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QE2 Weighs on Dollar

In a few weeks, the US could overtake China as the world’s biggest currency manipulator. Don’t get me wrong: I’m not predicting that the US will officially enter the global currency war. However, I think that the expansion of the Federal Reserve Bank’s quantitative easing program (dubbed QE2 by investors) will exert the same negative impact on the Dollar as if the US had followed China and intervened directly in the forex markets.

For the last month or so, markets have been bracing for QE2. At this point it is seen as a near certainty, with a Reuters poll showing that all 52 analysts that were surveyed believe that is inevitable. On Friday, Ben Bernanke eliminated any remaining doubts, when he declared that, “There would appear — all else being equal — to be a case for further action.” At this point, it is only a question of scope, with markets estimates ranging from $500 Billion to $2 Trillion. That would bring the total Quantitative Easing to perhaps $3 Trillion, exceeding China’s $2.65 Trillion foreign exchange reserves, and earning the distinction of being the largest, sustained currency intervention in the world.

The Fed is faced with the quandary that its initial Quantitative Easing Program did not significantly stimulate the economy. It brought liquidity to the credit and financial markets – spurring higher asset prices – but this didn’t translate into business and consumer spending. Thus, the Fed is planning to double down on its bet, comforted by low inflation (currently at a 50 year low) and a stable balance sheet. In other words, it feels it has nothing to lose.

Unfortunately, it’s hard to find anyone who seriously believes that QE2 will have a positive impact on the economy. Most expect that it will buoy the financial markets (commodities and stocks), but will achieve little if anything else: “The actual problem with the economy is a lack of consumer demand, not the availability of bank loans, mortgage interest rates, or large amounts of cash held by corporations. Providing more liquidity for the financial system through QE2 won’t fix consumer balance sheets or unemployment.” The Fed is hoping that higher expectations for inflation (already reflected in lower bond prices) and low yields will spur consumers and corporations into action. Of course, it is also hopeful that a cheaper Dollar will drive GDP by narrowing the trade imbalance.

QE2- US Dollar Trade-Weighted Index 2008-2010
At the very least, we can almost guarantee that QE2 will continue to push the Dollar down. For comparison’s sake, consider that after the Fed announced its first Quantitative Easing plan, the Dollar fell 14% against the Euro in only a couple months. This time around, it has fallen for five weeks in a row, and the Fed hasn’t even formally unveiled QE2! It has fallen 13% on a trade-weighted basis, 14% against the Euro, to parity against the Australian and Canadian Dollars, and recently touched a 15-year low against the Yen, in spite of Japan’s equally loose monetary policy.

If the Dollar continues to fall, we could see a coordinated intervention by the rest of the world. Already, many countries’ Central Banks have entered the markets to try to achieve such an outcome. Individually, their efforts will prove fruitless, since the Fed has much deeper pockets. As one commentator summarized, It’s now becoming “awfully hypocritical for American officials to label the Chinese as currency manipulators? They are, but they’re not alone.”

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FOMC To Print Or Not To Print

The Federal Open Market Committee (FOMC) is a key component of the Federal Reserve that is responsible for overseeing the country’s open market operations. Since 1981, FOMC has met eight times per year at intervals of five to eight weeks. At today’s meeting, the principal item on the table is the Federal Reserve’s decision relative to quantitative easing; the magical process by which the government turns on the presses and prints more money.

FOMC is the committee that makes decisions about interest rates and the growth of the United States money supply. How the committee votes today will set the monetary policy until the next meeting. Many of the members with voting rights have opposing views about quantitative easing, the state of the USD, the slowing growth of the economy and inflation.

Most analysts believe the Fed will stand firm on interest rates and hold off on quantitative easing. Yesterday’s announcement that the recession officially ended in June 2009 may have played well on Wall Street but drew skepticism on Main Street where the recession is better measured by the employment crises.

Quantitative Easing Round Two

Immediate quantitative easing has support among some of the FOMC voters. It is expected that whether quantitative easing is approved or not, guidelines for activation will be set.

The sharp rise in commodities is driving consumer prices up while there is high unemployment and a weak dollar, a formula that fuels fears of inflation. Gold hit a fifteen year high early Tuesday. Commodities like sugar and cotton are also approaching record highs.

The Fed and FOMC have also been criticized over the effectiveness of the first round of printing, which may have saved the financial sector but did little for the taxpayer. A second round of quantitative easing could only be justified to significantly bolster employment and growth.

The slowing of the growth of the GDP is another major concern. Fed chairman Bernanke has bet heavily on growth, which has been slower than expected.

Opponents of quantitative easing fear the creation of market imbalances and horrific inflation rates. These opponents maintain that there is no evidence that QE will solve the employment crises and may in fact lessen the credibility of the Federal Reserve.

At The End Of The Day

By a vote of 8-1, FOMC made no changes in its monetary policy. However, the committee expressed great concern over the unemployment rate and the sluggishly slow pace of the recovery.

The official statement issued by FOMC said, “The committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.”

The Fed purchased $1.7 trillion in long-term U.S. government debt and mortgage bonds. The easing policy implemented by the Fed has weakened the dollar and raised the value of other currencies.

Statements by Bernanke suggest that the Fed stands ready to boost the economy if growth does not show signs of improvement. In other words, FOMC is on hold until November, but if unemployment does not decline and growth is stagnant, the presses will most likely get to work.

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Boom Time for Forex

It has been three years since the Bank of International Settlements’ last report on foreign exchange was released. Since then, analysts could only speculate about how the forex market has evolved and changed.

The wait is now over, thanks to a huge data release by the world’s Central Bank, which showed that daily trading volume currently averages $4.1 Trillion, a 28% jump since 2007. Trading in London accounted for 44% of the total, with the US – in a distant second – claiming nearly 19%. Japan and Australia accounted for 7% and 5%, respectively, with an assortment of other financial centers splitting the remainder.

This data is consistent with a recent survey of fund managers, which indicated a growing preference for investing in currencies: “Thirty-eight per cent of fund managers said they were likely to increase their allocations to foreign exchange, while 37 per cent named equities and 35 per cent commodities. Currency was most popular even though this was the asset class where managers felt risks had risen most over the past 12 months.” In short, the zenith of forex has yet to arrive.

There are a few of explanations for this growth. First, there are the inherent draws of trading forex: liquidity, simplicity, and convenience. Second, investors are in the process of diversifying their portfolios away from stocks and bonds, which have underperformed in the last few years (on a comparative historical basis). As investors brace for a long-term bear market in stocks and low yields on bonds for the near future (thanks to low interest rates), they are turning to forex, with its zero-sum nature and the implication of a permanent bull market. Additionally, programmatic trading and risk-based investing strategies are causing correlations in the other financial markets to converge to 1. While there are occasional correlations between certain currencies and other securities/commodities markets, the forex markets tend to trade independently, and hence, represent an excellent vehicle for increasing diversification in one’s portfolio.

There is also a more circumstantial explanation for the rapid growth in forex: the credit crisis. In the last two years, volatility in forex markets reached unprecedented levels, with most currencies falling (and then rising) by 20% or more. As a result, many fund managers were quite active in adjusting their portfolios to reduce their exposure to volatile currencies: “The volume growth was really a result of the volatility and the fact that you had real end users actively hedging their exposures.” Another contingent of “event-driven” investors moved to increase their exposure to forex, as the volatility simultaneously increased opportunities to profit. Moreover, these adjustments were not executed once. With a succession of mini-crises in 2009 and 2010 (Dubai debt crisis, EU sovereign debt crisis) and the possibility of even larger crises in the near future, investors have had to monitor and rejigger their portfolios on a sometimes daily basis: “If you have a big piece of news, such as the Greek debt crisis, there’s more incentive to change your position,” summarized one strategist.

What are the implications of this explosion? It’s difficult to say since there is a chicken-and-egg interplay between the growth in the forex market and volatility in currencies. [In theory, it should be that greater liquidity should reduce volatility, but if we learned anything from 2008, it is that the opposite can also be the case]. As I wrote last week, I think it means that volatility will probably remain high. Investors will continue to adjust their exposure for hedging purposes, and traders will churn their portfolios in the search for quick profits.

It will also make it more difficult for amateur traders to turn profits trading forex. There are now millions of professional eyes and computers, trained on even the most obscure currencies. As if it needed to be said, forex is no longer an alternative asset.

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Gold Rises as “Alternative Currency”

Everything in forex is relative, right? Actually, it turns out this adage is wrong, as there is now a way you can short the entire forex market! I’m not talking about some innovative new financial product that you’ve never heard of, but rather something that everyone already knows about: Gold.

Before you accuse me of sounding like an infomercial, consider that while gold has been an investable commodity for quite some time, its trading pattern has changed recently, especially in the context of forex. Before, the link between gold and forex was inverse and clear: “When the greenback strengthens…this tends to pressure gold since it reduces the need to buy as a hedge against a soft dollar. Also, a strengthening dollar makes commodities generally more expensive in other currencies.” In other words, a rising Dollar is usually accompanied by falling gold prices, and vice versa.

Over the course of 2010, this relationship has steadily grown weaker and weaker, and in the last month, it has almost completely broken down. To understand the rationale for such a change, one needs not to look any further than the sovereign debt crisis currently facing Greece and indirectly, the Eurozone. This crisis has affected the way that investors think about gold; while previously it was primarily viewed as an inflation hedge, now it is seen as a hedge against fiscal/financial crisis. In this regard, it has assumed the characteristics of a “safe haven” currency, much like the US Dollar.

“Gold is going to move higher regardless of what happens in the currency market, as long as there are fears of problems in Europe. People are starting to have more skepticism to a lot of these sovereign entities,” explained one analyst. At the moment, that means that the inverse correlation between the Dollar and Gold (Dollar Up = Gold Down) appears to have reversed itself, such that a rising Dollar is also accompanied by rising gold. In this case, there may be correlation (since investors are buying both gold AND the Dollar as safe haven vehicles) but there is no causation between the two as there was before.

At the moment, the correct interpretation is that anything is preferable to the Euro (whose sovereign debt problems are the most pressing). Thus, gold prices are rising at basically the same rate as the Euro as falling, and gold prices in local currency (EUR, CHF, GBP) terms are already at record levels.

Euro Versus Gold - 2010

As for the future, however, many are betting that gold will distance itself from the Dollar as well, if/when the fiscal “problems” of the US escalate to the level of a Greek-style crisis. At this point, Gold will start to trade as an alternative to the entire forex market! In fact, gold contracts denominated in US Dollars have also been rising, which means that investors already perceive it as more than just an alternative to the Euro. (If this was the case, one would expect gold to appreciate in terms of Euros, but to remain constant or even fall when priced in Dollars. This clearly hasn’t happened).

Admittedly, gold is outside of my expertise, so I’ll refrain from personally making any predictions. According to Deutsche Bank, “If the correlation re-establishes itself before July, either the dollar must continue to decline or investment into bullion-backed funds must pick up in order to avoid erosion in gold prices.”

Regardless of what happens, my intention here is simply to point out the emergence of this trend, for its own sake. While it doesn’t have any serious implications about the internal dynamics of forex markets, it most certainly is important insofar as it reflects what investors (forex and otherwise) are generally thinking about. In this case, it signals that concern over the ongoing sovereign debt crisis isn’t going to abate anytime soon.

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Playing Chicken with the BOC

The Canadian Dollar has been one of the world’s top performers this year, especially relative to the Dollar. The Bank of Canada is less than thrilled about this distinction, which is why it takes advantage of nearly every opportunity to remind the markets that it will do everything in its power to prevent the Loonie from rising further. The markets are beginning to wonder, however, whether the BOC is actually prepared to put its money where its mouth is, if push comes to shove.

It’s impossible to say definitively whether the Canadian Dollar’s rise is justified by fundamentals. On the one hand, the ongoing economic recovery and commodities boom will specifically benefit resource-rich economies, such as Canada. It’s no surprise that Canada has been one of the most popular destinations for so-called “risk-averse” investment. Summarized one analyst, “It all revolves around the risk-aversion trade. Last week with equity markets and commodities selling off, we also saw the Canadian dollar selling off in that environment. Today the market settled down a little bit, so we were able to see the Canadian dollar claw back some of its losses.” In addition, it’s not as if the Loonie’s appreciation has been universal. Its gains are primarily against the US Dollar; in this sense, it has merely been subsumed into a larger trend, rather than having been singled out by forex traders.

On the other hand, the economy is forecast to contract in 2010, before returning to full capacity at some point in 2011. The Bank of Canada has flooded the market with currency, via its own version of quantitative easing. Non-commodity exports are stalling, and the government is running record budget deficits. The benchmark interest rate is only .25%, and the BOC has committed to holding it there until June 2010, barring any unforeseen developments. Thus, there is no “positive carry” to be earned from parking money in Canada.

In the context of forex intervention, this analysis is almost beside the point, since the BOC is clearly impervious to logic. Its decision to intervene at this point will probably be based less on economics and more on politics. You see, the Bank has left itself with very little wiggle room, should the Canadian Dollar continue to rise towards, or even past parity with the US Dollar. Its rhetoric has been fairly consistent; whether or not it actually has the wherewithal to intervene successfully (it probably doesn’t) it has conveyed to the markets that has both the means and the determination.

As a result, the BOC has pushed itself into a no-win situation. If the Loonie appreciates further and it doesn’t intervene, then it will have very little credibility going forward. If the Loonie rises and it does intervene, it risks incurring the wrath of the international community and wasting money towards a futile cause. “It’s hard for a modest-sized central bank such as Canada’s to flood the market with so much currency that it alters the balance of the world’s huge and complex foreign-exchange markets,” explained one economist.

canadian dollar

The Bank’s best hope is that the markets continue to take its threats seriously and abstain from betting on the Loonie. For now, it looks like this is the case. “No one wants to go heavily long through the next few months in fear that the Bank of Canada does step in some way,” said one trader. In fact, the threat of intervention may have even brought speculators into the market to bet against the Loonie, having derived support from the last round of intervention (1998): “Traders took the bank’s willingness to intervene as an open invitation to bet heavily on the other side of the equation – knowing they had a big trading partner back-stopping their bet.”

It’s basically a giant game of chicken between the markets and the BOC. Who will blink first?

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Emerging Markets Bubble Continues to Inflate, but for How Long?

Yesterday, emerging markets (proxied by the MSCI Emerging Markets Index) recorded their biggest fall since July, ending a week of solid gains. Still, this one-day slide of 1.4% pales in comparison to the nearly 100% gain that the index has achieved since bottoming last March. In other words, while investors might be starting to pull back, the direction of asset prices is still upward.

Emerging Market Stocks

As for what’s causing this across-the-board appreciation, that was the subject of my previous post (Inverse Correlation between Dollar and Everything Else…Still), in which I merely stated the obvious; that the Fed’s year-long program of negative real interest rates and quantitative easing (i.e. wholesale money printing) has unleashed a flood of cash into global capital markets. Since we’re not just talking about the Dollar, here, it makes sense to point out that the Fed’s easy money policies have been copied by Central Banks in most other industrialized countries, including the UK, Canada, Switzerland, Sweden, and to a lesser extent, the EU.

As for why emerging market assets and currencies seem to be outpacing appreciation in other asset classes, that’s also not difficult to explain. First of all, by some measures, emerging market stocks have hardly outperformed other assets. Oil, for example, has risen by 131% in less than a year, to say nothing of other commodities. Still, by other measures, growth has been remarkable. Most emerging market stock indexes and currencies have fully erased (or come close to erasing) the losses recorded during the peak of the credit crisis. Bonds, meanwhile, have gone one step further. Yields are collapsing, and prices have exploded – by 25% in the last year, sending the JP Morgan Emerging Market Bond Index to a new record.

Emerging Market Currencies

Is it safe to call this a bubble? Intuition would suggest so; given that all assets are rising across the board, without regard to particular fundamentals, it would seem that only a herd/bubble mentality could offer an explanation. Some analysts, in fact, have given up completely on fundamental analysis, instead using fund inflows (i.e. investor demand) to predict whether some emerging market assets will continue rising. As Nouriel Roubini (the NYU economist that famously predicted the credit crisis) summarizes: “Traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade.” P/E ratios are nearly twice as high in some emerging markets, compared to stocks in the S&P 500.

On the other side of the equation are the bulls and the efficient market theorists.”By historical price-to-earnings ratios — the ratio of stock prices to per-share profits — these levels can be justified, if the economic recovery continues. With massive layoffs, business costs have been cut sharply. “The hope is that when consumers and companies start spending, the added sales will drop quickly to the bottom line [profits].” Other proponents argue that the rise in asset prices is exactly what the Fed wants, since it implies that the markets are once again characterized by stability and liquidity.

Regardless of whether growth materializes, however, that doesn’t change the fact that the free ride can’t and won’t last forever. At some point, Central Banks will be forced to raise interest rates and start withdrawing Trillions of Dollars from global capital market. This will cause the Dollar to rise, and investors to rapidly unwind their carry trade positions. Warns Roubini, “A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.”

If the tech-bubble and real-estate bubble taught us anything, it is that there is no free lunch in the markets. It is not possible for all investors in all assets classes to simultaneously win. At least, in the long-term. In the short-term, meanwhile – it pains me to say this – let the party continue. My only warning is this: when the music stops, don’t be the one caught with your pants down…

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Inverse Correlation between Dollar and Everything Else…Still

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

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


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

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

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

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

History is never far from repeating itself.

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