Volatility returning to currency markets

Today the dollar gave up much of its Friday's gains that were driven by stronger than expected US employment situation report. We haven't seen such volatility in currency markets in some time. What happened?

Source: Investing.com

On one hand we have a developing story in the Eurozone as a number of economists continue to believe that the ECB will have to undertake government bond purchases. The central bank will probably need to increase the Eurosystem balance sheet by at least €1 trillion in order to be credible. But it will be impossible to purchase enough ABS and covered bonds without drastically distorting the markets. These markets and the TLTRO program just aren't sufficiently large to achieve such balance sheet expansion without a more traditional QE program that involves purchases of government bonds.

However Mario Draghi dampened expectations for a full QE program at the last ECB press conference. The explanation seems to be that Germany continues to be heavily opposed to such efforts. In fact Jens Weidmann is even opposed to ABS purchases - particularly from periphery states such as Greece and Cyprus. And some senior politicians in Germany are saying that Draghi is turning the ECB into "junk bank". With such headwinds for the ECB, it is not at all clear if QE will even be possible in the nearterm. Questions about the ECB's programs' effectiveness have introduced increased uncertainty into the euro's trajectory, causing volatility to rise.

Similarly the uncertainty is increasing around the Fed's liftoff as well. Expectations of timing vary dramatically between as early as Q1 of next year and as late as a year from now. With rate uncertainty comes increased currency volatility.

The volatility is further helped by the fact that speculative accounts have jumped on the long-USD bandwagon (as can be seen from the CFTC commitments of traders futures data).

Source: Timingcharts.com

Now add to that sharp swings in emerging markets currencies of nations such as Brazil, Russia, South Africa and Turkey and we finally see volatility returning to FX markets.


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SoberLook.com

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From our sponsor:

The 2012 winner for the best performing currency against the US dollar

The table below shows the world's top performing currencies against the dollar. Poland, which was somewhat shielded from the Eurozone by its ties with the big neighbor to the east (considerable capital inflows from Russia and elsewhere in Europe) has been the best performer among the mainstream currencies. In fact Poland, together with other EU nations who stayed out of the euro area - such as Sweden, and the UK - have seen their currencies appreciate.

As of 12/21/12 (source: WSJ)

There is one currency however that has outperformed all of these by a long shot, but you won't find it on the list. The currency is called Bitcoin (ticker symbol BTC) and it more than tripled this year.

Dollars per one Bitcoin (source: http://bitcoincharts.com/)

It's not issued by a country, nor is it a precious metal or a rare-earth. Bitcoin is an electronic currency that can be exchanged for some goods and services, particularly online. The currency is not controlled by a central bank. Instead it is maintained by a global registrar and managed via a private network of participants who get paid to "rent" their computing power to the network. The "rented" machines are used to maintain the integrity of Bitcoin transactions and act as a virtual decentralized registrar.

The network "node" providers (called miners) of course receive their payment in Bitcoin, with the overall currency amount growing gradually over time (current value of Bitcoins in circulation is about USD 140mm). The gradual growth in the "monetary base" is designed to prevent inflation. This is done via a complex algorithm that requires rapidly increasing computing power by the network providers to get paid the same amount. The number of Bitcoins paid to participants is halved periodically. At some point in the future the amount of Bitcoin will become fixed, with network providers relying fully on transaction fees rather than newly "minted" Bitcoins.

For more background on Bitcoins see this story from Wired Magazine (Wikipedia does a terrible job describing this process). It is a brilliant scheme to create a global currency that is separate from governments and central banks. The network however has had its share of growing pains due to hacker activities (specifically on a major Bitcoin currency exchange - not the network itself) and regulators. But it has survived.

The whole premise of this type of private network is to create anonymity online (see TOR Project). That means it is impossible to trace an online transaction. And therein lies the flaw of the Bitcoin concept: transaction anonymity attracts illicit activity. As an example, a website called Silk Road (you won't find it on the internet, since it lives on this private network) sells all sorts of things (paid only in Bitcoin), including illegal drugs. The site is estimated to have made some $22mm in the first half of 2012 but has received all sorts of scrutiny from law enforcement (for more on the site and the market, see the research paper from Carnegie Mellon).

So why has the currency tripled this year? A number of rumors have been circulating in the online forums trying to explain the rally. Unfortunately one explanation that stands out is the increased demand for illicit drugs online. Quite sad actually. Another explanation is the fact that the number of newly minted Bitcoins has been halved again in November, reducing the available supply.

Nevertheless Bitcoin is the 2012 winner for the best performing currency against the dollar.

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The US dollar is now the currency of choice for the carry trade

With the collapse of US interest rates, the dollar is replacing the Yen as the "carry trade" base currency. It's an easy trade to put on, even for a retail investor. A dealer or a fund can simply sell dollars forward against another currency. This trade is equivalent to borrowing dollars, converting them to another currency and lending the currency for a period of time. The interest expense on the borrow is significantly lower than the income from the lending because of the interest rate differential between dollars and the other currency. For example, the three month Euro LIBOR is 0.72%, while the dollar rate for the same maturity is under 0.3%.

Putting this trade on with the Australian Dollar gives about a 3% annualized rate differential (the trade of course could be one week, 3 months, etc., depending on the optimal point on the curve and other considerations).



But what makes this trade interesting for many is the amount of leverage one can get, even as a retail investor. A currency futures contract (see attached futures specs) may require less than 2% initial margin (50:1), creating 150% annualized return assuming FX rates stay where they are. So not only is the investor betting against the dollar, but even if the exchange rate doesn't move from current spot levels, the trade has a nice return. Of course in reality one needs much more capital than the initial margin because the dollar could rally as it did today, forcing either a variation margin posting or an unwind.

For those brave souls who really like risk, a Brazilian Real trade may be just the thing. The rate differential is over 11% annualized.

Of course this trade is getting increasingly crowded. The dollar is now viewed as a safe-haven currency, and any sudden perceived increase in global economic or geopolitical risk could precipitate a sudden dollar rally, forcing a violent carry unwind.





Important: this is not any type of investment advice, just an observation.

The single reserve currency pipe dream

Here we go again with the calls for a new reserve currency (or a new world currency). From Reuters:

A U.N. panel will next week recommend that the world ditch the dollar as its reserve currency in favor of a shared basket of currencies, a member of the panel said on Wednesday, adding to pressure on the dollar.

It's a strange proposal because central banks are free to create their own baskets of currencies and nobody is requiring them to hold dollars. And most of them do just that. It just so happens that the dollar tends to be a large part of those baskets because most nations have significant trade with the US and want to control their currency strength against the dollar (particularly the exporters). It is also because the US has the deepest government paper market (and getting deeper), which gives these central banks tremendous liquidity.

What's interesting is that the UN is convinced that this new global currency, which would be an equivalent of the ECU, would achieve more stable exchange rates.

Currency specialist Avinash Persaud, a member of the panel of experts, told a Reuters Funds Summit in Luxembourg that the proposal was to create something like the old Ecu, or European currency unit, that was a hard-traded, weighted basket. (Reuters)

ECU however did not reduce volatility among the member currencies. The only way exchange rate stability was achieved in Europe was for central banks to cede control of their monetary policy to a single central bank with the creation of the Euro. And there is no chance of countries such as the BRIC nations giving up control of their monetary policy to some central body. Simply having a basket currency out there will not introduce any additional exchange rate stability.

The UN is actually suggesting having an international body "manage" exchange rates. From Bloomberg:

“There’s a much better chance of achieving a stable pattern of exchange rates in a multilaterally-agreed framework for exchange-rate management,” Heiner Flassbeck, co-author of the report and a UNCTAD director, said in an interview from Geneva. “An initiative equivalent to Bretton Woods or the European Monetary System is needed.”

Flassbeck suggests that the exchange rate mechanism should not rely on the free markets, because financial-market participants don't know how to "price risk".

“The most important lesson of the global crisis is that financial markets don’t get prices right,” Flassbeck said. “Governments are being tempted by the resulting confidence game catering to financial-market participants who have shown they’re inept at assessing risk.

..."Today the Americans complain that when the world wants to save, it means a deficit. A shared (reserve) would reduce the possibility of global imbalances."”

Of course a body set up by the UN or the IMF will be able to price risk better and deficits will not impact exchange rates in the new world. Right.

In practice the way this mechanism would work is that every country contributes a pro rata share of their currency in exchange for this new currency. The problem however is that if this basket includes a relatively small amount of dollars (which seems to be the goal here), exporter nations will still need to hold dollars to control their currency value against the dollar. And with some constituent currencies tightly controlled by the various nations, while a UN body controls the basket, it's difficult to envision significant liquidity in this new world currency.