posted by 4x-news on Jun 21

Something incredible has happened: The Euro has reversed is 16.5% decline (from peak to trough), and since bottoming on June 7 at $1.1876, it has risen by an impressive 4%. I guess that means the Euro has been rescued from parity (which I characterized as “inevitable” on June 5)?
Not exactly. While financial journalists have interpreted this as a recovery in risk appetite, and mainstream investors dismiss all of it as mundane fluctuations in exchange rates, currency traders – both fundamental and technical – know better. They know that this rally is merely a correction, the product of the Euro falling too much too fast against the Dollar and a consequent short-squeeze. They know that there is nothing underpinning the Euro rally, and that since the bad news continues to emanate from the Eurozone, a further decline is inevitable. ” ‘We could be one or two headlines away from a crisis again. This problem didn’t occur in a couple of days, nor is it going to resolve itself in a couple of days,’ ” summarized one trader.

According to Brown Brothers Harriman, ” ‘The recent euro rally is a corrective phase in a bear market and not a change in trend.’ National Bank Financial added, ” ‘Ultimately, when the market is this short a particular currency and a pullback happens, it results in some price volatility. It doesn’t necessarily reverse the longer-term trend.’ ” Given that so-called net-short bets against the Euro rose to a near record high in the beginning of June, it was inevitable [to borrow my favor word of the moment] that traders would eventually “cut positions when momentum in a currency [the Euro] shifted.”

From a fundamental standpoint, the last two weeks have brought further indications that the crisis is still mounting. The credit rating on Greek sovereign debt was cut to junk (A3) by Moody’s, following a similar move by S&P in the spring. Fitch, while arguing that the Euro has already declined “too far” is simultaneously threatening to do the same.

Meanwhile, Spain managed a successful debt auction, but at interest rates nearly 1.5x what it had to pay the last time around. Still, it’s in a more favorable position than Greece, which is now paying a yield premium of more than 600 basis points on its debt, compared to Germany. The implications for currency markets are clear enough: “There is a little bit of a disjuncture between what the currency is doing and what these bond markets are doing, and that’s a problem for the euro.”

Politicians, for their part, are still struggling to convince investors that they are serious about trimming their budgets and uniting for the sake of the Euro. “I see good news from the current euro-dollar rate, French Prime Minister Francois Fillon told reporters…’and I have been saying for years that the euro-dollar rate didn’t reflect reality and was penalizing our exports.’ ” With comments like that, is there any cause for believing them?!

Even putting politics and economics aside, there is a force that will continue to punish the Euro regardless of what happens: the carry trade. According to the WSJ, there is “some evidence that investors are indeed using euros to finance their bets. That is important because it means there may be structural reasons in the investment world why any lift in the euro will simply be quashed.” Thanks to the promise of continued low interest rates and confidence in its decline, ” ‘The euro is the clear-cut funding currency of choice.’ ”

At this point, then, the only issue is when the Euro will resume its decline. Those with a technical bend think that the Euro will fail to breach a psychologically important level (perhaps $1.25 or $1.27) after exhausting the rest of its momentum, at which point it will resume its precipitous decline. Those who see things in fundamental terms argue that when this happens, it will likely be due to more bad news about the crisis and/or a recovery in risk appetite (the contradiction between the two notwithstanding).

posted by 4x-news on Jun 17

Throughout 2010, I have continuously reported on the apparent inevitability of the Chinese Yuan appreciation. That the currency still remains firmly fixed in place against the Dollar is a testament not only to the unpredictability of forex, but also to the doggedness of Chinese officials.

It seemed that China’s policymakers were all but set in February to allow the currency to resume its upward path (its appreciation was halted in 2008). If anything, the case for appreciation is stronger now than it was then. China’s economy grew by a blistering 11.9% in the first quarter. The bilateral trade surplus with the US has widened on the basis of strong export growth. Inflation has exploded, and there is a property bubble that refuses to cool.

Allowing the RMB to appreciate would cool China’s economy and presumably induce a moderation in inflation. In the short-term, it would lead to a slight expansion in the trade surplus (since prices would rise, but quantity would remain unchanged), but this would also moderate over the medium term. Decoupling from the Dollar would also enable China to pursue a more flexible monetary policy; in this case, that means raising interest rates to cool the property bubble as well as the economy at large. As Treasury Secretary Timothy Geithner himself has noted, ” ‘It’s in China’s interest to move.’ “

In the same speech, Secretary Geithner conceded that China is still dragging its heels: ” ‘I do not know if we are at the point now where we will see meaningful progress in the short-term.’ ” This inkling was confirmed by the Chinese Foreign Ministry, “China will reform its exchange-rate mechanism based on developments in the global economy and its own economic performance.” Chinese President Hu JinTao, meanwhile, has personally pledged to a visiting delegation from the US State Department to “continue reform of his country’s exchange-rate regime.”

This isn’t doing much to assuage American lawmakers, whom are currently being slighted by both sides. While China irks Congress by refusing to adjust the RMB, the Treasury Department is also irritating it by both refusing to label China a currency manipulator and by not establishing a deadline for appreciation. As a result, “There is a broad consensus in Congress for a simple proposition: ‘China is not acting in good faith and is aggressively engaged in a series of troubling and downright protectionist policies that put our economic relationship at risk.’ ” Finally, it seems that rhetoric will become reality, as a bill is currently being mulled that would aim to punish China (via punitive tariffs and WTO action) for failure to revalue.

posted by 4x-news on Apr 20

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…

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.
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%.

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).
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.

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.

posted by 4x-news on Apr 19

As I pointed out in last Friday’s post (Volatility, Carry, Risk, and the Forex Markets), volatility has been declining in forex markets since peaking after the collapse of Lehman Brothers. In fact, volatility among emerging market currencies has been falling particularly fast, and recently, something amazing happened: “Three-month implied volatility for the seven biggest developing country currencies fell to 10 percent in March compared with 11.4 percent for industrialized nations.” This inversion could rank as one of this year’s most important developments in terms of its impact on forex. The only runner-up that I can think of is Japanese LIBOR falling below American LIBOR.

Despite its remarkableness, this development isn’t unsurprising, since 8 of the 10 best performers in forex this year are emerging market currencies, led by the Costa Rican Colon, Mexican Peso, and Malaysian Ringgit. Still, we usually assume that with high return, comes high risk. How could it be that are thought of as risky currencies are now less volatile than the so-called majors. Does it really make sense, for example, that the Turkish Lira is less volatile than the British Pound.

Without exploring this particular pair in detail, in a word, the answer is yes. In 2010, emerging market growth is projected to be higher than in the industrialized world. Inflation is relatively stable, and debt levels are comparatively low. Meanwhile, all of the G4 currencies (US Dollar, Euro, Japanese Yen, and British Pound) are plagued by the possibility of Double-Dip recessions and debt crises of varying seriousness. In sum, “Developing nations reduced their foreign debt to 26 percent of GDP last year from 41 percent in 1999, while advanced nations’ debt may surge to 106.7 percent of GDP this year from 78.2 percent in 2007.” Talk about heading in opposite directions!
Thus, emerging markets are projected “to lure $722 billion in overseas investment this year, 66 percent more than in 2009…Developing-nation bond funds attracted $7 billion this year, pushing assets under management to a record $74.7 billion.” Many portfolio managers are betting that this will be a long-term trend: “The rally in emerging-markets has barely started yet.”

What are the forex implications? For the first time, we could see the G4 currencies start trading as a bloc. [Previously, it was the US Dollar versus everything else. The introduction of the Euro ten years ago only strengthened this trend, which is ironic considering the EU has also become an establishment currency. But, if you look at the charts, the Dollar/Euro pair has rarely traded sideways, and traders have used it as a basis for making broader claims about the markets]. Now, it looks like this could finally change: “The big trends will be in non-G4 currencies against G4, such as dollar/Norway or euro/Aussie, and in emerging market currencies.”

posted by 4x-news on Feb 17

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