The Diminished Case for Chinese Yuan Appreciation

The Chinese yuan has appreciated by more than 27.5% since 2005, when the People’s Bank of China (“PBOC”) formally acceded to international pressure and began to relax the yuan-dollar peg. For China-watchers and economists, that the Yuan will continue to appreciate is thus a given. There is no question of if, but rather of when and to what extent. But what if the prevailing wisdom is wrong? What if the yuan is now fairly valued, and economic fundamentals no longer necessitate a further rise?

Prior to the 2005 revaluation, economists had argued that the yuan (also known as the Chinese RMB) was undervalued by 15% – 40%, and American politicians had used this as a basis for proposing a 27.5% across-the-board tariff on all Chinese imports. Given that the yuan has now appreciated by this exact margin (and by even more when inflation is taken into account), shouldn’t this alone be enough to silence the critics, without even having to look at the picture on the ground? How can Senator Charles Schumer continue to press for further appreciation when the yuan’s rise exceeds his initial demands? Alas, election season is upon us, and we can’t hope to make political sense out of this issue. We can, however, attempt to analyze the economic sense of it.

China manipulates the value of the yuan in order to give a competitive advantage to Chinese exporters, goes the conventional line of thinking. Look no further than the Chinese trade surplus for evidence of this, right? As it turns out, China’s trade surplus is shrinking rapidly. In 2006, it was a whopping 11% of GDP. Last year, it had fallen to 5%, and it is projected by the World Bank to settle below 3% for each of the next two years. Thanks to a first quarter trade deficit – the first in over seven years – China’s trade surplus may account for a negligible portion (~.2%) of GDP growth in 2010.

With this in mind, why would the PBOC even think about allowing the RMB to appreciate further? According to one perspective, the narrowing trade imbalance is only temporary. When commodities prices settle and global demand fully recovers, a wider trade surplus will follow. In fact, the IMF forecasts China’s current surplus will rise to 8% by 2016. As you can see from the chart below (courtesy of The Economist), however, the IMF’s forecasts have proven to be too pessimistic for at least the last three years, and it now has very little credibility. Besides, China’s economy is gradually reorienting itself away from exports and towards domestic spending. As a resident of China, I can certainly attest to this phenomenon, and the last few years has seen an explosion in the number of cars on the road, domestic tourism, and conspicuous consumption.

A better argument for further RMB appreciation comes in the form of inflation. At 5.4%, inflation is officially nearing a 3-year high, and there is evidence that the PBOC already recognizes that allowing the RMB to keep rising represents its best tool for containing this problem. It has already raised banks’ required reserve ratio several times, but there is a limit to what this can accomplish. Meanwhile, the PBOC remains reluctant to raise interest rates because it will invite further “hot-money” inflows (estimated at more than $100 Billion per year, if not much higher) and potentially destabilize the banking sector. By raising the value of the yuan, the PBOC can blunt the impact of rising commodities prices and other inflationary forces.

In fact, some think that the PBOC will quicken the pace of appreciation, a view that as supported by last month’s .9% rise. Others think that a once-off appreciation would be more effective, and is hence more likely. This would not only remove the motivation for further hot-money inflows, but would also reduce the PBOC’s need to continue accumulating foreign exchange reserves. At $3 trillion+ ($1.15 trillion of which are held in US Treasury Securities), these reserves are already a massive headache for policymakers. Merely stating the obvious, PBOC Governor Zhou Xiaochuan has officially called the reserves “really too much.” (It’s worth pointing out that the promotion of the yuan as an international currency is backfiring in some ways, causing the reserves to balloon even faster).

For the record, I think that the Chinese yuan is pretty close to being fairly valued. That might seem like a ridiculous claim to make when Chinese wages and prices are still well below the global average. Consider, however, that the same is true for the majority of emerging market economies, including those that don’t peg their currencies to the dollar. That doesn’t mean that the yuan won’t – or that it shouldn’t – continue to rise. In fact, the PBOC needs to do more to ensure that the Yuan appreciates evenly against all currencies, since most of the yuan’s rise to-date has taken place relative to the US Dollar. It’s merely a commentary that the PBOC is close to fulfilling the promises it has made regarding the yuan, and going forward, I think that observers should expect that its forex policy will be reconfigured to promote domestic macroeconomic policy objectives.

Dollar will Rally when QE2 Ends

In shifting their focus to interest rates, forex traders have perhaps overlooked one very important monetary policy event: the conclusion of the Fed’s quantitative easing program. By the end of June, the Fed will have added $600 Billion (mostly in US Treasury Securities) to its reserves, and must decide how next to proceed. Naturally, everyone seems to have a different opinion, regarding both the Fed’s next move and the accompanying impact on financial markets.

The second installment of quantitative easing (QE2) was initially greeted with skepticism by everyone except for equities investors (who correctly anticipated the continuation of the stock market rally). In November, I reported that QE2 was unfairly labeled a lose-lose by the forex markets: “If QE2 is successful, then hawks will start moaning about inflation and use it as an excuse to sell the Dollar. If QE2 fails, well, then the US economy could become mired in an interminable recession, and bears will sell the Dollar in favor of emerging market currencies.”
The jury is still out on whether QE2 was a success. On the one hand, US GDP growth continues to gather force, and should come in around 3% for the year. A handful of leading indicators are also ticking up, while unemployment may have peaked. On the other hand, actual and forecast inflation are rising (though it’s not clear how much of that is due to QE2 and how much is due to other factors). Stock and commodities prices have risen, while bond prices have fallen. Other countries have been quick to lambaste QE2 (including most recently, Vladimir Putin) for its perceived role in inflating asset bubbles around the world and fomenting the currency wars.

Personally, I think that the Fed deserves some credit- or at least doesn’t deserve so much blame. If you believe that asset price inflation is being driven by the Fed, it doesn’t really make sense to blame it for consumer and producer price inflation. If you believe that price inflation is the Fed’s fault, however, then you must similarly acknowledge its impact on economic growth. In other words, if you accept the notion that QE2 funds have trickled down into the economy (rather than being used entirely for financial speculation), it’s only fair to give the Fed credit for the positive implications of this and not just the negative ones.
But I digress. The more important questions are: what will the Fed do next, and how will the markets respond. The consensus seems to be that QE2 will not be followed by QE3, but that the Fed will not yet take steps to unwind QE2. Ben Bernanke echoed this sentiment during today’s inaugural press conference: “The next step is to stop reinvesting the maturing securities, a move that ‘does constitute a policy tightening.’ ” This is ultimately a much bigger step, and one that Chairman Bernanke will not yet commit.
As for how the markets will react, opinions really start to diverge. Bill Gross, who manages the world’s biggest bond fund, has been an outspoken critic of QE2 and believes that the Treasury market will collapse when the Fed ends its involvement. His firm, PIMCO, has released a widely-read report that accuses the Fed of distracting investors with “donuts” and compares its monetary policy to a giant Ponzi scheme. However, the report is filled with red herring charts and doesn’t ultimately make any attempt to account for the fact that Treasury rates have fallen dramatically (the opposite of what would otherwise be expected) since the Fed first unveiled QE2.
The report also concedes that, “The cost associated with the end of QEII therefore appears to be mostly factored into forward rates.” This is exactly what Bernanke told reporters today: “It’s [the end of QE2] ‘unlikely’ to have significant effects on financial markets or the economy…because you and the markets already know about it.” In other words, financial armmagedon is less likely when the markets have advanced knowledge and the ability to adjust. If anything, some investors who were initially crowded-out of the bond markets might be tempted to return, cushioning the Fed’s exit.

If bond prices do fall and interest rates rise, that might not be so bad for the US dollar. It might lure back overseas investors, grateful both for higher yields and the end of QE2. Despite the howls, foreign central banks never shunned the dollar.  In addition, the end of QE2 only makes a short-term interest rate that much closer. In short, it’s no surprise that the dollar is projected to “appreciate to $1.35 per euro by the end of the year, according to the median estimate of 47 analysts in a Bloomberg News survey. It will gain to 88 per yen, a separate poll shows.”

Forex Markets Focus on Central Banks

Over the last year and increasingly over the last few months, Central Banks around the world have taken center stage in currency markets. First, came the ignition of the currency war and the consequent volley of forex interventions. Then came the prospect of monetary tightening and the unwinding of quantitative easing measures. As if that wasn’t enough to keep them busy, Central Banks have been forced to assume more prominent roles in regulating financial markets and drafting economic policy. With so much to do, perhaps it’s no wonder that Jean-Claude Trichet, head of the ECB, will leave his post at the end of this year!

The currency wars may have subsided, but they haven’t ended. On both a paired and trade-weighted basis, the Dollar is declining rapidly. As a result, emerging market Central Banks are still doing everything they can to protect their respective currencies from rapid appreciation. As I’ve written in earlier posts, most Latin American and Asian Central Banks have already announced targeted strategies, and many intervene in forex markets on a daily basis. If the Japanese Yen continues to appreciate, you can bet the Bank of Japan (perhaps aided by the G7) will quickly jump back in.

You can expect the currency wars to continue until the quantitative easing programs instituted by the G4 are withdrawn. The Fed’s $600 Billion Treasury bond buying program officially ends in June, at which point its balance sheet will near $3 Trillion. The European Central Bank has injected an equally large hunk of cash into the Eurozone economy. Despite inflation that may soon exceed 5%, the Bank of England voted not to sell its cache of QE assets, while the Bank of Japan is actually ratcheting up its program as a result of the earthquake-induced catastrophe. Whether or not this manifests itself in higher inflation, investors have signaled their distaste by bidding up the price of gold to a new record high.

Then there are the prospective rate hikes, cascading across the world. Last week, the European Central Bank became the first in the G4 to hike rates (though market rates have hardly budged). The Reserve Bank of Australia, however, was the first of the majors to hike rates. Since October 2009, it has raised its benchmark by 175 basis points; its 4.75% cash rate is easily the highest in the industrialized world. The Bank of Canada started hiking in June 2010, but has kept its benchmark on hold at 1% since September. The Reserve Bank of New Zealand lowered its benchmark to a record low 2.5% as a result of serious earthquakes and economic weakness.
Going forward, expectations are for all Central Banks to continue (or begin) hiking rates at a gradual pace over the next couple years. If forecasts prove to be accurate, the US Federal Funds Rate will stand around .5% at the beginning of 2012, tied with Switzerland, and ahead of only Japan. The UK Rate will stand slightly above 1%, while the Eurozone and Canadian benchmarks will be closer to 2%. The RBA cash rate should exceed 5%. Rates in emerging markets will probably be even higher, as all four BRIC countries (Russia, Brazil, China, India) should be well into the tightening cycles.

On the one hand, there is reason to believe that the pace of rate hikes will be slower than expected. Economic growth remains tepid across the industrialized world, and Central Banks are wary about spooking their economies with premature rate hikes. Besides, Fed watchers may have learned a lesson as a result of a brief bout of over-excitement in 2010 that ultimately led to nothing. The Economist has reported that, “Markets habitually assign too much weight to the hawks, however. The real power at the Fed rests with its leaders…At present they are sanguine about inflation and worried about unemployment, which means a rate rise this year is unlikely.”  Even the ECB disappointed traders by (deliberately) adopting a soft stance in the press release that accompanied its recent rate hike.
On the other hand, a recent paper published by the Bank for International Settlements (BIS) showed that the markets’ track record of forecasting inflation is weak. As you can see from the chart below, they tend to reflect the general trend in inflation, but underestimate when the direction changes suddenly. (This is perhaps similar to the “fat-tail” problem, whereby extreme aberrations in asset price returns are poorly accounted for in financial models). If you apply this to the current economic environment, it suggests that inflation will probably be much higher-than-expected, and Central Banks will be forced to compensate by hiking rates a faster pace.
Finally, in their newfound roles as economic policymakers, Central Banks are increasingly engaged in macroprudential policy. The Economist reports that, “Central banks and regulators in emerging economies have already imposed a host of measures to cool property prices and capital inflows.” These measures are worth watching because their chief aim is to indirectly reduce inflation. If they are successful, it will limit the need for interest rate hikes and reduce upward pressure on their currencies.
In short, given the enhanced ability of Central Banks to dictate exchange rates, traders with long-term outlooks may need to adjust their strategies accordingly. That means not only knowing who is expected to raise interest rates – as well as when and by how much – but also monitoring the use of their other tools, such as balance sheet expansion, efforts to cool asset price bubbles, and deliberate manipulation of exchange rates.

Record Commodities Prices and the Forex Markets

Propelled by economic recovery and the recent Mideast political turmoil, oil prices have firmly shaken off any lingering credit crisis weakness, and are headed towards a record high. Moreover, analysts are warning that due to certain fundamental changes to the global economy, prices will almost certainly remain high for the foreseeable future. The same goes for commodities. Whether directly or indirectly, the implications for forex market will be significant.


First of all, there is a direct impact on trade, and hence on the demand for particular currencies. Norway, Russia, Saudia Arabia, and a dozen other countries are witnessing record capital inflow expanding current account surpluses. If not for the fact that many of these countries peg their currencies to the Dollar and/or seem to suffer from myriad other issues, there currencies would almost surely appreciate. In fact, the Russian Rouble and Norwegian Krona have both begun to rise in recent months. On the other hand, Canada and Australia (and to a lesser extent, New Zealand) are experiencing rising trade deficits, which shows that their is not an automatic relationship between rising commodity prices and commodity currency strength.

Those countries that are net energy importers could experience some weakness in their currencies, as trade balances move against them. In fact, China just recorded its first quarterly trade deficit in seven years. Instead of viewing this in terms of a shift in economic structure, economists need to understand that this is due in no small part to rising raw materials prices. Either way, the People’s Bank of China (PBOC) will probably tighten control over the appreciation of the Chinese Yuan. Meanwhile, the nuclear crisis in Japan is almost certainly going to decrease interest in nuclear power, especially in the short-term. This will cause oil and natural gas prices to rise even further, and magnify the impact on global trade imbalances.

A bigger issue is whether rising commodities prices will spur inflation. With the notable exception of the Fed, all of the world’s Central Banks have now voiced concerns over energy prices. The European Central Bank (ECB), has gone so far as to preemptively raise its benchmark interest rate, even though Eurozone inflation is still quite low. In light of his spectacular failure to anticipate the housing crisis, Fed Chairman Ben Bernanke is being careful not to offer unambiguous views on the impact of high oil prices. Thus, he has warned that it could translate into decreased GDP growth and higher prices for consumers, but he has stopped short of labeling it a serious threat.
On the one hand, the US economy is undergone some significant structural changes since the last energy crisis, which could mitigate the impact of sustained high prices. “The energy intensity of the U.S. economy — that is, the energy required to produce $1 of GDP — has fallen by 50% since then as manufacturing has moved overseas or become more efficient. Also, the price of natural gas today has stayed low; in the past, oil and gas moved in tandem. And finally, ‘we’re closer to alternative sources of energy for our transportation,’ ” summarized Wharton Finance Professor Jeremy Siegal. From this standpoint, it’s understandable that every $10 increase in the price of oil causes GDP to drop by only .25%.
On the other hand, we’re not talking about a $10 increase in the price of oil, but rather a $50 or even $100 spike. In addition, while industry is not sensitive to high commodity prices, American consumers certainly are. From automobile gasoline to home eating oil to agricultural staples (you know things are bad when thieves are targeting produce!), commodities still represent a big portion of consumer spending. Thus, each 1 cent increase in the price of gas sucks $1 Billion from the economy. “If gas prices increased to $4.50 per gallon for more than two months, it would ‘pose a serious strain on households and could put the entire recovery in jeopardy. Once you get above $5, [there is] probably above a 50% chance that the economy could face a downturn.’ ”
Even if stagflation can be avoided, some degree of inflation seems inevitable. In fact, US CPI is now 2.7%, the highest level in 18 months and rising. It is similarly 2.7% in the Eurozone and Australia, where both Central Banks have started to become more aggressive about tightening monetary policy. In the end, no country will be spared from inflation if commodity prices remain high; the only difference will be one of extent.

Over the near-term, much depends on what happens in the Middle East, since an abatement in political tensions would cause energy prices to ease. Over the medium-term, the focus will be on Central Banks, to see if/how they deal with rising inflation. Will they raise interest rates and withdraw liquidity, or will they wait to act for fear of inhibiting economic recovery? Over the long-term, the pivotal issue is whether economies (especially China) can become less energy intensive or more diversified in their energy consumption.
At the moment, most economies are dangerously exposed, with China and the US topping the list. Russia, Norway, Brazil and a select few others will earn a net benefit from a boom in prices, while most others (notably Australia and Canada) are somewhere in the middle.

Fed Mulls End to Easy Money

Forex traders have very suddenly tilted their collective focus towards interest rate differentials. Given that the Dollar is once again in a state of free fall, it seems the consensus is that the Fed will be the last among the majors to hike rates. As I’ll explain below, however, there are a number of reasons why this might not be the case.

First of all, the economic recovery is gathering momentum. According to a Bloomberg News poll, “The US economy is forecast to expand at a 3.4 percent rate this quarter and 3.3 percent rate in the second quarter.” More importantly, the unemployment rate has finally begun to tick down, and recently touched an 18-month low. While it’s not clear whether this represents a bona fide increase in employment or merely job-hunting fatigue among the unemployed, it nonetheless will directly feed into the Fed’s decision-making process.

In fact, the Fed made such an observation in its March 15 FOMC monetary policy statement, though it prefaced this with a warning about the weak housing market. Similarly, it noted that a stronger economy combined with rising commodity prices could feed into inflation, but this too, it tempered with the dovish remark that “measures of underlying inflation continue to be somewhat low.” As such, it warned of “exceptionally low levels for the federal funds rate for an extended period.”
To be sure, interest rate futures reflect a 0% likelihood of any rate hikes in the next 6 months. In fact, there is a 33% chance that the Fed will hike before the end of the year, and only a 75% chance of a 25 basis point rise in January of 2012. On the other hand, some of the Fed Governors are starting to take more hawkish positions in the media about the prospect of rate hikes: “Minneapolis Federal Reserve President Narayana Kocherlakota said rates should rise by up to 75 basis points by year-end if core inflation and economic growth picked up as he expected.” Given that he is a voting member of the FOMC, this should not be written off as idle talk.

Meanwhile, Saint Louis Fed President James Bullard has urged the Fed to end its QE2 program, and he isn’t alone. “Philadelphia Fed President Charles Plosner and Richmond Fed President Jeffrey Lacker have also urged a review of the purchases in light of a strengthening economy and concern over future inflation.” While the FOMC voted in March to “maintain its existing policy of reinvesting principal payments from its securities holdings and…purchase $600 billion of longer-term Treasury securities by the end of the second quarter of 2011,” it has yet to reiterate this position in light of these recent comments to the contrary, and investors have taken notice.
Assumptions will probably be revised further following tomorrow’s release of the minutes from the March meeting, though investors will probably have to wait until April 27 for any substantive developments. The FOMC statement from that meeting will be scrutinized closely for any subtle tweaks in wording.
Ultimately, the take-away from all of this is that this record period of easy money will soon come to an end. Whether this year or the next, the Fed is finally going to put some monetary muscle behind the Dollar.

UK Forex Reserve Plan could Harm Pound

Yesterday, UK Chancellor George Osborne announced that his government was ready to begin rebuilding its foreign exchange reserves. Depending on when, how, (or even if) this program is implemented, it could have serious implications for the Pound.
Forex reserve watchers (myself included) were excited by the updated US Treasury report on foreign holdings of US Treasury securities. As the Dollar is the world’s de-facto reserve currency and the US
Treasury securities are the asset of choice, the report is basically a rough sketch of both the Dollar’s global popularity and the interventions of foreign Central Banks. Personally, I thought the biggest shocker was not that China’s Treasury holdings are $300 Billion greater than previously believed (with $3 Trillion in reserves, that’s really just a rounding error), but rather that the UK’s holdings declined by 50% in 2010, to a mere $260 Billion.

Given that the Bank of England (BoE) injected more than $500 Billion into the UK money supply in 2010, I suppose that shouldn’t have been much of a revelation. After all, selling US Treasury Securities and using the proceeds to buy British Gilts (sovereign debt) and other financial instruments would enable the BoE to achieve its objective without having to resort to wholesale money printing. In addition, if not for this sleight of hand, UK inflation would probably be even higher.
Still, this is little more than a mere accounting trick, and those funds will probably still need to be withdrawn from the money supply at some point anyway. Whether the BoE burns the proceeds or reinvests them back into foreign instruments is certainly worth pondering, but insofar as it won’t impact inflation, it is a matter of economic policy, and not monetary policy.
As Chancellor Osborn indicated, the UK will probably send these funds back abroad. In addition to providing support for the Dollar (as well as another reason not to be nervous about the upcoming end of the Fed’s QE2), this would seriously weaken the Pound, at a time  that it is already near a 30-year low on a trade-weighted basis. After falling off a cliff in 2009, the Pound recovered against the Dollar in 2010, largely due to the BoE’s shuffling of its foreign exchange reserves. To undo this would certainly risk sending the Pound back towards these depths.

On the one hand, the UK is certainly conscious of this and would act accordingly, perhaps even delaying any foreign exchange reserve accumulation until the Pound strengthens. On the other hand, the BoE is under pressure to fight inflation. It is reluctant to raise interest rates because of the impact it would have on the fragile economic recovery. The same can be said for unwinding its asset purchases. However, if it offset this with purchases of US Treasury securities and other foreign currency assets, it could weaken the Pound and maintain some form of economic stimulus. Especially since the UK has run a sizable trade/current account deficit for as long as anyone can remember, the BoE has both the flexibility/justification it needs to coax the exchange rate down a little bit.
Ultimately, we’ll need more information before we can determine how this will impact the Pound. Still, this is an indication that the GBP/USD might not have much more room to appreciate.

British Pound Continues Gradual Ascent

The British Pound has risen almost 15% against the Dollar over the last twelve months. It seems that the markets are ignoring the fiscal concerns that sent the Pound tumbling in 2010, and focusing more on inflation and the prospect of interest rate hikes. At this point, the Bank of England (BOE) is now racing with the European Central Bank (ECB) to be the first “G4″ Central Bank to hike rates.

You can find cause for optimism towards the Pound in technical factors alone. That’s because while dozens of currencies appreciated against the Dollar in 2010, most were starting from a stronger base. For example, the Canadian and Australian Dollars collapsed during the credit crisis. However, both currencies made speedy recoveries to the extent all losses were erased in only two years. The British Pound, in contrast, still remains 25% below its pre-credit crisis high, more depressed than perhaps any other currency.

On the one hand, this is probably justifiable. The British economy is still in abysmal shape; the latest GDP figures revealed a .6% contraction in the fourth quarter of 2010. Meanwhile, the ECB forecasts only 1.4% growth in 2011, and many analysts think that might even be too optimistic. With the exception of Japan, which suffers from a unique strain of economic malaise (not to mention the 5% hit to GDP caused by the earthquake), the UK is unequivocally the weakest economy in the industrialized world.
On the other hand, this is mostly old news. The reason that investors are starting to get excited is interest rate hikes. According to the minutes from its March meeting, the BOE voted 6-3 to hold its benchmark interest rate at .5%. That means its awfully close to acting. The market consensus is for a 25 basis point rate hike in the next three months, and 2-3 additional hikes over the rest of the year. Depending on how the other G4 Central banks act, that will put the UK rates at the top of the pack.
However, it’s unclear how extensive this tightening will be. According to one analyst, “The probability of a hike in the next three months is significant but the lingering credit crunch, fiscal tightening and bleak outlook for real incomes suggest that if this is the beginning of a tightening cycle, it will be a very shallow one.” Moreover, low bond yields suggest that long-term inflation expectations (and hence, the need for rate hikes) remain low.

At this point, it looks like the UK is looking at a few years of stagflation. That’s certainly going to be bad for UK consumers and probably negative for most UK asset prices. However, short-term currency speculators are less concerned about economic fundamentals, and more concerned about (risk-adjusted) interest rate differentials. That means that if the BOE fulfills expectations, the Pound will probably get a little short-term kick.

Euro Buoyed by Rate Hike Expectations, Despite Unresolved Debt Issues

From trough to peak, the Euro has risen 9% over a period of only two months. You wouldn’t ordinarily expect to see this kind of appreciation from a G4 currency, especially not one whose member states are on the brink of insolvency and which itself faces threats to its very existence. In this case, the Euro is benefiting from expectations that the European Central Bank (ECB) will be among the first and most aggressive in hiking interest rates. As I warned in my previous post, however, those that focus solely on interest rate differentials and ignore the Euro’s lingering Sovereign debt crisis do so at their own peril.


Indications that the ECB will hike interest rates came out of nowhere. Jean-Claude Trichet, President of the ECB, announced last week that it would be particularly aggressive in taking steps to deal with inflation. This caught the markets by surprise, since Eurozone inflation is still below 2% and GDP growth is similarly low. Later, Governing Council members Mario Draghi and Axel Weber (both of whom are potential candidates to replace Trichet when he steps down later this year), issued similar statements, and the question of rate hikes was suddenly changed from If to When/How much.
Futures markets are currently pricing in 3 interest rate hikes, which would bring the Eurozone benchmark rate to 1.75% by year end. According to economist Nouriel Roubini’s (who gained fame by predicting the financial crisis) think tank: “Jean-Claude Trichet has been careful not to commit to a series of hikes, but we believe that is what it will be. The ECB is bluffing. We think the ECB will hike by a total of 75 basis points, probably by August.” Axel Weber, himself, coyly echoed this sentiment: “I see no reason at this stage to signal any dissent with how markets priced future policies.”
On the one hand, the recent rise in oil prices strengthens the case for rate hikes. On the other hand, the EU does not consume energy at the same intensity as the US, which means that its impact on inflation is likely to be muted. In addition, while the ECB’s mandate is indeed titled towards price stability (rather than boosting employment or spurring economic growth), to hike rates now would risk endangering the still-fragile Eurozone economic recovery. Unwinding its quantitative easing would similarly add to the risk of another financial crisis, since banks still make heavy use of its emergency lending facilities.
Speaking of which, it’s still way too early to say that the the EU sovereign debt crisis is behind us. Despite the loans and pledges and bailouts, interest rates for all four PIGS (Portugal, Ireland, Greece, Spain) countries continue to rise, and or nearing unsustainable levels. At the moment, currency investors have chosen to ignore this, since the EU has basically guaranteed them funding until 2013. What will happen then, or as the date draw near, is anyone’s guess.

In the end, one or more defaults seems inevitable. There is only so much that financial engineering can do to conceal and restructure debt which exceeds 100% of GDP in the cases of Greece and Ireland. If that were to happen, significant losses would be incurred by EU banks, which lent heavily to at-risk countries during the boom years. In order to minimize this situation, I think the ECB will probably continue to subsidize the banks via low interest rates.
Even if the ECB does hike rates, it will be extremely gradual. Furthermore, By the time Eurozone interest rates reach attractive levels, the other G4 Central Banks (with the exception of Japan) will probably already have started to close the gap. That means that interest rate differentials probably won’t soon be wide enough to lure more than a modicum of risk-averse investors. (Besides, if you assume a 5% chance of default, risk-adjusted rates are probably still negative).
In short, I think that the ongoing Euro rally is really just a short squeeze in disguise. Basically, speculators are conceding that shorting the Euro is both risky and unprofitable. (According to one hedge fund manager, “It was a very popular trade,” the portfolio manager says. A lot of us stuck with it, and it went wrong in January.”) In anticipating of higher future interest rates, they are preemptively moving to liquidate their short positions. However, not being short is not the same thing as going long. And until the EU sorts through the fiscal issues in a convincing way, I think it would be foolish to start making long-term bets on the Euro.

Forex Markets Look to Interest Rates for Guidance

There are a number of forces currently competing for control of forex markets: the ebb and flow of risk appetite, Central Bank currency intervention, comparative economic growth differentials, and numerous technical factors. Soon, traders will have to add one more item to their list of must-watch variables: interest rates.
Interest rates around the world remain at record lows. In many cases, they are locked at 0%, unable to drift any lower. With a couple of minor exceptions, none of the major Central Banks have yet raised their benchmark interest rates. The same applies to most emerging countries. Despite rising inflation and enviable GDP growth, they remain reluctant to hike rates for fear that they will invite further speculative capital inflows and consequent currency appreciation.
Emerging markets countries can only toy with inflation for so long. Over the medium-term, all of them will undoubtedly be forced to raise interest rates. The time horizon for G7 Central Banks is a little longer, due to high unemployment, tepid economic growth, and price stability. At a certain point, however, inflation will compel all of them to act. When they raise rates – and by much – may well dictate the major trends in forex markets over the next couple years.
Australia (4.75%), New Zealand (3%), and Canada (1%) are the only industrialized Central Banks to have lifted their benchmark interest rates. However, the former two must deal with high inflation, while the latter’s benchmark rate is hardly high enough for carry traders to take interest. In addition, the Reserve Bank of Australia has basically stopped tightening, and traders are betting on only one or two 25 basis point hikes in 2011. Besides, higher interest rates have probably already been priced into their respective currencies (which is why they rallied tremendously in 2010), and will have to rise much more before yield-seekers take notice.
China (~6%) and Brazil (11.25%) are leading the way in emerging markets in raising rates. However, their benchmark lending rates belie lower deposit rates and are probably negative when you account for soaring inflation in both countries. The Reserve Bank of India and Bank of Russia have also hiked rates several times over the last year, though again, not yet enough to offset rising prices.
Instead, the real battle will probably be fought primarily amongst the Pound, Euro, Dollar, and Franc. (The Japanese Yen is essentially moot in this debate, and its Central Bank has not even humored the markets about the possibility of higher interest rates down the road). The Bank of England (BoE) will probably be the first to move. “The present ultra-low rates are unsustainable. They would be unsustainable in a period of low inflation but they are especially unsustainable with inflation, however you measure it, approaching 5 per cent,” summarized one columnist. In fact, it is projected to hike rates 3 times over the next year. If/when it unwinds its quantitative easing program, long-term rates will probably follow suit.

The European Central Bank will probably act next. Its mandate is to limit inflation – rather than facilitate economic growth, which means that it probably won’t hesitate to hike rates if inflation remains above its 2% threshold. In addition, the front runner to replace Jean-Claude Trichet as head of the ECB is Axel Webber, who is notoriously hawkish when it comes to monetary policy. Meanwhile, the Swiss National Bank is currently too concerned about the rising Franc to even think about raising rates.

That leaves the Federal Reserve Bank. Traders were previously betting on 2010 rate hikes, but since these have failed to materialized, they have pushed back their expectations to 2012. In fact, there is reason to believe that it will be even longer than that. According to a Bloomberg News analysis, “After the past two U.S. recessions, the Fed didn’t start raising policy rates until joblessness had fallen about three- quarters of the way back to the full-employment level…To satisfy that requirement, the jobless rate would need to be 6.5 percent, compared with today’s 9 percent.” Another commentator argued that the Fed will similarly hold off raising rates in order to further stabilize (aka subsidize) banks and to help the federal government lower the real value of its debt, even if it means tolerating slightly higher inflation.

When you consider that US deposit rates are already negative (when you account for inflation) and that this will probably worsen further, it looks like the US Dollar will probably come out on the losing end of any interest rate battles in the currency markets.