011 FOMC Federal Funds Rate Forecast" width="504" /></a></div>Meanwhile, Saint Louis Fed President James Bullard has urged the Fed to end its QE2 program, and <a href="http://www.bloomberg.com/news/2011-03-26/bullard-says-federal-reserve-s-qe-program-has-been-successful-.html">he isn’t alone</a>. “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.<br /> 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.<br /> 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.

Fed Mulls End to Easy Money

Forex traders have very suddenly tilted their collective focus towards interest rate differentials. Given that the Dollar is once again in...

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UK Forex Reserve Plan could Harm Pound

<div class="entrytext"> Yesterday, UK Chancellor George Osborne <a href="http://online.wsj.com/article/BT-CO-20110323-711759.html">announced</a> that his government was ready to begin rebuilding its foreign exchange reserves. Depending on when, how, (or even if) this program is implemented, it could have serious implications for the Pound.<br /> Forex reserve watchers (myself included) were excited by the <a href="http://www.bloomberg.com/news/2011-03-01/china-treasury-holdings-rise-to-1-16-trillion-in-december-u-s-data-show.html">updated US Treasury report</a> on foreign holdings of US Treasury securities. As the Dollar is the world’s de-facto reserve currency and the US<br /><a name="more"></a> Treasury securities are the asset of choice, the report is basically a rough sketch of both the Dollar’s global popularity and the interventions of foreign Central Banks. Personally, I thought the biggest shocker was not that China’s Treasury holdings are $300 Billion greater than previously believed (with $3 Trillion in reserves, that’s really just a rounding error), but rather that the UK’s holdings declined by 50% in 2010, to a mere $260 Billion.<br /> <a href="http://www.forexblog.org/wp-content/uploads/2011/03/GBP-USD-5-Year-Chart.png"><img alt="" class="aligncenter size-full wp-image-3787" height="288" src="http://www.forexblog.org/wp-content/uploads/2011/03/GBP-USD-5-Year-Chart.png" title="GBP USD 5 Year Chart" width="512" /></a><br />Given that the Bank of England (BoE) injected more than $500 Billion into the UK money supply in 2010, I suppose that shouldn’t have been much of a revelation. After all, selling US Treasury Securities and using the proceeds to buy British Gilts (sovereign debt) and other financial instruments would enable the BoE to achieve its objective without having to resort to wholesale money printing. In addition, if not for this sleight of hand, UK inflation would probably be even higher.<br /> Still, this is little more than a mere accounting trick, and those funds will probably still need to be withdrawn from the money supply at some point anyway. Whether the BoE burns the proceeds or reinvests them back into foreign instruments is certainly worth pondering, but insofar as it won’t impact inflation, it is a matter of economic policy, and not monetary policy.<br /> As Chancellor Osborn indicated, the UK will probably send these funds back abroad. In addition to providing support for the Dollar (as well as another reason not to be nervous about the upcoming end of the Fed’s QE2), this would seriously weaken the Pound, at a time  that it is already near a 30-year low on a trade-weighted basis. After falling off a cliff in 2009, the Pound recovered against the Dollar in 2010, largely due to the BoE’s shuffling of its foreign exchange reserves. To undo this would certainly risk sending the Pound back towards these depths.<br /><a href="http://www.forexblog.org/wp-content/uploads/2011/03/UK-Current-Account-Trade-Balance-2000-2011.jpg"><img alt="" class="aligncenter size-full wp-image-3788" height="294" src="http://www.forexblog.org/wp-content/uploads/2011/03/UK-Current-Account-Trade-Balance-2000-2011.jpg" title="UK Current Account Trade Balance 2000 - 2011" width="614" /></a><br /> On the one hand, the UK is certainly conscious of this and would act accordingly, perhaps even delaying any foreign exchange reserve accumulation until the Pound strengthens. On the other hand, the BoE is under pressure to fight inflation. It is reluctant to raise interest rates because of the impact it would have on the fragile economic recovery. The same can be said for unwinding its asset purchases. However, if it offset this with purchases of US Treasury securities and other foreign currency assets, it could weaken the Pound and maintain some form of economic stimulus. Especially since the UK has run a sizable trade/current account deficit for as long as anyone can remember, the BoE has both the flexibility/justification it needs to coax the exchange rate down a little bit.<br /> Ultimately, we’ll need more information before we can determine how this will impact the Pound. Still, this is an indication that the GBP/USD might not have much more room to appreciate.<br /> </div>

UK Forex Reserve Plan could Harm Pound

Yesterday, UK Chancellor George Osborne announced that his government was ready to begin rebuilding its foreign exchange reserves. D...

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British Pound Continues Gradual Ascent

The British Pound has risen almost 15% against the Dollar over the last twelve months. It seems that the markets are ignoring the fiscal concerns that sent the Pound tumbling in 2010, and focusing more on inflation and the prospect of interest rate hikes. At this point, the Bank of England (BOE) is now racing with the European Central Bank (ECB) to be the first “G4″ Central Bank to hike rates.<br /><a name="more"></a><br /> <div style="text-align: left;"><a href="http://www.forexblog.org/wp-content/uploads/2011/03/GBP-USD-5-Year-Chart.jpg"><img alt="" class="aligncenter size-full wp-image-3758" height="252" src="http://www.forexblog.org/wp-content/uploads/2011/03/GBP-USD-5-Year-Chart.jpg" title="GBP USD 5 Year Chart" width="571" /></a><br />You can find cause for optimism towards the Pound in technical factors alone. That’s because while dozens of currencies appreciated against the Dollar in 2010, most were starting from a stronger base. For example, the Canadian and Australian Dollars collapsed during the credit crisis. However, both currencies made speedy recoveries to the extent all losses were erased in only two years. The British Pound, in contrast, still remains 25% below its pre-credit crisis high, more depressed than perhaps any other currency.</div>On the one hand, this is probably justifiable. The British economy is still in abysmal shape; the latest GDP figures revealed a .6% contraction in the fourth quarter of 2010. Meanwhile, the ECB forecasts only 1.4% growth in 2011, and many analysts think that might even be too optimistic. With the exception of Japan, which suffers from a unique strain of economic malaise (not to mention the 5% hit to GDP caused by the earthquake), the UK is unequivocally the weakest economy in the industrialized world.<br /> On the other hand, this is mostly old news. The reason that investors are starting to get excited is interest rate hikes. According to the <a href="http://online.wsj.com/article/BT-CO-20110223-706462.html">minutes from its March meeting</a>, the BOE voted 6-3 to hold its benchmark interest rate at .5%. That means its awfully close to acting. The <a href="http://www.businessweek.com/news/2011-03-14/u-k-pound-gains-against-dollar-as-fitch-affirms-aaa-rating.html">market consensus</a> is for a 25 basis point rate hike in the next three months, and 2-3 additional hikes over the rest of the year. Depending on how the other G4 Central banks act, that will put the UK rates at the top of the pack.<br /> However, it’s unclear how extensive this tightening will be. According to <a href="http://www.investmentweek.co.uk/investment-week/news/2033920/burgess-mpc-growth-forecast-optimistic">one analyst</a>, “The probability of a hike in the next three months is significant but the lingering credit crunch, fiscal tightening and bleak outlook for real incomes suggest that if this is the beginning of a tightening cycle, it will be a very shallow one.” Moreover, low bond yields suggest that long-term inflation expectations (and hence, the need for rate hikes) remain low.<br /> <div style="text-align: left;"><a href="http://www.forexblog.org/wp-content/uploads/2011/03/GBP-USD-1-Year-Chart.jpg"><img alt="" class="aligncenter size-full wp-image-3759" height="213" src="http://www.forexblog.org/wp-content/uploads/2011/03/GBP-USD-1-Year-Chart.jpg" title="GBP USD 1 Year Chart" width="485" /></a><br />At this point, it looks like the UK is looking at a few years of stagflation. That’s certainly going to be bad for UK consumers and probably negative for most UK asset prices. However, short-term currency speculators are less concerned about economic fundamentals, and more concerned about (risk-adjusted) interest rate differentials. That means that if the BOE fulfills expectations, the Pound will probably get a little short-term kick.</div>

British Pound Continues Gradual Ascent

The British Pound has risen almost 15% against the Dollar over the last twelve months. It seems that the markets are ignoring the fiscal c...

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Euro Buoyed by Rate Hike Expectations, Despite Unresolved Debt Issues

From trough to peak, the Euro has risen 9% over a period of only two months. You wouldn’t ordinarily expect to see this kind of appreciation from a G4 currency, especially not one whose member states are on the brink of insolvency and which itself faces threats to its very existence. In this case, the Euro is benefiting from expectations that the European Central Bank (ECB) will be among the first and most aggressive in hiking interest rates. As I warned in my <a href="http://www.forexblog.org/2011/02/despite-recent-rise-euro-still-looks-weak.html">previous post</a>, however, those that focus solely on interest rate differentials and ignore the Euro’s lingering Sovereign debt crisis do so at their own peril.<br /><a name="more"></a><br /> <a href="http://www.forexblog.org/wp-content/uploads/2011/03/Euro-Dollar-3-month-chart.png"><img alt="" class="aligncenter size-full wp-image-3745" height="288" src="http://www.forexblog.org/wp-content/uploads/2011/03/Euro-Dollar-3-month-chart.png" title="Euro Dollar 3 month chart" width="512" /></a><br /> Indications that the ECB will hike interest rates came out of nowhere. Jean-Claude Trichet, President of the ECB, <a href="http://www.marketwatch.com/story/ecb-rates-unchanged-focus-on-trichet-2011-03-03%5C">announced last week</a> that it would be particularly aggressive in taking steps to deal with inflation. This caught the markets by surprise, since Eurozone inflation is still below 2% and GDP growth is similarly low. Later, Governing Council members <a href="http://www.bloomberg.com/news/2011-02-26/draghi-says-exit-strategy-timing-key-amid-inflation-pressures.html">Mario Draghi</a> and <a href="http://www.bloomberg.com/news/2011-03-08/weber-signals-ecb-may-raise-rates-several-times-this-year.html">Axel Weber</a> (both of whom are potential candidates to replace Trichet when he steps down later this year), issued similar statements, and the question of rate hikes was suddenly changed from <em>If</em> to <em>When/How much</em>.<br /> Futures markets are currently pricing in 3 interest rate hikes, which would bring the Eurozone benchmark rate to 1.75% by year end. According to economist Nouriel Roubini’s (who gained fame by predicting the financial crisis) think tank: “<a href="http://online.wsj.com/article/BT-CO-20110309-703774.html">Jean-Claude Trichet has been careful</a> not to commit to a series of hikes, but we believe that is what it will be. The ECB is bluffing. We think the ECB will hike by a total of 75 basis points, probably by August.” Axel Weber, himself, coyly echoed this sentiment: “<a href="http://www.bloomberg.com/news/2011-03-08/weber-signals-ecb-may-raise-rates-several-times-this-year.html">I see no reason</a> at this stage to signal any dissent with how markets priced future policies.”<br /> On the one hand, the recent rise in oil prices strengthens the case for rate hikes. On the other hand, the EU does not consume energy at the same intensity as the US, which means that its impact on inflation is likely to be muted. In addition, while the ECB’s mandate is indeed titled towards price stability (rather than boosting employment or spurring economic growth), to hike rates now would risk endangering the still-fragile Eurozone economic recovery. Unwinding its quantitative easing would similarly add to the risk of another financial crisis, since <a href="http://online.wsj.com/article/BT-CO-20110218-705506.html">banks still make heavy use of its emergency lending facilities</a>.<br /> Speaking of which, it’s still way too early to say that the the EU sovereign debt crisis is behind us. Despite the loans and pledges and bailouts, interest rates for all four PIGS (Portugal, Ireland, Greece, Spain) countries <a href="http://www.economist.com/node/18285565">continue to rise</a>, and or nearing unsustainable levels. At the moment, currency investors have chosen to ignore this, since the EU has basically guaranteed them funding until 2013. What will happen then, or as the date draw near, is anyone’s guess.<br /> <a href="http://www.forexblog.org/wp-content/uploads/2011/03/Eurzone-sovereign-debt-crisis-PIGS-bond-yields-2010-2011.gif"><img alt="" class="aligncenter size-full wp-image-3746" height="302" src="http://www.forexblog.org/wp-content/uploads/2011/03/Eurzone-sovereign-debt-crisis-PIGS-bond-yields-2010-2011.gif" title="Eurzone sovereign debt crisis PIGS bond yields 2010 - 2011" width="290" /></a><br />In the end, one or more defaults seems inevitable. There is only so much that financial engineering can do to conceal and restructure debt which exceeds 100% of GDP in the cases of Greece and Ireland. If that were to happen, significant losses would be incurred by EU banks, which lent heavily to at-risk countries during the boom years. In order to minimize this situation, I think the ECB will probably continue to subsidize the banks via low interest rates.<br /> Even if the ECB does hike rates, it will be extremely gradual. Furthermore, By the time Eurozone interest rates reach attractive levels, the other G4 Central Banks (with the exception of Japan) will probably already have started to close the gap. That means that interest rate differentials probably won’t soon be wide enough to lure more than a modicum of risk-averse investors. (Besides, if you assume a 5% chance of default, risk-adjusted rates are probably still negative).<br /> In short, I think that the ongoing Euro rally is really just a short squeeze in disguise. Basically, speculators are conceding that shorting the Euro is both risky and unprofitable. (According to <a href="http://www.forexblog.org/category/%22It%20was%20a%20very%20popular%20trade,%22%20the%20portfolio%20manager%20says.%20%22A%20lot%20of%20us%20stuck%20with%20it,%20and%20it%20went%20wrong%20in%20January.%22">one hedge fund manager</a>, “It was a very popular trade,” the portfolio manager says. A lot of us stuck with it, and it went wrong in January.”) In anticipating of higher future interest rates, they are preemptively moving to liquidate their short positions. However, <em>not being short</em> is not the same thing as <em>going long</em>. And until the EU sorts through the fiscal issues in a convincing way, I think it would be foolish to start making long-term bets on the Euro.

Euro Buoyed by Rate Hike Expectations, Despite Unresolved Debt Issues

From trough to peak, the Euro has risen 9% over a period of only two months. You wouldn’t ordinarily expect to see this kind of appreciatio...

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Forex Markets Look to Interest Rates for Guidance

<div class="entrytext"> 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: <em>interest rates</em>.<br /> 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.<br /> <a href="http://www.forexblog.org/wp-content/uploads/2011/02/Market-Expectations-for-Interest-Rates-Pound-Euro-Dollar-2011-2013.jpg"><img alt="" class="aligncenter size-full wp-image-3690" height="151" src="http://www.forexblog.org/wp-content/uploads/2011/02/Market-Expectations-for-Interest-Rates-Pound-Euro-Dollar-2011-2013.jpg" title="Market Expectations for Interest Rates Pound Euro Dollar 2011 - 2013" width="270" /></a>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.<br /> 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 <a href="http://www.businessweek.com/news/2011-02-10/aussie-weakens-after-stevens-says-rate-level-judged-sensible.html">Reserve Bank of Australia has basically stopped tightening</a>, 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.<br /> <a href="http://www.businessweek.com/news/2011-02-08/china-raises-rates-to-counter-accelerating-inflation.html">China (~6%)</a> and <a href="http://www.bbc.co.uk/news/business-12234927">Brazil (11.25%)</a> 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 <a href="http://www.marketwatch.com/story/india-raises-interest-rates-by-quarter-point-2011-01-25">Reserve Bank of India</a> and Bank of Russia have also hiked rates several times over the last year, though again, not yet enough to offset rising prices.<br /> 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 <a href="http://www.independent.co.uk/news/business/comment/hamish-mcrae/hamish-mcrae-the-case-for-higher-rates-a-better-supply-of-more-expensive-money-is-needed-2211119.html?action=Popup">unsustainable</a>. 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 <a href="http://www.niesr.ac.uk/">projected</a> to hike rates 3 times over the next year. If/when it unwinds its quantitative easing program, long-term rates will probably follow suit.<br /><a name="more"></a><br /> 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 <a href="http://knowledge.wharton.upenn.edu/article.cfm?articleid=2666">front runner to replace Jean-Claude Trichet</a> 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.<br /> <div style="text-align: left;"><a href="http://www.forexblog.org/wp-content/uploads/2011/02/June-2011-FOMC-Meeting-Rate-Hike-Expectations.jpg"><img alt="" class="aligncenter size-full wp-image-3691" height="398" src="http://www.forexblog.org/wp-content/uploads/2011/02/June-2011-FOMC-Meeting-Rate-Hike-Expectations.jpg" title="June 2011 FOMC Meeting Rate Hike Expectations" width="561" /></a><br />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 <a href="http://www.bloomberg.com/news/2011-02-09/fed-focus-on-jobs-may-mean-market-ahead-of-itself-on-rates-chart-of-day.html">Bloomberg News analysis</a>, “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 <a href="http://seekingalpha.com/article/251122-jim-rickards-on-inflation-and-currency-wars">argued</a> 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.</div><div style="text-align: left;"><a href="http://www.forexblog.org/wp-content/uploads/2011/02/US-Interest-Rates-and-Unemployment-History-and-Forecast.jpg"><img alt="" class="aligncenter size-full wp-image-3692" height="302" src="http://www.forexblog.org/wp-content/uploads/2011/02/US-Interest-Rates-and-Unemployment-History-and-Forecast.jpg" title="US Interest Rates and Unemployment History and Forecast" width="575" /></a><br />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.</div></div>

Forex Markets Look to Interest Rates for Guidance

There are a number of forces currently competing for control of forex markets: the ebb and flow of risk appetite, Central Bank currency...

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New Zealand: No Forex Intervention

Despite reaching a temporary stalemate, the currency war rages on, and individual countries continue to debate whether they should enter or watch their currencies continue to appreciate. Nowhere is that debate stronger than in <strong>New Zealand</strong>, whose Kiwi currency has fallen 37% against the US Dollar since its peak in early 2009, and over 15% since June of this year.<br /><a name="more"></a><br /> <img alt="USD NZD 5 Year Chart" class="aligncenter size-full wp-image-3169" height="288" src="http://www.forexblog.org/wp-content/uploads/2010/11/USD-NZD-5-Year-Chart.png" title="USD NZD 5 Year Chart" width="512" /><br />With most countries, the war cries are coming from the political establishment, who feel compelled to demonstrate to their constituents that they are diligently monitoring the currency war. This is largely the case in New Zealand, as Members of Parliament have argued forcefully in favor of intervention. <a href="http://home.nzcity.co.nz/news/article.aspx?id=122141&fm=newsmain,nrhl">Prime Minister John Key</a> is a little more pragmatic: He “says his Government is concerned about the strength of our dollar, but is not convinced intervention would work…politicians who think intervention can happen without economic consequences, are fooling themselves.” Showing an astute understanding of economics, he pointed out that trying to limit the Kiwi’s appreciation would manifest itself in the form of higher inflation, higher interest rates, and/or reduced access to capital.<br /> This is essentially the position of <a href="http://www.nzherald.co.nz/business/news/article.cfm?c_id=3&objectid=10686720">Alan Bollard</a>, Governor of the Central Bank of New Zealand. He has insisted (correctly) that the New Zealand is being driven up, so much as its currency counterparts – namely the US Dollar – are being driven downward, by forces completely disconnected from New Zealand and way beyond its control. Thus, if New Zealand tried to intervene, it would quickly be overpowered (perhaps deliberately!) by speculators. Ultimately, it would end up spending lots of money in vain, and the Kiwi would continue to appreciate.<br /> Mr. Bollard has pointed out that a stronger currency is not without its perks: such as lower (relative) prices for certain natural resources, such as oil. In addition, since New Zealand is largely a commodity economy, its producers are being compensated for an expensive currency in the form of higher prices for milk, wool, and other staple exports. While its other manufacturing operations have been punished by the expensive Kiwi, its economy is still relatively robust. Thanks to a series of tax cuts and the lowest interest rates in New Zealand history, <a href="http://www.treasury.govt.nz/budget/forecasts/befu2010/003.htm">GDP is forecast</a> to return to trend in 2010 and 2011.<br /> <img alt="New Zealand Current Account Balance 2000 - 2014" class="aligncenter size-full wp-image-3170" height="352" src="http://www.forexblog.org/wp-content/uploads/2010/11/New-Zealand-Current-Account-Balance-2000-2014.jpg" title="New Zealand Current Account Balance 2000 - 2014" width="522" /><br /> New Zealand’s concerns are understandable, and there is an argument to be made for preventing the Dollars that are printed from the Fed’s QE2 from being put to unproductive purposes in New Zealand. At the same time, New Zealand is not such an attractive target for speculators. Its benchmark interest rate, at 3%, is relatively low compared to developing countries. Its current account balance is projected to continue declining, perhaps down to -8%, which means that the net flow of capital is actually out of New Zealand. In addition, while the Kiwi has appreciated against the US Dollar, it has fallen mightily against the Australian Dollar en route to a multi-year low.<br /> Going forward, there is reason to believe that the New Zealand Dollar will continue to appreciate against the US Dollar as a result of QE2 and a general sense of pessimism towards the US. The same is true with regard to currencies that actively intervene to prevent their currencies from appreciating. Still, I don’t think the New Zealand Dollar will reach parity – against any currency – anytime soon, and after the currency fracas subsides, it will probably trend towards its long-term average.

New Zealand: No Forex Intervention

Despite reaching a temporary stalemate, the currency war rages on, and individual countries continue to debate whether they should enter or...

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Currency War Will End in Tears

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.<br /> There have been a handful of developments since the my last <a href="http://www.forexblog.org/2010/11/currency-wars-will-everyone-please-stop-whining.html">analysis of the currency war</a>. First of all, more Central Banks (and hence, more currencies) are now affected. In the last week, <a href="http://www.reuters.com/article/idUSN2526882420101025">Argentina</a> pledged to continue its interventions into 2011, while <a href="http://www.bloomberg.com/news/2010-10-19/taiwan-s-central-bank-says-will-step-in-market-if-currency-overshoots-.html">Taiwan</a>, and <a href="http://www.google.com/url?sa=t&source=news&cd=2&ved=0CDIQqQIwAQ&url=http%3A%2F%2Fwww.google.com%2Fhostednews%2Fafp%2Farticle%2FALeqM5hjvn-Zz7CZESqp77lDuDhOct_phQ%3FdocId%3DCNG.615e81fcbfde979d9029b9abee0c4ef6.501&ei=4MXXTNHqDZG8vgPJl6XKCQ&usg=AFQjCNGK1h_X7IdFTrVUANgVN10Otk-n0g&sig2=ADqmtCgtOdH_EzLU72U11w">India</a> – among other less prominent countries – have hinted towards imminent involvement.<br /><a name="more"></a><br /> Of greater significance was the official <a href="http://www.forexblog.org/2010/11/fed-surprises-markets-with-scope-of-qe2.html">expansion of the Fed’s Quantitative Easing Program (QE2)</a>, 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.”  <a href="http://www.ibtimes.com/articles/77519/20101101/china-currency-war-fed-stimulus-qe-quantitative-easing-commerce-ministry-g20.htm">According to Chinese officials</a>, “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 “<a href="http://www.theglobeandmail.com/report-on-business/economy/emerging-markets-slam-feds-qe2-stimulus/article1786329/">weak-dollar policy</a>.”<br /> <img alt="Currency War Dollar Depreciation" class="aligncenter size-full wp-image-3164" height="468" src="http://www.forexblog.org/wp-content/uploads/2010/11/Currency-War-Dollar-Depreciation.jpg" title="Currency War Dollar Depreciation" width="200" /><br /> As of now, there is no indication that other industrialized countries will follow suit, though given concerns that QE2 “<a href="http://www.google.com/hostednews/afp/article/ALeqM5griNH5ZOy63EOPorTqiLJnVmvdrA?docId=CNG.655cd458e9f0eee8f064a9acb8e76a65.e1">at the end of the day</a> 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.”<br /> 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.<br /> 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 ” ‘<a href="http://www.google.com/hostednews/afp/article/ALeqM5griNH5ZOy63EOPorTqiLJnVmvdrA?docId=CNG.655cd458e9f0eee8f064a9acb8e76a65.e1">There aren’t any legal obligations</a>‘…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.<br /> 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: “<a href="http://www.ft.com/cms/s/0/9b6d79c0-d885-11df-8e05-00144feabdc0,dwp_uuid=9c33700c-4c86-11da-89df-0000779e2340.html">The history of capital controls</a> 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.<br /> In short, the “<a href="http://www.forexblog.org/2010/10/emerging-market-wall-of-money-spurs-currency-war.html">wall of money</a>” 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 <a href="http://www.csmonitor.com/Commentary/David-R.-Francis/2010/1022/Currency-market-Fix-the-rules.-Avoid-a-trade-war">new currency agreement</a> can change.

Currency War Will End in Tears

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 bel...

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Fed Surprises Markets with Scope of QE2

<div style="text-align: left;">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.</div><a name="more"></a><br /> <div style="text-align: center;"><img alt="Fed Balance Sheet 2010 QE2" class="aligncenter size-full wp-image-3160" height="491" src="http://www.forexblog.org/wp-content/uploads/2010/11/Fed-Balance-Sheet-2010-QE2.png" title="Fed Balance Sheet 2010 QE2" width="545" /></div><a href="http://www.nytimes.com/2010/11/04/business/economy/04fomc.html">On Wednesday</a>, 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.<br /> 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, “<a href="http://www.google.com/url?sa=t&source=web&cd=1&ved=0CBIQFjAA&url=http%3A%2F%2Foneclick.indiatimes.com%2Fquote%2F08K40Jc3l64jX&ei=P6fSTMq1BYHIuAOm95n0Dg&usg=AFQjCNFIqKj-Qp0hD-Z_9Vijt8K18sUNwQ&sig2=f2j4oqtRM39UZDNn1RKfVw">I would put very little weight on what is priced into the market</a>.” 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.<br /> <div style="text-align: center;"><img alt="EUR-USD 5 Day Chart 2010" class="aligncenter size-full wp-image-3156" height="247" src="http://www.forexblog.org/wp-content/uploads/2010/11/EUR-USD-5-Day-Chart-2010.jpg" title="EUR-USD 5 Day Chart 2010" width="566" /></div>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.<br /> 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 <em>reality</em> 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.<br /> 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.

Fed Surprises Markets with Scope of QE2

For the last few months, and especially over the last few weeks, the financial markets have been obsessed with the rumored expansion of th...

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China Diversifies Forex Reserves

China’s foreign exchange reserves continue to surge. As of September, the total stood at $2.64 Trillion, an all-time high. However, it’s becoming abundantly clear that China is no longer content for Dollar-denominated assets to represent the cornerstone of its reserves. Instead, it has embarked on a campaign to further diversify its reserves, with important implications for the currency markets.<br /><a name="more"></a><br /> <img alt="China Forex Reserves 2010" class="aligncenter size-full wp-image-3140" height="281" src="http://www.forexblog.org/wp-content/uploads/2010/10/China-Forex-Reserves-2010.jpg" title="China Forex Reserves 2010" width="234" /><br /> Despite China’s allowing the Chinese Yuan to appreciate (or perhaps because of it), hot money continues to flow in – nearly $200 Billion in the the third quarter alone. Foreign investors are taking advantage of strong investment prospects, rising interest rates, and the guarantee of a more valuable currency. In order to prevent the inflows from creating inflation and putting even more upward pressure on the RMB, the Central Bank “sterilizes” the inflows by purchasing an offsetting quantity of US Dollars and other foreign currency.<br /> Since the Central Bank does not release precise data on the breakdown of its reserves, analysts can only guess. Estimates range from the world average of 62% to as high as 75%. At least $850 Billion (this is the official tally; due to covert buying through offshore accounts, the actual total is probably higher) of its reserves are held in US Treasury securities. It also controls a $300 Billion Investment Fund, which has made very public investments in natural resource companies around the world. The allocation of the other $1.5 Trillion is a matter of speculation.<br /> Still, China has stated transparently that it wants to diversify its reserves into emerging market currencies, following the global shift among private investors. Investment advisers praise China for its shrewdness, in this regard: “The <a href="http://www.bloomberg.com/news/2010-10-11/china-seeks-to-add-emerging-market-currencies-to-foreign-exchange-reserves.html">Chinese authorities are some of the smartest in the world</a>. If you look at the fundamentals of a lot of these emerging markets, they are considerably better than developed markets. Who wants to be holding U.S. dollars at this stage?” However, these investments serve two other very important objectives.<br /> The first is diplomatic/political. When China recently signed an <a href="http://online.wsj.com/article/BT-CO-20101008-707616.html">agreement with Turkey</a> to conduct bilateral trade in Yuan and Lira (following similar deals with Brazil and Russia), it was interpreted as an intention snub to the US, since trade is currently conducted in US Dollars. In addition, by funding projects in other emerging markets through a combination of loans investments, China is able to curry favor with host countries, as well as to help its own economy at the same time. The second is financial: by buying the currencies of trade rivals, China is able to make sure that its own currency remains undervalued. This year, it has already purchased more than $5 Billion in South Korean bonds, and perhaps $20 Billion in Japanese sovereign debt, sending the Won and the Yen skywards in the process.<br /> China’s purchases of Greek and (soon) Italian debt serve the same function. It is seen as an ally to financially troubled countries, while its efforts help to keep the Euro buoyant, relative to the RMB. <a href="http://online.wsj.com/article/SB10001424052748704657304575539423408190924.html?mod=googlenews_wsj">According to Chinese Premier Wen JiaBao</a>, “China firmly supports Greece’s efforts to tackle the sovereign debt crisis and won’t cut its holdings of European bonds.”<br /> For now, China remains deeply dependent on the US Dollar, and is still very vulnerable to a sudden depreciation it its value. For as much as it wants to diversify, the supply of Dollars and the liquidity with which they can be traded means that it will continue to hold the bulk of its reserves in Dollar-denominated assets. In addition, the Central Bank has no choice but to continue buying Dollars for as long as the RMB remains pegged to it. At some point in the distant future, the Yuan will probably float freely, and China won’t have to bother accumulating foreign exchange reserves, but that day is still far away. For as long as the peg remains in place, the Dollar’s status as global reserve currency is safe.

China Diversifies Forex Reserves

China’s foreign exchange reserves continue to surge. As of September, the total stood at $2.64 Trillion, an all-time high. However, it’s b...

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QE2 Weighs on Dollar

<div class="entrytext"> 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 <em>currency war</em>. However, I think that the expansion of the Federal Reserve Bank’s quantitative easing program (dubbed <em>QE2</em> 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.<br /><a name="more"></a><br /> For the last month or so, markets have been bracing for QE2. At this point it is seen as a near certainty, with a <a href="http://www.reuters.com/article/idUSTRE69B14B20101015">Reuters poll</a> showing that all 52 analysts that were surveyed believe that is inevitable. On Friday, <a href="http://www.bloomberg.com/news/2010-10-16/dollar-declines-for-fifth-week-on-prospects-of-more-monetary-easing-by-fed.html">Ben Bernanke</a> 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.<br /> 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.<br /> 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: “<a href="http://www.minyanville.com/businessmarkets/articles/quantitative-easing-qe2-securities-commodity-prices/10/15/2010/id/30575">The actual problem with the economy</a> 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.<br /> <div style="text-align: left;"><img alt="QE2- US Dollar Trade-Weighted Index 2008-2010" class="aligncenter size-full wp-image-3113" height="411" src="http://www.forexblog.org/wp-content/uploads/2010/10/QE2-US-Dollar-Trade-Weighted-Index-2008-2010.jpg" title="QE2- US Dollar Trade-Weighted Index 2008-2010" width="572" /><br />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.</div>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 “<a href="http://www.theglobeandmail.com/report-on-business/economy/economy-lab/milner-economy/qe2-whos-the-currency-manipulator-now/article1757674/">awfully hypocritical </a>for American officials to label the Chinese as currency manipulators? They are, but they’re not alone.”<br /> </div>

QE2 Weighs on Dollar

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 t...

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Emerging Market “Wall of Money” Spurs Currency War

<div class="entrytext"> According to Goldman Sachs (which if nothing else, is good at characterizing financial trends. Remember “BRIC?”), there is a “<a href="http://www.hurriyetdailynews.com/n.php?n=goldman-sees-record-8216wall-of-money8217-flooding-emerging-markets-2010-09-12">Wall of Money</a>” that is already flooding emerging markets and will continue to do so for the foreseeable future.<br /><a name="more"></a><br /> <div style="text-align: center;"><img alt="MSCI Emerging Markets Chart 2006 - 2010" class="aligncenter size-full wp-image-3101" height="435" src="http://www.forexblog.org/wp-content/uploads/2010/10/MSCI-Emerging-Markets-Chart-2006-2010.jpg" title="MSCI Emerging Markets Chart 2006 - 2010" width="573" /></div>“The <a href="http://www.marketwatch.com/story/flows-into-emerging-markets-jump-2010-10-04">Institute of International Finance</a> projected 2010 capital flows of $825 billion, up from $581 billion in 2009 and from the $709 billion that the trade group for global financial-services firms had projected for 2010 in April.” In hindsight, the outflow of capital from emerging markets that took place during the financial crisis will probably look like a blip, as risk appetite has already recovered to pre-crisis levels, and then some!<br /> “The move into emerging markets has been led by stock investors, who will pour an estimated $186 billion into these countries this year, — fully three times the annual average of $62 billion generated between 2005 and 2009.” Emerging Market Bond funds, meanwhile, now routinely receive more than $1 Billion per week. Sovereign wealth funds are also starting to shift some of their assets into emerging market assets/currencies as part of their respective diversification strategies. As you can see from the chart below (courtesy of <a href="http://www.economist.com/node/17199508?story_id=17199508&CFID=150472507&CFTOKEN=92076672">The Economist</a>), Asia is by far the largest recipient of investment, followed by Latin America.<br /> <img alt="Emerging Markets Net Capital Flows, Forex Reserves" class="aligncenter size-full wp-image-3103" height="347" src="http://www.forexblog.org/wp-content/uploads/2010/10/Emerging-Markets-Net-Capital-Flows-Forex-Reserves.gif" title="Emerging Markets Net Capital Flows, Forex Reserves" width="412" /><br />The continued shift of capital from the industrialized world into emerging markets as being driven both by economic fundamentals and the desire to earn a greater return on investment. “<a href="http://www.bloomberg.com/news/2010-10-11/china-seeks-to-add-emerging-market-currencies-to-foreign-exchange-reserves.html">The IMF forecast</a> this month that developing nations will expand 6.4 percent next year, outstripping growth of 2.2 percent among advanced economies.” Meanwhile, the ratio of foreign debt to GDP among developing nations has been cut to 26 percent, compared to 41 percent in 1999. And yet, even as analysts predict that emerging markets will account for 85% of global growth going forward, “emerging markets account for $3 trillion, or only 15 percent of market capitalisation of the benchmark MSCI world index.”<br /> While it’s understandable, then, that investors would want to rectify this imbalance as quickly as possible, they need to realize that developing countries’ capital markets simply aren’t deep enough to absorb all of the incoming capital. In other words, an limited pool of capital is chasing a limited stock of accessible investments, and the result is that asset prices and exchange rates are climbing inexorably higher.<br /> Analysts argue, “Some appreciation is due: a rise against rich-world currencies is both a natural consequence of the faster growth of emerging economies and a way to correct global imbalances.” But a 50% rise over five years (notched by a handful of currencies) does not represent some appreciation, but rather an explosion. This is precisely the sentiment echoed by many of the emerging markets, themselves, which have taken to using guerilla tactics to hold down their currencies. Since the latest phase of the “currency war” was ignited by Japan in September, every week has led to increasingly far-flung countries – Peru, Chile, Czech Republic, Poland, South Africa – <a href="http://www.marketwatch.com/story/more-countries-may-seek-to-cool-currencies-2010-10-09?reflink=MW_news_stmp">reputedly contemplating intervention</a>.<br /> According to an interesting <a href="http://www.economist.com/node/17199508?story_id=17199508&CFID=150472507&CFTOKEN=92076672">economic analysis</a>, which scaled intervention to the size of the given country’s monetary base, South Korea and Taiwan have been among the most active participants in forex markets, while Thailand and Malaysia have been among the most restrained. This is born out by the sizable appreciation of both the Thai Baht and Malaysian Ringit over the last few years. However, I wonder if some economists will take issue with their assessment that Brazil and China have been relatively modest interveners.<br /> Of course, this doesn’t make it any easier to forecast, since how a country behaved in the past isn’t necessarily indicative of how it will behave in the future. For example, Thailand just announced that it will not intervene, but Brazil will double its forex tax from 2% to 4%. Case in Point!<br /> </div>

Emerging Market “Wall of Money” Spurs Currency War

According to Goldman Sachs (which if nothing else, is good at characterizing financial trends. Remember “BRIC?”), there is a “ Wall of M...

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Currency War: Who are the Winners and Losers?

<div class="entrytext"> On September 27, Brazilian Finance Minister, Guido Montega, used the term “currency war” to describe the series of recent Central Bank interventions in forex markets. While he may not have intended it, the term stuck, and financial journalists everywhere have run wild with it.<br /><a name="more"></a><br /> In the current cycle (dating back a couple years), more than a dozen Central Banks have entered the forex markets with the intention of holding down their respective currencies, both against each other and also against the US Dollar. What makes it a war is that the Central Banks are fighting to outspend and outdo each other. It is a <em>War of Attrition</em>, in that Central Banks will fight until they’ve exhausted all of their wherewithal, conceding defeat for their currencies. On the other hand, unlike in a conventional war, there aren’t any alliances, nor is there much in the way of little strategy. Central Banks simply buy large blocks of counter currencies and hope their own currencies will then depreciate on the spot market. In addition, since the counter currencies are almost always Dollars and/or Euros, the participants in this war are not even competing directly against each other, but rather against an enemy that isn’t doing much to fight back. [<a href="http://www.spiegel.de/international/world/bild-721044-138065.html">Chart below</a>courtesy of Der Spiegel].<br /> <div style="text-align: center;"><img alt="Unequal Competition- Global Trade and Currency Wars" class="aligncenter size-full wp-image-3082" height="419" src="http://www.forexblog.org/wp-content/uploads/2010/10/Unequal-Competition-Global-Trade-and-Currency-Wars.jpg" title="Unequal Competition- Global Trade and Currency Wars" width="595" /></div>The Swiss National Bank (SNB) was the first to intervene, and staged a one-year campaign over the course of 2009 to hold the Swiss Franc at 1.50 against the Euro. Ultimately, it failed when the sovereign debt crisis caused an exodus of Euro selling. The Bank of Brazil was next, although its interventions havebeen more modest; it seems to have accepted the ultimate futility of its efforts, and will seek to slow the Real’s appreciation rather than halt it. Last month, the Bank of Japan spent $20 Billion in one session in order to show the markets how serious it is about fighting the Yen’s rise. In fact, it was this intervention that sparked Montega’s comments about currency war. (The BOJ hasn’t intervened since). All along, the People’s Bank of China has continued to add to its war chest of reserves – currently $2.5 Trillion – as part of the ongoing Yuan-Dollar peg. And of course, there have been a handful of smaller interventions (South Korea, Singapore, Taiwan) and no shortage of rhetorical (Canada, South Africa) interventions, as well as indirect (US, UK) intervention.<br /> That’s right- don’t forget that the Fed and the Bank of England, through their respective quantitative easing programs, have injected Trillions into the financial markets and caused their currencies to weaken. In a sense, all of the subsequent interventions have been effected in order to restore the equilibrium in the currency markets that was lost when these two Central Banks deflated there currencies through wholesale money printing. Since much of this cash has found its way into emerging markets (See chart below), you can’t blame their Central Banks from trying to soften some of the upward pressure on their currencies.<br /> It’s still too early too early to say how far the currency war will go. The G7/G20 has announced that it will address the issue at its next summit, though it probably won’t lead to much in the way of action. Ultimately, politicians can’t do much more than shake their fingers at countries that try to hold down their currencies. In the case of the Yuan-Dollar peg, American politicians have tried to take this one step further by threatening to slap China with punitive trade sanctions, but this probably won’t come to pass and may disappear as an issue altogether after the November elections. As I <a href="http://www.forexblog.org/2010/10/brazilian-real-at-2-year-high-despite-currency-war.html">reported on Friday</a>, Brazil has taken matters into its own hands by taxing all foreign capital inflows, but this hasn’t had much effect on the Real.<br /> <div style="text-align: center;"><img alt="Emerging Market Capital Inflows 2009-2010" class="aligncenter size-full wp-image-3081" height="298" src="http://www.forexblog.org/wp-content/uploads/2010/10/Emerging-Market-Capital-Inflows-2009-2010.jpg" title="Emerging Market Capital Inflows 2009-2010" width="496" /></div>That brings me to my final point, which is that all currency intervention is futile in the long term, because most Central Banks have limited capacity to intervene. If they print too much money to hold down their currencies, they risk stoking inflation. Of course China is the exception to this rule, but this is less because of the size of its war chest and more because of the mechanics of its exchange rate regime. For Central Banks to successfully manipulate their currencies on the spot market, they must fight against the Trillions of Dollars in daily forex turnover. Eventually, every Central Bank must reckon with this truism.<br /> In terms of identifying the winners and losers of the currency war (as I promised to do in the title of this post, the Euro will probably lose (read: appreciate) because the ECB is not willing to participate. The same goes for the Swiss Franc, since the SNB has basically forsaken currency intervention for the time being. The Bank of Japan has deep pockets, and if the markets push the Yen back up above 85 Yen/Dollar, I wouldn’t be surprised to see it intervene again. With the Fed mulling an expansion of its quantitative easing program, meanwhile, the Dollar will probably continue to sink. And as for the countries that are doing the actual intervening, they might succeed in temporarily holding down the valuer of their respective currencies.  As capital shifts to emerging markets over the long-term, however, their currencies will soon resume rising.<br /> </div>

Currency War: Who are the Winners and Losers?

On September 27, Brazilian Finance Minister, Guido Montega, used the term “currency war” to describe the series of recent Central Bank ...

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Bullish on the Euro?

<div class="entrytext"> Wouldn’t life just be a little easier if the EUR/USD, the most important forex pair and bellwether of currency markets, could simply pick a direction and stick to it. It dove during the financial crisis, only to surge during the apparent recovery phase, fell during the sovereign debt crisis, and rose during the <a href="http://www.forexblog.org/2010/08/euro-recovery-paradigm-shift-confirmed.html">paradigm shift</a>, then fell as risk appetite waned, only to rise again in September, en route to a 5-month high.<br /><a name="more"></a><br /> <div style="text-align: left;"><img alt="Euro Dollar 5 Year Chart 2006-2010" class="aligncenter size-full wp-image-3064" height="244" src="http://www.forexblog.org/wp-content/uploads/2010/09/Euro-Dollar-5-Year-Chart-2006-20102.png" title="Euro Dollar 5 Year Chart 2006-2010" width="568" /><br />There are a handful of factors which currently underlie the Euro’s strength, which can all generally be explained by the fact that <a href="http://www.forexblog.org/2010/08/risk-on-risk-off.html">risk is “on”</a> at the moment, and the markets are moving away from so-called safe haven currencies and back towards growth investments. Of course that could change tomorrow (or even 5 minutes from now!), but at the moment, risk appetite is high and the Euro symbolizes risk. Never mind how ironic it is, that <a href="http://www.neurope.eu/articles/Better-prospects-for-the-EU-economy/102827.php">growth in the EU</a> is projected at 1.8% for the year while Rest of World (ROW) GDP will probably top 5%. All that matters is compared to the Dollar (and Yen, Pound, Franc to a lesser extent) the Euro is perceived as the currency of risk.</div><div style="text-align: left;">The Euro’s cause is also helped by the ongoing “<a href="http://www.ft.com/cms/s/0/7610475e-cb45-11df-95c0-00144feab49a.html">currency wars</a>,” which heated up last week with Japan’s entry into the game. Basically, Central Banks around the world are now competing with each other to devalue their currencies. In contrast, the European Central Bank (ECB) has decided to remain on the sidelines (in favor of fiscal austerity), which is forcing the Euro up (or rather all other currencies down). To make matters even worse, “The <a href="http://online.wsj.com/article/BT-CO-20100928-709960.html">U.S. Federal Reserve indicated this summer</a> that it may ease monetary policy further… often seen as printing money to pump up the economy.” As a result, “The euro looks set to keep on climbing in a trend that looks increasingly entrenched.”</div>There are certainly those that argue that the Euro’s recent surge reflects renewed confidence in the Eurozone economy and prospects for resolving the EU debt crisis. After all, most Euro members will reduce their budget deficits in 2010 and auctions of new bonds are once again oversubscribed. On the other hand, interest rates for the PIGS (Portugal, Italy, Greece, and Spain) have <a href="http://www.economist.com/node/17093339?story_id=17093339&fsrc=rss">risen to multi-year highs</a>, as investors are finally trying to make a serious effort at pricing the possibility of default.<br /> <div style="text-align: left;"><img alt="Eurozone sovereign debt interest rates graph 2007-2010" class="aligncenter size-full wp-image-3065" height="281" src="http://www.forexblog.org/wp-content/uploads/2010/09/Eurozone-sovereign-debt-interest-rates-graph-2007-2010.gif" title="Eurozone sovereign debt interest rates graph 2007-2010" width="290" /><br />In addition, the credit markets in the EU are barely functioning, and large institutions remain dependent on the ECB’s credit facilities for financing. Finally, it shouldn’t be forgotten that the only reason crisis was due to the <a href="http://online.wsj.com/article/SB10001424052748703904304575497871279626904.html?mod=googlenews_wsj">massive support (€140 Billion) extended to Greece</a>. When this program expires in less than three years, the fiscal problems of Greece (and the other PIGS) will be exposed once again, and a new (stopgap) solution will need to be proposed.</div>As every analyst has pointed out, none of the EU’s fiscal problems have been solved. EU members have certainly proven adept at resolving acute crises and the ECB certainly deserves credit for keeping credit markets functioning, but none has proposed a viable solution for repairing of member countries’ fiscal and economic health. Currency devaluation is impossible. Sovereign default is being prevented. That leaves wage cuts and increased productivity as the only two paths to equilibrium. The former could be accomplished through inflation, but the ECB seems reluctant to allow this to happen.<br /> <div style="text-align: left;"><img alt="Eurozone Budget Deficits, GDP" class="aligncenter size-full wp-image-3066" height="310" src="http://www.forexblog.org/wp-content/uploads/2010/09/Eurozone-Budget-Deficits-GDP.PNG" title="Eurozone Budget Deficits, GDP" width="575" /></div>For better or worse, the EU seems to have pushed these problems down the road, and if all goes according to plan, they won’t need to be revisited for 2-3 years. For now, then, the Euro is probably safe, and may even thrive. Short positions in the Euro are being unwound with furious speed and data indicate that there is still plenty of scope for further unwinding. Inflation remains subdued, economic growth is stable, and the ECB so far hasn’t voiced any disapproval of the Euro’s rise. While I promote this bullishness with the caveat that “traders have shown a willingness to smack the euro lower from time to time on the slightest news or rumor of downgrades to euro-zone sovereign or bank ratings,” the general Euro trend is now unquestionably UP.<br /> </div>

Bullish on the Euro?

Wouldn’t life just be a little easier if the EUR/USD, the most important forex pair and bellwether of currency markets, could simply p...

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Keep an Eye on Central Banks

<div style="text-align: left;">From monetary policy to quantitative easing to forex intervention, the world’s <a href="http://www.forexblog.org/category/central-banks">Central Banks</a> are quite busy at the moment. Even though the worst of the credit crisis has past and the global economy has moved cautiously into recovery mode, there is still work to be done. Unemployment remains stubbornly high, inflation is too low, and asset prices are teetering on the edge of decline. In short, Central Banks will continue to hog the spotlight.</div><a name="more"></a><br /> On the monetary policy front, Central Banks have begun to divide into two camps. One camp, consisting of the Federal Reserve Bank, European Central Bank, Bank of England, Bank of Japan, and Swiss National Bank (whose currencies, it should be noted, account for the majority of foreign exchange activity), remains frozen in place. Interest rates in all five countries/regions remain at rock bottom, near 0% in most cases. While the ECB’s benchmark interest rate is seemingly set higher than the others, its actual overnight rate is also close to 0%. Meanwhile, none of these Banks has given any indication that it will hike rates before the end of 2011.<br /> In the other camp are the Banks of Canada, Australia, Brazil, and a handful of other emerging market Central Banks, all of which have cautiously moved to hike rates on the basis of economic recovery. Among industrialized countries, Australia (4.5%) is now at the head of the pack, with New Zealand (3%) in a distant second. Brazil’s benchmark Selic rate, at 10.75%, makes it the world leader among (widely-followed) emerging market countries. It is followed by Russia (7.75%), Turkey (7%), and India (6.1%), among others. The lone exception appears to be China, which maintains artificially low rates to influence the Yuan. [More on that below.]<br /> <div style="text-align: left;">None of the industrialized Central Banks have yet unwound their <a href="http://online.wsj.com/media/balancesheets_cs_20090517210846.jpg">quantitative easing programs</a>, unveiled at the peak of the credit crisis. The Fed’s balance sheet currently exceeds $2 Trillion; its asset-purchase program has driven Treasury rates and mortgage rates to record lows. The same goes for the Banks of England and Japan, the latter of which has actually moved to expand its program in a bid to hold down the Yen. Meanwhile, many of the credit lines that the ECB extended to beleaguered banks and other businesses remain outstanding, and have even expanded in recent months.</div><div style="text-align: center;"><img alt="Central Bank Credit Crisis Intervention 2007-2008" class="aligncenter" height="765" src="http://www.forexblog.org/wp-content/uploads/2010/09/Central-Bank-Credit-Crisis-Intervention-2007-2008.jpg" title="Central Bank Credit Crisis Intervention 2007-2008" width="500" /></div>Central Banks have been especially busy in the currency markets. The Swiss National Bank (SNB) was the first to intervene, and as a result of spending €200 Billion, it managed to hold the Franc below €1.50. As a result of the EU sovereign debt crisis, however, the Franc broke through the peg and his since risen to a record high against the Euro. Unsurprisingly, the SNB has abandoned its forex intervention program. Throughout the past year, the Central Banks of Canada, Brazil, Thailand, Korea have threatened to intervene, but only Brazil has taken action so far, in the form of a levy on all foreign capital inflows. Last week, the Bank of Japan broke its 6-year period of inaction by intervening on behalf of the Yen, which instantly rose 3% on the move. The BOJ has pledge to remain involved, but the extent and duration is not clear.<br /> Finally, the Bank of China allowed the Yuan to appreciate for the first time in two years, but its pace has been carefully controlled, to say the least. In the last few weeks, the Yuan has actually picked up speed, but critics insist that it remains undervalued. In addition, China has contradicted the Yuan’s rise against the Dollar through its purchases of Japanese bonds, which has spurred a rise in the Yen. This is both ironic and counter-productive to global economic recovery: “Since <a href="http://online.wsj.com/article/SB10001424052748703369704575461872519015104.html">China is growing at 10%</a>, it can afford to undermine exports and boost domestic demand by letting the yuan appreciate more rapidly against the dollar. But China doesn’t want to do that. In fact, although China’s State Administration of Foreign Exchange deregulated the currency market overnight, the measures, which allow some exporters to retain their foreign currency holdings for a year, should boost private demand for dollars, not yuan.”<br /> The efforts listed above have undoubtedly moderated the impacts of the financial crisis and consequent economic downturn. However, the banks have found it impossible to engineer a convincing recovery, and at this point, there probably isn’t much more that they do can do. As a result, many analysts are now pinning their hopes on fiscal policy (despite its equally dubious track record). Perhaps, the title of this post should have been: Keep an Eye on Governments and their Stimulus Plans.

Keep an Eye on Central Banks

From monetary policy to quantitative easing to forex intervention, the world’s Central Banks are quite busy at the moment. Even though the ...

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