With the onset of the Eurozone sovereign debt crisis this year, volatility levels in forex (as well as in other financial markets), surged to levels not seen since the height of the credit crisis. While volatility has subsided slightly over the last few months, it still remains above its average for the year, and significantly above levels of the last five years.

The spike in volatility was easy enough to understand. Basically, the possibility of a default by a member of the EU or even worse, a breakup of the Euro created massive uncertainty in the markets, spurring the flow of capital from regions and assets perceived as risky to those perceived as safe havens. As you can see from the chart below, this trend has begun to reverse itself, but still remains prone to sudden spikes.

While the crisis in the EU seems to have (temporarily) settled, investors are attuned to the possibility that it could flare up again at any moment. A failed bond issue, a higher-than-forecast budget deficit, political stalemate, labor strikes – all signal a failure to resolve the crisis, and would surely trigger a renewed upswing in volatility and sell-off in risky assets.

The same goes for (unforeseen) crises in other regions, affecting other currencies. Muses one analyst: “Next week? Who knows. One strong candidate is for flight out of the yen as investors start to fear there won’t be enough domestic demand for mountains of Japanese debt and foreign buyers will insist on much higher yields. Another might be that Swiss banking exposure to insolvent east European households causes another banking crisis.” Don’t forget about the UK and US, both of which have hardly put the recession behind them, and whose Trillions in debt represent powder kegs waiting to explode.

It will be months or years before these latent crises even begin to manifest themselves, let alone achieve some kind of resolution. As a result, many analysts predict that volatility will remain high for the foreseeable future: “Big and sudden currency market moves shouldn’t come as a surprise, whatever the direction…Higher market volatility should follow on from greater macroeconomic volatility. Increased economic fluctuations increase uncertainty. And there’s no question macroeconomic volatility has risen.”

In addition, there is no way for governments for Central Banks to alleviate these crises due to the “Trillema of International Finance.” Greg Mankiw, Harvard Economics Professors, explains that in prioritizing an independent monetary policy and open capital markets have forced many countries to forgo exchange rate stability: “Any American can easily invest abroad…and foreigners are free to buy stocks and bonds on domestic exchanges. Moreover, the Federal Reserve sets monetary policy to try to maintain full employment and price stability. But a result of this decision is volatility in the value of the dollar in foreign exchange markets.” While the Euro has eliminated exchange rate fluctuations between members of the Eurozone, meanwhile, there is nothing that the ECB can (or desires to) do to minimize volatility between the Euro and outside currencies.

From the standpoint of forex strategy, there are a couple of lessons that can be learned. First of all, the carry trade will remain underground until volatility returns to more attractive levels. Until then, the potential gains from earning a positive yield spread will be offset by the possibility of sudden, irascible currency depreciation. Second, growth currencies – despite boasting strong fundamentals – will remain vulnerable to sudden declines. That doesn’t mean that they should be avoided; rather, you should simply be aware that small corrections could easily turn into multi-month weakness.

The South Korean Won has been one of the biggest losers from the EU sovereign debt crisis. After a stellar 2009, the Won is off to a shaky start in 2010, and has lost 12% of its value in the last month alone. According to analysts, The won is “most sensitive to risk aversion” of any currency in Asia – or even the world. Thus, when the President of Hungary likened his country’s fiscal situation to that of Greece and inadvertently ignited fears that the crisis was spreading, the Korean Won immediately fell by 5% – the largest decline in 17 months.

Given all of the economies/currencies from which to choose, it seems bizarre that investors would gang up on the Won. That is, until you consider that South Korea’s fiscal situation is somewhat unique and that funding crises tend to hit the country especially hard. Summarized one analyst: “We are concerned that the negative market view of events in Europe will not dissipate and that the longer the stress continues, the more concerns will arise that the peripheral funding crisis could segue into a more extended funding crisis and into lower growth expectations.”

To elaborate, South Korea’s short-term foreign currency debt is extremely high (60% of foreign exchange reserves). That’s primarily due to Korean exporters’ hedging activities, which for risk management purposes, need to be offset by short-term borrowing by banks in the money market. Since this debt needs to be rolled over frequently, South Korea is especially vulnerable to liquidity crunches. In fact, the Won has been called a “VIX currency,” since it tends to fall when volatility (proxied by the VIX index) rises. Hence, the Won lost 50% of its value during the peak of the credit crisis, and has already declined 10% this time around.

The Central Bank is doing its part to relieve the liquidity shortage and stem the Won’s decline. It has already placed modest limits on speculative derivative transactions with the goal of limiting capital flight. It is pressing to renew currency swaps with the Fed and the Bank of Japan in order to increase the supply of alternative currency. In addition, it has taken to intervening directly in currency markets by selling Billions of Dollars on the spot market. Explaining the first market intervention in more than a year, the Central Bank declared, “The dollar’s surge against the won today was overdone. The authorities will try to prevent one-way currency moves.”

There are also a handful of market analysts who attribute the Won’s fall to the ongoing conflict with North Korea. In response to the sinking of a warship in March, South Korea has responded by imposing trade sanctions on North Korea, which in turn has responded with threats of “all-out war.” From a forex standpoint, “The largest concern is that the cutting off of economic links raises the risk of a sudden regime collapse, resulting in the South facing a huge influx of refugees. This would have a significant — and possibly prolonged — impact on the Korean won.”

How should one proceed? If indeed you believe that the Won is being harmed by the prospect of conflict with North Korea, you might be inclined to agree with the notion that, “The recent sell-off in the won has been overdone and should correct, assuming that the North-South tensions will ease in the months ahead.” In fact, if war is avoided, the current bear market could be an excellent buying opportunity, and the Won could still be on track to rise to 1,100 USD/KRW by year-end, conforming to analysts’ median expectations.

On the other hand, if you believe that the Won’s woes are largely attributable to the EU fiscal crisis, there is very little reason to hold the Won, since that crisis will probably only get worse before it gets better: “The Korean market was precariously positioned, with high multiples, above-trend earnings, heavy positioning towards risk and ominous technicals suggesting little sponsorship for strength.” In this case, the Won could easily fall to 1,300 – or worse – before the year is out.

In any event, South Korea will host a meeting of the G20 this week, which should yield more clarity into what the rest of 2010 has in store for the Won.

Generally speaking, investors are bullish about Brazil. The emerging market superstar emerged from the credit crisis essentially unscathed, and some believe that “Brazil will be the world’s fifth-biggest power by the next decade.” This year, the IMF is forecasting GDP growth of 5.5%, while the Central Bank of Brazil is projecting 6%.

But this post isn’t about the economy of Brazil. It’s about its currency, the Real. To put it mildly, investor sentiment surrounding the Real is slightly less rosy. The 30% appreciation (from trough to peak) against the Dollar has come to an end. “ ‘Buyers are exhausted. The real has been a pretty crowded trade and what’s happening is a lot of these long-term crowded positions are getting sold,’ ” summarized one money manager.

There are a handful of issues. First is the technical concern that the Real simply rose too far, too fast. “The currency’s weekly TD Sequential indicator suggests an almost yearlong rally against the dollar ended in October, while the moving average convergence/divergence, or MACD, chart shows the real is likely to weaken.  ‘A new trend has started and it’s strongly bearish.’ ” This notion is supported by an explosion in the so-called risk-reversal rate on the Real, in favor of options that give investors the right to sell. In fact, “insurance” on the Real is now the most expensive of any emerging market currency.

Investors are also nervous about the sovereign debt crisis in the EU, and are responding by temporarily moving funds back to safe haven currencies. “ ‘We’re seeing a lot of declines on top of concerns about Greece and Europe. Flows will come back to Brazil when you have signs of stability out there, and it doesn’t look like that will happen in the short term.’ ” Of course, this is also impacting the carry trade, as investors re-examine their models governing the trade-off between risk and return.

To be fair, increased risk could be accompanied by increased returns. Even withstanding a poor performance by the Real, itself, the benchmark Brazilian Selic rate stands at a healthy 9.5%. In all likelihood, it will be hiked past 10% next month, and to 11% by the end of the year. On the flipside, inflation is also surging (5.5% at last count). From the standpoint of investors, this is not really a concern, since there is no intention of using invested capital for consumption purposes. In fact, it could even be seen as positive, insofar as it will force the Central Bank of Brazil to continue to be aggressive in conducting monetary policy.

There seems to be a slight dichotomy between the data and the markets. On the one hand, there is plenty for investors to be excited about when looking at Brazil. On the other hand, the reality is that there just isn’t much excitement at the moment being channeled towards the Real. If interest rates continue to rise, and the debt crisis in Euro can achieve some kind of (stopgap) resolution, perhaps this will change.

Even before the sovereign debt crisis in Europe damped confidence in the world’s second most important reserve currency, the Chinese Yuan was on the cusp of being accepted as a global reserve currency.

We’re all familiar with the arguments attacking the Yuan in this context: its currency is pegged, its capital controls are rigid, and its capital markets are shallow and illiquid. Say what you want about the world’s major currencies (volatile, debt-ridden, etc.), but at least none of these factors applies, goes this line of thinking. With the Euro’s future up in the air, however, a potential hole has been created in Central Banks’ respective forex reserves. As replacement(s) for the Euro are sought, such long-held assumptions are being challenged.

The Chinese Yuan is attractive for a number of reasons. First, investors and Central Banks want exposure to China’s economy; its average annual growth rate of 10% over the last 30 years is far-and-away the highest in the world. “China’s economic output will be more than $5 trillion, or around 9% of the world’s economy, according to the International Monetary Fund.” Second, the fact that the RMB is fixed is in some ways a perk: the wild fluctuations that most currencies witnessed as a result of the credit crisis has made some wonder if market-determined exchange rates aren’t overrated. Finally, the widespread consensus is that the RMB will appreciate anyway, so holding it seems like a safe bet.

Therefore, “Central banks or sovereign wealth funds from Malaysia, Norway and Singapore have received special quotas from the Chinese government to allow them to gain a bit of exposure to China’s currency. The bet is that holding yuan-denominated assets is an important feature of a diversified national reserve.” In addition, China has signed Yuan-denominated swap agreements with a handful of its most important trade partners, totaling $100 Billion over the last year.

Still, these are small-scale agreements, and Central Banks are really just testing the waters. According to a recent study by the Reserve Bank of India (RBI), “The Chinese yuan is ‘far from ready’ to gain reserve currency status. Rather, it said China’s yuan was likely first to become a regional currency as trade links with its neighbours expand.” The main issue is not one of stability, but rather of supply. Simply, there are not enough liquid, attractive investments, denominated in RMB. China’s stock and bond markets are filled with unreliable companies, whose primary loyalty is to the State, rather than to investors. Buying Chinese government bonds seems like a safe option, but given, that China finances most of its spending with cash, such bonds are not widely available.

For now, the Chinese Yuan will remain most attractive (from the standpoint of a reserve currency) to regional trade partners, because such countries have a genuine use for RMB. Investors seem to understand this idea, and are using the currencies of such countries to bet indirectly on the RMB. According to one analyst, “On days when trading is especially volatile, the Singapore dollar moves in tandem with the yuan bets. The Malaysian ringgit, Taiwanese dollar and Korean won are also high on the list of currencies affected by the yuan.” In short, the RBI’s assessment of the Yuan seems pretty apt. It will probably be at least a decade before holding the Yuan is as viable (not to say attractive) as the Japanese Yen. For investors who don’t want to wait that long, there are a handful of other regional currencies that they can hold in the interim.

I must confess: I never expected the Greek debt crisis to reach such a dire threshold in such a short time period. Over a matter of mere months, the Euro has fallen 15% against the Dollar. That’s the kind of drop that you would have expected from the Greek Drachma, not from the Euro!

Moreover, it’s not as if this slide is anywhere close to abating. “I don’t think you’d want to bet on a bottom, at this stage, in euro. We’re headed closer to $1.2000 at some point in the game. It’s just a question of when,” said one prominent analyst. Meanwhile, net shorts against the Euro have reached a record 89,000 contracts, according to the weekly Commitments of Traders report. What is producing this swell of bearish sentiment, which is causing the markets to trade in a manner best described as “panic mode?”

The answer, it seems, is a self-fulfilling belief not only that Greece will default on its debt, but also that the credit crisis will spread to the rest of Europe. Greek interest rates recently topped 8%, and the spread with comparable German bonds (this spread has become a crude way of gauging the seriousness of the crisis) is close to an all-time record. Credit default swaps, which insure against the risk of default, surged to 674 bas points, reflecting a 15% probability of default. Meanwhile, credit default swap spreads on Spanish and Portuguese debt is also creeping up.

At this point, there seems to be very little that Greece can do to mitigate the crisis. It has already announced a series of austerity measures, including wage cuts and tax hikes, designed to narrow its budget deficit. In addition, it has successfully obtained an aid package from the EU and IMF, valued at $160 Billion. In April, it successfully refinanced $12 Billion in debt, even though experts insisted that such would be very difficult, given current investor sentiment.

On the other hand, the austerity measures were met with riots, which left 3 people dead, and signaled that the Greek citizenry would sooner vote out the incumbent government than accept their proposals to reduce the budget deficit. Speaking of which, under the best case scenario, the deficit will decline to a still-whopping 8% of GDP in 2010 (from a revised 13% in 2009), and Greece’s budget will remain in the red until at least 2014, by which point its gross national debt is projected to have reached 140% of GDP. Of course, this assumes that GDP growth will turn positive in 2012, and this is no guarantee. Meanwhile, the aid package will probably be enough to tide Greece over for only about 18 months, after which point it will have to return to the capital markets. Even before it can tap the bailout, it must first refinance another $10 Billion in debt in May.

In other words, even if Greece can forestall default for 2010 and 2011, who’s to say that it won’t default in 2012? With this possibility in mind, it makes it very unlikely that investors will continue to buy Greek bonds at all, let alone at affordable interest rates. “People are becoming well aware of the fact that the solvency issue for Greece hasn’t been resolved with the aid package. They still have to repay the money. They still have to repay the interest.”

Finally, there is the risk that the crisis will spread to the rest of Europe. Both the IMF and the Spanish government have been busy refuting rumors that Spain is seeking a similar bailout. Regardless of its veracity, the fact that such a rumor even exists will be enough to make investors sweat. When investors get nervous, they stop buying government bonds and/or demanding higher interest rates, which ironically only makes it more likely that the government in question will default. Fortunately, it seems that Spain (and its neighbor, Portugal) are in strong enough shape that they could survive a sudden speculative attack from investors.

Greece, however, is basically a lost cause. “Greece is functionally bankrupt,” and the only solution is for it to leave the Euro and/or default. Until that day comes, uncertainty will persist, and investors will continue to doubt the Euro.

The Canadian Dollar’s performance of late has been eerily redolent of its sudden rise in 2007, when propelled by nothing more than sheer momentum, it rose 20% against the Dollar and breached the parity mark (1:1) en route to a 30-year high. [Of course, we all remember what happened next: the credit crisis struck, and the Loonie plummeted even faster than it had risen].

Last week, the Canadian Dollar breached parity again, and after a brief retreat, it touched parity again today. On the one hand, this latest rise was simply a matter of making up for the ground lost in 2008, when risk-averse investors shifted capital en masse to the US. On the other hand, Canadian fundamentals are fairly strong, and that the Loonie is once again at parity is deservedly so.

Last week’s jobs report was pretty solid, but the Canadian unemployment rate is still high, at 8.2%, mirroring the “jobless recovery” phenomenon in the US. According to the Bank of Canada’s own estimates, GDP growth is projected at a healthy 3.7% for 2010, thanks to a strong recovery in oil and commodity prices. As a result, the Bank of Canada has finally given the indication that it is ready to hike interest rates, perhaps as soon as July.  After concluding its monthly meeting yesterday, it noted, “With recent improvements in the economic outlook, the need for such extraordinary policy is now passing, and it is appropriate to begin to lessen the degree of monetary stimulus.”

On the other hand, one has to wonder how long the momentum in the Canadian Dollar can continue. While Canada’s economic recovery has indeed been strong, it is no more impressive than the recovery in the US. (In fact, it should be noted that the two economies remain deeply intertwined). In addition, the (Canadian) economy is already expected to slow down slightly in 2011 (3.1%), and slow further in 2012 (1.7%), which makes me wonder whether the Bank of Canada will have to tighten slightly in order to achieve its inflation objectives. Moreover, while the BOC will probably hike rates slightly before the Fed, the arc of monetary policy followed by the two Central Banks will probably be pretty similar for the next few years, regardless of what happens.  This means that interest rate differentials between the two economies should remain pretty close to the current level (near 0%), and won’t expand enough to make a CAD/USD carry trading strategy viable.

It seems the futures markets concur, as the Canadian Dollar is projected to hover around parity with the USD for the bulk of the next 12 months. Granted, futures prices have pretty closely mirrored the Canadian Dollar’s performance in the spot market, but the point is that investors seem to expect the CAD/USD exchange rate to settle down for a while.

Remarked one analyst, “The Canadian dollar parity party is in full swing, however further Canadian gains will be at a much slower pace as the existing long Canadian positions get trimmed on profit taking in the absence of new bullish Canadian catalysts.” Incidentally, this is exactly what the Bank of Canada wants, and spent the better part of 2009 trying to convey to forex markets. If the Loonie were to rise further, it could threaten the economic recovery, and at the very least, the BOC would proba1bly hold off on hiking rates.

In the end, 1:1 does seem like a reasonable exchange rate. I haven’t seen any economic models that argue one way or the other, but it certainly makes sense from the standpoint of convenience and market psychology. Barring any unforeseen developments, I don’t see it fluctuating very much in the short-term, one way or the other.

Analysts and Fed-watchers have been speculating for almost half a year about the possibility of a Federal Funds Rate (FFR) hike. With each prognostication of a rate hike comes a flurry of market activity, followed by an invariable ebb, as investors accept that the Fed will hold the FFR at 0% until at least its next meeting.
Many traders (forex and other) look to interest rate futures for guidance as to when the Fed will ultimately hike. If you “believe” that futures prices are an accurate predictor, then there is currently a 68% chance that the FFR will rise by 25 basis points at the Fed’s December meeting. Until then, markets are pricing in a very low probability of any rate hikes. Besides, there is very little reason to put any stock in interest rate futures more than a few months away, because uncertainty is high and volume is low. Think about it: if you had looked at interest rate futures in the summer of 2008 (right before the onset of the credit crisis), you would have been anticipating a continued tightening of monetary policy, rather than the torrential loosening that followed the collapse of Lehman Brothers.

In fact, “Researchers at the Federal Reserve Bank of Cleveland said, in 2006, the fed funds futures market isn’t terribly good at predicting actual rate moves more than a few months into the future, even when the Fed is actively adjusting its target.” That being the case, there really isn’t any point in scrutinizing futures contracts that mature after May 2010. With regard to contracts that mature during the next two months, well, you don’t need to monitor futures prices to know that there is very little likelihood that the Fed will hike rates any time soon.

But don’t take my word for it. What do members of the Fed’s Board of Governors have to say about the matter? In his semi-annual testimony before the House of Representatives last week, Chairman Ben Bernanke said that ” ‘the economy continues to require the support of accommodative monetary policies.’ And in response to questions, he reaffirmed that the high level of unemployment and low rate of inflation will continue to justify very low rates ‘for an extended period.’ ”

Janet Yellen, President of the San Francisco Fed, has also insisted that “the U.S. economy still needs ‘extraordinarily low’ rates.” That “Yellen is the Fed’s extended-period language personified” is worth noting, since she is reputed to be President Obama’s pick to serve as vice-Chairman of the Fed. If it isn’t enough that Bernanke is a monetary Dove in the extreme, now he may be joined by Yellen, who will certainly echo his belief in the need for low rates.

Without a doing a further role call of the Fed’s power players, suffice it to say that low rates are in the cards for the near future. You’re probably wondering: Who cares?! With so much else to focus on in currency markets these days (namely the still-evolving EU fiscal crisis), is it really worthwhile to pay close attention to the Fed? The answer is Yes. While long-term interest rates (i.e. those that are most impacted by sovereign debt concerns) weigh heavily on all asset prices, currencies are driven largely by short-term interest rate differentials.

The related phenomena of the Carry Trade, Fisher Effect, Purchasing Power Parity, etc. are all based on short-term interest rates. If the Fed leaves rates low for an extended period as it promises, and/or other Central Banks (Australia, Canada, Brazil) nudge their respective rates higher, it probably won’t bode well for the Dollar. It helps that the Dollar is still ahead of the curve compared to the other majors (EU, UK, Japan) both monetarily and fiscally, which means that the Dollar should fare okay against their currencies. When you put the Dollar head-to-head against some of the smaller currencies, its position is much less favorable, due in no small part to the Fed.

Rumor has it that the Dollar is about to make a run. As the credit crisis slowly subsides, (currency) investors are once again looking at the long-term, and they like what they see when it comes to the Dollar.

For those that care to remember, 2008 was a great year for the Dollar, as the credit crisis precipitated an increase in risk aversion, and investors realized that despite its pitfalls, the Dollar was (and still is) the most stable and really the only viable global reserve currency. [This reversed a trend which had essentially been in place since the inception of the Euro in 1999]. In 2009, meanwhile, the Dollar resumed its multi-year decline, and many analysts were quick to label the rally of 2008 as an aberration.

Then came the debt crises, first in Dubai, then in Greece. Suddenly, a handful of smaller EU countries appeared vulnerable to fiscal crises. Japan officially became the first of the Aaa economies to receive a downgrade in its credit rating. The British Pound is dealing with crises on both the political and economic fronts. According to Moody’s, “The ratings of the Aaa governments — which also include Britain, France, Spain and the Nordic countries — are currently ’stable’…But…their ‘distance-to-downgrade’ has in all cases substantially diminished.”  Suddenly, the Greenback doesn;t look so bad.

I want to point out that in forex, everything is relative. (Novice) forex investors are often baffled by how sustained economic and financial crises don’t immediately result in currency depreciation. The explanation is that when the crises are worse in (every) other countries, the base currency still looks attractive.

This is precisely the case when it comes to the US Dollar. To be sure, the economy is still flawed, financial markets have yet to fully to recover, the federal budget deficit topped $1.8 Trillion in 2009, and government finances seem close to the breaking point. Moody’s has also identified the US as a candidate for a ratings downgrade. And yet, when you look at the situation in every other currency that currently rivals the US for reserve currency status, the Dollar still wins hands down.

Its economy is the world’s largest. So are its financial markets, which are also the deepest and most liquid. Its sovereign finances are still manageable from the standpoint of debt-to-GDP and interest-to-revenue ratios. It is the only currency whose circulation can even come close to meeting the needs of global trade. Summarized S&P – when it confirmed the AAA credit rating of the US, “The dollar’s widespread acceptance stems from the U.S. economy’s fundamental strength, which in our view comes from the economy’s size and the flexibility of labor and product markets. We view U.S. banking and capital markets to be dynamic and unfettered relative to their peers.”

That’s why auctions of US Treasury bonds remain heavily oversubscribed (demand exceeds supply), despite the rock-bottom interest coupons. China has reaffirmed its commitment to Treasuries (what other choice does it have), confirmed by some forensic accounting work. Gold might continue to rally. So will other commodities, for all I know. Emerging market currencies are still in good shape as well, but none of these will seriously rival the US Dollar for a long-time, if ever. In short, when it comes to the other majors, the Dollar is still King: “You can say whatever you want, but the dollar is the currency of last resort It’s the currency people want in a crisis.”

I can’t remember how long it’s been since I was hyping the Yen carry trade (though a browsing of the ForexBlog archives indicates 2 years). Upon the outset of the credit crisis, forex markets went haywire, and one of the main “beneficiaries” was the Yen, which soared as carry trades were unwound. Now, however, a similar set of circumstances that made the Yen carry trade attractive from 2006-2008 have re-appeared, and it looks like the trade could be on the verge of making a big comeback.

Practitioners of the carry trade understand that it has a few pre-conditions. The first is low interest rates. In this case, the benchmark Japanese interest rate is only .1%. While that would have meant something a few years ago, however, it no longer counts for much, since benchmark rates in other industrialized countries are just as low. Where Japan has the edge is in market interest rates. Long-term rates have historically been well below the global average, and short-term rates are finally following suit after a 3-year hiatus. In fact, for the first time since August, the 3-month Japanese LIBOR rate – a lending benchmark – fell below its US counterpart: “On Thursday, the yen Libor JPY3MFSR= was fixed at 0.25063 percent — its lowest level since May 2006 — and the dollar USD3MFSR= rate at 0.25219 percent.” In short, the Japanese Yen is once again the cheapest currency in the world to borrow.

In addition, interest rates in Japan will probably remain low for the immediate future, as the Bank of Japan is actually looking to make its monetary policy even more accommodative (I didn’t think this was possible with a benchmark rate of only .1%!), in order to further stimulate the economy and alleviate the risk of deflation. This contrasts with Central Banks in other countries, which are already contemplating interest rate hikes.

The second condition is low volatility. ” ‘Realized trading vols has not been so low for many years.’ For example, three-month implied vols in the euro have slipped from a 25-plus high at the peak of the subprime crisis to levels around 10.68 currently…’As volatility goes down,’ the FX market tends to move toward a ‘classic carry trade environment.’ ” Low volatility is important because it enables investors to make low-risk bets on interest rate differentials without worrying too much about currency fluctuation. However, it doesn’t hurt that aversion to risk is also trending lower, such that investors can borrow in Yen to make higher-risk bets. According to the Bank of International Settlements, “The carry-to-risk ratios, a measure of the appeal of carry trades, have ‘been steadily rising over the past 14 years, consistent with an increasing attractiveness of the yen-funded carry trades for Australia and New Zealand.’ ”

The pickup in risk aversion – as a result of the Greek debt crisis – may have delayed the return of the Yen carry trade. In January, volatility rose slightly and the Yen rallied as the safe-haven mentality set in. Personally, I find this somewhat ironic, since Japan’s debt problems are even more pronounced, and unlike Greece, it can’t count on a bailout from Greece if things really get rough. Still, the markets work in strange ways, and the fact that the Yen has benefited from the crisis is probably due to the fact that traders can’t short all currencies simultaneously.

The third condition is really an outgrowth of the first two: belief that the funding currency will remain stable, or even decline. In this regard, the Yen is still hovering near an all-time high against the US Dollar, and given the confluence of bearish economic and political factors, it would seem to ne headed downward irrespective of the carry trade. For those looking for specific reasons to short the Yen, there are plenty from which to choose: low economic growth, dismal performance in finance markets, high public debt, dwindling savings and an upcoming retirement boom. As one analyst argued, “Tokyo is due to announce its medium-term fiscal plans in June. ‘Either this will mark the start of a prolonged period of fiscal restraint, weakening the economy again and requiring further monetary loosening, or the plans will lack credibility, in which case Japan’s financial markets would be hit hard. In either scenario, the yen looks vulnerable.’ ”

I don’t mean to get excited, but it’s hard to state a better case in favor of an imminent return of the Yen carry trade.

One of the pitfalls of forex blogging (or all financial reporting for that matter) is that it’s inherently after-the fact. In other words, any information about the past – while relevant – is inherently useless, since it has theoretically already been priced into the asset (or currency in this case). Before I begin my post on the Pound’s recent decline and the factors that wrought it, then, I wanted to offer the caveat that in analyzing past events, we must simultaneously look to the future.

Anyway, for anyone watching the Pound Sterling over the last month, its performance has been startling. It is down 7.5% for the year already (we’re only in March!), and has fallen 12% from its August peak of 1.70 USD/GBP. This represents an unbelievable about-face, as the Pound spent much of 2009 floating upwards following its lows from the credit crisis.

What’s behind the decline? In short, economics and politics, or more precisely, the junction of economics and politics. As the British economy began its recovery from recession, analysts began to turn their attention to UK government finances. Another way of looking at this would be to say that analysts have shifted their gaze from the positive effect of government intervention (i.e. economic recovery) to the many lasting negative effects. Inflation and government solvency, of course, are the two most pernicious of the bunch.

The Bank of England’s quantitative easing program was comparable to the Fed’s program in relative terms, and in the aftermath of all of that money creation, inflation is slowly creeping up. The government’s free spending also contributed, and now, so is the sinking Pound, as prices for commodities and other imports are rising fast in local currency terms. Speaking of government spending, the UK government budget deficit is projected at 12% for 2010, slightly higher than 2009. You can see from the chart below that budget deficits are forecast to remain large for the next few years. Expectations are so low, in fact, that a reduction in the deficit to 3% of GDP by 2014-2015 would be viewed as a victory.

Naturally, the UK government feels some pressure to reduce its deficit, both for the sake of financial solvency and to control inflation. The problem is that an election must be called before June, and until then, there is natural pressure to continue operating the money printing presses 24/7 in order to appease the voting public. The same goes for the Bank of England; it can’t be expected to tighten monetary policy and/or reverse quantitative easing until after the election.

I’m not going to pretend that I understand British politics, but from what I’m hearing, it seems the problem is that the election polls are now very close. Previously, a major victory by the Conservative Party was seen as inevitable, and this was viewed positively by financial markets because of the expectation that they would rein in spending. Recently, the incumbent Labour Party has closed the gap, to the extent that a hung Parliament is now a likely outcome. This would be even less desirable than an outright Labour victory, because the sharing of power would make it unlikely that reforms of any kind would be enacted. With regard to forex, some have posited an inverse correlation between the rising popularity of Labour and the falling Pound.

With the crisis in Greece still unresolved, analysts are also making comparisons to the UK. Some have suggested that if Greece were to receive a bailout, then, investors would turn their attention to the UK, whose finances are in equally bad shape. Without the protection of the Euro, the Pound would be open to speculative attack. On the other hand, that the (declining) Pound is independent from the Euro could become in advantage, if it boosts exports.

Going forward, it’s difficult to make any predictions until after the elections and/or the government makes a firm commitment to reduce spending and lower its deficit. Some analysts think that regardless, the Pound is doomed to continue falling, perhaps all the way to the $1.40 mark. Others see the current decline as the “darkness before the dawn.” As I noted in the introduction to this post, the latter could certainly be right. Besides, most of the uncertainty has probably already priced in. While most of the factors currently weighing on the Pound are bearish, some contrarian investors might see this as a good opportunity to buy. And who’s to say they’re wrong?