Trading foreign exchange for profit is like judging a beauty contest in reverse, picking the least ugly currency...
THE TRICK to profitable foreign-exchange trading is to pick the least ugly currency. Nearly all fiat or paper currencies are ugly, because 18 of the world's top-20 central banks are inflating the money supply at double-digit rates.
But at the moment, the world's two ugliest currencies are the Japanese Yen and the US Dollar.
The Bank of Japan pegs its overnight loan rate at just 0.50%, in a brazen effort to devalue the Yen, to boost exports abroad, and prevent an abrupt unwinding of the mushrooming "Yen carry" trade. Meanwhile the US Federal Reserve is inflating its M3 money supply at a 13.7% annualized clip according to private economists. If correct, that would be the fastest rate of expansion in more than 30 years.
US Treasury chief Henry Paulson, and former chairman of Goldman Sachs, "monitors the financial markets closely." He has also reinvigorated the infamous "Plunge Protection Team" which comes to the rescue of the US stock market whenever nasty revelations come to the surface.
At the moment, Paulson's grand strategy is to offset losses in the US housing sector with big gains in the stock market, to prevent the US economy from sliding into recession.
A key player in the "Plunge Protection Team" (PPT) is none other than Federal Reserve chief Ben "Helicopter" Bernanke. Since the Bernanke Fed discontinued the decades-old reporting of the broad M3 money supply in March 2006, the growth rate of M3 has accelerated from an 8% rate to that sizzling 13.7% clip.
The Bernanke Fed is thus preventing borrowing rates from rising at a time of explosive loan demand for US corporate mergers and takeovers, by rapidly increasing the US money supply.
The Bank of America, Citigroup, and JP Morgan led US-loan underwriting in the first half of 2007, which totaled $943 billion – up 5.4% from a year earlier. Global mergers and takeovers soared to an astronomical $2.78 trillion during the first six months of the year, up 51% from a year ago, led by $1.05 trillion in the US alone. Buy-outs by private takeover artists soared 23% to a record high of $568 billion in H1 2007, with 35% of US takeovers and 13% of European takeovers financed with debt.
But one sector of the US stock market which has not responded positively to the Fed's heavy injections of monetary steroids has been the home builders, once regarded as a top bull-market leader from 2003 through to August 2005.
The Dow Jones Home Construction Index, a yardstick that measures home builder performance, is off 25% this year. It's now flirting with key support at the 525 level, which if penetrated, would be especially bearish.
On July 2nd, Paulson sent a discreet signal to Wall Street power-brokers to avoid dumping the home builders. "In terms of housing, it's had a significant impact on the economy. No one is forecasting when, with any degree of clarity, the upturn in housing is going to come, other than it's at or near the bottom."
The Fed has obscured its money-printing operations by discontinuing the reporting of M3, in order to limit the damage to the fixed income markets. But word of the explosive growth of the M3 money supply is slowly leaking out, and it's taking its toll on the US Treasury Note market, which briefly tumbled to its lowest level in five years in June, lifting 10-year yields as high as 5.30% before receding back to 5.00% on a "flight to safety" from the riskiest of the sub-prime home loan market.
Because the US credit markets are swimming in a tidal wave of rising liquidity, there will always be bargain hunters who are happy to park excess cash in the bond market whenever yields surge higher.
Asian central banks – and Arab Oil kingdoms in particular – have been big buyers of US T-bonds over the past four years. They hold roughly $1.3 trillion of the United States' I.O.U.s. But even this massive intervention couldn't turn the tide of the four-year bear market in terms of the Chinese Yuan.
There are now indications that China's insatiable appetite for US Treasury bonds is waning. Beijing was a net seller of $5.8 billion in April, the first drop in Chinese holdings since October 2005. That sparked the recent slide that lifted 10-year yields by 70 basis points at its high mark.
Since Beijing unhinged the Dollar from a fixed peg of 8.27 Yuan in July 2005, the value of the US 10-year T-note, when converted into Yuan, has declined by 15%. Earlier this week, the Dollar slipped to 7.59 Yuan, or 8.9% lower since the Yuan was freed from the Dollar peg.
If Beijing understood the full extent of the Fed's money printing operations, it might think twice about putting its hard earned Dollars into Treasury I.O.U.s. Beijing is almost guaranteed to take further losses on its massive $900 billion US bond portfolio, with its secret agreement with Paulson limiting the Dollar's annual devaluation against the Chinese Yuan to 5% to avoid the US Treasury gaining a reputation as a currency manipulator.
China diversifying away from the Dollar
But China's old guard is finally waking up to reality, and looking for new ways to invest its bulging foreign currency reserves. China's FX reserves have more than tripled in three years. In the first quarter of 2007 alone, its treasure chest was bloated by a whopping $136 billion to a record $1.2 trillion total.
Late in June, the National People's Congress authorized the Ministry of Finance to set up the State Investment Company (SIC), which will invest $200 billion of the country's FX stash into publicly listed companies, real estate, or private deals around the globe.
Most likely at the bottom of the list of possible Chinese investments are US Treasury bonds, which are a losing proposition due to heavy pressure for a further slide of the US Dollar against the Yuan.
The Ministry of Finance plans to issue 1.55 trillion Yuan ($203.5 billion) of bonds to the People's Bank of China (PBoC) in a swap for the FX reserves that will be managed by a new investment fund. But the PBoC is also authorized to re-sell the giant bond offering, which would mop-up liquidity in the Shanghai money markets.
If the PBoC parcels out the entire block of bonds, it would have the same effect as lifting the bank reserve requirements by 10 times with a magnitude of 0.5% each times.
The sale of 1.55 trillion Yuan of these special bonds would be equivalent to more than 50% of the government's 2.9 trillion Yuan outstanding debt.
China's parliament also authorized the State Council to abolish or reduce the 20% withholding tax levied on interest income. The measure is aimed at staunching the flow of cash into the surging stock market by making bank deposits more attractive.
Cancelling the tax entirely would be the equivalent to an increase in the after-tax one-year deposit rate of about 60 basis points, while a 50% reduction would boost after-tax interest by about 30 basis points. It would also increase the after-tax interest rate on China's 7-year bond by as much as 80 basis points. Already, China's 7-year bond yield has climbed 120 basis points to 4.22% since April 2nd, and now the central bank has new tools to drain liquidity from the money markets.
Higher Chinese interest rates have put a roadblock before the powerful Shanghai red-chip index, which has found stiff resistance at the 4,300 level, but finding support at 3,700.
"China should appropriately tighten monetary policy to prevent relatively fast economic growth from overheating, and maintain stability," the People's Bank of China said on July 3rd. The PBoC said it "would resort to a range of monetary policy tools to achieve reasonable growth in money and credit."
With higher after-tax interest rates on Chinese bonds, and pressure on the Fed to lower the fed funds rate due to the sub-prime home loan meltdown, hot money from abroad should continue to flow into the Chinese Yuan, greasing the skids for the US Dollar's slide against other Asian currencies, such as the Korean Won.
BIS chief calls for responsible monetary policies
The Bank for International Settlement's general Manager Malcolm Knight is now calling on the world's top central bankers to slow down the printing presses, and allow borrowing rates to rise, to start draining the "Global Liquidity Glut" in earnest.
"Financial conditions are still accommodative, access to credit remains easy and credit spreads are at record lows. Containing inflationary pressures seems to require further tightening in most jurisdictions, as is expected by financial markets," Knight said.
"The credibility of central banks around the world may hinge on their response to surging money and credit growth, which is helping fuel asset bubbles. Some central banks need to ask soul-searching questions about the appropriate policy response. Ultimately, the credibility of central banks lies in the balance," he added.
Central banks in Australia, Canada, China, the UK, the Eurozone, Korea, South Africa, and Switzerland are expected to heed the call of the BIS chief, by lifting short-term rates a half-percent higher, albeit at a baby-step pace in the second half of 2007. Even the radical inflationist Bank of Japan is laying the groundwork for a long overdue quarter-point rate hike to 0.75% this summer.
FX market expects an easier Fed policy in late '07
But one central bank that cannot contemplate higher interest rates however, is the Bernanke Fed, which is hamstrung by a sliding market for the weakest sector of the sub-prime mortgage loan market.
The benchmark ABX 07-1 BBB index, which is tied to sub-prime mortgage loans, fell to 53.16 cents on the Dollar in early July, and has tumbled 43% since January. ABX's are sub-prime loan mortgages which are bundled in securities.
The fallout from the slide in sub-prime ABX's is uncertain, but if left unchecked, tighter lending standards could sink the US home building sector and housing prices, which were 2.7% lower in May from a year earlier.
Foreign currency traders are already upping their bets that the Bernanke Fed will continue its clandestine policy of injecting more US Dollars into the banking system, and eventually lower the fed funds rate in a crisis situation. Coupled with the likelihood higher rates overseas, yet another global exodus from the US Dollar has been set in motion.
In retrospect, it was Bernanke's infamous comments in a letter to California Rep Brad Sherman, dated Feb 15th 2006, which began the Dollar's latest 18-month descent:
"A precipitous decline in the Dollar should not necessarily disrupt financial markets, production or employment," Bernanke wrote, portending the central bank's rapid increase in the growth rate of the US money supply.
Two months later, Russian finance chief Alexei Kudrin put the knife into the US Dollar by telling the International Monetary Fund (IMF) that Moscow could not consider the Dollar as a reliable reserve currency because of its instability.
"This currency has devalued by 40% against the Euro in recent years. The US Dollar is not the world's absolute reserve currency. The unsustainable US trade deficit is causing concern and the international community can hardly be satisfied with this instability," Kudrin told a stunned audience of the world's top central bankers in April 2006.
On November 24th 2006, Chinese deputy central bank governor Wu Xiaoling warned "The exchange rate of the US Dollar, which is the major reserve currency, is going lower, increasing the depreciation risk for East Asian reserve assets."
Russian Bear aligned with "Axis of Oil"
Russian kingpin, Vladimir Putin, has been a notorious bear on the US Dollar for the past few years, and is a key member of the "Axis of Oil" – including American foes Mahmoud Ahmadinejad in Iran and Venezuela's Hugo Chavez. All three members of the "Axis of Oil" have been switching their FX reserves away from the US Dollar and into Euros.
At a two-day meeting in Kennebunkport, Maine, Bush called Putin a "solid partner" – and added that "Russia has made amazing progress in such a short period of time" since the Soviet Union collapsed in 1991.
"Russia is a country with no debt, and it's a significant international player. Is it perfect in the eyes of America? Not necessarily. Is the change real? Absolutely," Bush said.
Putin responded by saying, "The deck's been dealt and we are here to play. I would very much hope that we are playing one and the same game."
At the core of their disputes, however, is Putin's alignment with Iran's Ayatollah Khamenei, his support for Iran's nuclear program, and Moscow's opposition to further UN sanctions on Tehran, which could wreak havoc on Iran's economy. Putin also opposes Bush's plan to create a European-based missile-defense system with radar based in the Czech Republic and interceptors based in Poland.
Russia is the world's largest natural gas producer, and is second to Saudi Arabia as the world's top crude oil exporter. Rising oil and base metal prices have enabled Russia to amass foreign currency reserves of $405 billion, the third largest after China and Japan.
Russia's economy expanded at a 7.7% annualized rate in the first five months of this year, while the US economy grew at only 0.7% in Q1 – just a tenth of Russia's performance.
On April 6th 2007, Russian central bank chief Sergei Ignatyev said the approximate structure of Russia's foreign exchange reserves was 50% in US Dollars, 40% in Euros, and 10% in British Pounds. Last year, Putin ordered payments for Russia's Ural oil exports in Roubles, abandoning the US Dollar as a medium of payment. Iran's Ahmadinejad has ordered payment for Iranian oil exports in Euros.
Higher oil prices would increase the wealth of the "Axis of Oil", and the clout of the Arab Oil kingdoms in the Persian Gulf, which control an estimated $1.6 trillion of FX reserves, outstripping the Chinese Dragon.
One has to wonder what impact a possible military confrontation over Iran's nuclear weapons program would have on the foreign exchange market.
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