Tag Archive | "Same Time Period"

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Construction Sector Slowdown Weighs On Pound Sterling

Pound sterling gains were halted in the overnight following the release of the Markit/CIPS UK construction PMI survey.  Although still relatively positive, survey results were worse than had been anticipated by analysts, leaving some still skeptical of any short term UK economic recovery.  As a result, the British pound traded slightly lower to yesterday’s high at 1.5841 against the US dollar.  The exchange rate hit as high as 1.5869 in midday trading yesterday.

According to the construction sector survey, index readings dipped to a 51.4 in January – below the December 53.2 mark.  Although this is the 13th consecutive month of gains, the figure stands as the weakest reading in 4 months and compounds fears that the recession isn’t just over yet.  Notably, however, today’s survey findings still portend to a thin silver lining for Europe’s second largest economy.  According to subcomponent readings, confidence among construction companies and business leaders continues to be optimistic – although the same companies are unlikely to add to current payrolls.

The recent round of optimism seems to have been spurred on by improving month to month comparisons in recent weeks.  Notably, manufacturing sector activity improved to an 8-month high, while confidence among consumers recovered to the highest in almost the same time period.

Given the overwhelming and rising optimistic sentiment, today’s results may be temporary as traders begin to shift their sentiment to a potential turnaround in the UK economy.  This should support the current sterling momentum – if at least for another session or two.

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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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Inflation: Much Ado about Nothing?

One of the cornerstones of exchange rate theory is that currencies rise and fall in accordance with inflation differentials. All else being equal, if US inflation averages 5% per annum and EU inflation averages 0% per annum, then we would expect the Euro to appreciate (or the Dollar to depreciate, depending on how you look at it) by 5% against the Dollar on an annualized basis. If only it were that simple…

You can see from the chart below that since the introduction of the Euro, inflation in the US has slightly outpaced Eurozone inflation (by about 5% on a cumulative basis). Over that same time period, the Euro first appreciated from slightly below parity with the US Dollar to $1.60, and then fell back to the current level of around $1.35. It’s clear (from the current sovereign debt crisis if nothing else) that the EUR/USD exchange rate, then, cannot be explained entirely by the theory of purchasing power parity.

Cumulative Inflation- US versus EU 1999-2009
Still, insofar as inflation bears on interest rates and can be a consequence of economic overheating or excessive government spending, it is something that must be heeded. On that note, after a dis-inflationary 2009, prices in the US are once again rising in 2010, and inflation is projected to finish the year around 2%.

Over the longer term, there is a tremendous amount of uncertainty regarding US inflation, for a couple reasons. The first is related to the Fed’s quantitative easing program, which pumped more than $1 Trillion into credit markets. While the Fed has basically stopped its asset purchases, all of this printed money is still technically in circulation, and some inflation hawks think it represents a ticking inflation time bomb. Doves respond that the Fed will withdraw these funds before they become inflationary, and that besides, most of the funds are actually being held by commercial banks in the form of excess reserves. (This notion is in fact born out by the chart below).

Excess Reserves versus Monetary Base
The second potential driver of inflation is the skyrocketing national debt. While US budget deficits have long been the norm, they have grown alarmingly high in the past few years and are projected to remain high for at least the next decade. Beyond that, the US faces up to $70 Trillion in unfunded entitlement liabilities, which means that net debt will probably grow before it can fall. Hopefully, the US economy will outpace the national debt and/or foreign Central Banks continue to buy Treasury securities in bulk. The alternative would be wholesale money printing (to deflate the debt) and hyperinflation.

Yields on both 10-year and 30-year Treasury securities remain enviably low, which means that buyers aren’t bracing for hyperinflation just yet. In addition, while gold continues to attract buyers despite record high prices, its rise has been closely tied to the performance of the stock market, which means that investors are currently using it to bet on economic recovery, rather than as a hedge against inflation.

gold vs S&P

In short, inflation in the US certainly remains a real possibility. At this point, however, it remains too hazy to be actionable, and the forex markets will probably wait for more information before pricing it into the Dollar.

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Swiss Franc Surges to Record High: Where was the SNB?

One of the clear victors of the Greek sovereign debt crisis has been the Swiss Franc, which has risen 5% against the Euro over the last quarter en route to a record high. 5% may not sound like much until you consider that the Franc had hovered around the €1.50 for most of 2009. Every time it budged from that mark, the Swiss National Bank (SNB) moved swiftly to return the Franc to its “resting spot.” So where was the SNB this time around?
Swiss Franc Euro chart
Beginning last March, the SNB was an active player in forex markets: “Quarterly figures indicate the central bank spent some 4 billion euros worth of francs in March, 12 billion in the second quarter, some 700 million euros in the third quarter, and some 4 billion in the fourth.” In fact, the SNB might still be intervening, and it won’t be until 2010 Q1 data is released that we will be able to say for sure. The Franc’s rise has certainly been steep, but who’s to stay that it couldn’t have been even steeper. For comparative purposes, consider that the US Dollar has risen more than 10% against the Euro over this same time period.
But the fact remains that the “line in the sand” was broken and the Swiss Franc touched an all-time high of €1.43. According to SNB Chairman Philipp Hildebrand, “We have a broad range of means to prevent an excessive appreciation and we are going to do this to ensure that the recovery can continue. The instruments are clear: We buy foreign currencies. We can do that in very large quantities.” In other words, he is sticking to the official line, that the SNB forex policy has not yet been abandoned. On the other hand, “SNB directorate member Jean-Pierre Danthine said Swiss companies and households should prepare for a market-driven exchange rate some time in the future.”
Actually, I don’t think these two statements are necessarily contradictory. The Franc is rising against the Euro for reasons that have less to do with the Franc and more to do with the Euro. At this point, if the SNB continued to stick to its line in the sand, it would look almost illogical, especially since by some measures, the Swiss Franc is already the world’s most manipulated currency. Besides, by all accounts, the interventionist policy has been a smashing success. The forex markets were cowed into submission for almost a year, which prevented the Swiss economy from contracting more and probably paved the way for recovery. 2009 GDP growth is estimated at -1.5% with 2010 growth projected at 1.5%.
By its own admission, the SNB did not target currency intervention as an end in itself. “If you want to assess the success, then you should not only look at a certain exchange rate, but look at the success of the Swiss economy.” Rather, its goal was monetary in nature. Since, it cut rates to nil very early on, the only other way it could tighten is by holding down the value of the Franc. Along these lines, the SNB will continue to use the Franc as a proxy for conducting monetary policy: “An excessive appreciation is if deflation risks were to materialise. We will not allow this to happen.”
Going forward then, it seems the Franc will continue to appreciate. “I think the marketwill cautiously continue to sell the euro against the Swiss franc and perhaps see whether the SNB will step in and try and stop the Swiss franc strength,” said one analyst. As long as the Swiss economy continues to expand and deflation remains at bay, there is little reason for the SNB to continue. Besides, intervention is not cheap, as the SNB’s forex reserves grew by more than 100% in 2009. On the other hand, the SNB has probably intervened in forex markets on 100 separate occasions over the last two decades, which means that it won’t be shy about stepping back in if need be.

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Forex Implications of China-US Economic Codependency

The Economist recently published a special report on China and America (”Round and round it goes“). As the title suggests, the article described the increasing interdependency between the economies of the US and China. In a nutshell, China maintains an undervalued currency, in order to stimulate exports. The resulting overseas (American) demand puts upward pressure on the RMB, which China defuses by buying US Treasury securities. This results in artificially low US interest rates, causing American consumers to import more, putting even more pressure on the RMB, which is further defused by buying more US Treasuries. And the cycle continues ad nauseum.

The article focused primarily on the political side of this precarious relationship, at the expense of the financial implications. It got me thinking about the forex forces at work, and how a disruption in the cycle could have tremendous ramifications for currency markets. It’s clear that in its current form, this system keeps the Yuan artificially low, but does that means that the Dollar is also being kept artificially high.

Given the depreciation of the Dollar over the last six months, this seems almost hard to believe. Over the same time period, though, China (as well as many other Central Banks) have vastly increased their Treasury holdings. This would seem to imply that indeed, the Dollar’s fall has been slowed to some extent by the actions of China. It’s kind of a paradox; as US consumers recover their appetite for Chinese goods, the Dollar should decline. But as China responds by plowing all of those Dollars back into the US, then the net effect is zero.

Biggest holders of US Treasuries
As the Economist article intimated, there are a couple of developments that would seem to upset this equilibrium. The first would be if the Central Bank of China began diversifying its forex reserves into other currencies. By definition, however, it would be impossible for China to continue pegging the RMB to the Dollar without simultaneously buying Dollars. Thus, the day that China stops recycling its export proceeds into the US, the RMB would start to appreciate, almost instantaneously. In addition, the sudden surcease in US Treasury bond purchases would cause interest rates to rise. Both higher rates and a more expensive currency would presumably result in lower demand for Chinese exports, and hence eliminate some of the need to recycle its trade surplus back into the US. In this way, we can see that China’s Treasury purchases are actually self-fulfilling. The sooner it stops purchasing them, the sooner it will no longer need to purchase them.

I’m tempted to elaborate further on this point, but it seems that I’ve already taken it to its logical conclusion. China must recognize the dilemma that it faces, which is why it refuses to break from the status quo. If it allows the Yuan to appreciate, it will naturally face a decline in exports AND the relative value of its US Treasury holdings will decline in RMB terms. Both would be painful in the short-run. However, by refusing to concede the un-sustainability of its forex/economic policy, China is merely forestalling the inevitable. With every passing day, the adjustment will only become more painful.

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