Tag Archive | "Risk Appetite"

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Emerging Market Currencies Brace for Correction


“It was the spring of hope, it was the winter of despair,” begins Charles Dickens’ The Tale of Two Cities. In 2011, the winter of despair was followed by the spring of uncertainty. Due to the earthquake/tsunami in Japan, the continued tribulations of Greece, rising commodity prices, and growing concern over the global economic recovery, volatility in the forex markets has risen, and investors are unclear as to how to proceed. For now at least, they are responding by dumping emerging market currencies.


As you can see from the chart above (which shows a cross-section of emerging market forex), most currencies peaked in the beginning of May and have since sold-off significantly. If not for the rally that started off the year, all emerging market currencies would probably be down for the year-to-date, and in fact many of them are anyway. Still, the returns for even the top performers are much less spectacular than in 2009 and 2010. Similarly, the MSCI Emerging Markets Stock Index is down 3.5% in the YTD, and the JP Morgan Emerging Market Bond Index (EMBI+) has risen 4.5% (which is reflects declining growth forecasts as much as perceptions of increasing creditworthiness).

There are a couple of factors that are driving this ebbing of sentiment. First of all, risk appetite is waning. Over the last couple months, every flareup in the eurozone debt crisis coincided with a sell-off in emerging markets. According to the Wall Street Journal, “Central and eastern European currencies that are seen as being most vulnerable to financial turmoil in the euro zone have underperformed.” Economies further afield, such as Turkey and Russia, have also experienced weakness in their respective currencies. Some analysts believe that because emerging economies are generally more fiscally sound than their fundamental counterparts, that they are inherently less risky. Unfortunately, while this proposition makes theoretical sense, you can be assured that a default by a member of the eurozone will trigger a mass exodus into safe havens – NOT into emerging markets.


While emerging market Asia and South America is somewhat insulated from eurozone fiscal problems. On the other hand, they remain vulnerable to an economic slowdown in China and to rising inflation. Emerging market central banks have avoided making significant interest rate hikes (hence, rising bond prices) – for fear of inviting further capital inflow and stoking currency appreciation – and the result has been rising price inflation. You can see from the chart above that the darkest areas (symbolizing higher inflation) are all located in emerging economic regions. While high inflation is not inherently problematic, it is not difficult to conceive of a downward spiral into hyperinflation. Again, a sudden bout of monetary instability would send investors rushing to the exits.


While most analysts (myself included) remain bullish on emerging markets over the long-term, many are laying off in the short-term. “RBC emerging market strategist Nick Chamie says his team has recommended ‘defensive posturing’ to clients since May 5 and isn’t recommending new bullish emerging currency bets right now….HSBC said Thursday that it isn’t recommending outright short positions on emerging market currencies to clients but suggested a more ‘cautious’ and selective approach in making currency bets.” This phenomenon will be exacerbated by the fact that market activity typically slows down in the summer chart above courtesy of Forex Magnates) as traders go on vacation. With less liquidity and an inability to constantly monitor one’s portfolio, traders will be loathe to take on risky positions.

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S&P 500 Decouples from Euro?


While I have written quite about forex correlations in recent posts, the focus has primarily been on correlations that exist between currencies. In this post, I would like to address a correlation that exists between currencies and other forex markets- specifically the relationship between the Euro and US stocks.


If you look at the chart above, you can see that an unmistakable correlation exists between the S&P500 and the EUR/USD that stretches back at least six months. Generally speaking, when the EURUSD has risen, so has the S&P 500, and vice versa. In fact, this correlation is so airtight that one analyst recently discovered that the two financial vehicles often reach intra-day highs and lows within minutes of one another!

Why is this the case? In a nutshell, it is because the Euro – especially relative to the dollar – is a proxy for risk appetite. The same is necessarily true for US stocks. When investors are confident in the strength of the global economic recovery and the possibility of crisis is distant, the euro will rise. This has nothing to do with fundamentals in Europe, which are probably at least as bad as they are in the US. Of course, it may be connected with dollar weakness, since it is arguably the case that quantitative easing has both depressed the dollar and buoyed US stocks.

As I intimated in the title of this post, however, the S&P recently decoupled from the euro. Since the beginning of June, US equities have declined sharply, to the extent that they have given back most of their gains in the year-to-date. The EUR/USD, meanwhile, continued rising all the way until last week. While this has happened on a couple previous occasions, this was perhaps the sharpest break between the two.

I’m personally at a loss to explain why this happened. It has been conjectured that the driving force behind the correlation is algorithmic trading, and that hence, it must also represent the source of the break. In other words, high-frequency traders – which account for an ever-increasing proportion of forex volume – tweaked their trading algorithms so as not to buy the S&P 500 when the EURUSD rises, and vice versa.

It’s probably also the case that S&P 500 was falling for endogenous reasons- specifically a decline in GDP growth and earnings expectations which need not necessarily reflect itself in a stronger euro. In fact, in a normal functioning market, you would expect an inverse correlation; strong US economic fundamentals should translate into both a strong dollar and rising stocks. Could it be that worsening fundamentals are manifesting themselves in the form of a weak dollar and weak stocks?

Alas, the correlation has re-established itself over the last week, which means this is largely a moot issue. At the very least, it’s still worth being aware of, both insofar as it remains intact and in the event that it breaks down again.

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How to Trade the Franc-Yen-Dollar Correlation


Last week, the Wall Street Journal published an article entitled, “Currency Correlations Lose Their Way for Now.” My response: It depends on which currencies you’re looking at. I, too, recently posted about the break-down of multi-year correlations, specifically involving the Australian Dollar and the New Zealand Dollar. However, one has to look no further than the Swiss Franc to see that in fact currency correlations are not only extant, but flourishing!

I stumbled upon this correlation inadvertently, with the intention (call it a twisted hobby…) of refuting the crux of the WSJ article, which is that “Standard relationships between risk appetite and safe havens, and yields and risky assets, are lost as investors appear to scramble in their efforts to adapt to a new direction.” Basically, the author asserted that forex traders are searching for guidance amidst conflicting signals, but this has caused the three traditional safe haven currencies to behave erratically: apparently, the Franc has soared, the Yen has crashed, and the US Dollar has stagnated.


I pulled up a one-year chart of the CHFUSD and the CHFJPY in order to confirm that this was indeed the case. As you can see from the chart above, it most certainly is not. With scant exception, the Swiss Franc’s rise against both the US Dollar and the Japanese Yen has been both consistent and dependable. The only reason that there is any gap between the two pairs is because the Yen has outperformed the dollar over the same time period. If you shorten the time frame to six months or less, the two pairs come very close to complete convergence.

In order to provide more support for this observation, I turned to the currency correlations page of Mataf.net (the founder of which I interviewed only last month). Sure enough, there is a current weekly correlation of 93% [it is displayed as negative below because of the way the currencies are ordered] between the CHFUSD and the CHFJPY, which is to say that the two are almost perfectly correlated. (Incidentally, the correlation coefficient between the USDCHF and the USDJPY is a solid 81%, which shows that relative to the Dollar, the Yen and Franc are highly correlated). Moreover, if Mataf.net offered correlation data based on monthly fluctuations, my guess it that the correlations would be even tighter. In any event, you can see from the chart that even the weekly correlation has been quite strong for most of the weeks over the last year.


The first question most traders will invariably ask is, “Why is this the case?” What is causing this correlation? In a nutshell, the answer is that the WSJ is wrong. As I wrote last month, the safe haven trade is alive and well. Otherwise, why would two currencies as disparate as the Franc and the Yen (whose economic, fiscal, and monetary situations couldn’t be more different) be moving in tandem? The fact that they are highly correlated shows that regardless of whether they are rising or falling is less noteworthy than the fact that they tend to rise and fall together. Generally speaking, when there is aversion to risk, both rise. When there is appetite for risk, they both fall.

The superseding question is, “What should I do with this information?” Here’s an idea: how about using this correlation for diversification purposes? In other words, if you were to make a bet on risk aversion, for example, why not sell both the USDJPY as well as the USDCHF? In this way, you can trade this idea without putting all of your eggs in one basket. If risk aversion picks up, but Japan defaults on its debt (an extreme possibility, but you see my point), you would certainly do better than if you had only sold the USDJPY. The same goes for making a bet on the Franc. Whether you believe it will continue rising or instead suffer a correction, you can limit your exposure to counter currency (i.e. the dollar and yen) risk by trading two (or more) correlated pairs simultaneously.

In the end, just knowing that the correlation exists is often enough because of what it tells you about the mindset of investors.  In this case, it is just more proof that they remain heavily fixated on the idea of risk.

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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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Untangling the Puzzle of Risk Appetite


When analyzing forex, nothing is more satisfying than establishing a strong correlation between a particular currency pair and another quantifiable investment vehicle. You see – we fundamental analysts love to kid ourselves that we can actually explain what’s going in the forex markets, but it’s only when you can visually observe (and statistically confirm) a correlation can you actually pretend that this self-assuredness is justified.

On that note, I found myself looking at in interesting chart today: the EUR/USD vs. CHF/USD vs. S&P 500 Index. My purpose in drawing this particular chart was to ascertain how risk appetite (represented by the S&P) is being reflected in forex markets. As you can see, two observations can immediately be made. CHF/USD very closely tracks the S&P (or vice versa), while the EUR/USD similarly mirrored the S&P for most of the last 12 months, before suddenly diverging in November 2010.


By extension, this raises two questions. First, why should a rising S&P be accompanied by the Swiss Franc? After all, the former is a proxy for risk appetite, while the latter is a symbol of risk aversion. That means that tither the S&P is a weak indicator of risk appetite, or the Swiss France is not being driven by risk aversion. In a way, I think both notions are true. Specifically, US equity prices are are primarily a sign of US economic recovery and strong corporate profits. It’s probably equally accurate to say that the S&P promotes risk appetite, as saying it reflects risk appetite.

Moreover, as US stocks and investor risk appetite have increased, interest in the US Dollar has (somewhat ironically) decreased. One would think that this would spur a depreciation in the Swiss Franc, but I guess this was superseded by the falling Dollar. [For that reason, I actually added the MSCI Emerging Markets Stock Index after I started writing this post, because I realized it was a better proxy for global investor risk appetite. Sure enough, the recent continuation in the Franc’s rise has coincided with a correction in emerging market stocks].

While this explains why the Euro should also appreciate for five consecutive months, it doesn’t offer any insight into why the EUR/USD correlation with the S&P should suddenly breakdown. [Question #2]. Recall from my earlier posts that there was a sudden flareup in the Eurozone sovereign debt crisis in November 2010. Around that time, there were a handful of debt downgrades, Ireland received an EU bailout, and there was heightened concern that the crisis would soon spread from Greece to the rest of the PIGS.

This caused a bout of intense Euro instability, against both the US Dollar and Swiss Franc. While the S&P continued rising, interest in emerging market stocks began to flag. It’s extremely tempting to posit a connection between these two trends, especially since it would seem to be implied by the chart. However, I think the correction in emerging markets is due more to Central Bank intervention and a recognition that a bubble was forming, than to the EU sovereign debt crisis. That the Euro has rallied in 2011 even as emerging market stocks have begun to decline, supports this interpretation.

Trying to draw meaningful conclusions from these correlations is frustrating at best, and dangerous at worst. Namely,  that’s because it’s impossible to completely distinguish cause from effect. The two stock market indexes are probably the least dependent of the four items. For instance, the Euro is derived in part from the Dollar, which is derived in part from the S&P. You could say that the Franc takes its cues from the S&P (as a proxy for risk appetite) and the Euro. Second of all, the strongest correlation on the chart (CHF/USD and S&P) is also the most unexpected.

In the end, I think only one solid conclusion can be drawn: uncertainty surrounding the Euro will continue to boost the Franc. While I probably could have told you that without the use of this chart, at the very least, it reinforces the interconnectedness of all financial markets and that even if poorly understood, all trends are ultimately related.

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Hedging High Forex Uncertainty


In forex, everything is relative. That is no less the case for forex volatility, which is low relative to the spikes in 2008 (credit crisis) and 2010 (EU Sovereign debt crisis), but high relative to the preceding 5+ years of stability. On the one hand, volatility is approaching a two year low. On the other hand, analysts continue to warn of high volatility for the foreseeable future. Under these conditions, what are (currency) investors supposed to do?!

Despite the steady pickup in risk appetite in 2010, there remains a whole a host of forex risk factors. On the economic front, GDP growth remains anemic in western countries, unemployment is high, and consumer confidence is low. Budget deficits and national debts are rising, perhaps to the point that default by a major industrialized countries is inevitable. Emerging market countries seem to be ‘suffering’ from the opposite problem, whereby rapid growth, high commodities prices, and capital inflow has caused inflation to rise precipitously. Some Central Banks will be forced to hike interest rates, while others will try to maintain an easy monetary policy for as long as possible. Political crises flare-up without warning, the Euro risks breaking up, and inclement weather is wreaking havoc on food production.

As a result, most currency-market watchers expect 2011 to be a continuation of 2010. In other words, while we might be spared a major crisis, a generalized sense of uncertainty will continue to pervade forex. According to JP Morgan, “Implied volatility on options for major exchange rates averaged 12.34 percent this year, compared with an average of 10.6 percent since January 2000.”  The currency team of UBS predicts, “The divergence between the strength in emerging markets and the unusual levels of uncertainty in the world’s major economies will cause…super volatility,” whereby massive swings in exchange rates will become the norm.

In this environment, there are a number of things that currency traders should do. The first step is simply to be aware that volatility remains high, which means that wider-than-average fluctuations shouldn’t be a surprise. The next step is to decide whether you think that this volatility will remain at an elevated level for the near-term, or whether you expect it to continue declining. (It’s worth pointing out that volatility is not necessarily a perception of absolute risk, but investor perception of risk). The final step is deciding if/how you will tailor your trading strategy in response to changes in volatility.

In fact, you don’t necessarily need to limit your exposure to volatility. If you are a fundamental investor with a long-term approach, you may very well choose to write-off short-term fluctuations as noise. (Of course, if you are a short-term swing trader, you can’t afford to be quite so indifferent). In addition, if your primary interest is in another asset type, you may choose not to hedge any currency risk. Perhaps you believe that the base currency will continue appreciated and/or you relish the exposure to currency movements as an added benefit of asset price exposure. Along these lines, “During the planning stages of the UBS Emerging Markets Equity Income fund, UBS Global Asset Management considered offering investors a hedged share class. The team abandoned the idea when investors showed a preference for unhedged share classes.”

In addition, hedging currency risk is expensive, especially for exotic/illiquid currencies, and currencies characterized by above average volatility. Not to mention that currency hedges can still move against investors, resulting in heavy losses. Still, in 2010, “Corporations from the U.S., Japan and Europe increased the percentage of projected income protected against swings in exchange rates to a record,” which suggests that fear of adverse exchange rate movements still predominates.

Finally, there are those that want to construct second-order currency strategies based entirely on volatility. Using basic options techniques, such as spreads and straddles, it’s possible to profit from volatility (or lack thereof) regardless of which direction the underlying currencies move in. In fact, the CME Group recently introduced a new product series which seeks to perform this very function. Investors can already buy and sell futures based on short-term volatility in the EUR/USD, which will soon be replicated for all of the major currency pairs.


For those of you who like to keep it simple, it’s probably enough to monitor the JP Morgan G7 Currency Volatility Index, which is a good proxy for the risk associated with trading (major) currencies at any given time. When this index spikes, chances are the US Dollar and other safe haven currencies will follow suit.

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Forex Markets Look to Interest Rates for Guidance


There are a number of forces currently competing for control of forex markets: the ebb and flow of risk appetite, Central Bank currency intervention, comparative economic growth differentials, and numerous technical factors. Soon, traders will have to add one more item to their list of must-watch variables: interest rates.

Interest rates around the world remain at record lows. In many cases, they are locked at 0%, unable to drift any lower. With a couple of minor exceptions, none of the major Central Banks have yet raised their benchmark interest rates. The same applies to most emerging countries. Despite rising inflation and enviable GDP growth, they remain reluctant to hike rates for fear that they will invite further speculative capital inflows and consequent currency appreciation.

Emerging markets countries can only toy with inflation for so long. Over the medium-term, all of them will undoubtedly be forced to raise interest rates. The time horizon for G7 Central Banks is a little longer, due to high unemployment, tepid economic growth, and price stability. At a certain point, however, inflation will compel all of them to act. When they raise rates – and by much – may well dictate the major trends in forex markets over the next couple years.

Australia (4.75%), New Zealand (3%), and Canada (1%) are the only industrialized Central Banks to have lifted their benchmark interest rates. However, the former two must deal with high inflation, while the latter’s benchmark rate is hardly high enough for carry traders to take interest. In addition, the Reserve Bank of Australia has basically stopped tightening, and traders are betting on only one or two 25 basis point hikes in 2011. Besides, higher interest rates have probably already been priced into their respective currencies (which is why they rallied tremendously in 2010), and will have to rise much more before yield-seekers take notice.

China (~6%) and Brazil (11.25%) are leading the way in emerging markets in raising rates. However, their benchmark lending rates belie lower deposit rates and are probably negative when you account for soaring inflation in both countries. The Reserve Bank of India and Bank of Russia have also hiked rates several times over the last year, though again, not yet enough to offset rising prices.

Instead, the real battle will probably be fought primarily amongst the Pound, Euro, Dollar, and Franc. (The Japanese Yen is essentially moot in this debate, and its Central Bank has not even humored the markets about the possibility of higher interest rates down the road). The Bank of England (BoE) will probably be the first to move. “The present ultra-low rates are unsustainable. They would be unsustainable in a period of low inflation but they are especially unsustainable with inflation, however you measure it, approaching 5 per cent,” summarized one columnist. In fact, it is projected to hike rates 3 times over the next year. If/when it unwinds its quantitative easing program, long-term rates will probably follow suit.

The European Central Bank will probably act next. Its mandate is to limit inflation – rather than facilitate economic growth, which means that it probably won’t hesitate to hike rates if inflation remains above its 2% threshold. In addition, the front runner to replace Jean-Claude Trichet as head of the ECB is Axel Webber, who is notoriously hawkish when it comes to monetary policy. Meanwhile, the Swiss National Bank is currently too concerned about the rising Franc to even think about raising rates.


That leaves the Federal Reserve Bank. Traders were previously betting on 2010 rate hikes, but since these have failed to materialized, they have pushed back their expectations to 2012. In fact, there is reason to believe that it will be even longer than that. According to a Bloomberg News analysis, “After the past two U.S. recessions, the Fed didn’t start raising policy rates until joblessness had fallen about three- quarters of the way back to the full-employment level…To satisfy that requirement, the jobless rate would need to be 6.5 percent, compared with today’s 9 percent.” Another commentator argued that the Fed will similarly hold off raising rates in order to further stabilize (aka subsidize) banks and to help the federal government lower the real value of its debt, even if it means tolerating slightly higher inflation.


When you consider that US deposit rates are already negative (when you account for inflation) and that this will probably worsen further, it looks like the US Dollar will probably come out on the losing end of any interest rate battles in the currency markets.

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Despite Recent Rise, Euro Still Looks Weak


As the Euro moves past $1.38 per Dollar towards a 1-year high, many traders are wondering if perhaps the common currency’s woes aren’t in the past. This would be a mistake. That’s because most of the forces behind the Euro’s rally actually have very little to do with the Euro.

The main cause of Euro strength has been a pickup in risk appetite. Investors are becoming increasingly more confident in the prospects for global economy recovery, and the crisis mentality is rapidly fading. Ironically, the flurry of positive economic data emanating from the US has been terrible for the Dollar. You can see from the chart below that except for a gap in 2010 Q4 (due to a flareup in the EU sovereign debt crisis….more on that below), the US stock market rally has coincided with a shift away from the Dollar and towards the Euro.

In fact, the Euro still remains extremely vulnerable to the ebb and flow of investor risk tolerance. That applies not only to events endogenous tot the EU, but also to global market shocks. That means that any reminder of the Eurozone’s fiscal issues (such as last week’s downgrade of Ireland’s credit rating) is likely to be reflected in a weaker Euro. For another example, look no further than the recent political turmoil in Egypt and the wider Middle East. Summarized one analyst, “In itself, Egypt is not that big an economy. But there is some worry about the supply of oil through the Suez Canal. It does impart a negative vibe on risk.”

The Euro’s recent appreciation is also rooted in technical factors. What began as a modest rally quickly turned into a upward surge as investors moved to cover their short positions. The WSJ reported that “much of the recent rally was fueled by hedge funds and other speculative investors covering short positions…Investors are ‘not going out and buying the euro because they love it.’ ” This apparent short squeeze can be seen in the sudden and massive reversal of positions that was documented in the most recent CFTC Commitment of Traders Report.

On a related note, there are signs that Euro puts (which allow investors to hedge Euro exposure by giving them the right to sell) are unusually cheap at the moment. “Demand for euro puts, which give investors the right to sell the euro in the future, appears to be growing, relative to euro calls, which allow them to buy, analysts say. That reverses a recent trend that had investors actively selling euro puts or sitting on their hands as the euro climbed…[and] suggests investors are becoming more biased towards selling the euro.” If speculators think that the options market is mis-pricing risk, they might start buying up puts and exert downward pressure on the Euro.

The only factor which could be construed as legitimately positive for the Euro pertains to interest rate differentials. Currently, Euro rates are just as low as in the US and the rest of the G4 world. However, that could soon change. The European Central Bank (ECB) is notoriously hawkish when it comes to conducting monetary policy. If you recall, it foolishly raised its benchmark interest rate during the height of the credit crisis. With inflation already running above 2%, you can bet that it will only be a matter of time before it reacts in kind. For the sake of contrast, consider that the Fed is still in the process of easing, via QE2.

While rate hikes would certainly provide a boost for the Euro, it is unlikely that rate differentials will be wide enough to spur any serious among yield-seeker in the immediate future. In short, I think the downside risks to the Euro (which is apparently on the verge of “disintegration,” according to George Soros) far outweigh any further upside support, and I think the rally will peter out soon.

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Varied Forecasts for Canadian Dollar in 2011


The Canadian Dollar (“Loonie”) recorded a fairly strong 2010. It appreciated 5.5% against the US Dollar, as an encore to a 16% gain in 2009. Moreover, its rise occurred with remarkably little volatility, fluctuating within a tight range of $0.99 – $1.08 (CAD/USD. It total, it rose against “seven of its major peers,” and “gained 4.4 percent over the past year in a measure of 10 developed-nation currencies, Bloomberg Correlation-Weighted Currency Indexes showed.” As for 2011, it is expected to continue trading close to 1:1 against the USD, though analysts differ over which side of parity it will tend towards.

At the moment, there are a few key fundamental trends driving the Loonie. As the WSJ encapsulated, the first factor is investor risk tolerance: “The fortunes of the risk-sensitive Canadian dollar in 2011 will be determined in large part by the issues driving global market fluctuations.”  Due primarily to the EU sovereign debt crisis, risk appetite continues to experience dramatic ebbs and flows. Based on conventional wisdom, risk averse investors should incline towards shunning the Loonie in favor of the US Dollar and other safe haven currencies. However, if you track the Loonie’s actual performance, you can see that concerns over global financial instability have hardly impacted it. Thus, bulls see this uncertainty as a force that “pushes investors to diversify their foreign exchange holdings by picking up some Canadian dollars.”

The second set of factors are macroeconomic. While slowing slightly in the second half of the year, the Canadian economy nonetheless exhibited a solid performance, which is expected to continue into 2011. Goldman Sachs, for example, “now sees growth accelerating to 3.3 per cent in the second quarter of this year, and 3.5 per cent in both the third and fourth quarters amid improving domestic demand.” However, the strong performance by natural resources and Canadian export strength that drove growth in 2010 could also be interpreted as a wild card in 2011, as the trade surplus narrows from a moderation in commodities prices and an expensive Canadian Dollar.

Finally, there is the continuing search for “value currencies” that is driving investors towards the Loonie. According to Bill Gross, manager of the world’s biggest bond fund, “It’s a critical strategy going forward to get…into some currency that holds its value…I’d suggest Mexico, Brazil or Canada as three examples of countries with good fiscal balance sheets.” It doesn’t hurt that the Bank of Canada was the first G7 central bank to raise interest rates, and that its benchmark interest rate compares favorably with the US Dollar, Yen, etc. Moreover, it is forecast to hike rates by an additional 50 basis points in 2011, beginning in the third quarter. On the other hand, it will still be a couple years before rates are high enough to make carry trading viable. Besides, long-term interest rates are currently higher in the US, which means that investors hungry for yield will ultimately have to find other reasons for shifting funds to Canada.

Forecasts for the Canadian Dollar in 2011 are extremely varied. If there’s any consensus, it is that barring any unforeseen developments, the Loonie will spend the year close to parity with the US Dollar. A couple analysts expect a big (downside) move, but the majority expects that regardless of which way the Loonie ultimately trends, it probably won’t be far removed from current levels. “The Bloomberg composite of 32 forecasts has the loonie spending most of the year at parity, then dipping slightly by the fourth quarter.” A similar WSJ survey shows a median forecast of 1:1 throughout the entire year.

Some analysts expect more movement in the currency crosses (i.e. against currencies besides the US Dollar). Given that the Canadian Dollar accounts for such a small portion of overall forex trading volume, however, it seems more likely that CAD cross rates will take their cues entirely from the USD and the rule of triangular arbitrage. (For example, if the Dollar rises against the Loonie but falls against the Aussie in 2011, the Loonie will necessarily also fall against the Aussie, regardless of whether fundamentals dictate such a movie).

I’m personally inclined to agree with the majority. There are many good reasons to buy the Loonie, but most of these were already priced in during the Loonie’s steady climb over the last two years. Going forward, I think that the US economy represents a double-edged sword that will prevent the Loonie from rising further. In short, if the US economy falters, so will the Canadian economy. If the US economic recovery gathers momentum, however, there will be good reason to buy the US Dollar in lieu of its counterpart to the north.

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Emerging Market Currencies in 2011


Emerging market assets/currencies registered some unbelievable gains in 2010 as the global economy emerged from recession and investor risk appetite picked up. In the last few months, however, emerging market currencies gave back some of their gains as the EU sovereign debt crisis flared up and the currency wars began to rage. Given that neither of these uncertainties is likely to be resolved anytime soon, 2011 could be a tumultuous year for emerging markets.

Let’s look at the numbers for emerging markets in 2010. The highlights for currencies were the Malaysian ringgit and Thai baht rose, both of which “rose around 10% against the dollar, to their strongest levels since the Asian financial crisis in the late 1990s. The South African rand was up 14% versus the dollar. It was a minor currency, however, that was the world’s best-performing: Mining-rich Mongolia’s togrog finished the year 15% higher against the dollar.” After being allowed to resume its appreciation, the Chinese Yuan rose by a modest 3.5%.

The J.P. Morgan Emerging Markets Bond Index Global returned a record 11.9% in 2010, to the extent that now trades at a modest 2.5% spread over US Treasury bonds. The standout was probably Argentina, whose sovereign debt returned a whopping 35% over the year. Switching to equities, the MSCI Emerging Markets Index returned 16.4%, handily beating the MSCI World Index, which itself rose by an impressive 9.6%. The individual top performing stock markets in 2010 unsurprisingly were “Frontier markets such as Sri Lanka (+96.0%), Bangladesh (+83.5%), Estonia (+72.6%), Ukraine (+70.2%), the Philippines (+56.7%) and Lithuania (+56.5%).” In total, an estimated $825 Billion in private capital flowed into emerging markets during the year, including $53 Billion into local currency bonds.

Emerging markets took advantage of the surge in investor interest to issue record amount of local currency debt and through a plethora of massive stock IPOs. Still, the intractable rise in currency and asset prices was generally seen as an undesirable trend, and emerging markets took significant steps to counter it. More than a dozen central banks have already intervened directly in currency markets in a bid to hold down their currencies. According to the IMF, “Emerging nations had accumulated $1.2 trillion in currency reserves between the financial crisis’s peak in early 2009 and the third quarter of 2010,” including ~$300 Billion in Asia ex-China. Some countries, such as Brazil – poured $1 Billion a week into forex markets during the height of their intervention campaigns.

Speaking of Brazil, it was also among the first to impose capital controls, in the form of a 6% tax on foreign bond investors. Thailand, South Korea, Taiwan and Indonesia have also imposed capital controls, while Mexico has tapped an IMF credit line, which it can use to “manage the stability of its external balances.” Moreover, these countries collectively won an important victory at the fall meeting of the G20, by receiving formal permission for all of these measures.

Alas, most of these inflows were probably justified by fundamentals, which means that they are more difficult to fight against than if they were merely the product of speculation. For example, “Developing countries expanded at a 7.1 per cent rate, compared with 2.7 per cent in advanced countries.” Moreover, emerging market stocks are trading at an average P/E multiple of 14.5, well below their recent historical average. This means that in spite of impressive performance in 2010, corporate profits are still rising faster than share prices. In addition, yields on emerging market sovereign debt still exceed the yields on comparable debt for western countries, despite being lower risk in some ways.

While most of these trends are expected to persist in 2011, there is one overriding wild card. How emerging markets respond to this issue could determine whether emerging market currencies outperform again in 2011 or whether they sink back to more normal levels. Thanks to stimulative economic and fiscal policies, easy credit, and relatively loose monetary policies, emerging markets recorded phenomenal GDP growth in 2010. The downside has been inflation.

Inflation in Brazil and China, for example, officially exceeds 5%. (The actual rates are almost certainly higher). These countries, and a handful of others, are now in the awkward position of trying to control inflation without stimulating further currency appreciation. If they raise interest rates, economic growth and price growth will almost certainly moderate. By the same token,speculative hot money will probably continue to flow in. If they don’t tighten policy, however, inflation could easily spiral out of control, provoking economic stability and even social unrest. The upside is that real interest rates will turn negative, and their currencies will probably be depreciated by investors.

Most analysts expect emerging market central banks to gradually hike interest rates over the next couple years. For fear of stoking further speculation, however, policy will probably remain somewhat accommodative and will be accompanied by strict capital controls. Meanwhile, economic growth should begin to pick up in the industrialized world, accompanied by a similar tightening of monetary and fiscal policy. As a result, investors will be forced to decide whether risk-adjusted real returns in emerging markets are adequate, and if not, whether to reverse the flow of funds back into the industrialized word.

Emerging Market Currencies in 2011
Emerging market assets/currencies registered some unbelievable gains in 2010 as the global economy emerged from recession and investor risk appetite picked up. In the last few months, however, emerging market currencies gave back some of their gains as the EU sovereign debt crisis flared up and the currency wars began to rage. Given that neither of these uncertainties is likely to be resolved in the near future, 2011 could be a tumultuous year for emerging markets.
Let’s look at the numbers for emerging markets in 2010. The highlights for currencies were the Malaysian ringgit and Thai baht rose, both of which “rose around 10% against the dollar, to their strongest levels since the Asian financial crisis in the late 1990s. The South African rand was up 14% versus the dollar. It was a minor currency, however, that was the world’s best-performing: Mining-rich Mongolia’s togrog finished the year 15% higher against the dollar.” After being allowed to resume its appreciation, the Chinese Yuan rose by a modest 3.5%.
The J.P. Morgan Emerging Markets Bond Index Global returned a record 11.9% in 2010, to the extent that now trades at a modest 2.5% spread over US Treasury bonds. The standout was probably Argentina, whose sovereign debt returned a whopping 35% over the year. Switching to equities, the MSCI Emerging Markets Index returned 16.4%, handily beating the MSCI World Index, which itself rose by an impressive 9.6%. The individual top performing stock markets in 2010 unsurprisingly were “Frontier markets such as Sri Lanka (+96.0%), Bangladesh (+83.5%), Estonia (+72.6%), Ukraine (+70.2%), the Philippines (+56.7%) and Lithuania (+56.5%).” In total, an estimated $825 Billion in private capital flowed into emerging markets during the year, including $53 Billion into currency bonds.
Emerging markets took advantage of the surge in investor interest to issue record amount of local currency debt and through a plethora of massive stock IPOs. Still, the intractable rise in currency and asset prices was generally seen as an undesirable trend, and emerging markets took significant steps to counter it. More than a dozen central banks have already intervened directly in currency markets in a bid to hold down their currencies. According to the IMF, “Emerging nations had accumulated $1.2 trillion in currency reserves between the financial crisis’s peak in early 2009 and the third quarter of 2010,” including ~$300 Billion in Asia ex-China. Some countries, such as Brazil – poured $1 Billion a week into forex markets during the height of their intervention campaigns.
Speaking of Brazil, it was also among the first to impose capital controls, in the form of a 6% tax on foreign bond investors. Thailand, South Korea, Taiwan and Indonesia have also imposed capital controls, while Mexico has tapped an IMF credit line, which it can use to “manage the stability of its external balances.” Moreover, these countries collectively won an important victory at the fall meeting of the G20, by receiving formal permission for all of these measures.
Unfortunately for emerging markets, most of these inflows were probably justified by fundamentals, which means that they are more difficult to fight against than if they were merely the product of speculation. For example, “Developing countries expanded at a 7.1 per cent rate, compared with 2.7 per cent in advanced countries.” Moreover, emerging market stocks are trading at an average P/E multiple of 14.5, well below their recent historical average. This means that in spite of impressive performance in 2010, corporate profits are still rising faster than share prices. In addition, yields on emerging market sovereign debt still exceed the yields on comparable debt for western countries, despite being lower risk in some ways.
While most of these trends are expected to persist in 2011, there is one overriding wild card. How emerging markets respond to this issue could determine whether emerging market currencies outperform again in 2011 or whether they sink back to more normal levels. Thanks stimulative economic and fiscal policies, easy credit, and relatively loose monetary policies, emerging markets recorded phenomenal GDP growth in 2010. The downside has been inflation.
Inflation in Brazil and China, for example, officially exceeds 5%. (The actual rates are almost certainly higher). These countries, and a handful of others, are now in the awkward position of trying to control inflation without stimulating further currency appreciation. In other words, if they raise interest rates, economic growth and price growth will almost certainly moderate. By the same token, speculative hot money will probably continue to flow in. If they don’t tighten policy, however, inflation could easily spiral out of control, provoking economic stability and even social unrest. The upside is that real interest rates will turn negative, and their currencies will probably be depreciated by investors.
Most analysts expect emerging market central banks to gradually hike interest rates over the next couple years. For fear of stoking further speculation, however, policy will probably remain somewhat accommodative and will be accompanied by strict capital controls. Meanwhile, economic growth should begin to pick up in the industrialized world, accompanied by a similar tightening of monetary and fiscal policy. As a result, investors will be forced to decide whether risk-adjusted real returns in emerging markets are adequate, and whether to reverse the flow of funds into emerging markets.

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