Posts from — July 2007

Two words have dominated the forex market recently: carry trades.  Much of the dynamic price action in foreign exchange has been influenced by the drive for yield best demonstrated by the carry trade.  Currency traders have made a killing borrowing Japanese yen and Swiss francs and using that money to fund high-yielding purchases in Australia and New Zealand.  But the story is about the changing nature of the international carry trade.

The big worry previously was that the problems with the US economy would spread internationally.  The slowdown in consumer spending and the subprime mortgage crisis would trigger a bout of risk aversion, spelling doom for the carry trade.  But the data released today shows those worries to be unfounded.  The US stock market has never been stronger, with the Dow hitting 14,000 this morning.  And foreign investment into US assets reached record highs, climbing $126.1 billion in May.  Japanese investors alone, already the largest foreign holders of US Treasuries, increased their holdings by $400 million, bringing their total to $615.2 billion.  The explosion in American investment certainly accounted for a lot of yesterday’s gains in USD/JPY, suggesting that the forex market’s appetite for risk is still alive and kicking.

The real danger to the carry trade lies elsewhere.  The Swiss franc has been the funding vehicle for those traders scared off by the relative instability of the Japanese economy.  This makes the franc’s recent rally disconcerting to those carry traders.  All elements are in place for a consistent appreciation: a strong economy, a consistent rise in prices and a near certainty of multiple interest rate increases by the central bank this year.  So it should be no surprise to those paying attention that the franc-based carry trade is beginning to unwind with USD/CHF hitting a seven month low.

There are also significant concerns regarding the yen-based carry trade.  A lot of the cheap yen has been used to buy New Zealand dollars, the latter being attractive by virtue of Zealand’s 8.00% interest rate.  This has fueled post-float highs in the New Zealand dollar with regard to both the yen and greenback.  But the New Zealand finance minister came out last night and said that the high domestic currency was causing undue pain for the country’s exporters.  Lacking significant foreign exchange resources, there is really not much the country can do, but the comments should still place a brake on some carry trading.

Japan might also prove discouraging to carry traders.  The odds are relatively high that the Bank of Japan will raise rates at its next meeting in August.  There is also an incredible amount of pressure from the United States and Europe about the unfair advantage that the undervalued yen gives to Japanese exporters.  And Japan actually has the resources to intervene in the forex markets and make it stick.  It is for that reason that some Asian traders, fond of the carry trade, are now using the Singapore dollar and the Chinese yuan as their funding currency.  I would not recommend this course of action, however, as the market for the latter two currencies is too illiquid.

So what should the average currency investor do about this situation?  You are probably okay sticking with the Japanese yen for right now.  The major yen crosses, especially the pound and the dollar should continue to gain.  It is true that the yen losses are overextended; the depreciation is not entirely supported by fundamentals.  But the market’s appetite for risk and hunger for yield should trump all other concerns for right now.

For anyone betting against the pound this year could not have been more wrong. The pound rose 4 percent to $2.0403 this year to reach a 26-year high. Among disappointed investors are strategists at Deutsche Bank AG, UBS AG, and Citigroup Inc., who in December predicted the pound to trade at $1.96 or lower this year. An unexpected strong housing market and the Bank of England raising the main interest rate three times to 5.75% are the two main reasons for the increase in the pound.

The Bank of England expects the economy to expand 3 percent this year, the fastest since 2004. And with a strong economy come higher government bond yields as well. The Nationwide Building Society, the U.K.’s largest mortgage lender, reports that housing prices have increased 11.1 percent from a year ago in June. Masako Horri, at the Global Sovereign Open fund in Tokyo states the pound is a high income currency in comparison with the U.S. dollar. The U.K. economy will be spurred by housing and the consumer. Traders in the futures market have even doubled bets that the pound will continue to rise to unprecedented levels.   

The pound has come a long way since the English government left the European Community’s system of managed exchange rates in 1972. During this decade rampant inflation at 27 percent was the root of the prevalent economic problems throughout the country. Not until Margaret Thatcher’s rise to power in 1979 did the problems subside.

As a word of caution to investors, now may not be the best time buy U.K bonds despite signs of future gains by the pound. The reason is fear of inflation. Faster inflation may reduce the appeal of U.K. bonds and even possibly the pound. A stark increase in a currency makes investing in bonds more alluring as the return is magnified through the change in valuation. But investing in U.K. debt may be at its end as potential faster inflation looms ahead. Graeme Caughley, a fund manager at Scottish Widows Investment Partnerships Ltd., claims that inflation in the U.K. is not under control yet. On the other hand, for some analysts the high yield on U.K. debt along with a further appreciated currency is still outweighing the risks of faster inflation. The pound may still be increasing in value, but the allure of U.K. bonds may fall sooner than expected.

The forex market has not been kind to the US dollar recently. Losses have been sustained across the board, and DailyFX.com has even proclaimed the dollar as on the ropes. And there is plenty of data to support that assertion. Retail Sales printed last week at a loss of 0.9% versus an expected gain of 0.2%. That by itself triggered huge concerns in the currency market because of the influence that retail sales has on consumer spending, which is 2/3 of the US economy.

This overall dollar weakness was felt throughout the forex markets. USD/JPY finally saw some real unwinding in the carry trade, further weakened by the decision made by Iran to accept yen in payment for oil. The decision may signal an overall shift away from dollar-dominated international trade. GBP/USD continues to test multi-decade highs, confounding industry “experts,” primarily through the central bank’s hawkish stance on inflation. The commodity currencies continue to kill in the market on the back of high oil and gold prices. Even the euro is threatening record levels, despite the historic unwillingness of the ECB to allow that kind of appreciation.

But investors might be underestimating the resiliency of the US dollar. The recent releases concerning job and wage growth both surprised to the upside, suggesting that the situation surrounding consumer spending might not be as dire as we may think. The New York Fed Factory Index printed this morning at 26.5, surprising a market that was only expected 18. The state of manufacturing nationwide looks pretty rosy and it can only be helped by the weaker US dollar. But that’s still not the main reason that I am still bullish on the greenback.

It’s because of inflation; more specifically, it is because the Fed continues to be worried about inflation. There is a growing movement internationally to focus on headline inflation, instead of core inflation, which is more commonly considered now but excludes energy and some food prices. Oil is still above $70/bbl and according to Bloomberg.com, we might be experiencing the biggest boom in food commodity prices in years. Headline inflation is likely to stay high because of those two factors, and that is likely to keep interest rates up. The only thing the Fed can really control is prices and as long as that is its focus, the dollar will not be lacking in support.

The yen enjoyed big gains as the National Iranian Oil Co. asked Japanese refiners to make payments in yen instead of U.S. dollars for Iranian crude oil. The Japanese currency traded at 122.10 U.S. dollars at 9:21 a.m. in New York. This level is significantly up from yesterday’s close of 122.42. Against the euro, the yen rose to 168.49 from 168.80. According to Steven Butler, director of foreign-exchange trading at Scotia Capital Inc. in Toronto, this increase in demand for the yen is forcing Japanese companies to sell dollars to raise money for their oil payments.

It is rather clear that the National Iranian Oil Company, under the direction of the Ministry of Petroleum of Iran, has shifted to the yen from U.S. dollars in response to risks imposed by further sanctions that would freeze U.S. dollar transfers. As Japan’s third largest supplier of oil, Iran is taking steps to secure its oil interests amid growing tensions with the U.S. This move should not be entirely unexpected seeing that over a year ago, the Iranian oil colossal already started asking its buyers of crude oil to pay with currencies other than the dollar. In a March 27^th statement by Central Bank Governor Sheibany, Iran decided to cut U.S. currency holdings to less than 20% of total foreign currency holdings.

Tension with the U.S. will not subside as Iran continues to reject appeals for cooperation. On July 10^th, an Iranian newspaper quoted a senior advisor to Supreme Leader Ayatollah Ali Khamenei claiming that Iran was producing centrifuges for refining uranium domestically. The statement showed that UN sanctions had very limited impact. In response, the U.S. Navy sent a third aircraft carrier to its 5^th fleet, which is in close proximity to Iranian waters.

As future conflict looms, the U.S. will have a tough time resolving matters favoring its own interests. As the holder of the world’s second-largest oil and gas reserves, Iran is in an interesting position to heed to multiple foreign interests.  

Recent developments in the forex market do not bode well for the US dollar.  Short-term economic data is bearish.  The long-term outlook for the US economy is getting worse every day.  And the currency crosses are not just about dollar weakness as there is strong support for the other highly traded currencies (even the yen).  To exacerbate matters for dollar bulls, there is a movement to unravel the dollar’s preeminent position as the financial medium of choice internationally.

A good place to start is the economic data released today: US Retail Sales.  The Commerce Department reported a drop of 0.9% blowing past initial estimates of a drop of only 0.1%.  It is the largest one month drop since August 2005.  With oil prices above $70 per barrel and home values tumbling, consumers are being stretched further than many economists had anticipated.

The recent numbers put the US economy in a precarious position.  Higher job and wage growth should be conducive for a steady pace of expansion.  But the retail sales number is particularly significant.  Retail Sales accounts for one half of all consumer spending which itself accounts for two-thirds of the economy.  A slowdown in this sector could be a harbinger for a larger contraction.  Concern over this matter, coupled with the continuing problems over subprime loans sets the stage for greater bond demand and lower interest rates.

As if that wasn’t enough bad news for the US dollar, Iran has made some very troublesome moves.  Bloomberg News has reported the National Iranian Oil Co. just asked Japanese oil refiners to pay for their oil imports ($10.1 billion worth) with yen instead of dollars.  With rising tensions with the United States, the Iranians are trying to hedge their risk by limiting their dollar exposure.  To this end, Iran is also seeking to diversify their foreign exchange holdings, limiting US dollar reserves to 20% of the total while buying more euros and yen.  Central bankers in Venezuela, Indonesia and the United Arab Emirates are pursuing much the same course with regard to their foreign exchange reserves.  USD/JPY is now down 0.22% to 122.13.  Much of the reason the US dollar has been able to maintain much of its strength all these years despite long-term double deficits is because of its preeminent position as the currency of exchange throughout the world.  If that position is being eroded (and it looks like it might be), then the decline of the dollar might be just beginning.

The U.S. housing slump may seem like old news, but its stark consequences are taking a further toll on the U.S. dollar. The continued concern of the housing slump spilling over into the economy caused the dollar to fall against 11 of the 16 major currencies. Against the euro specifically, the dollar hit a record low. The latest industry report has shown that U.S. foreclosures have increased by 87 percent in June from a year earlier. Traders have strong convictions that the Fed will keep interest rates unchanged. Jens Nordvig, a senior currency strategist at Goldman, Sachs & Co. in New York stated: “The weakness in the housing sector may feed into consumption and weigh on growth, which may bring a Fed ease back on the table.”

The U.S. dollar traded at $1.3768 against the euro this morning, only slightly up from yesterday’s record low of $1.3798. Ian Gunner, head of foreign-exchange research at Mellon Bank NA in London, has predicted a further fall in the U.S. currency to $1.41 by next week. Overall, the dollar has fallen 1.2 percent against the euro in the past 3 days as Standard and Poor’s and Moody’s Investors Services downgraded ratings on the majority of loans backed by subprime mortgages. And more negative ratings are yet to come.

The U.S. currency also fell to 122.18 yen from yesterday’s 122.48 despite today’s decision by the Japanese Central Bank to hold interest rates at 0.5 percent. According to the Daiwo Institute of research in Tokyo, the U.S. dollar may even weaken by 5 percent to 116 yen by the end of the year. The Institute is predicting the U.S. housing slump to hurt consumption forcing the Fed to lower interest rates by year end. Today’s traders betting on interest-rate futures believe there is a 21 percent chance of lowered interest rates. This prediction is up 8.9 percent from last week. Further indicators of a spill by the housing market are poor profit expectations for July by Sears Holding Corp. and Home Depot Inc. Both companies have stated profits for July will fall as the decline in housing prices have hurt demand for home building goods.

Another factor affecting the weakened dollar is a new report indicating a widened U.S. trade deficit for May. Despite record exports, imports still remain on top by $60 billion. The widened gap has largely been due to rising prices on imported oil which rose by 3.6 percent. The fact that a third of this gap is the trade imbalance with China has had a diminishing influence on the dollar as well. Despite mixed reviews on running a trade deficit, the U.S. dollar will have to come a long way before regaining in strength.      

It’s become a common refrain among traders that emerging markets are the place to be if you want to make real money. Investments in developed economies carry less risk, but in emerging markets, you have the possibility of higher returns. The same is true with currency trading. The forex markets in developed countries are more developed, more liquid, more safe. The currencies of developing countries are more volatile but, if good, also more profitable. And at the forefront of profitable emerging market currencies is the Brazilian real.

The real is up 61.8% against the dollar over the last three years. Over the past six months alone, the real has gained 13.8% against the dollar, the best-performing of all the sixteen most actively traded currencies. As of 9:45 this morning, the currency was valued at 1.8762 per dollar. The reason why forex traders are so in love with the Brazilian real is pretty simple. High interest rates and robust economic growth, the key to any strong currency, are on full display in South America’s largest economy.

Brazil’s high yields should continue to serve as an attracting force for foreign investment. As such, look for the real to appreciate even further in the second half of this year. Brazil has an out-of-this-world 12% interest rate, and even after accounting for relatively high inflation, its real interest rate is 8%.

There are some forex analysts that are preaching caution with regard to the Brazilian currency. There is a sense that the surging demand will produce inflation that outpaces interest rate growth. And that would certainly cut demand for the real and drop it back down to earth.

But I think Brazil is still a great bet. The economy is looking great, with exports of iron ore, soybeans and orange juice to the United States surging. They have a compliant pending with the WTO regarding US farm subsidies, and if they win that case, they should be able to export even more to their largest trading partner. And let’s not forget the fact that Brazil and India have the two most stable governments of all the emerging markets in the world and how attractive that fact is. I am very bullish on the real, and I don’t think we have seen the last of its rise.

FX Week just announced their e-FX awards for this year.  FX Week is a trade magazine for the forex market that focuses mainly on institutional investing (banks, funds, etc.), but there’s something for retail investors as well.  They give out these awards every year to recognize those companies in the industry who have the best electronic presence and services for their customers. 

            Any company working in e-FX could have been nominated for an award.  And with FX Week recognized as the preeminent weekly paper for the forex market, its yearly awards confer to its recipients a recognition of excellence.  Those who win an e-FX Award have set themselves apart from their competitors and demonstrated to their customers the quality of their offerings.  So without further ado, here’s a list of this year’s e-FX Award recipients (broken down by category:

THE WINNERS

* Best electronic brokerGFI
 
* Best trading technology vendor

Currenex
 
* Most innovative bank e-trading platform

Deutsche Bank
 
* e-FX initiative of the year (bank)

Citi
 
* e-FX initiative of the year (vendor)

FXMarketSpace
 
* Best post-trade services to clients

UBS
 
* Best vendor for post-trade services

DEALHub
 
* Best professional e-trading venue

FXall
 
* Best algorithmic trading technology (bank)

Credit Suisse
 
* Best algorithmic trading technology (vendor)

FlexTrade
 
* Best retail platform

Saxo Bank
 
* Best liquidity outsourcing service

Deutsche Bank
 
* Achievement Award

Lars Seier Christensen and Kim Fournais
Saxo Bank
 

Congratulations to everyone!

Speculation that the Bank of England will raise interest rates and a continued weak U.S. housing market have allowed the British pound the highest gain against the U.S. dollar in 26 years. The pound rose to 2.0330 U.S. dollars by 1:53 p.m. today in London. This marks a 3.5 percent gain this year alone. Sean Callow, a senior currency strategist at Westpac Banking Corp. in Singapore, states that the pound is an attractive yielder if you want to play a weak dollar.

Last week the Bank of England raised its federal fund rate for the 5^th time this year to 5.75 percent. This monetary decision was taken amid worries of continued inflation, which has been 2.00 percent above the target level this year. Investors are speculating that the British central bank will continue to raise interest rates. Futures trading on interest rates have shown that investors are expecting a quarter point increase by the end of the year. Higher interest rates correlate with a stronger value of the domestic currency relative to others.

The other factor affecting the high gain by the pound is the continuing weak U.S. housing market. Yesterday, Standard and Poor’s Rating Services put 612 securities backed by subprime mortgages on “CreditWatch negative”, due to their high delinquency and foreclosure rates. On the other hand, Moody’s Investor Services cut ratings on $5.2 billion of bonds backed by U.S. subprime mortgages. The rating agency downgraded 399 securities and an additional 32 will also be likely downgraded following review. The S&P expects these loans to borrowers with poor credit histories to continue to lose money.

The majority of the loans affected by the downgrade in ratings are held in portfolios by major Wall Street firms Bear Stearns, Citigroup, JP Morgan, Merrill Lynch, and Morgan Stanley. Standard and Poor’s has indicated that the 2006 subprime loans have accumulated delinquencies to an unprecedented level at much higher rates than initially anticipated. Continued falling house prices and increasing interest rates on many subprime adjustable rate mortgage loans will make it even more difficult for subprime borrowers to pay back loans. The U.S. housing slump seems to be far from over. This means a weaker U.S. dollar and a potentially higher pound in the long run.

The problems with sub prime mortgages might not be as contained as some observers have tried to claim.  The S&P announced yesterday that they may cut the credit ratings on $12 billion worth of bonds backed by sub prime mortgages.  And it is increasingly likely that if this decision is made, it will force a reevaluation of all similar assets in the US market.  Rather than have the crisis confined to a particular sector, the mortgage situation reveals a poor and rotting basis for the entire economy.

This is bad news for the US dollar.  The sub prime fiasco will spill over into the overall market for US securities and bonds.  With US dollar-denominated assets less attractive, demand for the US dollar in the forex market goes down.  The domino effect does not end there, however.  The US market is the most important one globally, and problems there will trigger another bout or world-wide risk aversion.  What that means for currency traders, primarily, is an unwinding of the carry trade.  The problems with sub prime mortgages and CDO’s in the United States have some currency analysts suggesting that it may not even take an interest rate hike by the Bank of Japan to end the carry trade.  Investors have even started to abandon US assets for Japanese ones, driving Japanese bond prices to their highest levels since last August, with USD/JPY nearing 122.00.

Dollar weakness is running rampant throughout the currency markets today.  EUR/USD is approaching stratospheric heights with concerns in the dollar compounded by the likelihood of higher interest rates in Europe.  A similar situation (although with better fundamental data) is playing out with the cable, as it crashes through 2.0300.  And the irony is this entire situation is that the US economy is generally pretty healthy.  According to Bloomberg, growth is at the moderate target level and inflation is under control.  Economically, the country is humming along like a trusted old car; it is not going to impress anyone but it isn’t going to give you any problems either.  Despite all that, you might want to stay away from the greenback until further notice.