After a slight respite following the culmination of the Eurozone debt crisis, emerging markets financial markets are back to the their former selves, with stocks, bonds, and currencies all performing well.

The rally is being driven by two principal factors. First, investors came to the gradual realization that the trend towards risk aversion had reached extreme proportions. Given that the crisis in the EU has been fairly limited both in scope and extent (at least so far), it made little sense to punish emerging markets. If anything, emerging markets should have been the financial safe havens: “Debt-to-GDP ratios in the developed world are about double those in emerging markets, and they’re growing. This makes emerging markets interesting because you’re picking up incremental spread and in return you’re actually taking less macroeconomic risk.”

Other analysts see a certain futility in targeting a risk-averse strategy: “It’s not that people suddenly think emerging markets are a lot safer, it’s that they’re realising risk is everywhere and they can’t just assume the developed world is safe.” In other words, some investors are wondering whether it doesn’t make sense to focus less on risk – which  has become increasingly random – and more on return. In this aspect, emerging market investments of all kinds are more attractive than their counterparts in the developed world.

The second source of momentum for the rally is a long-term shift in capital allocation. Thanks to foreign demand, Emerging Market “borrowers, including governments and companies, have raised almost $300bn (£200bn) to date, up 10 per cent on the same period in 2009.” A microcosm of this surge can be seen in US mutual funds: “Emerging market equity funds…posted combined inflows of more than $3 billion for the week ended July 14, while emerging market bond funds took in $745 million, bringing their year-to-date inflows to an all-time high of $18.5 billion.”

Across all sectors, money is pouring into emerging markets at an even faster pace than before the credit crisis. This time around, however, analysts argue that it is justified by fundamentals: “Economies in the developing world are slated to grow 6.3% this year and are expected to maintain a similar growth rate through 2013, according to the International Monetary Fund. Advanced economies are seen expanding around 2.4% annually over the same time period.” The Brazilian economy alone expanded at an annualized rate of 9% in 2010 Q1, the fastest rate in 15 years!

Emerging market investors share the confidence of foreign investors, and it seems the flow of funds will primarily be one-way. According to a recent survey, “Just 19 per cent of Brazilians, 15 per cent of Indians and 11 per cent of Chinese…said they anticipated increasing cross-border investment.”

At this point, the only thing that could derail emerging markets is if investors get too ahead of themselves. According to Citigroup, “Developing-nation shares will rally 20 percent to 25 percent by the end of this year as the world economy avoids a double-dip recession and attractive valuations lure investors.” That would bring share prices past the current level and dangerously close to the pre-credit crisis highs of 2008. The JP Morgan Emerging Market Bond Index (EMBI+) has already shattered its previous record, and given the current spread of only 300 basis points to US Treasuries (which themselves are trading near all-time lows), one has to wonder if investors aren’t at risk of re-entering bubble territory.

If for whatever reason investors get spooked, it could spark the same capital flight that followed the bankruptcy of Lehman Brothers, in which emerging market and commodity currencies alike fell 30-50% over a duration of mere months. While no one is predicting a similar outcome this time around, I think prudence and caution are nonetheless advisable.

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.

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

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

Without exploring this particular pair in detail, in a word, the answer is yes. In 2010, emerging market growth is projected to be higher than in the industrialized world. Inflation is relatively stable, and debt levels are comparatively low. Meanwhile, all of the G4 currencies (US Dollar, Euro, Japanese Yen, and British Pound) are plagued by the possibility of Double-Dip recessions and debt crises of varying seriousness. In sum, “Developing nations reduced their foreign debt to 26 percent of GDP last year from 41 percent in 1999, while advanced nations’ debt may surge to 106.7 percent of GDP this year from 78.2 percent in 2007.” Talk about heading in opposite directions!

Investors are taking notice. While the JP Morgan Emerging Market Bond Index (EMBI+) is now rising at annualized rate of 22% (implying a decline in emerging market bond yields), rates on comparable EU and US debt is rising. Last week, the 10-Year Treasury Rate topped 4% for the first time in 18 months (though it has since retreated). Meanwhile, credit default swaps are pricing in a .4% chance of default in the US. Granted, this is still infinitesimal, but anything above 0% would have been derided as ridiculous only a few years ago. This year, the US is projected to spend more on servicing its debt than any other country except for the UK. The projected $1.6 Trillion deficit for 2010 certainly won’t help things.

Thus, emerging markets are projected “to lure $722 billion in overseas investment this year, 66 percent more than in 2009…Developing-nation bond funds attracted $7 billion this year, pushing assets under management to a record $74.7 billion.” Many portfolio managers are betting that this will be a long-term trend: “The rally in emerging-markets has barely started yet.”

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

Forget about Greece: What about the US, Japan, and the UK? Almost 75% of trading in the forex markets involves some combination of the US Dollar, Euro, Japanese Yen, and British Pound. This figure rises to more than 95% when you include trading in which at least one of the currencies (as opposed to both) is one of the aforementioned. In short, these four currencies are by far the most important in forex markets, and most patterns/narratives in forex markets tend to involve them.

It’s simple supply and demand, really. These currencies are the most heavily traded because their economies are the largest and their capital markets are the deepest and most liquid. [The absence of the Chinese Yuan from this list can be explained by the lack of flexibility in its capital controls and exchange rate regime]. When investors flee one of these major currencies, they tend towards one of the others, and vice versa.

This phenomenon has especial relevance in the realm of sovereign debt. While some investors would love no more than to move their capital from the four debt-ridden currencies above, there just isn’t enough supply of alternative currencies to absorb the outflow. The Swiss Franc, Australian Dollar, and Canadian Dollar (#5, 6, & 7 on the list of most traded currencies), for example, have all surged over the last year as investors have looked for stable and liquid alternatives to what can be dubbed the Big-4 currencies. While these currencies still have some room for appreciation, they can’t continue to rise forever. For better or worse, then, the most useful comparison when it comes to to sovereign debt is not between the Big-4 and everything else (aka the major currencies and the emerging market currencies), but rather between the Big-4 themselves.

Forgive me for this long-winded introduction, but I think it’s important to understand the usefulness of comparing Japan with the US with the EU with the UK when all of these economies have terrible fiscal problems, and why we can’t just compare them to fiscally sound economies. With that being said, let the comparison commence!

Most of the fallout from the sovereign debt crisis has affected the EU and the Euro. This is for good reason, since the focal point of the crisis is a member of the Euro (Greece), and several other Eurozone countries are on the periphery. I addressed the EU in a previous post (EU Debt Crisis: Perception is Reality), so I think it makes sense to focus on the others here.

In terms of debt sustainability, the UK is not far behind Greece. “The flood of British debt is likely to ‘lead to inflationary conditions and a depreciating currency,’ lowering the return on bonds. ‘If that view becomes consensus, then at some point the UK may fail to attain escape velocity from its debt trap,’ ” explained one analyst. With high budget deficits projected for at least the next five years,  the Bank of England no longer buying UK bonds, and the possibility that the ucoming elections could produce political stalemate, the fiscal position of the UK can only deteriorate. On the plus side, the average maturity for UK bonds is 13.7 years, twice the OECD average, which means that it could be more than a decade, before Britain really begins to feel the squeeze.

Japan might not be so lucky. Its net debt already exceeds 100% of GDP and its gross debt is approximately 200% of GDP; both are the highest in the OECD. Meanwhile, the average maturity of its debt is only five years, so there isn’t a lot of time to act. According to analysts, the crisis would most likely assume the following form: “ ‘A surge in yields would lead to a combination of extreme fiscal contraction, through tax increases and welfare cuts’…as well as to even more monetary expansion, perhaps less central bank independence and ‘presumably a much weaker exchange rate.’ ” In the case of Japan, the mitigating factor is that 90% of government debt is held domestically. Therefore, Japan isn’t vulnerable to the whims of foreign creditors, and an outright default is unlikely.

Then, there is the US. Its Trillion Dollar budget deficits, and multi-Trillion Dollar national debt and entitlement obligations are the highest in the world in nominal terms. On the other hand, the US government has not really encountered any difficulty in financing its spending. Political opposition is fierce, but investors have lined up to buy Treasury bonds and record low yields. This will likely change as the Fed curtails its purchases, and the economic recovery gives rise to higher interest rates. Analysts expect that borrowing costs (i.e. Treasury yields) could rise more than 1.5% by the end of 2010.

From the standpoint of markets, its impossible to say which economy’s fiscal problems are the most serious, since sovereign debt yields have declined across-the-board over the last 20 years. One Professor of Finance explains this trend as follows: “Behavioral factors keep many bond traders and investors from recognizing the reality of the situation…since there is no well-defined crisis point.” In other words, the crisis in Greece is only a test run. The real one could come in a few years, and involve a much larger economy. At that point, currency traders will have to decide who to back.

By now, most investors are well aware of the acronym BRIC, which stands for the emerging market powerhouses of Brazil / Russia / India / China. When the idea was conceived in 2003, it seemed to make a lot of sense, as these four economies were at the top of the GDP ‘league tables,’ year-after-year. While China, India, and to a lesser-extent, Brazil, all continue to outperform, Russia has begun to lag. Perhaps Russia needs to be replaced as a member of BRIC. If the acronym is to be preserved, the only choices are Romania or Rwanda.

But seriously, last year Russia’s economy declined by 8%, compared to expansions of 6.5% and 8.3% in India and China, respectively. The Ruble fared equally poorly, relatively speaking. Compared to the Brazilian Real, which erased most of its 2008 decline, the Ruble’s rise offset less than half its previous losses. A similar picture can be painted with its. stock market. Not coincidentally, oil/gas prices have followed a similar pattern.

That the fortunes of Russia’s economy are too closely tied to energy exports is only half of the problem. The other half is as much cultural as structural. Russia’s economy is still largely oligarchical, and competition is lacking. Corruption is rampant, and the bureaucracy is out of control. In short, there is “a combination of corruption, poor governance, government interference in the private sector, and insufficient investment in the oil and gas sector,” which makes it unlikely that the Russian economy will embark on a stable course of development anytime soon. “What’s more, the warning signs of more economic trouble ahead are growing — for example, the increasing rate of non-performing loans on Russian banks’ balance sheets.” To put it bluntly, Russia’s economic prospects are somewhere between bleak and pathetic.

What about the Ruble, then? In the long-term, the Central Bank has pledged to shift its monetary policy away from micromanaging the Ruble. For the time being however, it remains focused on keeping the Ruble within a carefully prescribed range. Of course, it’s unclear whether the Central Bank sees its charge as defending the Ruble against a decline or against excessive depreciation, so currency traders shouldn’t read too much into it.

On the surface, the Ruble would seem to represent an excellent candidate for the carry trade. Despite being trimmed 10 times in 2009 alone, the Central Bank’s benchmark interest rate still stands at a healthy 8.75%. Moreover, the Central Bank has basically promised not to cut rates any further from the current record low. Remarkably, though, real interest rates are slightly negative, as Russia’s estimated inflation rate is 8.8%. Even more remarkably, this is the lowest level in decades! In other words, there is no interest too be earned from a Ruble carry trade, and the only upside is the appreciation in the Ruble.

And that ignores the downside risks, which are significant. After Russia defaulted on its debt in 1998, the international financial community basically lost confidence in the Ruble. Now, all of Russia’s government debt is denominated in foreign currency, mainly Dollars and Euros. Russian investors seem to harbor the same suspicions about their currency, and in 2008, the Ruble’s fall became self-fulfilling as investors transferred more than $150 Billion out of Russia, in the fourth quarter alone.

In short, I see very little upside from investing in the Ruble. There is no money to be earned from a Ruble carry trade. Betting on the Russian economy seems misguided. Betting on a continued rise in oil and gas prices would be better achieved by buying oil and gas futures directly. Meanwhile, any hiccup in the global economic recovery will certainly be met with an exodus of capital from Russia. Stick to the BIC countries instead.

With so much to think about these days, I havn’t spent much time poring over foreign exchange reserve statistics. Apparently, this is to my detriment, as there have been a number of important developments on this front, some of which carry far-reaching forex implications.

I’m guessing a lot of you are probably in the same boat as me, wondering why forex reserves are worth paying any attention to. While busy looking at complex charts and GDP/inflation statistics, however, we forget that a currency’s value is fundamentally determined by supply and demand. In other words, while bullish/bearish indicators and interest rates are the proximal factors behind forex, the supply/demand dynamic is the ultimate factor. And Central Banks, collectively, comprise one of the largest contingents behind this supply/demand.

As I was saying, this equilibrium is currently undergoing a seismic shift. Specifically, “The dollar’s share in official foreign exchange reserves in 140 countries has fallen to its lowest level since euro cash was introduced in 2002, according to the IMF.” The Euro, Yen, and “other currencies” (i.e. minor currencies that are collectively important but individually unimportant), meanwhile, have seen increased interest from Central Banks. This is consistent with another report I saw recently, enunciating that,”Global reserves probably gained by about $180 billion in the third quarter with U.S. dollar-denominated reserves accounting for about $50 billion or less than 30 percent.”

This came as a shock to many market observers, who assumed that many economies lacked either the capacity or the impetus to diversify their reserves, especially since many of them peg their currencies to the Dollar. These countries are savvier than they used to be, however: “Emerging market central banks are selling their local currencies and buying U.S. dollars to prevent appreciation of their currencies. They’re avoiding having a bigger concentration of U.S. dollars in their portfolio by turning around and selling dollars against the euro and other currencies.”

Even industrialized countries, whose forex reserves are dwarfed by their emerging market counterparts, are jumping into diversification. After a nearly 10-year hiatus, Canada will jump back into the forex reserve game, by $1 Billion in foreign currency bonds, denominated in Euros. According to one analyst, “This…should be viewed in the context of the entire developed world, which is in the process of generally ramping up the size of its foreign reserves, and subtly shifting away from USD.”

The wild card is China. I use the term wild card both because China’s forex reserves are the world’s largest (recently confirmed at $2.4 Trillion) and hence whatever it decides will have major implications, and because it does not report the specific composition of its reserves to the IMF, so it’s unclear how it’s outlook is changing from month to month. Plus, it offers only vague indications of its intentions, so all we can do is speculate.

But speculate we will! While China has publicly maintained its support for the Dollar, quasi-publicly, there is an abundance of concern. This has most recently manifested itself in the form of internal calls for China to use its hoard of reserves to buy natural resources abroad. This wouldn’t necessary involve large-scale selling of its Dollar-denominated assets – since most oil contracts, for example, are still settled in Dollars – but would certainly involve shedding some of them.

As for why Central Banks are dumping Dollars (or simply choosing not to accumulate more of them), that seems pretty obvious. Even ignoring the Dollar’s problems, a well-balanced portfolio is an exercise in risk management. Especially now that many of the Dollar’s rivals are as liquid and as stable as the Greenback, itself, it makes little sense to put all one’s eggs in one basket.

In some ways, 2009 was a wild year in forex markets. Compared to 2008, however, it was relatively tame. And that is all I have to say about forex in 2009.

Ah, if only it were that simple…

The year began as a continuation of 2008. Global capital markets were still in the throes of the credit crisis, and risk aversion was in vogue. Investors continued to remove funds en masse from virtually every economy – with an emphasis on emerging markets – and parked the proceeds in the US. More specifically, they put the proceeds in US Treasury securities. US corporate bonds and equities declined, as did interest rates, to such an extent that short-term rates briefly dipped below zero.

As this trend gathered momentum, the Dollar continued its rally against virtually every currency, with the notable exceptions of the Swiss Franc and Japanese Yen. For reasons related both to the unwinding of the Japanese Yen carry trade and the bizarre perception that Japan was also a safe haven against the storm of the financial recession, despite the fact that its economy contracted by the largest amount of perhaps any economy due to its reliance on exports. Against other currencies, the Dollar was nothing short of brilliant, surging 30% against many emerging market currencies, and 50% against the Korean Won, from trough to peak. Some analysts predicted that it was only a matter of time before the Dollar reached parity with the Euro.

But it wasn’t to be, as the Dollar never topped $1.25 against its chief rival. The markets pulled an abrupt about-face in March, and began a rally that would last 8 months (and might still be in progress, depending on who you talk to). The S&P 500 rose by more than 50%, impressive, but still paling in comparison to emerging market equity prices. As investors grew more and more comfortable with risk, they reversed the flow of funds, and bond spreads between the US and the rest of the world gradually declined. More importantly, so did volatility. For the forex markets, that meant a rapid appreciation in every single currency against the Dollar.

Around the same time, the Swiss National Bank (SNB) intervened for the first time (it would intervene again in June) in forex markets, ostensibly to guard against deflation. As a result, the Swiss Franc has largely been exempted from the forex rally which sent the Euro up 15%, the Brazilian Real up 35%, and the Australian and Canadian Dollars back towards parity with the the US Dollar.

After a modest rally, the British Pound stabilized around pre-bubble levels, due to concerns about the UK’s quantitative easing program (i.e. wholesale money printing), and consequent impact on inflation and the British national debt. Similar concerns have plagued the US Dollar, but interestingly have spared the Euro and Canadian Dollar, despite the fact that their respective Central Banks’ response to the credit crisis have largely mirrored that of the Fed. As a result, the Pound was quickly segregated with the Dollar as a fellow “sick” currency.

By the summer, currencies and asset prices had risen by such an extent that investors began to fear the formation of bubbles. Governments and Central Banks, meanwhile, grew concerned about the potential impact of expensive currencies on their nascent economic recoveries. A handful of Central Banks – many in Asia – intervened successfully to thwart the appreciation of their respective currencies, while Brazil resorted to taxes to try to stem the appreciation of the Real. The Bank of Canada threatened intervention, while the Bank of Japan was more ambiguous; investors ultimately shrugged off both, and the Japanese Yen touched an all-time high against the Dollar in November.

Towards the end of the year, the rally began to lose steam as investors began to fret that they had gotten ahead of themselves. In addition, the prospect of interest rate hikes was moved to the fore, thanks to early action by the Bank of Australia. While it’s clear that the Fed won’t be moving to tighten monetary policy anytime soon, investors have been forced to re-evaluate their short-Dollar carry trade positions within this context.

Meanwhile, a handful of credit market scares, first involving Dubai, and later, a handful of EU member countries, reminded investors that the recovery was both fragile and unequal. As a result of the renewed focus on fundamentals, commodity currencies and currencies backed by strong economic growth projections, continued to appreciate. The Dollar, despite comparatively weak fundamentals, also appreciated, due to its safe-haven appeal and perceptions that the Fed would be among the earliest Central Banks in the industrialized world to hike rates. Ironically, forex markets ended the year ironically just as they began (though for different reasons), with the Dollar in the ascendancy.

While the Indian Rupee has risen more than 10%, since bottoming in March, it has increased only 4.3% in value in the year-to-date. Still, given how turbulent the first few months of 2009 were (a continuation of 2008, really), this modest appreciation was actually the third highest, among Asian currencies, behind only the Indonesian Rupiah and Korean Won.

For those of you that don’t regularly follow the Rupee (to be fair, I probably fall into this category), it has basically ebbed and flowed over the last couple years in accordance with risk appetite, hardly breaking ranks with other emerging market currencies. It rose to record highs in 2007, only to lose 30% of its value in 2008 as the credit crisis exploded. In 2009, as I pointed out above, it has staged a modest recovery, as investors have hungrily poured money back into emerging markets.

In fact, the benchmark Indian stock market index has risen 79% this year, its best performance since 1991. The bond market has also been performing well, thanks to a recent upgrade by Moody’s of the government’s sovereign local currency debt. “Moody’s said the move reflects ‘increasing evidence that the Indian economy has demonstrated its resilience to the global crisis and is expected to resume a high growth path with its underlying credit metrics relatively intact.’ ” As a result, foreign capital, some of which is bound to be speculative, is pouring into India. $100 million a day is being plowed into Indian stocks by foreign funds.

Analysts remain extremely optimistic about near-term prospects of India, partly because of its association with China (termed “Chindia.”) “India’s exports climbed in November for the first time in 14 months after sliding an average 21 percent since October 200…Overseas shipments rose 18 percent to $13.3 billion from a year earlier.” The result is blazing GDP growth, clocked at 7.9% in the recent quarter. Interest rates are already a healthy 3.25%, and can be expected to rise in the near-term as the economic recovery continues to cement itself.

Certain risks remain, namely that the government is spending money like there’s no tomorrow. It will borrow the equivalent of $100 Billion this year to finance a record budget deficit, equal to 6.8% of GDP. Compared to other economies, however, this is hardly remarkable, which is why India’s sovereign credit rating was upgraded despite the rising debt. “Moody’s said the government’s debt trajectory was stable and the government had high debt financing capability.”

Going forward, forex traders are relatively conservative in their forecasts for the Rupee, with consensus estimates for the currency to remain relatively flat during the course of the next year. This is surprising, given that it remains well off of its 2007 highs and thus, relatively cheap. Perhaps, its a sign that investors are nervous about the Indian government’s lack of a coherent long-term plan. Perhaps, it reflects uncertainty about bubbles that are forming in other corners of emerging markets. Probably, it shows that despite all of the progress that was made in 2009 towards containing the credit crisis, investors still remain vigilant, and are hedging their bets accordingly.

More about this next time.

Karl Marx would be pleased…well, maybe not. In any event, the world’s Central Banks are tired of the weak Dollar, and are separately taking matters into their own hands. [Before I continue, I should probably acknowledge the inherent dangers of lumping every Central Bank together under one umbrella. Still, given the current market environment, and the fact that all Central Banks are acting uni-directionally, it seems like a fair categorization].

As I was saying, Central Banks – especially in the developing world – are extremely unhappy with the Dollar’s continued decline, and with the opposing strength in their respective currencies. Over the last year, these Central Banks have waded into the forex markets, one after another, in a non-concerted effort to stem the gains in their currencies. As the Dollar’s decline has gained new momentum, so have they redoubled and intensified their efforts.

In the last couple weeks alone, at least a dozen (and these are only the ones on my radar screen) have issued threats and/or taken action aimed directly at the “speculators,” which are blamed for the across-the-board rise in emerging market currencies and asset prices. Their concerns are twofold: that currency appreciation could choke off economic recovery, and that speculative investment is driving the creation of new asset price bubbles.

While their goals are largely the same, their tactics differ. Some are testing the old approach of simply buying Dollars on the spot market. Thailand, Israel, South Korea, Philipines, and Russia, for example, are now intervening heavily on a regular basis. “Experts estimate that some of the largest emerging economies may have spent as much as $150 billion on currency intervention over the past two months, judging from the growth of their international reserves, according to data from Brown Brothers Harriman.”

Other Central Banks have resorted to policy-making measures; Taiwan and Brazil are perhaps the best examples here. The former has essentially banned foreigners from opening new time deposits in the country, while the latter has just imposed a 1.5% tax on investment in Brazilian ADR shares to match the 2% tax on new FDI. In addition, sources claim that other measures are being considered, including “an overseas sovereign bonds issue denominated in Brazilian reals and a change in rules that would allow foreign equities investors to deposit guarantees overseas.”

South Korea and Sri Lanka have been even more creative in restraining their currencies. Sri Lanka is now making it easier for its citizens to take money out of the country, while South Korea is now placing limits on the hedging activities of exporters, who “have sold large amounts of dollars in the forward market to hedge foreign orders, putting upward pressure on the won.”

Still other Banks are still in the “rhetorical” stage of intervention, whereby they simply convey to investors that they are monitoring forex markets for “instability” and “irregularities.” Such code-words are designed to signal that rapid currency appreciation will not be accepted idly. “People see the central bank looking closely at the dollar and think maybe it’s a good time to unwind some of their positions,” explained one analyst in response to “rhetorical intervention” by the Bank of Chile.

Unfortunately for these Central Banks, their efforts are ultimately unlikely to be successful. They can probably succeed in slowing, or even temporarily halting the rise in their respective currencies, but won’t be able to achieve a permanent cessation. That’s because the forces they are fighting against are simply too large ($3 Trillion per day of forex turnover) and too determined (Russian and Brazilian interest rates are both above 8%, compared to 0% in the US) to be stopped. “It’s [intervention] not working, and it’s a good thing that it’s not working. Emerging-market currencies are appreciating and they’re going to keep on appreciating against currencies from the old world. [Central Banks] has to adapt to that,” declared one trader. Still, you can’t blame them for trying.

Almost two months ago, I wrote a series of posts (Dollar Down, Everything Else Up and Dollar Down, Gold Up) with self-explanatory titles. Last week, the Wall Street Journal finally got around to covering this story, and were able to quantify the extent of the trend with the use of statistical analysis. Accordingly, they observed an incredible 71% correlation between the Dollar and the S&P 500, compared to an average correlation of 2%. This implies that every 1% rise in the S&P is matched by a .71% fall in the value of the Dollar, and vice versa.

Furthermore, this trend appears to be both strengthening and spreading. The average correlation between the Dollar and stocks since July is 60%; given that it’s now 71%, this suggests that it was closer to 50% over the summer. In addition, the correlation between stocks and oil has touched 75%, the highest level since 1995. By extension, this implies a proportionately high correlation between the Dollar and gold. In short, the notion that as the Dollar is tanking, virtually every other commodity/asset under the sun is rising, now has some weight behind it.

Understanding the basis for this relationship is not complicated. You can think of it in terms of the Fed’s liquidity program or in terms of the carry trade, but regardless of what you call it, the concept is the same. Basically, the Federal Reserve Bank has printed nearly $2 Trillion as part of its quantitative easing program. For better or worse, most of this money found its way into the markets, rather than into the economy. Investors have been faced with the dilemma of either holding the currency in cash or investing it. (Here, I would argue that “speculate” is a more appropriate descriptor than “invest,” but anyway…) The simultaneous rise in stocks, bonds, emerging market currencies, commodities, and even real estate is proof enough about where that money went.

Stepping outside of forex markets a moment, the fact that all asset prices are rising in unison suggests that a new bubble is forming. Normally, one would expect that in a bull market, some assets would outpace others, but in this case, it seems that fundamentals are being pushed to the backburner, and investors are piling into anything and everything that’s liquid. Even traditional relationships, like that which leads bond prices to fall as stock prices rise seems to have broken down.

Getting back to the Dollar, the fact that bubbles are forming in stocks/bonds/commodities probably means that an inverse bubble is forming under the Dollar. One can draw understanding from last year’s partial collapse of the Yen carry trade, which began to deflate after several reliably strong years. The same could very well happen to the Dollar carry trade.

If and when the Fed raises interest rates, and/or begins to draw the excess liquidity out of the markets by offloading its inventory of securities, well, the markets should witness a simultaneous correction. How violent the correction is depends largely on the degree to which the markets anticipated it as well as the finesse of the Fed. If everybody rushes for the exits at the same time, it could create the same kind of panic that ensued after Lehman Brothers went bankrupt, whereby asset prices collapsed and the markets flooded into the Dollar.

History is never far from repeating itself.