Tag Archive | "Monetary Policy"

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Pound Stagnates, Lacking Direction


The British Pound has struggled to find direction in 2011. After getting off to a solid start – rising 4% against the US dollar in less than a month –  the Pound has since stagnated. At 1.625 GBP/USD, it is now at the same level that it was at five months ago. Given the paltry state of UK fundamentals, the fact that it still has any gains to hold on to is itself something of a miracle.


The Pound’s failure to make any additional headway shouldn’t come as a surprise. First of all, the Pound is not a safe haven currency. That means that the only chance it has to rise is when risk is “on.” Unfortunately, the Pound also scores pretty low in this regard. Annual GDP growth is currently a pathetic .5%, and is projected at only 1.8% for the entire year. Inflation is high, and both the trade balance and the current account balance are in deficit. Deficit spending has caused a surge in government debt, and there is a possibility that the UK could lose its AAA credit rating.

Investors might be willing to overlook all of this if interest rates were at an attractive level. Alas, at .5%, the Bank of England’s (BOE) benchmark rate is among the lowest in the world. Moreover, it isn’t expected to begin hiking rates for many months, and even then, the pace will be slow. Simply, the economy is too fragile to support a serious tightening of monetary policy. Interest rate futures reflect a consensus expectation that rates will be only 75 basis points higher one year from now.

If that’s the case, why hasn’t the Pound crashed entirely? To be fair, the Pound is losing groroundround against both the euro and the franc, the former of which has it bested in economic grounds while the latter is cashing in on its status as a safe haven currency. On the other hand, the Pound is still up for the year against the US dollar and Japanese Yen, both of which are also safe haven currencies.

It could be the case that the Pound is simply not the ugliest currency, since all of the charges that can be leveled against it can similarly be leveled against the dollar. Head-to-head, it’s actually quite possible that the Pound still wins, if only because its interest rates are slightly higher than the US. Or, it could be the case that investors still believe the BOE will come around and begin hiking rates. After all, at the beginning of the year (when by no coincidence, the Pound was still rising), expectations were that the BOE would have already hiked twice by this time, bringing the benchmark to a level that would make the Pound attractive to carry traders. While the BOE hasn’t followed through, carry traders may be sticking around, since the opportunity cost of holding the Pound is basically nil.

As for whether the Pound correction (that I first observed last month) will continue, that depends entirely on the BOE. Unfortunately, there is very little reason to believe that the UK economy will suddenly pick up, and hence very little reason to expect the BOE to suddenly tighten. At some point, earning .5% interest on Pounds will become unattractive to investors. Until that day comes, that might stick with the Pound out of sheer inertia. While the Pound may hold its value for this reason, I don’t think it has any hope of appreciating further this year.

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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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Pound Correction is Already Underway


Last week, I was preparing to write a post about how the British pound was overvalued and due for a correction, but was sidetracked by a series of interviews (the second of which – with Caxton FX – incidentally also hinted at this notion). Alas, the markets beat me to the bunch, and the pound has since fallen more than 3% against the dollar- the sharpest decline in more than six months. Moreover, I think there is a distinct possibility that the pound will continue to fall.

Not much has changed since the last time I wrote about the pound. If anything, the fundamentals have deteriorated. Fortunately, the latest GDP data showed that the UK avoided recession in the latest quarter, but this is offset by the fact that overall GDP remains the same as six months ago and still 4% below pre-recession levels. Despite a slight kick from the royal wedding in April, the UK will almost certainly finish 2011 towards the low end of OECD countries, perhaps above only Japan. Ed Balls, shadow chancellor of the UK, has conceded, “We’ve gone from the top end of the economic growth league table to being stuck at the bottom just above Greece and Portugal.”

Of course, the question on the minds of traders is whether the Bank of England (BOE) will raise interest rates. Initially, it was presumed (by me as well) that the BOE would be the first G4 central bank to hike, if only to contain high inflation. In fact, at the March monetary policy meeting, three members (out of nine) voted to do just that. However, there stance softened at the April meeting, and they have since been beaten to the bunch by the European Central Bank (ECB) which is notoriously more hawkish.

Now, it seems reasonable to wonder whether the BOE might also fall behind the Fed. While still high (4%), the British CPI rate has slowed in recent months. “The bank’s Governor Mervyn King said on Jan. 26 that rising prices would be temporary.” Moderating commodity prices have reduced the need for a rate hike, and bolstered the case for keeping the pound week. Unemployment is high, construction spending is falling, and the current account deficit remains wide. Moreover, budget cuts (declined to contain a national debt that has almost doubled in the last three years) and a a hike in the VAT rate have dampened the economy further, to the point that it might not be able to withstand even a slight rate hike.

Furthermore, record low Gilt (the British equivalent of the US Treasury bond) rates reflect expectations for continued low rates for the immediate future. If Q2 GDP growth – which won’t be released for another 3 months -is strong, the BOE might conceivably vote to tighten. Still, we probably won’t see more than one 25 basis point before 2012.

It seems that the only thing that kept the pound afloat so long was its correlation with the euro, which recently rose above $1.50. It has since fallen dramatically and dragged the pound down with it. In fact, the pound probably needs to fall another 3% just to stay on track with the euro. If this correlation were to break down, it would almost certainly fall much further.

It has become cliched to suggest that the forex markets have become a reverse beauty pageant, whereby investors vote not on the most attractive currencies, but rather on the least ugly. At this point, it is safe to say that among G4 currencies, the pound is the ugliest.

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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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Dollar will Rally when QE2 Ends


In shifting their focus to interest rates, forex traders have perhaps overlooked one very important monetary policy event: the conclusion of the Fed’s quantitative easing program. By the end of June, the Fed will have added $600 Billion (mostly in US Treasury Securities) to its reserves, and must decide how next to proceed. Naturally, everyone seems to have a different opinion, regarding both the Fed’s next move and the accompanying impact on financial markets.

The second installment of quantitative easing (QE2) was initially greeted with skepticism by everyone except for equities investors (who correctly anticipated the continuation of the stock market rally). In November, I reported that QE2 was unfairly labeled a lose-lose by the forex markets: “If QE2 is successful, then hawks will start moaning about inflation and use it as an excuse to sell the Dollar. If QE2 fails, well, then the US economy could become mired in an interminable recession, and bears will sell the Dollar in favor of emerging market currencies.”

The jury is still out on whether QE2 was a success. On the one hand, US GDP growth continues to gather force, and should come in around 3% for the year. A handful of leading indicators are also ticking up, while unemployment may have peaked. On the other hand, actual and forecast inflation are rising (though it’s not clear how much of that is due to QE2 and how much is due to other factors). Stock and commodities prices have risen, while bond prices have fallen. Other countries have been quick to lambaste QE2 (including most recently, Vladimir Putin) for its perceived role in inflating asset bubbles around the world and fomenting the currency wars.

Personally, I think that the Fed deserves some credit- or at least doesn’t deserve so much blame. If you believe that asset price inflation is being driven by the Fed, it doesn’t really make sense to blame it for consumer and producer price inflation. If you believe that price inflation is the Fed’s fault, however, then you must similarly acknowledge its impact on economic growth. In other words, if you accept the notion that QE2 funds have trickled down into the economy (rather than being used entirely for financial speculation), it’s only fair to give the Fed credit for the positive implications of this and not just the negative ones.

But I digress. The more important questions are: what will the Fed do next, and how will the markets respond. The consensus seems to be that QE2 will not be followed by QE3, but that the Fed will not yet take steps to unwind QE2. Ben Bernanke echoed this sentiment during today’s inaugural press conference: “The next step is to stop reinvesting the maturing securities, a move that ‘does constitute a policy tightening.’ ” This is ultimately a much bigger step, and one that Chairman Bernanke will not yet commit.

As for how the markets will react, opinions really start to diverge. Bill Gross, who manages the world’s biggest bond fund, has been an outspoken critic of QE2 and believes that the Treasury market will collapse when the Fed ends its involvement. His firm, PIMCO, has released a widely-read report that accuses the Fed of distracting investors with “donuts” and compares its monetary policy to a giant Ponzi scheme. However, the report is filled with red herring charts and doesn’t ultimately make any attempt to account for the fact that Treasury rates have fallen dramatically (the opposite of what would otherwise be expected) since the Fed first unveiled QE2.

The report also concedes that, “The cost associated with the end of QEII therefore appears to be mostly factored into forward rates.” This is exactly what Bernanke told reporters today: “It’s [the end of QE2] ‘unlikely’ to have significant effects on financial markets or the economy…because you and the markets already know about it.” In other words, financial armmagedon is less likely when the markets have advanced knowledge and the ability to adjust. If anything, some investors who were initially crowded-out of the bond markets might be tempted to return, cushioning the Fed’s exit.

If bond prices do fall and interest rates rise, that might not be so bad for the US dollar. It might lure back overseas investors, grateful both for higher yields and the end of QE2. Despite the howls, foreign central banks never shunned the dollar.  In addition, the end of QE2 only makes a short-term interest rate that much closer. In short, it’s no surprise that the dollar is projected to “appreciate to $1.35 per euro by the end of the year, according to the median estimate of 47 analysts in a Bloomberg News survey. It will gain to 88 per yen, a separate poll shows.”

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Emerging Market Dilemma: Currency Appreciation or Inflation?


By now, we’re all too familiar with both the so-called currency wars and its underlying cause – the inexorable appreciation of emerging market currencies. As more and more Central Banks enter the war in the form of forex intervention and capital controls, however, they are inadvertently stoking the fires of price inflation. They will all soon face a serious choice: either raise interest rates and cease trying to weaken their currencies or risk hyperinflation and concomitant economic instability.

This dilemma is fairly basic: a Central Bank cannot simultaneously control its currency and conduct an independent monetary policy. For example, if it seeks to adjust interest rates to serve domestic economic goals, it must understand that this will have unavoidable implications for demand for its currency, and vice versa. These days, that dilemma is becoming increasingly sharp. Inflation in many emerging markets is rising to dangerous levels, real interest rates or negative, and all the while, latent pressure continues to bubble under their currencies.

The problem is that investors have become so desperate for yield that they are willing to tolerate negative real interest rates in the short-term if they believe that interest rates and/or currencies will inevitably rise over the long-term. While capital controls have forced a modest decline in the carry trade, the expectation is that an inevitable tightening of monetary policy will soon make it viable once again.

Due to the ongoing (perception of) currency wars, emerging market Central Banks are trying to hold out for as long as possible, lest they make themselves into sudden targets for carry traders and currency speculators. Some have already bitten the bullet. Brazil, for example, raised its benchmark Selic rate to 11.25% recently and indicated additional rate hikes will follow. China has embarked on a similar path, but from a lower base. The majority of countries remain in firm denial, however. Last week, Turkey took the unbelievable step of lowering interest rates in a vain attempt to decrease pressure on the Lira.

Most Central Banks believe that they can enjoy the best of both worlds by cutting access to credit and raising banks’ reserve requirements (in order to combat inflation) and maintaining strict capital controls (in order to limit inflation). While they should be patted on the back for creativity, such Central Banks must understand that their efforts are probably doomed to fail over the long-term. That’s because currency investors understand that only a masochistic, short-sighted Central Bank would pursue a weak currency policy in spite of rising inflation for a sustained period of time. Unless economic growth slows (which is unlikely without certain policy measures) and/or inflation magically abates (due to steadying food/commodity prices, etc.), they will eventually have no choice to concede defeat. “Central banks view the level of exchange rates as the priority rather than using them to help slow inflation. Once you start targeting multiple objectives, the odds for policy mistakes increase,” summarized one strategist.

The only win/win solution involves a simultaneous appreciation of all emerging market currencies. This would alleviate some inflationary pressures without altering the competitive dynamics of national export sectors and negatively impacting economic growth. According to the Financial Times, “There could be a surprise agreement to rebalance currencies at the Group of 20 this spring, although the failure of its November summit does not augur well.” Besides, any agreement would probably be in the form of a reiteration of the status quo, in which emerging markets independently (rather than in concert) pursue similar economic policy objectives.

For better or worse, emerging market governments have started to refocus the blame for the currency wars away from the US and towards China. Regardless of whether the US is at fault for its quantitative easing program, emerging markets compete with China – and its allegedly undervalued currency – in matters of trade. Pressuring China to allow the Yuan to appreciate, then, would ultimately go a lot further in ending the currency war and eliminating their predicament than screaming at the Fed for flooding the world with Dollars. Due to a new President and shifting politics, Brazil is angling to force the issue.  Given that China is currently in the same boat (rising inflation with low interest rates), this might be the straw that breaks the camel’s back. “China may be more sensitive to what the other major emerging market countries think about its currency. It undermines their moral high ground when it’s Brazil criticizing them instead of the U.S,” observed one analyst.

In any event, barring some unforeseen crisis and a flare-up in risk aversion, emerging markets are expected to continue attracting outside capital (more than $1 Trillion in 2011 alone), and their currencies are expected to continue their steady, upward march.

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Why is the Japanese Yen Still Rising?


Most of today’s headlines regarding the Japanese Yen focus on one thing: Central Bank intervention. Basically, reporters have become focused on the likelihood of additional intervention in the currency markets by the Bank of Japan. However, this obsession has caused them to overlook the larger issue: Why is the Yen still rising?

JPY Versus USD Chart 1970 - 2010

I was prompted to ask this question after coming across the above chart, which tracks the historical performance of the Japanese Yen against the US Dollar. You can see that since 1970, the Yen has risen by a whopping 350% against the Dollar. It has doubled in value since 1990 and risen 14% since the start of the year, en route to a 15-year high. Over the same period (actually since 1980; I couldn’t find data from the 1970), Japan’s economy has expanded by an average annualized growth rate of 2.2%. Over the last 10 years, the average is a paltry .9%. The contradiction between fundamentals and reality could not be more stark!

In addition, investor risk appetite has been reinvigorated. During most of the last decade, carry trading caused the Yen to decline to 120 USD/JPY as investors borrowed Yen in bulk in order to purchase high-yielding assets. The credit crisis spurred a short squeeze (i.e. rapid unwinding of carry trade positions) in early 2007, and caused the Yen to rocket upward. If anything, we would expect the Yen to mirror its performance of a few years ago, as investors take advantage of low Japanese interest rates and rebuild carry trade positions in the Yen.

The recent run-up in emerging market currencies, global equities, commodities, and other risky assets would certainly seem to support a carry trade strategy. For its part, the Bank of Japan is also doing its best to create a healthy environment for carry trading by printing currency, easing monetary policy, and fighting to keep the Yen from rising. And yet, if indeed there are still carry traders (and there certainly are!), the current trend in forex markets suggests that they are very much outnumbered by those betting on the Yen’s rise.

It’s difficult to understand this phenomenon. Those that hold Yen earn a nominal return of near 0%. Long-term interest rates (proxied by 10-year government bonds) are only slightly higher – at 1% – and certainly too low to attract any foreign institutional interest. Besides, it’s well-known that 90% of Japanese government debt is held by domestic savers. Meanwhile, the Japanese stock market has stagnated for more than 2 decades, and the Nikkei average is lower than at any point since 1985 (except for a brief period following the dot-com bust. Japanese real estate is equally unattractive.

As a result, there are only two conceivable reasons for the Yen’s continued upward push. The first is fundamental/structural and is connected to Japan’s trade surplus. In spite of an appreciating currency, the Japanese export sector continues to be the lone bright spot in an economy with otherwise limited sources of growth. Compared to 2009, the trade surplus is up 83%, helped by a rise of 50% in September. It is on pace to top $100 Billion for the year. In this regard, foreigners that buy Japanese Yen do so because they must- for purposes of trade.

Japan inflation rate chart 1970 - 2010

The second source of demand for Japanese Yen is so-called safe haven flows. While the Japanese Yen is not a high-yielding currency, it is actually an excellent store of value. [This is one of the three primary functions that a currency should fulfill. The other two are medium of exchange and unit of account]. That’s because inflation in Japan is the lowest in the world, often to the point of being nil. Since 1970, the inflation rate has averaged only 3%, compared to 4.5% in the US. Over the last 15 years, inflation has been 0%. In other words, even if they are invested in low-yielding savings accounts, Japanese savers can ensure that 1 Yen today will probably still be worth 1 Yen 5 years from now. Foreign investors can take advantage of the same phenomenon, when they bet that the exchange value of the Yen will be equally stable.

On the one hand, it is somewhat surprising that the Yen has been able to thrive in the current “risk-on” investing climate. On the other hand, there is a parallel thread of risk-aversion that will always exist and gravitate towards safe-haven currencies, such as the Yen. In fact, it can be argued that this contingent of investors is as large as the risk-taking contingent, as evidenced by the inexorable appreciation of gold (if not also by the Yen). Insofar as inflation in Japan remains nil and the Japanese export sector proves it can be competitive regardless of exchange rates, demand for Yen will continue to confound the gloomy forecasts and rebuff the best efforts of the Bank of Japan.

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Euro Due for a Correction


Since touching a four-year low in June, the Euro has risen a whopping 19% against the Dollar – a veritable surge! One has to wonder, however, if perhaps the Euro hasn’t gotten ahead of itself in its race back upward.

The Euro’s nonstop rise has perplexed me. During the throes of the Eurozone Sovereign debt crisis, it seemed as if the Euro was headed back towards parity, if it even remained in existence! The European Commission’s $500 Billion bailout plan seemed to assuage the markets, but didn’t do much to mitigate against the risk of sovereign default. Besides, it looks like all of the austerity measures will be undone after the next election cycle. Opposition to further budgets is so vehement, and unemployment is so high (12% in Greece, 20% in Spain) that it will be difficult for leaders to stay in office if they continue to push an agenda that reduces their deficits.

Euro Dollar 1 Year Chart

As evidence that bond investors remain skeptical, consider that Greek debt still trades at a 700 basis point premium to German bonds. EU cheerleaders love to point to the fact that at-risk Eurozone countries are having no trouble tapping the credit markets, but that’s not really surprising when you consider the lofty returns that investors receive for buying bonds that are essentially backed by the good credit of the EU.

Even ignoring the fiscal problems of the EU, the economic picture is not pretty. “The Economist Intelligence Unit, in its just-released report…is forecasting that growth in Western Europe will reach only 1.1% next year, and at or below 1.7% at least through 2015, beyond which it wisely declines to look.” When you subtract out Germany – the engine of the EU economy –  GDP growth will be even more pathetic. And don’t even mention the peripheral economies, many of which are at serious risk for sliding back into recession.

Moreover, the European Central Bank (ECB) monetary policy is just as loose as in other industrialized countries. Through its quantitative easing program, the ECB has injected hundreds of billions of Euros into the banking system and credit markets. Jean Claude Trichet, President of the ECB, bristled at the idea of ending this support: “No! This is not the position of the Governing Council, with an overwhelming majority.This non-standard measure…was designed to help restore a more normal functioning of our monetary policy transmission mechanism.”

On the other hand, the ECB is sterilizing all of its market intervention, which means that most of the funds that it is injected into the economy will remain in the EU. Contrast this with the Fed’s quantitative easing program (which hasn’t been sterilized) and you begin to understand why the Euro has held up well. In addition, Eurozone inflation currently exceeds US inflation (at a 50-year low), which means that the ECB will hesitate before following the Fed in easing monetary policy further.

Still, I don’t think there is a strong foundation for the Euro’s rise. It’s understandable that the expansion of the Fed’s quantitative easing program (”QE2″) is making investors nervous, causing them to send cash out of the US as a preventative measure. However, this seems a little too much like the tail wagging the dog, since until QE2 is officially implemented, all anticipatory shifts in capital flows are purely speculative – not fundamental. And as a fundamental analyst, that concerns me.

I think investors got ahead of themselves when they pushed the Euro down 20% over the first half of 2010, but now they are in danger of making the same mistake, and are pushing the Euro too far in the opposite direction. According to the most recent Commitment of Traders report, investors are building up long positions in the Euro, to the point that trading is becoming lopsided. I’m not much for short-term technical analysis, but when the Relative Strength Index (RSI) and Moving Average Convergence Divergence (MACD) are both approaching 2-year highs, it tells me that a correction is coming.

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Bullish on the Euro?


Wouldn’t life just be a little easier if the EUR/USD, the most important forex pair and bellwether of currency markets, could simply pick a direction and stick to it. It dove during the financial crisis, only to surge during the apparent recovery phase, fell during the sovereign debt crisis, and rose during the paradigm shift, then fell as risk appetite waned, only to rise again in September, en route to a 5-month high.

Euro Dollar 5 Year Chart 2006-2010
There are a handful of factors which currently underlie the Euro’s strength, which can all generally be explained by the fact that risk is “on” at the moment, and the markets are moving away from so-called safe haven currencies and back towards growth investments. Of course that could change tomorrow (or even 5 minutes from now!), but at the moment, risk appetite is high and the Euro symbolizes risk. Never mind how ironic it is, that growth in the EU is projected at 1.8% for the year while Rest of World (ROW) GDP will probably top 5%. All that matters is compared to the Dollar (and Yen, Pound, Franc to a lesser extent) the Euro is perceived as the currency of risk.

The Euro’s cause is also helped by the ongoing “currency wars,” which heated up last week with Japan’s entry into the game. Basically, Central Banks around the world are now competing with each other to devalue their currencies. In contrast, the European Central Bank (ECB) has decided to remain on the sidelines (in favor of fiscal austerity), which is forcing the Euro up (or rather all other currencies down). To make matters even worse, “The U.S. Federal Reserve indicated this summer that it may ease monetary policy further… often seen as printing money to pump up the economy.” As a result, “The euro looks set to keep on climbing in a trend that looks increasingly entrenched.”

There are certainly those that argue that the Euro’s recent surge reflects renewed confidence in the Eurozone economy and prospects for resolving the EU debt crisis. After all, most Euro members will reduce their budget deficits in 2010 and auctions of new bonds are once again oversubscribed. On the other hand, interest rates for the PIGS (Portugal, Italy, Greece, and Spain) have risen to multi-year highs, as investors are finally trying to make a serious effort at pricing the possibility of default.

Eurozone sovereign debt interest rates graph 2007-2010
In addition, the credit markets in the EU are barely functioning, and large institutions remain dependent on the ECB’s credit facilities for financing. Finally, it shouldn’t be forgotten that the only reason crisis was due to the massive support (€140 Billion) extended to Greece. When this program expires in less than three years, the fiscal problems of Greece (and the other PIGS) will be exposed once again, and a new (stopgap) solution will need to be proposed.

As every analyst has pointed out, none of the EU’s fiscal problems have been solved. EU members have certainly proven adept at resolving acute crises and the ECB certainly deserves credit for keeping credit markets functioning, but none has proposed a viable solution for repairing of member countries’ fiscal and economic health. Currency devaluation is impossible. Sovereign default is being prevented. That leaves wage cuts and increased productivity as the only two paths to equilibrium. The former could be accomplished through inflation, but the ECB seems reluctant to allow this to happen.

Eurozone Budget Deficits, GDP

For better or worse, the EU seems to have pushed these problems down the road, and if all goes according to plan, they won’t need to be revisited for 2-3 years. For now, then, the Euro is probably safe, and may even thrive. Short positions in the Euro are being unwound with furious speed and data indicate that there is still plenty of scope for further unwinding. Inflation remains subdued, economic growth is stable, and the ECB so far hasn’t voiced any disapproval of the Euro’s rise. While I promote this bullishness with the caveat that “traders have shown a willingness to smack the euro lower from time to time on the slightest news or rumor of downgrades to euro-zone sovereign or bank ratings,” the general Euro trend is now unquestionably UP.

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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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