June, 2008

The field of currency exchange-traded products keeps getting better and
better. Only a few years ago, the selection of such products was quite
small, and limited to the major currencies (i.e. Dollar, Euro, Yen).
Next came the introduction of riskier currencies, namely those of the
so-called emerging markets, such as the Mexican Peso, Brazilian Real,
Indian Rupee, and most recently the Chinese Yuan. This was followed by
multi-currency and strategy funds, such as the Dollar Bearish fund and
a Carry Trade fund. This brings us to the present day, where Barclays
Capital has brought to the market the Asian and Gulf Currency
Revaluation ETN. As its name suggests, this ETN aims to capture any
gains from the revaluation of five select currencies that are currently

The Indian Rupee has fallen to a 14-month low as a result of the sagging Indian stock market and surging inflation. Foreign investors have withdrawn $5.7 Billion from the Indian stock market in the first half of 2008, reinforcing the 30% drop in stock prices that occurred over the same time period. Meanwhile, the nation's benchmark inflation rate has risen to the highest level in nearly 13 years, and investors are clamoring for the Royal Bank of India to do more. The RBI has already raised interest rates as well as intervening on the Rupee's behalf in forex markets, as indicated by data on the RBI's foreign exchange reserves. Both moves were explicitly aimed at combating inflation, but may also carry the unavoidable consequence of stunted economic growth.

At its most recent meeting, the Fed voted to hold rates steady at 2%. Only one week ago, 90% of investors (based on interest rate futures) had expected the Fed to lower rates.  What changed?

The Carry Trade is one of the simplest strategies in forex, and if executed correctly, can also be one of the most profitable. The basic mechanics of a carry trade involve borrowing in one currency that offers a low interest rate, and selling it in favor of a higher-yielding currency, in order to capture the interest rate spread. This strategy carries two key risks. The first risk is that the "long" currency will depreciate. This also includes country risk, the possibility that political or macroeconomic instability will adversely affect the long currency. Then, there is the risk that the interest rate differential will change such that the spread shrinks, and a smaller carry is earned.

The looming possibility of forex intervention in response to the Dollar's continued weakness is causing an uproar in forex circles. Some analysts don't feel intervention is a real possibility because it is so inconsistent with the ideology espoused by the current US presidential administration. In a piece published in the AsiaTimes, however, one expert noted that the history of the Dollar is also a history of intervention. Even when the Dollar was still linked to the Gold Standard, the Fed intervened by buying or selling gold depending on the result it wanted to achieve.

Forex analysts reckon the two most powerful forces weighing on the Dollar are commodity prices and European prices, so-to-speak. With regard to commodity prices, it seems plausible that rising commodity prices have contributed to a weaker Dollar, as much as vice versa. Thus, when Saudi Arabia announced recently that it would increase oil production, the Dollar received a nice boost. Conversely, European prices, or inflation, are important for traders to monitor because they represent a proxy for the future of EU monetary policy. Specifically, Eurozone inflation just touched another high, at 3.7%, which analysts point out is now 1.7% higher than the ECB's stated comfort zone.

At the recent Reuters Investment Outlook Summit, forex was a popular topic of discussion among the investment strategists in attendance. Specifically, many of the participants were bullish about emerging market currencies. This is somewhat ironic, since these currencies have marked one of the few bright spots for the Dollar, which has benefited from a recent trend towards risk aversion as a result of the credit crisis. In addition, the Fed is certainly finished with its current cycle of lowering rates, and may in fact hike rates as early as this year. However, the experts insist that this will be offset by corresponding rate hikes in emerging markets, which are beginning to come to terms with surging inflation.

G8 finance ministers met last week to discuss the detrimental effects of rising (commodity) prices on the global economy. Oil prices and commodity prices have in some cases doubled over the last year, contributing  to a nasty surge in worldwide inflation rates. While the Dollar was not technically a topic of the discussion at these particular meetings, it was broached tangentially because of the perceived relationship between the weak Dollar and high commodity prices. Accordingly, Central Bank intervention on the Dollar's behalf could theoretically be justified on the basis of both mitigating inflation and facilitating global macroeconomic stability.

In a recent article for Seeking Alpha, financial journalist Ray Hendon offered an overview on the four principal strategies employed in the forex markets: carry trade, technical trade, fundamental trade, and arbitrage. The carry trade, which involves borrowing in a low-interest rate currency and buying a higher-yielding currency, can be undertaken by either buying ETF(s) or by trading directly using a retail forex account. The ETF route can be further subdivided into two possibilities: to buy a particular currency ETF to take advantage of the spread, or instead to buy one of two ETFs (symbols: ICI & DBV) that use computer models to mimic the carry trade.

Over the weekend, the people of Ireland resoundingly rejected the Lisbon Treaty, throwing up roadblock in the way of the most recent attempt to solidify the bond of the EU. Surprisingly, the Euro shrugged off the news and actually rose on the first day of trading following the release of the results. This marks a sharp departure from 3 years ago, when the rejection of a comparable treaty by the people of France and The Netherlands caused a panic in forex markets as analysts sounded the knell of the EU. The explanation for the diverging reactions is that the European Political Union has been de-coupled from the European Monetary Union.