Tag Archive | "Central Banks"

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CAD Retail Sales Bucking Growth Trend?

Countering previous notions of “above trend” growth, Canadian retail sales figures were released to the downside during the session.  Disappointing expectations of a 0.1% advance, retail sales figures actually fell by 0.4% in June.  The ex-auto figure additionally dropped by 0.4% in the month and countered a 0.2% gain in the prior month, according to Statistics Canada.

Now, although today’s release is likely to be taken with a grain of salt by some, there are some negative takeaways from the report.  Upon initial review, the monthly report could be considered a one off or isolated incident.  However, the indication of weaker consumer demand for the month falls in line with other more pessimistic surveys in key areas like building permits, wholesale activity and especially employment.  Specifically reviewing the report, notable declines in household spending led the way in pushing final survey findings lower.  Department store sales dipped by almost 3%, while gasoline stations witnessed a 1.3% dip in receipts.  This means that consumers are pulling back on spending, usually at a time when consumption should be higher.  Growing economy should equal growing sales.

Unfortunately, the bevy of dour data is counteracting previous statements and forecasts by policymakers at the Bank of Canada.  In an interview earlier this month, BOC Governor Mark Carney noted that the world’s tenth largest economy was “firing on all cylinders” and that a withdrawal of stimulus may be needed.  To market participants, this translated into an increase in benchmark interest rates.  For the record, prior to the report, expectations remained in the slightly above 40% range that Carney and company were set to increase rates by 25 basis points in the first quarter of next year.  This is compared to other central banks in Asia and the US, which are still searching for ways to increase monetary stimulus in their respective economies. However, questions now remain as to whether or not the Canadian economy truly is churning higher at a sustainable rate – and whether a rate increase is really necessary.

The surfacing notion should make things a bit choppy for the USDCAD pair in the short term, even though the overall bearish trend continues to remain intact.  The USDCAD major pair jumped on the announcement of the report, rising through 0.9910 resistance established overnight – recently bouncing from support via the 0.9850 figure.

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South Korean Inflation Likely To Boost Bank Cuts

With Statistics Korea showing price inflation in the South Korean economy declining to the slowest pace in more than a decade, it all but confirms that the Bank of Korea’s next move will be a rate cut.  According to statistical data, annualized price increases slowed to 1.5%.  On a month over month comparison, the measure actually showed a decline of 0.2%.

Now by itself, the figure is rather shocking.  The slowdown follows an annualized pace of 2.2% in the prior month, and is below forecasts of 2.0%.  But when combined with additional economic data, the report is downright pessimistic and confirms that Asia’s fourth largest economy is set to slow down even further in the coming quarters.  The sentiment is in line with sentiment shared by the BoK’s Governor Kim Choong Soo.  Last month, Governor Kim noted that the pace of expansion in the economy was placing current forecasts for a 3% pace of growth in jeopardy.  The announcement prompted downward revisions in Korea’s forecasted annualized growth.

Further evidence of a slowdown can be seen in recent export reports that show the steepest decline in South Korean exports since the depth of the global financial crisis, and manufacturers’ confidence that remains severely depressed.

The recent spate of data leaves plenty of room for Bank of Korea policymakers in readjusting the benchmark rate lower, especially when the sentiment is in line with other regional central banks.  The People’s Bank of China is expected to issue at least two more rounds of rate cuts, in addition to further monetary easing, with Japanese counterparts siding with further asset purchase plans.

Ultimately, rate cuts would help to boost morale in the economy and the South Korean won.  Looser monetary policy would help to ensure the competitiveness of South Korean manufacturers and help to buttress a domestic consumer base that is suffering under amassed credit loans.  In addition, even with a forecasted rate cut of 25 basis points, yields in the Asian economy remain higher by 250 basis points.  This will keep trader and investor interest in the currency piqued, especially dollar holders, at least for now.


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BoE, ECB and The People’s Bank Act

In response to data suggesting a global slowdown, the Bank of England, the People’s Bank of China and the European Central Bank made conventional moves to attempt to breathe life into staggering markets.  The People’s Bank lowered its interest rate by 31 basis points to 6 percent.  The ECB trimmed rates to 0.75 percent, a historic low. The Bank of England left its interest rate at 0.50 percent but announced, the bank would begin another round of quantitative easing.

Britain is expected to print 50 billion pounds and use the funds to purchase distressed assets.  Previously, the Bank of England used quantitative easing to flood the market with 325 billion pounds.  Flooded with negative economic data, the ECB vowed to maintain their interest rate but stopped short of investing in upcoming bond markets or putting any cohesive remedies on the table.

ECB president Mario Draghi has continually stressed the need for a comprehensive overhaul of the euro zone debt crisis. Draghi appeared to be delivering a call to unified action to euro zone members. At this time, the ECB has no plans to revisit national bond markets.

Draghi’s frustration with the euro zone’s unwillingness to put a long-term program in place has come to a head.  On Thursday, Draghi told the media that new information pointed to deepening financial difficulties in the region. “We see now a weakening basically of growth in the whole of the euro zone including the country or the countries that had not experienced that before.”

Draghi emphasized that it is not just the southern tier of the euro zone that has economies fighting recession. The euro zone economies are no longer growing.  Most of the countries are either in recession or are headed there. Draghi appears to favor a combination of growth and more reasonable terms for floundering euro zone members.

The central banks of England and Europe were expected to act but China’s rate-cut surprised analysts.  The People’s Bank lowered rates last month, but in anticipation of next week’s data, the bank acted. It has been projected that China will suffer a six consecutive month of sliding growth.  It is believed that China’s second quarter will show the lowest growth since the collapse of Lehman Brothers.

Bank lending in China has experienced very little demand.  The interest rate decrease is intended to inspire businesses to grow.  The central bank previously lowered the reserve requirement ratio (RRR) to 20 percent.  This move freed more than 1.2 trillion yuan for new lending.  The bank is expected to lower the RRR to 19 percent before year’s end. However, analysts were quick to say that the central bank’s willingness to cut deposit and lending rates is more incentive than the RRR changes.

The People’s Bank launched a massive 4 trillion yuan spending bill in late 2009.  The spending policy has caused large volumes of bad debt that the country’s banks are struggling to retire.  However, it is believed that a continuation of poor economic data will spark some form of quantitative easing, which China has the resources to manage.

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Greece Gets Lifeline

In the world theater of economics, Greece has been center stage or just off curtain for three years.  The world has learned more than they care to know about the euro zone, the European Union and the interactions between the European Central Bank (ECB), the International Monetary Fund (IMF) and the European Stabilization Facility.  All the acronyms have become part of the global lexicon.

Years of tough, rigid negotiations have served to forestall the economic collapse of Greece.  However, while the Greek economy may enjoy a breath of fresh air, the civilian population is in a state of unrest. The one thing the Greek populace and the international community share is a sense of permanency.  It is difficult to feel secure with an economy where the optimistic projection is –3.0 percent GDP. 

For the rest of the world, Greece’s relief comes at the expense of the other European Union members and all the private and central banks that hold Greek bonds.  And, there are serious doubts about the euro zone bad boy’s will to continue the aggressive austerity programs that are slated to take an even sharper turn in the next three years.

More than 85.8 percent of private bondholders came to a painful arrangement with Greece.  Losses are estimated to be 75 percent of the investment’s value.  To reign in most of the unhappy private investors, Greece triggered payments on default insurance contracts through legislative actions.   

The International Swaps and Derivatives (ISDA) acknowledged the action supported by the Europe, Middle East Africa (EMEA) Determinations Committee.  The terms of the collective action clauses (CAC) are sufficient to amend the terms of Greek law governing the issuance of Hellenic Bonds.  The trigger of the CAC increases the percentage of investor compliance to more than 95 percent.   In essence, this means bondholders must accept payment terms offered by Greece.

For Greece this action limits their exposure on the default swaps to $3.16 billion.  The actual amount paid could be significantly lower as participants will not get full refund of their principal investments.  ISDA classifies this action as a “credit event.”

The credit event has left most public and private investors feeling bitter.  The bitterness is also apparent every hour of every day in Athens.  The investors who ended up facing the bleak reality that the bailout had to happen feel the Greece may very well retreat from the austerity measures that saved the country from complete collapse.

There is reason to be concerned.  With new elections scheduled for April, Germany and a host of other euro zone members fear that a new regime will be under great pressure to maintain compliance.

However, the larger concern is what will happen next to Portugal, Spain and Ireland.  All along, the leaders of the euro zone nations have maintained there would be no contagion.  Portugal, Ireland and Spain have worked in earnest to reduce spending and trim deficits.  While the countries have progressed, it is neither quick enough nor deep enough to enable the countries to meet their obligations.  Ireland has already requested more bailout funds.

The ratings agency Fitch lowered Greece’s rating to restricted default.  Fitch was the only holdout of the big three ratings agency.  After the press release confirming the credit event, markets reacted passively. The news was expected.  However, the likelihood of more euro zone defaults will now weigh on investors. 

As for Greece, there was light demand for 10-year bonds; even with 20 percent yields. Portugal’s bonds are now yielding between 11 and 14 percent.  If we look back at the start of the euro zone crisis, the underlying reason for engaging Greece’s debt was to prevent contagion.  That mission has failed.

Compare this to the US bank bailout initiative and there are striking differences.  One component of the banking bailout was that when the financial institutions accepted the funds, the government took a seat at the board meetings and has a voice.  This process was designed to protect the People’s money.  Most of the big banks could not wait to get the federal government out of their boardrooms so they repaid the debt as quickly as possible.

The US is just beginning to see some sustainable upward momentum but it is tenuous at best.  On the other hand, Greece has been in recession for five years. Most members of the euro zone are also in recession.  As the US is learning slowly and painfully, the two primary key ingredients for recovery are employment increases and GDP growth.  Unemployment is always considered a lagging indicator on the way down to recession but a leading indicator on the way out of recession.  Greece unemployment is at 20% and probably much higher.  A serious look at the data from Greece, Portugal, Spain, Ireland and Italy is sobering. It seems impossible that the euro zone will not be faced with these same issues in the near future.

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Central Banks To The Rescue!

In one of the most productive meetings between G20 finance ministers, central bankers from the European Central Bank, Canada, the UK, Japan, Switzerland and the U.S. agreed to lower the cost of existing dollar swap lines by 50 basis points.  In a surprisingly harmonious unified effort, the central bankers agreed on this strategy to combat the anticipated liquidity crunch.

The cost of these short terms loans will be the Overnight Index Swap (OIS) rate plus 50 points.  The program will be effective December 5, 2011 through February 1, 2013. Prior to this agreement, the short term borrowing rates was the OIS plus 100 points.

The bankers also established a working agreement for bilateral swaps for central banks to draw funds in their own currencies when needed.  This aggressive action is designed to assure global markets liquidity when central banks come under liquidity pressure.

In a joint statement the banks said, “The purpose of these actions is to ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help economic activity.”

The Federal Reserve of the U.S. issued another statement relaying that U.S. banks are not experiencing liquidity issues at this time.  If the U.S. economy turns down, the central bank said it has tools at its disposal that could alleviate a credit freeze.

European Union Weighs In

Late Tuesday night, the financial ministers of the euro zone set aside their political agendas and uniformly faced the banking and sovereign debt crises throughout the euro zone.  Economic and Affairs Commissioner Olli Rehn said, “We are now entering the critical period of 10 days to complete and conclude the crisis response of the European Union.

Germany and France temporarily mended their fences as euro zone ministers came to grips with a plan to leverage the European Financial Stability Fund (EFSF).  Previously, German Chancellor Angela Merkel had rejected this option. 

However, the need for swift and immediate action to curtail the contagion in the region has magnified.  Italy and Spain are paying unsustainable yields and Germany was unable to sell more than 50 percent of its debt in the country’s most recent offering. Apparently Merkel got the message.

It has been two years since the euro zone crisis erupted.  Initially, it was hoped that by bailing out Greece the contagion would be checked.  Euro zone ministers seek more support from the ECB.  Financial ministers want the ECB to aggressively purchase regional bonds.

The finance ministers did not agree to beef up the EFSF.  Instead, they announced that even with successful leveraging of the rescue fund, they would have to ask the IMF for more assistance.

The Japan, the U.S. and several other Asian banks resisted adding funds to the IMF.  The countries will not consider boosting the IMF until the euro zone has exercised all their financial options.  

China Surprises Global Markets

Global markets received China’s policy change that lowered the capital reserves enthusiastically.  The requirement relaxed from 21.5 percent to 21.0 percent.  China’s banks have been required to meet high reserve standards without any easing for the past three years. 

China’s economy is slowing.  Inflation rates remain high.  In response to the euro zone crisis, central banks in China, Brazil, Thailand and Indonesia all agreed to ease monetary policy.

China economic growth has now eased for three consecutive months.  Demand from outside China and tight credit has handcuffed the GDP growth.  Manufacturing declined sharply in November

In Other News

Italy’s new prime minister submitted an austerity plan that the other euro zone members rejected.  Mario Monti was sent back to Rome to expand the cuts.  Italy has committed to a balanced budget by 2013.

The Eurogroup ministers did agree to release the 8 billion euros Greece needs to meet next week’s call.  The payment is the sixth installment of the 110 billon euros promised by the EU and IMF.

Germany formally finalized its authority to review budgets submitted by other nations.  The euro zone’s biggest economy reserves the right to insist upon tighter spending. This was a major consideration in holding the 17-member euro zone together.

The results of this G20 meeting appear a positive step.  Unified and coordinated central banks have taken the first step in stabilizing the euro zone.  However, there is work to do.  In the past, when facing the heavy lifting, the European Union and euro zone have both come up empty.

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Emerging Market Currencies Still Look Good for the Long-Term

In my previous update on emerging market currencies, I wrote that in the short-term, it’s important not to lump them all together; high-yielding currencies must be distinguished from low-yielding ones. In this post, I’m going to backpedal a bit and argue that over the medium-term and long-term, emerging market currencies as an asset class are still a good bet.

Most emerging market central banks have already begun to tighten monetary policy in order to mitigate against runaway inflation, overheating economies, and asset bubbles. You can see from the chart above (where a dark shade of green signifies a higher benchmark interest rate) that the overwhelming majority of high-yielding currencies belong to emerging market economies. (In fact, if not for Australia, it would be possible to say all high-yielding currencies).

While industrialized central banks are also expected to begin tightening, the timetable is much less certain, due to slowing growth, high unemployment, and low inflation. If current trends continue, then, interest rate differentials should only widen further between industrialized currencies and emerging currencies. Without taking risk into account, the most profitable carry trade will involve shorting the lowest-yielding currency against the highest-yielding currency(s). Alas, liquidity must also be taken in account, and the Angolan Kwanza – with an interest rate of 20% – is probably not a viable candidate. As one fund manager summarized, “[If] we feel like it’s a country where if we exit we are sort of going to shoot ourselves in the foot [due to lack of liquidity], then we won’t go in the first place.

Over the long-term, meanwhile, emerging market currencies will receive a boost from two related forces: strong fundamentals and capital inflows. With regard to the former, emerging market economies already account for the lion’s share of global GDP growth. The World Bank projects that over the next 15 years, emerging market economies will collectively expand by 4.7%, compared to 2.3% in the developed world. As a result of this strong growth, combined with fiscal prudence, debt levels across the developing world are generally falling. It marks a significant reversal that none of the current sovereign debt crises involves an emerging market country. What is more amazing is that some emerging market economies (Mexico, Russia, and Brazil) that struggled with bankruptcy less than a decade ago now have investment-grade credit ratings!

As a result, capital flows into emerging markets should continue to surge. Even though emerging market equity and bond funds have witnessed record inflows over the last few years, portfolio allocations still remain extremely low. For example, “U.S. defined-contribution pension plans only have 2.1% of their funds allocated to developing economies, which make up nearly 50% of global GDP.” Emerging market bonds, meanwhile, account for an estimated 1% of total assets under management. This trend will be further reinforced by domestic investors, which will probably opt to keep more capital in-country.

Of course, the risks are manifold. First of all, there is a risk that these capital inflows will provoke a backlash. “Emerging countries have adopted a broad range of measures to regulate inflows and stem currency rises, increasingly resorting to capital controls and so-called macro-prudential measures such as credit curbs.” Now that they have the blessing of the IMF, emerging market currencies might conceivably be more audacious in trying to limit currency appreciation. On a related note, there is also the possibility that emerging market central banks will fall behind the curve, perhaps deliberately. Lower-than-expected interest rates and hyperinflation would certainly dent the attractiveness of going long such currencies.

Finally, it is possible that in all of their excitement, investors are bidding up emerging market assets to bubble levels. The Wall Street Journal recently reported, for instance, that commodity prices and emerging market currency returns have become strongly correlated. Given that many of these countries are in fact net importers of energy and raw materials, this shows that emerging market currencies are rising more in proportion to risk appetite than to economic fundamentals. If when this risk appetite ebbs, then, this could send emerging market currencies crashing.

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Risk Still Dominates Forex. The Dollar as “Safe Haven” is Back!

Well over two years have passed since the collapse of Lehman Brothers and the accompanying climax of the credit crisis. Most economies have emerged from recession, stocks have recovered, credit markets are strong, and commodities prices are well on their way to new record highs. And yet, even the most cursory scanning of headlines reveals that all is not well in forex markets. Hardly a week goes by without a report of “risk averse” investors flocking to “safe haven” currencies.

As you can see from the chart below, forex volatility has risen steadily since the Japanese earthquake/tsunami in March. Ignoring the spike of the day (clearly visible in the chart), volatility is nearing a 2011 high.What’s driving this trend? Bank of America Merrill Lynch calls it the “known unknown.” In a word: uncertainty. Fiscal pressures are mounting across the G7. The Eurozone’s woes are certainly the most pressing, but that doesn’t mean the debt situation in the US, UK, and Japan are any less serious. There is also general economic uncertainty, over whether economic recovery can be sustained, or whether it will flag in the absence of government or monetary stimulus. Speaking of which, investors are struggling to get a grip on how the end of quantitative easing will impact exchange rates, and when and to what extent central banks will have to raise interest rates. Commodity prices and too much cash in the system are driving price inflation, and it’s unclear how long the Fed, ECB, etc. will continue to play chicken with monetary policy.

Every time doubt is cast into the system – whether from a natural disaster, monetary press release, surprise economic indicator, ratings downgrade – investors have been quick to flock back into so-called safe haven currencies, showing that appearances aside, they are still relatively on edge. Even the flipside of this phenomenon – risk appetite – is really just another manifestation of risk aversion. In other words, if traders weren’t still so nervous about the prospect of another crisis, they would have no reasons to constantly tweak their risk exposure and reevaluate their appetite for risk.

Over the last few weeks, the US dollar has been reborn as a preeminent safe haven currency, having previously surrendered that role to the Swiss Franc and Japanese Yen. Both of these currencies have already touched record highs against the dollar in 2011. For all of the concern over quantitative easing and runaway inflation and low interest rates and surging national debt and economic stagnation and high unemployment (and the list certainly goes on…), the dollar is still the go-to currency in times of serious risk aversion. Its capital markets are still the deepest and broadest, and the indestructible Treasury security is still the world’s most secure and liquid investment asset. When the Fed ceases its purchases of Treasuries (in June), US long-term rates should rise, further entrenching the dollar’s safe haven status. In fact, the size of US capital markets is a double-edge sword; since the US is able to absorb many times as much risk-averse capital as Japan (and especially Switzerland, sudden jumps in the dollar due to risk aversion will always be understated compared to the franc and yen.

On the other side of this equation stands virtually every other currency: commodity currencies, emerging market currencies, and the British pound and euro. When safe haven currencies go up (because of risk aversion), other currencies will typically fall, though some currencies will certainly be impacted more than others. The highest-yielding currencies, for example, are typically bought on that basis, and not necessarily for fundamental reasons. (The Australian Dollar and Brazilian Real are somewhere in between, featuring good fundamentals and high short-term interest rates). As volatility is the sworn enemy of the carry trade, these currencies are usually the first to fall when the markets are gripped by a bout of risk aversion.

Of course, it’s nearly impossible to anticipate ebbs and flows in risk appetite. Still, just being aware how these fluctuations will manifest themselves in forex markets means that you will be a step ahead when they take place.

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G7 Leads Shift in Forex Reserves

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

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

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

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

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

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

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

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

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Emerging Market Currency Correlations Break Down

A picture is truly worth a thousand words. [That probably means I should stop writing lengthy blog posts and instead stick to posting charts and other graphics, but that’s a different story…] Take a look at the chart below, which shows a handful of emerging market (“EM”) currencies, all paired against the US dollar. At this time last year, you can see that all of the pairs were basically rising and falling in tandem. One year later, the disparity between the best and worst performers is already significant. In this post, I want to offer an explanation as to why this is the case, and what we can expect going forward.

In the immediate wake of the credit crisis, I think that investors were somewhat unwilling to make concentrated bets on specific market sectors and specific assets, as part of a new framework for managing risk. To the extent that they wanted exposure to emerging markets, then, they would achieve this through buying broad-based indexes and baskets of currencies. As a result of this indiscriminate investing, prices for emerging market stocks, bonds, currencies, and other assets all rose simultaneously, which rarely happens.

Around November of last year, that started to change. The currency wars were in full swing, inflation was rising, and there were doubts over whether EM central banks would have the stomach to tighten monetary policy, lest it increase the appreciation pressures on their respective currencies. EM stock and bond markets sputtered, and EM currencies dropped across the board. Shortly thereafter, I posted Emerging Market Currencies Still Have Room to Rise, and currencies resumed their upward march. It wasn’t until recently, however, that bond and stock prices followed suit.

What changed? In a nutshell, emerging market central banks have gotten serious about tackling inflation. That’s not to say that they raised interest rates and accepted currency appreciation as an inevitable byproduct. On the contrary, they have adopted so-called macroprudential measures (quickly becoming one of the buzzwords of 2011!), with the goal of heading off inflation without influencing broader economic growth. Most EM central banks have sought to achieve this by raising their required reserve ratios (see chart above), limiting the amount of money that banks can lend out. In this way, they sought to curtail access to credit and limit growth in the money supply without inviting a flood of yield-seeking investors from abroad. Other central banks have gone ahead and hiked interest rates (namely Brazil), but have used taxes and other types of capital controls to discourage speculators.

You can see from the chart of the JP Morgan Emerging Market Bond Index (EMBI+) below that EM bond markets have rallied, which is the opposite of what you would normally expect from a tightening of monetary policy. However, since EM central banks have thus far implemented tightening without directly influencing interest rates, bond yields haven’t risen as you might expect. In addition, whereas sovereign credit ratings are falling in the G7 as a result of weak fiscal and economic outlooks, ratings are actually being raised for the developing world. As a result, EM yields are falling, and the EMBI+ spread to US Treasury securities is currently under 3 percentage points.

The primary impetus for buying emerging markets continues to come from interest rate differentials. Given that interest rates remain low (on both an historical and inflation-adjusted basis), however, it’s unclear whether support for EM currencies will remain in place, or is even justified. Furthermore, I wonder if demand isn’t being driven more by dollar weakness than by EM strength. If you re-cast the chart above relative to the euro, the performance of EM currencies is much less impressive, and in some cases, negative. This trend is likely to continue, as Ben Bernanke’s recent press conference confirmed that the Fed isn’t really close to hiking interest rates.

Ultimately, the outlook for EM currencies is tied closely to the outlook for inflation. If raising the required reserve ratios is enough to head off inflation (and other forces, such as rising commodity prices, abate), then EM central banks can probably avoid raising interest rates. In that case, you can probably expect a correction in forex markets, which will be amplified by rate hikes in the G7. On the other hand, if inflation continues to rise, broad EM interest rate hikes will become necessary, and the floodgates will have been opened to carry traders.Either way, the gap between the high-yielding currencies and the low-yielding ones will continue to widen. In answering the question that I posed above, I expect that regardless of what happens, investors will only become more discriminate. EM central banks are diverging in their conduct of monetary policy, and it no longer makes sense to treat all EM currencies as one homogeneous unit.

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Time to Short the Euro

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.

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