USD Gets Double Kick

<div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Over the last couple months, a raft of positive economic developments has driven the USD steadily to its highest level in months. These developments include GDP data, retail sales data, and housing data have all shown signs of strength after an all-encompassing slump in the first quarter. However, it was not until last week that the markets fully removed the possibility of</div><a name="more"></a> near-term rate cuts out of the markets, sending US benchmark interest rates to their highest levels in years. As a result, the USD received a second bump, as higher yields sucked in a risk-averse capital from other parts of the world.  The delay between positive economic data and the subsequent rise in yields that took place here is rare, but Dollar bulls were probably happy to ride the wave upwards.  Dow Jones News reports:<br /><blockquote style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;"><div class="MsoNormal" style="margin-bottom: 10px; margin-top: 10px;">Amid soaring rates, the dollar’s rally got a second lease of life, confounding those who had been calling for a reversal in the greenback’s fortunes. Contrast that with late April, when the euro hit a record high of $1.3682 – and analysts were forecasting a run to $1.40.</div></blockquote><div class="MsoNormal" style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Read More: <a href="http://biznes.onet.pl/5,1553133,wiadomosci.html" style="color: #003366;">Dollar Perhaps Undeserving Of Recent Rally</a></div>

USD Gets Double Kick

Over the last couple months, a raft of positive economic developments has driven the USD steadily to its highest level in months. These deve...

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Chinese Yuan: Appreciation or Inflation?

<div id="beta" style="background-color: white; color: #333333; display: inline; float: left; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; min-height: 1px; position: relative; width: 600px;"><div class="pkg" id="beta-inner" style="background-attachment: initial; background-clip: initial; background-image: initial; background-origin: initial; background-position: initial; background-repeat: initial; background-size: initial; border: 0px; padding: 15px; position: static;"><div class="post" id="post-3265"><div class="top_meta">Based on nominal exchange rates, the Chinese Yuan has appreciated by a modest 2% against the US Dollar since the month of September (when the People’s Bank of China (PBOC) adjusted the currency peg for the first time in nearly two years). If you take inflation into account, however, the Chinese Yuan has risen by much more. In fact, if current trends persist, the Chinese Yuan exchange rate controversy might resolve itself.<a name="more"></a></div><div class="entrytext"><div style="margin-bottom: 10px; margin-top: 10px;"><img alt="CNY USD 1 year chart" class="aligncenter size-full wp-image-3266" height="288" src="http://www.forexblog.org/wp-content/uploads/2010/12/CNY-USD-1-year-chart.png" style="display: block; margin: 0px auto 5px;" title="CNY USD 1 year chart" width="512" /><br />Demands from the international community for China to appreciate its currency hinge on two related arguments. The first is that at its current level, the artificially low exchange has allowed China to build up a massive trade surplus. The second is that Chinese prices seem to be lower than they should be (when quoted in other currencies), and the economic principle of <em>Purchasing Power Parity (PPP)</em> suggests that for this discrepancy to be eliminated, the Chinese Yuan must rise.</div><div style="margin-bottom: 10px; margin-top: 10px;">As it turns out, both of these claims are more problematic than they would appear. For example, China’s official <a href="http://www.bloomberg.com/news/2010-12-10/china-reports-more-than-estimated-november-trade-surplus-of-22-9-billion.html" style="color: #003366;">trade surplus</a> is already massive, and is steadily increasing. For 2010, it will probably near $200 Billion. However, it turns out that majority of that surplus is being captured by <a href="http://english.peopledaily.com.cn/90001/90778/90861/7227376.html" style="color: #003366;">foreign-funded companies</a>: “Their 112.5-billion U.S.-dollar surplus accounts for 66 percent of China’s total surplus over the past 11 months.”</div><div style="margin-bottom: 10px; margin-top: 10px;">In addition, trade statistics are calculated in such a way that the country that assembles the finished product gets credit for the full export value of that product. By looking specifically at Apple’s popular iPhone, <a href="http://online.wsj.com/article/SB10001424052748704828104576021142902413796.html?mod=WSJ_hp_us_mostpop_read" style="color: #003366;">researchers calculated</a> that the product officially contributed $2 Billion to the US trade deficit with China. When the nuances of the iPhone’s supply chain are taken into account, that figure swings to a surplus of $48 million. In both of these cases, the fact that these products are manufactured in China doesn’t detract from US GDP (though it probably does cost the US jobs). Hence, the US probably isn’t hurting as much from the weak RMB to the extent that some lobbyists insist.</div><div style="margin-bottom: 10px; margin-top: 10px;"><img alt="iPhone US China trade deficit" class="aligncenter size-full wp-image-3267" height="357" src="http://www.forexblog.org/wp-content/uploads/2010/12/iPhone-US-China-trade-deficit.jpg" style="display: block; margin: 0px auto 5px;" title="iPhone US China trade deficit" width="555" /><br />As for inflation, the official rate is now 5.1% on an annualized basis. Even if we accept this (and living in China, I can tell you that the actual rate is much, much higher), that means that the value of other currencies is eroding at a much faster rate than is implied by official exchange rates. That’s because a currency is only worth its purchasing power; as prices and wages in China rise, the purchasing power of the US Dollar (and other currencies) falls.</div><div style="margin-bottom: 10px; margin-top: 10px;">The Chinese government is trying to address the problem in the form of price controls and mandated increases in supply, but it is still reluctant to rein in inflation using conventional monetary policy measures. M2 money supply in China is increasing at a rate of 20% a year, the majority of which is being spent on another boom in fixed asset investment. While the PBOC has responded by increasing the required reserve ratio of Chinese banks, it remains reluctant to raise interest rates lest it contribute to further inflows of “hot money” on more upward pressure on the Yuan. As a result, the consensus among economists is that inflation will continue rising unabated: “<a href="http://blogs.wsj.com/chinarealtime/2010/11/11/economists-react-chinas-inflation-spike/" style="color: #003366;">We see</a> a strong chance of underlying price pressures continuing to build over the medium-term.”</div><div style="margin-bottom: 10px; margin-top: 10px;"><img alt="China inflation rate 2004-2010" class="aligncenter size-full wp-image-3268" height="255" src="http://www.forexblog.org/wp-content/uploads/2010/12/China-inflation-rate.jpg" style="display: block; margin: 0px auto 5px;" title="China inflation rate 2004-2010" width="563" /><br />Unless circumstances change, then, the argument for further RMB appreciation is somewhat weak. Nonetheless, analysts remain optimistic: “A <a href="http://www.china-briefing.com/news/2010/12/17/goldman-and-nomura-rate-yuan-forwards-as-asias-most-profitable-bet-in-2011.html" style="color: #003366;">Bloomberg survey</a> based on the median estimates of 20 analysts predicts the yuan to increase 6.1 percent to 6.28 percent by the end of 2011.” Given that Hu Jintao is schedule to visit the US in January – and China’s fondness for symbolic policy gestures – a token move of 1% or so before then wouldn’t be surprising. As for the predicted 6% rise next year, well, that depends on inflation.</div></div></div></div></div>

Chinese Yuan: Appreciation or Inflation?

Based on nominal exchange rates, the Chinese Yuan has appreciated by a modest 2% against the US Dollar since the month of September (when th...

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Currency Wars: Will Everyone Please Stop Whining!

<div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">I read a provocative piece the other day by Michael Hudson (“<a href="http://www.alternet.org/news/148481/why_the_u.s._has_launched_a_new_financial_world_war_--_and_how_the_rest_of_the_world_will_fight_back_?page=entire" style="color: #336699;">Why the U.S. Has Launched a New Financial World War — and How the Rest of the World Will Fight Back</a>“), in which he argued that the ongoing currency wars are the fault of the US. Below, I’ll explain why he’s both right and wrong, and why he (and everyone else) should shut up and stop complaining.</div><a name="more"></a><br /><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">It has become almost cliche to argue that the US, as the world’s lone hegemonic power, is also the world’s military bully. Hudson takes this argument one step further by accusing the US of using the Dollar as a basis for conducting “financial warfare.” Basically, the US Federal Reserve Bank’s Quantitative Easing and related monetary expansion programs create massive amounts of currency, the majority of which are exported to emerging market countries in the form of loans and investments. This puts upward pressure on their currencies, and rewards foreign speculators at the expense of domestic exporters.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Hudson is right that the majority of newly printed money has indeed been shifted to emerging markets, where the best returns and greatest potential for appreciation lies. Simply, the current economic and investing climate in the US is not as strong as in emerging markets. Indeed, this is why the (first) Quantitative Easing (QE) program was not very successful, and why the Fed has proposed a second round. While there is a bit of a chicken-and-egg conundrum (does economic growth drive investing, or do investors drive economic growth?) here, current capital flow trends suggest that any additional quantitative easing will also be felt primarily in emerging markets, rather than in the US. Not to mention that the US money supply has expanded at the same pace (or even slower) as the US economy over the long-term.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px; text-align: center;"><img alt="M3 Money Supply 2010" class="aligncenter size-full wp-image-3151" height="250" src="http://www.forexblog.org/wp-content/uploads/2010/11/M3-Money-Supply-2010.png" style="display: block; margin: 0px auto 5px;" title="M3 Money Supply 2010" width="425" /></div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">While the point about QE being ineffective is well-taken, Hudson completely ignores the strong case to be made for investing in emerging markets. He dismissively refers to all such investing as “extractive, not productive,” without bothering to contemplate why investors have instinctively started to prefer emerging markets to industrialized markets. As I said, emerging market economies are individually and collectively more robust, with faster growth and lower-debt than their industrialized counterparts. Calling such investing predatory represents a lack of understanding of the forces behind it.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Hudson also overlooks the role that emerging markets play in this system. The fact that speculative capital continues to pour into emerging markets despite the 30% currency appreciation that has already taken place and the asset bubbles that may be forming in their financial markets suggests that their assets and currencies are still undervalued. That’s not to say that the markets are perfect (the financial crisis proved the contrary), but rather that speculators believe that there is still money to be made. On the other side of the table, those that exchange emerging market currency for Dollars (and Euros and Pounds and Yen) must necessarily accept the exchange rate they are offered. In other words, the exchange rate is reasonable because it is palatable to all parties.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">You can argue that this system unfairly penalizes emerging market countries, whose economies are dependent on the export sector to drive growth. What this really proves, however, is that these economies actually have no comparative advantage in the production and export of whatever goods they happen to be producing and exporting. If they can offer more than low costs and loose laws, then their export sectors will thrive in spite of currency appreciation. Look at Germany and Japan: both economies have recorded near-continuous trade surpluses for many decades in spite of the rising Euro and Yen.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">The problem is that everyone benefits (in the short term) from the fundamental misalignments in currency markets. Traders like to mock <em>purchasing power parity</em>, but over the long-term, this is what drives exchange rates. Adjusting for taxes, laws, and other peculiarities which distinguish one economy from another, prices in countries at comparable stages of development should converge over the long-term. You can see from The Economist’s Big Mac Index that this is largely the case. As emerging market economies develop, their prices will gradually rise both absolutely (due to inflation) and relatively (when measured against other currencies).</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;"><img alt="Economist-Big-Mac-Index-July-2010" class="aligncenter size-full wp-image-3147" height="607" src="http://www.forexblog.org/wp-content/uploads/2010/11/Economist-Big-Mac-Index-July-2010.gif" style="display: block; margin: 0px auto 5px;" title="Economist-Big-Mac-Index-July-2010" width="290" /><br />Ultimately, the global economy (of which currency markets and exchange rates represent only one part) always operates in equilibrium. The US imports goods from China, which sterilizes the inflows in order to avoid RMB appreciation by building up a stash of US Dollars, and holding them in US Treasury Bonds. Of course, everything would be easier if China allowed the RMB to appreciate AND the US government stopped running budget deficits, but neither side is willing to make such a change. In reality, the two will probably happen simultaneously: China will gradually let the RMB rise, which will cause US interest rates  to rise, which will make it more expensive and less palatable to add $1 Trillion to the National Debt every year, and will simultaneously make it more attractive to produce in the US.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Until then, politicians from every country and hack economists with their napkin drawings will continue to whine about injustice and impending economic doom.</div>

Currency Wars: Will Everyone Please Stop Whining!

I read a provocative piece the other day by Michael Hudson (“ Why the U.S. Has Launched a New Financial World War — and How the Rest of the ...

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Much Ado About Debt

<div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">In addressing the financial/credit/economic crisis, governments around the world have lowered interest rates, bailed-out bankrupt financial insititutions, engaged in wholesale money printing, guaranteed debt, and pumped cash into their economies. However, while such programs may have had some mitigating impact on the crisis, they did little to address the underlying cause. Specifically, debt was merely moved from one institution – one balance sheet – to another. Most of the bad debt that was at the heart of the credit crisis is still outstanding; the only thing that has changed is who is responsible for repaying it.</div><a name="more"></a><br /><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">In many cases, it is governments which have assumed ownership of this debt. Fannie Mae and Freddie Mac remain in a US government conservatorship. The Federal Reserve Bank owns more than $2 Trillion in US Treasuries and Mortgage Backed Securities. The European Union has agreed to collectively back more than $500 Billion in debt belonging to Greece and other unspecified “troubled” member states. The Japanese government has managed to pass off 90% of its sovereign debt onto its own citizens. The UK Treasury has printed money and lent it to the government of the UK. [The <a href="http://www.economist.com/blogs/newsbook/2010/08/government_and_private_debt_after_crisis" style="color: #003366;">graphic below</a> is actually interactive, and is worth a few minutes of perusing].</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;"><img alt="Global Debt by Country 2010" class="aligncenter size-full wp-image-3131" height="399" src="http://www.forexblog.org/wp-content/uploads/2010/10/Global-Debt-by-Country-2010.jpg" style="display: block; margin: 0px auto 5px;" title="Global Debt by Country 2010" width="585" /></div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">So what are the possibilities for dealing with this debt? In terms of government debt, the first is to hope that economies can grow faster than the debt, so that it becomes more manageable in relative terms and that one day it can be repaid. Another option is to raise taxes and/or cut spending, and use the extra funds to retire the debt. Given the current economic environment, the former possibility is unlikely. Industrialized economies continue to stall, and much of this growth is being funded with new debt. The latter option would amount to political suicide; any government that is politically naive enough to approve any austerity measures will be voted out of office at the next election. (With the election season about to begin, we won’t have to wait long for confirmation!)</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">The only alternative then is to reduce the real amount of debt through monetary inflation or currency depreciation. In the US, inflation is at a 50-year low. In Japan, it is non-existent. In the UK and the EU, prices are hardly growing. Monetary policymakers around the world are now actively trying to spur inflation (for reasons unrelated to the reduction of debt), but to no avail. Interest rates are already at rock bottom, and Central Banks have injected Billions of newly minted money into circulation without any impact on prices.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Currency devaluation is already taking place, but the main participants are emerging market economies (which are incidentally more concerned about export competitiveness than reducing the size of the debts). The Japanese Yen is nearing an all-time high, while the Euro has recovered from its spring lows. The British Pound is near its long-term average, while the US Dollar has declined only slightly on a trade-weighted average. In the end, since all of these countries are characterized by high levels of debt, it would be impossible for all of them to devalue their currencies. In addition, the nature of the Euro currency union precludes Eurozone countries from being able to lower their debts through currency devaluation.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">The story is the same for private debt. For example, most of the real estate (commercial and residential) debt associated with the collapse of the housing market has yet to be written off. Financial institutions and investors continue to hold onto it with the hope that the real estate market will soon recover, such that the losses will never need to be recognized. While this strategy could vindicate lenders/investors over the long-term, it continues to have a devastating effect in the short-term since it forces the holders of debt to keep more cash on their balance sheets, where it won’t find its way into the global economy.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;"><img alt="Euro Franc Dollar Yen 1990-2010 Real Exchange Rates" class="aligncenter size-full wp-image-3130" height="317" src="http://www.forexblog.org/wp-content/uploads/2010/10/Euro-Franc-Dollar-Yen-1990-2010-Real-Exchange-Rates.gif" style="display: block; margin: 0px auto 5px;" title="Euro Franc Dollar Yen 1990-2010 Real Exchange Rates" width="290" /></div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">What are the implications for forex markets? Namely, it would seem to support the notion that emerging market currencies will continue to outperform the G4 currencies over the long-term. Over the near-term, it’s possible that G4 currencies will experience some appreciation, due both to the ebb and flow of risk appetite and the interventions of emerging market Central Banks on behalf of their currencies. Over the long-term, however, the only realistic alternative to default is currency devaluation, and at some point, the forex markets will have to come to terms with the fact that the G4 currencies need to decline. [Chart above courtesy of <a href="http://www.economist.com/node/17093549?story_id=17093549&CFID=150472507&CFTOKEN=92076672" style="color: #003366;">The Economist</a>].</div>

Much Ado About Debt

In addressing the financial/credit/economic crisis, governments around the world have lowered interest rates, bailed-out bankrupt financial ...

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Australia Dollar Ebbs and Flows with Risk

<div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">If you chart the course of the Australian Dollar over the last twelve months alongside the S&P 500, the overlap is jarring. You can see from the chart below that the two lines zig and zag in almost perfect unison. It would seem that there was a slight break in the second quarter of 2010, but even this is an illusion, since the Aussie and the S&P continued to rise and fall in the same patterns over that time period, differing only in degree of fluctuation.</div><a name="more"></a><br /><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;"><img alt="Australian Dollar Versus S&P 500: 2009-2010" class="aligncenter size-full wp-image-3002" height="288" src="http://www.forexblog.org/wp-content/uploads/2010/09/z.png" style="display: block; margin: 0px auto 5px;" title="Australian Dollar Versus S&P 500: 2009-2010" width="512" /><br />Since the S&P 500 is a pretty good proxy for risk it can be said that the Australian Dollar is a manifestation of investor risk appetite. When risk aversion was high, the S&P and the Aussie were low. When risk tolerance picked up, they rose. It’s funny how this came to be. It is probably best seen as a vestige from the credit crisis, whereby investors evenly divided assets into two classes: risky and safe. When you look at the performance of the Australian Dollar, it is pretty clear as to which side of the dividing line it was placed.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">This is probably fair, since the Australian Dollar is a growth currency. According to the just-released Bank of International Settlements (BIS) <a href="http://www.bis.org/publ/rpfx10.pdf?noframes=1" style="color: #003366;">Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity</a>, the Australian Dollar is now the world’s fifth most traded currency (behind only the G4: Dollar, Euro, Yen, & Pound), having usurped that position from the Swiss Franc. In 2010, it accounted for 7.6% (out of a total of 200%) of all trading volume, primarily as a result of trading in the USD/AUD currency pair, which was the fourth most popular in forex.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Investors have come to see the Australian Dollar in somewhat contradictory terms. It is both stable and liquid, but its economy is unpredictable and inflation is usually above average. The current economic situation was strong, with GDP growth projected to exceed 3% in 2010. Its benchmark interest rate (4.5%) is the highest in the industrialized world, and may touch 5% before the year is over. On the other hand, its political situation is currently uncertain, thanks to an election that produced a <a href="http://www.bloomberg.com/news/2010-08-22/election-deadlock-primed-to-fuel-market-jitters-amp-s-oliver-predicts.html" style="color: #003366;">hung Parliament</a> and the recent resignation of its Prime Minster. In addition, while its <a href="http://www.dfat.gov.au/publications/stats.html" style="color: #003366;">trade balance</a> is currently in surplus, it fell in July thanks to<a href="http://news.smh.com.au/breaking-news-business/china-slows-down-aussie-buying-in-july-20100902-14ooc.html" style="color: #003366;">decreased demand from China</a>. Analysts wonder whether it isn’t entirely dependent on China (directly via exports and indirectly via high commodity prices) to generate positive GDP growth.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;"><img alt="Australia Balance of Trade - 2009- July 2010" class="aligncenter size-full wp-image-3003" height="163" src="http://www.forexblog.org/wp-content/uploads/2010/09/Australia-Balance-of-Trade-2009-July-2010.png" style="display: block; margin: 0px auto 5px;" title="Australia Balance of Trade - 2009- July 2010" width="555" /><br />Ultimately, investors don’t care about any of this. They care only whether the global economy is stable and whether another financial/credit/economic crisis is likely to occur. Even though any such crisis will probably spare Australia, the Aussie is punished by even the whiff of crisis because Australia is perceived as being riskier to invest than the US, for example. “The Australian dollar is going to stay heavy. Markets don’t like uncertainty,” <a href="http://www.bloomberg.com/news/2010-08-22/election-deadlock-primed-to-fuel-market-jitters-amp-s-oliver-predicts.html" style="color: #003366;">summarized JP Morgan</a>.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Sadly, it’s currently not worth parsing the nuances of trade statistics and monetary policy, because it has no bearing on the Aussie, though at least this makes my job easier. For the time being, the Australian Dollar will tick up if it looks like the global economy (principally the US) will avoid a double-dip recession. Otherwise, it is in for the same rough stretch as the S&P.</div>

Australia Dollar Ebbs and Flows with Risk

If you chart the course of the Australian Dollar over the last twelve months alongside the S&P 500, the overlap is jarring. You can see ...

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Safe Haven Trade Returns

<div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">I shouldn’t have been so complacent in <a href="http://www.forexblog.org/2010/08/euro-recovery-paradigm-shift-confirmed.html" style="color: #003366;">declaring the paradigm shift</a> in forex markets, whereby risk aversion had given way to comparative growth and interest rate differentials. While such a shift might have been present – or even dominant – in forex markets over the last couple months, it appears to have once again been superseded by the so-called <em>safe haven trade</em>.</div><a name="more"></a><br /><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">In hindsight, it wasn’t that the interplay between risk appetite and risk aversion had ceased to guide the forex markets, but rather that they had been deliberately been put on the backburner. In other words, it’s now obvious that investors have remained vigilant towards the possibility of another crisis and/or an increase in risk/volatility.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">How do I know this is the case? This week, there was a major correction in the markets, as diminished growth prospects for the global economy led stocks down, and bonds and the Dollar up. If investors were truly focused on growth differentials, the Dollar would have declined, due to a poor prognosis for the US economy. Instead, investors bought the Dollar and the Yen because of their safe-haven appeal.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;"><img alt="EUR-USD Versus S&P 500" class="aligncenter size-full wp-image-2941" height="289" src="http://www.forexblog.org/wp-content/uploads/2010/08/EUR-USD-Versus-SP-500.JPG" style="display: block; margin: 0px auto 5px;" title="EUR-USD Versus S&P 500" width="521" /></div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">What exactly was it that produced such a backlash in the markets, sending both the DJIA and the Euro down by 2% apiece in less than one trading session? First, the most recent jobs report confirmed that unemployment is not falling. Then, the Commerce Department released trade data which showed that the recovery in US exports has already leveled off. This sent economists scrambling to adjust their forecasts for 2010 GDP growth: “<a href="http://www.nytimes.com/2010/08/12/business/12markets.html?hp" style="color: #003366;">After downward revisions</a> to other economic data like inventories and the export figures, even that 2.4 percent annual rate is now looking too rosy — and may even be as low as 1 percent.”</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">To top it all off, the meeting of the Fed Reserve Bank confirmed investors’ worst fears as the Fed warned of continued economic weakness and voted to further entrench its quantitative easing program. According to the <a href="http://www.federalreserve.gov/newsevents/press/monetary/20100810a.htm" style="color: #003366;">official FOMC statement</a>: “The pace of recovery in output and employment has slowed in recent months. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit…Bank lending has continued to contract….the pace of economic recovery is likely to be more modest in the near term than had been anticipated.”</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">The Fed also indicated slowing inflation, which <a href="http://www.nytimes.com/roomfordebate/2010/8/11/should-we-brace-for-deflation-now/politics-may-get-in-the-way" style="color: #003366;">set off a debate</a> among economists about the once-unthinkable prospect of defaltion. While the consensus is that deflation remains unlikely, investors are no longer automatically inclined to give the Fed the benefit of the doubt: “The Fed’s determined effort to build up its inflation-fighting credibility over the past few decades may be working against it here.”</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">It was no wonder that the markets reacted the way they did! Cautious optimism has now given way to unbridled pessimism: “Given the uneven rebound in the United States, and now signs that the world’s other economic engines are slowing, economists say Americans may confront high unemployment and lackluster growth for some time to come.” Ironically, if such an outcome were to obtain, it could provide a boost for the Dollar, and even for the Yen.</div>

Safe Haven Trade Returns

I shouldn’t have been so complacent in  declaring the paradigm shift  in forex markets, whereby risk aversion had given way to comparative g...

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Greek Debt Crisis Widens

<div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">I must confess: I never expected the Greek debt crisis to reach such a dire threshold in such a short time period. Over a matter of mere months, the Euro has fallen 15% against the Dollar. That’s the kind of drop that you would have expected from the Greek Drachma, not from the Euro!</div><a name="more"></a><br /><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;"><img alt="5y Euro" class="aligncenter size-full wp-image-2700" height="288" src="http://www.forexblog.org/wp-content/uploads/2010/05/5y-Euro.png" style="display: block; margin: 0px auto 5px;" width="512" /></div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Moreover, it’s not as if this slide is anywhere close to abating. “I don’t think you’d want to bet on a bottom, at this stage, in euro. <a href="http://online.wsj.com/article/BT-CO-20100504-714962.html?mod=WSJ_World_MIDDLEHeadlinesAsia" style="color: #003366;">We’re headed closer to $1.2000</a> at some point in the game. It’s just a question of when,” said one prominent analyst. Meanwhile, net shorts against the Euro have reached a record 89,000 contracts, according to the weekly Commitments of Traders report. What is producing this swell of bearish sentiment, which is causing the markets to trade in a manner best described as “panic mode?”</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">The answer, it seems, is a self-fulfilling belief not only that Greece will default on its debt, but also that the credit crisis will spread to the rest of Europe. Greek interest rates recently topped 8%, and the spread with comparable German bonds (this spread has become a crude way of gauging the seriousness of the crisis) is close to an all-time record. Credit default swaps, which insure against the risk of default, surged to 674 bas points, reflecting a 15% probability of default. Meanwhile, credit default swap spreads on Spanish and Portuguese debt is also creeping up.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">At this point, there seems to be very little that Greece can do to mitigate the crisis. It has already announced a series of austerity measures, including wage cuts and tax hikes, designed to narrow its budget deficit. In addition, it has successfully obtained an <a href="http://www.google.com/hostednews/ap/article/ALeqM5iXUJvBknZVGqsBenIusBgBvWj5WQD9FEMVC01" style="color: #003366;">aid package</a> from the EU and IMF, valued at $160 Billion. In April, it successfully refinanced $12 Billion in debt, even though experts insisted that such would be very difficult, given current investor sentiment.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">On the other hand, the austerity measures were met with riots, which left 3 people dead, and signaled that the Greek citizenry would sooner vote out the incumbent government than accept their proposals to reduce the budget deficit. Speaking of which, under the best case scenario, the deficit will decline to a still-whopping 8% of GDP in 2010 (from a revised 13% in 2009), and Greece’s budget will remain in the red until at least 2014, by which point its gross national debt is projected to have reached 140% of GDP. Of course, this assumes that GDP growth will turn positive in 2012, and this is no guarantee. Meanwhile, the aid package will probably be enough to tide Greece over for only about 18 months, after which point it will have to return to the capital markets. Even before it can tap the bailout, it must first <a href="http://www.businessweek.com/ap/financialnews/D9F4S07O0.htm" style="color: #003366;">refinance</a>another $10 Billion in debt in May.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px; text-align: center;"><img alt="Europe's Web of Debt" class="aligncenter size-large wp-image-2701" height="614" src="http://www.forexblog.org/wp-content/uploads/2010/05/Europes-Web-of-Debt-943x1024.jpg" style="display: block; margin: 0px auto 5px;" width="566" /></div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">In other words, even if Greece can forestall default for 2010 and 2011, who’s to say that it won’t default in 2012? With this possibility in mind, it makes it very unlikely that investors will continue to buy Greek bonds at all, let alone at affordable interest rates. “<a href="http://www.nytimes.com/2010/05/03/world/europe/03austerity.html?ref=business" style="color: #003366;">People are becoming well aware</a> of the fact that the solvency issue for Greece hasn’t been resolved with the aid package. They still have to repay the money. They still have to repay the interest.”</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Finally, there is the risk that the crisis will spread to the rest of Europe. Both the IMF and the Spanish government have been busy refuting rumors that Spain is seeking a similar bailout. Regardless of its veracity, the fact that such a rumor even exists will be enough to make investors sweat. When investors get nervous, they stop buying government bonds and/or demanding higher interest rates, which ironically only makes it more likely that the government in question will default. Fortunately, it seems that Spain (and its neighbor, Portugal) are in strong enough shape that they could survive a sudden speculative attack from investors.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Greece, however, is basically a lost cause. “Greece is functionally bankrupt,” and the only solution is for it to leave the Euro and/or default. Until that day comes, uncertainty will persist, and investors will continue to doubt the Euro.</div>

Greek Debt Crisis Widens

I must confess: I never expected the Greek debt crisis to reach such a dire threshold in such a short time period. Over a matter of mere mon...

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Inflation: Much Ado about Nothing?

<div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">One of the cornerstones of exchange rate theory is that currencies rise and fall in accordance with inflation differentials. All else being equal, if US inflation averages 5% per annum and EU inflation averages 0% per annum, then we would expect the Euro to appreciate (or the Dollar to depreciate, depending on how you look at it) by 5% against the Dollar on an annualized basis. If only it were that simple…</div><a name="more"></a><br /><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">You can see from the chart below that since the introduction of the Euro, inflation in the US has slightly outpaced Eurozone inflation (by about 5% on a cumulative basis). Over that same time period, the Euro first appreciated from slightly below parity with the US Dollar to $1.60, and then fell back to the current level of around $1.35. It’s clear (from the current sovereign debt crisis if nothing else) that the EUR/USD exchange rate, then, cannot be explained entirely by the theory of purchasing power parity.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;"><img alt="Cumulative Inflation- US versus EU 1999-2009" class="aligncenter size-full wp-image-2604" height="289" src="http://www.forexblog.org/wp-content/uploads/2010/04/Cumulative-Inflation-US-versus-EU-1999-2009.jpg" style="display: block; margin: 0px auto 5px;" width="481" /><br />Still, insofar as inflation bears on interest rates and can be a consequence of economic overheating or excessive government spending, it is something that must be heeded. On that note, after a dis-inflationary 2009, prices in the US are once again rising in 2010, and inflation is projected to finish the year around 2%.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Over the longer term, there is a tremendous amount of uncertainty regarding US inflation, for a couple reasons. The first is related to the Fed’s quantitative easing program, which pumped more than $1 Trillion into credit markets. While the Fed has basically stopped its asset purchases, all of this printed money is still technically in circulation, and some inflation hawks think it represents a ticking inflation time bomb. Doves respond that the Fed will withdraw these funds before they become inflationary, and that besides, most of the funds are actually being held by commercial banks in the form of excess reserves. (This notion is in fact born out by the chart below).</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;"><img alt="Excess Reserves versus Monetary Base" class="aligncenter size-full wp-image-2605" height="378" src="http://www.forexblog.org/wp-content/uploads/2010/04/Excess-Reserves-versus-Monetary-Base.png" style="display: block; margin: 0px auto 5px;" width="630" /><br />The second potential driver of inflation is the skyrocketing national debt. While US budget deficits have long been the norm, they have grown alarmingly high in the past few years and are projected to remain high for at least the next decade. Beyond that, the US faces up to $70 Trillion in unfunded entitlement liabilities, which means that net debt will probably grow before it can fall. Hopefully, the US economy will outpace the national debt and/or foreign Central Banks continue to buy Treasury securities in bulk. The alternative would be wholesale money printing (to deflate the debt) and hyperinflation.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Yields on both 10-year and 30-year Treasury securities remain enviably low, which means that buyers aren’t bracing for hyperinflation just yet. In addition, while gold continues to attract buyers despite record high prices, its rise has been closely tied to the performance of the stock market, which means that investors are currently using it to bet on economic recovery, rather than as a hedge against inflation.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;"><img alt="gold vs S&P" class="aligncenter size-full wp-image-2606" height="214" src="http://www.forexblog.org/wp-content/uploads/2010/04/gold-vs-SP.jpg" style="display: block; margin: 0px auto 5px;" width="507" /></div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">In short, inflation in the US certainly remains a real possibility. At this point, however, it remains too hazy to be actionable, and the forex markets will probably wait for more information before pricing it into the Dollar.</div>

Inflation: Much Ado about Nothing?

One of the cornerstones of exchange rate theory is that currencies rise and fall in accordance with inflation differentials. All else being ...

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Brazilian Real Recovers on Rate Hike Hopes

<div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">One of the main themes (even if not always overt) of my posts recently has been the revival of the carry trade, if not the already extant revival than at least the imminent one. In this context, there is no better candidate than the Brazilian Real.</div><a name="more"></a><br /><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">After a stellar 2009, the Brazilian Real opened 2010 in much the same way that most emerging market currencies did: down. In the month of January, alone, it fell almost 10% against the Dollar, as fears of a widespread sovereign debt crisis took hold in currency markets. Its modest recovery since then, is not so much due to a decreased likelihood of such a debt crisis, but rather to a shift in the markets’ perspective away from long-term fiscal problems and back towards short-term economic and monetary conditions.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;"><img alt="real dollar" class="aligncenter size-full wp-image-2586" height="288" src="http://www.forexblog.org/wp-content/uploads/2010/04/real-dollar.png" style="display: block; margin: 0px auto 5px;" width="512" /><br />It is here where Brazil (and the Real) shines. As <a href="http://business.timesonline.co.uk/tol/business/markets/article7078258.ece" style="color: #003366;">one analyst</a> summarized, “The Brazilian economy has been transformed over the past few years. The boom-and-bust and hyperinflation of previous decades has been replaced by steady growth. The country was one of the last major economies into recession, but one of the first out.” <a href="http://online.wsj.com/article/BT-CO-20100311-708076.html?mod=WSJ_World_MIDDLEHeadlinesAmericas" style="color: #003366;">2009 Q4 GDP</a> came in at 4.3% on a year-over-year basis, and is projected at 6% for 2010. Moreover, its economy is very well-balanced, and consumer debt levels are relatively low. Unlike in China, for example, infrastructure investment in Brazil still has plenty of room to grow, without <em>crowding out</em> private investment. This is important, given that the 2014 World Cup and 2016 Olympics are right around the corner.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">After rebounding from the lows of the 1999 currency crisis, meanwhile, the Brazilian stock market has had an incredible decade, returning an average of 20% annually. For the sake of comparison, consider that emerging markets have averaged 10%, and all stock markets have averaged only .2%. It doesn’t hurt that Brazil just discovered a huge (the fifth largest in the world) coastal oil reserve.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">In fact, it might just be the latter that currency traders are most excited about: “Thus far this year, BRL is 68% <a href="http://seekingalpha.com/article/197003-brazil-s-real-remains-firm-as-country-moves-into-tightening-mode" style="color: #003366;">correlated with crude oil prices</a>…Last year the correlation was 53% and in 2008 the correlation was just shy of 32%.” This is the highest among any currency, even those that derive a much larger portion of GDP from oil exports, such as Canada and Norway. While there are almost certainly lurking variables in this correlation, a continued rise in the price of oil can’t hurt the Real.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Where does the carry trade fit into this? Look no further then Brazil’s benchmark interest rate of 8.5%. Impossibly, this represents a record low, despite the fact that this is nearly 8.5% higher than the current Federal Funds Rate. And the Brazilian rate is only set to rise. At the last meeting of the Bank of Brazil, 3 out of 8 Board members voted to hike the Selic rate by 50 basis points. The main opposition came from the Bank’s President, Henrique Meirelles, who steered a dovish course for political reasons.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Since then, <a href="http://www.brazilcham.com/default.asp?id=248&c002_ui=sa&c002_id=940" style="color: #003366;">inflation</a> has continued to creep up and Mr. Meirelles has firmly<a href="http://www.bloomberg.com/apps/news?pid=20601086&sid=aZJJfGKpGgvE" style="color: #003366;">renounced his political ambitions</a>, and the stage is now set for a 75 basis point hike at the next meeting, to be held on April 28. Most analysts are projecting an “<a href="http://www.reuters.com/article/idUSN259863720100325" style="color: #003366;">increase</a>of between 200 and 300 basis points through mid-2011, [and] some investors are pricing about 450 basis points of hikes in the same period.”</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">It’s hard to predict if/when the Fed will follow suit, but most certainly won’t be to the same extent. As long as Brazilian interest rates can keep up with inflation, then, it looks like the Real will end 2010 in much the same fashion as 2009.</div>

Brazilian Real Recovers on Rate Hike Hopes

One of the main themes (even if not always overt) of my posts recently has been the revival of the carry trade, if not the already extant re...

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CAD/USD Parity: Reality or Illusion?

<div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">In January, the Canadian Dollar (aka Loonie) registered its worst monthly performance since June. Many analysts pointed to this as proof that its run was over, after coming tantalizingly close to parity. Others insisted that the decline was only a temporary correction, a mere squaring of positions before the Loonie’s next big run. Who’s right? <em>Both</em>!</div><a name="more"></a><br /><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;"><img alt="cad1" class="aligncenter size-full wp-image-2479" height="288" src="http://www.forexblog.org/wp-content/uploads/2010/02/cad1.png" style="display: block; margin: 0px auto 5px;" width="512" /></div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">There are (at least) two separate narratives presently weighing on the Loonie. The first is causing it to decline against its arch-rival, the US Dollar, for reasons that essentially have nothing to do with the Canadian Dollar and everything to do with the US Dollar. Specifically, the mini-crisis that is playing out in Greece and the EU has caused risk aversion to resurface, such that investors are now returning capital to the US. <a href="http://www.bloomberg.com/apps/news?pid=20601082&sid=a8Cj8q4Ao5X0" style="color: #003366;">One analyst</a> explains the impact of this seemingly tangential development on the Loonie as follows: “When you get any sort of ‘risk-off’ type of environment like we’ve had over the past week or so, currencies like the Canadian dollar and the Australian dollar will come under pressure.”</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">The second narrative explains why the Canadian Dollar continues to hold its own against most other currencies. Specifically, Canada’s economic recovery continues to gain momentum as commodity prices continue their rally. In the latest month for which figures are available, the economy added about 80,000 jobs, more than five times what forecasters were expecting. This turn of events is helping to <a href="http://www.canadianbusiness.com/managing/strategy/article.jsp?content=20100113_10033_10033" style="color: #003366;">quash the “view</a> that the Canadian trade sector is incapable of growth with a strong currency,” and making traders less nervous about sending the Loonie up even higher.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Going forward, there is tremendous uncertainty. Both short-term (determined by the Bank of Canada) and long-term (determined by investors) interest rates remain quite low, such that the Loonie is not really a candidate for the carry trade. In addition, the Bank of Canada hasn’t completely ruled out the possibility of intervention on behalf of the Loonie; it may simply leave its benchmark interest rate on hold (at the current record low of .25%) for longer than it otherwise would have. In addition, a series of recent tightening measures by the government in China threatens to crimp demand for commodities and weigh on prices. Finally, the market turmoil in Greece is causing investors to look afresh at the balance sheets (in order to weigh the likelihood of default) of other economies. This probably won’t help Canada, which continues to run large deficits and whose debt level once earned it the dubious distinction of “honorary member of the Third World.”</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Still, Canada’s capital markets are among the most liquid and stable in the industrialized world, and if risk-aversion really picks up, it won’t suffer as much as some other economies. “<a href="http://www.marketwatch.com/story/canadas-loonie-on-bumpy-path-to-us-parity-2010-01-26?dist=afterbell" style="color: #003366;">The Canadian economy</a> is not as structurally impaired as the U.S. or the U.K. It creates a sense that Canada is less exposed to the fickleness of foreign investors that are causing uncertainty in other locations.” In fact, the Central Bank of Russia just announced that it will switch some of its foreign exchange reserves into Canadian Dollars, and other Central Banks could follow suit.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;"><img alt="cad2" class="aligncenter size-full wp-image-2480" height="288" src="http://www.forexblog.org/wp-content/uploads/2010/02/cad2.png" style="display: block; margin: 0px auto 5px;" width="512" /></div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">While the Canadian Dollar should continue to hold its own against other currencies, the same cannot necessarily be said for its relationship to the US Dollar. “Options traders are the most bearish on the Canadian dollar in 13 months…The three-month options showed a premium today of as much as 1.34 percentage points in favor of Canadian dollar puts.” In other words, the price of insurance against a sudden decline in the CAD/USD is rising as investors move to cushion their portfolios against such a possibility. While this trend could ease slightly in the coming weeks, I personally don’t expect it to disappear altogether. All else being equal, given a choice between owning Loonies or Greenbacks, I think most investors would choose Greenbacks.</div>

CAD/USD Parity: Reality or Illusion?

In January, the Canadian Dollar (aka Loonie) registered its worst monthly performance since June. Many analysts pointed to this as proof tha...

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“Logic” Returns to the Forex Markets, Benefiting the Dollar

<div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Many analysts are pointing to Friday, December 4, as the day that logic returned to the forex markets. On that day, the scheduled release of US non-farm payrolls indicated a drop in the unemployment rate and shocked investors. This was noteworthy in and of itself (because it suggests that the recession is already fading), but also because of the way it was digested by investors; for the first time in perhaps over a year, positive news was accompanied by a rise in the Dollar. Perhaps the word <em>explosion</em> would be a more apt characterization, as the Dollar registered a 200 basis point increase against the Euro, and the best single session performance against the Yen since 1999.</div><a name="more"></a><br /><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;"><img alt="US Dollar Index" class="aligncenter size-full wp-image-2263" height="331" src="http://www.forexblog.org/wp-content/uploads/2009/12/US-Dollar-Index.jpg" style="display: block; margin: 0px auto 5px;" width="500" /><br />Previously, the markets had been dominated by the unwinding of risk-aversion, whereby investors flocked back into risky assets that they had owned prior to the inception of the credit crisis. During that period, then, all positive economic news emanating from the US was interpreted to indicate a stabilizing of the global economy, and ironically spurred a steady decline in the value of the Dollar. On December 4, however, investors abandoned this line of thinking, and used the positive news as a basis for buying the Dollar and selling risky currencies/assets.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">If you look at this another way, it reinforces the notion that investors are paying closer attention to the possibility of changes in interest rate differentials. The fact that the recession seems to have ended suggests that the Fed must now start to consider tightening monetary policy. This threatens the viability of the US carry trade – which has veritably dominated forex markets – because it literally increases the cost of borrowing (carry): “<a href="http://online.wsj.com/article/SB10001424052748704240504574586283055119454.html" style="color: #003366;">If the market thinks</a> that Fed rates are about to move higher, the dollar will cease to be a funding currency and the inverse correlation between the dollar and risky assets will break.”</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">To be fair, it will probably be a while before the Fed hikes rates: “It’s a prerequisite to have a continuing decline in the unemployment rate for at least three months before the Fed considers tightening,” asserted one analyst. At the same time, investors must start thinking ahead, and can no longer afford to be so complacent about shorting the Dollar. As a result, emerging market currencies probably don’t have much more room to appreciate, since the advantage of holding them will become relatively less attractive as yield spreads narrow with comparable Dollar-denominated assets.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">To be more specific, investors will have to separate risky assets into those whose risk profiles justifies further speculation with those whose risk profiles do not. For example, currencies that offer higher yield but also higher risk will face depressed interest from investors, whereas high yield/low risk currencies will naturally greater demand. You’re probably thinking ‘Well Duh!’ but frankly, this was neither obvious nor evident in forex markets for the last year, as investors poured cash indiscriminately into high-yield currencies, regardless of their risk profiles.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">To be more specific still, currencies such as the Euro and Pound face a difficult road ahead of them (<a href="http://www.marketwatch.com/story/dollar-carry-trade-a-potential-probem-for-equities-2009-12-10?reflink=MW_news_stmp" style="color: #003366;">as does the US stock market</a>, for that matter), mainly due to concerns over sovereign solvency. (<em>Try saying that three times fast!</em>) On the other hand, “<a href="http://online.wsj.com/article/BT-CO-20091210-711096.html" style="color: #003366;">Commodity-linked currencies</a> such as the New Zealand, Australian and Canadian dollars [have] rallied sharply, and will probably continue to outperform as their economies strengthen and their respective Central Banks (further) hike interest rates.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">It remains to be seen whether investors will remain logical in 2010, since part of the recent rally in the US Dollar is certainly connected to year-end portfolio re-balancing and profit-taking, and not exclusively tied to a definitive change in perceived Dollar fundamentals. Especially since they remain skittish about the possibility of a double-dip recession, investors could very easily slip back into their old mindsets. For now, at least, it looks like reason is in the front seat, making my job much less complicated.</div>

“Logic” Returns to the Forex Markets, Benefiting the Dollar

Many analysts are pointing to Friday, December 4, as the day that logic returned to the forex markets. On that day, the scheduled release of...

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Dollar Could Go Either Way, Depending on the Carry Trade

<div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">As I outlined in my last two posts, the Dollar could witness a rapid appreciation if/when the Fed finally raises interest rates. Given Chairman Bernanke’s frequent erring on the side of inflation, however, it could be months (at the earliest) before the Fed actually pulls the trigger. With forex markets guided by interest rate differentials, and traders’ uncertainty about the timing of interest rate hikes, its fair to say that the Dollar is at a crossroads.</div><a name="more"></a><br /><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Currently, the case for an interest rate hike (as the Fed confirmed this week) remains weak: “They will need to see a lot more, better numbers consistently, not just for one or two months, before they would start to genuinely be talking more hawkish…<a href="http://www.bloomberg.com/apps/news?pid=20601101&sid=ahMXDpYpRlro" style="color: #003366;">I think the markets may be disappointed</a> if they’re looking for hints of hikes coming soon,” said one strategist. While the data continues to improve – witness last week’s <em>miracle</em> jobs report – it has not yet been demonstrated convincingly and unequivocally that the economy has exited the recession. There are too many contingent possibilities that could send the economy into relapse for the Fed to even consider acting. As I said in my <a href="http://www.forexblog.org/2009/12/bernankes-background-and-near-term-us-monetary-policy.html" style="color: #003366;">last post</a>, I don’t personally expect a rate hike until next summer.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Still, the markets are alert to the possibility. And where perception is reality, any sniff of rate hikes is enough to send the Dollar soaring; it has risen an impressive 5% against the Euro over the last couple weeks. That investors are acting so early to protect themselves against a possible rate hike shows the precariousness of the foundation on which the Dollar’s rise has been predicated.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;"><img alt="euro" class="aligncenter size-full wp-image-2250" height="288" src="http://www.forexblog.org/wp-content/uploads/2009/12/euro.png" style="display: block; margin: 0px auto 5px;" width="512" /></div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">What I’m talking about here is the Dollar carry trade, in which investors borrowed in Dollars at record low rates, and invested the proceeds in riskier currencies and assets. It wasn’t so much the interest rate differentials they were chasing (only a few percentage points in most cases, hardly enough to compensate for the risk), but rather outsized returns from currency and asset price appreciation. In other words, while the S&P has risen by an impressive 50% from trough to peak (providing a handsome return to any investor smart enough to have foreseen it), stock markets outside of the the US have performed just as well. Factor in currency appreciation, and in some cases you are talking about gains of around 100%.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">But we all know that volatility is the enemy of the carry trade, and volatility is slowly creeping up. First, there was the Dubai debt crisis, then came the downgrading of Greece’s sovereign debt. With talk of interest rate hikes, it’s no wonder that investors are becoming jittery. <a href="http://www.bloomberg.com/apps/news?pid=20601091&sid=aZuUmlXtfpcU" style="color: #003366;">Bloomberg News reports</a> that, “The so-called 25-delta risk-reversal rate, which was flat as recently as October, hasn’t shown such high relative demand for dollar calls since hitting a record 2.595 percentage points in November 2008….[and] JPMorgan Chase & Co.’s G7 Volatility Index rose to 14.43 last month from the low this year of 12.32 in September.”</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;"><img alt="JP Morgan G7 Volatility Index" class="aligncenter size-full wp-image-2251" height="332" src="http://www.forexblog.org/wp-content/uploads/2009/12/JP-Morgan-G7-Volatility-Index.jpg" style="display: block; margin: 0px auto 5px;" width="554" /><br />The consensus remains that neither the Dubai nor Greece episodes signals broad systemic risk, and that the Fed probably won’t hike rates for a while. Still, investors must brace themselves for the possibility of surprise on one of these fronts, or from a completely unsuspected “bolt from the blue” as one analyst put it, because of what happened to the Dollar after Lehman’s collapse in 2008. As evidenced by the Dollar’s sudden turnaround in the last couple weeks, this kind of uncertainty is self-begetting. As some investors get nervous and begin to unwind their carry trade positions, other investors also begin to move towards the exists, lest they get stuck short the Dollar after the music stops (or when it starts, depending on how you look at it.)</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">In that sense, the best paradigm for analyzing the Dollar is the end of the carry trade on one hand, weighed against the possibility of interest rate hikes on the other hand. “The dollar will depreciate to $1.55 against the euro by March from $1.49 last week, and to $1.62 by June, according to JPMorgan,” which is betting heavily that investors will remain clear-headed about interest rate differentials. Those that are looking at the Dollar from a risk-aversion/carry trade standpoint have slightly different projections: “I wouldn’t surprised if the euro makes it to $1.40 before the end of the month without much trouble, maybe a little bit lower.”</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">In short, in forex, it’s never enough to be able to predict the economic future. Instead, you must be able to predict how these predictions will be syncretized into currency valuations by the markets. In this case, that means you need not necessarily be able to accurately predict when the Fed will hike rates; rather you need only be concerned with how other investors view that possibility, and whether that makes them feel more or less confident about holding certain currencies.</div>

Dollar Could Go Either Way, Depending on the Carry Trade

As I outlined in my last two posts, the Dollar could witness a rapid appreciation if/when the Fed finally raises interest rates. Given Chair...

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Euro: It’s Still Mostly About the Dollar

<div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">It’s been a while since I last wrote about the Euro (October 26: <a href="http://www.forexblog.org/2009/10/euro-optimism-and-not-just-dollar-pessimism.html" style="color: #003366;"><em>Euro Optimism (And not just Dollar Pessimism)</em></a>). That’s because my perspective recently has been mainly Dollar-centric; I continue to believe that much of the recent movement in forex markets (with the exception of certain cross rates) can best be explained by the Dollar. Nowhere is this more evident than the Euro, whose rise should really be thought of in terms of the depreciation of the Dollar. It’s no surprise then that yesterday’s Euro decline – the steepest in months – was the result not of internal European developments, but rather of the US jobs report.</div><a name="more"></a><br /><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;"><img alt="eurp dollar" class="aligncenter size-full wp-image-2230" height="284" src="http://www.forexblog.org/wp-content/uploads/2009/12/eurp-dollar.jpg" style="display: block; margin: 0px auto 5px;" width="562" /><br /><a href="http://online.wsj.com/article/BT-CO-20091203-714547.html" style="color: #003366;">One analyst</a> summarized the Euro’s ascent by noting, “The bias for risk-seeking is still in vogue.” This has nothing to do with the Euro, but rather is a roundabout way of speaking about the Dollar carry trade, which is responsible for an exodus of capital from the US, some of have which has no doubt found its way into Europe. In some ways, then, it’s almost pointless to scrutinize EU economic indicators too closely.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">That being said, there are a few meaningful observations that can be made. The first is that the EU economy is tentatively in recovery mode. Some of the most <a href="http://online.wsj.com/article/SB125931610159166191.html" style="color: #003366;">closely-watched indicators</a> such as the German IFO index, capacity utilization, and Economic Sentiment Indicator, have all ticked up in the last month, while the unemployment rate is holding steady. For better or worse, this improvement can attributed entirely to export growth, due to the recovery in world trade. <a href="http://www.economist.com/world/europe/displaystory.cfm?story_id=14885956" style="color: #003366;">GDP rose by .4% in the most recent quarter</a>, which means that the Euro Zone has officially exited the recession.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">The second observation is that many expect this exit to be short-lived. Due to the relative rigidity of the EU economy, specifically regarding the labor market, it may take additional time to get back on really solid footing. Thus, the <a href="http://www.economist.com/world/europe/displaystory.cfm?story_id=14803275" style="color: #003366;">European Commission</a> “thinks that euro-area unemployment will continue to rise next year, reaching 10.9% in 2011. That will dampen consumer spending. Another worry is investment, which the commission thinks will fall by 17.9% this year. Businesses are unlikely to waste scarce cash on new equipment and offices when they have spare capacity. Firms confident enough to splash out may find it hard to secure the necessary financing from fragile and risk-averse banks.” The Commission also expects public finances to continue to deteriorate, perhaps bottoming at some point next year. There is even an outside concern that one of the fringe members of the EU could <a href="http://www.economist.com/research/articlesBySubject/displaystory.cfm?subjectid=348930&story_id=15016124" style="color: #003366;">default on its debt</a>, requiring a bailout in the same vein as the lifeline grudgingly being thrown to Dubai by the UAE.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Finally, there is the European Central Bank. Much like the Fed – and every other Central Bank in the industrialized world, except for Australia – the ECB is nowhere near ready to hike rates. “The overall economic context doesn’t suggest that they would want to tighten anytime soon. There is a feeling that, yes, things have improved, but that nonetheless, the outlook is still quite fragile,” summarized one economist. Sure, the ECB is winding down its liquidity programs, but so is the Fed. Based on long-term bond yields, investors believe that US rates could even eclipse EU rates at some point in the future.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">In short, there isn’t really much to be optimistic about, when it comes to the Euro. The nascent recovery is hardly remarkable, and probably not even sustainable. While the Euro might continue to perform the Euro in the short-term for technical reasons, I would expect this edge to evaporate in the medium-term.</div>

Euro: It’s Still Mostly About the Dollar

It’s been a while since I last wrote about the Euro (October 26:  Euro Optimism (And not just Dollar Pessimism) ). That’s because my perspec...

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Debunking the Myth: The Dollar and the Deficit

<div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Last week, I opined on the official US forex policy (<em><a href="http://www.forexblog.org/2009/11/strong-dollar-policy-is-a-joke.html" style="color: #003366;">“Strong Dollar” Policy is a Joke</a></em>). Most of my analysis was directed towards the lackluster efforts of US policymakers in failing to execute this policy, and I paid short shrift to the policy itself. With this post, then, I would like to address whether a Strong Dollar is, on balance, actually good for the US economy, specifically as it bears on the balance of trade.</div><a name="more"></a><br /><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Dean Baker, of the American Prospect, in a <a href="http://www.prospect.org/csnc/blogs/beat_the_press_archive?month=10&year=2009&base_name=the_trade_deficit_and_the_doll" style="color: #003366;">post</a> germane to this discussion, wrote that “Folks who took econ 101 know that currency fluctuations are the mechanism through which trade imbalances adjust.” Unfortunately, as anyone who follows the forex markets no doubt understands, reality is much more complicated. As the <a href="http://online.wsj.com/article/SB10001424052748703811604574532110208089606.html" style="color: #003366;">WSJ reported</a>, US exports skyrocketed during the last decade when the Dollar was falling. Case closed, right? However, exports also rose during the 1990′s, when the Dollar was in fact rising. This contradiction should make make anyone think twice before assuming a cut-and-dried relationship between the Dollar and exports think twice.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;"><img alt="Dollar and US exports 1990-2009" class="aligncenter size-full wp-image-2225" height="244" src="http://www.forexblog.org/wp-content/uploads/2009/12/Dollar-and-US-exports-1990-2009.gif" style="display: block; margin: 0px auto 5px;" width="183" /><br />While exchange rates certainly correlate with export volume, there are a few confounding variables. Fist is the lag time between fluctuations in exchange rates and corresponding changes in exports. That’s because the majority of international trade is conducted by large companies and because global supply chains are not completely fluid. In other words, if the Dollar collapses tomorrow, it will take years before companies can fully modify their sourcing arrangements accordingly.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">In addition, it is mainly on non-durable goods that companies have relative flexibility on choosing sourcing locations. In this age of ODM and OEM, it’s not difficult for Nike to shift production to Vietnam if the Chinese Yuan is suddenly revalued. On the other hand, it is significantly more complicated to move an automobile manufacturing plant or oil refinery. Investments in production facilities for durable goods are made on a long-term basis, then, and aren’t responsive to short-term changes in exchange rates. If you look at the breakdown of US exports, it is heavily concentrated in services and high-tech products, many of which it’s not (yet) practical to outsource.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">For goods and services that are low-skilled labor-intensive, it’s obviously cost-effective to produce them overseas, because wages are lower. This is not a product of exchange rates, but rather to disparities in standards of living and levels of development. In China (where I am based), factory wages rarely exceed 8RMB per Dollar (about $1.25 at current exchange rates). Conservatively, that’s probably less than 1/20th of US counterpart wages, when you look at salary and benefits. That’s why the weak Dollar hasn’t done much to dent US demand for imports. Personally, I don’t expect to see the RMB rise 1500% in the next few years to erase this discrepancy, which means that’s unrealistic to ever expect the US Dollar to depreciate enough to ever make the US competitive enough in certain export categories.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Obviously, the inverse is true for imports. From the perspective of the US, the shifting of non-durable goods production outside the US represents a permanent structural changes in the US economy. Regardless of how low the Dollar sinks, it’s not reasonable to assume that the US will once again become the hotbed of low-tech manufacturing activity that it once was.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Overall, exports have actually risen steadily over the last decade (and the last 50 years, on average); the problem is that imports have risen even faster. In fact, ebbs and flows in the trade deficit can be better explained by global economic cycle than by short-term fluctuations in exchange rates. Despite the weak Dollar, the US trade deficit has exploded over the last decade because of a comparable explosion in US consumption, which was made possible by cheap credit. When that cycle came to an abrupt end in 2008, the trade deficit narrowed dramatically, despite the rise in the Dollar that took place simultaneously.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;"><img alt="US trade deficit 1945-2009" class="aligncenter size-full wp-image-2226" height="349" src="http://www.forexblog.org/wp-content/uploads/2009/12/US-trade-deficit-1945-2009.jpg" style="display: block; margin: 0px auto 5px;" width="600" /></div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Given that the US has basically committed itself to importing certain goods, a Strong Dollar is actually beneficial, because it reduces the cost of those imports. In the short-run, then, a 20% decline in the Dollar might be expected to correlate with a 20% rise in the trade deficit. The hope is that this can be offset over the long-term, with the relocation of production facilities (yes, foreign companies also outsource to the US; it’s a not a one-way exodus) to the US and the creation of new products/services that can fill the void of those that have already been outsourced.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">In short, it’s not clear that a weak Dollar will dramatically improve the US trade imbalance. This can best be accomplished not through a weak exchange rate, but through incentives that stimulate innovation and discourage consumption of low-quality, non-durable goods, the majority of which are produced overseas. When you consider the inflation (Strong Dollar keeps prices in check) and financing (Strong Dollar increases the willingness of foreigners to invest in and lend to US entities) perks, the Strong Dollar probably provides a net benefit to the US economy. If Bernanke and Geithner actually believe this, it would be nice if they conducted policy accordingly.</div>

Debunking the Myth: The Dollar and the Deficit

Last week, I opined on the official US forex policy ( “Strong Dollar” Policy is a Joke ). Most of my analysis was directed towards the lackl...

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Dollar Reverts Back to Former Self

<div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Only two weeks ago, analysts were singing about a new day for the Dollar, which had risen on the basis of good news <a href="http://www.forexblog.org/2009/08/dollar-reverses-course.html" style="color: #003366;">for the first time in months</a>. In hindsight, it looks like such talk was premature, as the Dollar has returned to its old ways. Good news once again causes the Greenback to fall, while bad news causes it to rise.</div><a name="more"></a><br /><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">This development (or lack thereof) suggests that investors may have gotten ahead of themselves, when they sent the Dollar surging after the employment picture brightened slightly. At the time, the news was interpreted as a sign that rate hikes were imminent. On a broader level, it was a sign that investors had dumped the paradigm of risk aversion, in favor of a model based on comparing economic fundamentals. Since then, investors have slowly moved to distance themselves from the notion that the Fed will soon hike rates, and in the process have moved back towards trading based on risk dynamics.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">As a result, positive news developments over the last couple weeks have coincided both with a rise in equity prices and a decline in the Dollar. When the Chinese stock market collapsed one day last week, investors responded by dumping high-yield assets, and moving temporarily back into “safe haven” currencies. “<a href="http://online.wsj.com/article/BT-CO-20090819-704417.html" style="color: #003366;">Diving Shanghai Helps Dollar</a>” read one headline. “Worries over the continued fragility of the world economy outweighed a firmer tone in overseas equity markets to underpin the U.S. dollar versus major counterparts,” explained <a href="http://www.nasdaq.com/aspx/stock-market-news-story.aspx?storyid=200908200903dowjonesdjonline000435&title=currencieseconomic-warnings-underpin-dollar" style="color: #003366;">another report</a>.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Meanwhile, a divide is forming among fundamental analysts. There is one school of thought which argues that the US will be the first industrialized economy to recover, and hence the first to raise rates. Based on this line of reasoning, then, positive economic news provides a foundation upon which to buy the Dollar. A competing school of thought, meanwhile, has suggested that regardless of if/when a US recovery materializes, it will be overshadowed by out-of-control inflation. In this regard, then, the Dollar is not such an attractive buy.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">No less than the venerable <a href="http://www.nytimes.com/reuters/2009/08/19/business/business-us-buffett.html" style="color: #003366;">Warren Buff</a> has insisted that the Fed’s quantitative easing program and the US economic stimulus plan – while necessary – threaten to create even bigger problems than the ones they purport to solve. “But enormous dosages of monetary medicine continue to be administered and, before long, we will need to deal with their side effects. For now, most of those effects are invisible and could indeed remain latent for a long time. Still, their threat may be as ominous as that posed by the financial crisis itself,” he said.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">If this true, then the Dollar is damned either way. Damned in the short-term as a result of a pickup in risk appetite, and damned in the long-term due to inflation.</div>

Dollar Reverts Back to Former Self

Only two weeks ago, analysts were singing about a new day for the Dollar, which had risen on the basis of good news  for the first time in m...

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Euro retreats from 2009 Highs

<div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">In forex, timing is everything. If I had written this post a couple weeks ago, the headline would read “Euro Touches 2009 High.” Perhaps if I had waited another week, it would have read, “Euro Approaching 2009 High.” But alas, I chose today to write about the Euro, and the headline I chose is probably the most appropriate under the circumstances.</div><a name="more"></a><br /><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;"><img alt="euro-dollar1" class="aligncenter size-full wp-image-2046" height="288" src="http://www.forexblog.org/wp-content/uploads/2009/08/euro-dollar1.png" style="display: block; margin: 0px auto 5px;" width="512" /><br />On August 5, “<a href="http://online.wsj.com/article/BT-CO-20090803-708404.html" style="color: #003366;">The euro hit a high for the year</a> against the dollar as stocks trimmed their losses in afternoon trading Wednesday despite a generally cautious tone in currency markets.” Analysts were careful to point out that the markets remained cautious and the Euro eased past – rather than smashed through – its previous high.<a href="http://www.bloomberg.com/apps/news?pid=20601083&sid=a9AxwFFWOMLA" style="color: #003366;">Technical analysts</a> would and have argued that this paved the way for the subsequently rapid decline: “The euro is testing the base of an ascending channel with daily momentum charts showing a ‘double top in overbought territory.’ ”</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">This notion might have some merit, considering that fundamentals arguably favor a continued Euro appreciation. “The <a href="http://www.nytimes.com/2009/08/14/business/global/14euro.html" style="color: #003366;">economy</a> of the 27-country European Union shrank 0.3 percent in the three months ended June 30, for an annual rate of roughly 1.2 percent. The 16 countries that use the euro registered a 0.1 percent decline for the second quarter, or an annual rate of roughly 0.4 percent.” While output remains well below its 2008 levels, the slight contraction represents a tremendous improvement from the first quarter, when GDP shrank by 2.5%.<br /><img alt="eu-2009-gdp" class="aligncenter size-full wp-image-2047" height="342" src="http://www.forexblog.org/wp-content/uploads/2009/08/eu-2009-gdp.jpg" style="display: block; margin: 0px auto 5px;" width="455" /></div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">“Underlying the strong reading were solid performances in France and Germany, each of which grew 0.3 percent in the second quarter, government data showed.” This is helping to offset further contractions in Italy and Spain, which have turned into economic laggards as a result of the housing bust. In addition, exports in Germany grew by 7% last month, and “Investor sentiment improved more than analysts had expected in August to its best level since April 2006.” On an aggregate basis, “the euro zone’s trade balance with the rest of the world rose to 4.6 billion euros ($6.5 billion) in June, compared to a flat balance in the same month last year,”</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Still, <em>explorers</em> looking for bad news and/or cracks beneath the surface will have no difficulty finding them. German exports (and output in general remain down year-over-year. In addition, there are still trouble spots in the EU, notably in western Europe. “Already, the euro area’s unemployment rate stands at 9.4 percent, its highest level in 10 years, and the anemic growth of the coming quarters will not be enough to arrest the slide. That, in turn, could drag down consumer confidence or even generate political backlash in Europe, economists said.” Most worrying is perhaps that, “consumer prices in the euro area dropped 0.6 percent in July…” ‘<a href="http://www.bloomberg.com/apps/news?pid=20601087&sid=a4sMw1EJfW_g" style="color: #003366;">Deflation is becoming entrenched in the euro area, which would be very bad for the economy</a>.’ ” Good thing the ECB left some room to lower rates further.</div>

Euro retreats from 2009 Highs

In forex, timing is everything. If I had written this post a couple weeks ago, the headline would read “Euro Touches 2009 High.” Perhaps if ...

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The Force is With the Yen

<div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Just when it looked like <a href="http://www.forexblog.org/2009/08/yen-carry-trade-is-back-but-for-how-long.html" style="color: #003366;">the carry trade was back</a> for good and all signs pointed to a Yen depreciation, out of nowhere came a series of surprise developments, propping the Yen back up. Spanning finance, economics, and politics – a Forex Trifecta – these developments moved swiftly through the markets, creating optimism for the Yen where before there was only pessimism. Of course, it’s possible that this bump will prove temporary, and a reversal could transpire just as quickly.</div><a name="more"></a><br /><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;"><img alt="yen-dollar" class="aligncenter size-full wp-image-2041" height="288" src="http://www.forexblog.org/wp-content/uploads/2009/08/yen-dollar.png" style="display: block; margin: 0px auto 5px;" width="512" /></div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">The biggest news, by a large margin, was a <a href="http://www.nytimes.com/2009/08/17/business/global/17econ.html?hp" style="color: #003366;">report</a> that the Japanese economy had returned to growth. Similar in scale and in tenor to stories coming out of other countries, the data showed that Japan grew at an annualized rate of 3.6% in the second quarter of 2009, a sharp reversal from the 11.7% contraction in the previous quarter (which was itself revised upward from -14%).</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;"><img alt="Japan GDP 2008-2009" class="aligncenter size-full wp-image-2043" height="377" src="http://www.forexblog.org/wp-content/uploads/2009/08/japan-gdp1.jpg" style="display: block; margin: 0px auto 5px;" width="190" /></div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">The sudden sea change was brought about by a combination of government spending and export growth. “New tax breaks and incentives to help sales of energy-efficient cars and household appliances, coupled with lower gas prices and a rebound in share prices, spurred consumer spending. Prime Minister Taro Aso has pledged 25 trillion yen (about $263 billion) in stimulus money, including a cash handout plan and more public spending on programs like quake-proofing the country’s public schools, to revive the economy.” Meanwhile exports grew by a healthy 6.3% from the previous quarter, while imports fell, causing the trade surplus to widen.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">The announcement of economic recovery was accompanied by a noteworthy <a href="http://www.bloomberg.com/apps/news?pid=20601087&sid=a4sMw1EJfW_g" style="color: #003366;">reversal in capital flows</a>, such that Japan’s capital account swung into surprise weekly surplus: “Foreign investors bought 292.9 billion yen ($3.1 billion) more Japanese stocks than they sold during the week ended Aug. 8 and domestic investors were net buyers of 125 billion yen in overseas bonds and notes.” Meanwhile, speculation is mounting that Japanese investors will move to repatriate some of the coupon and redemption payments they receive on their US Treasury investments.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">While seemingly unrelated to the economic turnaround (it’s important not to read too much into weekly data), this could be a sign that Japanese investors are growing more optimistic about domestic economic prospects and are moving to invest more at home. It’s worth noting that such a shift could actually be necessary if the recovery is to be sustained, in order to increase the role of (capital) investment, relative to exports and government spending. Ironically, it could instead be <a href="http://www.reuters.com/article/usDollarRpt/idUSN1430419620090814" style="color: #003366;">a sign of excessive pessimism</a>, if Japanese believe that prospects for US/global growth have been overestimated, in which case risk appetite and the carry trade would be due for a combined correction.</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Domestic consumption could also play an increasing role in Japan’s economy going forward, as a result of imminent political changes. “To stimulate consumption at home, the Democrats have pledged to put more money in the hands of consumers by providing child allowances, eliminating highway tolls and making fuel cheaper. That marks a shift away from the long-ruling LDP’s emphasis on steps to help companies.”</div><div style="background-color: white; color: #333333; font-family: Verdana, Arial, sans-serif; font-size: small; line-height: 19.5px; margin-bottom: 10px; margin-top: 10px;">Along similar lines, the Democratic Party (which has a wide lead over the incumbent Liberal Democratic Party), has also conveyed its opposition to currency intervention, since such tactics inherently prioritize export growth over domestic consumption. “<a href="http://www.reuters.com/article/usDollarRpt/idUST489620090810" style="color: #003366;">Japan’s export-led growth is reaching its limits</a> and Tokyo should not intervene in markets to weaken the yen as long as currency moves match fundamentals, the No.2 executive in the main opposition party said on Monday.” Could the carry trade be in trouble?</div>

The Force is With the Yen

Just when it looked like  the carry trade was back  for good and all signs pointed to a Yen depreciation, out of nowhere came a series of su...

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