US National Debt and the US Dollar

Pessimists love to point to the surging US National Debt as an indication that the Dollar will one day collapse. And yet, not only has the US Dollar avoided collapse , but is actually holding steady in spite of record-setting budget deficits. That being the case, one has to wonder: As far as the forex markets are concerned, does this debt even matter?

In attempting to answer this question, it makes sense to start by asking whether investors in general care about perennial budget deficits and an-ever increasing national debt. A rudimentary examination suggests that they don’t. Treasury Bond Yields have been falling slowly over the last 30 years. In fact, this fall has accelerated over the last two years, to the point that US Treasury Yields touched an all-time low in 2009, and are currently hovering close to those levels. As of today, the 10-year Treasury rate is an astonishingly tiny 2.7%.

Of course, everyone knows that this most recent drop in Treasury rates is not connected to the creditworthiness of the federal government, but rather an increase in risk aversion engendered first by the credit crisis and second by the EU Sovereign debt crisis. The Federal Reserve Bank and other Central Banks should also receive some of the credit, thanks to their multi-billion Dollar purchases. Still, the implication is that US Treasury securities are the safest investment in the world and that a default by the US government is seen as an unlikely outcome. Thus, investors are willing to accept meager returns for lending to the US.

While demand has remained strong in spite of record issuance of new debt, the structure of that demand has undergone a profound shift. Less than 20 years ago, the overwhelming majority (~85%) of Treasury Bonds were held by domestic investors. In 2010, that proportion had fallen to about half. The largest individual holders of US debt are no longer US institutional investors, but Central Banks, namely those of China, Japan, and Oil Exporting countries. Due to the continued expansion of its quantitative easing program, The Federal Reserve Bank has also become a major buyer of US Treasuries.

It’s tempting to dismiss these purchases as unrepresentative of overall market sentiment, since Central Banks have objectives different from private investors. What matters, though, is that ultimately, such Central Banks would not continue lending to the US government is they thought there was a real possibility of not being repaid. To illustrate this point, consider that the People’s Bank of China (PBOC) actually jettisoned nearly $100 Billion in Treasury debt over the last year as part of a restructuring of its foreign exchange reserves. However, it still has $840 Billion in its possession.  In contrast, the Bank of Japan increased its reserves over the same time period by a similar amount.

As for the forex markets’ assessment of the US debt situation, this is difficult to isolate. There appears to be a relatively stable correlation between the Dollar (vis-a-vis the Euro) and long-term US interest rates, as exemplified by the Euro rally and simultaneous fall in US interest rates. One explanation for the fall in the Dollar, then, could be that falling interest rates made it an attractive funding currency for a carry trade strategy. On the other hand, there would also appear to be an inherent contradiction here, since a rising Euro is an indication of increased risk tolerance and, thus, should be accompanied by a sell-off in US Treasury bonds and rising yields. That in reality, rates fell as the Euro rose confounds our efforts means any correlation is probably dubious.

You don’t need me to tell you that in the short-term, the skyrocketing US debt is of zero concern to the forex markets. There is simply too many other issues on the radar screens of investors for them to make a meaningful attempt at assessing the likelihood of default. Such concerns might become more pronounced in the long-term, but it seems kind of silly to incorporate them into present forecasts. Even if the Eurozone debt crisis were to resolve itself and the global economy managed to avoid a double-dip recession, some other crisis or development – especially one more concrete and immediate than the distant possibility of a US debt default – would materialize. In short, it will be many years before the US debt problem becomes serious enough as to warrant serious consideration by the forex markets.

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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.

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China Currency Revaluation: More Than Just the Yuan at Stake

I concluded my last post (Euro Recovery: Paradigm Shift Confirmed) by musing about how interesting it is that nobody has taken credit for predicting/profiting from the sudden reversal in forex markets, whereby the Euro has surged and the Dollar has tanked. Two days later, I think I can offer an explanation: China.

That’s right. The force behind the sudden sea change might not be private investors, which up until the spike entrenched itself as a full-fledged connection, remained firmly behind the declining Euro. Instead, it seems quite reasonable that China – via its sovereign wealth fund, which is charged with investing its foreign exchange reserves – might be the responsible party.

That China is buoying the Euro would make sense on a couple fronts. First of all, it would explain the mysterious silence behind the rally. China is naturally secretive in pretty much everything it does, especially in the way it conducts currency policy and manages its forex reserves. That China hasn’t even formally announced, let alone bragged about, “diversifying” its reserves, makes perfect sense.

More importantly, that China is responsible also makes sense from a strategic standpoint. China has long spoken about its intentions to change the allocation of its forex reserve holdings, and in hindsight, its timing was perfect. In the beginning of June, the Euro stood at a multi-year low, and the price of US Treasury Bonds stood at a multi-year high. Thus, China’s sovereign wealth fund was able to simultaneously lock in some profits from lending to the US and dissipate risk by swapping US assets for those denominated in Euros and Yen. “China has already bought $20 billion worth of yen financial assets this year, almost five times as much as it did in the previous five years combined.” [Analysts have noted that buying Yen also achieves the peripheral end of making Japanese exports less competitive relative to those from China].

Moreover, China can achieve this diversification without influencing the value of the Yuan, since Dollars can be exchanged directly for Yen and Euros. That is important, since the RMB is still effectively pegged to the Dollar. Speaking of which, the Yuan has hardly budged since its 1% revaluation in June. On a trade-weighted basis, it has actually fallen.

Pressure continues to mount on China to allow the RMB to appreciate. As a result of the 1% nudge in June, speculative hot money is now flowing into China at an increasing rate, because investors are “thematically looking for ways that they can participate in the currency markets in China.” They are supported by the IMF, which most recently called on China to re-balance its economy away from exports and towards trade. Its report included predictions that China’s currency account / trade surplus will continue to rise, seemingly for as long as the RMB remains undervalued. Due to pressure from China, however, it removed precise figures on the recommended extent of said revaluation.

According to a consensus of analysts, China’s exports were probably lower in the month of July, which could give the Central Bank pause in allowing the RMB to rise too much too soon. Instead, it has announced that it will make a more sincere effort to tie the Yuan to a basket of currencies, rather than just the Dollar. ” ‘The yuan should be kept stable at a reasonable and balanced level overall, while it may have two-way moves against particular currencies,’ Hu [XiaoLian, Deputy Governor] said, adding that the composition of the central bank’s currency basket should be mainly based on trade weightings.”

Going forward, then, the Yuan will probably remain basically stable against the Dollar. As China moves towards a trade-weighted peg, however, it is conceivable that it will continue to buy Euros (and Yen, for spite) against the Dollar. As this could have a confounding effect on currency markets, traders should plan accordingly.

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Euro Recovery: Paradigm Shift Confirmed

In early July, when the Euro rally was (in hindsight) just getting under way, I reported on the apparent paradigm shift in forex markets, whereby risk-driven trades that benefited the Dollar were giving way to trades driven by fundamentals, which could conceivably favor the Euro. Since then, the Euro has continued to rally (bringing the total to 12% since the beginning of June), confirming the paradigm shift. Or so it would seem.

Euro fundamentals are indeed improving, with an improvement in the German IFO Index, which measures business sentiment, seen as a harbinger for recovery in the entire Eurozone economy. To be sure, Spain and Italy, two of the weakest members, registered positive growth in the most recent quarter. Contrast that with the situation across the Atlantic, where a growing body of analysts is calling for a double-dip recession with a side of deflation. The Fed has certainly embraced this possibility, and seems set to further entrench – if not expand – its quantitative easing program at its meeting next week.

As a result, investors are rushing to reverse their short EUR/USD bets. What started as a minor correction – and inevitable backlash to the record short positions that had built up in April/May – has since turned into a flood. As a result, shorting the Dollar as part of a carry trade strategy is back in vogue. According to Pi Economics, “The dollar carry trade may now be worth more than $750bn, approaching the size of the yen carry trade at its peak in 2004-07.”

Naturally, all of the big banks were completely caught off guard, and are rushing to revise their forecasts, with UBS calling the Euro “exasperating” and HSBC comparing the USD/EUR to a “lunatic asylum.” An analyst at the Bank of New York summarized the frustration of Wall Street: ” ‘I’ll put my hands up on this—I have had a difficult time trying to call the market. The last time I remember it being this hard was in 2001 to 2002.’ ”

In this case, hindsight is 20/20, and if it wasn’t the stress tests that buoyed the Euro, it must be the acceptance that an outright sovereign default is unlikely. Personally, I’m not really sure what to think. There isn’t anyone who has come out to say I told you So, in the context of the Euro rally, which means it’s ultimately not clear who/what is driving it, and who is profting from it. In fact, you can recall that many hedge fund managers referred to shorting the Euro as the trade of the decade. It’s certainly possible that some of these investors took their profits from the Euro’s 20% depreciation in ran. It’s equally possible that investors are once again behaving irrationally.

The latter is supported by volatility levels which are gradually falling. Still, something smells fishy. A rally in the Euro only a few months after analysts were predicting its breakup is hard to fathom, even in these uncertain times. A columnist from the WSJ may have unwittingly hit the nail on the head, when he mused, “So, unless a European bank goes belly up or some other stink bomb explodes in the region’s debt markets, the old-fashioned relationship between [economic] data and currencies looks set to persist.”

To borrow his terminology, a stink bomb is probably inevitable. That’s not to say that investors aren’t focused on fundamentals; on the contrary, any stink bomb would probably directly harm the currency with which it is associated, rather than radiate through forex markets based on some convoluted sorting of risk . The only question is where the stink bomb will explode: the EU or the US?

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Interview with Roland Manarin: “Don’t Try to Beat the Market”

Today, we bring you an interview with Roland Manarin, founder of Manarin Investment Counsel and Manarin-On-Money. Below, he shares his thoughts on risk management and the EU Sovereign Debt Crisis, among other topics.

Forex Blog: How would you summarize your general approach to investing?

In the management of retirement assets, I subscribe to global diversification using low-cost, asset-class funds that adhere to Modern Portfolio Theory.  From an economics perspective, I follow the Austrian model.

Forex Blog:  Which risks do you currently perceive as most problematic and which are therefore most important to monitor?

There are always risks but for me a concern is the massive amount of malinvestment in the world financial system.  What�s the next spasm to show up?  A bond bubble burst?  A major shift in velocity shooting inflation upwards?  I�m no good at trading, and in today�s world I wonder if anyone is.  There is no one investment plan that is safe but some are safer than others.

Forex Blog:  What is your assessment of the sovereign debt crisis in EU?

I stress broad diversification because I think the world�s financial markets are in the hands of major risk-addicts so as an investor, I must be prepared for anything.  I could be wrong, but it appears we are nearing the collapse of the European welfare state.

Forex Blog:  Are you optimistic about the near-term prospects for US economic recovery?

I want to be but what shakes my confidence is America being on the same road as Europe.

Forex Blog:  Do you think the Fed is close to raising interest rates?

Who knows?  If you can tell me what moves Bernanke and Co. are going to make in the near term, I would feel very good about where to invest my money for maximum return.  But we don�t so everything is just a guess.

Forex Blog: Do you think there is a risk that failure to unwind its quantitative easing program could drive inflation?

I think malinvestment and currency debasement could drive inflation.

Forex Blog:  Considering the recent surge in volatility, what approach do you think Central Banks should take to managing the value of their respective currencies?  Do you think intervention is necessary/desirable?

The federal government/Federal Reserve model of intervention typically follows a simple model:  Tax, spend, borrow, print, subsidize, regulate, go broke.  I don�t think that would be desirable.

Forex Blog:  What�s your advice to investors that want to beat the market during this period of uncertainty?

Don�t try.  Few pros have the long term track record of outperforming the market.  Instead adopt a simple, diversified plan that will allow you to get through this historic turning point we are living through in fine shape.

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Japanese Yen: Intervention is Imminent?

I last mused about the possibility of Japanese Yen intervention in June (Japanese Yen: 90 or 95?): �It seems that anything between 90 and 95 is acceptable, while a drop below 90 is cause for intervention.� Since then, the Japanese Yen has fallen below 86 Yen per Dollar (the USD/JPY pair is now down 7% on the year), and analysts are beginning to wonder aloud about when the Bank of Japan (BOJ) will step in.

The BOJ last intervened in 2004. Given both the price tag ($250 Billion) and the fact that in hindsight its efforts were futile, it appears somewhat determined to avoid that route if possible. In addition, any intervention would have to be implemented unilaterally, since the goal of a cheaper Yen is not shared by any other Central Banks. As if that were not enough, the cause of intervention would be further contradicted by improving reports on the economy and by higher-than-forecast earnings by Japanese exporters, both in spite of the strong Yen.

Finally, the Bank of Japan would be wise to consider that it is impossible to calculate an ideal exchange rate, since prior to intervening in 2004, it declared that � �a dollar at �115.00 is the ultimate life-and-death line for Japanese exporters.� � Six years later, the Yen is 25% more expensive, and Japanese exporters appear to be doing just fine. On the other hand, �If the yen keeps rising, BOJ officials may become more concerned over whether exports will really continue to grow and prop up the economy.�

Analysts remain mixed about the likelihood/desirability of intervention. Most admit that as with the last time around, it would be an exercise in futilty, since �the yen�s gain isn�t being driven by speculation,� and investors would probably be willing to buy any Yen that the Central Bank sells. Instead, the BOJ will probably continue to pursue a policy of vocal intervention, which can be equally effective and much less expensive.

Government officials � at least the ones with any jurisdiction in currency issues � have remained reticent on the topic of intervention. That�s not to say that they couldn�t be swayed by pressure from the Minister of Trade and others, which have repeatedly voiced their irritation over the Yen�s strength.

Ultimately, trying to predict whether intervention will take place is probably just as futile as any intervention, itself. Still, 85 is a level of obvious psychological importance, as is 84.83, the 14-year high set last November. If the Yen drifts below that, one would expect the Bank of Japan to at least make a token effort to depend the Yen. Even if the economy can withstand a weaker Yen, it will nonetheless benefit from a stronger Yen, and regardless of what the BOJ says, that is what it would like to see.

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