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Currency Manipulation Questioned At G-7


As an anxious world awaits President Obama’s State of The Union address, a bitter game of cat and mouse seems to be circulating global currency markets. At the center of the controversy is Japan’s yen causing the Group of Seven nations to call for cessation of devaluing of currencies to gain trade advantages.

Of late, currency markets have been volatile. As the USD has given ground to the euro, the euro has also soared against the yen. The euro has gained 24 percent against the yen in just three months. China has long been accused of manipulating its currency and international tensions are high.

Mario Draghi of the ECB spoke on Tuesday saying that exchange rates are equally important for growth and stability. Japan has implemented a large quantitative easing initiative that has lowered the US policy of continuing assistance from the Federal Reserve have kept the two currencies at low levels.

The US has made headway in its trade balance in the past two months with December closing the imbalance to its lowest level since the mid 1990’s. China also rode a strong export balance to its main buyers the US and Europe to a big spike in its January GDP.

Draghi said that he believes Spain is “on the right track” towards economic recovery. Meanwhile, Italy captured a significant windfall from its 2012 property tax enforcement. Italy collected 23.7 billion euros in property taxes, surpassing Treasury’s estimate by 1.2 billion euros.

It is expected that the windfall will be used to reduce the nation’s budget deficit below 3 percent of 2012 GDP. The target was 2.6 percent but analysts think that bar will not be achieved even with the windfall. The 2012 annual review will be published on march 1, 2013.

The US, Britain, France, Germany, Japan, Canada and Italy, the member nations of the G-7, was called to consider Tokyo’s expansive monetary policy. Reuters quoted a spokesperson for the G-7 as saying; “The G7 statement signaled concern about excess moves in the yen. The G7 is concerned about unilateral guidance on the yen. Japan will be in the spotlight at the G20 in Moscow this weekend.”

The G20 finance ministers are scheduled to convene in Moscow this weekend. It is a full plate this time around and currency valuations will be at the fore.

Britain heads the G-8 which includes the G-7 nations and Russia and released a statement saying that as far as Britain’s easing and restructuring: “We reaffirm that our fiscal and monetary policies have been and will remain oriented towards meeting our respective domestic objectives using domestic instruments, and that we will not target exchange rates.” This is the intent of easing to assist national economies meet oppressive challenges.

Japan’s Finance Minister, Taro Aso, insists that the country’s policy is aimed at reviving the stagnant economy. It is unclear what leverage the G-20 has to stabilize the disparities.

Japan gained support for the US when Treasury official Lael Brainard told the media that the US recognized Tokyo as easing efforts as a remedy for the lackluster economy with massive unemployment.

Regarding the euro, France has been most vocal about setting a large for the currency that does not yield a competitive edge. Many euro members have concerns about the exchange rate but Germany lowered the anchor on such speculation. Finance minister Wolfgang Schaeuble said, “There’s no foreign exchange problem in Europe. There are concerns that there could be something like this in other parts of the world.”

Since December 2012, the euro has climbed 10 cents against the USD. This is the effect of the ECB tightening its balance sheet while Japan and the US continue to expand their easing programs.

Analysts hope that the President’s State of the Union will pave the way for a political compromise to reduce the deficit in reasonable terms and engage the public sector in a powerful growth initiative.

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Euro Zone Supranational After Greece and Spain?


One day after Greece’s Prime Minister, Antonis Samaras, announced that Greece was in a Great Depression similar to the US depression of the 1930’s, fears that Spain would need a full scale government bailout, sent the euro spiraling down.  At one point Monday, the euro touched the 1.2073USD mark before settling at 1.2118USD, the lowest mark in more than two-years.  Samaras projected that Greece’s GDP will shrink another 20 percent before year’s end.

The Prime Minister spoke two days before a team of international lenders are expected to meet in Athens to discuss a last gasp attempt to avoid an unstructured default. Under the terms of the country’s bailout agreement, Greece must reduce its budget deficit to 3 percent of GDP by the conclusion of 2014. By today’s standards, that translates to additional cuts and/or tax increases amounting to 12 billion euros. Currently, Greece’s debt is 9.3 percent of GDP.

Adding to the instability of the country, the IMF appears to be pulling back from negotiations. The IMF’s resistance is based on Greece’s inability to meet already agreed upon terms. Germany economy minister, Phillip Roseler, reiterated Germany’s hard line that Greece could receive no further bailout funds until promised obligations were met.

Former President Bill Clinton met with Samaras on Sunday and told reporters that Greece’s financial planners were making a mistake on focusing strictly on austerity. He recommended that Greece continue to pursue privatization of state-owned assets and new pro-growth initiatives to get the workforce back to work.

Greece’s woes have been predictable, but the rain of bad news from Spain fueled the fire for euro zone doubters. With a bank bailout in hand, Greece appears to need what many analysts have said all along, a massive sovereign bailout. Spain was late to arrive at the bailout table and the delays have proved very costly. Spain’s ten-year bonds topped 7 percent today and the country finds itself embroiled in controversy.

Spain’s provincial governments are strapped for operating funds. Valencia has already applied to the government for assistance and Murcia appears ready to apply for aid. Estimates for the magnitude of the government bailout are in the range of 100 billion euros. If the euro zone bailout in Greece continues and if Spain is granted the already agreed-upon bank bailout and the new funds for government operations, the European Stability Mechanism will be virtually depleted.

On Saturday the ECB head, Mario Draghi told France’s newspaper that the euro was safe. He suggested that the public was unaware of the political capital expended on preserving the euro. Draghi added that the ECB had no weapons left. As he has said for months, it is time for the euro zone members to rise to the fore.

Draghi referred to the creation of “supranational bodies.” The euro zone and the euro may survive but there are no guarantees for Greece and Spain.

 

 

 

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Debt Deal – Everybody Loses


After the Senate passed the exhausting debt ceiling extension by a majority of 74 – 29, angry and disillusioned Americans have emerged from the process.  A Washington Post survey asked taxpayers how they felt about the debt ceiling debate.  The immediate response from the majority of those interviewed was “ridiculous.”  The next two most popular responses were “disgusting” and “stupid.”

In 2010, voters made it clear that they were disenchanted with the House and with the Senate.  Americans empowered Tea Party candidates who promoted fiscal responsibility and shrinking the size of government.

The Tea Party’s no compromise position placed the country’s credit rating at stake and clearly established a component of the Republican Party that is far right and most likely to vote “no” on all legislation.  More than representing taxpayers, Tea Party activists have preventing Obama a second term is their primary goal.  That may well come at the expense of the needy and seniors.

This particular Congress has proven to be the least effective Congress in history.  As the country tackles a huge jobs problem and a double dip in the housing industry, this Congress has only passed 60 of 260 legislative bills.

After a first hand look at the scene in Washington, the American taxpayers on Main Street witnessed the dysfunction that the Tea Party has created.  The most promising solution to the debt ceiling increase and budget deficit gap was structured by House Speaker John Boehner and President Obama. 

As happened to Boehner on at least three occasions, when he took the plan to his caucus, the unified Tea Party said no.  After each setback, Boehner launched torrents of aggressive language criticizing the President.

In truth, Boehner painted himself into a corner and he found his Speakership threatened by the Tea Party that had more control over the caucus than the Speaker.  On Tuesday before the Senate voted, Boehner continued his assault saying that dealing with the White House was like dealing with a bowl of jell.  Actually, Boehner was describing his own dilemma.

No Winners

There are no political winners in this legislation that passed the Senate at the 11th hour.  Fiscally, this bill does not satisfy the left or the right.  While the Republicans gained a compromise that there would be no revenue increases, the ace in the hole is held by Obama.  If he is re-elected, the President is certainly not going to approve an extension of the Bush tax cuts, which Republicans hold as the Holy Grail for job creation. Unfortunately, the Republican position is not valid. The Bush tax cut benefactors and “job creators” were nowhere to be found when the recession spiked.

Bush and his Republican cohorts turned Bill Clinton’s government surplus into a massive deficit that Obama has increased.  Federal Reserve Chairman Ben Bernanke is a scholar of the Great Depression.  His philosophy is that the government must spend its way out of the recession.

Bernanke and Obama are both under heavy criticism because while they spent plenty, they failed to create jobs.  Combined with the fact that there is no jobs program on the table now, Main Street is on the verge of large protest groups. 

The debt ceiling argument left most Americans wondering what the three-ring circus would do next.  Republicans attacked Obama about the jobs situation but offered no solutions as they once again held the President hostage.

The first time Obama was under the gun was in December.  At that time, Republicans declined to pass legislation to pay unemployment benefits to 7 million Americans unless the President approved the extension of the Bush tax cuts. 

On Main Street, the popular sentiment is that this is no way to run a business and certainly no way to manage the world’s biggest economy. 

Credit Downgrade

Immediately after the passage of the legislation, Treasury Secretary Timothy Geithner was scrambling to try to convince credit agencies that this plan was merely the beginning of serious efforts to trim spending.  By 2:00 p.m. only Standard and Poor’s was the last holdout to give the country a break.

While the bill details $2 trillion in spending cuts over the next ten years, the most important component is the establishment of a bi-partisan committee to recommend a deficit reduction package by late November.  Given the reality that there is now a three party system in Washington, this will be a challenging undertaking.

There is reasonable doubt that a committee can accomplish anything approaching the scope of the Simpson Bowles plan or the Gang of Six program.  Of course, this committee is headed for disaster, because Republicans will not support legislation that includes revenue increases and Democrats are determined to protect the middle class and the existing entitlement programs.

The good news for Americans is that the House is on break for thirty days.  The bad news is that when they return they will knock heads again on setting budget allowances for various divisions of government.  The appropriations legislation must be completed by the end of September.

What these vacationing congressmen are likely to face are unnerved voters in their districts.  President Obama expressed it correctly when he made a Rose Garden talk after the Senate vote.  Americans may have voted for divided government but they did not vote for dysfunctional government. Amen!

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Buzz But No Debt Ceiling Resolution


The morning buzz has taken a very different tone since the alarming economic reports and specifically the jobs report from last week.  For President Obama, polls reflect that he has lost the confidence of the voting public in terms of how the economy is being handled.

Politicians are making serious recommendations about both the budget deficit and the pending budget negotiations.  On the financial news stations, the private sector is bravely stressing the importance of extending the federal debt ceiling and then attacking the debt crises in the budget negotiations.

Washington is sick and the world is taking notes.

Just two weeks ago, Obama seemed on the right track with voters.  His success with Bin Laden and with three solid months of private sector job growth, made Obama’s ratings numbers soar and in fact discouraged many Republican possible candidates for moving ahead for the 2012 elections.

In one poll, the American public placed jobs ahead of the ongoing debt crises in terms of priorities.  Economists take a very different view.  The global markets are edgy about the inability of Congress to increase the debt ceiling.

With Moody’s applying pressure to lawmakers to increase the debt ceiling or watch the U.S. credit rating suffer and with China now sending cautionary signals about the amount of money invested in the U.S. one would think Congress would get the message.

Raising the debt ceiling and setting a budget that accounts for reducing the national debt are separate items.  This is no longer a debate about Medicare, Medicaid, Social Security and Defense sending, this is a debate about integrity and the ability of Congress to honor the nation’s commitments. 

China Expresses Concerns

With Federal Reserve Chairman Ben Bernanke ready to address the media at 3:45 p.m. today, China may well have been sending a message to the U.S.  Guan Tao of the State Administration of Foreign Exchange advised that China should be concerned about the “excessive” holdings in the United States.  Guan Tao expects the U.S. to further weaken the dollar.  The comments were posted on a website and withdrawn shortly thereafter.

“The United States has taken an expansionary fiscal and monetary policy to stimulate economic growth, and the United States may find it hard to resist the policy temptation of weakening the dollar abroad and pushing up inflation abroad,” said Tao.

The federal budget deficit will reach $1.4 trillion this year. The current debt limit is $14.3 trillion.  This condition was caused by a variety of factors but the Federal Reserve has held interest rates near zero and has poured money on key sectors and the ailing real estate market to safe and jump start the economy. 

The People’s Republic Premier Wen Jiabao has publicly called on the U.S. to protect the country’s mammoth holdings in the U. S.  It has been estimated that 70 percent of China’s foreign exchange reserves, about $3.05 trillion, are invested in American assets.  The People’s Republic has begun to diversify its holdings and has been slow to act for fear of causing global alarm.  

The yuan has been criticized for its sustained low value but the country says there is no reason to upgrade the currency.  Internally, China is facing a housing crunch and battling inflation as the economy continues to emerge.  The Central Bank continues to buy U.S. dollars to keep the yuan exchange rate stable.  One advisor to the Bank is call9ing for a deep cut in foreign investment.  At this time, that would be a devastating blow to the U.S.  

The yuan was “depegged” from the U.S. dollar in 2010.  Since that time the yuan has gained 5.33 percent.  This year, the yuan has increased in value by 1.65 percent.

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New Zealand Dollar: Come Back to Earth!


In March, I wondered aloud about whether the New Zealand Dollar might be the most overvalued currency in the world. Since then, it has continued its unlikely ascent, rising 10% on a correlation-weighted basis and 3% against the US Dollar, hitting a 26-year high in the process. While there are signs that the New Zealand economy might be able to withstand an expensive currency, at some point, the chickens must come back to roost.


Surely the expensive kiwi must be wreaking havoc on the New Zealand dollar? “How is New Zealand supposed to rebalance its economy away from consumption, importing, borrowing and asset selling towards investment, production, exporting and asset buying when our currency is headed for record highs?” Wonders one commentator. In fact, exporters are coping just fine, and New Zealand just recorded its highest quarterly trade surplus on record. Never mind that this is due almost entirely to soaring prices for commodities and unflagging demand. In spite of two earthquakes and other related downside factors, the New Zealand economy is nonetheless forecast to grow by 2.3% in 2011.

On the other hand, New Zealand’s current account deficit continues to rise, as foreign investors pour in to New Zealand to make acquisitions, portfolio investment, and loans to the government. New Zealand’s largest dairy conglomerate could soon be sold to Chinese investors, while China’s sovereign wealth fund (which manages a portion of the country’s sprawling forex reserves) has announced plans to purchase a big chunk of New Zealand government debt. This is just as well, since a record 2011 budget deficit will require a significant issuance of new debt.

Meanwhile, New Zealand price inflation is currently 4.5%, which means that the country’s real interest rate is -2%, certainly among the lowest in the world. Moreover, even as two-year inflation expectations tick up, rate hike expectations remain unchanged. The consensus is that the Reserve Bank of New Zealand will avoid hiking its benchmark until the first quarter of 2012. Regardless of what happens in the interim, it seems unlikely that Bank president Alan Bollard will give in, for fear of stoking further speculative interest in a currency that is already “undesirably high.”

Let’s review: record low interest rates and record low real interest rates. Record budget deficit. Large current account deficit. Declining expectations for GDP growth. Record high New Zealand Dollar. Does anyone see a contradiction here? It’s no wonder that the IMF recently speculated that the Kiwi might be overvalued by as much as 20%, echoing the sentiments of yours truly.

At the same time, commentators concede that “The New Zealand dollar or any currency can deviate for a long period of time from academic measures of valuation.” And that is why making fundamental bets on currencies is so difficult. Even if all signs point to down (as is basically the case here), a currency can continue rising for many more months, before suffering a massive correction. For what it’s worth, this is the fate that the New Zealand Dollar is resigned to. Whether it will happen tomorrow or next year, alas, will depend more on global macroeconomic factors (such as the ebb and flow of risk aversion) than on what happens in New Zealand.

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Japanese Yen Strength is Illogical, but Does it Matter?


On a correlation-weighted basis, the Japanese Yen has been one of the world’s weakest performing currencies in 2011. Alas, while this information is interesting for theoretical purposes, it is of little concern to traders, who focus instead on individual pairs. Against the dollar (USDJPY), the Japanese yen is still quite strong, having recovered most of the losses inflicted upon it by the coordinated G7 intervention in March. Does the yen deserve such a lofty valuation? No. Will it continue to remain strong as the dollar? Well, that is a different question altogether.

As a fundamental analyst, I am inclined to look at the data before making a determination on whether a particular currency will rise or fall. In this case, the fundamentals underlying the yen are beyond abysmal. The recent release of Q1 GDP showed a 3.7% contraction in GDP. Thanks to an interminable streak of weak growth combined with deflation, Japan’s nominal GDP is incredibly the same as it was in 1996! Based on industrial production, consumption, and other economic indicators – all of which were negatively impacted by the earthquake/tsunami – this trend will undoubtedly continue.

The only force that is keeping Japan’s economy afloat is government spending. While this was a necessary response to anemic growth and natural disaster, it is clearly a double-edged sword. The government’s own (inherently optimistic) forecasts show a budget deficit of 5% in 2015, which doesn’t even include the costs of rebuilding the earthquake region. This will necessitate tax hikes, which will further erode growth, requiring ever more government spending. It seems self-evident that Japan’s national debt will remain the highest in the G7 for the foreseeable future.

From a macro standpoint, there is very little to be gained from investing in Japan. The stock market continues to tank, and bond yields are the lowest in the world. To be fair, years of deflation have made the yen an excellent store of value, but this is hardly of interest to speculator, whose time horizons are usually measured in weeks and months, rather than years and decades.

If not for the yen’s safe haven status, it would and does make an excellent funding currency for the carry trade. Short-term rates are around 0%, and the Bank of Japan (BOJ) has made it clear that this will remain the case at least into 2013. As you can see from the chart above (which mimics a strategy designed to take advantage of interest rate differentials), the carry trade is alive and well. Granted, it has suffered a bit since 2010, due to increased fiscal and financial uncertainty. However, given that the rate gap between high-yielding emerging market currencies and low-yield G7 currencies continues to widen, this strategy should remain viable.

And yet, the Yen continues to rise against the US dollar. It has receded in the last couple weeks, but remains close to the magic level of 80, and it’s not hard to find bullish analysts that expect it to keep rising. They argue that Japanese investors are eschewing risky asset, and that the yen remains an attractive safe haven currency. Not to mention that volatility (aka uncertainty) serves as an effective deterrent to those thinking about shorting it and/or using it as a funding currency for carry trades.

Personally, I’m not so sure that this is the case. If you look at the way the yen has performed against the Swiss Franc, for example, the picture is completely reversed. The Franc has risen 20% against the Yen over the last twelve months, which shows that heads-up, the Yen is hardly the world’s go-to safe haven currency. In addition, you can see from the chart below that on a composite basis, the yen peaked during the height of the financial crisis in 2009, and has since fallen by more than 10%. This shows that its performance in 2011 should be seen as much as dollar weakness as yen strength. Since I’ve spent countless previous posts explaining why I think dollar bearishness is overblown, I won’t revisit that topic here.

In the end, the majority of traders don’t care about this nuance – that the Yen has conformed to fundamental logic and depreciated in the wake of the natural disasters against a basket of currencies – and want to know only whether the yen will rise or fall against the dollar. Even though, I think that shorting the Yen remains an attractive (and as I argued yesterday, comparatively riskless) proposition. Given that the dollar also remains weak, however, traders would be wise to short it against other currencies.

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“Currency Manipulation” Will Continue, Despite G20


Last month, the G20 finally agreed on the specific factors that would be used to determine whether a country was manipulating its currency. Despite being watered-down (by the usual suspects), the so-called “scorecard” is nonetheless extremely substantive. Unfortunately, the resolution will be backed only by “peer pressure,” rather than any kind of real enforcement mechanism, which means that in practice it is basically worthless.
 
While the proximate goal of the resolution is to eliminate exchange rate manipulation, it’s ultimate goal is to minimize the risk of another economic/financial crisis. Towards that end, a country’s “budget deficit levels, the external imbalance and private savings rates” will be closely scrutinized, and will be warned if any of these factors reach levels that are deemed to be unsustainable. The idea is that an early warning system will prevent the global economy from reaching a point of disequilibrium that is so severe that crisis would be impossible to avert.
 
Of course, the problems with this program are manifold. First of all, there are no concrete numbers. For example, it’s not clear how large a country’s national debt or trade deficit has to reach before it receives a phone call and slap on the wrist from the G20. In fact, you could argue that the same imbalances that precipitated the crisis are largely still in place, which means that some countries should have been warned yesterday.
 
Second, there is no meaningful enforcement mechanism. That means that countries that disregard the resolution don’t really have anything to fear, other than the wrath of investors. In other words, if governments and Central Banks know that they can manipulate their exchange rates with impunity, what’s to stop them? Look at Japan: its public debt is the highest in the world. It runs a perennial trade surplus. Its citizens are notorious savers. And yet, when the Yen rose to a record high, which you might expect from such an imbalanced economy, the G7 (in this case) took the unusual step of pushing the Yen down. I’m not saying this wasn’t the right thing to do, but what kind of signal does this send to other rule breakers.
 
While all emerging market countries took an active interest in exchange rates (and seek to exert some control over their currencies), China is certainly Public Enemy #1, and is the clear target of the “currency manipulation” talk. To its credit, the People’s Bank of China (PBOC) has permitted the Chinese Yuan to appreciate 20% against the Dollar (probably 30% when inflation is taken into account) over the last few years. Meanwhile, both internal government statisticians and the IMF expect its current account surplus to narrow to a mere 5% in 2011, as its economy slowly rebalances.
 
In this sense, I think China is a case in point that the best enforcement mechanism is reality. Specifically, China has reached a point where it cannot continue to pursue an economic policy based on exports, without spurring inflation and causing the inefficient allocation of domestic capital (such as in real estate). It must raise interest rates and accept the continued appreciation of the RMB is an unavoidable byproduct.
 
The same goes for other countries that attempt to hold their currencies down. If they can get away with it, then so be it. If not, I can guarantee that it won’t be the G20 that forces them to change.

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The Obama Budget and the Dollar


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


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

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

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


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

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

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

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

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Euro-Watchers Pull About-Face


Only last month, the Euro was on top of the forex markets. Especially relative to its “G4″ competitors (Dollar, Yen, Pound) – all of which are plagued by economic uncertainty and loose monetary policies – the Euro was seen as a smart bet. In the last few weeks, however, the EU sovereign debt crisis resurfaced, and the Euro has plunged, losing 7.5% of its value against the Dollar. As a result, investors have pulled an about-face: instead of banking on the European Central Bank (ECB) to buoy the Euro through monetary restraint, they are now counting on it to hold the Euro together by adopting the same tactics as its counterparts.

Before I explain what I mean here, I’d like to offer an update on the EU fiscal situation. In the last week, there were a handful of developments. First, Ireland accepted a tentative €85 Billion in aid from the EU/IMF, officially joining the ranks of an infamous club that also includes Greece. Still, it wasn’t clear whether such a bailout would also include Irish banks, which are seen as perhaps in deeper trouble than the Irish government. As a result, investors were unmoved, and S&P moved ahead with a cut to Ireland’s sovereign credit rating.

Ireland Public Deficit of GDP

Naturally, rumors began to circulate that Portugal was also preparing a formal bailout request. Said one trader, “In Portugal the kind of language you’re hearing is similar to what you heard in Ireland a few weeks ago.” Despite promises to the contrary, Portugal’s budget deficit has widened in 2010. Interest in its most recent bond issue was healthy, but at the highest interest rate since the Euro was introduced in 1999 and more than .5% higher than last month.

Ultimately, bailouts of Greece, Ireland, and Portugal can be managed. It is a default and/or preemptive rescue of Spain – the other PIGS member – that worries investors. Its economy represents more than 11% of the EU and any hiccup would seriously shake the foundations of the Euro: “It may well be that we are approaching the endgame of this part of the crisis as Spain is of such importance that one can only imagine that the EU will regard it as the line in the sand that cannot be crossed.” While Spain is working hard to cut its budget deficit to a still-stratospheric 9.3% in 2010, investors have balked. As a result, interest rates in its bonds have surged to a post-Euro high (relative to German bonds), and credit default swap spreads (which insure against the risk of default) have risen substantially.

The problem with the EU sovereign debt crisis – like most credit crises, for that matter – is that they tend to be self-fulfilling. As investors begin to doubt the ability of institutions (governmental and otherwise) to service their debts, they naturally demand greater compensation for the (perceived) increase in risk. This further inhibits that institution’s ability to repay its loans, which only makes funding more difficult to attract, and so on.

It is ironic on multiple levels then that even as investors abandon the debt of EU member countries, they are hoping that the ECB steps in to fill the void they create. As I alluded to the title of this post, this marks a stunning about-face from only a few months ago, when the Euro was rising against the Dollar because of the ECB’s commitment to a responsible monetary policy. Nowadays, the Euro rallies only on news that the ECB is maintaining or expanding its intervention. For example, the Irish banking sector is “increasingly more reliant on the ECB funding,” and as a result, “The euro edged up…as the European Central Bank continued buying Portuguese and Irish government bonds.”

Based on this change in investor mentality, it seems unlikely that the Euro will recover its losses anytime soon. Of course, the ECB has nearly unlimited resources at its disposal. German central bank chief Axel Weber declared confidently that, “An attack on the euro has no chance of succeeding.” However, the ECB can never hope to fully supplant the important role played by private capital, and besides, “What we are experiencing at present is not a speculative attack but a justified depreciation due to unsolved problems.”

Euro Dollar chart December 2010

There are still plenty of optimists who believe that the fear will soon die down and that higher interest rates will attract some of the yield-hungry investors that are currently focused on emerging markets. Goldman Sachs forecast “the euro will rise to $1.50 by year-end 2011 as big economies in the area continue expanding.”

I think the most realistic assessment is somewhere in between. On the one hand, it seems unlikely that the Spain will default on its debt at anytime in the near future or that the Euro will cease to exist. On the other hand, the fact that investors now see the ECB as a savior for following in the footsteps of the Fed implies that there is no reason for investors to buy the Euro against the US Dollar.

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Forex Volatility to Remain High


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.

5 Year Forex Currency Volatility Chart
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.

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