Forex Market Inverts as Emerging Markets Soar

As I pointed out in last Friday’s post (Volatility, Carry, Risk, and the Forex Markets), volatility has been declining in forex markets since peaking after the collapse of Lehman Brothers. In fact, volatility among emerging market currencies has been falling particularly fast, and recently, something amazing happened: “Three-month implied volatility for the seven biggest developing country currencies fell to 10 percent in March compared with 11.4 percent for industrialized nations.” This inversion could rank as one of this year’s most important developments in terms of its impact on forex. The only runner-up that I can think of is Japanese LIBOR falling below American LIBOR.

Despite its remarkableness, this development isn’t unsurprising, since 8 of the 10 best performers in forex this year are emerging market currencies, led by the Costa Rican Colon, Mexican Peso, and Malaysian Ringgit. Still, we usually assume that with high return, comes high risk. How could it be that are thought of as risky currencies are now less volatile than the so-called majors. Does it really make sense, for example, that the Turkish Lira is less volatile than the British Pound.

Without exploring this particular pair in detail, in a word, the answer is yes. In 2010, emerging market growth is projected to be higher than in the industrialized world. Inflation is relatively stable, and debt levels are comparatively low. Meanwhile, all of the G4 currencies (US Dollar, Euro, Japanese Yen, and British Pound) are plagued by the possibility of Double-Dip recessions and debt crises of varying seriousness. In sum, “Developing nations reduced their foreign debt to 26 percent of GDP last year from 41 percent in 1999, while advanced nations’ debt may surge to 106.7 percent of GDP this year from 78.2 percent in 2007.” Talk about heading in opposite directions!

Investors are taking notice. While the JP Morgan Emerging Market Bond Index (EMBI+) is now rising at annualized rate of 22% (implying a decline in emerging market bond yields), rates on comparable EU and US debt is rising. Last week, the 10-Year Treasury Rate topped 4% for the first time in 18 months (though it has since retreated). Meanwhile, credit default swaps are pricing in a .4% chance of default in the US. Granted, this is still infinitesimal, but anything above 0% would have been derided as ridiculous only a few years ago. This year, the US is projected to spend more on servicing its debt than any other country except for the UK. The projected $1.6 Trillion deficit for 2010 certainly won’t help things.

Thus, emerging markets are projected “to lure $722 billion in overseas investment this year, 66 percent more than in 2009…Developing-nation bond funds attracted $7 billion this year, pushing assets under management to a record $74.7 billion.” Many portfolio managers are betting that this will be a long-term trend: “The rally in emerging-markets has barely started yet.”

What are the forex implications? For the first time, we could see the G4 currencies start trading as a bloc. [Previously, it was the US Dollar versus everything else. The introduction of the Euro ten years ago only strengthened this trend, which is ironic considering the EU has also become an establishment currency. But, if you look at the charts, the Dollar/Euro pair has rarely traded sideways, and traders have used it as a basis for making broader claims about the markets]. Now, it looks like this could finally change: “The big trends will be in non-G4 currencies against G4, such as dollar/Norway or euro/Aussie, and in emerging market currencies.”

China Inches Toward Revaluation

The hoopla surrounding the semi-annual release of the Treasury’s currency report has been awkwardly resolved. As a result of Chinese Prime Minister Hu Jintao’s last minute decision to participate in a US conference on nuclear disarmament, the Treasury has agreed to delay the release of the report for an indeterminate period.

While a handful of commentators saw this as a simple quid pro quo, the consensus among most of us is that a revaluation of the Chinese Yuan is now imminent. Technically, the RMB has been rising steadily for the last few months, and in fact, it recently touched a 9-month high against the USD. However, this appreciation has amounted to a mere .3%, certainly not enough to placate critics, many of whom insist that the RMB is undervalued by 25-40%. Probably within the next couple months (and as soon as tomorrow), the RMB peg will probably be lifted by at least 5% against the Dollar, and allowed to appreciate incrementally from there.

On the surface, it looks like President Obama deserves much of the credit for the sudden capitulation by China. From tire tariffs to a meeting with the Dalai Lama, he signaled that he was willing to play hard ball. As Senator Charles Schumer, one of the most vocal critics of China’s forex policy, said recently, “Every administration has thought it could get something done by talking to China. But years of experience have shown that the Chinese will not be moved by words; they only respond to tough action.”

While this game of high-stakes International Poker was being played, there was an internal debate taking place within China. On one side was the Central Bank, frustrated by its inability to conduct monetary policy independent of the currency peg. On the other side was the more powerful Commerce Ministry, which is responsible for representing the interests of Chinese exporters, among others. It appears that the Commerce Ministry has lost the debate, although it isn’t going down without a fight. After economic data showed the first monthly trade deficit ($7+ Billion) in 6 years, a press release argued that, “The continued improvement in our country’s balance of trade has created the conditions for the renminbi’s exchange rate to remain basically stable, case received a boost from the March $7 Billion trade deficit, the first monthly deficit in 6 years.”

At this point, analysts have stopped arguing about whether the revaluation is necessary (though this debate has not officially been resolved) and moved on to simply trying to predict the outcome of the internal Chinese negotiations. Some are skeptical:”Based on off-the-record briefing from officials in Beijing, one development that does not appear likely in the short term is any Chinese action to change the currency peg that ties the renminbi to the dollar.” However, this is contradicted by the prevailing view among China-watchers, which is that “Beijing will move on the currency not because they want to placate international pressure on trade flows but because domestic conditions suggest that such a move will be in their own interests.”

This is reflected in futures prices, which are now pricing in a 3% appreciation in the RMB by the end of the year, compared to expectations of a mere 1.5% appreciation in March. What’s harder to gauge (and speculate on) is how other currency pairs will be affected. Some analysts believe that an RMB appreciation will trigger a decline in the Euro, since China’s currency peg had also necessitated tangential purchases of Euros: “The euro will be more vulnerable from the perspective that the People’s Bank of China in the past diversified away from Treasuries to buy euro zone bonds.”

Asian currencies should also benefit, since a more expensive Yuan will trigger a marginal shift of (speculative) capital to regional competitors, especially those with undervalued currencies. In fact, the Bank of Korea is already on high alert for any “unusual” (code for sudden appreciation of the Won) activity in the forex markets, and has suggested that intervention is always a possibility.

As for me, well, I’m not taking any chances. I just transferred some of my savings from Dollars into Yuan (of course this wouldn’t really make sense if I didn’t live in China). I like to think of it as a rudimentary form of hedging.