Forex Rally Comes to an End

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These days, the Dollar and the Yen are veritable proxies for investor confidence/risk tolerance. As a result, on days when US stocks rise, the Dollar (somewhat ironically) will typically experience a decline.

Over the last couple weeks, it should therefore come as no surprise that the tremendous rise in US stock prices was matched by a proportional fall in both the Dollar and the Yen.

If only for technical reasons (i.e. that the scale tipped too much in the other direction), it seems investors have regained some of their comfort with investing in emerging markets, leading some of the hardest-hit currencies (Korean Won, Brazilian Real, Mexican Peso) to recover some of their gains. Call it wishful thinking, but some investors now believe that the US recession will be milder than originally forecast, which would certainly exert a positive impact on such emerging market economies.

In addition, there were monetary factors underlying the currency reversal, reports The Washington Post:
There were more specific reasons for some of the fluctuations. A news report that the Bank of Japan might cut rates in the near future was a factor in driving down the yen.

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Forex Intervention: Back on the Table?

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With the Dollar rallying to multi-year highs and the Yen surging to multi-decade highs, some analysts have begun to re-assess the possibility of Central Banks intervening in forex markets. As if on cue, leaders from the G8 countries also released a statement expressing their concern.

It is not a stretch to say the last few weeks have been awash with stories about emerging market economies that have been destabilized as a result of the rapid depreciation of their currencies, as well as companies that were forced into bankruptcy as a result of currency speculation gone bad.

Meanwhile, the US and Japan are certainly nervous about the impact of more expensive currencies on their respective export sectors.

Ironically, it was only six months ago that some analysts were gaging the same probability of intervention; at that time, however, the purpose would have been to prop up the Dollar, whereas now it would be to bring it back down to earth.

I suppose the moral of the story is that in forex terms, six months is practically an eternity. Besides, as we reported yesterday, both the Dollar and the Yen have already begun to fade.

The Wall Street Journal reports:

"But, this is not a currency crisis" said a foreign exchange strategist. "This is a liquidity crisis, a growth crisis, a confidence crisis. As such, probably the first step should not be to intervene to save currencies."

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Forex Liquidity and the Credit Crisis

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Most of the commentary surrounding the dual Dollar-Yen rally that has unfolded over the last couple months has focused around monetary policy and risk aversion.

Accordingly, the prevailing theory is that both currencies are being driven upwards because of narrowing interest rate differentials and a collapse in risk tolerance.

However, it's also important to consider the role of technical/financial factors.

Specifically, liquidity in forex markets is dissipating rapidly as market participants have found it difficult to secure lines of credit to finance leveraged currency trades.

In addition, those with leveraged short positions in the Dollar and Yen have been forced to partially unwind their positions for the same reason.

In hindsight, the decline in both the Dollar and the Yen over the last few years now appears to have been driven primarily by the same expansion in credit that underlied the real estate bubble, which enabled traders to take advantage of interest rate differentials to earn relatively risk-free profits from a carry trade strategy.

Regardless of the fact that these interest rate differentials persist and a carry trade strategy remains theoretically viable, it's becoming impossible to undertake because of a shortage of credit and liquidity.

FX Solutions reports:
The credit crash has affected participation rates in all markets. Many speculative players who depended on credit and leverage to fuel their trading have withdrawn.

They will not return anytime soon.

In the currency markets this permanent drop in liquidity may keep price movement volatile long after calm has returned to other markets.

It has substantially diminished liquidity in the yen crosses which were, for so long, the speculative favorites of currency traders.

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All Signs Point to Down

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Regardless of your preference, all economic indicators seem to be heading in the same direction: down.

Home sales and home starts, as well as home prices, are way down and projected to fall further. Consumer spending is declining by double-digits (in annualized percentage terms), which is no surprise considering consumer sentiment recently touched an all-time low.

The national unemployment rate and unemployment insurance claims are rising nearly every month and week, respectively.

Factory production is falling, and inventories are rising.

Stock market capitalization is down across the world, especially in export-driven markets like Japan and Korea.

The US economy as a whole contracted in the last quarter.

The distinct lack of nuance in the economic picture has led most economists to project that the current recession (although not officially a recession) will be the worst in decades.

The Wall Street Journal reports:
The current downturn is shaping up to be worse than the recessions of 1990-91 and 2001 and the prolonged downturn that ended in 1982.

Banks are cutting back on lending, consumers are spending less, companies are shedding jobs amid sinking profits, and the housing bust that triggered the slide persists.

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How to Choose a Forex Broker

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Today, I'm going to take a break from covering the credit crisis in order to cover an important logistical topic: how should one go about choosing a forex broker? There are dozens (if not hundreds) of retail forex brokers, a fact which can be overwhelming to those considering dabbling in forex for the first time.

The first step is to assess the quality of the broker, itself.

Where is it registered? Those based in offshore tax havens should be treated with some degree of skepticism, as they are subject to lax, if any, regulation.

It could be difficult to withdraw funds from an account held with such a broker.

Along the same lines, what is the broker's reputation? Typically, the most "visible" brokers will also offer the best customer service, as much of their business is generated through word-of-mouth.

Next, you should examine the product(s)? What kind of trading platform will you have access to? Will you have access to research and advanced (technical) analysis tools? What is the average execution time? The final considerations are financial.

In other words, what is the spread and what are the terms of financial leverage.

At the same time, you should be careful not to allow this latest aspect to weigh too strongly on your selection,

reports The American Chronicle:
It's far too easy to be attracted to brokers that offer up to say 1:400 leverage, and therefore allow you to take out very large positions with a small margin, but this is a very dangerous game and it's all too easy to over-leverage yourself and wipe out your account completely.

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Will Obama Embrace Strong Dollar Policy?

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While the Bush Administration nominally embraced a strong Dollar policy, the currency's 20% decline over the last eight years suggests it was actually a low priority.

The Obama administration, in contrast, is much more likely to maintain such a policy, a circumstance which could help the Dollar to continue its year-long rally. Obama will assume the office of the presidency at a time when US finances are looking particularly tenuous, with a projected 2009 budget deficit of $1 Trillion.

In order to finance the government bailout, as well as an additional economic stimulus plan and a host of other initiatives (let's not forget the two ongoing wars), Obama will need to spearhead an effort to attract more foreign capital.

For this to happen, the Dollar's status as the world's reserve currency must be cemented and confidence in the Greenback must be restored.

Ironically, Obama may receive a boost in this aspect from the credit crisis.

The Guardian reports:
The dollar [rally] is likely to persist as market participants looked to snap up more U.S. assets after the decisive election of a candidate that promised to bring sweeping changes to a country mired in the worst economic crisis since the Great Depression

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UK Rate Cut Backfires

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Last week, the Bank of England acquieced to the seriousness of the credit crisis by cutting its benchmark interest rate by 150 basis points- the largest margin in nearly two decades.

While the move was intended to restore confidence in the UK economy and its financial markets, the opposite result obtained.

In other words, investors interpreted the rate cut as an indication that the UK economic situation is even more precarious than was initially feared.

In fact, this bearish sentiment is born out by economic data, which shows falling home prices and rising unemployment.

Since peaking against the Dollar late last year, the British Pound has since declined 25%.

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Russia to Devalue Ruble

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Russia is currently facing its worst currency crisis since 1998, when it defaulted on its debt and the Ruble plunged 71% against the Dollar.

This time around, Russia is being attacked on two fronts: the sell-off in emerging markets and the collapse in the price of oil.

Both trends occurred suddenly and with such force that the economy swung from current account surplus to deficit in a matter of months.

Meanwhile, the Central Bank of Russia has spent nearly 1/5 of its $500 Billion in forex reserves to slow the proportional decline in its currency.

If the price of oil and the stock market continue to decline in tandem, the Central Bank will no doubt find it increasingly difficult to defend the currency, and a massive devaluation would inevitably follow.

The Central Bank has already hiked rates; it is running out of options.

Bloomberg News reports:
Today's central bank decision will prompt "further runs on deposits," wrote [one group of] analysts in a research note today. "Flight from rubles now is the key factor to watch."

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Euro: To Praise or Condemn?

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In light of the credit crisis, commentators on the Euro have taken to one of two extremes; either they believe the Euro is doomed, or they argue that the Euro represents the key to EU economic salvation.

The naysayers point to recent trends in financial markets such as the widening spread between German and Italian bond yields.

They further argue that a common monetary policy exacerbated the credit crisis by fomenting real estate booms in overheated economies, namely Ireland and Spain.

Supporters, on the other hand, need to look no further than the complete economic collapse in Iceland to understand the advantages of the Euro. Moreover, some of the more fragile EU members (Luxembourg, Belgium) would have witnessed runs on their currencies, if not for their participation in the common currency.

In the end, the Euro probably represents a viable investment alternative to the Dollar and it brings the benefit of relative stability to its members.

While its supporters are prone to overstating its benefits, it's not likely at risk of crumbling in the next few years.

The Economist reports:
The euro's defenders are convinced that the currency will still be there at the end of the crisis. That is a reasonable bet.

But public support for the euro may still be painfully tested as economies deteriorate.

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British Pound Under Pressure

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The British Pound has already fallen 25% against the Dollar, since the credit crisis kicked off earlier this year.

On a technical basis, therefore, it would seem that the Pound is due for a rally.

From the standpoint of economic fundamentals however, the picture is quite bleak.

While the Bank of England's recent 150 basis point interest rate cut could help restore the UK economy to solid footing, it sent a massive shock to investors.

UK interest rates now stand at a 50-year low, and futures prices suggest that the benchmark rate will fall another 1% in the next 12 months.

In addition, the Bank of England has not ruled out ruling interest rates all the way to zero. As unlikely as this scenario may be, investors are now fully aware of the scope of Britain's economic troubles.

The next couple weeks could be make-or-break for the Pound, as a series of economic data releases, as well as the minutes from the latest BOE meeting, will help investors craft a more accurate forecast.

Daily FX reports:
Housing, industrial trends, consumer spending and public borrowing readings...provide additional confirmation that this evolving recession will be far worse than the slump of 1992.

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Fed's Hands Are Tied

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It's a little-known fact that the US Federal Reserve Bank does not actually set interest rates. As a result, there is often a discrepancy between the "suggested" Fed rate and the actual rate.

Since the onset of the credit crisis, this gap has widened considerably, such that the "effective" benchmark interest rate is nearing 0%.

Some commentators are beginning to draw parallels with Japan, where interest rates have remained close to 0% for several years. If/when the global economy finds its footing, the Dollar could follow the lead of the Yen, and once again find itself a funding currency for the carry trade. The Economist reports:
If the effective rate remains near zero, the Fed will have to turn to more unconventional means of stimulating growth.

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FX Correlations Surge on Risk Aversion

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Since the credit crisis heated up several months ago, the theme of risk aversion has predominated in equity markets.

This is also true in forex markets, where deleveraging and a shift to perceived investing "safe havens" has led to a collapse in the carry trade, leading to a sharp rally in both the Dollar and Yen.

In fact, the recent rise of these two currencies has coincided remarkably with stiff declines in the prices of virtually every class of risky asset.

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Fed to Lower Rates to 0%

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The consensus among economists is now that the US Federal Reserve Bank will lower its benchmark interest rate all the way to 0%.

The Fed Funds Rate currently stands at 1%, and two projected 50 basis point cuts within the next two months would bring the rate to its lowest level ever, where it could remain for as long as one year.

Apparently, the concern among economic policymakers is that the sagging economy and falling asset prices will ignite a protracted period of deflation.

Given the extent to which the Federal Reserve Bank as well as the Federal Government have already moved to stimulate the economy, it's unclear whether any further loosening will have an effect.

Currency investors remain unfazed about this prospect, perhaps because the rest of the world is in equally dire straits, and foreign central banks are mulling proportionately drastic measures. Marketwatch reports:
"This [interest rate cut] move confirms a highly pro-active and aggressive central banking community and there will be more to come" from the Bank of England and European Central Bank, said one currency strategist.

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Should G20 Crack Down on Forex Speculation?

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The last few months have born witness to an unprecedented level of volatility in forex markets, to say nothing of the fluctuations in other areas of securities markets.
Emerging markets currencies in particular, as well as a handful of industrialized currencies, have crashed violently, as a process of de-leveraging continues to send capital back to the US and Japan.
This instability has led some policy-makers to revive an erstwhile exhortation to limit the role of speculators in forex markets, who collectively may account for as much as 90% of daily forex turnover.
Specifically, a 1% tax on all forex trades has been proposed, which would be deducted automatically and used to finance infrastructure projects around the world.
It has also been suggested that forex markets follow the lead of equity markets by adopting a so-called "up-tick" rule, which would be used to counter sudden waves of predatory short-selling that can cripple a country's currency in minutes.
CSRwire reports:
Such bear raids are rarely to "discipline" a country's policies, as traders claim, but rather to make quick profits.
In the transparent FXTRS system, traders selling falling currencies begin to see that the rising tax is cascading into the country's currency stabilization fund and cutting into their gains.
do not forget to add comment

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Currency Pegs back in Style

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Having endured years of abuse from free-market advocates and the International Monetary Fund, fixed exchange rate regimes are officially back in vogue.

This is because the sole currencies not to have been affected by the recent surge in forex volatility are those that are pegged to the US Dollar, namely the Chinese Yuan and Hong Kong Dollar.

Both countries have stood by calmly as other emerging market economies have witnessed speculators lay waste to their currencies, driving them down by 5% or more per day. Fortunately, both HK and China have significant stockpiles of foreign exchange reserves, which virtually eliminates any possibility of a speculative attack.

Iceland, meanwhile, was forced to abandon a half-hearted attempt at a currency peg when it ran out of cash to defend it.

Of course, a fixed currency can also be a disadvantage, as exports may become expensive relative to competitors that experience declines in their currencies.

Given the current economic climate, however, it seems HK is happy to give up this potential upside in favor of stability.

The Wall Street Journal reports:
Like Japan, Hong Kong was a source of funds for the carry-trade.

Turbulent markets have taken that strategy apart, and investors who borrowed in Hong Kong are pulling money back into the territory at a rapid clip.

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daily forex news - US Bailout Highly Inflationary

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The Treasury Department's most recent attempt to stabilize credit markets involves an injection of $800 Billion into the banking sector.

According to one estimate, the total amount of Federal money committed so far (in the form of investments, guarantees, and loans) now exceeds $7 Trillion, and shows no signs of abating.

In theory, the possibility exists that such investments could prove profitable, in which case the bailout wouldn't end up costing taxpayers a cent.

In all likelihood however, a significant portion of these investments will have to be written off, causing a net increase of trillions of dollars to the money supply.

In the long-term, this is certain to be highly inflationary.

It seems currency traders have finally begun to take note of this inevitability, and the Dollar rally has stalled accordingly.

The New York Times reports:
The Federal Reserve and the Treasury... [are] sending a message that they would print as much money as needed to revive the nation’s crippled banking system.

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EU Stimulus No Help to Euro

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The European Union has unveiled an economic stimulus package to match the US, as the two economies continue to mirror each other's strategies for fighting the credit crisis.
Given the evident lack of effectiveness of the US plan, it is no surprise that analysts reacted pessimistically to the policy proposal.
At this point, investors and consumers alike appear resigned to the inevitability of economic recession in both economies.
In other words, there isn't much that government can achieve, as their respective efforts will certainly be undermined by increased saving. Besides, investors (including currency traders) remain focused on the financial aspects of the credit crisis, rather than the economic aspects. Accordingly, the theme of risk aversion continues to dominate, as part of a trend that favors the Dollar.
Reuters reports:
Analysts said that the plan marked a step in the right direction, but uncertainty about its efficacy, and general concerns about a deep slowdown in the global economy were keeping investors in the mood to sell risky assets.

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Indonesian Rupiah Faces Collapse

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The economic situation in Indonesia is similiar to that of several other emerging market economies, characterized by falling export revenue, shrinking government coffers, and capital flight.

The consequent decline in the Indonesia Rupiah has almost become self-fulfilling.

In other words, as skittish investors rush to move their capital out of Indonesia for fear of complete collapse, they are simultaneously making such a collapse more likely.

Indonesian policy-makers are conscious of this tendency of nervousness to feed back into itself, and are delicately trying to avoid shocking the markets. On the one hand, they want to limit the decline of the Rupiah. On the other hand, they don't want to take actions that will make investors nervous, even if it means making it more difficult for them to short the currency.

The International Herald Tribune reports:
Last week, Indonesia changed its currency rules to make it more difficult to buy foreign exchange.

The measures, mostly affecting Indonesians rather than foreigners, would make speculative bets against rupiah depreciation more difficult.

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New Treasury Secretary Understands Currencies

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What does the appointment of New York Federal Reserve President Timothy Geithner as Treasury Secretary mean to forex traders? To answer this question, it depends on which side of the Dollar you fall in. Geithner worked in the Treasury Department under Bill Clinton, which means he is well versed in the Strong Dollar policy.

It is not clear whether such a policy will be implemented under the Obama administration, which may be counting on the export sector to fill the gap created by a decline in domestic consumption.

Regardless, the consensus among analysts is that Geithner understands currency markets, and is not likely to take steps that will rattle them.

This would mark a sharp break from his predecessor Henry Paulson, whose bungling of the economic bailout has given rise to record levels of volatility (read: uncertainty) in forex and financial markets.

The Australian reports:
"For all the currency traders out there, this means he was in charge of US dollar policy and is steeped in the nuance of the currency markets...Unlike during rookies Paul O'Neill or John Snow's tenure, we won't get many mistakes to make easy money," said [one analyst].

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Could the RMB Fall?

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Since China revalued the Yuan in July 2005, it was considered a foregone conclusion that the currency would continue appreciating at a steady clip.
The global credit crisis, generally, and the Chinese economic downturn, specifically, has turned that assumption on its head.
Last week, the RMB declined by the biggest margin since the revaluation, prompting speculation that China will adopt a currency policy diametrically opposed to that which it has pursued over the last few years.
The move also coincided with the annual China-US trade summit, attended by none other than Treasury Secretary Henry Paulson.
The new consensus among currency traders (proxied by futures contracts) is that the Yuan will depreciate slightly over the next two years, as China moves to provide a boost to its export sector.
Given that the currencies of most of China's Asian neighbors have fallen by double digits over the last year, the Yuan may have to fall sharply in order to maintain competitiveness.
The Wall Street Journal reports:
the Chinese currency hasn't experienced a large devaluation in at least a decade.
Such a move would go against the realities of geopolitics and against signals that Beijing is more focused on boosting domestic consumption than on stimulating exports.

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When will the Dollar Rally End?

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At this point, it should be clear to everyone that the ongoing Dollar Rally is due more to technical factors than US economic strength.

In short, the Greenback is benefiting from the intertwined trends of risk aversion, capital flight from emerging markets, unwinding of carry trade positions, and the perception that the US is a safe haven to invest during periods of global economic uncertainty.
If this is indeed the case, shouldn't the Dollar rally eventually come to an end? Based on economic fundamentals, the answer is a resounding 'yes.'

The twin deficits of trade and government spending are unlikely to abate as a result of the credit crisis.

In fact, the trillions of dollars in fresh government spending, combined with a decline in exports wrought by the suddenly strong Dollar, will probably exacerbate these dual trends.

Based on almost every measure, the US economy remains dangerously over-leveraged.

Fueled by cheap credit, household debt, government debt, and financial sector debt have exploded over the last couple decades, such that total US debt is estimated at a whopping %350 of GDP.

Given that both China and the Middle East are facing domestic economic crises brought on by a drop in exports and a decline in the price of oil, respectively, it seems unlikely that they will have the resources, let alone the inclination, to continue to fund this debt.

Seeking Alpha reports:
Chinese have recently lowered interest rates considerably, have started large domestic stimulus packages and have even tried to depreciate their currency.

Again, one should anticipate a much lower appetite for U.S. assets going forward.

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Japan Stays out of Forex

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Officially, Japan has not intervened in forex markets since 2004, when it spent the equivalent of $300 Billion to hold down the value of the Yen.

That impressive streak could soon come to and end, however, as the Yen continues to surge on the unwinding of the carry trade.

The performance of the Yen- which recently touched a 13-year high- is particularly impressive since it comes at a time when virtually every other currency has collapsed relative to the US Dollar.

Now, analysts have once again taken to pouring over monthly data on Japan's Central Banking activities, in order to confirm that it is keeping its finger off of the trigger.

Given that the Yen's appreciation has already prompted several high-level meetings among global economic and political leaders, however, it is probably only a matter of time before Japan ends its multi-year abstinence from forex.

Reuters reports:
Japanese Finance Minister said earlier this month that the authorities must be ready to deal with big swings in markets as they are undesirable.

His comments pushed the yen lower against the dollar as market players were wary of intervention.

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Russian Ruble Declines with Price of Oil

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Having already fallen 12% in 2008, the Russian Ruble is well on is way to fulfilling analysts' predictions that it will fall 30% before stabilizing against the US Dollar.

While the credit crisis has not been kind to Russia, the Ruble is suffering more from a collapse in the price of oil, which recently slipped below $50 a barrel.

For reference, the government needs the price of oil to stay above $70 in order to balance its budget.

Now, the country's current account surplus is eroding almost as quickly as its foreign exchange reserves, which it is deploying in a vain effort to forestall the decline in the Ruble.

The response of the Central Bank has been to widen the band within which the currency is permitted to fluctuate; in practice, this is tantamount to defeat, and is sure to trigger a further decline.

Bloomberg News reports:
"The central bank is letting it fall because of oil, reserves depletion, all of that," said an emerging-markets currency strategist.

"We can probably expect to see more of this."

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Will China Fund US Deficit?

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When all is said and done, the US government will have injected trillions of dollars into the economy, in the form of bailouts, guarantees, economic stimuli, etc.

Whether it will have the desired effect is debatable.

The question that no one seems to be asking is, "How is the government going to finance such exorbitant spending?" It appears that China, which has become of of the largest holders of US government debt, will continue to participate- not necessarily because it wants to, but because it doesn't have a choice.

China's economy remains heavily reliant on the export sector to drive growth.

Because its exchange rate regime does notpermit the RMB to fluctuate freely, the proceeds from the consequent trade surplus must be invested abroad, rather than domestically.

For both symbolic and economic reasons, it seems the bulk of the surplus will continue to be invested in the US, probably in safer assets like US Treasury Securities.

This is certainly good news for deficit hawks and Dollar bulls.

The Wall Street Journal reports:
Even if China wanted to invest outside the U.S., it couldn't. If China recycled its foreign currency into, for instance, the European Union or Japan, it would effectively force those trading partners to run large trade deficits with China, which neither can absorb.

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AUD Continues to Dive

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On the basis of technical factors, the Australian Dollar had halted its precipitous decline against most major currencies.

As a result of an unbelievable 100 basis point interest rate cut, however, the currency has resumed its fall.

That the rally was short-lived is not a mystery.

The yield advantage enjoyed by Australia over the last few years has almost completely evaporated.

Combined with lackluster Australian equity performance and tanking commodity prices, foreign investors have little reason to maintain capital in Australian holdings.

On the plus side, the rate cut showed investors how serious Australian economic policy-makers are in dealing with the credit crisis.

Unfortunately, diligence doesn't always translate into efficacy.

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Emerging Markets Shed FX Reserves

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According to the most recent monthly data, the foreign exchange reserves of most developing countries are disappearing faster than they can be replenished.

As a result of the global credit crisis, central banks have taken to deploying vast sums of capital towards the dual ends of stimulating their economies and propping up their currencies.

The latter can be especially expensive, as countries like Ukraine and South Korea can attest. Both countries have spent 20% of their respective reserves to halt the decline of their currencies, and both abandoned such a strategy after accepting its futility.

Ironically, there seems to be a direct correlation between dwindling forex reserves and a depreciating currency, as investor nervousness and currency devaluation reinforce each other. There is one bright spot in this quagmirem, however.

The Guardian reports:
China says its reserves are continuing to rise, with the chief economist at the National Bureau of Statistics telling Reuters they would exceed $2 trillion by the end of the year.

Beijing [will] not resort to "panic selling" of reserves, instead maintaining a "prudent and responsible" stance.

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Investors Uncertain about RMB

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Only a few weeks ago, investors had made significant bets that China would reverse its official policy of RMB appreciation.

Futures prices indicated that investors collectively expected the currency to depreciate over 7% against the Dollar over the next year, as part of a comprehensive Chinese policy to boost the faltering economy.

Since then, however, the RMB recorded its biggest one-day rise since the currency peg was abandoned three years ago, and investors subsequently scaled back their bets.
While it's unclear what caused the sudden change in sentiment, there are a few factors which probably contributed.

First is Treasury Secretary Henry Paulson's recent visit to China, in which he encouraged China to continue to permit the the Yuan to appreciate.

In addition, high-ranking Chinese economic policy-makers have indicated that market forces will increasingly determine the valuation of the Yuan.

Finally, there is the recent election of Barack Obama, a long-standing critic of what he believes to be the undervalued RMb.

Bloomberg News reports:
"Any attempt to devalue the currency is likely to be met with considerable opposition from China’s trading partners." The new U.S. administration under President-elect Barack Obama "will be less tolerant of the 'crawling peg' appreciation policy," said one analyst.

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Canadian Dollar Hurt by Economy, Politics

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Having fallen well below parity with the USD, the Canadian Loonie is now being attacked on two fronts.

First, there is the deteriorating economic situation.

Prices for virtually all commodities, namely oil, have declined significantly this year, dealing a harsh blow to the natural resource-dependent Canadian economy.

In addition, its largest trade partner, the US, is suffering from economic woes of its own and is in no position to support the Canadian export sector.

The result is surging unemployment and the most precipitous decline in factory production in 25 years.

The most optimistic economists are forecasting GDP growth of 0.0% in 2009.

The second prong of the attack against the Loonie is being waged unintentionally by the country's Prime Minister, who recently suspended Parliament in order to avoid a no-confidence vote in his leadership. In short, bulls for the Canadian Dollar (not to mention democracy) don't have much to be excited about these days.

Bloomberg News reports:
"The global backdrop is bearish for the Canadian dollar and domestic numbers are merely piling on,"said a senior currency strategist. "No one is looking for reasons to buy the Canadian dollar right now.

They want reasons to sell."

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Central Europe Continues to Chase Euro

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While the credit crisis has led some skeptics to presage the end of the European common currency, some in Central Europe are still eager to join it.

However, their cause may have been jeopardized by the credit crisis.

The economies of Poland, Hungary, and Czech Republic-the three most qualified candidates to join the Euro-have been plunged into turmoil.

Capital flight has wrought precipitous declines in all of their respective currencies.

In light of record volatility and continued bearish sentiment, some analysts have argued that the Euro represents the key to their salvation.

The only problem is that the credit crisis is scrambling their ability to meet the necessary pre-requisites to membership.

Bond yields trade at an unacceptable spread to those of Euro members, inflation has yet to be tamed, budgets have shifted from surplus to deficit, and reserves are shrinking faster than they can be replenished.

And yet, there are those who remain optimistic.

Bloomberg News reports:
"In Poland and Hungary the crisis has increased the public support for euro adoption and I'm keeping my bet that both countries will enter ERM-2 in the second half of 2009.

The more euro-skeptic Czechs may do it a year later," said [one analyst].

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Emerging Markets Poised for Recovery?

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In a recent interview, three emerging market fund managers aired a common view: the asset class which comprises emerging markets represents a solid investment.
Their reasoning is that the tremendous declines wrought in emerging market equities and currencies over the last six months were caused primarily by technical factors, rather than a substantive change in the long-term economic picture.
In other words, this drop was effected by foreign investors that withdrew money en masse from emerging markets in order to meet fund redemptions and repay loans denominated in Dollars.
At the same time, economic analysis, as well as common sense, dictate that an increasing portion of future global growth will be realized in the developing world.
Many such countries have invested wisely in infrastructure and built up sizable foreign exchange reserves.
Consequently, they are well-positioned to survive the current downturn intact.
Accordingly, once investors "come to their senses" and recover their collective appetite for riskier investments, it probably won't be long before emerging market assets and currencies are bid up to pre-crisis levels.
Forbes reports:
"Current valuation of emerging markets is the lowest it has been since I began investing in this asset class in 1988.
Based on trailing 12-month earnings, emerging markets is trading at a price/earnings ratio of only 7.7x, and a price/book of 1.3x (with return on equity at 17%)," [observed one analyst].

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Central Banks Still Prefer Dollars

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Since its introduction only ten years ago, the Euro has ascended at an incredible pace.

Perhaps the best proxy for its respectability is its growing share (currently estimated at 27%) of Central Banks' foreign exchange reserves.

Still, most analysts reckon that the Dollar will remain ascendant for the near-term.

For one thing, the perception remains that the US is the safest place to invest, and in fact this attitude has been reinforced by the current economic downturn.

In addition, there is very limited doubt that the Dollar will be around for a very long time, whereas there are many skeptics who invariably insist that the Euro is on the verge of breaking up.

In short, as the global economy rebalances itself, reserve accumulation will slow generally, and diversification into the Euro will slow specifically.

Marketwatch reports:
In view of the value already tied up in holdings of U.S. government paper, it would take a decisive -- and probably foolhardy -- shift for the world's largest reserve holders in Asia or Latin America to transfer significant holdings of present reserves out of the dollar and into the euro.

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Softening Risk Aversion Impacts Forex

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The last two weeks have proved the old adage, "What goes up must come down." In other words, the year-long Dollar rally has begun to fade, as investors once again embrace economic reality.

Previously, Dollar strength could be largely attributed to exit trades out of other currencies, rather than any substantive benefit of investing in the US.

Now, risk appetite is slowly recovering, having received a boost from the just-completed government bailout of the US automobile industry.

Less concerned about risk/volatility, investors have taken to re-assessing economic fundamentals.

In the case of the US, unemployment is rising, the twin deficits continue to expand at a breakneck pace, and the interest rate disparity between the ECB and Fed will remain in place for the near-term.

The Wall Street Journal reports:
Whether the dollar will continue to weaken is a matter of debate.

Currency strategists caution that the dollar often is weaker toward the end of the year, particularly against the euro, as companies and investors adjust bets.

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Fed is Debasing Dollar

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Several years ago, Ben Bernanke earned the nickname "Helicopter Ben" by joking that the Fed would drop Dollars from helicopters if the American economic situation ever became desperate enough to warrant it.

In hindsight, the bestowers of this nickname could not have been more prescient, as the Federal Reserve Bank has now officially pledged to do everything in its power to stimulate the flow of money, short of literally dropping currency from the sky.

Capital markets naturally reacted to this policy prescription with delight, as some of the surplus dollars will certainly be used to bid up and stock and bond prices.

Currency markets, on the other hand, were not so complacent, sending the Dollar back down from the depths from which it only recently emerged.

In other words, zero-interest rates and a surfeit of dollars hot off the printing press has analysts and forex traders wondering aloud about who will be foolish enough to want to own Dollars in the future.

The Wall Street Journal reports:
If the Fed is going to create boatloads of depreciating, non-yielding dollar bills, who will absorb them? Who will finance the Obama administration's looming titanic fiscal deficits? Who will finance America's annual surplus of consumption over production (after 25 more or less continuous years, almost a national trait)?

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Lower Pound a Mixed Blessing

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The British Pound has fallen so sharply in 2008 that parity with the Euro isn't that far-fetched.
The problem is that the UK economy now closely mirrors that of the US, minus the perceived "safe haven" aspects.
In fact, the UK now has a twin deficits problem of its own, with a trade imbalance that exceeds 4% of GDP and government spending set to rise in response to the credit crisis.
Meanwhile, UK interest rates have already been reduced drastically, and could fall all the way to zero, again mirroring the US.
The combination of cheap money and higher imports is raising the specter of inflation, and frightening away foreign investors.
Under ordinary circumstances, a cheaper Pound could be an effective remedy for recession, but when the entire global economy is reeling, it probably can't accomplish much.
The Telegraph reports:
Even though sterling has fallen, exports orders remain weak.
Competitive devaluations rarely work.
But they have no chance of when the rest of the world is slowing too.

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Japan: Intervention Unlikely

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If ever there was a case for Japanese intervention in forex markets, it is now.

The Yen has emerged as the unquestionable victor from the credit crisis, having appreciated against every major currency and notching a 13-year high against the Dollar.

Japanese exports have plunged, inducing the country's first monthly trade deficit in almost three decades.

Meanwhile, corporate profits are sagging as a result of forex conversion losses, and the unemployment rate could soon set a new record.

Notwithstanding comments to the contrary by a high-ranking official, however, the Central bank of Japan is perhaps unlikely to intervene on behalf of the Yen, if only for political reasons. The G7 countries, namely the US, have urged Japan to allow the market to run its course, as it hopes the weaker Yen can help restore some of America's export competitiveness.

The Asia Times reports:
Japan will be criticized internationally, especially by the US, the country's strongest ally, if it acts to stem the currency's gain as US automakers are still on the brink of bankruptcy.

The stronger yen drives up the price of cars imported to the US.

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Investors Uncertain about Fed Rate Cut

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More than a week after America's Federal Reserve Bank slashed its benchmark interest rate to the historic (low) level of .25%, investors are still struggling to assess the implications.

The immediate reaction was mostly positive, as Central Banks around the world (namely Hong Kong and Japan) quickly followed suit, and stocks rallied.

In other words, investors were buoyed by the belief that Central Banks can and will employ all available financial tools to maintain acceptable liquidity in financial markets and to prevent the economic downturn from turning into a depression.

On the other hand, forex traders were understandably dismayed by the growing gap between US and foreign interest rates, as well as the inflationary implications of the Fed's plan to essentially print money and inject it directly into the economy.

The Associated Press reports:
"While there was applause for the (Fed) cuts...investors are now standing back and reflecting further on what that means," said...an analyst. "

Some nervousness has been expressed in the currency markets.

We have seen a weakened dollar, which has probably had an effect on the markets across the board."

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Ruble to Depreciate Gradually

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The perfect economic storm continues to brew in Russia; the financial crisis is sapping demand for Russian securities, and a decline in the price of oil (as well as other commodities) has turned the balance of trade from surplus to deficit.
As a result, Russian banking officials seem resigned to a depreciation in the Ruble, but are understandably averse to a sudden devaluation, which could shock the economy into complete collapse.
Nonetheless, in the last week, the currency recorded record drops as the Central Bank took advantage of Dollar weakness to adjust the band in which the Ruble is permitted to fluctuate (read: decline).
Given continued weakness in the price of oil, combined with a faltering economy and surging domestic unemployment, investors should continue to expect precipitous drops in the Ruble, as it sinks to a sustainable level.
Bloomberg News reports:
Troika Dialog, the nation’s oldest investment bank, and Goldman Sachs Group Inc.
predict the ruble will have to weaken by at least 20 percent against the basket to reignite an economy stymied by a 62 percent drop in oil prices since July.

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USD Up in 2009?

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As 2008 comes to a violent end, forex analysts are releasing their predictions for 2009.
Most believe that risk aversion and interest rate discrepancies will cease to weigh on forex markets, especially compared to 2008, when investors unwound carry trades and parked their money in low-yielding (but apparently less risky) US and Japanese securities.
Instead, investors will probably begin to focus more on economic fundamentals.
With regard to the Dollar, this approach could work either way.
On the one hand, it is conceivable that the US will outperform (this could translate into a milder recession) the EU and Japan, since the Fed's interest rate cuts were implemented at such an early stage.
On the other hand, the US twin deficits continue to expand, which suggests the possibility of long-term inflation as well as a potential reluctance in foreigners to continue to lend to the US. Marketwatch reports:
To be sure, the dollar's 2009 trajectory depends a lot on what the U.S. and global economies do, and when they do it.
The U.S. recovery could begin midyear, or the clouds could linger until the fourth quarter or even longer.

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Interest Revives in Yen Carry Trade

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On the basis of a 25% appreciation against the Dollar, 2008 marked the strongest year for the Japanese Yen since 1972, as the credit crisis caused a rapid unwinding of carry trades as investors abandoned risky positions.
2009 may not be as auspicious for the Yen, however, as a bevy of factors coalesces to halt its upward progress.
First of all, global credit and forex markets have begun to stabilize over the last few months. The seemingly unending US government bailout has restored confidence in riskier sectors, such as the automotive sector.
Coupled with a cut in Japanese interest rates, investors are being lured back into the carry trade. In addition, Japanese economic officials are becoming more vocal about the Yen's rise, which is threatening to send the export-dependent economy into another deep recession.
It is therefore conceivable that the Central Bank could intervene on behalf of the Yen, despite the pleas of the G8.
Bloomberg News reports:
The last time Japan intervened on its own, it sold a record 20.4 trillion yen ($226 billion) in 2003 and 14.8 trillion yen in the first quarter of 2004, when the yen rose as high as 103.42 per dollar.

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China's FX Reserves Fall

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Anyone curious about whether China is intentionally allowing the RMB to depreciate, need look no further than the Central Bank's latest forex reserve figures, which registered a decline for the first time in nearly six years.
At the same time, Chinese trade figures indicate that exports fell for the first time in seven years, which limits the government's ability to build up new reserves.
As a result of the credit crisis, it's conceivable that the Central Bank will continue to spend down its reserves in order to provide a boost to its faltering economy.
US President-elect Obama will have to deal with such forces if he wishes to successfully take on China's currency policy.
Otherwise, the RMB currency could appreciate in 2009, bucking its trend over the last few years.

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Interest Revives in Yen Carry Trade

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On the basis of a 25% appreciation against the Dollar, 2008 marked the strongest year for the Japanese Yen since 1972, as the credit crisis caused a rapid unwinding of carry trades as investors abandoned risky positions.
2009 may not be as auspicious for the Yen, however, as a bevy of factors coalesces to halt its upward progress.
First of all, global credit and forex markets have begun to stabilize over the last few months.
The seemingly unending US government bailout has restored confidence in riskier sectors, such as the automotive sector.
Coupled with a cut in Japanese interest rates, investors are being lured back into the carry trade.
In addition, Japanese economic officials are becoming more vocal about the Yen's rise, which is threatening to send the export-dependent economy into another deep recession. It is therefore conceivable that the Central Bank could intervene on behalf of the Yen, despite the pleas of the G8.
Bloomberg News reports:
The last time Japan intervened on its own, it sold a record 20.4 trillion yen ($226 billion) in 2003 and 14.8 trillion yen in the first quarter of 2004, when the yen rose as high as 103.42 per dollar.

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Rand Benefits from Carry Trade

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Yesterday, the Forex Blog reported that the Yen could soon peak as a result of renewed interest in the carry trade.
On the other side of this equation are emerging market currencies, most of which offer interest rates well above their industrialized counterparts.
The spread between South Africa's benchmark interest rate and the rates of Switzerland, Japan, and the US, now exceeds 10%.
As a result of near-zero rates in these countries, investors have once again taken to scouring the earth for yield.
Apparently, government stimulus plans and monetary incentives have restored confidence in risk-taking.
South Africa is especially poised to benefit, as it is one of the world's largest producers of gold, which recently resumed its upward trend. Bloomberg News reports:
“South African interest rates are very high relative to other markets and that yield differential is underpinning the rand at a time when trading is very thin.”

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Consensus: Fed is Devaluing Dollar

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The Fed is officially in panic mode, having lowered its benchmark federal funds rate close to zero and exhausted all of the tools in its monetary arsenal, with one notable exception:
its printing press. In other words, the Fed is trying to jumpstart credit markets by acting as a market participant- investing funds to compensate for the reticence of private investors. Capital markets are naturally enthusiastic about this policy, since some of the new cash will probably be used to make leveraged bets on asset prices and erase some of the losses of the last year. Forex markets are palpably less excited that the Fed has essentially eroded much of the impetus for foreigners to hold their ash in the US, with paltry short-term yields and long-term gains that will likely be offset by inflation. Unless foreign Central Banks follow suit
and eliminate the current interest rate disparity with the US, it could be a bumpy 2009 for the Dollar. Forbes reports:
Citi Analyst Steven Wieting opined: "If you want yield, you'll have to take some risk." With borrowing rates suddenly close to zero and the Fed saying it will keep them at “exceptionally low levels ... for some time, you'll get as little of it from government-issued debt as possible."

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Vietnam Dong Finally Devalued

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The Central Bank of Vietnam finally acceded to reality and devalued its currency, the Vietnam Dong, by 3%.
Prior to the change, the Dong (as well as its neighbor, the Chinese Yuan, which has also experienced a decline) was one of the few relative winners of the credit crisis.
Perhaps this was because the currency had already depreciated significantly in recent years (35% since 1994), as well as because it remains fixed to the Dollar and hence it is impossible for the markets to short it when it becomes overvalued.
Vietnam continues to be plagued by double-digit inflation and a surging current account imbalance, which suggest that the currency will probably have to suffer an additional 'correction' before reaching a sustainable level.
In fact, the black market rate remains well below the official rate, reports Bloomberg News:
The devaluation followed five interest-rate cuts by the central bank this quarter to help bolster the economy.
Policy makers last lowered the benchmark rate on Dec.
19 by the most ever this year to 8.5 percent, from 10 percent.

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Tobin Tax Could Restore Yen

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While the Yen's 30% rise in 2008 is no mystery (a result of the unwinding of carry trades), its performance nonetheless defies economic fundamentals.
Exports have fallen and industrial production has collapsed, such that recession now appears inevitable.
Japan is not alone in this regard, as a number of economies have suffered unnecessarily as a result of excessive volatility in currency markets.
The solution could be the so-called "Tobin tax," which aims to limit forex speculation by levying a nominal tax on short-term currency trades.
The proceeds from such a tax would be used to restore some equilibrium in forex markets by providing Central Banks with funds for direct intervention.
While the tax itself has never been implemented, countries have previously taken to cooperating on forex matters for the sake of global macroeconomic stability.
Seeking Alpha reports:
Exchange rates have to be within a certain range for all economies to prosper.
The major economies have to work together to ensure this. If the Group of Five could work together to depreciate the "Super Dollar" in 1985, so the major nations today can and should work together to stem the surge of the super Yen.

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Pound Versus the Euro

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In recent years, the idea of parity seemed to pop up repeatedly in forex markets.
First, the Canadian Dollar breached the mythical 1:1 barrier against the USD; then, it looked as though the Australian Dollar would follow suit.
The most recent battle for parity is being waged across the Atlantic Ocean, between the British Pound and the Euro.
Both economic and monetary circumstances favor the Euro, as the housing crisis pummeled the UK economy and the UK Central Bank subsequently embarked on a steep program of monetary easing.
The Euro has probably also received a boost from the perception that the EU is one of the most stable economies and investing locales, outside of the US.
In any event, investors tend to get carried away with psychological milestones and ignore economic fundamentals, which means the Euro could quickly achieve parity, before pulling back. The Wall Street Journal reports:
On Monday, one euro briefly bought almost 98 pence, a new record.
That paves the way for parity “as early as this week,” wrote Ashraf Laidi, chief market strategist at CMC Markets.

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