Category — Americas

In the London market last night, EUR/USD underwent the correction that we had predicted yesterday.  The euro fell amid concerns that the forex market was overextended.  But there’s another currency that has performed even better against the US dollar: the British pound.  GBP/USD seems to reach new multi-decade highs every day.  The early momentum in this pair might have been about the interest rate differential between the two countries, but that is not the driving factor anymore.  If it was, then we would have seen a correction already because of the recent dovish data.  The Bank of England is still on track to raise interest rates to 6.00% this year, but the actual decision might not be for another couple of months.

The real reason for the success of the pound is the growing popularity of British assets.  British assets are denominated in pounds, and so when foreigners want to buy British assets, they are compelled to purchase pounds on the forex market.  Just recently, the investment fund of the Dubai royal family bought a stake in HSBC Bank, and the Chinese government bought shares in Barclay’s Plc.  DailyFX.com has some great analysis on the rise of the cable.  The demand for pounds is skyrocketing, and that is the main driver of growth in GBP/USD.

This very phenomenon is the reason that the US dollar has been so stable and strong through the years despite the twin deficits (budget and trade).  The demand for US stocks, US real estate and US Treasuries never waned, and the US dollar was the prime beneficiary.  But the global environment has changed.  Iran recently asked Japan to pay for its oil in yen instead of dollars.  Six Middle Eastern countries (Saudi Arabia, Kuwait, UAE, Qatar, Bahrain and Oman) are planning to drop their dollar pegs and establish a single currency for the region.  The growing protectionism in the United States (the scrapped deals for Dubai Ports World and CNOOC) certainly does not help matters.  American real estate is not as attractive in this market with prices sinking and the bottom in danger of falling out.  And US equities are not doing as well from an international perspective due to the depreciation of the US dollar.

In the face of the shifting paradigm, the pound did hit some stumbling blocks in the forex market today.  GBP/USD declined from its 26-year high last night, falling as low as 2.0539.  But the fall was not due to changes in the currency’s fundamentals.  Rather, the losses in the US equities markets triggered a bout of risk aversion, and the carry trade unwind led many currency traders to pare back on pound holdings.  But futures traders have positioned both the US stock market and the British pound for a rebound in later trading.  The sterling is looking like the currency du jour in the forex market, and traders would be smart to go along for the ride.

Inflation has always been an important concern for currency analysts, if only because it has a direct relationship with interest rates.  Central banks have a mandate to keep inflation under control, and so signs of rising inflation indicate a strong currency.  But the new paradigm of an increasingly international economy could leave monetary policy makers impotent in the face of global inflationary surges.

Commodity prices are near record highs, and interest rates do not have the power to completely moderate supply-side inflationary pressures.  Oil is selling for almost $80/bbl, and there are market analysts who believe we are likely to see $100 oil by 2008.  That would put oil at the $100 level one full year before Goldman’s now infamous oil projections of last year.  Gold and food prices are also through the roof (they are the primary driver of high prices in Australia and New Zealand).  With growing demand for commodities from developing economies, price pressures are not in line to let up anytime soon.  In the forex market, the most prominent consequence of the commodity boom is the incredible rise of the three major commodity currencies (Canadian dollar, Australian dollar and New Zealand dollar).

But more troubling for fans of domestic monetary policy is that inflation is also being stoked by rising prices for finished goods and services.  This phenomenon has surprised many observers because it seems counterintuitive to the idea of globalization.  Free trade was supposed to lead to higher efficiency and lower prices.  But with emerging markets all over the world on the rise, we are seeing more and more wealth in the developing world.  A booming economy naturally leads to higher prices, and the Chinese yuan, Indian rupee and other emerging market currencies have appreciated significantly this year.  Goods from these countries are now more expensive, and so as we buy imports from the rest of the world, we see China and India and Brazil exporting inflation.

Growing wealth in the world’s developing areas has other consequences of inflation as well.  Rich foreigners buy assets in the developed economies, and more buyers drives up the price of these assets.  This is partly the cause of exploding real estate prices in London.  For those concerned about the US dollar, we should note that the weak dollar makes US assets especially attractive.  It is as if US products were being sold at a discount relative to prices in the past.  This is why foreign ownership of US securities reached record levels last May.  But forex traders should still keep track of the current state of the US dollar.  Traders like to invest in markets that are growing (and economies that are healthy.  So while a weak dollar might be good for the US economy, a weakening dollar is bad.  And with central banks less powerful in the face of the new global economy, we might not be able to do anything about it.

The Chinese government has been under a great deal of pressure recently to allow the country’s currency to appreciate.  The yuan has been on a managed flat regime since July 21, 2005, when it was first taken off its fixed dollar peg.  And since that date, the yuan has actually appreciated 9.3% against the dollar.  But that has not done much to cool China’s overheated economy.  Most market observers agree that the domestic stock market is overpriced and likely nearing the bursting point of a bubble.  China’s exports are hitting record highs bringing with them enormous trade surpluses that only exacerbate the trade inequality between the United States and China.  US lawmakers have whipped themselves into a frenzy criticizing China and its exchange rate regime (saying the yuan is undervalued).

China has tried to deal with these problems in a variety of ways.  Earlier this summer, the government raised the country’s capital gains tax, hoping to cool the stock market rush.  Just last night, the central bank raised borrowing and lending costs by 0.27%.  But market speculators suggest that in conjunction with the release of that decision, the government also sold large quantities of yuan on the open market.  And so between the announcement of the interest rate hike and the close of trading at 5:30 PM in Shanghai, the yuan actually fell 0.14% to 7.5740.

Most analysts believe the yuan is on track to gain in value, however.  Standard Chartered Plc, which does 2/3 of its business in Asia, forecasts a gain of 1.9% to 7.42 by the end of this year.  By the end of 2008, the yuan should be all the way up to 7.00 per dollar, according to bank forecasts.  But the appreciation is expected to be modest in character as the Chinese government is loath to use the currency to manage the economy.  An undervalued currency is still too important for the export-driven economy, and inflation and liquidity (while at high levels) are not at crisis points yet.  And so look for the yuan to stay undervalued with relation to the dollar for the time being.

Speaking of the US dollar, forex traders saw a consolidation of the currency after Fed Chairman Bernanke’s congressional testimony yesterday.  The greenback stemmed its losses and looks as if it has entered a period of relative stabilization.  The US dollar might even be ready to break out against the pound, euro and yen in the coming days and weeks.  For a more detailed evaluation of those and other popular currency pairs, check out DailyFX.com’s 2007 Third Quarter Forex Market Outlooks.

Bernanke spent a good deal of time on the subprime mortgage crisis, even admitting that the total losses could amount to over $100 billion.  But most of his testimony concerned the growth and inflation forecasts for the US economy in 2007.  This is in marked contrast to his predecessor as Chairman, Alan Greenspan who loathed forecasts and projections.  Bernanke’s style is formatted to a more transparent rendering of Fed decision-making, and this is good news for forex traders.  More information and more transparency mean less volatility in the currency markets.  Admittedly, a decrease in volatility is less exciting for some traders, but I would gladly sacrifice the excitement (and anxiety) for more safety and security in my investments.  Especially since, over the long run, Bernanke’s style is conducive to a more profitable investment strategy.

Commodity currencies have been beating up on the US dollar and the Japanese yen recently and yesterday was no different.  The Canadian dollar, the New Zealand dollar and the Australian dollar all hit new highs, an occurrence so common in that last couple of weeks that’s most traders simply yawned.  Some of the underlying support for these currencies comes from high commodity prices, especially oil and gold, of course.  But much of the gains should also be attributed to weakness in the US dollar and the yen carry trade.

It is pretty easy to spot the strength the commodity currencies have derived from greenback bears.  The data released in the respective countries has not been really great.  Canada’s inflation numbers yesterday printed lower than expected.  Australia and New Zealand have not released much data recently, and what has been released has been worse than expected.   But the rise of the Loonie, Aussie and Kiwi cannot be stopped.  And that can be traced back to the sluggishness of the US dollar.  And the market consensus after Fed Chairman Bernanke’s speech is that US interest rates are likely to stay the same for some time.  Bernanke also seemed more concerned about the slumping housing market than he has been in earlier speeches.  And so the commodity currencies should continue to benefit from the weak dollar.

The other factor fueling the fresh highs in this area of the forex market is the yen-based carry trade.  The interest rate advantage for Australia and New Zealand compared to Japan is enormous, and currency traders just cannot seem to get away from the high yields.  And that differential is likely to get higher as the futures market lists a 66% probability that the Reserve Bank of New Zealand will raise the country’s interest rates, already the highest in the industrialized world, at its next meeting.  Most currency analysts are pricing in another rate hike this year for the Royal Bank of Australia as well.

The appetite for risk (as well as the hunger for yield) in the market is tremendous, and the surging carry trade is reflective of that.  AUD/USD is at an 18-year high and NZD/USD is at its highest level since the currency was floated in 1985.  While the amazing rate of appreciation might be hurting the country’s exporters, the situation is only exacerbated by the weak greenback.  It is because of this phenomenon that the Canadian dollar is up 12% already this year, with the USD/CAD hitting 1.0416 this morning, its highest level since 1977.  But the latter pressure is not likely to go away anytime soon as many analysts are touting the weak US dollar as good for the American economy.

In the highly volatile forex market the dollar rebounded slightly from a previous falling trend. A government report today unexpectedly showed a record level of U.S. securities bought by foreign investors in May. Holdings in U.S. stocks, bonds, and notes rose to a net $126.1 billion in May, up from a net $80.3 billion in April. This surge is an indication that confidence in the U.S. economy has not diminished. Economic data in May suggested that the housing slump did not necessarily spill into other sectors as had been feared. Economists had predicted that international investors would buy a net $72.5 billion in U.S. long-term securities for June, but in fact a net $105.9 billion was bought.

The dollar traded at 122.30 yen at 9:42 a.m. in New York up from 121.89 yen yesterday. Against the euro the U.S. currency traded at $1.3783, a significant increase from the July 13^th record low level of $1.3814. Earlier gains in the dollar were due to a report showing an increase core prices for May. Core prices, which exclude energy and food, rose 0.3 percent giving investors reason to speculate that the Fed will not be cutting interest rates. However, it remains to be seen what Fed Chairman Ben Bernanke will report during tomorrow’s testimony before Congress.

The gains made by the dollar are only short term. Investors should be careful and not overly optimistic as both the European and England Central Banks are about to raise interest rates. European Central Bank Council Member Nicholas Garganas is wary of inflation pressures from stronger than expected economic growth. This would prompt the ECB to raise the interest rate above the six-year benchmark of 4 percent. Likewise, inflation in England exceeded the central bank’s 2 percent target level for a 14^th month in June. Interest rates will likely be increased to cool the economy.  

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.

The market for emerging market currencies is entering an interesting phase. As I mentioned yesterday, global risk aversion is on the upswing. That would suggest a capital flight from emerging markets to more blue chip investments like the US dollar. But conversely, record commodity prices all over the world have boosted demand for these emerging market currencies to an extent that has not been seen in recent years.

To illustrate this dilemma, it’s important to understand what risk aversion does to forex demand in different parts of the world. US Treasury bonds have historically been some of the safer investments internationally. With the recent volatility in the foreign exchange market and the US equities market, demand for bonds has skyrocketed. Bond yields have dropped to 5.07%. Investors have bailed out of riskier investments, including high-yielding and emerging market currencies. Even when bond yields were at record highs a couple weeks ago, empirical data has shown that international central banks had not been the ones to start the sell-off.

But counteracting this flight to safety is the attractive of emerging markets. Brazil is a great example. The Brazilian real is at 1.905 per dollar, up 9.6% this year and 59% over the past three years. The real’s meteoric climb has been supported by a pair of factors. Record commodity prices in iron ore, orange juice and soybeans have led to record current account surpluses. Foreign investment in Brazilian stocks and bonds has led to record capital account surpluses. Most economists believe that the currency level will stay constant for the rest of the year. But there is some hope for short sellers as a vocal minority warns of a drop to 2.5 reals per dollar on the back of lower commodity prices.

The rest of Latin America is caught in a similar situation. Risk-averse investors are cashing out right now. But overall, the appetite for high yields is insatiable. High demand for commodities, from corn to copper to oil, continues to push currencies higher. But investors must proceed with caution. The market for emerging market currencies is relatively illiquid; meaning the risk for potential volatility is much higher.

This sounds like a scam right? Well, it’s happening. The Wall Street Journal published an interesting article today about the discount placed on certain bills based of age, condition, and even the signature on the bill.

In many countries, from Russia to Singapore, the dollar’s value depends not just on global economic forces that move international currency markets, but also on the age, condition and denomination of the bills themselves. Some money changers and banks worry that big U.S. notes are counterfeit. Some can’t be bothered to deal with small bills. Some don’t want to take the risk that they won’t be able to pass old or damaged bills onto the next person. And some just don’t like the looks of them.

Even hotels discriminate against certain bills:

The Stella Matutina Lodge in Goma, Democratic Republic of Congo, accepts 2001 series C-notes — the ones with Treasury Secretary Paul H. O’Neill’s signature — but says they’re only worth $90. The hotel accepts the 2003 Snow bills at face value.

Notes have always been discounted for various reasons. Before the United States had one currency, prices of notes from banks of different cities were published in local papers. The discounting there however was generally due to the transportation of the currency. A note from the Bank of New Orleans would not be worth as much in Chicago as it would in New Orleans. Interesting to see this factor combined with counterfeiting still plays a role in money.

It seems that the US dollar has been plagued with a string of poor economic data in recent weeks. Within the last week, the market saw the Philly Fed, Richmond Fed, GDP, and today, Chicago PMI and Consumer Confidence all print at worse than expected levels. This shouldn’t come as a surprise as the US Fed has already stated that the economy has been slowing in expansion this year, lead by the housing market. Dollar bulls are desperately searching for positive data and this week’s NFP numbers may be their last breath of hope. Traders holding on to dollars are looking for both a better than expected figure (consensus is 125k) AND a revision from last month’s release (51K). Speculators remember last month’s upward employment revision which caused a USD rally and with a figure as low as 51k, many are hoping that this Friday will be a repeat of last month.

As November begins soon the United States Dollar (USD) bulls will attempt what hasn’t done is five years. The Canadian Dollar (CAD) has dominated the exchange rate battle since 2001 against the United States Dollar. 1 USD used to buy over 1.60 CAD back then. Recently the exchange rate was less than 1.10 CAD. After rising and falling again, the last two months USD/CAD has been climbing. Not since the end of September 2001 has the it made monthly gains three consecutive times. Today USD/CAD is staying the course up about 70 pips so far and if it continues the end of November will break a pattern. Could this be the end of a five year Canadian Dollar reign or is it still too early to tell?