More woes and strikes in Greece and disagreement about ECB policy in German high courts could not discourage the euro from posting four-month highs against the USD. The euro reached its highest point, $1.3346, against the US Dollar since February 20^th. Meanwhile, a lack of a policy statement from the Bank of Japan (BoJ) about the volatility of its equity markets prompted global selloffs in equities. The yen continued its surge against the dollar falling to 95.16 before settling at 95.40, down 0.6 percent on the day.

Currency market trade was light on Wednesday but the concern about Federal Reserve policy outweighed the negative sentiment from Europe and Japan.

Athens in Upheaval

Demonstrations erupted in Athens as unions rallied in support of journalists after the Samaras government unexpectedly shut down the nation’s public television station, ERT, in the middle of the night. The closing of the liberal network eliminated 2,600 jobs including 600 journalists. The Helenic Broadcasting Corporation ETR has been up and running for 75 years.

The beleaguered station only has  a 13 percent viewing rate. Several dismissed journalists continued to occupy the building in protest of the shutdown. The Athens journalistic union ESTEA immediately announced a strike. Thousands of citizens protested in front of the Athens station and then proceeded to march on the capital.

The station was closed as a result of a ministerial decree and surprised many members of the divided Parliament. Prime Minister Samaras’ short reign has been marred by controversy and dissension.

The most recent setback was the revelation that a sale for the national gas company fell through. This failure puts Greece on the verge of default with its bailout commitments. Under terms of the bailout, Greece was obligated to terminate at least 2,000 state employees. The closing of ERT meets that stipulation. However, the government has failed to meet its commitment to liquidate state-held assets.

The closing of the state television network overshadowed more serious problems. MSCI reclassified the country as an emerging market. MSCI stated that the Athens bourse has been to small for a developed economy for the past two years. This could have serious repercussions with funds that have invested in Greek bonds. Optimists believe the reclassification will open up other investment vehicles.

Yields on Greek 10-year bonds nudge above the 10 percent mark when Athens announced failure to sell DEPA, the state gas company. Equity markets traded at two month lows following the reclassification.

MSCI’s world index slipped by 0.13 percent on Wednesday. The Euro STOXX 50 index dropped 0.62 percent to 2,666.52. The euro climbed 0.27 percent.

The yen gains were sparked by the Fed’s perceived slowdown in asset buying and the BoJ’s inference that it will continue its easing program. The markets has expected a pullback by the BoJ.

US equities held on to opening gains despite weak employment data and a slight reduction in 1^st quarter GDP, down from 2.5 to 2.4. The dollar lost ground against a basket of currencies and the euro but remained stable against the yen. Nervous investors have been on edge since Federal Reserve Chairman Ben Bernanke hinted that the Fed was considering tapering down the current easing levels.

Across the pond, euro zone optimism lifted on positive consumer confidence from the region’s five biggest economies; Germany, France, Italy, Spain and the Netherlands. The euro reached a two-week high against the dollar at $1.2974 as analysts are reconsidering the ECB’s potential rate cut.

In overnight trading, the Nikkei had fallen 5 percent to a five- week low. Rumors emerged that Japan’s pension funds were considering investing in equities. The Bank of Japan’s $1.4 trillion quantitative easing has not accomplished the anticipated goals.  Economists are grappling with new solutions. The dollar-yen remains over the 100 threshold.

Housing Surges

S&P/Case Shiller composite index gave more credence to a housing recovery. The index of 50 metropolitan areas showed an increase in average March selling prices of 10.9 percent year-over-year. This marks the largest increase since April 2006 when housing was booming. March house prices rose by 1.1 percent over February.

Confidence in the real estate market also climbed to its highest level in 5 years. Analysts see this as giving legs to the industry’s recovery.

Some of the cities hit hardest by the recession showed strong sales data.

• Phoenix selling prices are up 22.5 percent this year.
• San Francisco residential real estate is up 22.2 percent.
• Las Vegas housing prices are up 20.6 8in 2013.
• Los Angeles housing prices are up 16.6 percent.

Case Shiller’s national index was up 3.9 percent in the first quarter compared to a 2.4 percent gain in the last quarter 2012.

Barclay’s economist, Michael Gapen, told Reuters:

“Low inventories and gradually improving housing demand have combined to push housing starts higher and support home price appreciation.

“We see these factors as remaining in place and expect residential investment to add to GDP growth in the coming quarters. We also expect rising real estate wealth to support household balance sheets and underpin consumption, helping the broader economy to offset a substantial fiscal drag in 2013.”

Unemployment Claims Rise 10,000

Initial claims for state unemployment benefits jumped by 10,000 last week. This caught analysts by surprise but might help the markets as the trend will ensure the Fed stays in the game. Seasonally adjusted unemployment sits at 354,000 as the four-week moving average climbed up 6,750 to 347,250.

The Consumer Board had encouraging news, reporting that consumer attitudes moved up to 76.2 from 69 in April. This marks the Consumer Board’s highest rating since February, 2008.

Consumer spending accounts for two-thirds of the nation’s GDP. However, second quarter consumption has slowed to 2.5 percent from the encouraging 3.2 percent during the first quarter. Consumer perception of the job market also improved.

GDP

The Commerce Department reported that GDP grew by 2.4 percent during the first quarter, revised down from 2.5 percent. GDP concerns are fueled by the inability of Congress to attend to the people’s financial business. First quarter growth was influenced by reduced government spending, down 4.9 percent in the first quarter alone. The full impact of the sequestration has yet to be felt and many analysts believe growth in the second and third quarters will be low. A pickup in the fourth quarter is expected.

Regrettably, increased fuel prices have contributed to first quarter growth. Reduced energy prices in the second quarter will hurt growth unless consumers spend their savings.

Another factor weighing on GDP is the volatile inventory levels. If the inventory component of GDP is excluded, GDP rose at 1.8 percent.

As details of the Memorandum of Understanding (MoU) between government and the “Supreme Savings‘ international lenders” were revealed on Tuesday, markets stepped back to gauge the 10 billion euro bailout. Markets also slowed in anticipation of this week’s updates from the Bank of Japan (BoJ) and the European Central Bank (ECB). Investors are concerned about whether the BoJ will scale down its proposed easing initiative. At the same time, the ECB will need to calm investor fears in the wake of the Cyprus fiasco that cost international investors billions of euros.

One of the big concerns facing the euro zone and the European Union is whether the Cyprus model is the model that could befall Spain and Italy. A general lack of confidence in the EU has led to the paring of the euro. Investors are unclear as to the direction of the BoJ and the USD rose to its highest level in two weeks against the yen.

Cyprus Turnaround Outlined

The MoU leaves little doubt about what the bailout investors, who contributed 10 billion euros to the troubled banking sector, will require of Cyprus. Meanwhile, the former finance minister resigned in anticipation of legal action for his roll as President of the country’s second largest bank, which failed last week.

As if there was not enough disgruntlement on the island nation, Cypriots are now staring at some lofty goals that are likely to impose the similar austerity sanctions other southern tier euro zone neighbors face.

The MoU says Cyprus must attain a four percent of GDP primary surplus by fiscal year 2017. This would a significant turnaround.

Reuters reports there are a number of other goals established by the MoU:

• In 2013, Cyprus will suffer a 395 million euro budget shortfall (2.4 percent of GDP) in 2013.
• This shortfall exceeded the 1.9 percent deficit in 2012.
• In 2014, the deficit will expand further to 678 million euros.
• The MoU expects the deficit to pare down to 344 million (2.1 percent GDP) by 2015.
• In 2016, Cyprus is charged to achieve a primary surplus of 204 million euros (1.2 percent GDP) by 2016.
• By 2017, Cyprus must achieve a 4 percent surplus by 2017.
• Growth in Cyprus will contract by 8 percent this year.
• Growth in Cyprus will contract 3 percent in 2014.
• Growth will finally increase by 1 percent in 2015 and 2016.

In light of these assumptions, Cyprus has much work to do to live up to expectations. The 8 percent paring of GDP suggests a good amount of austerity will be necessary and Cypriots have thus far rejected most EU initiatives.

The MoU states that Cyprus will earn about 1.4 billion euros by selling certain state-owned assets, such as state-owned telecoms. Additionally, Cyprus expects to realize revenue from selling off rights to undersea natural gas deposits, which have been found of the island coastline.

The future of the public sector will be under pressure with new actions taken by government. The banking sector employment is already in turmoil. Now, government has announced that public sector pensions are frozen. The retirement age will be raised by 2 years. New taxes will be imposed upon alcohol, tobacco products and petrol. The VAT will be increased and corporate taxes on earnings and on interests earnings will also rise. Fees for all government services will increase by 17 percent effective immediately.

These measures are designed to ensure that debt in Cyprus is at 100 percent by 2020.

The ECB, BoJ and BoE

Investors are anxiously awaiting results from the three central banks. There are concerns that the BoJ will scale back on its proposed quantitative easing policy.

The ECB is now expected to hold steady on current interest rates. Prior to the Cyprus crisis, it was projected that the EC would raise interest rates.

In England, the BoE is expected to continue its current purchase of asset program without increasing the stimulus. British sterling gave back recent gains in anticipation of the upcoming central bank meeting. It is nervous times on the currency front.

Wednesday morning saw US equity markets climb slightly higher as commodities also rose while the US dollar gave ground to the euro and hit four month lows against the Australian and New Zealand dollar. The USD gained strength against the yen on belief that the Bank of Japan is on the verge of a major quantitative easing initiative.

Fed Chairman Ben Bernanke is expected to announce a continuance of the Fed’s purchase of mortgage-backed securities and to replace a stimulus package that is winding down. The Fed is also expected to keep interest rates at the current, favorable levels.

As markets await the Bernanke announcement, the furor surrounding the fiscal cliff leaves many Americans and international investors wringing their hands in frustration. More importantly, the American consumer is retreating even as equity markets continue to climb. Some analysts predict a selloff in equity markets if Bernanke does not ease investor concerns.

The pressure on the Fed remains strong as doubts about the success of the ongoing Fiscal Cliff negotiations befuddle Americans. IMF President Christine LaGarde, who was not shy about criticizing how the US handled the failure of Lehman Brothers when she was President of France’s Central Bank, has reprimanded Congress for not arriving at a balanced approach to the deficit. The airwaves are filled with what appear to be incompetent and confused members of Congress.

While the Republicans reject the President’s request to act on a standalone bill calling for relief for person earning less than $250,000 per year, Democrats are holding firm on reductions to entitled programs.

The Republicans are in a no-win situation. The result of the decay of the GOP is that Independent ranks are swelling as a group of congressional members, who appear to be oblivious to the fallout the expiration of the Bush Tax cuts will reap on the economy. To many Americans, the presence of Eric Cantor, Paul Ryan and Grover Norquist is what is holding up an agreement. Hopefully, voters will not vote for Norquist pledge signers and the Tea Party will take a hit in the 2014 election as Democrats will gain control of the House and the Senate.

House Speaker John Boehner has aged considerably this week. He is taking criticism within his party and is getting little help from President Obama, who is adamant that he was elected on a ticket to increase taxes on the top 2 percent of the income earners.

Recently Boehner and Obama have had head-to-head discussions. On January 1^st, the tax rate hike caused by the expiration of the Bush Tax cuts is one of several critical issues constituting the Fiscal Cliff. American taxpayers will lose the temporary payroll tax reduction. However there are more than $600 billion in budget cuts that will add thousands of government workers to unemployment list.

Just as Republicans have dug their heels in on tax rate increases, Democrats are just as stubborn about trimming entitlements, Medicare, Social Security and Medicaid. More than 60 percent of Americans support increasing taxes on high income earners while Congress mulls a complete tax reform package. Republicans have proposed a series of revocations concerning tax deductions. The President and many experts agree these deductions may raise revenue but will fall far short of expectations.

Americans want less talk and more work. This is the time for a large scale move that should exceed the Simpson-Bowles deficit reduction plan of $4.6 trillion.

This, according to a hedge fund manager that has decided to cancel all of his fund’s bearish bets on the Japanese Yen. The reason: the yen is rising, and it’s unclear when – or even if – the government will intervene to push it back down. Even though the yen’s strength is fundamentally illogical, it seems that investors are growing increasingly wary of betting against it.

As I pointed out in my previous post on the Yen (“Japanese Yen Strength is Illogical, but Does it Matter?“), the yen has actually fallen over the last twelve months, on a correlation weighted basis (though to be fair, it has staged a pretty impressive comeback since the beginning of April). Unfortunately, investors mainly care about how it is performing against a handful of key currencies, namely the US Dollar. Simply, the yen continues to rise against the dollar, and it is unclear when it will stop.

Japanese government analysis has indeed confirmed that “speculators” are behind the strong yen, as the alleged wide-scale repatriation of yen by Japanese insurance companies has yet to materialize. Of course, there isn’t really much doubt: Japan’s economy is contracting, due to decrease in output spurred by the tsunami. In May, it recorded its second largest monthly trade deficit ever.

Meanwhile, interest rates and bond yields are pathetically low, and the Bank of Japan is being urged to expand its asset buying program, which would theoretically result in a devaluation of the yen. As  a result, retail Japanese forex traders (nicknamed “Mrs. Watanabes“) have resumed shorting the Yen as part of a carry trade strategy.

Alas, speculators either don’t share their pessimism or are running out of patience. While everyone continues to assume that the BOJ will intervene if the Yen rises to 80 against the dollar, no one can be sure whether the line in the sand might not be 78 or even 75. At this point, intervention seems to hinge more on politics than on economics, which means predicting it is beyond the scope of this post. In other words, “There is too much uncertainty and volatility in markets right now to make that yen trade appealing.” And sure enough, the most recent Commitments of Traders data shows that speculators have been re-building their yen long positions over the last month.

In the end, the speculators are probably right. The Bank of Japan has intervened twice over the last twelve months, and the impact has always been short-lived. Besides, given that many speculators still remain committed to shorting the yen, it remains extraordinarily vulnerable to the kind of short squeeze that sent it soaring 5% in a single session en route to the record high it touched in March.

I’m personally still bearish on the yen, but I also think it’s too risky to short it against the dollar, which seems to be declining for its own reasons. As you can see from the chart below, the yen has fallen against virtually every other major currency. Yen shorters, then, might be wise to avoid the dollar altogether and focus instead on any number of other currencies.

Over the last year and increasingly over the last few months, Central Banks around the world have taken center stage in currency markets. First, came the ignition of the currency war and the consequent volley of forex interventions. Then came the prospect of monetary tightening and the unwinding of quantitative easing measures. As if that wasn’t enough to keep them busy, Central Banks have been forced to assume more prominent roles in regulating financial markets and drafting economic policy. With so much to do, perhaps it’s no wonder that Jean-Claude Trichet, head of the ECB, will leave his post at the end of this year!

The currency wars may have subsided, but they haven’t ended. On both a paired and trade-weighted basis, the Dollar is declining rapidly. As a result, emerging market Central Banks are still doing everything they can to protect their respective currencies from rapid appreciation. As I’ve written in earlier posts, most Latin American and Asian Central Banks have already announced targeted strategies, and many intervene in forex markets on a daily basis. If the Japanese Yen continues to appreciate, you can bet the Bank of Japan (perhaps aided by the G7) will quickly jump back in.

You can expect the currency wars to continue until the quantitative easing programs instituted by the G4 are withdrawn. The Fed’s $600 Billion Treasury bond buying program officially ends in June, at which point its balance sheet will near $3 Trillion. The European Central Bank has injected an equally large hunk of cash into the Eurozone economy. Despite inflation that may soon exceed 5%, the Bank of England voted not to sell its cache of QE assets, while the Bank of Japan is actually ratcheting up its program as a result of the earthquake-induced catastrophe. Whether or not this manifests itself in higher inflation, investors have signaled their distaste by bidding up the price of gold to a new record high.

Then there are the prospective rate hikes, cascading across the world. Last week, the European Central Bank became the first in the G4 to hike rates (though market rates have hardly budged). The Reserve Bank of Australia, however, was the first of the majors to hike rates. Since October 2009, it has raised its benchmark by 175 basis points; its 4.75% cash rate is easily the highest in the industrialized world. The Bank of Canada started hiking in June 2010, but has kept its benchmark on hold at 1% since September. The Reserve Bank of New Zealand lowered its benchmark to a record low 2.5% as a result of serious earthquakes and economic weakness.

Going forward, expectations are for all Central Banks to continue (or begin) hiking rates at a gradual pace over the next couple years. If forecasts prove to be accurate, the US Federal Funds Rate will stand around .5% at the beginning of 2012, tied with Switzerland, and ahead of only Japan. The UK Rate will stand slightly above 1%, while the Eurozone and Canadian benchmarks will be closer to 2%. The RBA cash rate should exceed 5%. Rates in emerging markets will probably be even higher, as all four BRIC countries (Russia, Brazil, China, India) should be well into the tightening cycles.

On the one hand, there is reason to believe that the pace of rate hikes will be slower than expected. Economic growth remains tepid across the industrialized world, and Central Banks are wary about spooking their economies with premature rate hikes. Besides, Fed watchers may have learned a lesson as a result of a brief bout of over-excitement in 2010 that ultimately led to nothing. The Economist has reported that, “Markets habitually assign too much weight to the hawks, however. The real power at the Fed rests with its leaders…At present they are sanguine about inflation and worried about unemployment, which means a rate rise this year is unlikely.”  Even the ECB disappointed traders by (deliberately) adopting a soft stance in the press release that accompanied its recent rate hike.

On the other hand, a recent paper published by the Bank for International Settlements (BIS) showed that the markets’ track record of forecasting inflation is weak. As you can see from the chart below, they tend to reflect the general trend in inflation, but underestimate when the direction changes suddenly. (This is perhaps similar to the “fat-tail” problem, whereby extreme aberrations in asset price returns are poorly accounted for in financial models). If you apply this to the current economic environment, it suggests that inflation will probably be much higher-than-expected, and Central Banks will be forced to compensate by hiking rates a faster pace.
Finally, in their newfound roles as economic policymakers, Central Banks are increasingly engaged in macroprudential policy. The Economist reports that, “Central banks and regulators in emerging economies have already imposed a host of measures to cool property prices and capital inflows.” These measures are worth watching because their chief aim is to indirectly reduce inflation. If they are successful, it will limit the need for interest rate hikes and reduce upward pressure on their currencies.

In short, given the enhanced ability of Central Banks to dictate exchange rates, traders with long-term outlooks may need to adjust their strategies accordingly. That means not only knowing who is expected to raise interest rates – as well as when and by how much – but also monitoring the use of their other tools, such as balance sheet expansion, efforts to cool asset price bubbles, and deliberate manipulation of exchange rates.

Over the last three months, the Euro has appreciated 10% against the Dollar and by smaller margins against a handful of other currencies. Over the last twelve months, that figure is closer to 20%. That’s in spite of anemic Eurozone GDP growth, serious fiscal issues, the increasing likelihood of one or more sovereign debt defaults, and a current account deficit to boot. In short, I think it might be time to short the Euro.

There’s very little mystery as to why the Euro is appreciating. In two words: interest rates. Last week, the European Central Bank (ECB) became the first G4 Central Bank to hike its benchmark interest rate. Moreover, it’s expected to raise rates by an additional 100 basis points over the next twelve months. Given that the Bank of England, Bank of Japan, and US Federal Reserve Bank have yet unwind their respective quantitative easing programs, it’s no wonder that futures markets have priced in a healthy interest rate advantage into the Euro well into 2012.

From where I’m sitting, ECB rate hike was fundamentally illogical, and perhaps even counterproductive. Granted, the ECB was created to ensure price stability, and its mandate is less nuanced its counterparts, which are charged also with facilitating employment and GDP growth. Even from this perspective, however, it looks like the ECB jumped the gun. Inflation in the EU is a moderate 2.7%, which is among the lowest in the world. Other Central Banks have taken note of rising inflation, but only the ECB feels compelled enough to preemptively address it. In addition, GDP growth is a paltry .3% across the EU, and is in fact negative in Greece, Ireland, and Portugal. As if the rate hike wasn’t bad enough, all three countries must contend with a hike in their already stratospheric borrowing costs, ironically making default more likely. Talk about not seeing the forest for the trees!

If the rumors are true, Portugal will soon become the third country to receive a bailout from the EU. (It should be noted that as recently as November, Portugal insisted that it was just fine and that a bailout wasn’t necessary). Its sovereign credit rating is now three notches above junk status. Today, Greece became the first Eurozone country to be awarded this dubious distinction, and Ireland is now only one downgrade away from suffering the same fate. Of course, Spain insists that it is just fine and denies the possibility of a bailout. At this point, though, does it have any credibility? Based on rising credit default swap rates (which serve as a gauge of the probability of default), I think that investors have become a little more cynical about taking governments at face value.

I have discussed the fiscal woes of the Eurozone in previous posts, and don’t want to dwell on them here. For now, I’d only like to add a footnote on the extent to which their problems are intertwined.  Banks in Germany and France (as well as the rest of the EU) have tremendous balance sheet exposure to PIGS’ sovereign debt, which means that any default would multiply across the Eurozone in the form of bank failures. (You can see from the chart below that the exposure of the US is small, relative to GDP).

Some analysts insist that all of this has already been priced into the Euro. Citigroup Said, “The market is treating many of these [sovereign credit rating] downgrades as rearguard actions which are already well discounted.” Personally, I don’t think that forex markets have made a sincere effort to grapple with the possibility of default, which appears increasingly inevitable. In fact, when S&P issued a warning on the US AAA rating, traders responded by handing the Euro its worst intraday decline in 2011.

Anyway you cut it, I think the Euro is overvalued. Regardless of what the ECB is doing, market interest rates don’t really confer much benefit from holding Euros. Even if the rate differential widens to 1-2% over the next year (which is certainly not guaranteed, as Jean-Claude Trichet himself has conceded!) this isn’t really enough to compensate for the possibility of default or other risk event. Regardless of whether you want to be long or short risk, there isn’t much to be gained at the moment from holding the Euro.

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.

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.

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.