Tag Archive | "Credit Crisis"

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US Progresses, Euro Soars


A number of economic reports showed a positive trend for the recovering US economy while actions from the ECB raised the euro above the 1.35USD benchmark. The Labor Department reported that initial claims for unemployment last week rose by 38,000 to 368,000. This figure comes on the heels of a week where new claims were at their lowest level in five years. This figure was slightly above analyst’s projections but well within a range to suggest the paper-thin recovery had momentum.

Employment has been robust in January with 160,000 new jobs already filled. The total for December was 155,000.

Perhaps the most interesting and positive fact is the increase in personal income on December. The Commerce Department reported that personal income rose by 2.6 percent in December. This figure far surpassed the projected 0.8 percent gain.

However, much of this gain may be attributable to advance payments made by US corporations prior to December 31, the end of the tax year when Tax policy was unclear. Consumer spending fell just short of expectations rising by 0.2 percent.

Importantly, planned layoffs declined in December. This is the first decline in four months. December job cuts totaled 32,556, a sharp decline from November’s 57,081 job cuts, a 41 percent improvement.

Euro Continues Surge Against Dollar

The euro continued an impressive upward trend against the dollar as the European Central Bank (ECB) said that 137 billion euros would be repaid to the bank on the earliest due date. These payments are in the bank’s three-year loan program.

President Mario Draghi’s aggressive three-year loan program is credited with stabilizing the banking and credit crisis in the euro zone. The ECB will announce its second payment date on Friday. This will allow banks to properly assess their capital needs and liquidity.

The move to repay suggests that the borrowing banks have stabilized and that they have sufficient liquidity to meet their operating costs. The repayment is likely to be interpreted as an endorsement for higher interest rate, a consideration the ECB will likely determined after the next tranche.

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Forex Volatility Continues Rising


This week witnessed another flareup in the eurozone sovereign debt crisis. As a result, volatility in the EUR/USD pair surged, by some measures to a record high. Even though the Euro rallied yesterday and today, this suggests that investors remain nervous, and that going forward, the euro could embark on a steep decline.


There are a couple of forex volatility indexes. The JP Morgan G7 Volatility Index is based on the implied volatility in 3-month currency options and is one of the broadest measures of forex volatility. As you can see from the chart above, the index is closing in on year-to-date high (excluding the spike in March caused by the Japanese tsunami), and is generally entrenched in an upward trend. Barring day-to-day spikes, however, it will take months to confirm the direction of this trend.

For specific volatility measurements, there is no better source of data than Mataf.net (whose founder, Arnaud Jeulin, I interviewed only last month). Here, you can find data on more than 30 currency pairs, charted across multiple time periods. You can see for the EUR/USD pair in particular that volatility is now at the highest point in 2011 and is closing in on a two-year high.


Meanwhile, the so-called risk-reversal rate for Euro currency options touched 3.1, which is greater than the peak of the credit crisis. This indicator represents a proxy for investor concerns that the Euro will collapse suddenly, and its high level suggests that this is indeed a growing concern. In addition, implied volatility in options contracts has jumped dramatically over the last week, which confirms that investors expect the euro to move dramatically over the next month.

What does all of this mean? In a nutshell, it shows that panic is rising in the forex markets. Last month, I used this notion as a basis for arguing that the dollar safe-haven trade will make a come-back. This would still seem to be the case, and should also benefit the Swiss Franc, which is nearing an all-time high against the euro. Naturally, it also implies that forex investors remain extremely concerned about a continued decline in the euro, and are rushing to hedge their exposure and/or close out long positions altogether.

Mataf.net suggests that this could make the EUR/USD an interesting pair to trade, since large swings in either direction will necessarily create opportunities for traders. While I have no opinion on such indiscriminate trading [I prefer to make directional bets based on fundamentals], I must nonetheless acknowledge the logic of such a strategy.

http://www.forexblog.org/2011/05/interview-with-arnaud-jeulin-of-mataf-net-try-a-lot-of-strategies.html

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Has the US Dollar Hit Bottom?


In April, I declared that the dollar would rally when QE2 ended. That date – June 30 – is now only a few weeks away, which means it won’t be long before we know whether I was right. Meanwhile, the dollar is close to pre-credit crisis levels on a composite basis, and has already fallen to record lows against a handful of specific currencies. In other words, it’s now do-or-die for the dollar.


Since my last update, a number of things have happened. Commodity prices have continued to rise, and inflation has ticked up slightly. Meanwhile, GDP growth has moderated, the unemployment rate has stagnated at 9%, and the S&P has fallen slightly as investors brace for the possibility of an economic downturn. Finally, long-term interest rates have fallen, despite concerns that the US will be forced to breach the debt ceiling imposed by Congress.

From the standpoint of fundamentals, there is very little to get excited about when it comes to the dollar. While the US is likely to avoid a double-dip recession (the case for this was most convincingly made by TIME Magazine, of all sources), GDP growth is unlikely to rebound strongly. Exports are growing, but slowly. Businesses are investing (in machines, not people), but they are still holding record amounts of cash. Consumption is strong, but unsustainable. The government will do what it can to keep spending, but given that the deficit is projected at 10% of GDP in 2011 and that Congress is playing hardball with the debt ceiling, it can’t be expected to provide the engine of growth.

Meanwhile, Ben Bernanke, Chairman of the Fed, has implied that QE2 will not be followed by QE3. Still, he warned that “economic conditions are likely to warrant exceptionally low levels for the federal-funds rate for an extended period.” With low growth, high unemployment, and low inflation, there isn’t any impetus to even think about raising interest rates. In fact, Bernanke and his cohorts will continue to do everything in their power to hold down the dollar, if only to provide a boost to exports. Bill Dudley, head of the New York Fed, intimated in a recent speech that the Fed’s current monetary policy is basically a response to emerging market economies’ failure to allow their currencies to rise.

In short, if I was arguing that fundamentals would provide the basis for renewed dollar strength, I would have a pretty weak case. As I wrote a few weeks ago, however, there is a wrinkle to this story, in the form of risk. You see- the dollar continues to derive some significant support from risk-averse investors, as evidenced by the fact that Treasury yields have fallen to record lows.


Ironically, demand for the US dollar is inversely proportional to the strength of US fundamentals. As the US economy has rebounded, investors have become more comfortable about risk, and have responded by unloading safe haven positions in the dollar. With the US recovery faltering, investors are slowly moving back into the dollar, re-establishing safe haven positions. While the dollar faces some competition in this regard from the Franc and the Yen, it still compares favorably with the euro and pound.

In fact, some traders are betting that the dollar’s fortunes may be about to reverse. It has fallen 15% over the last year, en route to a 3-year low. With short positions so high, it would only take a minor crisis to trigger a short squeeze. Said the CEO of the world’s largest forex hedge fund (John Taylor of FX Concepts): “We see a big upside USD catalyst in the next ’3 or 4 days’ on the grounds that…’Our analysis of the markets has shown that they are very, very dangerous.’ ”

For what it’s worth, I also think the dollar is oversold and expect a correction to take hold at some point over the next month.

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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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Are Forex Markets Underpricing Volatility?


This question has been raised by several market commentators, including The Wall Street Journal. Its recent analysis, entitled “Currency Investors: What, Me Worry?” wondered whether the forex markets might not have become too complacent about risk and have seriously underestimated the possibility of another shock.
First, some basics. There are two principal volatility measurements: implied
volatility and realized volatility. The former is so-called because it must be deduced indirectly. In the Black-Scholes model for pricing options, volatility is the only unknown variable and thus is implied by current market prices. It serves as a proxy for investor expectations for volatility over the period for which the option is valid. Realized volatility is of course the actual volatility that is observed in currency markets, calculated based on the size of fluctuations over a given period of time. When fluctuations are greater (whether upward or downward), volatility is said to be high.
 
For short time frames, implied volatility tends to be very close to realized volatility. For longer time-frames, however, this is not necessarily the case: “The long-dated implied volatilities are often driven to extreme values by one-sided demand or supply – the difference between implied and realised volatilities this causes is particularly large during periods of risk aversion in the market…making implied volatility a particularly poor proxy for realised volatility during periods of market unrest.” In practice, this is reflected by higher prices for long-dated put or call options (depending on the direction of the move that investors are trying to hedge against).
 
Indeed, most volatility metrics are well below their historical averages and are rapidly closing in on pre-credit crisis levels. This is true for the JP Morgan G7 3-month forex volatility index, the S&P VIX, as well as for specific currencies. Mataf.net (whose content manager I interviewed yesterday) contains replete short-term and long-term data for a few dozen currency pairs, and you can see that almost all of them feature the same downward trend. According to the WSJ, “Investors believe there is a 66% chance each day for the next month that the euro and pound will move no more than 0.6% and 0.5%, respectively—both limited moves.” In addition, “A gauge of the euro’s ‘realized’ volatility, which measures how much daily changes deviate from their recent average, is only 8.6%, lower than its 11% rolling one-year average.”
Of course, some commentators don’t see any problem here. They see it both as a positive indication that the markets have returned to normal following the financial crisis, and as a reflection of the correlation that has developed between stock prices and forex markets. (You can see from the chart below the strong inverse correlation between the S&P and the US dollar). According to Deutsche Bank, “Most news that should have shocked the market this year has not managed to do so for sufficiently long to make volatility rise sustainably. Our analytical models tell us that we are indeed moving to a low volatility environment again.”
 
On the other side of the debate is a growing consensus of investors that sees a pendulum that has swung too far. “I just don’t see how volatility will not increase quite substantially,” said one money manager. “There is significant potential for shocks to the system that currency volatility levels suggest the market is not prepared for,” added another, citing higher commodities prices and inflation, growing public debt, and the imminent end of the Fed’s QE2 monetary stimulus.
 
To be sure, volatility has started to tick up over the last month. This trend has also been reflected in options prices: “Many investors have avoided buying short-dated currency options this year, instead focusing on longer-dated protection, a phenomenon called a ‘steep volatility curve’…that trend has slowed a bit, with investors moving to hedge against near-term yen, euro and dollar swings.”
 
Currency traders should start to think about making a few adjustments. Those that think that volatility will continue to rise and/or that the markets are currently underpricing risk can employ a volatility strangle strategy, buying way out-of-the-money puts and calls. The options will pay off if there is a big move in either direction, with no downside risk. Those that think that volatility will continue declining or at least remain at current low levels can make use of the carry trade. Those pairs where interest rate differentials are highest and volatility levels are lowest represent the best candidates. BNP Paribas is also reportedly developing a product that will make it easier for traders to make volatility bets without having to rely on indirect means.

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SA Rand in Bubble Territory


The story of the South African Rand (ZAR) is nearly identical to that of other leading emerging market currencies: multi-year gains were completely undone by the 2008 credit crisis, only to be restored in 2009 and 2010. From trough to peak, the Rand has now risen 64%, including 15% over the last twelve months and 10% over the last six weeks. While the reasons for its renewal are understandable, they are far from justifiable. Based on a number of metrics, the Rand now appears to be somewhat overvalued.
 
Just like its BRIC (which it was recently invited to join) peers, the Rand’s appeal lies in high growth prospects and even higher nominal interest rates. It has also been bought amidst the general pickup in risk appetite (complacency) that has spurred investors back into emerging markets. Given the relatively small size of its economy and proportionately small money supply, it’s no surprise that demand for Rand – made worse by the difficulty of betting directly on China – has overwhelmed the supply.
Despite repeated cuts, South Africa’s benchmark interest rate still stands at a lofty 5.5%. Relative price stability also means that interest rates are positive in real terms, a claim which few countries can make nowadays. Thanks to bond yields hovering around 8% and a comparatively modest government debt, lending to South Africa still carries a significant risk-adjusted return advantage over other emerging markets. The Bank of South Africa is trying to hold off on hiking rates for as long as possible, partly to avoid stimulating the Rand. Its decision to tighten will essentially be determined by the battle between unemployment and inflation. With more than 25% of South Africans out of work, the Bank is understandably reluctant to take any steps that would ameliorate that problem.
 
Perhaps above all else, the Rand’s rise has been closely correlated with the ongoing commodities boom. South Africa is the world’s largest producer of platinum and palladium, second largest of gold, and at the top of the rankings for a handful of other precious metals and minerals. Thus, you can see from the chart below that the Rand/Dollar rate has very closely tracked platinum and gold prices for the last twelve months. Aside from a modest correction (induced by a temporary ebb in risk aversion) at the end of 2010, the three assets appear to have moved in lockstep!
 
While rising commodities prices have certainly been a boon to South Africa’s foreign exchange reserves, it hasn’t done much for its economy. In fact, mining comprises only 3% of South Africa’s economy (down from 14% two decades ago), and analysts expect that this proportion will decline further as deposits are mined to exhaustion. Its balance of trade fluctuates between surplus and deficit, as revenues from increased commodities exports are turned around and spent on imports. (China is now South Africa’s largest trading partner). Still, given the record current account deficits of the last few years, foreign investors evidently are undeterred from bridging the South African shortfall in domestic investment, even (or especially!) at current exchange rates.
 
Going forward, there are plenty of analysts that believe the Rand will continue rising, at a healthy rate of around 10% per year. This notion is based as much on the depreciation of major currencies – which were punished for their respective Central Banks’ expansionary monetary policies – as it is in the appreciation of the Rand. In fact, the Rand’s performance against a basket of emerging market currencies has been more modest; on a trade-weighted basis, it has still risen an estimated 15% since 1995. Regardless, this suggests that any bubble underlying the Rand is no different from that which may affect any number of other currencies.
 
Still, it’s hard to argue with fundamentals. According to one back-of-the-envelope analysis based on purchasing power parity (ppp) differentials, the Rand will need to depreciate significantly if it is to return to more normalized valuation levels. “Since 2000, South African inflation has exceeded that of the US by 44 percent, while the rand has depreciated by just over 10 percent, which means that goods in South Africa are now over 30 percent more expensive for Americans than they were a decade ago… it is impossible to know when this difference will unwind, but…it is reasonable to assume that it will unwind in every five-year period, and this would entail a depreciation in the rand-US dollar exchange rate of six percent a year.” Reasonable indeed.
 
Ultimately, it is going to be tough to sell this argument to carry traders, who care more about interest rate differentials than inflation differentials, which means the Rand could continue to rise over the short-term. Over the medium-term, however, the Bank of South Africa may see to it that this trend does not continue.

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Korean Won Poised for Further Gains


It was in November 2010 that I last blogged about the South Korean Won. As a result of the standoff with North Korea and a recent flareup in the Eurozone sovereign debt crisis, the Won had plummeted. Still, I viewed these as temporary problems and concluded that, “Ultimately, both the EU fiscal crisis and the tensions with North Korea will subside, which should cause the Won to resume its rise.” Since then, the Won has indeed risen by more than 8% against the US dollar. Rather than call for a correction, however, I’m ignoring my best instincts and arguing in favor of a further rise.


In a nutshell, the Korean Won has almost everything going for it at the moment. In the words of one columnist, “South Korea is today the 15th largest global economic power [and] is also the leading global nation in shipbuilding, production of LCD screens and in the distribution of broadband per capita. It is the third leading nation in the production of semi-conductors, the fifth in automobile manufacturing and in scientific research.” GDP is growing at a healthy clip of 4.2%. After recording real GDP growth in excess of 6% in 2010, South Korea’s economy is projected to grow by a further 4.5% in 2011, which means that it has more than made up for the recession that it suffered alongside the rest of the word in 2008-2009.  Exports reached a record level in 2010, propelling Korea’s current account balance well into surplus. “It seems that a target of $1 trillion of trade this year will be achieved, in spite of unfavorable conditions from the massive quake in Japan and the Middle East unrest,” declared Korea’s commerce minister. On balance then, money coming into Korea well exceeds money flowing out.

Moreover, unlike Japan and China – both of whose currencies are hovering around record levels – the Korean Won remains about 20% below its 2008 pre-credit crisis high. That means that the Won has plenty of scope for further appreciation before its exporters will be squeezed to the same extent as its Asian competitors. If the Bank of Korea (BOK) has its way, it will be a long time before this even happens. The BOK continues to intervene on behalf of the Won on a daily basis, and as a result, its foreign exchange reserves have risen to $300 billion, a record high.

Granted, Korean inflation is also rising, and most recently touched 4.7%, which is at or above the level in neighboring economies. The Bank of Korea has taken steps to counter this, but it is understandably wary about inadvertently stoking speculative interest in the Won. Thus, it has raised its benchmark interest rate only four times since last summer, and the rate is still at a historically low level. According to the Wall Street Journal, “That’s still well below the 4% to 4.5% level where economists estimate the neutral policy rate to be.”

When you consider both that the carry trade is back in vogue and that most other emerging market currencies have recovered most of their credit crisis losses and then some, it’s downright surprising that the Won hasn’t risen more. Perhaps, lamented one commentator, South Korea still lacks cachet among investors and is known more as the political counterbalance to North Korea than as the economic juggernaut that it has become. Even though its economy is larger than that of Australia, the Won doesn’t have nearly as much appeal as the Aussie.

Since it’s the weekend, I’ll keep this post short and sweet! Suffice it to say that the Won still has plenty of scope for further appreciation, and unless the BOK completely avoids hiking rates, I don’t see real downside pressures. At this rate, it will probably be one of the big success stories of 2011.

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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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Icelandic Kronur: Lessons from a Failed Carry Trade


A little more than two years ago, the Icelandic Kronur was one of the hottest currencies in the world. Thanks to a benchmark interest rate of 18%, the Kronur had particular appeal for carry traders, who worried not about the inherent risks of such a strategy. Shortly thereafter, the Kronur (as well as Iceland’s economy and banking sector) came crashing down, and many traders were wiped out. Now that a couple of years have passed, it’s probably worth reflecting on this turn of events.


At its peak, nominal GDP was a relatively modest $20 Billion, sandwiched between Nepal and Turkmenistan in the global GDP rankings. Its population is only 300,000, its current account has been mired in persistent deficit, and its Central Bank boasts a mere $8 Billion in foreign exchange reserves. That being the case, why did investors flock to Iceland and not Turkmenistan?

The short answer to that question is interest rates. As I said, Iceland’s benchmark interest rate exceeded 18% at its peak. There are plenty of countries that offered similarly high interest rates, but Iceland was somehow perceived as being more stable. While it didn’t join the European Union until last year, Iceland has always benefited from its association with Europe in general, and Scandinavia in particular. Thanks to per capita GDP of $38,000 per person, its reputation as a stable, advanced economy was not unwarranted.

On the other hand, Iceland has always struggled with high inflation, which means its interest rates were never very high in real terms. In addition, the deregulation of its financial sector opened the door for its banks to take huge risks with deposits. Basically, depositors – many from outside the country – parked their savings in Icelandic banks, which turned around and invested the money in high-yield / high-risk ventures. When the credit crisis struck, its banks were quickly wiped out, and the government chose not to follow in the footsteps of other governments and bail them out.


Moreover, it doesn’t look like Iceland will regain its luster any time soon. Its economy has shrunk by 40% over the last two years, and one prominent economist has estimated that it will take 7-10 years for it to fully recover. Unemployment and inflation remain high even though interest rates have been cut to 4.25% – a record low. The Kronur has lost 50% of its value against the Dollar and the Euro, the stock market has been decimated, and the recent decision to not remunerate Dutch and British insurance companies that lost money in Iceland’s crash will only serve to further spook foreign investors. In short, while the Kronur will probably recover some of its value over the next few years (aided by the possibility of joining the Euro), it probably won’t find itself on the radar screens of carry traders anytime soon.

In hindsight, Iceland’s economy was an accident waiting to happen, and the global financial crisis only magnified the problem. With Iceland – as well as a dozen other currencies and securities – investors believed they had found the proverbial free lunch. After all, where else could you earn an 18% by putting money in a savings account? Never mind that inflation was just as high; with the Kronur rising, carry traders felt assured that they would make a tidy profit on any funds deposited in Iceland.

The collapse of the Kronur, however, has shown us that the carry trade is anything but risk-free. In fact, 18% is more than what lenders to Greece and Ireland can expect to earn, which means that it is ultimately a very risky investment. In this case, the 18% that was being paid to depositors were generated by making very risky investments. As the negotiations with the insurance companies have revealed, depositors had nothing protecting them from bank failure, which is ultimately what happened.
Now that the carry trade is making a comeback, it’s probably a good time to take a step back and re-assess the risks of such a strategy. Even if Iceland proves to be an extreme case – since most countries won’t let their banks fail – traders must still acknowledge the possibility of massive currency depreciation. In other words, even if the deposits themselves are guaranteed, there is an ever-present risk that converting that deposit back into one’s home currency will result in losses. That’s especially true for a currency that is as illiquid as the Kronur (so illiquid that it took me a while to even find a reliable quote!), and is susceptible to liquidity crunches and short squeezes.

When you enter into a carry trade, understand that a spike in volatility could wipe out all of your profits in one session. The only way to minimize your risk is to hedge your exposure.

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Record Commodities Prices and the Forex Markets


Propelled by economic recovery and the recent Mideast political turmoil, oil prices have firmly shaken off any lingering credit crisis weakness, and are headed towards a record high. Moreover, analysts are warning that due to certain fundamental changes to the global economy, prices will almost certainly remain high for the foreseeable future. The same goes for commodities. Whether directly or indirectly, the implications for forex market will be significant.


First of all, there is a direct impact on trade, and hence on the demand for particular currencies. Norway, Russia, Saudia Arabia, and a dozen other countries are witnessing record capital inflow expanding current account surpluses. If not for the fact that many of these countries peg their currencies to the Dollar and/or seem to suffer from myriad other issues, there currencies would almost surely appreciate. In fact, the Russian Rouble and Norwegian Krona have both begun to rise in recent months. On the other hand, Canada and Australia (and to a lesser extent, New Zealand) are experiencing rising trade deficits, which shows that their is not an automatic relationship between rising commodity prices and commodity currency strength.

Those countries that are net energy importers could experience some weakness in their currencies, as trade balances move against them. In fact, China just recorded its first quarterly trade deficit in seven years. Instead of viewing this in terms of a shift in economic structure, economists need to understand that this is due in no small part to rising raw materials prices. Either way, the People’s Bank of China (PBOC) will probably tighten control over the appreciation of the Chinese Yuan. Meanwhile, the nuclear crisis in Japan is almost certainly going to decrease interest in nuclear power, especially in the short-term. This will cause oil and natural gas prices to rise even further, and magnify the impact on global trade imbalances.

A bigger issue is whether rising commodities prices will spur inflation. With the notable exception of the Fed, all of the world’s Central Banks have now voiced concerns over energy prices. The European Central Bank (ECB), has gone so far as to preemptively raise its benchmark interest rate, even though Eurozone inflation is still quite low. In light of his spectacular failure to anticipate the housing crisis, Fed Chairman Ben Bernanke is being careful not to offer unambiguous views on the impact of high oil prices. Thus, he has warned that it could translate into decreased GDP growth and higher prices for consumers, but he has stopped short of labeling it a serious threat.

On the one hand, the US economy is undergone some significant structural changes since the last energy crisis, which could mitigate the impact of sustained high prices. “The energy intensity of the U.S. economy — that is, the energy required to produce $1 of GDP — has fallen by 50% since then as manufacturing has moved overseas or become more efficient. Also, the price of natural gas today has stayed low; in the past, oil and gas moved in tandem. And finally, ‘we’re closer to alternative sources of energy for our transportation,’ ” summarized Wharton Finance Professor Jeremy Siegal. From this standpoint, it’s understandable that every $10 increase in the price of oil causes GDP to drop by only .25%.

On the other hand, we’re not talking about a $10 increase in the price of oil, but rather a $50 or even $100 spike. In addition, while industry is not sensitive to high commodity prices, American consumers certainly are. From automobile gasoline to home eating oil to agricultural staples (you know things are bad when thieves are targeting produce!), commodities still represent a big portion of consumer spending. Thus, each 1 cent increase in the price of gas sucks $1 Billion from the economy. “If gas prices increased to $4.50 per gallon for more than two months, it would ‘pose a serious strain on households and could put the entire recovery in jeopardy. Once you get above $5, [there is] probably above a 50% chance that the economy could face a downturn.’ ”

Even if stagflation can be avoided, some degree of inflation seems inevitable. In fact, US CPI is now 2.7%, the highest level in 18 months and rising. It is similarly 2.7% in the Eurozone and Australia, where both Central Banks have started to become more aggressive about tightening monetary policy. In the end, no country will be spared from inflation if commodity prices remain high; the only difference will be one of extent.

Over the near-term, much depends on what happens in the Middle East, since an abatement in political tensions would cause energy prices to ease. Over the medium-term, the focus will be on Central Banks, to see if/how they deal with rising inflation. Will they raise interest rates and withdraw liquidity, or will they wait to act for fear of inhibiting economic recovery? Over the long-term, the pivotal issue is whether economies (especially China) can become less energy intensive or more diversified in their energy consumption.

At the moment, most economies are dangerously exposed, with China and the US topping the list. Russia, Norway, Brazil and a select few others will earn a net benefit from a boom in prices, while most others (notably Australia and Canada) are somewhere in the middle.

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