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.

Volatility, Carry, Risk, and the Forex Markets

Upon reviewing my previous post on the Brazilian Real (BRL), I now realize that it lacked context. In other words, while both the interest rate outlook and economic prospects of Brazil are both incredibly bright, who’s to say that this hasn’t already been priced into the Real? At the very least, more information is needed to determine whether the Real is valued fairly on an historical and/or relative basis. [Alas, the focus of this post isn't on the Real specifically, but on the forex markets in general. Still, the concepts that will form the backbone of this post - volatility, risk, and carry - can be seen clearly through the prism of the Real.]

This doubt was sparked by an article that I read recently, entitled “Markets ‘Not Pricing’ Potential Risks,” which explored the idea that the renewed appetite for risk and consequent run-up in asset prices and re-allocation of capital is naively optimistic: ” ‘The unique environment we’re in now revolves around unprecedented level of government involvement in markets, which creates this complacency over risk because of this belief that governments will fix everything.’ Markets are under-pricing the risk that nations such as Dubai and Greece may default, and excess borrowing by others could lead to inflation.” From a financial standpoint, the practical implications of this idea is that the markets are underpricing risk.

In forex markets, complacency towards risk has manifested itself in the form of decreasing volatility. When you look at the 435 most commonly-traded currency pairs (actually most currency pairs involving the 35 most popular currencies), volatility is increasing for only nine of them. In addition, one month-volatility is now below 15% for all (widely-traded) currency pairs, which means that based on the most recent data, the highest, annualized standard deviation percentage change for every currency pair is only 15%. [It's difficult to translate that concept into plain-English, but the basic idea is that all currencies are (actually, only 68% of the time) currently fluctuating by less than 15% from the mean on an annualized basis. The idea of standard deviation is murky for non-mathematicians, so it's probably more useful to look at it on a relative and historical basis, rather than in absolute terms. In other words, the 15% figure can not be explained very well in an of itself; one must see how it compares to other currency pairs and to other time periods].

The fact that volatility is currently low suggests that the carry trade, for example, is set to become increasingly viable, especially when you factor in upcoming interest rate hikes. On the other hand, real interest rate differentials are currently modest (from a historical standpoint), and the concern is that rate hikes could be accompanied by rising volatility. The Brazilian Real, for example, “has a risk-adjusted carry of 45 percent, based on Morgan Stanley estimates, which means its carry rates had been better than current levels 55 percent of the time the last five years.” When you look at conditions from a few years ago, when volatility was at record low levels and interest rate differentials were larger than historically average, it’s obvious that the hey-day for the carry trade was in the past. It may come again in the future, but it certainly isn’t now.

From a practical standpoint, if you’re thinking about getting involved in the carry trade, you’ll want to choose a currency pair where the real (after adjusting for inflation) interest rate differential is high and volatility is low. You can cross-reference interest differentials with these charts – which uses recent mean return and volatility as the basis for forecasting confidence intervals – to get an idea about which pairs offer the best value (i.e. higher rate differentials at lower volatility). Just be aware that a sudden upswing in volatility could put a big dent in your risk-adjusted returns.

Brazilian Real Recovers on Rate Hike Hopes

One of the main themes (even if not always overt) of my posts recently has been the revival of the carry trade, if not the already extant revival than at least the imminent one. In this context, there is no better candidate than the Brazilian Real.

After a stellar 2009, the Brazilian Real opened 2010 in much the same way that most emerging market currencies did: down. In the month of January, alone, it fell almost 10% against the Dollar, as fears of a widespread sovereign debt crisis took hold in currency markets. Its modest recovery since then, is not so much due to a decreased likelihood of such a debt crisis, but rather to a shift in the markets’ perspective away from long-term fiscal problems and back towards short-term economic and monetary conditions.

It is here where Brazil (and the Real) shines. As one analyst summarized, “The Brazilian economy has been transformed over the past few years. The boom-and-bust and hyperinflation of previous decades has been replaced by steady growth. The country was one of the last major economies into recession, but one of the first out.” 2009 Q4 GDP came in at 4.3% on a year-over-year basis, and is projected at 6% for 2010. Moreover, its economy is very well-balanced, and consumer debt levels are relatively low. Unlike in China, for example, infrastructure investment in Brazil still has plenty of room to grow, without crowding out private investment. This is important, given that the 2014 World Cup and 2016 Olympics are right around the corner.

After rebounding from the lows of the 1999 currency crisis, meanwhile, the Brazilian stock market has had an incredible decade, returning an average of 20% annually. For the sake of comparison, consider that emerging markets have averaged 10%, and all stock markets have averaged only .2%. It doesn’t hurt that Brazil just discovered a huge (the fifth largest in the world) coastal oil reserve.

In fact, it might just be the latter that currency traders are most excited about: “Thus far this year, BRL is 68% correlated with crude oil prices…Last year the correlation was 53% and in 2008 the correlation was just shy of 32%.” This is the highest among any currency, even those that derive a much larger portion of GDP from oil exports, such as Canada and Norway. While there are almost certainly lurking variables in this correlation, a continued rise in the price of oil can’t hurt the Real.

Where does the carry trade fit into this? Look no further then Brazil’s benchmark interest rate of 8.5%. Impossibly, this represents a record low, despite the fact that this is nearly 8.5% higher than the current Federal Funds Rate. And the Brazilian rate is only set to rise. At the last meeting of the Bank of Brazil, 3 out of 8 Board members voted to hike the Selic rate by 50 basis points. The main opposition came from the Bank’s President, Henrique Meirelles, who steered a dovish course for political reasons.

Since then, inflation has continued to creep up and Mr. Meirelles has firmly renounced his political ambitions, and the stage is now set for a 75 basis point hike at the next meeting, to be held on April 28. Most analysts are projecting an “increase of between 200 and 300 basis points through mid-2011, [and] some investors are pricing about 450 basis points of hikes in the same period.”

It’s hard to predict if/when the Fed will follow suit, but most certainly won’t be to the same extent. As long as Brazilian interest rates can keep up with inflation, then, it looks like the Real will end 2010 in much the same fashion as 2009.

Japanese Yen: Will We See Intervention?

The Japanese yen has fallen 5% against the Dollar over the last month, and 10% since touching a record high in November. Since this certainly isn’t explainable in the context of the EU debt crisis, what’s going on?!

The primary factor behind the Yen’s decline appears to be seasonal, given the “end of the Japanese fiscal year on March 31, a time when Japanese corporations stop their annual repatriation of foreign profits by converting them into yen, which had kept demand for the currency high.” Analysts add that “A new fiscal year also is a chance for Japanese investors to reset strategies for sending capital abroad and for Japanese companies to set hedging bets for the coming year.” In short, this trend is short-term, and will likely abate in the coming weeks.

Beyond this, it’s difficult to explain the Yen’s decline in terms of financial and economic factors. Japans economy is still lackluster, though its stock market is performing well. I have blogged recently about Japan’s budget deficits and soaring national debt, but given that this debt is financed domestically, fluctuations in the risk of Japanese sovereign default have very little impact on the exchange rate. It’s possible that an increase in risk appetite and consequent revival in the carry trade is behind the Yen’s weakness, but given that US interest rates remain just as low, it makes little sense that the Yen should be falling so precipitously against the Dollar.

Rather, any full explanation must involve the the government of Japan, which appears to have grown increasingly uncomfortable with the persistent strength in the Japanese Yen. Previously, the government (through the Finance Minister) had vehemently denounced the possibility of, intervention on behalf of the Yen and that exchange rates should be determined by market forces, etc. After backtracking, that Minister was replaced (ostensibly for health reasons), and leaders are no longer mincing their words. Japanese Prime Minister Yukio Hatoyama recently declared, “the yen’s strength is out of step with the country’s fragile economic recovery, urging the government to take ‘firm steps’ to counter the growth-limiting effects of a strong currency.”

Even though the Japanese economy grew by a healthy 3.8% in the fourth quarter of 2009, there remain concerns of contraction and deflation. Many experts agree that the Yen is overvalued, which means that exports are less than what they could be. Analysts love to point out that Japan’s economy is so sensitive to changes in exchange rates, that a fall of one “unit” (100 pips) in the Japanese Yen would be enough to cause some companies to swing from profit to loss. Simply, there is too much at stake for the Japanese economy (and the incumbent Japanese government) to simply let the Yen be.

As a result, many analysts believe that intervention is now inevitable, unless the Yen continues to rise. According to Morgan Stanley, “The probability Japan will sell the yen has climbed to 47 percent, the highest since 2004…based on a company model that uses indicators such as market positioning and changes in momentum.” Other analysts believe that the markets will instead preemptively push down the Yen, which would achieve the same result as intervention: “Brown Brothers Harriman analyst Marc Chandler figures if the dollar breaks above 94 yen, because of the way investors place currency bets, the greenback could more easily extend its run as high as 96 or 98 yen.”

For now, the Central Bank of Japan will attempt to use monetary policy to coax down the Yen, perhaps through a combination of liquidity programs and money-printing, but there are a handful of important meeting coming up, during which time it could conceivably decide to join the ranks of a handful of other Central Banks which have already moved to depress their currencies. Let the Beggar Thy Neighbor Currency Devaluation begin.

Forget about Greece: What about the US, Japan, and the UK?

Forget about Greece: What about the US, Japan, and the UK? Almost 75% of trading in the forex markets involves some combination of the US Dollar, Euro, Japanese Yen, and British Pound. This figure rises to more than 95% when you include trading in which at least one of the currencies (as opposed to both) is one of the aforementioned. In short, these four currencies are by far the most important in forex markets, and most patterns/narratives in forex markets tend to involve them.

It’s simple supply and demand, really. These currencies are the most heavily traded because their economies are the largest and their capital markets are the deepest and most liquid. [The absence of the Chinese Yuan from this list can be explained by the lack of flexibility in its capital controls and exchange rate regime]. When investors flee one of these major currencies, they tend towards one of the others, and vice versa.

This phenomenon has especial relevance in the realm of sovereign debt. While some investors would love no more than to move their capital from the four debt-ridden currencies above, there just isn’t enough supply of alternative currencies to absorb the outflow. The Swiss Franc, Australian Dollar, and Canadian Dollar (#5, 6, & 7 on the list of most traded currencies), for example, have all surged over the last year as investors have looked for stable and liquid alternatives to what can be dubbed the Big-4 currencies. While these currencies still have some room for appreciation, they can’t continue to rise forever. For better or worse, then, the most useful comparison when it comes to to sovereign debt is not between the Big-4 and everything else (aka the major currencies and the emerging market currencies), but rather between the Big-4 themselves.

Forgive me for this long-winded introduction, but I think it’s important to understand the usefulness of comparing Japan with the US with the EU with the UK when all of these economies have terrible fiscal problems, and why we can’t just compare them to fiscally sound economies. With that being said, let the comparison commence!

Most of the fallout from the sovereign debt crisis has affected the EU and the Euro. This is for good reason, since the focal point of the crisis is a member of the Euro (Greece), and several other Eurozone countries are on the periphery. I addressed the EU in a previous post (EU Debt Crisis: Perception is Reality), so I think it makes sense to focus on the others here.

In terms of debt sustainability, the UK is not far behind Greece. “The flood of British debt is likely to ‘lead to inflationary conditions and a depreciating currency,’ lowering the return on bonds. ‘If that view becomes consensus, then at some point the UK may fail to attain escape velocity from its debt trap,’ ” explained one analyst. With high budget deficits projected for at least the next five years, the Bank of England no longer buying UK bonds, and the possibility that the ucoming elections could produce political stalemate, the fiscal position of the UK can only deteriorate. On the plus side, the average maturity for UK bonds is 13.7 years, twice the OECD average, which means that it could be more than a decade, before Britain really begins to feel the squeeze.

Japan might not be so lucky. Its net debt already exceeds 100% of GDP and its gross debt is approximately 200% of GDP; both are the highest in the OECD. Meanwhile, the average maturity of its debt is only five years, so there isn’t a lot of time to act. According to analysts, the crisis would most likely assume the following form: “ ‘A surge in yields would lead to a combination of extreme fiscal contraction, through tax increases and welfare cuts’…as well as to even more monetary expansion, perhaps less central bank independence and ‘presumably a much weaker exchange rate.’ ” In the case of Japan, the mitigating factor is that 90% of government debt is held domestically. Therefore, Japan isn’t vulnerable to the whims of foreign creditors, and an outright default is unlikely.

Then, there is the US. Its Trillion Dollar budget deficits, and multi-Trillion Dollar national debt and entitlement obligations are the highest in the world in nominal terms. On the other hand, the US government has not really encountered any difficulty in financing its spending. Political opposition is fierce, but investors have lined up to buy Treasury bonds and record low yields. This will likely change as the Fed curtails its purchases, and the economic recovery gives rise to higher interest rates. Analysts expect that borrowing costs (i.e. Treasury yields) could rise more than 1.5% by the end of 2010.

From the standpoint of markets, its impossible to say which economy’s fiscal problems are the most serious, since sovereign debt yields have declined across-the-board over the last 20 years. One Professor of Finance explains this trend as follows: “Behavioral factors keep many bond traders and investors from recognizing the reality of the situation…since there is no well-defined crisis point.” In other words, the crisis in Greece is only a test run. The real one could come in a few years, and involve a much larger economy. At that point, currency traders will have to decide who to back.