USD Gets Double Kick

Over the last couple months, a raft of positive economic developments has driven the USD steadily to its highest level in months. These developments include GDP data, retail sales data, and housing data have all shown signs of strength after an all-encompassing slump in the first quarter. However, it was not until last week that the markets fully removed the possibility of

near-term rate cuts out of the markets, sending US benchmark interest rates to their highest levels in years. As a result, the USD received a second bump, as higher yields sucked in a risk-averse capital from other parts of the world.  The delay between positive economic data and the subsequent rise in yields that took place here is rare, but Dollar bulls were probably happy to ride the wave upwards.  Dow Jones News reports:

Amid soaring rates, the dollar’s rally got a second lease of life, confounding those who had been calling for a reversal in the greenback’s fortunes. Contrast that with late April, when the euro hit a record high of $1.3682 – and analysts were forecasting a run to $1.40.

Read More: Dollar Perhaps Undeserving Of Recent Rally

Chinese Yuan: Appreciation or Inflation?

Based on nominal exchange rates, the Chinese Yuan has appreciated by a modest 2% against the US Dollar since the month of September (when the People’s Bank of China (PBOC) adjusted the currency peg for the first time in nearly two years). If you take inflation into account, however, the Chinese Yuan has risen by much more. In fact, if current trends persist, the Chinese Yuan exchange rate controversy might resolve itself.

Demands from the international community for China to appreciate its currency hinge on two related arguments. The first is that at its current level, the artificially low exchange has allowed China to build up a massive trade surplus. The second is that Chinese prices seem to be lower than they should be (when quoted in other currencies), and the economic principle of Purchasing Power Parity (PPP) suggests that for this discrepancy to be eliminated, the Chinese Yuan must rise.

As it turns out, both of these claims are more problematic than they would appear. For example, China’s official trade surplus is already massive, and is steadily increasing. For 2010, it will probably near $200 Billion. However, it turns out that majority of that surplus is being captured by foreign-funded companies: “Their 112.5-billion U.S.-dollar surplus accounts for 66 percent of China’s total surplus over the past 11 months.”

In addition, trade statistics are calculated in such a way that the country that assembles the finished product gets credit for the full export value of that product. By looking specifically at Apple’s popular iPhone, researchers calculated that the product officially contributed $2 Billion to the US trade deficit with China. When the nuances of the iPhone’s supply chain are taken into account, that figure swings to a surplus of $48 million. In both of these cases, the fact that these products are manufactured in China doesn’t detract from US GDP (though it probably does cost the US jobs). Hence, the US probably isn’t hurting as much from the weak RMB to the extent that some lobbyists insist.

As for inflation, the official rate is now 5.1% on an annualized basis. Even if we accept this (and living in China, I can tell you that the actual rate is much, much higher), that means that the value of other currencies is eroding at a much faster rate than is implied by official exchange rates. That’s because a currency is only worth its purchasing power; as prices and wages in China rise, the purchasing power of the US Dollar (and other currencies) falls.

The Chinese government is trying to address the problem in the form of price controls and mandated increases in supply, but it is still reluctant to rein in inflation using conventional monetary policy measures. M2 money supply in China is increasing at a rate of 20% a year, the majority of which is being spent on another boom in fixed asset investment. While the PBOC has responded by increasing the required reserve ratio of Chinese banks, it remains reluctant to raise interest rates lest it contribute to further inflows of “hot money” on more upward pressure on the Yuan. As a result, the consensus among economists is that inflation will continue rising unabated: “We see a strong chance of underlying price pressures continuing to build over the medium-term.”

Unless circumstances change, then, the argument for further RMB appreciation is somewhat weak. Nonetheless, analysts remain optimistic: “A Bloomberg survey based on the median estimates of 20 analysts predicts the yuan to increase 6.1 percent to 6.28 percent by the end of 2011.” Given that Hu Jintao is schedule to visit the US in January – and China’s fondness for symbolic policy gestures – a token move of 1% or so before then wouldn’t be surprising. As for the predicted 6% rise next year, well, that depends on inflation.

Currency Wars: Will Everyone Please Stop Whining!

I read a provocative piece the other day by Michael Hudson (“Why the U.S. Has Launched a New Financial World War — and How the Rest of the World Will Fight Back“), in which he argued that the ongoing currency wars are the fault of the US. Below, I’ll explain why he’s both right and wrong, and why he (and everyone else) should shut up and stop complaining.

It has become almost cliche to argue that the US, as the world’s lone hegemonic power, is also the world’s military bully. Hudson takes this argument one step further by accusing the US of using the Dollar as a basis for conducting “financial warfare.” Basically, the US Federal Reserve Bank’s Quantitative Easing and related monetary expansion programs create massive amounts of currency, the majority of which are exported to emerging market countries in the form of loans and investments. This puts upward pressure on their currencies, and rewards foreign speculators at the expense of domestic exporters.

Hudson is right that the majority of newly printed money has indeed been shifted to emerging markets, where the best returns and greatest potential for appreciation lies. Simply, the current economic and investing climate in the US is not as strong as in emerging markets. Indeed, this is why the (first) Quantitative Easing (QE) program was not very successful, and why the Fed has proposed a second round. While there is a bit of a chicken-and-egg conundrum (does economic growth drive investing, or do investors drive economic growth?) here, current capital flow trends suggest that any additional quantitative easing will also be felt primarily in emerging markets, rather than in the US. Not to mention that the US money supply has expanded at the same pace (or even slower) as the US economy over the long-term.

While the point about QE being ineffective is well-taken, Hudson completely ignores the strong case to be made for investing in emerging markets. He dismissively refers to all such investing as “extractive, not productive,” without bothering to contemplate why investors have instinctively started to prefer emerging markets to industrialized markets. As I said, emerging market economies are individually and collectively more robust, with faster growth and lower-debt than their industrialized counterparts. Calling such investing predatory represents a lack of understanding of the forces behind it.

Hudson also overlooks the role that emerging markets play in this system. The fact that speculative capital continues to pour into emerging markets despite the 30% currency appreciation that has already taken place and the asset bubbles that may be forming in their financial markets suggests that their assets and currencies are still undervalued. That’s not to say that the markets are perfect (the financial crisis proved the contrary), but rather that speculators believe that there is still money to be made. On the other side of the table, those that exchange emerging market currency for Dollars (and Euros and Pounds and Yen) must necessarily accept the exchange rate they are offered. In other words, the exchange rate is reasonable because it is palatable to all parties.

You can argue that this system unfairly penalizes emerging market countries, whose economies are dependent on the export sector to drive growth. What this really proves, however, is that these economies actually have no comparative advantage in the production and export of whatever goods they happen to be producing and exporting. If they can offer more than low costs and loose laws, then their export sectors will thrive in spite of currency appreciation. Look at Germany and Japan: both economies have recorded near-continuous trade surpluses for many decades in spite of the rising Euro and Yen.

The problem is that everyone benefits (in the short term) from the fundamental misalignments in currency markets. Traders like to mock purchasing power parity, but over the long-term, this is what drives exchange rates. Adjusting for taxes, laws, and other peculiarities which distinguish one economy from another, prices in countries at comparable stages of development should converge over the long-term. You can see from The Economist’s Big Mac Index that this is largely the case. As emerging market economies develop, their prices will gradually rise both absolutely (due to inflation) and relatively (when measured against other currencies).

Ultimately, the global economy (of which currency markets and exchange rates represent only one part) always operates in equilibrium. The US imports goods from China, which sterilizes the inflows in order to avoid RMB appreciation by building up a stash of US Dollars, and holding them in US Treasury Bonds. Of course, everything would be easier if China allowed the RMB to appreciate AND the US government stopped running budget deficits, but neither side is willing to make such a change. In reality, the two will probably happen simultaneously: China will gradually let the RMB rise, which will cause US interest rates  to rise, which will make it more expensive and less palatable to add $1 Trillion to the National Debt every year, and will simultaneously make it more attractive to produce in the US.

Until then, politicians from every country and hack economists with their napkin drawings will continue to whine about injustice and impending economic doom.

Much Ado About Debt

In addressing the financial/credit/economic crisis, governments around the world have lowered interest rates, bailed-out bankrupt financial insititutions, engaged in wholesale money printing, guaranteed debt, and pumped cash into their economies. However, while such programs may have had some mitigating impact on the crisis, they did little to address the underlying cause. Specifically, debt was merely moved from one institution – one balance sheet – to another. Most of the bad debt that was at the heart of the credit crisis is still outstanding; the only thing that has changed is who is responsible for repaying it.

In many cases, it is governments which have assumed ownership of this debt. Fannie Mae and Freddie Mac remain in a US government conservatorship. The Federal Reserve Bank owns more than $2 Trillion in US Treasuries and Mortgage Backed Securities. The European Union has agreed to collectively back more than $500 Billion in debt belonging to Greece and other unspecified “troubled” member states. The Japanese government has managed to pass off 90% of its sovereign debt onto its own citizens. The UK Treasury has printed money and lent it to the government of the UK. [The graphic below is actually interactive, and is worth a few minutes of perusing].

So what are the possibilities for dealing with this debt? In terms of government debt, the first is to hope that economies can grow faster than the debt, so that it becomes more manageable in relative terms and that one day it can be repaid. Another option is to raise taxes and/or cut spending, and use the extra funds to retire the debt. Given the current economic environment, the former possibility is unlikely. Industrialized economies continue to stall, and much of this growth is being funded with new debt. The latter option would amount to political suicide; any government that is politically naive enough to approve any austerity measures will be voted out of office at the next election. (With the election season about to begin, we won’t have to wait long for confirmation!)

The only alternative then is to reduce the real amount of debt through monetary inflation or currency depreciation. In the US, inflation is at a 50-year low. In Japan, it is non-existent. In the UK and the EU, prices are hardly growing. Monetary policymakers around the world are now actively trying to spur inflation (for reasons unrelated to the reduction of debt), but to no avail. Interest rates are already at rock bottom, and Central Banks have injected Billions of newly minted money into circulation without any impact on prices.

Currency devaluation is already taking place, but the main participants are emerging market economies (which are incidentally more concerned about export competitiveness than reducing the size of the debts). The Japanese Yen is nearing an all-time high, while the Euro has recovered from its spring lows. The British Pound is near its long-term average, while the US Dollar has declined only slightly on a trade-weighted average. In the end, since all of these countries are characterized by high levels of debt, it would be impossible for all of them to devalue their currencies. In addition, the nature of the Euro currency union precludes Eurozone countries from being able to lower their debts through currency devaluation.

The story is the same for private debt. For example, most of the real estate (commercial and residential) debt associated with the collapse of the housing market has yet to be written off. Financial institutions and investors continue to hold onto it with the hope that the real estate market will soon recover, such that the losses will never need to be recognized. While this strategy could vindicate lenders/investors over the long-term, it continues to have a devastating effect in the short-term since it forces the holders of debt to keep more cash on their balance sheets, where it won’t find its way into the global economy.

What are the implications for forex markets? Namely, it would seem to support the notion that emerging market currencies will continue to outperform the G4 currencies over the long-term. Over the near-term, it’s possible that G4 currencies will experience some appreciation, due both to the ebb and flow of risk appetite and the interventions of emerging market Central Banks on behalf of their currencies. Over the long-term, however, the only realistic alternative to default is currency devaluation, and at some point, the forex markets will have to come to terms with the fact that the G4 currencies need to decline. [Chart above courtesy of The Economist].

Australia Dollar Ebbs and Flows with Risk

If you chart the course of the Australian Dollar over the last twelve months alongside the S&P 500, the overlap is jarring. You can see from the chart below that the two lines zig and zag in almost perfect unison. It would seem that there was a slight break in the second quarter of 2010, but even this is an illusion, since the Aussie and the S&P continued to rise and fall in the same patterns over that time period, differing only in degree of fluctuation.

Since the S&P 500 is a pretty good proxy for risk it can be said that the Australian Dollar is a manifestation of investor risk appetite. When risk aversion was high, the S&P and the Aussie were low. When risk tolerance picked up, they rose. It’s funny how this came to be. It is probably best seen as a vestige from the credit crisis, whereby investors evenly divided assets into two classes: risky and safe. When you look at the performance of the Australian Dollar, it is pretty clear as to which side of the dividing line it was placed.

This is probably fair, since the Australian Dollar is a growth currency. According to the just-released Bank of International Settlements (BIS) Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity, the Australian Dollar is now the world’s fifth most traded currency (behind only the G4: Dollar, Euro, Yen, & Pound), having usurped that position from the Swiss Franc. In 2010, it accounted for 7.6% (out of a total of 200%) of all trading volume, primarily as a result of trading in the USD/AUD currency pair, which was the fourth most popular in forex.

Investors have come to see the Australian Dollar in somewhat contradictory terms. It is both stable and liquid, but its economy is unpredictable and inflation is usually above average. The current economic situation was strong, with GDP growth projected to exceed 3% in 2010. Its benchmark interest rate (4.5%) is the highest in the industrialized world, and may touch 5% before the year is over. On the other hand, its political situation is currently uncertain, thanks to an election that produced a hung Parliament and the recent resignation of its Prime Minster. In addition, while its trade balance is currently in surplus, it fell in July thanks todecreased demand from China. Analysts wonder whether it isn’t entirely dependent on China (directly via exports and indirectly via high commodity prices) to generate positive GDP growth.

Ultimately, investors don’t care about any of this. They care only whether the global economy is stable and whether another financial/credit/economic crisis is likely to occur. Even though any such crisis will probably spare Australia, the Aussie is punished by even the whiff of crisis because Australia is perceived as being riskier to invest than the US, for example. “The Australian dollar is going to stay heavy. Markets don’t like uncertainty,” summarized JP Morgan.

Sadly, it’s currently not worth parsing the nuances of trade statistics and monetary policy, because it has no bearing on the Aussie, though at least this makes my job easier. For the time being, the Australian Dollar will tick up if it looks like the global economy (principally the US) will avoid a double-dip recession. Otherwise, it is in for the same rough stretch as the S&P.

Safe Haven Trade Returns

I shouldn’t have been so complacent in declaring the paradigm shift in forex markets, whereby risk aversion had given way to comparative growth and interest rate differentials. While such a shift might have been present – or even dominant – in forex markets over the last couple months, it appears to have once again been superseded by the so-called safe haven trade.

In hindsight, it wasn’t that the interplay between risk appetite and risk aversion had ceased to guide the forex markets, but rather that they had been deliberately been put on the backburner. In other words, it’s now obvious that investors have remained vigilant towards the possibility of another crisis and/or an increase in risk/volatility.

How do I know this is the case? This week, there was a major correction in the markets, as diminished growth prospects for the global economy led stocks down, and bonds and the Dollar up. If investors were truly focused on growth differentials, the Dollar would have declined, due to a poor prognosis for the US economy. Instead, investors bought the Dollar and the Yen because of their safe-haven appeal.

What exactly was it that produced such a backlash in the markets, sending both the DJIA and the Euro down by 2% apiece in less than one trading session? First, the most recent jobs report confirmed that unemployment is not falling. Then, the Commerce Department released trade data which showed that the recovery in US exports has already leveled off. This sent economists scrambling to adjust their forecasts for 2010 GDP growth: “After downward revisions to other economic data like inventories and the export figures, even that 2.4 percent annual rate is now looking too rosy — and may even be as low as 1 percent.”

To top it all off, the meeting of the Fed Reserve Bank confirmed investors’ worst fears as the Fed warned of continued economic weakness and voted to further entrench its quantitative easing program. According to the official FOMC statement: “The pace of recovery in output and employment has slowed in recent months. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit…Bank lending has continued to contract….the pace of economic recovery is likely to be more modest in the near term than had been anticipated.”

The Fed also indicated slowing inflation, which set off a debate among economists about the once-unthinkable prospect of defaltion. While the consensus is that deflation remains unlikely, investors are no longer automatically inclined to give the Fed the benefit of the doubt: “The Fed’s determined effort to build up its inflation-fighting credibility over the past few decades may be working against it here.”

It was no wonder that the markets reacted the way they did! Cautious optimism has now given way to unbridled pessimism: “Given the uneven rebound in the United States, and now signs that the world’s other economic engines are slowing, economists say Americans may confront high unemployment and lackluster growth for some time to come.” Ironically, if such an outcome were to obtain, it could provide a boost for the Dollar, and even for the Yen.