I wonder if I wasn’t a little glib in my last post （Dollar Returns to Favor as World’s Reserve Currency）when I implied that the Euro would necessarily continue falling because of ongoing sovereign risk crises. In actuality, the situation is much more nuanced, and I want to qualify this idea below.
As I’ve said before, the sudden sovereign debt crisis in Greece is one of many. While its fiscal problems are certainly serious, they are not markedly worse than those of other countries, and it’s somewhat hard to understand why the markets suddenly decided to gang up on Greece. As many analysts have been quick to point out, Portugal, Ireland and Spain are in equally bad shape. Perhaps, it is the unique combination of factors which has led investors to focus on Greece in particular: “Greece stands out for the size of its debt stock, the scale of its budget deficit and the grimness of its growth prospects given high domestic costs and an inability to devalue.” But again, this inability to devalue its debt is shared by every other member of the EU. By virtue of belonging to the Euro, all of these countries must face their debt problems as they are, and cannot attempt to alleviate them through currency depreciation.
It is for this reason that I think that the EU will continue to be the main loser from real (and perceived) debt crises. As you can see from the table below, of the ten countries whose debt positions are least sustainable, seven of them are current members of the EU. This is problematic for the Euro, because as far as currency markets are concerned, one country’s problem is automatically a pan-EU problem.
If you look again at the Greek debt crisis specifically, there are really only three possible outcomes: “one of the most excruciating fiscal squeezes in modern European history – reducing the deficit from 13 per cent to 3 per cent of gross domestic product within just three years; outright default on all or part of the Greek government’s debt; or (most likely, as signalled by German officials on Wednesday) some kind of bail-out led by Berlin.” While such a bailout would temporarily stabilize the crisis, it would set a dangerous precedent in terms of dealing with fiscal crises in other EU countries and would do nothing to solve Greece’s underlying structural problems. Only under the first outcome, then, would the Euro not suffer, and unfortunately this one seems least likely.
Of course, the ultimate resolution of the crisis is still many years away. For now, currency traders are perhaps less interested in whether Greece will get its fiscal house in order and/or receive an EU bailout, and more concerned with how perceptions of the crisis will evolve. Recently, many investors have been taking their cues from the market for credit default swaps (CDS), which functions as insurance against and can be used to gauge the likelihood of sovereign default. In the case of Greece, CDS premiums have been rising (now implying a 4%+ chance of default), even though demand for Greek bond issuances remain strong at moderate interest rates. This discrepancy can best be explained by the presence of speculators, which are also working to push the Euro down.
Interestingly, the EU is currently mulling a ban on speculative (naked) CDS purchases, which would theoretically lead to lower CDS premiums and in turn, assuage other investors that the likelihood of a Greek default is low. On the face of things, this would probably - investment and lending in the EU, as sovereign risk would be less of an issue. However, there is still the possibility that speculators would continue to push down the Euro, for lack of a better strategy. In fact, they could even redouble their short bets against the Euro, since the CDS ban would deprive them of a valuable strategy for betting directly against Greece. (In fact, CDS speculation, while leading to higher interest rates and making it more difficult for Greece to finance its deficit, actually has no direct effect on the Euro, since it doesn’t necessitate a cross-border transaction).
Alas, then, it’s actually hard to predict (as always!) the near-term direction of the Euro. Since the crisis is still more perceived than actual, it’s clear that the Euro decline is a product of speculation and uncertainty, neither of which will disappear anytime soon. The best hope, then, for the Euro is probably just that investors will simply get bored with the story – as they eventually always do – and turn their attention to something else.
Rumor has it that the Dollar is about to make a run. As the credit crisis slowly subsides, (currency) investors are once again looking at the long-term, and they like what they see when it comes to the Dollar.
For those that care to remember, 2008 was a great year for the Dollar, as the credit crisis precipitated an increase in risk aversion, and investors realized that despite its pitfalls, the Dollar was (and still is) the most stable and really the only viable global reserve currency. [This reversed a trend which had essentially been in place since the inception of the Euro in 1999]. In 2009, meanwhile, the Dollar resumed its multi-year decline, and many analysts were quick to label the rally of 2008 as an aberration.
Then came the debt crises, first in Dubai, then in Greece. Suddenly, a handful of smaller EU countries appeared vulnerable to fiscal crises. Japan officially became the first of the Aaa economies to receive a downgrade in its credit rating. The British Pound is dealing with crises on both the political and economic fronts. According to Moody’s, “The ratings of the Aaa governments — which also include Britain, France, Spain and the Nordic countries — are currently ’stable’…But…their ‘distance-to-downgrade’ has in all cases substantially diminished.” Suddenly, the Greenback doesn;t look so bad.
I want to point out that in forex, everything is relative. (Novice) forex investors are often baffled by how sustained economic and financial crises don’t immediately result in currency depreciation. The explanation is that when the crises are worse in (every) other countries, the base currency still looks attractive.
This is precisely the case when it comes to the US Dollar. To be sure, the economy is still flawed, financial markets have yet to fully to recover, the federal budget deficit topped $1.8 Trillion in 2009, and government finances seem close to the breaking point. Moody’s has also identified the US as a candidate for a ratings downgrade. And yet, when you look at the situation in every other currency that currently rivals the US for reserve currency status, the Dollar still wins hands down.
Its economy is the world’s largest. So are its financial markets, which are also the deepest and most liquid. Its sovereign finances are still manageable from the standpoint of debt-to-GDP and interest-to-revenue ratios. It is the only currency whose circulation can even come close to meeting the needs of global trade. Summarized S&P – when it confirmed the AAA credit rating of the US, “The dollar’s widespread acceptance stems from the U.S. economy’s fundamental strength, which in our view comes from the economy’s size and the flexibility of labor and product markets. We view U.S. banking and capital markets to be dynamic and unfettered relative to their peers.”
That’s why auctions of US Treasury bonds remain heavily oversubscribed (demand exceeds supply), despite the rock-bottom interest coupons. China has reaffirmed its commitment to Treasuries (what other choice does it have), confirmed by some forensic accounting work. Gold might continue to rally. So will other commodities, for all I know. Emerging market currencies are still in good shape as well, but none of these will seriously rival the US Dollar for a long-time, if ever. In short, when it comes to the other majors, the Dollar is still King: “You can say whatever you want, but the dollar is the currency of last resort It’s the currency people want in a crisis.”
Following up on my last post, I want to use this post to write about the long side of the carry trade- specifically the Australian Dollar. The Bank of International Settlements (BIS) observed in a recent report that, “The role of short-term interest rate differentials in both the deprecations and their reversal has grown over time.” When you consider that the benchmark interest rate in Australia is now 4% and that interest rates in every other industrialized country (including Japan) or close to 0%, it’s not hard to connect the dots.
Earlier this month, the Reserve Bank of Australia (RBA) raised the benchmark by .25% for the fourth time since it began tightening. In an accompanying press release, the RBA stated that “The board judges that with growth likely to be close to trend and inflation close to target over the coming year, it is appropriate for interest rates to be closer to average. Today’s decision is a further step in that process. It’s worth noting that the Australian Dollar barely budged, because investors had expected the move. The larger question was, and still is, the ultimate extent of RBA rate hikes and how soon it will get there.
Glen Stevens, Governor of the RBA, has himself indicated that ”rates are still 50 to 100 basis points, or hundredths of a percentage point, below normal.” If you do that math, that means that the RBA will hike rates to 4.5-5% before stopping. Other more bullish analysts think 5-6% is a more realistic expectation because it is closer to the long-term average of Australian rate hikes.
As to when the benchmark will reach that point, it’s anyone’s guess. Going forward, analsysts have pegged the lilihood of an April rate hike at 40%. Said one analyst, “It’s now a line-ball call; indeed, if you put a gun to my head . . . I’d guess that the RBA is going to hike again by 25 basis points in April.” Still, most think that the RBA won’t hike again until May. Added another analyst, “They are not indicating any urgency. We think they will go again in a couple of months. It could be three months, it could be two, our formal view is two, that may depend on how the inflation numbers look.” It’s too early to project when the next next (after the next one) hike will take place, because it depends on the timing of the first one.
At this point, most Australian economic data is trending steadily in the right direction. “Australia’s economy is starting a new upswing…Unemployment fell to 5.3% in January, not far above levels considered full employment for the economy…A rebound in construction and an investment splurge in the mining sector are expected to restore growth in the economy back to historic averages by the end of 2010. The RBA has indicated it expects inflation to remain within its 2%-3% target band.” Without drilling too deeply into any of the other numbers, there’s very little reason to doubt that the Australian economic recovery is genuine, which reinforces the notion that it is only a question of when – not if – the RBA further hikes rates.
In fact, the picture surrounding the Australian Dollar is almost a mirror image of the Japanese Yen. While the Yen looks destined to fall irrespective of the carry trade, the Australian Dollar looks destined to fall. While further monetary easing in Japan will give the Yen a second life as a funding currency, higher rates in Australia will once again make it a popular long currency. In short, “With commodity prices likely to remain strong and the spread between Australian and US interest rates likely to widen further its only a matter of time before the Australian dollar breaches parity against the US dollar.”
In fact, the Australian Dollar just touched a 13-year high against the Euro – though that is as much due to the Greek debt crisis and Euro problems as it is with Aussie strength. Meanwhile, the Australian Dollar has zig-zagged against the US Dollar, and is now in a rising trend following a recovery in risk sentiment. Whether it sustains this momentum depends largely on whether the RBA hikes rates next month.
I can’t remember how long it’s been since I was hyping the Yen carry trade (though a browsing of the ForexBlog archives indicates 2 years). Upon the outset of the credit crisis, forex markets went haywire, and one of the main “beneficiaries” was the Yen, which soared as carry trades were unwound. Now, however, a similar set of circumstances that made the Yen carry trade attractive from 2006-2008 have re-appeared, and it looks like the trade could be on the verge of making a big comeback.
Practitioners of the carry trade understand that it has a few pre-conditions. The first is low interest rates. In this case, the benchmark Japanese interest rate is only .1%. While that would have meant something a few years ago, however, it no longer counts for much, since benchmark rates in other industrialized countries are just as low. Where Japan has the edge is in market interest rates. Long-term rates have historically been well below the global average, and short-term rates are finally following suit after a 3-year hiatus. In fact, for the first time since August, the 3-month Japanese LIBOR rate – a lending benchmark – fell below its US counterpart: “On Thursday, the yen Libor JPY3MFSR= was fixed at 0.25063 percent — its lowest level since May 2006 — and the dollar USD3MFSR= rate at 0.25219 percent.” In short, the Japanese Yen is once again the cheapest currency in the world to borrow.
In addition, interest rates in Japan will probably remain low for the immediate future, as the Bank of Japan is actually looking to make its monetary policy even more accommodative (I didn’t think this was possible with a benchmark rate of only .1%!), in order to further stimulate the economy and alleviate the risk of deflation. This contrasts with Central Banks in other countries, which are already contemplating interest rate hikes.
The second condition is low volatility. ” ‘Realized trading vols has not been so low for many years.’ For example, three-month implied vols in the euro have slipped from a 25-plus high at the peak of the subprime crisis to levels around 10.68 currently…’As volatility goes down,’ the FX market tends to move toward a ‘classic carry trade environment.’ ” Low volatility is important because it enables investors to make low-risk bets on interest rate differentials without worrying too much about currency fluctuation. However, it doesn’t hurt that aversion to risk is also trending lower, such that investors can borrow in Yen to make higher-risk bets. According to the Bank of International Settlements, “The carry-to-risk ratios, a measure of the appeal of carry trades, have ‘been steadily rising over the past 14 years, consistent with an increasing attractiveness of the yen-funded carry trades for Australia and New Zealand.’ ”
The pickup in risk aversion – as a result of the Greek debt crisis – may have delayed the return of the Yen carry trade. In January, volatility rose slightly and the Yen rallied as the safe-haven mentality set in. Personally, I find this somewhat ironic, since Japan’s debt problems are even more pronounced, and unlike Greece, it can’t count on a bailout from Greece if things really get rough. Still, the markets work in strange ways, and the fact that the Yen has benefited from the crisis is probably due to the fact that traders can’t short all currencies simultaneously.
The third condition is really an outgrowth of the first two: belief that the funding currency will remain stable, or even decline. In this regard, the Yen is still hovering near an all-time high against the US Dollar, and given the confluence of bearish economic and political factors, it would seem to ne headed downward irrespective of the carry trade. For those looking for specific reasons to short the Yen, there are plenty from which to choose: low economic growth, dismal performance in finance markets, high public debt, dwindling savings and an upcoming retirement boom. As one analyst argued, “Tokyo is due to announce its medium-term fiscal plans in June. ‘Either this will mark the start of a prolonged period of fiscal restraint, weakening the economy again and requiring further monetary loosening, or the plans will lack credibility, in which case Japan’s financial markets would be hit hard. In either scenario, the yen looks vulnerable.’ ”
I don’t mean to get excited, but it’s hard to state a better case in favor of an imminent return of the Yen carry trade.
One of the pitfalls of forex blogging (or all financial reporting for that matter) is that it’s inherently after-the fact. In other words, any information about the past – while relevant – is inherently useless, since it has theoretically already been priced into the asset (or currency in this case). Before I begin my post on the Pound’s recent decline and the factors that wrought it, then, I wanted to offer the caveat that in analyzing past events, we must simultaneously look to the future.
Anyway, for anyone watching the Pound Sterling over the last month, its performance has been startling. It is down 7.5% for the year already (we’re only in March!), and has fallen 12% from its August peak of 1.70 USD/GBP. This represents an unbelievable about-face, as the Pound spent much of 2009 floating upwards following its lows from the credit crisis.
What’s behind the decline? In short, economics and politics, or more precisely, the junction of economics and politics. As the British economy began its recovery from recession, analysts began to turn their attention to UK government finances. Another way of looking at this would be to say that analysts have shifted their gaze from the positive effect of government intervention (i.e. economic recovery) to the many lasting negative effects. Inflation and government solvency, of course, are the two most pernicious of the bunch.
The Bank of England’s quantitative easing program was comparable to the Fed’s program in relative terms, and in the aftermath of all of that money creation, inflation is slowly creeping up. The government’s free spending also contributed, and now, so is the sinking Pound, as prices for commodities and other imports are rising fast in local currency terms. Speaking of government spending, the UK government budget deficit is projected at 12% for 2010, slightly higher than 2009. You can see from the chart below that budget deficits are forecast to remain large for the next few years. Expectations are so low, in fact, that a reduction in the deficit to 3% of GDP by 2014-2015 would be viewed as a victory.
Naturally, the UK government feels some pressure to reduce its deficit, both for the sake of financial solvency and to control inflation. The problem is that an election must be called before June, and until then, there is natural pressure to continue operating the money printing presses 24/7 in order to appease the voting public. The same goes for the Bank of England; it can’t be expected to tighten monetary policy and/or reverse quantitative easing until after the election.
I’m not going to pretend that I understand British politics, but from what I’m hearing, it seems the problem is that the election polls are now very close. Previously, a major victory by the Conservative Party was seen as inevitable, and this was viewed positively by financial markets because of the expectation that they would rein in spending. Recently, the incumbent Labour Party has closed the gap, to the extent that a hung Parliament is now a likely outcome. This would be even less desirable than an outright Labour victory, because the sharing of power would make it unlikely that reforms of any kind would be enacted. With regard to forex, some have posited an inverse correlation between the rising popularity of Labour and the falling Pound.
With the crisis in Greece still unresolved, analysts are also making comparisons to the UK. Some have suggested that if Greece were to receive a bailout, then, investors would turn their attention to the UK, whose finances are in equally bad shape. Without the protection of the Euro, the Pound would be open to speculative attack. On the other hand, that the (declining) Pound is independent from the Euro could become in advantage, if it boosts exports.
Going forward, it’s difficult to make any predictions until after the elections and/or the government makes a firm commitment to reduce spending and lower its deficit. Some analysts think that regardless, the Pound is doomed to continue falling, perhaps all the way to the $1.40 mark. Others see the current decline as the “darkness before the dawn.” As I noted in the introduction to this post, the latter could certainly be right. Besides, most of the uncertainty has probably already priced in. While most of the factors currently weighing on the Pound are bearish, some contrarian investors might see this as a good opportunity to buy. And who’s to say they’re wrong?
