Korea May Regulate Borrowing

Over the last two years, South Korea's overseas borrowings more than doubled, to $388 Billion. Nervous, perhaps, that Korean businesses may be overextending themselves, the government is seeking to regulate such activities. Based on the way the forex markets responded to the news, it must be perceived that borrowing abroad is helping the Korean economy. On the one hand, if loans are denominated in foreign currency and must then be converted to local currency, this would exert upward pressure on the Korean Won. On the other hand, this also requires more local currency to be printed, which fuels inflation. Much of the borrowings are being undertaken by shipbuilders who are trying to hedge their exposure to a rising Dollar. The Edge Daily reports:

Some analysts say the forward-trading-linked borrowing is not as big a problem as borrowing to fund consumption would be, but the government is worried that the sharp rise in debt over a short period of time could undermine the local financial system.

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The Strong Dollar Myth

When asked to discuss the official position of the USA with regard to its currency, Treasury Secretary Henry Paulson typically invokes the "Strong Dollar Policy." According to former Treasury Secretary Paul O'Neill, however, this policy is a "vacuous notion." Mr. O'Neill served as Secretary from 2001-2002, during which time he echoed the strong dollar sentiments of his forebears, without apparently ever believing that the US had any ability or intention to influence the value of the Dollar in forex markets. The implications of Mr. O'Neill's comments are such that the rhetoric of Secretary Paulson, as well as a recent warning by the G7 nations, are both wholly empty, and the Dollar's value will continue to rise and fall as determined by the markets. Bloomberg News reports:

O'Neill roiled currency markets when he was in office from 2001 to 2002, at one point with comments in an interview with a German newspaper that the U.S. pursued a policy of a strong economy, rather than currency.

Vietnam Dong to Slide Further

In the year-to-date, the Vietnamese Dong has fallen by .7%. That may not seem like much, but since the Dong/Dollar exchange rate is approximately 16,000 to 1, every .1% is meaningful. Unfortunately for Vietnam, analysts are predicting that the Dong will fall further, due to a confluence of factors. First, the Vietnamese stock market is tanking; the 42% decline recorded thus far in 2008 makes it Asia's worst performer and unattractive for foreign investors. The second factor is inflation, which is nearing 20% and is directly eroding the value of the Dong. Finally, there are technical factors, such as rising imports and market sentiment that the Central Bank will hold down the Dong to support the export sector. Bloomberg News reports:

"The key concerns are that inflation and excessive domestic growth have been allowed to persist. Those pressures have flipped from dong positive to dong negative.''

BOC Cuts Rate$

The Bank of Canada has cut its benchmark lending rate by 50 basis points, to 3.0%. The move was widely expected by analysts, although some of them had forecast only a .25% cut. Last week, economic data confirmed a mild rate of inflation in Canada, giving the BOC a green light to ease monetary policy without having to worry about the effect on prices. Despite commodity prices that remain at stratospheric levels, Canada's economy is sagging, due to the subprime crisis unfolding across the border. Some analysts have analogized Canada's situation to the dilemma facing the European Central Bank, which is reluctant to cut interest rates for fear of stoking the fires of inflation. As a result, the Euro has surged 8.5% against the Dollar in the year-to-date, while the Canadian Dollar has fallen. If the BOC opts to cut rates further, the Dollar could retake some of the ground it lost last year. Marketwatch reports:

Against the Canadian dollar, the U.S. dollar is likely to hold support around par, gradually firming back toward C$1.03 ahead of the U.S. Federal Open Market Committee meeting on April 30.

AUD Nears Parity

The word "parity" is becoming a mainstay of traders in the forex markets. In 2007, it applied to the Canadian Dollar, which had rallied 70% over the course of five years to reach the mythical 1:1 level against the USD. This year, it is the Australian Dollar that is threatening to surpass the Dollar in value. The AUD has always benefited from general USD weakness, but now the focus is shifting to the AUD, itself. The most recent Australian price data suggests that inflation in Australia remains problematic, which could force its Central Bank to raise the benchmark lending rate to 7.5%. In addition, high commodity prices and consequently strong exports should provide demand for the currency. As always, analysts are divided over the likelihood of parity, but that hasn't stopped them from bandying the term about. The Australian Age reports:

Parity was never a "ridiculous suggestion." "But it's probably a bit tougher going because the Australian economy is slowing," says one analyst. "Then again, if you saw a reacceleration in growth, that might be a different story."

Chinks in the Euro's Armor

2008 has witnessed a rapid appreciation in the Euro, which recently breached the psychologically important $1.60 barrier. Last week, however, the Dollar dramatically reversed course, leading many traders to speculate that the Euro's best days may be temporarily behind it. There are two ideas underlying this theory. First, the Federal Reserve Bank is probably near the end of its tightening cycle, while the ECB has yet to begin. In addition, recent economic data suggests that the Euro-zone economy, which has appeared recession-proof in spite of the credit crisis, may soon falter. The best-case scenario, according to Dollar bulls, would be a loosening of monetary policy in the EU simultaneous with tightening in the US. If such a scenario were to obtain, it would bridge the interest rate differential between the two economies, which many believe is behind the weakness in the Dollar. The Wall Street Journal reports:

If bad news out of Europe starts to accumulate and the Fed stands pat, the dollar’s slide could taper off.

Forwards Gain Retail Appeal

The anecdotal evidence for surging retail interest in forex is cropping up everywhere. Moreover, investors are no longer even limiting themselves to the spot market, utilizing derivatives to speculate on future exchange rates. In the UK, for example, 10% of investors intending to purchase real estate in the EU are utilizing forward agreements to hedge their exposure to the Euro, which has risen 10% against the Pound since the beginning of 2008. Evidently, prospective home buyers are hoping that the Euro returns to 2007 levels, which would significantly lower the cost of buying property there. However, if the Euro continues to appreciate, such investors could end up losing more than they bargained for. Homes Worldwide reports:

Even the movement in the markets over a couple of days can make the difference between owning a property and no longer being able to afford it.

April Marks Dollar Turnaround

Earlier this week, the Forex Blog speculated that the tide was turning on the Euro, which had retreated from the $1.60 threshold. Sure enough, the month of April saw the best monthly performance by the Dollar in over two years. The sudden about-face by the Dollar stems from changes in interest rate expectations. Only a couple weeks ago, the consensus among investors was that the Fed would cut rates further at its next meeting; the only point of uncertainty was whether rates would be cut by 25 or 50 basis points.

As of today, however, there is only a 25% chance that the Fed will cut rates at all, if you go by futures prices. Regarding the Euro, investors are no longer so sure that the ECB will hike rates in response to surging inflation. In short, the new consensus is that the US/EU interest rate differential has stabilized. Then there is the economic picture; investors have "chosen" to be pleasantly surprised by the most recent economic data. While the economic downturn still seems inevitable, it may not be as severe as investors had previously feared. Reuters reports:

In contrast to slightly stronger U.S. data, the Ifo German business sentiment index this week showed the biggest monthly fall since September 2001.

Turkish Lira Set for Decline

2007 was a banner year for the Turkish Lira, which appreciated 21% against the US Dollar. However, in the year-to-date, the currency has returned nearly 10% of this gain, making it the third worst performing currency in the world. Turkey generally, and the Lira specifically, are considered by investors as proxies for emerging markets. The global trend towards risk aversion, as well as skyrocketing inflation, are hurting many such currencies. In Turkey, inflation is so problematic (9.4% at last count) that the Central Bank has raised its benchmark interest rate to 15.25%. Ironically, the more the Lira depreciates, the harder it becomes for the Central Bank to control inflation, causing the Lira to slide further as part of a self-perpetuating free-fall. In addition, the country is beset by political uncertainty, as the courts determine whether the nation's current government can stay in office. Bloomberg News reports:

"The recent political developments are likely to complicate policy-making and the investment climate. The deteriorating political backdrop will in turn undermine the prospects for restoring fiscal discipline and reviving the reform agenda."

Fed Lowers Ratess

The Federal Reserve Bank recently lowered interest rates for the seventh, and perhaps final, time, bringing its benchmark federal funds rate to 2.0%. Since inflation is still hovering around the 4% mark, the Fed will probably be reluctant to lower rates further. Thus, the markets have been given all of the boost that they are likely to receive, and it is "fate" that will determine whether the economy will find its footing. (GDP growth clocked in at an anemic .6% for the last two quarters). The most recent data (including the just-released jobs data) indicate that the economy may be stabilizing, although consumption and the employment situation are still deteriorating. As a result, the National Bureau of Research has yet to officially declare the current economic downturn a "recession," since the picture remains nuanced. The New York Times reports:

The recession-or-not question is now almost entirely academic, Mr. Bernstein contended, given the steady erosion of American spending power and soaring costs for food and gasoline.

Korean Won is Worst in Asia

In the year-to-date, the Korean Won has recorded the worst performance of any currency in Asia, having recently fallen to a 6-week low. The story is being driven as much by Dollar strength is by Won weakness. US equities have rallied over the last month, as investors may have been overly pessimistic in the previous months regarding near-term US economic prospects. In addition, the Fed has probably lowered interest rates for the last time, whereas the Central Bank of Korea has held its benchmark lending rate at 5% since the summer. This yield differential, which currently favors Korea, may narrow substantially over the coming months, as the Bank of Korea is forced to reckon with slowing growth and rising inflation. Bloomberg News reports:

Growth, at the slowest in more than three years last quarter, is losing momentum, the Bank of Korea said in a report on May 1. Policy makers next meet on May 8 to decide on the benchmark seven-day repurchase rate.

Commentary: The Dollar Conundrum

The Dollar is currently teetering on the edge of a precipice. Many analysts are predicting that, having recently retreated from a record low against the Euro, the Dollar's best days are still in front of it. On the other hand, the economic data and interest rate pictures remain nuanced, and still favor the Euro on paper. In this article, we aim to sort through this morass, and produce a clear summation of the factors which bear on the Dollar in the short term.

Let's begin with the bullish side of the equation, which is supported by the Dollar's recent upside swing. First of all, while interest rate differentials are currently hurting the Dollar, the Fed is probably near the end of its loosening cycle, while the ECB has yet to begin. The best-case scenario would be a tightening of US monetary policy simultaneous with a loosening of EU policy. Next, there is the economic picture. The most recent GDP data indicates an economy that is still growing, albeit slowly. In addition, the unemployment rate declined in the most recent month for which data is available. The US stock market has regained half the value it lost in the first three months of 2008, and the overall P/E ratio is close to its long-term average, which suggests the markets could appreciate further. Finally, the economic stimulus package that was approved by Congress in March will go into effect this month, as tax rebates worth $150 Billion are distributed to consumers and businesses.

On the bearish side, let's return to the interest rate story. While the future certainly bodes well for the US, the present still favors the EU. US interest rates are currently negative in real terms, and investors have already turned the Dollar into a funding currency for carry trades. Moreover, negative real interest rates implies high inflation. US CPI is hovering around 4.0%, and could continue to climb in proportion with surging food and energy prices. In fact, inflation is now viewed by economists as more problematic than the economy, itself. While US exporters have benefited from the resulting cheap Dollar, US consumers- which account for 75% of the US economy- have not. The economic downturn still has not officially been labeled a recession by the Bureau of Economic Research, but the situation remains tenuous, and the scales could easily be tipped by a few pieces of negative economic data.

The wild card in this mess is housing. In certain regional markets, real estate prices have tumbled by 30%. In other markets, they have hardly budged. While an estimated $350 Billion in subprime debt has already been written down, analysts disagree over the eventual total. Estimates vary from $1 Trillion to less than $350 Billion, which would imply "write-ups" on debt that was erroneously declared worthless. The difference represented here amounts to 6% of GDP, which could mean the difference between growth and contraction, a strong Dollar and a weak Dollar, respectively.