Tag Archive | "Current Account Deficit"

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Good Data Moves Markets, USD

The Commerce Department and the US Labor Department topped analyst’s expectations and added further momentum to the US equity markets and to the US dollar. The news is a boost to the fragile recovery and reflects consumer confidence that overrides the dysfunction in Washington. That is another story.

On Thursday, the Commerce Department reported that the current flow of goods, services and investments to out of country sources, called the “account deficit,” fell to $110.4 billion in the fourth quarter after an upward revision to $112.4 billion in the third quarter 2012. Projections had been that the fourth quarter current account deficit would expand to $112.8 billion.

The highest current account deficit was registered in the fourth quarter 2005 at 6.5 percent of GDP. The deficit in the fourth quarter 2012 2.8 percent GDP, the lowest since the second quarter 2009 (2.5%).

The breakdown of the deficits in the 4th quarter in the three sectors are:

  • Deficit on Goods – $180.60bn
  • Deficit on Services – $52.2bn
  • Surplus on Income – $52.4 up $5.8bn from quarter 3.

Big Surprise on Retail Sales

The wrangling over the fiscal cliff, the budget and the expiration of the payroll tax holiday did not deter the US consumer, who composes about 70 percent of the nation’s GDP. The surprising demand in retail sales is believed to be linked to more strength in the employment sector.

While employment is still the biggest challenge for the recovery, there appears to be some stabilization that the country’s politicians cannot derail. Retail sales increased 1.1 percent in February, the largest gain since September 2012. January retail sales were revised upwards to show  a 0.2 percent gain. The February projection had been 0.5 percent.

Gus Faucher, a senior economist at PNC Financial Services in Pittsburgh told Reuters that, “Consumers have been less fazed by the increase in taxes than we expected. Because the labor market has been doing a bit better than we were expecting, people are feeling a bit confident and not cutting back their spending.”

GDP Projections Improve

This data has encouraged economists to revise their GDP projections for the first quarter. GDP in the fourth quarter was 2.1 percent. Sage a neutral read for the first quarter, expectations are that the economy will post much needed gains in the current quarter.

The Commerce report indicates January expansion in business inventories to the highest levels in 18 months. Retail inventories, outside auto inventories, rose to their highest levels since August 1995.

JP Morgan has increased tier projection for growth during the first quarter to 2.3 percent. Goldman Sachs was even more bullish, raising expectations to 2.9 percent.

Some of the increase in retail sales should be tempered as it reflects the rising gas prices. However, sales of new cars rose by 1.1 percent in February.

If Washington stays in their cocoon, the economy may continue growth. However, the two conflicting budgets presetne3d by Democrats in the Senate and Republicans in the House ae so divergent that neither party seems to understand anything about the economy or their constituents.

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New Zealand Dollar: Come Back to Earth!

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

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

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

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

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

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

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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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Russian Ruble Undervalued According to Central Bank

In the midst of the currency war controversy, there is one emerging market country that continues to insist that its currency is undervalued: Russia. While being a member of the illustrious group of BRIC (Brazil / Russia / India / China) countries would seem to guarantee an appreciating currency, there are strong forces weighing on the Ruble. In other words, that it remains weak is not due to investor oversight.
Ruble Dollar Chart 2006-2010

If you view the performance of the Russian Ruble over the last few years, it’s clear that it never recovered from the rapid depreciation that took place during the height of the credit crisis. Given that nearly every other emerging market currency is either closing in on or has already breached its pre-credit crisis level, there must be something holding down the Ruble.

That something happens to be a sizable current account deficit. Unlike with other emerging markets, capital is actually flowing out of Russia. There are a few reasons for this: first of all, much of Russia’s debt is denominated in foreign currency, as a consequence of its massive default in 1998. Specifically, “The private sector has about $16 billion in foreign debt, including interest-rate payments, due this month [December], double the $8 billion of redemptions in October and November.” This means that every month, Russian companies must scramble to exchange Rubles for Dollars and Euros.

Next, the real returns of investing in Russia are currently negative. Russia’s Central Bank (Bank Rossii) continues to maintain the benchmark refinancing rate at a record-low 7.75%, and the 10-year yield on Russian bonds is even lower, at ~5%. This would seem to compare favorably with the 2.75% yield on comparable US Treasury Securities until you account for inflation, which is projected to top 8% for the year. While Ruble-denominated bonds pay a higher interest rate (7.75%), they also carry higher risk. For that reason, Russian yields and credit default swap spreads (which insure against default) are much higher in Russia than in other BRIC countries.

JPMorgan EMBI Russia Blended Yield Chart 2010

Meanwhile, Russian companies are taking advantage of low borrowing rates to engage in a reverse carry trade and invest in western countries: “Russian companies have announced $27 billion of foreign purchases this quarter, the most since the third quarter of 2008 and triple the amount in the last three-month period.” Finally, the reemergence of the EU fiscal crisis, combined with the skirmish in Korea has spurred a decrease in risk appetite. As one analyst summarized, “The whole of the emerging markets are on the back-foot at the moment and the ruble is no exception…it’s definitely risk off at the moment.”

As a result, Bank Rossii finds itself in a somewhat unique position among Central Banks of having to try to prop up its currency. Technically, the Rouble is pegged to a basket (consisting of 55% Dollars and 45% Euros), but pressure on it has been so intense that the range in which it is permitted to trade has been adjusted downward five times since the middle of October. To prevent it from declining further, Bank Rossii has been dipping into its $450 Billion stock of forex reserves, and selling foreign currency at the rate of $150 million per day. It insists that it will “allow” the Rouble to appreciate in 2011 in order to fight inflation, but that obviously depends on whether the current account shifts back to surplus.

What do investors think? According to a Bloomberg survey of currency analyst, “The Ruble will strengthen 4 percent versus the basket by the end of the first quarter of 2011. On the other hand, “Options traders are still bearish on the ruble with the currency’s one-week risk reversal rate — the premium of put options over calls — at 1.25 percent for the tenth straight day, from 0.5 percent at the end of October.” Non-deliverable forward contracts, meanwhile, reflect a weaker Ruble three months from now.

If the Bank Rosii fulfills analysts’ expectations and hikes rates in March, it will be step towards reinvigorating investor interest in Russia. More importantly, however, is that inflation is brought under control. Until that happens, the Ruble will remain the main standout in a sea of emerging market currencies that otherwise continues to outperform.

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Chinese Yuan Will Not Be Reserve Currency?

In a recent editorial reprinted in The Business Insider (Here’s Why The Yuan Will Never Be The World’s Reserve Currency), China expert Michael Pettis argued forcefully against the notion that the Chinese Yuan will be ever be a global reserve currency on par with the US Dollar. By his own admission, Pettis seeks to counter the claim that China’s rise is inevitable.

The core of Pettis’s argument is that it is arithmetically unlikely – if not impossible – that the Chinese Yuan will become a reserve currency in the next few decades. He explains that in order for this to happen, China would have to either run a large and continuous current account deficit, or foreign capital inflows into China would have to be matched by Chinese capital outflows.” Why is this the case? Simply, a reserve currency must necessarily offer (foreign) institutions ample opportunity to accumulate it.

China Trade Surplus 2009 - 2010
However, as Pettis points out, the structure of China’s economy is such that foreigners don’t have such an opportunity. Basically, China has run a current account/trade surplus, which has grown continuously over the last decade. During that time, its Central Bank has accumulated more than $2.5 Trillion in foreign exchange reserves in order to prevent the RMB from appreciating. Foreign Direct Investment, on the other hand, averages 2% of GDP and is declining, not to mention that “a significant share of those inflows may actually be mainland money round-tripped to take advantage of capital and tax regulations.”

For this to change, foreigners would need to have both a reason and the opportunity to hold RMB assets. The reason would come from a reversal in China’s balance of trade, and the use of RMB to pay for the excess of imports over exports, which would naturally imply a willingness of foreign entities to accept RMB. The opportunity would come in the form of deeper capital markets, a complete liberalization of the exchange rate regime (full-convertibility of the RMB), and the elimination of laws which dictate how foreigners can invest/lend in China. This would likewise an imply a Chinese government desire for greater foreign ownership.

China FDI 2009-2010

How likely is this to happen? According to Pettis, not very. China’s financial/economic policy are designed both to favor the export sector and to promote access to cheap capital. In practice, this means that interest rates must remain low, and that there is little impetus behind the expansion of domestic consumption. Given that this has been the case for almost 30 years now, this could prove almost impossible to change. For the sake of comparison, consider that despite two “lost decades,” Japan nonetheless continues to promote its export sector and maintains interest rates near 0%.

Even if the Chinese economy continues to expand and re-balances itself in the process (a dubious possibility), Pettis estimates that it would still need to increase the rate of foreign capital inflows to almost 10% of GDP. If economic growth slows to a more sustainable level and/or it continues to run a sizable trade surplus, this figure would rise to perhaps 20%. In this case, Pettis concedes, “we are also positing…a radical change in the nature of ownership and governance in China, as well as a radical redrawing of the role of the central and local governments in the local economy.”

So there you have it. The political/economic/financial structure of China is such that it would be arithmetically very difficult to increase foreign accumulation of RMB assets to the extent that the RMB would be a contender for THE global reserve currency. For this to change, China would have to embrace the kind of reforms that go way beyond allowing the RMB to fluctuate, and strike at the very core of the CCP’s stranglehold on power in China.

If that’s what it will take for the RMB to become a fully international currency, well, then it’s probably too early to be having this conversation. Perhaps that’s why the Asian Development Bank, in a recent paper, argued in favor of modest RMB growth: “sharing from about 3% to 12% of international reserves by 2035.” This is certainly a far cry from the “10 years” declared by Russia’s finance minister and tacitly supported by Chinese economic policymakers.

The implications for the US Dollar are clear. While it’s possible that a handful of emerging currencies (Brazilian Real, Indian Rupee, Russian Ruble, etc.) will join the ranks of the international currencies, none will have enough force to significantly disrupt the status quo. When you also take into account the economic stagnation in Japan and the UK, as well as the political/fiscal problems in the EU, it’s more clear than ever that the Dollar’s share of global reserves in one (or two or three) decades will probably be only slightly diminished from its current share.

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