Category — Currency

As the U.S. dollar fell to record lows against the euro last week, technical analysis may indicate an earlier than expected rebound in the short run. Last week traders speculated long-run rebounds due to the U.S. economy benefiting from a weak dollar and from pressure on the ECB by Nicolas Sarkozy to cool a strengthening euro. But as traders have been eyeing the Relative Strength Index (RSI) on the EUR/USD pair, there is a possibility of a short-run rebound.

The RSI measures the strength of a currency pair price movement typically within the past 14 days. When the RSI is over 70 there is a good chance the price movement will fall. At over 70 most sellers who have been looking to sell perceive the current price to be the best price. On the other hand, buyers will likely wait for the price to fall when the RSI is in fact over 70.

Thus, in the context of the current EUR/USD pair, the RSI is at 76.34 today hinting at a future fall in favor of the dollar. The U.S. currency did in fact make a small gain to $1.3817 per euro this morning. This level is up from last week’s record low of $1.3845, but not enough to indicate an actual rebound. Nevertheless, the high RSI value may indicate a rebound sooner than expected.

Currency Outlook and Strategy:
On July 25^th, the National Association of Realtors is due to report figures on last month’s existing U.S. home sales. It is expected that U.S. existing-home sales have fallen the lowest in 4 years. This could further hurt investor confidence in the dollar. Looking across the Atlantic, European Central Bank Executive Board member Lorenzo Bini Smaghi states he is not worried about euro appreciation. But Nicolar Sarkozy, newly elected French President, thinks otherwise.

Tim Shea, currency analyst at FXCM, concludes: “This week in the Euro looks very quiet news-wise. We’ve got next to nothing on the European calendar, and pretty much just housing data and GDP in the USA. So, watch the housing numbers and the Dow for some direction, and don’t forget about $75 per barrel oil.”  

The Chinese economy has grown at its fastest rate in 12 years during the second quarter. China’s GDP growth has increased to 11.9 percent from a year ago. This figure has exceeded all expectations from 23 economists at Bloomberg. Inflation has risen to 4.4 percent in June, the fastest rate since September 2004. The Chinese economy is on fire and needs cooling. The most obvious is a change in monetary policy. There is much speculation the Chinese central bank will increase interest rates and in turn this will strengthen the yuan. But is revaluation by direct policy of the yuan needed?

According to Glen Maguire, chief Asia economist at Societe Generale SA, a strict revaluation by the central bank is needed in order to quell the surge. He indicates the yuan may even need to appreciate as much as 3.5 percent in a single day. A stronger yuan would slow down the economy by making exports more expensive and thereby reducing China’s enormous trade surplus. U.S. lawmakers have been very keen on a strengthened yuan, claiming that U.S. companies have been taking hits by its artificially low value. Senator Charles Grassly has spoken on the issue extensively stating the Chinese currency has not risen fast enough.

Despite U.S. and Chinese economists having met and agreeing on the same direction for the yuan, the Chinese central bank does not want a fast acceleration. Bank of China Governor Zhou Xiaochuan has stated he does not want the yuan to accelerate nearly as fast as the U.S. would prefer. Other currency analysts do not see the yuan appreciating to unprecedented levels anytime soon. According to Tim Shea, a currency analyst in the Sales and Trading Department at FXCM, “China has shown since the initial dropping of the peg in 2005 that the strengthening of the yuan would happen gradually and at their own pace.” He points out, “…that a 3 percent change in one day would be a move of 2200 pips, the equivalent of all the movement made since January. This would not be in line with past policy.”

We have also seen changes in Chinese fiscal policy to help the cooling process. Inflation has actually outpaced the return on bank deposits spurring investments in the equities market. The benchmark CSI 300 stock index for the Chinese market has gained 87 percent this year. In response, fiscal measures have included legislation allowing the 20 percent tax on interest income to be reduced or even taken away. As a result, fixed-income investments have increased to 26.7 percent in the first half of the year from a year ago. Even though this increase in savings is modest in comparison to the spurring equity run, a future meltdown of the Chinese economy is unlikely. With the right fiscal and monetary policy the Chinese economy will continue to grow at a controllable pace. The yuan will strengthen, but most likely at a pace unsuitable to U.S. lawmakers.

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.  

European Central Bank President Jean Claude-Trichet spoke to a group of students and economists recently on the “overwhelming success of the euro.” Europe as a whole is definitely going through a boom period right now with unemployment in the continent at a 25-year low and steady growth. Much of that success, Trichet claims, should be credited to the unified economic and monetary policy. I want to spend some time this morning talking about that assertion and how the euro has been good (and bad) for Europe.

Now the economic virtues of the European Union are numerous, but I want to just focus on the currency today. One of the advantages of the euro is that weak economies get to piggyback on strong ones. And by strong ones, I mean Germany. For the last 60 or so years, Germany has been the engine that drives European growth, and its currency, the Deutschemark, has been Europe’s most stable. What the euro does is it allows countries like Italy, which had a notoriously bad currency, to benefit from the international confidence in German stability. Germany’s reputation basically grants a halo effect to the rest of Europe. This is essential for the central and eastern European countries because as emerging markets, their currencies might otherwise be subjected to dangerous volatility levels.

Another benefit is the political independence of the European Central Bank. Before European monetary policy became aligned, the central banks of many countries were headed by the finance ministers in those countries. But finance ministers are politically appointed, and so the economic and monetary decisions were often dependent on political gain or loss. The independence of the ECB from European governments has allowed for more stability in monetary policy. This is an especially important front to pay attention to as French President Nicolas Sarkozy continues to push for more input from finance ministers. Let’s hope that ECB can withstand this misguided effort.

While the stable monetary policy has been mostly a good thing for Europe, it does have its share of problems. A unified monetary policy eliminates some independence for individual areas. If most of Europe is going through a bust cycle, the bank will lower interest rates. But if Belgium is experiencing growth, this decision will lead to inflation in Belgium.

One great example of this scenario is Germany after re-unification. The government faced a need to invest in what used to be East Germany, and increased investment led to inflationary pressures. The German government needed to raise interest rates to combat this threat. France faced no such threats, but had to raise interest rates as well to maintain the integrity of the fixed Exchange Rate Mechanism (ERM). The French economy experienced a recession, and plans for a unified monetary policy almost fell apart eight then.

This problem is evident today as well. Most western European economies are stable and developed. Growth is consistent, but not especially fast. Unemployment and inflation are usually at manageable levels. But the newer EU countries, those from Eastern Europe, are at a different stage in their economic growth. They are, as a whole, growing faster as developing countries. Ideally, the different parts of Europe would have different monetary policies to accommodate the different conditions, but the euro would make that impossible. Sharing a currency means sharing a monetary policy. So while the euro is mainly a good thing, it might not be a good thing for everyone involved.

The recent report on U.S. jobs growth came in stronger than expected. The forecast for new jobs in June was 125,000, but instead the report showed 132,000 new workers being added. This is below the 190,000 workers added in May, but it beat expectations nevertheless. Wages also increased as reports showed average hourly earnings to have increased by 3.9 percent in June. Further reports showed the unemployment rate to be held steady at 4.5 percent for the third month.

In response to this news of strong economic performance treasury yields have increased as investors are worried about inflation. During this week, the rate on the 10-year note climbed 15 basis points. This has been the biggest increase since the 16 point increase in the week of June 16, 2006. The economy has been doing better than expected amid the subprime mortgage crisis. This has given bond holders reason to believe that there is potential for increases in inflation, and thereby, have increased demand for higher yields. If inflation does go higher than the target level, then the Fed is likely to increase interest rates to cool to economy.

On the other hand, Janet Yellen, President of the San Francisco Federal Reserve Bank, has indicated that the Fed should not change interest rates. According to Yellen, the best way to achieve faster growth while maintaining a low level of inflation in the current state of the economy is by keeping interest rates steady. Despite a very robust economy, Yellen indicates that inflationary pressures are not strong enough to hurt the goods and labor markets. She is more worried about future problems that are yet to come from the subprime mortgage defaults.

It is difficult to say where the value of the U.S. dollar will stand in the next two months. There are mixed opinions among investors and policymakers as to where interest rates will be held. The next FOMC meeting is not until early August.

As U.S. interest rates remain unchanged at 5.25% for the 8^th straight Federal Reserve meeting, and as terrorist arrests in London spur worldwide concern, the U.S. dollar has dropped against major currencies. The dollar fell 0.5% to 1.3605 per euro and 0.6% to 122.44 yen. Investors have become more risk-averse with the recent geopolitical events. As a result, demand for the yen and the swiss franc, a haven for security, has increased. According to Derek Halpenny, senior currency strategist at the Bank of Tokyo-Mitsubishi UFJ in London, interest-rate differentials will continue to move against the U.S. dollar as a result of the unchanged U.S. monetary policy.  

This trend may continue in the long run. Despite recent positive reports of increased retail sales and job growth, investors are worried that losses from hedge funds owning subprime mortgage bonds will slow economic growth. This increase in risk aversion has caused an increase in holdings of risk free debt. Treasury holdings are at 35% of funds overseeing $315 billion in bonds. This is 1% higher than holdings in corporate and sovereign debt for the second consecutive week. In the previous month for the first time in a year, U.S. treasuries have outperformed corporate and emerging-market bonds.

Investors like Bill Gross of Pacific Investment Management Co. are speculating that the housing slump will restrain the economy for the rest of the year. The subprime mortgage crisis is the worst since 1991, and the effects may even be felt next year as well. Investors are speculating that the Federal Reserve will be forced to lower interest rates in the long run in order to induce consumption.

What will lower interest rates mean for the value of the U.S. dollar? Lower interest rates will cause a drop in the value for the U.S. currency. If the Fed does in fact decide to lower interest rates, in the attempt to avert further dampening effects on the economy by the housing meltdown, currency traders will decrease demand for the U.S. dollar. A decrease in demand in will bring down the value of the currency.  

The United States Federal Reserve’s interest rate announcement and accompanying statement is scheduled to be released today at 2:15 PM Eastern Standard Time.  Barring a complete surprise, the Fed is likely to leave interest rates at 5.25% and issue a statement hawkish on inflation.  With contradictory data regarding economic growth and interest rates, the bank cannot do any more.  A move in either direction would prove harmful.

Economic growth in the United States is actually rather sluggish and does not bode well for the US dollar.  In today’s GDP report, we saw that the economy grew 0.7% in the first quarter of 2007, the slowest pace in four years.  This number was higher than the estimates last month of 0.6% but lower than the forecast of 0.8%.  The economy certainly is not growing at the pace it was last year, when the last quarter of 2006 registered growth of 2.5%.

Various sectors of the economy have felt the effects of the economic slowdown.  The housing market is undergoing it biggest slump in two decades.  Demand for housing seems to fall with every new report, and the sub prime woes have led to the number of foreclosures reaching record highs.  Consumer spending, which makes up the largest portion of the US economy, is cooling, mainly due to higher energy prices.  Its growth this quarter is half what it was last quarter.  Business investment is also falling, suggesting that the slow growth this quarter may not be an aberration.  Yesterday’s durable goods report showcased a larger than expected drop in May.

But even considering all this bad news, the FOMC cannot lower interest rates to stimulate the economy.  And the reason why is rising inflation.  Prices continue to rise, at a pace with which the Fed is certainly not comfortable.  Today’s numbers showed a 2.4% rise in core inflation, stripping out food and energy costs.  That is certainly discomforting to policy makers, especially compared to the 2.2% rise that was expected.  And when you consider that the Fed under Chairman Bernanke has professed to prefer inflation within a 1-2% range, you further get the sense that inflation is a big worry.  That is why interest rates are not likely to change, and the statement from the Fed is bound to be tough on inflation (Kathy Lien has a more detailed discussion of the Fed’s decision on interest rates).

What does the Fed’s announcement mean for the US dollar?  The cable should continue to rise, especially in anticipation of the likely interest rate hike in the next BoE meeting.  GBP/USD should not have much trouble staying above 2.000.  The euro should see some gains as well, with similar expectations on the interest rate decision of the ECB.  The yen is a little bit more interesting.  With core prices falling yesterday, the country’s battle with deflation is not yet over.  As long as the Fed remains consistently hawkish in its statement, we might see a reversal of yen gains against the dollar with USD/JPY testing 125.00 soon.

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.

Recent developments in the foreign exchange market prove that it is not just interest rates that drive action in the currency market.  Expectations of future interest rates also matter.   The currencies with the greatest chance of higher short-term interest rates are the currencies receiving the most support from traders.  The few currencies with bad prospects for an interest rate hike are getting hammered, and that will continue as long as expectations stay the same.  Just look at the results in the last 24 hours.  The pound and the Aussie have been the best performers while the Japanese yen continues to sink.

Much of this kind of activity is indicative of a strong carry trade.  Economic policy makers in Japan have been clear in their refusal to raise rates, at least until there are stronger signs of consumer recovery in Japan.  And when the Bank of Japan does start raising the overnight lending rate, they have committed to doing it as gradually as possible.  Japan’s rates are low, and people (investors) are encouraged to seek higher yields.  The can find those higher yields in other currencies, in the US stock market (witness the steady resilience of the market to any drops) and in foreign bonds.

The carry trade is simply an interest rate differential story.  There is a concern as it becomes more popular because that makes it inherently riskier (see Bloomberg’s stories on Japanese and Hungarian housewives engaging in the carry trade and beating the market).  But until the carry trade bet becomes untenable (and that will happen at some point), forex traders continue to reap their gains and push the yen lower.  The euro is at its highest level ever again the yen.  AUD/JPY is at a 15 year high and USD/JPY is at a 4 year high.  And perhaps most interestingly, the New Zealand dollar, the currency with the highest yield, is back to the rarefied levels it occupied before the RBNZ intervention.  The bank would like to push it down again, but it is running out of funds.  And central bank interventions do not usually work anyway.  The bottom line is that as long as the global market stays calm, carry traders will profit on the interest rate differentials.  But world-wide inflation, political uncertainty, a slowdown in the United States or anything else that throws the forex market into flux will put a wet blanket on the carry trade.

Carry trades are still a ubiquitous feature of the forex market, but the driving force in the market today is not Japanese interest rates.  The ten-year US bond market has been the largest influence on international currencies.  The bond market has suffered recently, and the high yields have provided crucial support for the US dollar.  Especially with little US economic data on the docket for this week, currency traders are increasingly relying on yields to make their bets.

Yesterday, the US dollar gained ground against the Japanese yen, the euro and the Canadian dollar while losing ground against the New Zealand dollar, British pound and the Swiss franc.  The most interesting part of that scenario is that, with the exception of the Swiss franc, the dollar gained against every currency over which it had a yield advantage and lost against the currencies that had a yield advantage over it.  What we should ask ourselves is why US bond prices continue to fall?  Unfortunately, there is not a clear cut answer to that question.  But it might have something to do with the sub prime mortgage loan crisis in the United States, typified by the shutdown of two large hedge funds by Bear Sterns.

The effects of this on the currency market are startling.  While carry trades are in play, much of the momentum for the USD/JPY growth is certainly coming from high US yields.  With 10-year bond yields again reaching 5.15%, the forex market is simply shrugging off most other economic news.  Wednesday’s European economic data was actually pretty heartening.  PMI readings, especially in manufacturing, were better than expected, but the euro still fell against the dollar, as US yields determined the action.

The general situation repeated itself this morning.  The Federal Reserve Report for Philadelphia came out, and there were more first-timers on the unemployment rolls.  But the rest of the data was strong, with manufacturing picking up after a long layoff.  But the movement in the currency market was dollar-negative.  The US dollar lost most of its gains versus the Japanese yen and the Euro on the basis of falling bond yields.  The Germany IFO Business Climate Report is scheduled to be released at 4:00 PM today, and the data is likely to be positive.  But if recent forex activity has shown us anything, it’s that what happens to US 10-year bonds will matter more when it comes to currencies.