Forex's blog

While the factors affecting gold are no doubt nuanced, its popularity is primarily vested in the belief that it represents a stable alternative to the Dollar. Accordingly, as the Dollar fell over the last five years, gold prices soared. Likewise, the ongoing Dollar rally has been matched by a proportional decline in gold prices. However, at least one analyst believes this link could soon break down. While gold is traditionally viewed as a specific protection against US inflation (and the concomitant Dollar depreciation), perhaps its role could expand to offer protection against worldwide inflation.

A (deliberately) leaked report has revealed what investors and analysts have suspected all along: the "Committee to Save the Dollar" is real. Evidently, back in March, when the credit crisis was threatening to spiral out of control, the world's leading bankers were busying themselves preparing a plan to prop up the ailing the Dollar. Their rationale is/was that a more valuable Dollar would do more to relieve inflation (via lower food and commodity prices) and ultimately be easier to implement than a worldwide hike in interest rates. Under the plan, the Central Banks of Europe and Japan would join the Federal Reserve Board to coordinate the large-scale sale of Yen and Euro assets, in exchange for Dollars.

Everyone has a theory to explain the Dollar's explosive rally, which has yet to run out of steam. A recent one identifies a shift in China's forex reserve policy as a driving force. Apparently, in an ostensible effort to clamp down on inflation, the Central Bank of China is resorting to draconian measures. One rule change, which was executed with both speed and lack of media coverage, requires commercial banks to hold a larger portion of their reserves in Dollars, rather than Chinese Yuan. In addition, such banks face new restrictions on foreign debt, which is designed to turn them into net buyers of Dollars. Analysts suggest that this policy represents a roundabout attempt to slow the appreciation of the Chinese Yuan.

Even given the Dollar's universally strong performance over the last month, the slide in the value of the Korean Won has been an anomaly, falling over 10% over the same time period and reaching a 4-year low. Analysts attribute the decline to a widening of the country's current account imbalance brought about by a collapse in confidence in Korean securities, namely stocks and bonds. Foreign investors are rushing for the exits in masse, and some are speculating that bonds worth $7 Billion that mature this week will lead to a further outflow of capital. Earlier this year, the Central Bank of Korea spent over $30 Billion propping up the Won, but it has thus far refrained from intervening in the midst of the current slide.

John Taylor is head of the world's largest currency hedge fund, International Foreign Exchange Concepts. Accordingly, when he speaks about currencies, people tend to listen. In an extended interview with Bloomberg News, Taylor noted that volatility has surged in the forex markets. On average, the Dollar is fluctuating 46% more against so-called major currencies and 23% more than emerging currencies, compared to 2007. However, this volatility is largely random- perhaps as a result of increased liquidity- which means inefficiencies in the markets are becoming harder to exploit and profit from. One of the fund's largest bets is against the US Dollar, specifically against the Euro.

I won't lie; the Forex Blog is admittedly Dollar-centric, in that developments in forex markets are usually assessed relative to their projected impact on the US Dollar. Sometimes, we forget that their are other currency pairs that move irrespective of the Dollar. Take the Australian Dollar and New Zealand Kiwi, for example. As both currencies are backed by high interest rates, they have benefited equally from the carry trade and as a result, they behave quite similarly. Combined with the fact that they are practically neighbors, it's easy to forget that there are unique circumstances that weigh separately on them.

When the credit crisis kicked off in 2007, several analysts quietly began to circulate the theory of "decoupling," which asserted the global economy was strong enough to weather a downturn in the US economy. In other words, it was expected that the credit crisis would be contained within the US, and the rest of the world would plod along, unaffected. This notion now appears to be completely without merit, except in a few isolated cases.

When the credit crisis kicked off in 2007, several analysts quietly began to circulate the theory of "decoupling," which asserted the global economy was strong enough to weather a downturn in the US economy. In other words, it was expected that the credit crisis would be contained within the US, and the rest of the world would plod along, unaffected. This notion now appears to be completely without merit, except in a few isolated cases.

Over the last few years, the inverse relationship between the price of oil and the value of the US Dollar has been remarkable. As the Dollar has fallen to record lows, oil has risen to record highs. Now, with a massive Dollar rally underway, the price of oil has virtually collapsed. This relationship is understandable, since expensive oil contributes to the US trade deficit and crimps the economy, while the weaker Dollar, in turn, drives oil-producing countries to charge more in Dollar terms for their oil so that the price remains constant in absolute terms.

The Euro has dropped almost 10% against the Dollar in a matter of mere weeks and everyone is wondering why. Setting aside the factors which favor the Dollar generally (irrespective of the Euro) because they were explored in previous posts, let's instead examine those factors weighing specifically in the Euro. First, the recent decline in commodity prices is causing European inflation to abate. The Euro had previously derived significant support from the ECB's hawkish stance towards fighting inflation. With lower prices, however, the need for further rate hikes may have evaporated. Second, the Euro-zone economy is looking increasingly fragile. Based on the most recent data, it actually contracted in the second quarter.