Tag Archive | "Swiss Franc"

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Spain Down Euro Up


With Spain on the brink of collapse and poor investor appetite for Italy’s bonds, a May Day rally moved the euro and the Swiss franc to one-month highs against the USD.  The euro climbed by 0.2 percent settling at $1.3274.  The dollar gave back 0.2 percent to the Swiss franc closing at 0.90500 francs.  Given the instability in the euro zone, the currency has not fallen below the $1.30 mark since December 20th.

The April fall of the euro by 0.8 percent seems more realistic. The currency finished April with its worst monthly performance since December 2011. The rise of the euro is based on unsettling economic developments in the US.  Data released on Monday lent to concerns about the strength and depth of the US recovery.  Poor consumer sentiment and disappointing manufacturing data from the Midwest caused a lowering of GDP projections to 2.2 percent.

Both the euro and the dollar fell against the yen.  The euro hit 2-weeks lows against the yen as the US fell to 2-month lows at 79.10.  In anticipation to Tuesday’s meeting of the Reserve Bank of Australia, the AUD fell 5 percent to $1.0418 USD.

In the US, equity markets look for relief from the Federal Reserve, but several of the Fed Governor’s have been vocal in dissent of a possible QE3 stimulus package. The demand for US exports has been diminished by the crisis in Europe, the USA’s largest importer.

Spain Fighting The Inevitable

Last week, S&P lowered Spain’s credit rating to BBB+, regarded as generous by many investors.  On Monday, the axe fell for 9 of the country’s 10 largest banks that were lowered to junk rating.  Spain has pushed for consolidation of the country’s banks.  The result of this has put undue pressure on the 10 banks.

The country’s banks have taken on large pools of distressed and defaulted assets and are finding dwindling deposits and skeptical investors.  The country’s banks are the largest holder’s of sovereign debt. 

Greece was spared because the region’s two largest economies, France and Germany, were heavily vested in the struggling economy.  Spain does not have that luxury.  The only elements that can help Spain are the continuation of the ECB to purchase Spain’s debt.  Technically, Spain does not meet the IMF’s stringent requirements.  Spain’s Prime Minister and his cabinet remain steadfast that Spain does not need outside support.

Without a rescue plan, the question is no longer will Spain default but rather when will Spain default. The populace wants change and a loosening of the austerity programs that are shrinking GDP.

A Monday report regarding Spain’s 24.4 percent unemployment rate eerily resembles US unemployment during the Great Depression in the 1930’s.  A study of the US unemployment rate in the 30’s suggests that Spain has not seen the worst.   Since July 2007, Spain’s unemployment rate has been a vertical climb without any plateaus of relief.

There appears no relief for Spain.  Unlike Greece, Spain’s default could easily be unstructured. This event may trigger a domino effect for nations like Portugal, Ireland and Italy. The European Stability Mechanism (ESM) is underfunded to meet these cumulative needs.

Spain’s ten-year bonds are yielding 6 percent, an unsustainable rate. While the country has implemented austerity cuts, they appear too little, too late.

France And Greece

Two key elections this week may shape the trajectory of the euro zone.  Incumbent French President Nicolas Sarkozy is a distinct underdog to keep his job.  Socialist Francois Hollande is the favorite and has run on a platform calling for reform in the euro zone treaty.

In Greece, the outcome to the elections is not clear.  However, there are undertones that Greece will not comply with its bailout agreement deemed unacceptable by the citizenry.

Austerity Programs

What has been increasingly apparent is that austerity cuts alone do not work.  The better formula for growth involves well-considered cuts and support by the ECB and IMF.  These loans are not quantitative easing, which would be the best way to proceed.  However, the ECB funds are low interest and fairly loose terms.

Austerity cuts only address one side of the problem.  Economists advocate a balanced approach that can lead to growth, the most important component in a recovery. The euro zone’s paymaster does not see it that way.  Germans have difficulty funding poorly administered economies.

No matter how you slice the pie, euro zone’s recovery must have a path for growth.  If Spain, or any other euro zone nation, were as focused on growth as they are on austerity, the economy would have broader appeal to investors.  There is no way standalone austerity cuts can accomplish the job.

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Swiss Franc is the Only Safe Haven Currency


According to conventional market wisdom, there are three safe haven currencies: the Swiss Franc, Japanese Yen, and US Dollar. It is to these currencies that investors flock whenever there is a crisis, or merely an outbreak of uncertainty, and for much of the period following the collapse of Lehman Brothers, the three were closely correlated. As you can see from the chart below, however, one of these currencies has begun to distinguish itself from the other two, leading some to argue that there is now only one true safe haven currency: the Swiss Franc.


What’s not to like about the Franc? It boasts a strong economy, low inflation, and low unemployment. Unlike the US and Japan, Switzerland is not plagued by a high national debt and perennial budget deficits. Its monetary policy has been extremely conservative: no quantitative easing, asset-purchases, or any other money printing programs with euphemistic names.

Ironically, the only thing that makes investors nervous about the franc is that it has already risen so much. Remember when it reached the milestone of parity against the dollar in 2010? Since then, it has appreciated by an additional 20%, and seems to breach a new record on an almost weekly basis. The same goes for the CHF/EUR and CHF/JPY. The President of Switzerland’s export association is expecting further gains: “Parity is a realistic scenario. Given the indebtedness of the eurozone and the strong attraction of the franc, the euro is likely to continue to lose value.”


Given that Swiss exports have surged in spite of (or even because of) the rising Franc, however, he has very little to worry about at the moment. As you can see fromt he graphic below (courtesy of the Financial Times), the balance of trade continues to expand, and has exploded in a handful of key sectors. To be sure, economists expect that this situation will eventually correct itself and are already moving to revise downward 2011 and 2012 GDP growth estimates. Then again, they made the same erroneous predictions in 2010.

The main variable in the Swiss Franc is the Swiss National Bank (SNB). Having booked a loss of CHF 20 Billion from failed intervention in 2010, the SNB is not in a position to make the same mistake again. In fact, SNB President Philipp Hildebrand has not even stooped to verbal intervention this time around, undoubtedly cognizant of the fact that he has very little credibility in forex markets.

At the same time, the SNB is not in any hurry to raise interest rates, lest it stoke further speculative interest in the Franc. Its June meeting came and went without any indication of when it might tighten. Interest rate futures currently reflect an expectation that the first rate hike won’t come until March 2012. Thus, the downside of holding the Franc is that it will continue to pay a negative real interest rate. The only upside, then, is the possibility of further appreciation. Fortunately, the SNB is unlikely to stop the Franc from rising, since it serves the same monetary end as higher interest rates. In other words, a more valuable Franc serves as a direct check on inflation because it lowers the cost of commodity imports and should (eventually) soften demand for Swiss exports.

It is possible that the Swiss Franc will suffer a correction at some point, if only because it rose by such a large margin in such a short period of time. On the other hand, given that its economy has proved its ability to withstand the Franc’s appreciation, it’s no wonder that investors continue to bet on its rise.

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Forex Volatility Continues Rising


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


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

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


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

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

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

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

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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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Aussie is Breaking Away from Kiwi


The correlation between the Australian Dollar and New Zealand Dollar is among the strongest that exists between two currencies. Given their regional bond and similar dependence on commodities to drive economic growth, perhaps this is no wonder. Over the last year, however, the Aussie has slowly broken away from the Kiwi. While the correlation between the two remains strong, the emergence of distinct narratives has given rise to a clear chasm, which can be seen in the chart below. Given that the NZD is evidently among the most overvalued currencies in the world, does that mean the same can be said about the AUD?

Alas, geographic proximity aside, the two economies have very little in common. Australia is rich in coal, precious metals and other natural resources , while New Zealand produces and export primarily agricultural products. Granted, the prices for both types of commodities have exploded over the last decade (and especially the last year), but let’s be clear about the distinction. This has enabled both economies to achieve trade surpluses, but oddly current account deficits. Australia’s economy is projected to grow by more than 4% in 2011, compared to 2% in New Zealand. Australia’s benchmark interest rate is also higher, its capital markets are deeper, and the supply of its currency necessarily exceeds that of New Zealand.

Taken at face value, then, it would seem commonsensical that the Aussie should rise both against the Kiwi and the US Dollar. Indeed, it recently touched an all-time high against the latter, and is now firmly entrenched above parity. On a trade-weighted basis, it has been among the world’s best performers over the last two years.

In fact, some are wondering (myself included), whether the Australian Dollar might have risen too much for its own good. According to OECD valuations based on purchasing power parity (ppp), the Aussie is now 38% overvalued against the dollar, behind only the Swiss Franc and Norwegian Krone. In fact, exporters of non-commodity products (i.e. those whose customers are actually price-sensitive) have warned of mounting competitive pressures, declining sales, and inevitable price cuts. In other words, the portion of the Australian economy that doesn’t deal in commodities is actually in quite fragile shape. Given that China’s economy is projected to slow over the next two years and that booming investment in Australia’s mining sector should boost output, the commodity sector of the economy might soon face similar pressures.

For that reason, the Reserve Bank of Australia (RBA) has avoided raising its benchmark interest rate is fast as some analysts had expected, and inflation hawks had hoped. There is a chance for a 25 basis point hike as soon as June – bring the base rate to an even 5% – but the RBA’s own statements indicate that it probably won’t be until June and July. Regardless of when the RBA tightens, Australian interest rate differentials will remain strong for the foreseeable future, and likely continue to attract speculative inflows for as long as risk appetite remains strong.

So why does the Australian dollar continue to rise? It might have something to do with gold. As you can see from the chart above, the correlation between the Aussie and gold prices is almost just as strong as the relationship between the Aussie and the Kiwi. Given that Australia is the world’s second largest gold exporter, it is perhaps unsurprising that investors would see rising gold prices as a reason for buying the Australian dollar. However, it seems equally possible that demand for both is being driven by the pickup in risk appetite. While some gold buyers might counter that gold is best suited for those who are averse to risk (i.e. afraid that the financial system will collapse), the performance of gold over the last five years suggests that in fact the opposite is true. When risk appetite is high, speculators have bought gold and the Australian dollar (among other assets).

It’s unclear whether this will remain the case going forward. The Wall Street Journal recently reported that gold is increasing attracting risk-averse investment, as buyers fret about the eurozone sovereign debt crisis and other threats to the system. However, the same cannot be said about the Australian Dollar. For as long as risk is “on,” demand for the Aussie will remain intact. And if the Aussie Dollar Barometer survey – which found that “exporters expect the Australian dollar to reach a post-float record of $US1.16 by September and to remain above parity well into next year” – is any indication, risk appetite will indeed remain strong for the foreseeable future.

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Swiss Franc at Record Highs


This month, the Swiss Franc touched a record high against not one, but two currencies: the US dollar and the Euro. Having risen by more than 30% against the former and 20% against the latter, the franc might just be the world’s best performing currency over the last twelve months. Let’s look at the prospects for continued appreciation.


As I wrote on Monday, the Swiss Franc has been one of the primary beneficiaries of the safe haven trade. With each spike in volatility, the Swiss Franc has ticked upward. Due to monetary and fiscal stability as well as political conservatism, investors have flocked to the Franc in times of crisis. Of course, the Japanese Yen (and the US dollar, of late) has also received a boost from this phenomenon, but to a lesser extent than the franc, as you can see from the chart above.

Personally, I wonder if this isn’t because the Swiss economy is significantly smaller than that of Japan and the US. In other words, its capacity to absorb risk-averse capital inflows is much smaller than that of Japan and the US. For example, the impact of one million people suddenly rushing out to buy shares in IBM stock would have a much smaller impact on its share price compared to a sudden speculative flood into FXCM. The same can be said about the franc, relative to the dollar and yen.

Ironically, the franc is also rising because of regional proximity to the eurozone. I use the term ironic to denote in order to signify that the franc is not being buoyed by positive association with the euro but rather because of contradistinction. In other words, each time there is another flareup in the eurozone sovereign debt crisis, the franc typically experiences the biggest bounce because it is the easiest currency to compare with the euro. In some ways, it is basically just a more secure version of the euro. This phenomenon has intensified over the last month, as the euro faces perhaps its most uncertain test yet.

It is curious that even as investors have gradually become more inclined to take risk, that not only has the franc held its value, but it has actually surged! Perhaps this is because it is expected that the Swiss National Bank (SNB) will soon hike interest rates, making the franc both high-yielding and secure. To be sure, some analysts think that the SNB will hike as soon as June. The fact the the economy has continued to expand and exports have surged in spite of the strong franc only seems to support this notion.


On the other hand, inflation is still basically nil. And just because the Swiss economy can withstand an interest rate hike hardly provides adequate justification for implementing one. Besides, the SNB hardly wants to give the markets further cause to buy the franc. If anything, it may even need to intervene verbally to make sure that it doesn’t rise any higher. Thus, “The median forecast among economists is for a rate increase in September.”

In short, I think the franc is overbought against the dollar. In fact, you can see from the most recent Commitment of Traders data that speculators have been net long the franc for almost an entire year, and it seems inevitable that this will need to reverse itself. On the other hand, the franc probably has more room to rise against the euro. The takeaway here is that it is less important to know where you stand on the franc in general and more important to understand the cross currency.

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What the Forex Markets Tell Us about Gold & Silver


All investors, regardless of stripe, must now be aware both of the bull market for gold/silver and the bear market in the US dollar. Despite all of the rhetoric, however, it seems that little is actually understood about how these two phenomena are actually connected. Ultimately, this connection (or lack thereof) has serious implications for both markets.


Many gold investors insist they are buying gold as a proxy for shorting the dollar. Commentary on gold prices is full of apocalyptic warnings about the current financial system and critcism of fiat currencies, which are backed by nothing except for good faith. They argue that buying gold is the best (or even the only) hedge against the eventual collapse of the dollar.

Unfortunately, I don’t think this argument holds up to close scrutiny. First of all, gold and silver [I am including silver in this analysis not because of any deep relationship to gold, but only because of the association ascribed by other commentators and an observable market correlation] prices have risen much faster over the last year (and decade, for that matter) than even the strongest currencies. Furthermore, gold is rising faster than the dollar is falling. In terms of the Swiss Franc – which is to forex markets as gold is to commodities markets – gold has risen more than 17% since the start of 2010.

Second, the putative correlation between gold and forex markets asserts itself sparingly (as you can see from the chart below, which plots gold against an index that shows dollar bearishness), and in difficult-to-understand ways. For example, gold stalled during the financial crisis, while the price of silver suffered a veritable collapse. Does it make sense that when financial anxiety was highest, interest in gold and silver ebbed? Along similar lines, the recent rally in the dollar followed the recent correction in gold and silver – NOT the other way around. If anything, this shows that gold investors are taking their cues from the broader commodity markets, and not from forex markets.

Third, the macroeconomic case for gold is flimsy. While I don’t think it’s fair to attack gold on political grounds, I still think it’s reasonable to try to ascertain what forces are supposedly being hedged against. If it is inflation that gold buyers are worried about, why aren’t other all investors equally concerned? Based on futures markets – whose credibility is just as solid as gold markets – inflation expectations are around 2-4% across the G7. If instead it is sovereign debt default that gold investors are concerned about, again, I have to ask why other markets don’t share their concerns. Credit default swap rates are higher for Japanese and European debt than for US Treasury securities, but the yen and euro remain positively buoyant against the dollar. Again, how do gold investors explain this contradiction?

To me, it seems obvious that gold and silver are rising for reasons that have very little to do with fundamentals. Monetary expansion has driven a wave of money into financial markets, and a significant portion of this has no doubt found its way into gold, silver, and other metals. In fact, it seems that last week’s correction was driven partly by higher margin requirements for speculators. Finally, their cause is being helped by low interest rates, since the opportunity cost of holding gold (which doesn’t pay interest) in lieu of dollars (which does) is currently close to zero. When interest rates rise, it will certainly be interesting to see if there is any impact on gold.

In the end, I don’t have a strong understanding of gold and silver markets. For all I know, their rise is genuinely rooted in supply/demand, as it should be. My only wish is that investors would stop pretending that it has anything to do with the dollar.

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Forex Volatility Rises from Multi-Year Lows


In the last month, volatility in the forex markets touched both a two-year low and a one-year high. In the beginning of March, volatility essentially returned to pre-credit crisis levels. One week later, when the earthquake and inception of the nuclear crisis in Japan, volatility surged 40%. While it has since resumed its downward path, investors are still bracing themselves for continued uncertainty.


The carry trade has perhaps born the brunt of the volatility spike. The carry trade depends on interest rate differentials – as opposed to currency appreciation – to drive profits, and  thus demands stability. When the markets become choppy and exchange rates spike wildly in one direction or another, it makes the carry trade significantly more risky. Hence the paradoxical rise of the Japanese Yen to a record high following a series of crushing disasters, as highly leveraged traders moved to unwind their Yen-short carry trades.

Likewise, high volatility should spur demand for so-called safe haven currencies. If only it were clear what constitutes a safe haven currency. Traditionally, that would send the US Dollar, Swiss Franc, and Japanese Yen upwards. In this case, the Franc has benefited most, followed closely by the Yen. The Dollar spiked against emerging market and high-risk currencies, but hardly budged against its G4 counterparts. Could it be that the Dollar’s multi-year positive correlation with volatility has (temporarily?) abated.

With regard to strategy, currency traders have a handful of choices. If you believe that volatility will continue declining or remain stable, you’re probably going to go long emerging market and high-yielding currencies, and short one of the safe-haven currencies, all of which are quite cheap to borrow. The main risk of such a strategy, of course, is that volatility will once again spike, in which these safe have currencies will rally.


If you think that the ebb and volatility isn’t sustainable, then you’re probably going to bet on the Franc, Dollar, or Yen. As I wrote in an earlier post, I think the Yen could theoretically appreciate in the short-term, but actually remains quite risky over the long-term. Despite the best efforts of the Swiss National Bank, the Franc will probably continue appreciation. Economically and monetarily, it is in an excellent shape. Besides, the fact that the supply of Francs is intrinsically small means that even modest capital inflow often translates into a big jump in its its value. As for the Dollar, it is now the most popular currency to short. It remains a safe choice and a good store of value, but probably won’t deliver the returns that safe-haven strategists have come to expect.

From a practical standpoint, you may also want to consider reducing your leverage. As everyone knows, high leverage increases profits but also magnifies losses. In the current environment of heightened volatility, leverage also magnifies risk. Either way, you may also want to consider hedging your exposure, by trading a basket of currencies and/or through the use of options.

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Why the Dollar is Here to Stay


In a recent piece published in the WSJ (“Why the Dollar’s Reign Is Near an End“), Berkley Professor Barry Eichengreen declared that the Dollar will soon cease to be the world’s reserve currency. According to Dr. Eichengreen, within 10 years and for various reasons, the Dollar will become one of many reserve currencies, competing for preference with the Euro, Chinese Yuan, Japanese Yen, and Swiss Franc. While Dr. Eichengreen makes some good points, however, I don’t think most of his arguments stand up to scrutiny.

His thesis can be boiled down into a few premises. First of all, he argues that it is fundamentally illogical that oil should be priced in Dollars, and that countries conducting bilateral trade should settle their accounts using Dollars. Dr. Eichengreen is right that this represents the main underpinning of the Dollar. He is wrong to suggest that it will change anytime soon.

That’s because oil ultimately has to be priced in currency. It’s entirely possible that oil exporting countries will band together and decide to price oil in Euros, instead. However, this would mainly be useful as a political tool (albeit a very potent one!) and would serve no economic or risk management purpose whatsoever. If oil were priced in terms of a basket of currencies (such as IMF Special Drawing Rights), it might make oil prices less volatile, but then would require oil exporters to receive 5 (or more!) currencies for their oil instead of one! Finally, the price of oil can and does adjust relative to what happens in forex markets. When the Dollar declined in 2007, oil prices skyrocketed commensurately in order to compensate exporters.

The same largely applies to bilateral trade. While it makes sense for two countries with stable currencies (such as Korea and Japan, for example) to use one of their currencies as the main unit for trade, the same cannot be said for countries with more volatile currencies. For example, if Argentina and Israel are trading, one country would be inherently dissatisfied if trade were denominated either in Shekels of Pesos. When bills are settled in Dollars, however, it is easy and economical for both countries to simply convert those Dollars into currencies which may have more utility for them. As with oil, it’s possible that some countries will decide that it makes more sense to settle trade in Euros instead of Dollars, but again, I don’t see what purpose this would serve and any such decision would probably be politically motivated.

Second, Dr. Eichengreen points out that changes in technology have made it easy to instantly calculate exchange rates and easily convert currency. While I think this point is well-taken, I think people enjoy having a common base currency, if only for psychological reasons. Ultimately, this point is irrelevant because it has very little bearing on the supply and demand for particular currencies.

Third, he argues that the Euro and Chinese Yuan both represent latent threats to the Dollar’s preeminence. Again, he’s both right and wrong. The Euro already represents a viable alternative to the Dollar. It’s economy is reasonably strong, its monetary policy is sensible, its capital markets are deep and liquid. On the other hand, it’s being held back by perennial fears about the a Euro breakup, and the fact that the sum of 20 separate parts is not the same as the whole. Since the EU doesn’t issue sovereign debt, risk-averse investors will be limited to buying German/French/etc. bonds, which are always going to be more less liquid and more risky than US Treasury Securities. Besides, you can see from the chart below that the US economy has actually been growing faster than the Eurozone for the last 30 years.


As for China, I expounded in a recent post about how unlikely it is that the Yuan will seriously rival the Dollar anytime soon. While China certainly has plenty of cachet and expanding vehicles for investment, its capital markets remain much too primitive and opaque for Central Banks and risk-averse investors. Most importantly, the structure of China’s economy is such that foreign institutions simply don’t have the opportunity to accumulate Yuan in massive quantities. Simply, the supply is too small. In fact, the Asian Development Bank forecasts that the Yuan will constitute a mere 3-12% of international reserves by 2035. That doesn’t sound very threatening.

Dr. Eichengreen’s final point is that the Dollar’s safe haven status has been compromised. First of all, this is old news. The Yen is already a – if not the – preeminent safe haven currency, thus headlines like “Safe-Haven Yen Gains As Radiation Concern Mounts” that take irony to a whole new level. The same goes for the Swiss Franc. However, any concerns that investors have about the Dollar must necessarily also be projected onto the Yen, Euro, and Pound. All of these currencies face current or looming fiscal crises and slowing economic growth. While investors might diversify into other countries, they’re not going to suddenly dump the Dollar in favor of the Euro.

In short, it makes sense that a currency that represents 80% (out of a total of 200%) of all forex transactions and more than 60% of global reserves but only accounts for 25% of GDP, should experience a decline of some sort of decline in popularity. Over the next 50 years, the Dollar will gradually cede share to other currencies. But 10 Years? Give me a break.

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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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