Emerging Markets Shed FX Reserves

According to the most recent monthly data, the foreign exchange reserves of most developing countries are disappearing faster than they can be replenished. As a result of the global credit crisis, central banks have taken to deploying vast sums of capital towards the dual ends of stimulating their economies and propping up their currencies. The latter can be especially expensive, as countries like Ukraine and South Korea can attest. Both countries have spent 20% of their respective reserves to halt the decline of their currencies, and both abandoned such a strategy after accepting its futility. Ironically, there seems to be a direct correlation between dwindling forex reserves and a depreciating currency, as investor nervousness and currency devaluation reinforce each other. There is one bright spot in this quagmirem, however. The Guardian reports:

China says its reserves are continuing to rise, with the chief economist at the National Bureau of Statistics telling Reuters they would exceed $2 trillion by the end of the year. Beijing [will] not resort to "panic selling" of reserves, instead maintaining a "prudent and responsible" stance.

Read More: Emerging reserves haemorrhage as currencies fall

Central Banks Still Prefer Dollars

Since its introduction only ten years ago, the Euro has ascended at an incredible pace. Perhaps the best proxy for its respectability is its growing share (currently estimated at 27%) of Central Banks' foreign exchange reserves. Still, most analysts reckon that the Dollar will remain ascendant for the near-term. For one thing, the perception remains that the US is the safest place to invest, and in fact this attitude has been reinforced by the current economic downturn. In addition, there is very limited doubt that the Dollar will be around for a very long time, whereas there are many skeptics who invariably insist that the Euro is on the verge of breaking up. In short, as the global economy rebalances itself, reserve accumulation will slow generally, and diversification into the Euro will slow specifically. Marketwatch reports:

In view of the value already tied up in holdings of U.S. government paper, it would take a decisive -- and probably foolhardy -- shift for the world's largest reserve holders in Asia or Latin America to transfer significant holdings of present reserves out of the dollar and into the euro.

Read More: Reserve shifts into the euro will slow

Emerging Markets Poised for Recovery?

In a recent interview, three emerging market fund managers aired a common view: the asset class which comprises emerging markets represents a solid investment. Their reasoning is that the tremendous declines wrought in emerging market equities and currencies over the last six months were caused primarily by technical factors, rather than a substantive change in the long-term economic picture. In other words, this drop was effected by foreign investors that withdrew money en masse from emerging markets in order to meet fund redemptions and repay loans denominated in Dollars. At the same time, economic analysis, as well as common sense, dictate that an increasing portion of future global growth will be realized in the developing world. Many such countries have invested wisely in infrastructure and built up sizable foreign exchange reserves. Consequently, they are well-positioned to survive the current downturn intact. Accordingly, once investors "come to their senses" and recover their collective appetite for riskier investments, it probably won't be long before emerging market assets and currencies are bid up to pre-crisis levels. Forbes reports:

"Current valuation of emerging markets is the lowest it has been since I began investing in this asset class in 1988. Based on trailing 12-month earnings, emerging markets is trading at a price/earnings ratio of only 7.7x, and a price/book of 1.3x (with return on equity at 17%)," [observed one analyst].

Read More: Emerging Markets: What To Buy

US Dollar Forecast to Recover Against Euro, British Pound

Written by David Rodriguez, Quantitative Analyst

EURUSD – Euro Forecast to Turn Against US Dollar on Shift in Forex Sentiment
USDJPY – US Dollar May Lose Further Against the Japanese Yen
USDCHF – Forex Sentiment Accurately Forecasts Massive Swiss Franc Rally
GBPUSD – British Pound Outlook Bearish Against Downtrodden US Dollar
USDCAD – Canadian Dollar Forecast Unclear Against US Dollar

Forex Positioning in the Euro/US Dollar

EURUSD – Forecasts for the Euro/US Dollar currency pair have now shifted to the downside, as a flip in retail forex positioning signals that the recent Euro/US Dollar uptrend may reverse. Last week we cited extremely net-short “crowd” positioning as a clear sign that the Euro would rally, but the forex crowd has now capitulated and the majority of traders are now long the EUR/USD. Indeed, the SSI ratio currently stands at 1.18 as nearly 54 percent of traders are long the pair. Yesterday only 40 percent of traders were long, and these reversals most often occur at turns in price. As such, our SSI-based forex trading signals recently went short the Euro/US Dollar via a sentiment-based trading strategy.

Forex Positioning in the US Dollar/Japanese Yen

USDJPY – The forex trading crowd continues to buy into US Dollar/Japanese Yen declines, and such stubbornness suggests that the pair may yet fall further. That said, positioning has become far less extreme through recent trading. The ratio of long to short positions in the USDJPY stands at 1.31 as nearly 57% of traders are long. This stands in contrast with a ratio of 2.11 at this point last week, and the slow capitulation from the forex trading crowd tells us that we are zeroing in on a bottom. Through the very short term we may expect the US Dollar to continue falling against the Japanese Yen, but a stronger shift in sentiment would signal that a turn is likely. As it stands, our USD/JPY trading strategies are currently flat after aggressively selling through previous price action.

Forex Positioning in the British Pound/US Dollar

GBPUSD –Forex positioning in the British Pound/US Dollar pair has been inconsistent through recent trading, but a recent increase in GBP/USD-long positions supports the case for near-term British Pound weakness against the US Dollar. Indeed, the ratio of long to short positions in the GBP/USD currently stands at 1.48, as nearly 60 percent of traders are currently long. Given that our Speculative Sentiment Index is most often contrarian in nature, the forex crowd’s long bias gives us reason to look for a downturn in the GBP/USD through the foreseeable future. In fact, two of our forex trading strategies have very recently gone short the British Pound against the US Dollar.

Forex Positioning in the US Dollar/Swiss Franc

USDCHF – Recent US Dollar/Swiss Franc price action is a testament to the effectiveness of Speculative Sentiment Index-based currency forecasts. Forex trading crowds had remained heavily net-short the USD/CHF since July, and the pair went on to mount an impressive multi-month rally. Most recently, that same crowd capitulated and actually went net-long the USD/CHF near the 1.2000 mark. The US Dollar subsequently went on to post its biggest monthly loss against the Swiss Franc in history—incredible by any standards. Looking to very short-term trading, the crowd is currently net-short the pair, with short positions outnumbering longs by 1.08 to 1. Such a flip gives us reason to look for a reversal, but a sharp drop in open interest gives us little conviction in our forecast. Our forex trading signals previously went short the USD/CHF for sizeable profits, but the strategies now hold a weaker bias.

Forex Positioning in the US Dollar/Canadian Dollar

USDCAD – The ratio of long to short positions in the USDCAD stands at 1.07 as nearly 52% of traders are long. Yesterday, the ratio was at -1.05 as 51% of open positions were short. In detail, long positions are 1.7% higher than yesterday and 50.6% weaker since last week. Short positions are 8.9% lower than yesterday and 11.1% stronger since last week. Open interest is 3.7% weaker than yesterday and 56.7% below its monthly average. The SSI is a contrarian indicator and signals more USDCAD losses. Tell us and other traders what you think in our forex forum.

How do we interpret the SSI? The FXCM SSI is based on proprietary customer flow information and is designed to recognize price trend breaks and reversals in the four most popularly traded currency pairs. The absolute number of the ratio itself represents the amount by which longs exceed shorts or vice versa. For example if the EURUSD ratio is 2.55, long customer orders exceed short orders by a ratio of 2.55 to 1. Conceptually similar to contrarian analyses using the CFTC IMM open position data or COT Report, the SSI provides an alternative approach that is both more timely and accurate in forecasting currency price movement. The SSI is a contrarian indicator that tells you how the market is weighted and where the trend may head. More long positions don't necessary suggest more confidence in the direction of the current trend. In general, when traders start having adverse movements against their position, many tend to increase the size of their position with the purpose to average down their entry price in one last attempt to recover from previous losses. However, the higher the number of short orders in a bull market the more dangerous is to take additional shorts because many of those traders who just entered the markets are also leaving their protective stop losses just above the current price action.

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Investors Uncertain about RMB

Only a few weeks ago, investors had made significant bets that China would reverse its official policy of RMB appreciation. Futures prices indicated that investors collectively expected the currency to depreciate over 7% against the Dollar over the next year, as part of a comprehensive Chinese policy to boost the faltering economy. Since then, however, the RMB recorded its biggest one-day rise since the currency peg was abandoned three years ago, and investors subsequently scaled back their bets.

While it's unclear what caused the sudden change in sentiment, there are a few factors which probably contributed. First is Treasury Secretary Henry Paulson's recent visit to China, in which he encouraged China to continue to permit the the Yuan to appreciate. In addition, high-ranking Chinese economic policy-makers have indicated that market forces will increasingly determine the valuation of the Yuan. Finally, there is the recent election of Barack Obama, a long-standing critic of what he believes to be the undervalued RMB. Bloomberg News reports:

"Any attempt to devalue the currency is likely to be met with considerable opposition from China’s trading partners." The new U.S. administration under President-elect Barack Obama "will be less tolerant of the 'crawling peg' appreciation policy," said one analyst.

Read More: Yuan Forwards Advance Most Since Peg as China Seeks Stability

Emerging Markets Shed FX Reserves

According to the most recent monthly data, the foreign exchange reserves of most developing countries are disappearing faster than they can be replenished. As a result of the global credit crisis, central banks have taken to deploying vast sums of capital towards the dual ends of stimulating their economies and propping up their currencies. The latter can be especially expensive, as countries like Ukraine and South Korea can attest. Both countries have spent 20% of their respective reserves to halt the decline of their currencies, and both abandoned such a strategy after accepting its futility. Ironically, there seems to be a direct correlation between dwindling forex reserves and a depreciating currency, as investor nervousness and currency devaluation reinforce each other. There is one bright spot in this quagmirem, however. The Guardian reports:

China says its reserves are continuing to rise, with the chief economist at the National Bureau of Statistics telling Reuters they would exceed $2 trillion by the end of the year. Beijing [will] not resort to "panic selling" of reserves, instead maintaining a "prudent and responsible" stance.

Read More: Emerging reserves haemorrhage as currencies fall

AUD Continues to Dive

On the basis of technical factors, the Australian Dollar had halted its precipitous decline against most major currencies. As a result of an unbelievable 100 basis point interest rate cut, however, the currency has resumed its fall. That the rally was short-lived is not a mystery. The yield advantage enjoyed by Australia over the last few years has almost completely evaporated. Combined with lackluster Australian equity performance and tanking commodity prices, foreign investors have little reason to maintain capital in Australian holdings. On the plus side, the rate cut showed investors how serious Australian economic policy-makers are in dealing with the credit crisis. Unfortunately, diligence doesn't always translate into efficacy.

Read More: Dollar back under pressure

Japan Stays out of Forex

Officially, Japan has not intervened in forex markets since 2004, when it spent the equivalent of $300 Billion to hold down the value of the Yen. That impressive streak could soon come to and end, however, as the Yen continues to surge on the unwinding of the carry trade. The performance of the Yen- which recently touched a 13-year high- is particularly impressive since it comes at a time when virtually every other currency has collapsed relative to the US Dollar. Now, analysts have once again taken to pouring over monthly data on Japan's Central Banking activities, in order to confirm that it is keeping its finger off of the trigger. Given that the Yen's appreciation has already prompted several high-level meetings among global economic and political leaders, however, it is probably only a matter of time before Japan ends its multi-year abstinence from forex. Reuters reports:

Japanese Finance Minister said earlier this month that the authorities must be ready to deal with big swings in markets as they are undesirable. His comments pushed the yen lower against the dollar as market players were wary of intervention.

Read More: Japan did not intervene in currency market in Nov

Will China Fund US Deficit?

When all is said and done, the US government will have injected trillions of dollars into the economy, in the form of bailouts, guarantees, economic stimuli, etc. Whether it will have the desired effect is debatable. The question that no one seems to be asking is, "How is the government going to finance such exorbitant spending?" It appears that China, which has become of of the largest holders of US government debt, will continue to participate- not necessarily because it wants to, but because it doesn't have a choice. China's economy remains heavily reliant on the export sector to drive growth. Because its exchange rate regime does notpermit the RMB to fluctuate freely, the proceeds from the consequent trade surplus must be invested abroad, rather than domestically. For both symbolic and economic reasons, it seems the bulk of the surplus will continue to be invested in the US, probably in safer assets like US Treasury Securities. This is certainly good news for deficit hawks and Dollar bulls. The Wall Street Journal reports:

Even if China wanted to invest outside the U.S., it couldn't. If China recycled its foreign currency into, for instance, the European Union or Japan, it would effectively force those trading partners to run large trade deficits with China, which neither can absorb.

Read More: China Will Keep Buying U.S. Government Debt

Russian Ruble Declines with Price of Oil

Having already fallen 12% in 2008, the Russian Ruble is well on is way to fulfilling analysts' predictions that it will fall 30% before stabilizing against the US Dollar. While the credit crisis has not been kind to Russia, the Ruble is suffering more from a collapse in the price of oil, which recently slipped below $50 a barrel. For reference, the government needs the price of oil to stay above $70 in order to balance its budget. Now, the country's current account surplus is eroding almost as quickly as its foreign exchange reserves, which it is deploying in a vain effort to forestall the decline in the Ruble. The response of the Central Bank has been to widen the band within which the currency is permitted to fluctuate; in practice, this is tantamount to defeat, and is sure to trigger a further decline. Bloomberg News reports:

"The central bank is letting it fall because of oil, reserves depletion, all of that," said an emerging-markets currency strategist. "We can probably expect to see more of this."

Read More: Ruble Falls on Speculation Central Bank Scaling Back Defense

Could the RMB Fall?

Since China revalued the Yuan in July 2005, it was considered a foregone conclusion that the currency would continue appreciating at a steady clip. The global credit crisis, generally, and the Chinese economic downturn, specifically, has turned that assumption on its head. Last week, the RMB declined by the biggest margin since the revaluation, prompting speculation that China will adopt a currency policy diametrically opposed to that which it has pursued over the last few years. The move also coincided with the annual China-US trade summit, attended by none other than Treasury Secretary Henry Paulson. The new consensus among currency traders (proxied by futures contracts) is that the Yuan will depreciate slightly over the next two years, as China moves to provide a boost to its export sector. Given that the currencies of most of China's Asian neighbors have fallen by double digits over the last year, the Yuan may have to fall sharply in order to maintain competitiveness. The Wall Street Journal reports:

the Chinese currency hasn't experienced a large devaluation in at least a decade. Such a move would go against the realities of geopolitics and against signals that Beijing is more focused on boosting domestic consumption than on stimulating exports.

Read More: Will China Finally Try Wielding Its Yuan?

Indonesian Rupiah Faces Collapse

The economic situation in Indonesia is similiar to that of several other emerging market economies, characterized by falling export revenue, shrinking government coffers, and capital flight. The consequent decline in the Indonesia Rupiah has almost become self-fulfilling. In other words, as skittish investors rush to move their capital out of Indonesia for fear of complete collapse, they are simultaneously making such a collapse more likely. Indonesian policy-makers are conscious of this tendency of nervousness to feed back into itself, and are delicately trying to avoid shocking the markets. On the one hand, they want to limit the decline of the Rupiah. On the other hand, they don't want to take actions that will make investors nervous, even if it means making it more difficult for them to short the currency. The International Herald Tribune reports:

Last week, Indonesia changed its currency rules to make it more difficult to buy foreign exchange. The measures, mostly affecting Indonesians rather than foreigners, would make speculative bets against rupiah depreciation more difficult.

Read More: Indonesia undergoing currency crisis