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June 30, 2013

The Obama Budget and the Dollar: Perennial Deficits and Rising National Debt Threaten the Dollar’s Long-Term Status as Global Reserve Currency.

Last week, the Obama Administration released its fiscal 2012 budget to much fanfare. Unfortunately, the budget makes only a token effort to address the rising National debt, and forecasts a budget deficit of $1.1 Trillion. While the release of the budget failed to make a splash in currency markets, traders would be wise to understand its implications for the future.


The budget proposes spending of $3.7 Trillion in 2012, and forecasts receipts of only $2.6 Trillion. As usual, entitlements (Social Security, Medicare, and Medicaid: $2 Trillion+), Defense ($760 Billion), and net interest on debt ($250 Billion) are projected to consume the brunt of spending. The Departments of State, Education, Energy, and Veterans Fairs will receive an increased allocation, while almost all other Departments face drastic cuts. (For more comprehensive breakdowns, the WSJ and NY Times offer excellent graphical representations of how the federal budget is funded and disbursed).

The proposed budget allows for a deficit of $1.1 Trillion (7% of GDP), which unbelievably represents a significant decrease from the $1.6 Trillion (11% of GDP) that is projected for fiscal 2011. The Congressional Budget Office (CBO) forecasts the deficit to return to a more “sustainable” level of 3% of GDP beginning in 2014, which should allow the national debt to remain constant in relative terms for the following decade. Beginning in 2021, however, entitlement spending is projected to skyrocket, which would cause debt to rise similarly.

CBO projections are based on a handful of rosy assumptions. First of all, it assumes that the US economy will grow at 3%+ for the indefinite future. Second, it assumes that deficit spending can be financed at reasonable interest rates. Third, it assumes that tax receipts will rise from current lows and revert back to historical levels. Given the ongoing economic uncertainty, high unemployment rates, tax cuts, rising interest rates, the difficulty of cutting spending, etc., there is reason to believe that actual deficits will be even higher.


In fact, net interest payments on national debt will rise 33% over the next year even as Treasury rates remain at record lows. If the economic recovery gathers momentum (something that the budget is counting on), risk appetite and interest rates must rise. In addition, given that the national debt will probably double from 2009 to 2012, it seems likely that investors will demand an increased risk premium for lending to the US. On the other hand, demand for Treasury Securities continues to remain strong: “Net long-term securities transactions showed total buying of $65.9 billion in long-term U.S. securities in December, after purchases of $85.1 billion the month before.” Many Central Banks continue to be net buyers.

In addition, there are some commentators that think the Fed will abet the US government in deflating the real value of its debt. Since the majority of US Treasury Securities are not inflation-protected, 15 years of high inflation (~5%) would be enough to decrease the real debt burden by half. Especially when you account for “contingent obligations,” this might be the only feasible way for the government to deal with its debt burden over the long-term. Then again, higher inflation would probably drive proportional increases in yield, such that the Treasury Department would have a tough time rolling over existing debt (let alone in issuing new debt) at reasonable interest rates.

The main variable in all of this is politics. Specifically, this budget is still only a proposal. The actual budget won’t be ratified for at least another six months, and only after tense negotiations with the Republican Party. (There is also the possibility that it won’t be passed at all, which is what happened with the fiscal 2011 budget). “House Majority Leader Eric Cantor, a Virginia Republican, said his party will propose ‘very bold’ changes to entitlements in their 2012 budget resolution.” Anything short of this wouldn’t dent the projected deficits and would push Social Security / Medicare closer towards the brink of insolvency.

In the end, the deficit merely represents business as usual for the US government. Barring a double-dip recession, it probably won’t be enough to seriously impact the Dollar’s status in the short-term as preeminent global reserve currency. However, that could start to change over the next decade, as the government either takes steps or does nothing to mitigate the looming entitlements crisis. At that time, the long-term viability of the Dollar (and the financial system as we know it) will become clear.

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Yen Surges to Record High, then Falls on G7 Intervantion. Yen May Rise Further in the Short-term, but Due for a Decline in the Long-term.

Filed under: Japanese Yen — Tags: , , , , , , , , , — admin @ 3:56 pm

The last week has witnessed unprecedented volatility in the Japanese Yen. Following the earthquake/tsunami and the inception of a nuclear crisis, the Yen defied all logic (and embarrassingly, my own predictions…mea culpa) by rising to a post-World War II high of 76.36 against the Dollar. Then, as rumors of Central Bank intervention began to circulate, it suddenly shot downwards, before resuming a steady upward path. Who knows what next week will bring?!

It’s unclear exactly what’s driving the Yen. Personally, it seems a no-brainer that the string of natural disasters that ravaged Japan would have caused an outflow of foreign capital and a drop in demand (due to a lack of supply) for Japanese imports. In reality, investors began to fear a wholesale selling of Japanese-owned foreign securities widespread repatriation of Japanese Yen by insurance companies and other financial institutions, in order to raise funds for rebuilding and the payout of insurance claims.

While there is still no evidence that such has actually taken place (in fact, the Japanese stock market collapsed as expected, and overseas markets experienced only modest declines), speculators feared the worse, and moved to unload all of their Yen short positions. As hedge funds and domestic Japanese investors tried to exit their Yen carry trades, it caused the market to panic, and the Dollar to fall off a cliff against the Yen, rising 3% in a matter of minutes! As if it wasn’t immediately obvious, “Asset managers, hedge funds, corporates and private clients were all net buyers of the yen for the first time since October,” which means that what we’re basically witnessing is really just a massive short squeeze.

As a result of the highly unusual circumstances, the G7 Finance Ministers held an emergency meeting. The decided not only to offer moral support to the Bank of Japan, but that all G7 Central Banks (Fed, ECB, Bank of Canada, Bank of England) would jointly act to hold down the Yen. Sure enough, the Fed confirmed yesterday that it intervened in the forex markets (probably by selling Yen) for the first time in a decade! This marks a massive about-face from 2010, when Japan was uniformly criticized by the G7 for entering the currency war. Desperate times call for desperate measures…

The Yen has since resumed its appreciation, which has a few implications. First of all, it shows that speculators are still nervous about carry trades that are funded by Yen and continue to think of Japan as a safe haven. This is especially true of domestic Japanese investors, who are naturally bound to become more conservative in the wake of the recent natural disasters. No one knows for certain the size of the Yen carry trade, but 2010 estimates pegged it around $1 Trillion. (Japanese investors purchased $1.25 Trillion in foreign assets between 2005 and 2010 alone!) If that’s the case, there is still quite a bit more unwinding that can be done. In addition, given that Japan is the world’s largest net creditor [the Bank of Japan owns $900 Billion in US Treasury securities, while Japanese sovereign debt is 95% owned by domestic investors], the phenomenon of risk-aversion would be net positive for the Yen.

Second, it shows that investors are skeptical that the Yen’s appreciation can be contained. And if market forces are determined to push the Yen upwards, they are probably right. Simply, the G7 Central Banks (not including Japan) have very limited Yen holdings, which means there is only so much Yen they can sell.

On the flipside, the Bank of Japan has potentially an unlimited supply of Yen at its disposal. In fact, the BOJ already expanded its money printing / quantitative easing program, by “doubling planned purchases of exchange-traded funds, real estate investment trusts, corporate debt, and Japanese government bonds to 10 trillion yen, and launching a program to supply financial institutions with 30 trillion yen in three- and six-month loans at 0.1 percent interest.” This is on top of the 28 trillion yen ($346 billion) that is had already injected into the financial system. While perennial deflation has afforded the BOJ a wide scope, it must still tread cautiously, lest it add inflation (and stagflation) to the country’s list of problems.

Some analyst point to the Kobe earthquake of 1995 as a basis for Yen bullishness. After a one-month lull, the Yen dramatically surged upward, rising 20% in only two months. That disaster also took place towards the end of the Japanese fiscal year (March 31), and seems to suggest that a proportionate Yen rise should take place this time, too.

On the other hand, the Yen proceeded to drop 50% in the two years following the Kobe earthquake, showing the extent to which investors had gotten ahead of themselves. In other words, while there might be significant repatriation of Yen in the short-term, this will more than be outweighed by the decline in GDP, collapse in production/exports, and destruction of stock market value over the long-term.

Until the nuclear crisis is resolved and estimates of the cost (currently pegged at $100-200 Billion) of reconstruction are finalized, the markets will remain jittery. And we all know that volatility will not help the Yen carry trade. Given the BOJ’s determination to hold down the Yen, and the fact that this crisis will only exacerbate Japan’s fiscal issues and its unending economic decline, I’m personally still long-term bearish on the Yen.

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Swiss Franc Surges to Record High: Where was the SNB? Will it Intervene Again?

Filed under: Swiss Franc — Tags: , , , , , , — admin @ 2:46 pm
One of the clear victors of the Greek sovereign debt crisis has been the Swiss Franc, which has risen 5% against the Euro over the last quarter en route to a record high. 5% may not sound like much until you consider that the Franc had hovered around the €1.50 for most of 2009. Every time it budged from that mark, the Swiss National Bank (SNB) moved swiftly to return the Franc to its “resting spot.” So where was the SNB this time around?
Swiss Franc Euro chart
 
Beginning last March, the SNB was an active player in forex markets: “Quarterly figures indicate the central bank spent some 4 billion euros worth of francs in March, 12 billion in the second quarter, some 700 million euros in the third quarter, and some 4 billion in the fourth.” In fact, the SNB might still be intervening, and it won’t be until 2010 Q1 data is released that we will be able to say for sure. The Franc’s rise has certainly been steep, but who’s to stay that it couldn’t have been even steeper. For comparative purposes, consider that the US Dollar has risen more than 10% against the Euro over this same time period.
 
But the fact remains that the “line in the sand” was broken and the Swiss Franc touched an all-time high of €1.43. According to SNB Chairman Philipp Hildebrand, “We have a broad range of means to prevent an excessive appreciation and we are going to do this to ensure that the recovery can continue. The instruments are clear: We buy foreign currencies. We can do that in very large quantities.” In other words, he is sticking to the official line, that the SNB forex policy has not yet been abandoned. On the other hand, “SNB directorate member Jean-Pierre Danthine said Swiss companies and households should prepare for a market-driven exchange rate some time in the future.”
 
Actually, I don’t think these two statements are necessarily contradictory. The Franc is rising against the Euro for reasons that have less to do with the Franc and more to do with the Euro. At this point, if the SNB continued to stick to its line in the sand, it would look almost illogical, especially since by some measures, the Swiss Franc is already the world’s most manipulated currency. Besides, by all accounts, the interventionist policy has been a smashing success. The forex markets were cowed into submission for almost a year, which prevented the Swiss economy from contracting more and probably paved the way for recovery. 2009 GDP growth is estimated at -1.5% with 2010 growth projected at 1.5%.
 
By its own admission, the SNB did not target currency intervention as an end in itself. “If you want to assess the success, then you should not only look at a certain exchange rate, but look at the success of the Swiss economy.” Rather, its goal was monetary in nature. Since, it cut rates to nil very early on, the only other way it could tighten is by holding down the value of the Franc. Along these lines, the SNB will continue to use the Franc as a proxy for conducting monetary policy: “An excessive appreciation is if deflation risks were to materialise. We will not allow this to happen.”
 
Going forward then, it seems the Franc will continue to appreciate. “I think the marketwill cautiously continue to sell the euro against the Swiss franc and perhaps see whether the SNB will step in and try and stop the Swiss franc strength,” said one analyst. As long as the Swiss economy continues to expand and deflation remains at bay, there is little reason for the SNB to continue. Besides, intervention is not cheap, as the SNB’s forex reserves grew by more than 100% in 2009. On the other hand, the SNB has probably intervened in forex markets on 100 separate occasions over the last two decades, which means that it won’t be shy about stepping back in if need be.

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June 29, 2013

Does Japan’s “Triple Disaster” Threaten the Dollar? Demand for US Treasury Securities Remains Strong.

Filed under: US Dollar — Tags: , , , , , , , , , — admin @ 5:14 pm

While analysts have been busy dissecting the implications of the natural disasters that ravage(d) Japan for forex markets, the focus has naturally been directed towards the Yen. Given all the rumors about the liquidation of foreign (i.e. Dollar-denominated) assets, it’s also worth examining the potential impact on the Dollar. In a nutshell, Japan’s holdings of US Treasury Securities are extensive, and even a partial unloading could have serious implications for the world’s de facto reserve currency.

As I explained in my previous post, the Yen rose to a record high (against the Dollar) following the earthquake/tsunami/nuclear crisis because of rumors that Japanese insurance companies and other financial institutions would begin repatriating all of their foreign assets in order to pay for rebuilding. (For the record, it’s worth pointing out again that this has yet to take place, and any repatriation is probably related to the approaching fiscal-year end. Thus, the Yen is being propelled by speculation/short squeeze. Period.)

Indeed, Goldman  Sachs has estimated that the rebuilding effort will probably cost around $200 Billion. A significant portion of this will no doubt be covered by the payout of insurance claims. How insurance companies will make their claims is of course, unknown. However, consider that Japanese insurance companies have insisted that they have ample cash reserves. In addition, Japan has what is perhaps the world’s most solid earthquake reinsurance (basically insurance for insurers) program, which means primary insurance companies can basically pass these claims up the chain, perhaps all the way to the government.

As for whether the Bank of Japan will sell some its $900 Billion in Treasury holdings, this, too appears unlikely. First of all, the Bank of Japan is doing everything in its power to soften the upward pressure on the Yen, which would not be consistent with selling any of its Dollar-assets. Second,  the Financial Times has further argued that they will be especially unlikely to sell US Treasury securities, because they would lose money on (US Dollar) currency depreciation. Besides, any assets that are sold now to pay for rebuilding would probably need to be repurchased later in order to restore balance sheet equilibrium.

While I am on the topic, I want to draw attention to a recent Treasury report that documented the overseas holdings of Treasury securities. The major surprise was China, whose holdings were revised upwards to $1.18 Trillion (from $892 Billion), which means it is well-entrenched as the most important creditor to the US. However, this was offset by a 50% drop in the Bank of England’s holdings, caused perhaps by a change from US debt to British debt.

As I have written in the past, it seems unlikely – for political, economic, and financial – reasons that China will move to pare its Treasury holdings in a significant way. Simply, it has no other viable options for investing the foreign exchange reserves that it is forced to accumulate because of the Yuan-Dollar peg. Other doomsdays have speculated that the crisis in the Middle East will end the “petro-Dollar” phenomenon, whereby oil exporters settle their bills almost exclusively in Dollars and use the proceeds to buy Treasuries. While US influence in the Mid East may indeed wane further as a result of the ongoing political turmoil, I don’t think this will force a change to the PetroDollar phenomenon, which is due as much to unavoidable trade surpluses as it is to settling oil transactions in US Dollars.

There is certainly some concern about what will happen when the Fed wraps up QE2 later this year and stops buying Trreasury securities. Two prominent investment companies (PIMCO and Vanguard) have warned that this will cause bond prices to fall and interest rates on debt to rise rapidly. While this is certainly possible, demand for Treasuries will remain strong for as long as the current risk-averse climate remains in place. In addition, given that the US Treasury is not in danger of defaulting anytime soon, yields reflect expectations for inflation and interest rates more than supply/demand for the bonds themselves. Finally, when the Fed stopped buying mortgage backed securities in 2010, mortgage rates fell, contrary to expectations.

In short, the Dollar might continue to fall against the Yen as speculators cover their short positions, but not because of any fundamental reasons. On an aggregate basis, the never-ending string of crises won’t cause the Dollar to collapse. If anything, it might even bring some risk-averse capital back to the US and re-affirm the Dollar’s status as global reserve currency.

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What’s Next for the Yen? Probably more Decline.

Filed under: Japanese Yen — Tags: , , , , — admin @ 3:56 pm

After the G7 intervened in forex markets last month, the Yen fell dramatically and bearishness spiked in line with my prediction. Over the last week, however, the Yen appears to have bottomed out and is now starting to claw back some its losses. One has to wonder: is the Yen heading back towards record highs or will it peak soon and resume its decline?


Some analysts have ascribed tremendous influence to the G7, since the Yen fell by a whopping 5% following its intervention. From a mathematical standpoint, however, it would be virtually impossible or the G7 to single-handedly depress the Yen. That’s because the Yen holdings of G7 Central Banks are decidedly small. For example, the Fed holds only $14 Billion in Yen-denominated assets (compared to the Bank of Japan’s $800+ Billion in Dollar assets), of which it deployed only $600 million towards the Yen intervention effort. Even if the Bank of Japan is covertly intervened (by printing money and advancing it to other Central Banks), its efforts would still pale in comparison to overall Yen exchanges. Trading in the USD/JPY pair alone accounts for an estimated $570 Billion per day. Thus, given the minuscule amounts in question, it would be unfeasible for the Central Banks alone to move the Yen.

Instead, I think that speculators – which were responsible for the Yen’s spike to begin with – purposefully decided to stack their chips on the side of the G7. Given the unprecedented nature of the intervention, and the resolute way in which it was carried out, it would certainly seem foolish to bet against it in the short-term.  In fact, the consensus is that, “Investors are confident that the G7 won’t let the yen go below 80 versus the dollar again.” Still, this notion implies that if speculators change their minds and are determined to bet on the Yen, the G7 will be virtually powerless to block their efforts.

For now, speculators lack any reason to bet on the Yen. Aside from the persistent financial uncertainty that has buttressed the Yen since the the 2008 credit crisis, almost all other forces are Yen-negative. First, the crisis in Japan has yet to abate, with this week bringing a fresh aftershock and an upgrading of the seriousness of the nuclear situation. The hit to GDP will be significant, and a chunk of stock market equity has been permanently destroyed.


Thus, foreign institutional interest in Yen assets – which initially surged as investors swooped in following the 20% drop in the Nikkei 225 average – has probably peaked. The Bank of Japan will probably continue to flood the markets with Yen, and the government of Japan will need to issue a large amount of debt in order to pay for the rebuilding effort. Given Japan’s already weak fiscal situation, it seems unlikely that it can count on foreign sources of funding.

Even worse for the Yen is that Japanese retail traders (which account for 30% of Yen trading) seem to have shifted to betting against it. They are now driving a revival in the carry trade, prompting the Yen to fall to a one-year low against the Euro (helped by the recent ECB rate hike) and a multi-year low against the Australian Dollar. “Data from the Commodity and Futures Trading Commission (CFTC) showed speculators went net short on the yen for the first time in six weeks and by the biggest margin since May 2010 at a net 43,231 contracts in the week to April 5.”

It’s certainly possible that investors will take profits from the the Yen’s fall, and in fact, the recent correction suggests that this is already taking place. However, the markets will almost certainly remain wary of pushing things too far, lest they trigger another G7 intervention. In this way, Yen weakness should become self-fulfilling, since speculators can short with the confidence that another squeeze is unlikely, and simply sit back and collect interest.

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SNB Abandons Intervention as Franc Rises to Record High Against Euro.

Filed under: Swiss Franc — Tags: , , , , , , , — admin @ 2:46 pm

The Swiss National Bank (SNB) has apparently admitted (temporary) defeat in its battle to hold down the value of the Franc. ” ‘The SNB has reached its limits and if the market wants to see a franc at 1.35 versus the euro, they won’t be able to stop it.’ ” The markets have won. The SNB has lost.

SNB Franc Intervention Chart - 2009-2010
Still, the SNB should be applauded for its efforts. As you can see from the chart above, it managed to keep the Franc from rising above €1.50 (its so-called line in the sand) for the better part of 2009. Furthermore, by most accounts, it managed to slow the Franc’s unavoidable descent against the Euro in 2010. While the Dollar has appreciated more than 15% against the Euro, the Franc has a risen by a more modest 10%. ” ‘Without that €90 billion [intervention], it’s fair to say that the euro would be closer to $1.10,’ ” argued one analyst. In fact, as recently as May 18, the SNB manifested its power in the form of 1-day, 2% decline in the Franc, its sharpest fall in more than a year.

Overall, the SNB has spent more than $200 Billion over the last 12 months, including $73 Billion in the month of May alone. ” ‘To put the figures in perspective, there have been only two months when China, the world’s largest holder of forex reserves with $2,249bn in assets, saw its reserves increase more.’ ” The SNB now claims the world’s 7th largest foreign exchange reserves, ahead of the perennial interveners of Brazil in Hong Kong, the latter of whose currency is pegged against the Dollar.

Swiss SNB Forex Reserves - Intervention
While the SNB can take some credit for halting the decline in the Franc, it was ultimately done in by factors beyond its control, namely the Eurozone sovereign debt crisis and consequent surge in risk aversion. At this point the forces that the SNB is battling against are too large to be contained: “We’re talking about a massive euro crisis, so no single central bank can prop it up on its own,” summarized one trader. As a result, the Franc is now rising to a fresh record high against the Euro nearly every trading session.

Still, the SNB remains committed to rhetorical intervention. “The central bank has a ‘clear aim‘ to maintain price stability and this is what guides its policy actions, SNB President Philipp Hildebrand said…The bank will act in a ‘decisive manner if needed.’ ” That means that if economic growth slows and/or deflation sets it, it may have to restart the printing presses. Given that its economy is slated to grow at a solid 1.5% this year, unemployment is a meager 3.8%, and the threat of inflation has largely abated. On the other hand, the prospect of a drawn-out crisis in the EU means the Franc will probably continue to appreciate – without help from the Central Bank: ” ‘The SNB may continue to intervene in the currency markets until 2020,’ ” declared the head of forex research for UBS.

The implications for currency markets are interesting. Not only has the SNB prevented the Euro from falling too fast against the Franc, but it may also have prevented it from falling too quickly against other currencies. ” ‘To suggest that the SNB has been the savior of the euro is too much. But one could imagine that if the euro starts to decline again, the market may blame the fact that the SNB isn’t buying,’ ” said a currency strategist from Standard Bank.

This episode is also a testament to the limits of intervention. It has always been clear (to this blogger, at least) that intervention is futile in the long-term. The best that a Central Bank can hope for is to stall a particular outcome long enough in order to achieve a certain short-term policy aim. When enough momentum coalesces behind a (floating) currency, there is nothing that a Central Bank can do to stop it from moving to the rate that investors collectively deem it to be worth.

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Forex Markets Look to Interest Rates for Guidance. In terms of yield, the Dollar looks vulnerable.

Filed under: Central Banks — Tags: , , , , , , , , , , — admin @ 1:54 pm

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.

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Daily Forex Fundamentals – June 28, 2013

Filed under: Currency Charts — Tags: , , , , — admin @ 1:27 am

What’s on the Economic Horizon

Chicago PMI to Print a Reading of 55.0
German Retail Sales Data on Tap
Canadian Economy Expected to Have Expanded 0.1% in May

U.S. Dollar (USD)

Now, that’s much better! After printing a mixed scorecard on Wednesday, the dollar traded with clearer direction on Thursday. It actually finished the day with wins against all of its counterparts save for the euro. EUR/USD bounced off 1.3000 on the heels of positive euro zone data. Read more…

Euro (EUR)

In a surprising turn of events, the euro managed to get a little bit of reprieve yesterday. The currency was able to stop the bleeding and actually turn higher versus the dollar. From EUR/USD’s opening price during the Tokyo session, the pair rallied as high as 1.3056 before settling at 1.3041. The pair gained 41 pips overall for the day. Read more…

British Pound (GBP)

You win some, you lose some. Although the pound managed to hold steady against the Japanese yen, it resumed its losing streak against the Greenback as GBP/USD dipped dangerously close to the 1.5200 mark. What’s in store for the pound pairs today? Read more…

Japanese Yen (JPY)

The yen failed to tap its inner Samurai in Thursday’s trading. It lost to almost all of its counterparts, giving up 48 pips to the dollar, 94 pips to the euro, and 15 pips to the pound. Read more…

Canadian Dollar (CAD)

USD/CAD traded in a “U” pattern yesterday. The pair, after opening the Tokyo trading session at 1.0479, fell to 1.0424, found support at the region, and then rallied back up to close the day barely changed at 1.0476. Read more…

Australian Dollar (AUD)

AUD/USD spent a good part of the Tokyo and London sessions above .9300. But all of a sudden, the Aussie crashed during the New York session! AUD/USD dropped from an intraday high of .9339 to finish the day at .9279. Read more…

New Zealand Dollar (NZD)

Yowza! After pulling up to the .7850 area, NZD/USD crashed once again and found itself trading below the .7800 major psychological level. Will it have a chance to get back on its feet today? Read more…

Swiss Franc (CHF)

Quite a topsy turvy day for the franc, as USD/CHF jumped to a high of .9488 before pulling back down and consolidating around .9450. EUR/CHF was able to stage a strong rally from a low of 1.2259 to a high of 1.2338 before moving sideways for the rest of the U.S. session. Read more…

Bonnie and Clyde, peanut butter and jelly, Justin Bieber and his hair. Some things just go well together.

In forex trading, you get better odds at securing pips when your fundamental analysis is complemented by technical analysis.

Head on to Big Pippin’s Daily Chart Art for some pip-locking technical setups!

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June 28, 2013

Fed Mulls End to Easy Money Policy. Early Rate Hike Would Boost the Dollar.

Filed under: US Dollar — Tags: , , , , , , , , , — admin @ 5:13 pm

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.

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G7 Leads Shift in Forex Reserves. Emerging economies will still favor the dollar but will accumulate fewer reserves than before.

Filed under: Japanese Yen — Tags: , , , , , , , , , , , , — admin @ 3:58 pm

As you can see from the chart below, the world’s foreign exchange reserves (held by central banks) have undergone a veritable explosion over the last decade. While emerging markets (especially China!) have accounted for the majority of this growth, there are indications that this could soon change. China’s reserve accumulation is set to slow, while advanced economies’ reserves are set to increase.


In the past, central banks from advanced economies have accumulated reserves only sparingly, and in fact, much of this growth can be claimed by Japan. This is no mystery. While held by emerging economy central banks, most of the reserves are denominated in advanced economy currencies. This has ensured a plentiful supply of cheap capital, to support both economic expansion and perennial current account deficits (namely in the US!). In addition, advanced economy central bankers tend to hew towards economic orthodoxy, which precludes them from intervening in forex markets, and obviates the need to accumulate forex reserves. Emerging economies, on the other hand, depend principally on exports to drive growth. As a result, many are driven towards holding down their currencies in order to maintain competitiveness. China has taken this to an extreme, by exercising rigid control over the value of the Yuan, and necessitating the accumulation of $3 trillion in foreign exchange reserves.

This trend accelerated in 2010 with the inception of the so-called currency wars (which have not yet abated). Competing primarily with each other, emerging economies bought vast sums of foreign currency in order to promote economic recovery. Many countries from South America and Asia which don’t normally intervene were also drawn in. The result was a tremendous accumulation of foreign exchange reserves, which is reflected in the chart above.

There is already evidence that this phenomenon is starting to reverse itself. Consider first that advanced economies have participated in the currency wars as well. Japan’s reserves have swelled to more than $1.1 Trillion. Switzerland spent $200 Billion defending the Franc, and South Korea has spent more than $300 Billion over the last five years trying to hold down the Won. The Bank of England (BOE) recently announced plans to rebuild its reserves (the majority of which were redeployed towards gilt purchases). The European Central Bank (ECB) has announced similar plans, and may be joined by the Bank of Canada and US Federal Reserve Bank.

Advanced economies need currency reserves for a couple reasons. First of all, they can no longer rely on monetary easing to reduce their exchange rates because of the inflationary side-effects. Second, the recent coordinated intervention on Japan’s behalf showed that the G7 will move to protect its members when need be. Finally, political forces are compelling advanced economies to slow the outflow of jobs and production, and this requires more competitive exchange rates.

Emerging economies, meanwhile, are starting to recognize that unchecked reserve accumulation is neither sustainable nor desirable. First of all, managing those reserves can be tricky. Intervention is not free, and exchange rate and investment losses must be accounted for somewhere. Second, continued intervention has several detrimental byproducts, namely inflation and the handicapping of domestic industry. Finally, emerging economy currency appreciation is inevitable. Constant intervention merely forestalls the inevitable and invites unending speculation and inflows of hot-money.

There are a few of ways that currency investors can position themselves for this change. As emerging market economies stop the accumulation of (or worse, sell off) their reserves, a major source of demand for advanced economy currency will be curtailed. This will accelerate the broad-based appreciation of emerging market currencies against their advanced economy counterparts. At the same time, I’m not sure how much reshuffling we will say in the composition of reserves. The euro is plagued by existential uncertainty, while the yen and pound have serious fiscal problems. In the short-term, the Chinese Yuan is prevented by several factors from becoming a legitimate reserve currency, namely that it is too difficult to obtain. (As soon as this changes, you can bet that emerging economy central banks will begin accumulating it. After all, they are competing with China – not with the US). The dollar is certainly also an “ugly” currency, but given the size of the US economy, the depth of its capital markets, and the liquidity with which the dollar can be traded, it will remain the go-to choice for the immediate future.

In the short-term, traders that wish to short advanced economy currencies (namely the Japanese yen) can do so in the secure knowledge that they are backstopped by the G7 central banks. It’s like you have an automatic put option that limits downside losses. If the Yen falls, you win! If the yen rises, the BOJ & G7 should step in, and at least you won’t lose!

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