Bullish on the Euro?

Wouldn’t life just be a little easier if the EUR/USD, the most important forex pair and bellwether of currency markets, could simply pick a direction and stick to it. It dove during the financial crisis, only to surge during the apparent recovery phase, fell during the sovereign debt crisis, and rose during the paradigm shift, then fell as risk appetite waned, only to rise again in September, en route to a 5-month high.

There are a handful of factors which currently underlie the Euro’s strength, which can all generally be explained by the fact that risk is “on” at the moment, and the markets are moving away from so-called safe haven currencies and back towards growth investments. Of course that could change tomorrow (or even 5 minutes from now!), but at the moment, risk appetite is high and the Euro symbolizes risk. Never mind how ironic it is, that growth in the EU is projected at 1.8% for the year while Rest of World (ROW) GDP will probably top 5%. All that matters is compared to the Dollar (and Yen, Pound, Franc to a lesser extent) the Euro is perceived as the currency of risk.

The Euro’s cause is also helped by the ongoing “currency wars,” which heated up last week with Japan’s entry into the game. Basically, Central Banks around the world are now competing with each other to devalue their currencies. In contrast, the European Central Bank (ECB) has decided to remain on the sidelines (in favor of fiscal austerity), which is forcing the Euro up (or rather all other currencies down). To make matters even worse, “The U.S. Federal Reserve indicated this summer that it may ease monetary policy further… often seen as printing money to pump up the economy.” As a result, “The euro looks set to keep on climbing in a trend that looks increasingly entrenched.”

There are certainly those that argue that the Euro’s recent surge reflects renewed confidence in the Eurozone economy and prospects for resolving the EU debt crisis. After all, most Euro members will reduce their budget deficits in 2010 and auctions of new bonds are once again oversubscribed. On the other hand, interest rates for the PIGS (Portugal, Italy, Greece, and Spain) have risen to multi-year highs, as investors are finally trying to make a serious effort at pricing the possibility of default.

In addition, the credit markets in the EU are barely functioning, and large institutions remain dependent on the ECB’s credit facilities for financing. Finally, it shouldn’t be forgotten that the only reason crisis was due to the massive support ( Billion) extended to Greece. When this program expires in less than three years, the fiscal problems of Greece (and the other PIGS) will be exposed once again, and a new (stopgap) solution will need to be proposed.

As every analyst has pointed out, none of the EU’s fiscal problems have been solved. EU members have certainly proven adept at resolving acute crises and the ECB certainly deserves credit for keeping credit markets functioning, but none has proposed a viable solution for repairing of member countries’ fiscal and economic health. Currency devaluation is impossible. Sovereign default is being prevented. That leaves wage cuts and increased productivity as the only two paths to equilibrium. The former could be accomplished through inflation, but the ECB seems reluctant to allow this to happen.

For better or worse, the EU seems to have pushed these problems down the road, and if all goes according to plan, they won’t need to be revisited for 2-3 years. For now, then, the Euro is probably safe, and may even thrive. Short positions in the Euro are being unwound with furious speed and data indicate that there is still plenty of scope for further unwinding. Inflation remains subdued, economic growth is stable, and the ECB so far hasn’t voiced any disapproval of the Euro’s rise. While I promote this bullishness with the caveat that “traders have shown a willingness to smack the euro lower from time to time on the slightest news or rumor of downgrades to euro-zone sovereign or bank ratings,” the general Euro trend is now unquestionably UP.

Posted by Adam Kritzer | in Central Banks, Euro, News | 1 Comment »

Keep an Eye on Central Banks

Sep. 20th 2010

From monetary policy to quantitative easing to forex intervention, the world’s Central Banks are quite busy at the moment. Even though the worst of the credit crisis has past and the global economy has moved cautiously into recovery mode, there is still work to be done. Unemployment remains stubbornly high, inflation is too low, and asset prices are teetering on the edge of decline. In short, Central Banks will continue to hog the spotlight.

On the monetary policy front, Central Banks have begun to divide into two camps. One camp, consisting of the Federal Reserve Bank, European Central Bank, Bank of England, Bank of Japan, and Swiss National Bank (whose currencies, it should be noted, account for the majority of foreign exchange activity), remains frozen in place. Interest rates in all five countries/regions remain at rock bottom, near 0% in most cases. While the ECB’s benchmark interest rate is seemingly set higher than the others, its actual overnight rate is also close to 0%. Meanwhile, none of these Banks has given any indication that it will hike rates before the end of 2011.
In the other camp are the Banks of Canada, Australia, Brazil, and a handful of other emerging market Central Banks, all of which have cautiously moved to hike rates on the basis of economic recovery. Among industrialized countries, Australia (4.5%) is now at the head of the pack, with New Zealand (3%) in a distant second. Brazil’s benchmark Selic rate, at 10.75%, makes it the world leader among (widely-followed) emerging market countries. It is followed by Russia (7.75%), Turkey (7%), and India (6.1%), among others. The lone exception appears to be China, which maintains artificially low rates to influence the Yuan. [More on that below.]

None of the industrialized Central Banks have yet unwound their quantitative easing programs, unveiled at the peak of the credit crisis. The Fed’s balance sheet currently exceeds Trillion; its asset-purchase program has driven Treasury rates and mortgage rates to record lows. The same goes for the Banks of England and Japan, the latter of which has actually moved to expand its program in a bid to hold down the Yen. Meanwhile, many of the credit lines that the ECB extended to beleaguered banks and other businesses remain outstanding, and have even expanded in recent months.

Central Banks have been especially busy in the currency markets. The Swiss National Bank (SNB) was the first to intervene, and as a result of spending Billion, it managed to hold the Franc below As a result of the EU sovereign debt crisis, however, the Franc broke through the peg and his since risen to a record high against the Euro. Unsurprisingly, the SNB has abandoned its forex intervention program. Throughout the past year, the Central Banks of Canada, Brazil, Thailand, Korea have threatened to intervene, but only Brazil has taken action so far, in the form of a levy on all foreign capital inflows. Last week, the Bank of Japan broke its 6-year period of inaction by intervening on behalf of the Yen, which instantly rose 3% on the move. The BOJ has pledge to remain involved, but the extent and duration is not clear.
Finally, the Bank of China allowed the Yuan to appreciate for the first time in two years, but its pace has been carefully controlled, to say the least. In the last few weeks, the Yuan has actually picked up speed, but critics insist that it remains undervalued. In addition, China has contradicted the Yuan’s rise against the Dollar through its purchases of Japanese bonds, which has spurred a rise in the Yen. This is both ironic and counter-productive to global economic recovery: “Since China is growing at 10%, it can afford to undermine exports and boost domestic demand by letting the yuan appreciate more rapidly against the dollar. But China doesn’t want to do that. In fact, although China’s State Administration of Foreign Exchange deregulated the currency market overnight, the measures, which allow some exporters to retain their foreign currency holdings for a year, should boost private demand for dollars, not yuan.”
The efforts listed above have undoubtedly moderated the impacts of the financial crisis and consequent economic downturn. However, the banks have found it impossible to engineer a convincing recovery, and at this point, there probably isn’t much more that they do can do. As a result, many analysts are now pinning their hopes on fiscal policy (despite its equally dubious track record). Perhaps, the title of this post should have been: Keep an Eye on Governments and their Stimulus Plans.

Posted by Adam Kritzer | in Central Banks, News | 1 Comment »

Intervention Looms as Yen Closes in on Record High

Aug. 20th 2010

It was only a few weeks ago that I last wrote about the possibility of intervention on behalf of the Japanese Yen, and frankly, not a whole lot has changed since then. On the other hand, the Japanese Yen has continued to appreciate, the Japanese economy has continued to deteriorate, and the Bank of Japan has continued to ratchet up its rhetoric. In short, whereas intervention once loomed as a distant prospect, it has now become a very real possibility

Last week, the Yen touched touched 84.73 (against the Dollar), the strongest level since July 1995. In the year-to-date, it has appreciated 10%. There are a handful of analysts, including the anointed Mr. Yen, who believe that the Yen will rise past its all-time high of 79.75, recorded in April 1995. At the same time, analysts caution that Yen strength is better interpreted as Dollar weakness, and that its overall performance is much less impressive: ” ‘Against a broader range of currencies, particularly in real terms, the yen is far less strong than it looks against the US$ in isolation.’ ”
As the global economic recovery has faded, so has investor appetite for risk. The Japanese Yen has been a big winner (or loser, depending on your point of view) from this sudden sea change. Investors are dumping risky assets and piling back into low-yielding safe havens, like the Yen and the Franc. Ironically, the US Dollar has also benefited from this trend, but to a lesser extent than the Yen. It’s not entirely clear to me why this should be the case. As one analyst observed, “The zero-yielding currency of a heavily indebted, liquidity- and deflation-trapped economy should hardly be the go-to currency of the world.” At this point, it’s probably self-fulfilling as investors flock to the Yen instinctively any time there is panic in the markets.
Some of the demand may be coming from Central Banks. The People’s Bank of China, for example, “has ramped up its stockpiling of yen this year, snapping up billion worth of the currency in June, Japan’s Ministry of Finance reported Monday. China has already bought billion worth of yen financial assets this year, almost five times as much as it did in the previous five years combined.” Given that “a one percentage point shift of China’s reserves into yen equals a month’s worth of Japan’s current account surplus,” it wouldn’t be a stretch to posit a connection between the Yen’s rise and China’s forex reserve “diversification.” Officially, China is trying to diversify its foreign exchange reserves away from the Dollar, but the Yen purchases also serve the ulterior end of making the Japanese export sector less competitive.
In this sense it is succeeding, as the economic fundamentals underlying the Yen could hardly be any worse. “Real gross domestic product rose 0.4% in annualized terms in the April-June period, the slowest pace in three quarters…GDP grew 0.1% compared with the previous quarter.” This was well below analysts’ forecasts, and due primarily to a drop in consumption. Exports increased over the same period, causing the current account surplus to widen, but it wasn’t enough to prevent GDP growth from slowing. Meanwhile, unemployment is at a multi-year high, and deflation is threatening. With such persistent weakness, it’s no wonder that China has officially surpasses Japan as the world’s second largest economy.

The Yen is a convenient scapegoat for these troubles. The Japanese Finance Minister recently declared: “Excessive and disorderly moves in the currency market would negatively affect the stability of the economy and financial markets. Therefore, I am watching market moves with utmost attention.” It is rumored that the government has convened high level meetings to try to build support for intervention, such that it could apply political pressure on the Bank of Japan and cajole it into intervening. “With regard to problems such as the strong yen or deflation, we want to cooperate with the Bank of Japan more closely than ever before.”
In the end, domestic politics are a paltry concern compared to the backlash that Japan would receive from the international community if it were to intervene: “Any U.S.-endorsed intervention would be interpreted in Beijing as hypocrisy. How can the U.S. criticize China for intervening in support of a weaker currency, Chinese officials would ask, while it does so itself in support of a weaker yen?” In other words, there is no way that any country would support the Bank of Japan because such would make it less likely that China would allow the Yuan to further appreciate.
For this reason, many analysts still feel that the possibility of intervention is low. According to Morgan Stanley, however, there is now a 51% chance of intervention, based on its forex models. From where I’m sitting, it’s basically a numbers game. As the Yen rises, so does the possibility of intervention. The only question is how high it will need to appreciate before a 51% probability becomes a 100% certainty.

Emerging Market “Wall of Money” Spurs Currency War

According to Goldman Sachs (which if nothing else, is good at characterizing financial trends. Remember “BRIC?”), there is a “Wall of Money” that is already flooding emerging markets and will continue to do so for the foreseeable future.

“The Institute of International Finance projected 2010 capital flows of $825 billion, up from $581 billion in 2009 and from the $709 billion that the trade group for global financial-services firms had projected for 2010 in April.” In hindsight, the outflow of capital from emerging markets that took place during the financial crisis will probably look like a blip, as risk appetite has already recovered to pre-crisis levels, and then some!
“The move into emerging markets has been led by stock investors, who will pour an estimated $186 billion into these countries this year, — fully three times the annual average of $62 billion generated between 2005 and 2009.” Emerging Market Bond funds, meanwhile, now routinely receive more than $1 Billion per week. Sovereign wealth funds are also starting to shift some of their assets into emerging market assets/currencies as part of their respective diversification strategies. As you can see from the chart below (courtesy of The Economist), Asia is by far the largest recipient of investment, followed by Latin America.

The continued shift of capital from the industrialized world into emerging markets as being driven both by economic fundamentals and the desire to earn a greater return on investment. “The IMF forecast this month that developing nations will expand 6.4 percent next year, outstripping growth of 2.2 percent among advanced economies.” Meanwhile, the ratio of foreign debt to GDP among developing nations has been cut to 26 percent, compared to 41 percent in 1999. And yet, even as analysts predict that emerging markets will account for 85% of global growth going forward, “emerging markets account for $3 trillion, or only 15 percent of market capitalisation of the benchmark MSCI world index.”
While it’s understandable, then, that investors would want to rectify this imbalance as quickly as possible, they need to realize that developing countries’ capital markets simply aren’t deep enough to absorb all of the incoming capital. In other words, an limited pool of capital is chasing a limited stock of accessible investments, and the result is that asset prices and exchange rates are climbing inexorably higher.
Analysts argue, “Some appreciation is due: a rise against rich-world currencies is both a natural consequence of the faster growth of emerging economies and a way to correct global imbalances.” But a 50% rise over five years (notched by a handful of currencies) does not represent some appreciation, but rather an explosion. This is precisely the sentiment echoed by many of the emerging markets, themselves, which have taken to using guerilla tactics to hold down their currencies. Since the latest phase of the “currency war” was ignited by Japan in September, every week has led to increasingly far-flung countries – Peru, Chile, Czech Republic, Poland, South Africa – reputedly contemplating intervention.
According to an interesting economic analysis, which scaled intervention to the size of the given country’s monetary base, South Korea and Taiwan have been among the most active participants in forex markets, while Thailand and Malaysia have been among the most restrained. This is born out by the sizable appreciation of both the Thai Baht and Malaysian Ringit over the last few years. However, I wonder if some economists will take issue with their assessment that Brazil and China have been relatively modest interveners.
Of course, this doesn’t make it any easier to forecast, since how a country behaved in the past isn’t necessarily indicative of how it will behave in the future. For example, Thailand just announced that it will not intervene, but Brazil will double its forex tax from 2% to 4%. Case in Point!

Posted by Adam Kritzer | in Central Banks, News | 1 Comment »

Currency War: Who are the Winners and Losers?

Oct. 6th 2010

On September 27, Brazilian Finance Minister, Guido Montega, used the term “currency war” to describe the series of recent Central Bank interventions in forex markets. While he may not have intended it, the term stuck, and financial journalists everywhere have run wild with it.
In the current cycle (dating back a couple years), more than a dozen Central Banks have entered the forex markets with the intention of holding down their respective currencies, both against each other and also against the US Dollar. What makes it a war is that the Central Banks are fighting to outspend and outdo each other. It is a War of Attrition, in that Central Banks will fight until they’ve exhausted all of their wherewithal, conceding defeat for their currencies. On the other hand, unlike in a conventional war, there aren’t any alliances, nor is there much in the way of little strategy. Central Banks simply buy large blocks of counter currencies and hope their own currencies will then depreciate on the spot market. In addition, since the counter currencies are almost always Dollars and/or Euros, the participants in this war are not even competing directly against each other, but rather against an enemy that isn’t doing much to fight back. [Chart belowcourtesy of Der Spiegel].

The Swiss National Bank (SNB) was the first to intervene, and staged a one-year campaign over the course of 2009 to hold the Swiss Franc at 1.50 against the Euro. Ultimately, it failed when the sovereign debt crisis caused an exodus of Euro selling. The Bank of Brazil was next, although its interventions havebeen more modest; it seems to have accepted the ultimate futility of its efforts, and will seek to slow the Real’s appreciation rather than halt it. Last month, the Bank of Japan spent $20 Billion in one session in order to show the markets how serious it is about fighting the Yen’s rise. In fact, it was this intervention that sparked Montega’s comments about currency war. (The BOJ hasn’t intervened since). All along, the People’s Bank of China has continued to add to its war chest of reserves – currently $2.5 Trillion – as part of the ongoing Yuan-Dollar peg. And of course, there have been a handful of smaller interventions (South Korea, Singapore, Taiwan) and no shortage of rhetorical (Canada, South Africa) interventions, as well as indirect (US, UK) intervention.
That’s right- don’t forget that the Fed and the Bank of England, through their respective quantitative easing programs, have injected Trillions into the financial markets and caused their currencies to weaken. In a sense, all of the subsequent interventions have been effected in order to restore the equilibrium in the currency markets that was lost when these two Central Banks deflated there currencies through wholesale money printing. Since much of this cash has found its way into emerging markets (See chart below), you can’t blame their Central Banks from trying to soften some of the upward pressure on their currencies.
It’s still too early too early to say how far the currency war will go. The G7/G20 has announced that it will address the issue at its next summit, though it probably won’t lead to much in the way of action. Ultimately, politicians can’t do much more than shake their fingers at countries that try to hold down their currencies. In the case of the Yuan-Dollar peg, American politicians have tried to take this one step further by threatening to slap China with punitive trade sanctions, but this probably won’t come to pass and may disappear as an issue altogether after the November elections. As I reported on Friday, Brazil has taken matters into its own hands by taxing all foreign capital inflows, but this hasn’t had much effect on the Real.

That brings me to my final point, which is that all currency intervention is futile in the long term, because most Central Banks have limited capacity to intervene. If they print too much money to hold down their currencies, they risk stoking inflation. Of course China is the exception to this rule, but this is less because of the size of its war chest and more because of the mechanics of its exchange rate regime. For Central Banks to successfully manipulate their currencies on the spot market, they must fight against the Trillions of Dollars in daily forex turnover. Eventually, every Central Bank must reckon with this truism.
In terms of identifying the winners and losers of the currency war (as I promised to do in the title of this post, the Euro will probably lose (read: appreciate) because the ECB is not willing to participate. The same goes for the Swiss Franc, since the SNB has basically forsaken currency intervention for the time being. The Bank of Japan has deep pockets, and if the markets push the Yen back up above 85 Yen/Dollar, I wouldn’t be surprised to see it intervene again. With the Fed mulling an expansion of its quantitative easing program, meanwhile, the Dollar will probably continue to sink. And as for the countries that are doing the actual intervening, they might succeed in temporarily holding down the valuer of their respective currencies.  As capital shifts to emerging markets over the long-term, however, their currencies will soon resume rising.

Posted by Adam Kritzer | in Central Banks, News | 2 Comments »

Brazilian Real at 2-Year High Despite “Currency War”

Oct. 1st 2010

Brazil is beating the drumbeat of war. The forex variety, that is. According to the Finance Minister, “We’re in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness.” By its own admission, Brazil will not be sitting on the sidelines of this war. Rather, it will do battle on behalf of its currency, the Real.

Brazil’s concerns are perhaps justified, since the Brazilian Real has surged to a 2-year high, and is amazingly not worth more than prior to the collapse of the Lehman Brothers and the ignition of the global financial crisis. (If anything, this shows just how far we’ve come in returning to stability). According to Goldman Sachs, the Real is now the most overvalued major currency in the world. This is confirmed by The Economist’s Big Mac Index, which shows that in Purchasing Power Parity (PPP) terms, Brazil is now the third most expensive country in the world, behind only Norway and Switzerland.

It’s not hard to understand why the Real is soaring. Its benchmark Selic rate is 10.75%, with government bonds yielding an even higher 12%. Even after controlling inflation, this is the highest among major currencies. Its economy is booming; GDP is projected at 10% in 2010. As a result, capital flow inflows have returned to pre-credit crisis levels: “Net foreign-exchange inflows totaled $11.14 billion in the September 1-17 period, up from $2.11 billion in the first 10 days of the month, according to data released Tuesday by the country’s central bank.” The inflows have been driven by a $70 Billion stock offering by PetroBras, the (formerly) state-owned oil company. It is a record sum, and over 3 times bigger than the eye-popping $23 Billion the Agricultural Bank of China raised only a few months ago. “If the Petrobras deal had never happened, the real might currently be trading somewhere around 1.75 per dollar,” compared to 1.70 today. With other companies rushing to follow suit with debt and equity offerings, cash will probably continue to pour in.
As I said at the beginning of this post, the Bank of Brazil has several tools up its sleeve. It has already resumed “surprise daily auctions to buy excess dollars in the spot market” (suspended in 2006), in which investors can trade Dollars for Brazilian government debt. It is also proposing reverse currency swaps, which would serve a similar purpose. ” ‘The order is to buy, buy and buy,’ ” said a government source. It has purchased nearly $1 Billion in foreign currency in the month of September alone, and has pledged to deploy its $10 Billion Sovereign investment fund if necessary. Finally, there is talk of raising the tax rate (currently 2%) on all foreign capital inflows, though there is no real timetable for such a move.
Alas, while the government of Brazil is certainly sincere in its intentions to hold down the Real, it lacks the wherewithal. Its $1 Billion intervention in September was dwarfed by the $20+ Billion spent by the Bank of Japan in one day to hold down the Yen. Even controlling for the difference in the size of their respective economies, Brazil has still been thoroughly outspent. Its $10 Billion investment fund pales in comparison to the ~$1 Trillion forex reserves of Japan. In short, Brazil would be wise to avoid full-fledged engagement in currency war.

Besides, the Real strength can better be seen in terms of weakness in the US Dollar and other G4 currencies. In this regard, Brazil’s measly purchases of US Dollars on the spot market probably won’t do much to counter the gradual exodus of cash from safe-havens back into growth currencies. Perhaps, it can take solace in the fact that the Real is so overvalued that it would seem to have no place to go but down.

China Diversifies Forex Reserves

China’s foreign exchange reserves continue to surge. As of September, the total stood at $2.64 Trillion, an all-time high. However, it’s becoming abundantly clear that China is no longer content for Dollar-denominated assets to represent the cornerstone of its reserves. Instead, it has embarked on a campaign to further diversify its reserves, with important implications for the currency markets.

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

QE2 Weighs on Dollar

Oct. 18th 2010

In a few weeks, the US could overtake China as the world’s biggest currency manipulator. Don’t get me wrong: I’m not predicting that the US will officially enter the global currency war. However, I think that the expansion of the Federal Reserve Bank’s quantitative easing program (dubbed QE2 by investors) will exert the same negative impact on the Dollar as if the US had followed China and intervened directly in the forex markets.
For the last month or so, markets have been bracing for QE2. At this point it is seen as a near certainty, with a Reuters poll showing that all 52 analysts that were surveyed believe that is inevitable. On Friday, Ben Bernanke eliminated any remaining doubts, when he declared that, “There would appear — all else being equal — to be a case for further action.” At this point, it is only a question of scope, with markets estimates ranging from $500 Billion to $2 Trillion. That would bring the total Quantitative Easing to perhaps $3 Trillion, exceeding China’s $2.65 Trillion foreign exchange reserves, and earning the distinction of being the largest, sustained currency intervention in the world.
The Fed is faced with the quandary that its initial Quantitative Easing Program did not significantly stimulate the economy. It brought liquidity to the credit and financial markets – spurring higher asset prices – but this didn’t translate into business and consumer spending. Thus, the Fed is planning to double down on its bet, comforted by low inflation (currently at a 50 year low) and a stable balance sheet. In other words, it feels it has nothing to lose.
Unfortunately, it’s hard to find anyone who seriously believes that QE2 will have a positive impact on the economy. Most expect that it will buoy the financial markets (commodities and stocks), but will achieve little if anything else: “The actual problem with the economy is a lack of consumer demand, not the availability of bank loans, mortgage interest rates, or large amounts of cash held by corporations. Providing more liquidity for the financial system through QE2 won’t fix consumer balance sheets or unemployment.” The Fed is hoping that higher expectations for inflation (already reflected in lower bond prices) and low yields will spur consumers and corporations into action. Of course, it is also hopeful that a cheaper Dollar will drive GDP by narrowing the trade imbalance.

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

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

Fed Surprises Markets with Scope of QE2

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

On Wednesday, rumor became reality, as the Fed announced that it would expand its balance sheet by $600 Billion through purchases of long-dated Treasury securities over the next six months. While the announcement (and the accompanying holding of the Federal Funds Rate at 0%) were certainly expected, markets were slightly taken aback by its scope.
Due to conflicting testimony by members of the Fed’s Board of Governors, investors had scaled back their expectations of QE2 to perhaps $300-500 Billion. To be sure, a handful of bulls forecast as much as $1-1.5 Trillion in new money would be printed. The majority of analysts, however, New York Fed chief William Dudley’s words at face value when he warned, “I would put very little weight on what is priced into the market.” It was also rumored that the US Treasury Department was working behind the scenes to limit the size of QE2. Thus, when the news broke, traders instantly sent the Dollar down against the Euro, back below the $1.40 mark.

On the one hand, the (currency) markets can take a step back and focus instead on other issues. For example, yields on Eurozone debt have been rising recently due to continued concerns about the possibility of default, but this is not at all reflected in forex markets. During the frenzy surrounding QE2, the forex markets also completely neglected comparative growth fundamentals, which if priced into currencies, would seem to favor a rally in the Dollar.
On the other hand, I have a feeling that investors will continue to dwell on QE2. While the consensus among analysts is that it will have little impact on the economy, they must nonetheless await confirmation/negation of this belief over the next 6-12 months. In addition, all of the speculation to date over the size of QE2 has been just that – speculation. Going forward, speculators must also take reality into account, depending on how that $600 Billion is invested and the consequent impact on US inflation. If a significant proportion of is simply pumped into domestic and emerging market stocks, then the markets will have been proved right, and the Dollar will probably fall further. If, instead, a large portion of the funds are lent and invested domestically, and end up buoying consumption, then some speculators will be forced to cover their bets, and the Dollar could rally.
Unfortunately, while QE2 is largely seen as a win-win for US stocks (either it stimulates the economy and stocks rally, or it fails to stimulate the economy but some of the funds are used to foment a stock market rally anyway), the same cannot be said for the US Dollar. If QE2 is successful, then hawks will start moaning about inflation and use it as an excuse to sell the Dollar. If QE2 fails, well, then the US economy could become mired in an interminable recession, and bears will sell the Dollar in favor of emerging market currencies.

New Zealand: No Forex Intervention

Despite reaching a temporary stalemate, the currency war rages on, and individual countries continue to debate whether they should enter or watch their currencies continue to appreciate. Nowhere is that debate stronger than in New Zealand, whose Kiwi currency has fallen 37% against the US Dollar since its peak in early 2009, and over 15% since June of this year.

With most countries, the war cries are coming from the political establishment, who feel compelled to demonstrate to their constituents that they are diligently monitoring the currency war. This is largely the case in New Zealand, as Members of Parliament have argued forcefully in favor of intervention. Prime Minister John Key is a little more pragmatic: He “says his Government is concerned about the strength of our dollar, but is not convinced intervention would work…politicians who think intervention can happen without economic consequences, are fooling themselves.” Showing an astute understanding of economics, he pointed out that trying to limit the Kiwi’s appreciation would manifest itself in the form of higher inflation, higher interest rates, and/or reduced access to capital.
This is essentially the position of Alan Bollard, Governor of the Central Bank of New Zealand. He has insisted (correctly) that the New Zealand is being driven up, so much as its currency counterparts – namely the US Dollar – are being driven downward, by forces completely disconnected from New Zealand and way beyond its control. Thus, if New Zealand tried to intervene, it would quickly be overpowered (perhaps deliberately!) by speculators. Ultimately, it would end up spending lots of money in vain, and the Kiwi would continue to appreciate.
Mr. Bollard has pointed out that a stronger currency is not without its perks: such as lower (relative) prices for certain natural resources, such as oil. In addition, since New Zealand is largely a commodity economy, its producers are being compensated for an expensive currency in the form of higher prices for milk, wool, and other staple exports. While its other manufacturing operations have been punished by the expensive Kiwi, its economy is still relatively robust. Thanks to a series of tax cuts and the lowest interest rates in New Zealand history, GDP is forecast to return to trend in 2010 and 2011.

New Zealand’s concerns are understandable, and there is an argument to be made for preventing the Dollars that are printed from the Fed’s QE2 from being put to unproductive purposes in New Zealand. At the same time, New Zealand is not such an attractive target for speculators. Its benchmark interest rate, at 3%, is relatively low compared to developing countries. Its current account balance is projected to continue declining, perhaps down to -8%, which means that the net flow of capital is actually out of New Zealand. In addition, while the Kiwi has appreciated against the US Dollar, it has fallen mightily against the Australian Dollar en route to a multi-year low.
Going forward, there is reason to believe that the New Zealand Dollar will continue to appreciate against the US Dollar as a result of QE2 and a general sense of pessimism towards the US. The same is true with regard to currencies that actively intervene to prevent their currencies from appreciating. Still, I don’t think the New Zealand Dollar will reach parity – against any currency – anytime soon, and after the currency fracas subsides, it will probably trend towards its long-term average.

Currency War Will End in Tears

Nov. 8th 2010

The “currency war” is heating up, and all parties are pinning their hopes on the G20 summit in South Korea. However, this is reason to believe that the meeting will fail to achieve anything in this regard, and that the cycle of “Beggar-thy-Neighbor” currency devaluations will continue.
There have been a handful of developments since the my last analysis of the currency war. First of all, more Central Banks (and hence, more currencies) are now affected. In the last week, Argentina pledged to continue its interventions into 2011, while Taiwan, and India – among other less prominent countries – have hinted towards imminent involvement.
Of greater significance was the official expansion of the Fed’s Quantitative Easing Program (QE2), which at $600 Billion, will dwarf the efforts of all other Central Banks. In fact, it’s somewhat ironic that the Fed is the only Central Bank that doesn’t see its monetary easing as a form of currency intervention when you consider its impact on the Dollar and its (inadvertent?) role in “intensifying the currency war.”  According to Chinese officials, “The continued and drastic U.S. dollar depreciation recently has led countries including Japan, South Korea and Thailand to intervene in the currency market,” while the Japanese Prime Minister recently accused the U.S. of pursuing a “weak-dollar policy.”

As of now, there is no indication that other industrialized countries will follow suit, though given concerns that QE2 “at the end of the day might be dampening the recovery of the euro area,” I think it’s too early to rule anything out. While the Bank of Japan similarly has stayed out of the market since its massive intervention in October, Finance Minister Yoshihiko Noda recently declared that, “I think the [Yen's] moves yesterday were a bit one-sided. I will continue to closely monitor these moves with great interest.”
As the war reaches a climax of sorts, everyone is waiting with baited breath to see what will come out of the G20 Summit. Unfortunately, the G20 failed to achieve anything substantive at last month’s Meeting of Finance Ministers and Central Bank Governors, and there is little reason to believe that this month’s meeting will be any different.

In addition, the G20 is not a rule-making body like the WTO or IMF, and it has no intrinsic authority to stop participating nations from devaluing their currencies. Conference host South Korea has lamely pointed out that while ” ‘There aren’t any legal obligations‘…discussion among G20 countries would produce ‘a peer-pressure kind of effect on these countries’ that violated the deal.” Not to mention that the G20 will have no effect on the weak Dollar nor on the undervalued RMB, both of which are at the root of the currency war.
It’s really just wishful thinking that countries will come to their senses and realize that currency devaluation is self-defeating. In the end, the only thing that will stop them from intervening is to accept the futility of it: “The history of capital controls is that they don’t work in controlling foreign exchange rates.” This time around will prove to be no different, “particularly with banks already said to be offering derivatives products to get around the new taxes.” The only exception is China, which is only able to prevent the rise of the RMB because of strict controls for dealing with the inflow of capital.
In short, the “wall of money” that is pouring into emerging market economies represents a force too great to be countered by individual Central Banks. The returns offered by investing in emerging markets (even ignoring currency appreciation) are so much greater than in industrialized countries that investors will not be deterred and will only work harder to find ways around them. Ironically, to the extent that controls limit the supply of capital and boost returns, they will probably drive additional capital inflows. The more successful they are, the more they will fail. And that’s something that no new currency agreement can change.

Euro Buoyed by Rate Hike Expectations, Despite Unresolved Debt Issues

From trough to peak, the Euro has risen 9% over a period of only two months. You wouldn’t ordinarily expect to see this kind of appreciation from a G4 currency, especially not one whose member states are on the brink of insolvency and which itself faces threats to its very existence. In this case, the Euro is benefiting from expectations that the European Central Bank (ECB) will be among the first and most aggressive in hiking interest rates. As I warned in my previous post, however, those that focus solely on interest rate differentials and ignore the Euro’s lingering Sovereign debt crisis do so at their own peril.

Indications that the ECB will hike interest rates came out of nowhere. Jean-Claude Trichet, President of the ECB, announced last week that it would be particularly aggressive in taking steps to deal with inflation. This caught the markets by surprise, since Eurozone inflation is still below 2% and GDP growth is similarly low. Later, Governing Council members Mario Draghi and Axel Weber (both of whom are potential candidates to replace Trichet when he steps down later this year), issued similar statements, and the question of rate hikes was suddenly changed from If to When/How much.
Futures markets are currently pricing in 3 interest rate hikes, which would bring the Eurozone benchmark rate to 1.75% by year end. According to economist Nouriel Roubini’s (who gained fame by predicting the financial crisis) think tank: “Jean-Claude Trichet has been careful not to commit to a series of hikes, but we believe that is what it will be. The ECB is bluffing. We think the ECB will hike by a total of 75 basis points, probably by August.” Axel Weber, himself, coyly echoed this sentiment: “I see no reason at this stage to signal any dissent with how markets priced future policies.”
On the one hand, the recent rise in oil prices strengthens the case for rate hikes. On the other hand, the EU does not consume energy at the same intensity as the US, which means that its impact on inflation is likely to be muted. In addition, while the ECB’s mandate is indeed titled towards price stability (rather than boosting employment or spurring economic growth), to hike rates now would risk endangering the still-fragile Eurozone economic recovery. Unwinding its quantitative easing would similarly add to the risk of another financial crisis, since banks still make heavy use of its emergency lending facilities.
Speaking of which, it’s still way too early to say that the the EU sovereign debt crisis is behind us. Despite the loans and pledges and bailouts, interest rates for all four PIGS (Portugal, Ireland, Greece, Spain) countries continue to rise, and or nearing unsustainable levels. At the moment, currency investors have chosen to ignore this, since the EU has basically guaranteed them funding until 2013. What will happen then, or as the date draw near, is anyone’s guess.

In the end, one or more defaults seems inevitable. There is only so much that financial engineering can do to conceal and restructure debt which exceeds 100% of GDP in the cases of Greece and Ireland. If that were to happen, significant losses would be incurred by EU banks, which lent heavily to at-risk countries during the boom years. In order to minimize this situation, I think the ECB will probably continue to subsidize the banks via low interest rates.
Even if the ECB does hike rates, it will be extremely gradual. Furthermore, By the time Eurozone interest rates reach attractive levels, the other G4 Central Banks (with the exception of Japan) will probably already have started to close the gap. That means that interest rate differentials probably won’t soon be wide enough to lure more than a modicum of risk-averse investors. (Besides, if you assume a 5% chance of default, risk-adjusted rates are probably still negative).
In short, I think that the ongoing Euro rally is really just a short squeeze in disguise. Basically, speculators are conceding that shorting the Euro is both risky and unprofitable. (According to one hedge fund manager, “It was a very popular trade,” the portfolio manager says. A lot of us stuck with it, and it went wrong in January.”) In anticipating of higher future interest rates, they are preemptively moving to liquidate their short positions. However, not being short is not the same thing as going long. And until the EU sorts through the fiscal issues in a convincing way, I think it would be foolish to start making long-term bets on the Euro.

Posted by Adam Kritzer | in Central Banks, Euro | 2 Comments »

Forex Markets Look to Interest Rates for Guidance

Feb. 11th 2011

There are a number of forces currently competing for control of forex markets: the ebb and flow of risk appetite, Central Bank currency intervention, comparative economic growth differentials, and numerous technical factors. Soon, traders will have to add one more item to their list of must-watch variables: interest rates.
Interest rates around the world remain at record lows. In many cases, they are locked at 0%, unable to drift any lower. With a couple of minor exceptions, none of the major Central Banks have yet raised their benchmark interest rates. The same applies to most emerging countries. Despite rising inflation and enviable GDP growth, they remain reluctant to hike rates for fear that they will invite further speculative capital inflows and consequent currency appreciation.
Emerging markets countries can only toy with inflation for so long. Over the medium-term, all of them will undoubtedly be forced to raise interest rates. The time horizon for G7 Central Banks is a little longer, due to high unemployment, tepid economic growth, and price stability. At a certain point, however, inflation will compel all of them to act. When they raise rates – and by much – may well dictate the major trends in forex markets over the next couple years.
Australia (4.75%), New Zealand (3%), and Canada (1%) are the only industrialized Central Banks to have lifted their benchmark interest rates. However, the former two must deal with high inflation, while the latter’s benchmark rate is hardly high enough for carry traders to take interest. In addition, the Reserve Bank of Australia has basically stopped tightening, and traders are betting on only one or two 25 basis point hikes in 2011. Besides, higher interest rates have probably already been priced into their respective currencies (which is why they rallied tremendously in 2010), and will have to rise much more before yield-seekers take notice.
China (~6%) and Brazil (11.25%) are leading the way in emerging markets in raising rates. However, their benchmark lending rates belie lower deposit rates and are probably negative when you account for soaring inflation in both countries. The Reserve Bank of India and Bank of Russia have also hiked rates several times over the last year, though again, not yet enough to offset rising prices.
Instead, the real battle will probably be fought primarily amongst the Pound, Euro, Dollar, and Franc. (The Japanese Yen is essentially moot in this debate, and its Central Bank has not even humored the markets about the possibility of higher interest rates down the road). The Bank of England (BoE) will probably be the first to move. “The present ultra-low rates are unsustainable. They would be unsustainable in a period of low inflation but they are especially unsustainable with inflation, however you measure it, approaching 5 per cent,” summarized one columnist. In fact, it is projected to hike rates 3 times over the next year. If/when it unwinds its quantitative easing program, long-term rates will probably follow suit.
The European Central Bank will probably act next. Its mandate is to limit inflation – rather than facilitate economic growth, which means that it probably won’t hesitate to hike rates if inflation remains above its 2% threshold. In addition, the front runner to replace Jean-Claude Trichet as head of the ECB is Axel Webber, who is notoriously hawkish when it comes to monetary policy. Meanwhile, the Swiss National Bank is currently too concerned about the rising Franc to even think about raising rates.

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

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

Posted by Adam Kritzer | in Central Banks, US Dollar | 1 Comment »

Chinese Yuan Will Not Be Reserve Currency?

Nov. 18th 2010

In a recent editorial reprinted in The Business Insider (Here’s Why The Yuan Will Never Be The World’s Reserve Currency), China expert Michael Pettis argued forcefully against the notion that the Chinese Yuan will be ever be a global reserve currency on par with the US Dollar. By his own admission, Pettis seeks to counter the claim that China’s rise is inevitable.
The core of Pettis’s argument is that it is arithmetically unlikely – if not impossible – that the Chinese Yuan will become a reserve currency in the next few decades. He explains that in order for this to happen, China would have to either run a large and continuous current account deficit, or foreign capital inflows into China would have to be matched by Chinese capital outflows.” Why is this the case? Simply, a reserve currency must necessarily offer (foreign) institutions ample opportunity to accumulate it.

However, as Pettis points out, the structure of China’s economy is such that foreigners don’t have such an opportunity. Basically, China has run a current account/trade surplus, which has grown continuously over the last decade. During that time, its Central Bank has accumulated more than $2.5 Trillion in foreign exchange reserves in order to prevent the RMB from appreciating. Foreign Direct Investment, on the other hand, averages 2% of GDP and is declining, not to mention that “a significant share of those inflows may actually be mainland money round-tripped to take advantage of capital and tax regulations.”
For this to change, foreigners would need to have both a reason and the opportunity to hold RMB assets. The reason would come from a reversal in China’s balance of trade, and the use of RMB to pay for the excess of imports over exports, which would naturally imply a willingness of foreign entities to accept RMB. The opportunity would come in the form of deeper capital markets, a complete liberalization of the exchange rate regime (full-convertibility of the RMB), and the elimination of laws which dictate how foreigners can invest/lend in China. This would likewise an imply a Chinese government desire for greater foreign ownership.

How likely is this to happen? According to Pettis, not very. China’s financial/economic policy are designed both to favor the export sector and to promote access to cheap capital. In practice, this means that interest rates must remain low, and that there is little impetus behind the expansion of domestic consumption. Given that this has been the case for almost 30 years now, this could prove almost impossible to change. For the sake of comparison, consider that despite two “lost decades,” Japan nonetheless continues to promote its export sector and maintains interest rates near 0%.
Even if the Chinese economy continues to expand and re-balances itself in the process (a dubious possibility), Pettis estimates that it would still need to increase the rate of foreign capital inflows to almost 10% of GDP. If economic growth slows to a more sustainable level and/or it continues to run a sizable trade surplus, this figure would rise to perhaps 20%. In this case, Pettis concedes, “we are also positing…a radical change in the nature of ownership and governance in China, as well as a radical redrawing of the role of the central and local governments in the local economy.”
So there you have it. The political/economic/financial structure of China is such that it would be arithmetically very difficult to increase foreign accumulation of RMB assets to the extent that the RMB would be a contender for THE global reserve currency. For this to change, China would have to embrace the kind of reforms that go way beyond allowing the RMB to fluctuate, and strike at the very core of the CCP’s stranglehold on power in China.
If that’s what it will take for the RMB to become a fully international currency, well, then it’s probably too early to be having this conversation. Perhaps that’s why the Asian Development Bank, in a recent paper, argued in favor of modest RMB growth: “sharing from about 3% to 12% of international reserves by 2035.” This is certainly a far cry from the “10 years” declared by Russia’s finance minister and tacitly supported by Chinese economic policymakers.
The implications for the US Dollar are clear. While it’s possible that a handful of emerging currencies (Brazilian Real, Indian Rupee, Russian Ruble, etc.) will join the ranks of the international currencies, none will have enough force to significantly disrupt the status quo. When you also take into account the economic stagnation in Japan and the UK, as well as the political/fiscal problems in the EU, it’s more clear than ever that the Dollar’s share of global reserves in one (or two or three) decades will probably be only slightly diminished from its current share.

British Pound Continues Gradual Ascent

The British Pound has risen almost 15% against the Dollar over the last twelve months. It seems that the markets are ignoring the fiscal concerns that sent the Pound tumbling in 2010, and focusing more on inflation and the prospect of interest rate hikes. At this point, the Bank of England (BOE) is now racing with the European Central Bank (ECB) to be the first “G4″ Central Bank to hike rates.

You can find cause for optimism towards the Pound in technical factors alone. That’s because while dozens of currencies appreciated against the Dollar in 2010, most were starting from a stronger base. For example, the Canadian and Australian Dollars collapsed during the credit crisis. However, both currencies made speedy recoveries to the extent all losses were erased in only two years. The British Pound, in contrast, still remains 25% below its pre-credit crisis high, more depressed than perhaps any other currency.

On the one hand, this is probably justifiable. The British economy is still in abysmal shape; the latest GDP figures revealed a .6% contraction in the fourth quarter of 2010. Meanwhile, the ECB forecasts only 1.4% growth in 2011, and many analysts think that might even be too optimistic. With the exception of Japan, which suffers from a unique strain of economic malaise (not to mention the 5% hit to GDP caused by the earthquake), the UK is unequivocally the weakest economy in the industrialized world.
On the other hand, this is mostly old news. The reason that investors are starting to get excited is interest rate hikes. According to the minutes from its March meeting, the BOE voted 6-3 to hold its benchmark interest rate at .5%. That means its awfully close to acting. The market consensus is for a 25 basis point rate hike in the next three months, and 2-3 additional hikes over the rest of the year. Depending on how the other G4 Central banks act, that will put the UK rates at the top of the pack.
However, it’s unclear how extensive this tightening will be. According to one analyst, “The probability of a hike in the next three months is significant but the lingering credit crunch, fiscal tightening and bleak outlook for real incomes suggest that if this is the beginning of a tightening cycle, it will be a very shallow one.” Moreover, low bond yields suggest that long-term inflation expectations (and hence, the need for rate hikes) remain low.

At this point, it looks like the UK is looking at a few years of stagflation. That’s certainly going to be bad for UK consumers and probably negative for most UK asset prices. However, short-term currency speculators are less concerned about economic fundamentals, and more concerned about (risk-adjusted) interest rate differentials. That means that if the BOE fulfills expectations, the Pound will probably get a little short-term kick.

Record Commodities Prices and the Forex Markets

Propelled by economic recovery and the recent Mideast political turmoil, oil prices have firmly shaken off any lingering credit crisis weakness, and are headed towards a record high. Moreover, analysts are warning that due to certain fundamental changes to the global economy, prices will almost certainly remain high for the foreseeable future. The same goes for commodities. Whether directly or indirectly, the implications for forex market will be significant.

First of all, there is a direct impact on trade, and hence on the demand for particular currencies. Norway, Russia, Saudia Arabia, and a dozen other countries are witnessing record capital inflow expanding current account surpluses. If not for the fact that many of these countries peg their currencies to the Dollar and/or seem to suffer from myriad other issues, there currencies would almost surely appreciate. In fact, the Russian Rouble and Norwegian Krona have both begun to rise in recent months. On the other hand, Canada and Australia (and to a lesser extent, New Zealand) are experiencing rising trade deficits, which shows that their is not an automatic relationship between rising commodity prices and commodity currency strength.

Those countries that are net energy importers could experience some weakness in their currencies, as trade balances move against them. In fact, China just recorded its first quarterly trade deficit in seven years. Instead of viewing this in terms of a shift in economic structure, economists need to understand that this is due in no small part to rising raw materials prices. Either way, the People’s Bank of China (PBOC) will probably tighten control over the appreciation of the Chinese Yuan. Meanwhile, the nuclear crisis in Japan is almost certainly going to decrease interest in nuclear power, especially in the short-term. This will cause oil and natural gas prices to rise even further, and magnify the impact on global trade imbalances.

A bigger issue is whether rising commodities prices will spur inflation. With the notable exception of the Fed, all of the world’s Central Banks have now voiced concerns over energy prices. The European Central Bank (ECB), has gone so far as to preemptively raise its benchmark interest rate, even though Eurozone inflation is still quite low. In light of his spectacular failure to anticipate the housing crisis, Fed Chairman Ben Bernanke is being careful not to offer unambiguous views on the impact of high oil prices. Thus, he has warned that it could translate into decreased GDP growth and higher prices for consumers, but he has stopped short of labeling it a serious threat.
On the one hand, the US economy is undergone some significant structural changes since the last energy crisis, which could mitigate the impact of sustained high prices. “The energy intensity of the U.S. economy — that is, the energy required to produce $1 of GDP — has fallen by 50% since then as manufacturing has moved overseas or become more efficient. Also, the price of natural gas today has stayed low; in the past, oil and gas moved in tandem. And finally, ‘we’re closer to alternative sources of energy for our transportation,’ ” summarized Wharton Finance Professor Jeremy Siegal. From this standpoint, it’s understandable that every $10 increase in the price of oil causes GDP to drop by only .25%.
On the other hand, we’re not talking about a $10 increase in the price of oil, but rather a $50 or even $100 spike. In addition, while industry is not sensitive to high commodity prices, American consumers certainly are. From automobile gasoline to home eating oil to agricultural staples (you know things are bad when thieves are targeting produce!), commodities still represent a big portion of consumer spending. Thus, each 1 cent increase in the price of gas sucks $1 Billion from the economy. “If gas prices increased to $4.50 per gallon for more than two months, it would ‘pose a serious strain on households and could put the entire recovery in jeopardy. Once you get above $5, [there is] probably above a 50% chance that the economy could face a downturn.’ ”
Even if stagflation can be avoided, some degree of inflation seems inevitable. In fact, US CPI is now 2.7%, the highest level in 18 months and rising. It is similarly 2.7% in the Eurozone and Australia, where both Central Banks have started to become more aggressive about tightening monetary policy. In the end, no country will be spared from inflation if commodity prices remain high; the only difference will be one of extent.

Over the near-term, much depends on what happens in the Middle East, since an abatement in political tensions would cause energy prices to ease. Over the medium-term, the focus will be on Central Banks, to see if/how they deal with rising inflation. Will they raise interest rates and withdraw liquidity, or will they wait to act for fear of inhibiting economic recovery? Over the long-term, the pivotal issue is whether economies (especially China) can become less energy intensive or more diversified in their energy consumption.
At the moment, most economies are dangerously exposed, with China and the US topping the list. Russia, Norway, Brazil and a select few others will earn a net benefit from a boom in prices, while most others (notably Australia and Canada) are somewhere in the middle.

Posted by Adam Kritzer | in Central Banks, Commentary | No Comments »

Fed Mulls End to Easy Money

Apr. 4th 2011

Forex traders have very suddenly tilted their collective focus towards interest rate differentials. Given that the Dollar is once again in a state of free fall, it seems the consensus is that the Fed will be the last among the majors to hike rates. As I’ll explain below, however, there are a number of reasons why this might not be the case.
First of all, the economic recovery is gathering momentum. According to a Bloomberg News poll, “The US economy is forecast to expand at a 3.4 percent rate this quarter and 3.3 percent rate in the second quarter.” More importantly, the unemployment rate has finally begun to tick down, and recently touched an 18-month low. While it’s not clear whether this represents a bona fide increase in employment or merely job-hunting fatigue among the unemployed, it nonetheless will directly feed into the Fed’s decision-making process.

In fact, the Fed made such an observation in its March 15 FOMC monetary policy statement, though it prefaced this with a warning about the weak housing market. Similarly, it noted that a stronger economy combined with rising commodity prices could feed into inflation, but this too, it tempered with the dovish remark that “measures of underlying inflation continue to be somewhat low.” As such, it warned of “exceptionally low levels for the federal funds rate for an extended period.”
To be sure, interest rate futures reflect a 0% likelihood of any rate hikes in the next 6 months. In fact, there is a 33% chance that the Fed will hike before the end of the year, and only a 75% chance of a 25 basis point rise in January of 2012. On the other hand, some of the Fed Governors are starting to take more hawkish positions in the media about the prospect of rate hikes: “Minneapolis Federal Reserve President Narayana Kocherlakota said rates should rise by up to 75 basis points by year-end if core inflation and economic growth picked up as he expected.” Given that he is a voting member of the FOMC, this should not be written off as idle talk.

Meanwhile, Saint Louis Fed President James Bullard has urged the Fed to end its QE2 program, and he isn’t alone. “Philadelphia Fed President Charles Plosner and Richmond Fed President Jeffrey Lacker have also urged a review of the purchases in light of a strengthening economy and concern over future inflation.” While the FOMC voted in March to “maintain its existing policy of reinvesting principal payments from its securities holdings and…purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011,” it has yet to reiterate this position in light of these recent comments to the contrary, and investors have taken notice.
Assumptions will probably be revised further following tomorrow’s release of the minutes from the March meeting, though investors will probably have to wait until April 27 for any substantive developments. The FOMC statement from that meeting will be scrutinized closely for any subtle tweaks in wording.
Ultimately, the take-away from all of this is that this record period of easy money will soon come to an end. Whether this year or the next, the Fed is finally going to put some monetary muscle behind the Dollar.

Posted by Adam Kritzer | in Central Banks, US Dollar | No Comments »

UK Forex Reserve Plan could Harm Pound

Mar. 24th 2011

Yesterday, UK Chancellor George Osborne announced that his government was ready to begin rebuilding its foreign exchange reserves. Depending on when, how, (or even if) this program is implemented, it could have serious implications for the Pound.
Forex reserve watchers (myself included) were excited by the updated US Treasury report on foreign holdings of US Treasury securities. As the Dollar is the world’s de-facto reserve currency and the US Treasury securities are the asset of choice, the report is basically a rough sketch of both the Dollar’s global popularity and the interventions of foreign Central Banks. Personally, I thought the biggest shocker was not that China’s Treasury holdings are $300 Billion greater than previously believed (with $3 Trillion in reserves, that’s really just a rounding error), but rather that the UK’s holdings declined by 50% in 2010, to a mere $260 Billion.

Given that the Bank of England (BoE) injected more than $500 Billion into the UK money supply in 2010, I suppose that shouldn’t have been much of a revelation. After all, selling US Treasury Securities and using the proceeds to buy British Gilts (sovereign debt) and other financial instruments would enable the BoE to achieve its objective without having to resort to wholesale money printing. In addition, if not for this sleight of hand, UK inflation would probably be even higher.
Still, this is little more than a mere accounting trick, and those funds will probably still need to be withdrawn from the money supply at some point anyway. Whether the BoE burns the proceeds or reinvests them back into foreign instruments is certainly worth pondering, but insofar as it won’t impact inflation, it is a matter of economic policy, and not monetary policy.
As Chancellor Osborn indicated, the UK will probably send these funds back abroad. In addition to providing support for the Dollar (as well as another reason not to be nervous about the upcoming end of the Fed’s QE2), this would seriously weaken the Pound, at a time  that it is already near a 30-year low on a trade-weighted basis. After falling off a cliff in 2009, the Pound recovered against the Dollar in 2010, largely due to the BoE’s shuffling of its foreign exchange reserves. To undo this would certainly risk sending the Pound back towards these depths.

On the one hand, the UK is certainly conscious of this and would act accordingly, perhaps even delaying any foreign exchange reserve accumulation until the Pound strengthens. On the other hand, the BoE is under pressure to fight inflation. It is reluctant to raise interest rates because of the impact it would have on the fragile economic recovery. The same can be said for unwinding its asset purchases. However, if it offset this with purchases of US Treasury securities and other foreign currency assets, it could weaken the Pound and maintain some form of economic stimulus. Especially since the UK has run a sizable trade/current account deficit for as long as anyone can remember, the BoE has both the flexibility/justification it needs to coax the exchange rate down a little bit.
Ultimately, we’ll need more information before we can determine how this will impact the Pound. Still, this is an indication that the GBP/USD might not have much more room to appreciate.