Could The Yuan Become The World's Next Reserve Currency?

The U.S. dollar has faced some serious attacks lately, and our economy here in the U.S. is struggling, but have things really gotten so bad that the USD could lose its place as the world's reserve currency? And even if it did, wouldn't the Euro be next in line to take its place? According to Nouriel Roubini, the next world reserve currency could in fact be the Chinese Yuan, and the transition could happen sooner than we think. For more on this, read the following blog post from Mark Thoma which looks at Roubini's recent article on the subject.

Nouriel Roubini is worried that the dollar will lose its status as a reserve currency if we don't change our ways:

The Almighty Renminbi?, by Nouriel Roubini, Commentary, NY Times: ...While the dollar’s status as the major reserve currency will not vanish overnight, we can no longer take it for granted. Sooner than we think, the dollar may be challenged by other currencies, most likely the Chinese renminbi. This would have serious costs for America, as our ability to finance our budget and trade deficits cheaply would disappear. ...

The... downfall of the dollar may be only a matter of time. But what could replace it? The British pound, the Japanese yen and the Swiss franc remain minor reserve currencies, as those countries are not major powers. Gold is still a barbaric relic whose value rises only when inflation is high. The euro is hobbled by concerns about the long-term viability of the European Monetary Union. That leaves the renminbi. ...

At the moment,... the renminbi is far from ready to achieve reserve currency status. China would first have to ease restrictions on money entering and leaving the country, make its currency fully convertible for such transactions, continue its domestic financial reforms and make its bond markets more liquid. It would take a long time for the renminbi to become a reserve currency, but it could happen. ...

We have reaped significant financial benefits from having the dollar as the reserve currency. In particular, the strong market for the dollar allows Americans to borrow at better rates. We have thus been able to finance larger deficits for longer and at lower interest rates, as foreign demand has kept Treasury yields low. We have been able to issue debt in our own currency rather than a foreign one, thus shifting the losses of a fall in the value of the dollar to our creditors. Having commodities priced in dollars has also meant that a fall in the dollar’s value doesn’t lead to a rise in the price of imports. ...

This decline of the dollar might take more than a decade, but it could happen even sooner if we do not get our financial house in order. ... For the last two decades America has been spending more than its income, increasing its foreign liabilities and amassing debts that have become unsustainable. A system where the dollar was the major global currency allowed us to prolong reckless borrowing.

Now that the dollar’s position is no longer so secure, we need to shift our priorities. This will entail investing in our crumbling infrastructure, alternative and renewable resources and productive human capital — rather than in unnecessary housing and toxic financial innovation. This will be the only way to slow down the decline of the dollar, and sustain our influence in global affairs.

This post can also be viewed on economistsview.typepad.com.

European Banks Offer Another Potential Problem

Here in the U.S. we just finished the widely publicized "stress tests," which showed us a great deal of capital shortfalls with the major banks. This was more or less to be expected, but what is getting less press here at home are the potential problems over in Europe. Many people had mistakenly thought Europe was buffered from the financial problems being experienced in the U.S., but the more we look into it the more we see that is not the case. Many European banks were exposed to the same products and other issues that brought down the U.S. financial system, and the struggles these European banks are facing could bring down the global financial system even further. For more on this, read the following article from Money Morning.

Now that the results of the U.S. bank stress tests are finally in the books, the extent of the capital shortfalls are known and – in many cases – are actually being addressed.

But there’s now another problem looming – one that could ultimately weigh down the global financial system.

The problem: Europe’s banks.

As economies slow in other parts of the world, rising joblessness and plunging housing prices and escalating loan losses are putting banks under pressure. That’s especially true in Europe, where consumers and companies are continuing to run into trouble.

Royal Bank of Scotland PLC (NYSE ADR: RBS), now 70% state-owned, fell to a loss in the first quarter and wrote down $3.17 billion in risky assets after its bad debts quadrupled to $4.37 billion.

Bank executives "[expect] a slowdown in financial-market activity compared with the very buoyant conditions seen in Q1," Chief Executive Officer Stephen Hester told Reuters.

In Germany, Commerzbank AG (OTC ADR: CRZBY) had to take a $1.61 billion charge from its investment bank and a $72.38 million charge from commercial real estate initiatives, resulting in a $1.2 billion loss for the quarter.

In late December, the Institute of International Finance released its global economic outlook for 2009, and estimated that banks around the world had collectively lost nearly $1 trillion – $678 billion from U.S. banks and $300 billion from their European counterparts.

That was in December. We know it got worse – a lot worse – for U.S. banks after that point. Thanks to a mix that included lots of government bailout and an injection of new capital from investors, U.S. banks have experienced an improvement in their outlook.

Indeed, U.S. Federal Researve Chairman Ben S. Bernanke stated that the banks tested are all solvent and the results should provide "considerable comfort about the health of the banking system.”

But in the five months since that Institute of International Finance report was issued, it’s likely that European banks have experienced a major decline in their fortunes.

Last week’s release of the bank stress tests results removed significant uncertainty about the U.S. banks, since it created a blueprint of what the troubled institutions needed to do to stabilize their finances. Morgan Stanley (NYSE: MS) and Wells Fargo & Co. (NYSE: WFC) have announced plans to raise an aggregate $15 billion in capital. Bank of America Corp. (NYSE: BAC) plans to sell assets and issue more common stock after being told by the federal government that it must raise $33.9 billion to adequately guard against “more adverse” economic conditions.

Bank of America was one of 10 banks told by the government to raise more capital following the so-called stress test. The government concluded that BofA faces a potential $136.6 billion in losses from troubled loans and investments in 2009 and 2010. The bank’s $34 billion capital shortfall was more than twice that of Wells Fargo, which had the second greatest capital need.
Are we destined to see this all play out now in Europe?

Market Matters

Shifting back to autos, General Motors Corp. (NYSE: GM) lost $6 billion in the first quarter and is shopping Saturn to Renault SA of France as it moves closer to its restructuring deadline (and potential bankruptcy). China’s Geely Automobile Holdings Ltd. (PINK: GELYF) has interest in GM’s Saab unit, and Fiat SpA (OTC ADR: FIATY) may look to complement its Chrysler LLC line with the German Opel (also late of GM). Meanwhile, Ford Motor Co. (NYSE: F) claims to be on track with its restructuring plan and still believes it can manage just fine without any government assistance. On the earnings’ front, The Walt Disney Co. (NYSE: DIS) and Kraft Foods Inc. (NYSE: KFT) bested estimates, while Cisco offered some mixed results as its better than expected numbers actually prompted some profit-taking among techs.

A poorly received 30-year Treasury auction sent bond prices tumbling as fixed income investors focused on the massive programs the government will need to finance over the next few years. Oil prices surged above $58 a barrel for the first time in six months as traders seemingly failed to consider rising inventory levels and instead bought on signs (feeble as they are) of an economic recovery that would lead to enhanced energy demand.

The Standard & Poor’s 500 Index pushed beyond the crucial 900 level and ended the week in positive territory for the year. Techs struggled late as investors realized any economic rebound would not translate into capital expenditures overnight. Still, the Nasdaq Composite Index has outperformed the other indexes on a year-to-date basis. With stress tests out of the way, where will the next leaks come from?

Market/ Index	Year Close (2008)	Qtr Close (03/31/09)	Previous Week (05/01/09)	Current Week (05/08/09)	YTD Change
Dow Jones Industrial	8,776.39	7,608.92	8,212.41	8,574.65	-2.30%
NASDAQ	1,577.03	1,528.59	1,719.20	1,739.00	+10.27%
S&P 500	903.25	797.87	877.52	929.23	+2.88%
Russell 2000	499.45	422.75	486.98	511.82	+2.48%
Fed Funds	0.25%	0.25%	0.25%	0.25%	0 bps
10 yr Treasury (Yield)	2.24%	2.68%	3.17%	3.29%	+105 bps

Economically Speaking

U.S. retailers released same-store sales data for April and the results were actually quite promising. As usual, Wal-Mart Stores Inc. (NYSE: WMT) led the charge with a 5% increase in activity, while Children’s Place Retail Stores Inc. (Nasdaq: PLCE), Stage Stores Inc. (NYSE: SSI), Gap Inc. (NYSE: GPS), and The TJX Cos. Inc. (NYSE: TJX) were among those stores that posted better-than-expected results and beat analysts’ expectations. A late-Easter holiday (April instead of March) helped many retailers as consumers waited until the last minute (as has become the norm) for their related holiday shopping.

On the global front, the European Central Bank dropped its key lending rate by 25 bps to 1%, and initiated other monetary moves to stabilize its (16-country) economy. Likewise, the Bank of England announced a plan to buy up government and corporate bonds, thus, increasing its money supply.

Speaking of the labor market, the U.S. unemployment rate climbed in April to 8.9%; however, only 539,000 jobs were lost from the economy. The contraction represented the smallest in six months and was below most analysts’ expectations. Still, since December 2007, about 5.7 million domestic jobs have disappeared and businesses continue to be slow to hire until they see additional signs of greater stability in the economy.

Construction spending climbed in March after five consecutive monthly declines, though the gains were attributed to non-residential activity and the housing sector remains sluggish at best. In more promising news, the National Association of Realtors reported a 3.2% increase in pending homes sales, the second straight monthly gain. Because the release is considered a predictive indicator, analysts took it as a favorable sign that sales activity may pick up in the months ahead.

This article can also be found on moneymorning.com.

How The European Central Bank Is Different

The European Central Bank (ECB) made several important announcements today, and the reaction from currency traders was much different than how they have reacted to similar moves from other central banks. Currency expert Kathy Lien looks closer at the recent announcements, and talks a bit about what sets the ECB apart from the Bank of England and Federal Reserve, in her blog post below.

Both the European Central Bank and the Bank of England announced asset purchases today, but the Euro skyrocketed while the British pound fell, leading many currency traders to wonder What Sets the ECB Apart from Fed and BoE?

Read Boris’ take on the Bank of England Rate Decision

Before talking about why the euro recovered, here are the 4 key announcements made by the ECB today:

1. Cut Repo Rate from 1.25 to 1.00%
2. Narrow Rate Corridor by 50bp (Marginal Lending Rate Cut by 50bp to 1.75%)
3. Extend maturity of refinancings to 12 months
4. Announced purchases of up to EU60 billion in euro-denominated covered bonds

There is no question that these are unprecedented measures for the European Central Bank. Everyone expected the quarter point rate cut to a record low of 1.00 percent, the decision to increase the maturity of refinancings to 12 months and also the narrowing of the rate corridor by 50bp, but the chance of purchasing euro-denominated covered bonds was low.

Nonetheless, Trichet has resorted to what many consider Quantitative Easing (even though he explicitly denied that this is QE) and rather than punishing the euro, currency traders are applauding the ECB for being flexible and realizing that there is no longer a stigma attached to asset purchases. Also, the amount of bonds that the ECB is purchasing is nominal compared to the rest of the central banks. The ECB plans on buying up to EU60 billion, which is less than half of the BoE’s Quantitative Easing program. More importantly however, Trichet suggested that they may sterilize the liquidity impact of bond purchases, which would limit the impact on the money supply and the pressure on the euro. The Fed and the BoE’s purchases are unsterilized. Finally, this is only an initial announcement. Further details on the bond plan will be released in June. Although rates are appropriate for the current time, the central bank could still take interest rates below 1 percent based upon Trichet’s comment that they have decided if rates have hit their lowest point.

This post can also be viewed on kathylien.com.

Deflation Taking Hold In Europe

We have been hearing a lot about deflation here in the U.S., but so far we have been able to hold it off for the most part. It appears that Europe is not having as much luck though. Deflation can be an economic killer as we saw during the Great Depression and more recently with Japan's Lost Decade. For more on this, read the following blog post from Tim Iacono.

Spain, the U.K., Luxembourg, Portugal, Ireland - who's next to succumb to the scourge of deflation? Yesterday, the New York Times reported that Spanish merchants have been slashing prices with abandon, auguring in the possibility of a dreaded "deflation death spiral".

Prices dipped everywhere, from restaurants and fashion retailers to pharmacies and supermarkets in March.
...
With the combination of rising unemployment and falling prices, economists fear Spain may be in the early grip of deflation, a hallmark of both the Great Depression and Japan’s lost decade of the 1990s, and a major concern since the financial crisis went global last year.

Deflation can result in a downward spiral that can be difficult to reverse. As unemployment rises sharply and consumers cut spending, companies cut prices. But if sales do not pick up, then revenue can decline further, forcing more cuts in workers or wages.

Once again, falling prices are characterized as the potential source of much bigger problems ahead, as if the world had something even remotely close to "sound money" where currency maintained its value over long periods of time as it did in the U.S. prior to the creation of the Federal Reserve in 1913.

To review -- in the hundred years prior to the Fed, inflation rounded to zero, whereas, in the nearly hundred years since 1913, the U.S. dollar has lost 96 percent of its value.

Policies that have resulted in this loss of value, now accepted as conventional wisdom by central bankers around the world, make real deflation (the minus 10 to 15 percent per year variety, not the -0.1 percent Spanish version) a near impossibility today.

But, that doesn't stop dimwitted dismal scientists from looking there instead of at the bursting of the biggest asset bubble in the history of Mankind when identifying villains in the current economic and financial market maelstrom.

“It doesn’t mean it will spread here to the U.S., but we need to look closely at Spain and other places to understand the dynamic,” says Simon Johnson, a professor at the Sloan School of Management at the Massachusetts Institute of Technology and a former chief economist for the International Monetary Fund. “It’s like the front line of a new virus outbreak.”

If only economists would spend more time examining how they failed the world so miserably over the last few years instead of at a 19th century phenomenon, we'd all be better off.

In the U.K. too there is much gnashing of teeth where annual deflation is running at a whopping four times the rate now experienced to the south - minus 0.4 percent.

The funniest thing about English deflation is that it is, in large part, directly caused by central bank actions. The broadest measure of consumer prices includes mortgage costs, the vast majority of which are variable rate loans, and, as short-term rates have been slashed, these consumer costs have tumbled as detailed in this report in the Telegraph.

The Retail Prices Index (RPI) measure of inflation fell to -0.4pc in March, indicating that prices paid by consumers last month were lower than a year ago - a trend not seen since March 1960.

RPI inflation, which includes housing and mortgage costs, has been driven down by the the series of aggressive interest rate cuts from the Bank of England which have triggered lower variable rate mortgage repayments .
...
The economy is expected to remain in deflationary territory for many months, which will mean pensioners will receive the lowest possible increase of 2.5pc next year, adding just £2.40 to the full weekly pension, an amount criticized as "derisory and pathetic" by campaigners.

If health care costs in the U.K. are anything like those in the U.S., there are probably a lot of irate senior citizens.

A related story explains why we should all be fearful about deflation beginning with the moronic example of how, after television prices have been falling for the last 20 years, additional price declines will cause consumers to think twice. Really!?

1. It causes consumers and businesses to feel concerned about spending. Why buy that £400 television this week when you are confident it will be cut in price to £350 next month? The same applies to businesses – why invest in new machinery, or software when you think it will fall in price? Deflation can, if it becomes entrenched, cause the whole economy to grind to a halt.

2. Deflation causes wage cuts. Employers can argue that they do not need to give their staff a pay rise, because their staff can buy more goods with the same salary. Many companies are freezing pay and started cutting wages in some cases.

3. In theory, falling wages should not matter if the price of goods and services fall as well. But in practice it is very damaging psychologically. People paid £30,000 one year do not like being paid £29,000 the following year even if they can buy the same amount of goods. Everyone feels less wealthy, especially home owners whose main asset is falling in price. And when they feel less wealthy, they spend less, causing a vicious downward spiral in the economy.

4. Deflation causes the value of people's debts to mount. A £100,000 mortgage might cost £4,000 to service each year, but the value of the house could fall by £4,000 or more – a dispiriting experience, but you will still need to keep on servicing the debt.

Wage cuts, tumbling asset prices, and making debt service more expensive are all legitimate arguments but falling consumer prices really don't belong in this discussion unless it's something more than volatile energy prices and, in the case of the U.K.-style deflation, lower interest rates caused by the central banks that, ironically, are desperately trying to avoid seeing consumer prices move lower.

For a more complete discussion on this subject, see Seven key points on deflation or the many other items categorized under "deflation" at this blog.

This post can also be viewed in themessthatgreenspanmade.blogspot.com.

Switzerland Cuts Interest Rates: Swiss Franc To Fall Hard

Switzerland has decided to match the U.S. Central Bank's near zero interest rate policy and as a result the Swiss Franc is set to take a beating. Currency expert Kathy Lien explains the impact of Switzerland's decision on their currency, and even throws out some potentially profitable trades for currency investors in her blog post below:

Switzerland has officially adopted a beggar thy neighbor policy approach by intervening in the currency market. This morning, they cut interest rates by 25bp to 0.25 percent matching U.S. levels. They have officially embarked on Quantitative easing and will be buying domestic and foreign bonds (fully synopsis of SNB rate decision) .

Source: FX360.com

For currency traders, this means that a BIG seller of Swiss Francs have just entered the market. They have deep pockets and will probably be in the market for a while. Therefore, expect more losses in EUR/CHF and USD/CHF, both of which have hit 2 month highs. Such a strong move begs a correction but ultimately, I believe that EUR/CHF will hit 1.55 and USD/CHF will break 1.20.

The US retail sales report was much stronger than the market expected and this should add to the gains in USD/CHF, which has already outperformed EUR/CHF this morning.

There are still unanswered questions such as how much Swiss Franc the SNB will sell, the scale of bond purchases and additional liquidity. Their announcement today is aimed at accomplishing 2 goals at their expense of their neighbors which is protect their export sector and prevent the economy from falling into a deflation trap.

This post can also be viewed on kathylien.com.

Defaults By Developing Countries Could Be Next Economic Timebomb

Just in case we needed one more thing to worry about, economic struggles in developing countries could cause them to default on their loans. This would have an effect on most developed countries, including the US. According to research compiled by Kathy Lien, though, the most vulnerable countries look to be in Western Europe. These countries lent a ton of money to developing countries, especially in Eastern Europe where unfortunately they are experience some very serious economic problems. Kathy Lien exposes more about this in her blog post below:

A time bomb is waiting to explode in the Eurozone with Western European banks at risk of defaults on Eastern European loans. This leads me to wonder how much the US and the UK are exposed to developing countries. So I compiled the following charts from the latest Bank of International Settlements data (as of September 2008).

Euro area loans to developing nations are heavily skewed towards Eastern Europe while UK lends predominately to Asia, Africa and the Middle East. The US on the other hand lends primarily to Asia and Latin America.

Default risk in Asian nations are lower than Eastern European nations, which makes the UK and US less vulnerable if a time bomb explodes in Eastern Europe.

Meanwhile USD/JPY hit a 6 week high this morning after President Obama announced a foreclosure program.

Follow the jump for Eurozone and Switzerland charts

This post can also be viewed on kathylien.com.

What The Central Bankers Are Saying...

Central bankers wield a lot of power in today's economies. Their mistakes can make a profound impact on the economy of their country, and even other countries. When these powerful figureheads talk the economic world listens. The slightest slip of the tongue can crash markets or send them shooting through the roof. James Picerno from The Capital Spectator takes a look at some recent quotes from Central bankers from across the world in his blog post below.

Central bankers aren't gods, even if a few of them sometimes think otherwise. For proof of their mortal status one need only survey the various errors linked to this group in the 21st century. Yes, many central bankers made good, even superb decisions. But there were also some rather large lapses in judgment in matters of monetary policy and related matters in recent years. Arguably the ill-advised decisions overwhelmed the brilliant ones. A number of central bankers tell us so.

Of course, the private sector made more than a few errors too. In sum, the blame for the current troubles stretches far and wide. But when it comes to concentrated power, and the capacity for generating pain or pleasure, central bankers are second to none. They're an influential lot—influential on a grand scale. For that reason alone, listening to what they say is productive, or shocking—especially when they're deconstructing what went wrong in the run-up to the crisis now pummeling the global economy.

With that in mind, here are a few choice quotes (courtesy of The Bank for International Settlements) from recent speeches by members of world's most elite and potent financial club. We don't necessarily agree with all that follows, but we're listening closely.

Mario Draghi, governor, Bank of Italy, 16 December 2008
One striking aspect of the crisis is precisely how its unfolding has continued to catch both policy makers and private sector players by surprise. It started with defaults in a marginal segment of the financial services industry, then quickly spread to virtually all assets. From being a US-only event, it has become global, and in fact it is forcing and accelerating the redressing of world macro imbalances that have been with us for 15 years. The current recession is the result.

Amando M Tetangco, Jr., governor, Central Bank of the Philippines, 2 February 2009
The roots of the US financial crisis can be traced back to the early years of this decade when the United States aggressively eased its monetary policy to facilitate recovery from the dotcom bubble and the September 11 terrorist attacks. If you will recall, the US Federal Reserve began a cycle of cuts in the Fed funds target rate from 6.5 percent in May 2000 to as low as one percent by June 2003. On the fiscal front, large public deficit spending beginning in 2001 was pursued to prop up the economy which was then on the brink of recession. The low interest rate regime fueled a boom in mortgages, including among borrowers with doubtful credit histories or those fancifully called NINJA loans – that is, loans to No Income, No Job or Assets loans. Thus, house prices in the US began rising in 2000, surpassing the growth of disposable income. The excessive lending itself would not have brought in such great financial distress because if the borrowers turned out to be poor borrowers, then foreclosures would just have followed. However, what made this risky behavior turn into a crisis event was the bundling of mortgages by various financial institutions into complex securities such as collateralized debt obligations (CDOs) which were largely unregulated.

Hervé Hannoun, acting general, manager, Bank for International Settlements, 7 February 2009
The global financial crisis and its macroeconomic fallout have dramatically changed the agenda of the central banks, fiscal authorities and supervisors and regulators. The change is illustrated by a remark surfacing repeatedly in the current economic debate: “We are all Keynesians now.” In some sense, indeed we are. But history teaches us that, in designing economic policies, policymakers always need to look beyond the short time horizon that crises seem to impose on us. In my view, current expansionary policy responses risk a failure to capture two crucial and interrelated facets of the present crisis. The first is that it is part of an underlying adjustment towards more sustainable macroeconomic conditions. The second is that it is a crisis of confidence which requires a recognition of the rational expectations of economic agents and of the behavioral effects associated with expansionary fiscal policies. To restore confidence in a sustainable way, policy actions should be credible from a medium-term perspective, address existing economic imbalances and pay attention to economic agents’ expectations.

José Manuel González-Páramo, member, executive board,
European Central Bank, 6 February 2009
The start of the financial crisis was triggered in the summer of 2007 by the realisation that the risks associated with the US market for sub-prime mortgages were not properly reflected in the price of related instruments, particularly mortgage-backed securities. A market-wide reassessment of financial risk led to sharp increases in premia and spreads across all segments of the credit market. The rapidly falling market values of credit instruments hit both the net worth and the profitability of the banking system.

Philipp Hildebrand, vice-chairman, governing board, Swiss National Bank, 5 February 2009
Financial markets react to incentives, and these incentives were misplaced in the past. It is in our power to start lobbying for clearly defined and risk-limiting conditions. If the responsible authorities wish to enact more stringent regulation, we ought to give them our unconditional support.

Christian Noyer, governor, Bank of France, 11 December 2008
In many respects, the current crisis is about valuation. To be sure, the factors underlying and accounting for the crisis are numerous. However, one of its significant features is that the uncertainty surrounding the “true” value of complex financial instruments has undermined the confidence of global markets, increased uncertainty about counterparty risk and led to contagion across asset classes, financial markets and economic regions. The crisis has highlighted the fact that the valuation of financial instruments is not only a question of accounting. It raises issues about risk measurement and management by financial institutions, prudential issues via the definition of capital requirements and, more widely, financial stability issues. However, valuation is also without any doubt an accounting issue. It is therefore hardly surprising that the debate about the application of accounting standards to financial instruments is a highly topical one.

Jürgen Stark, member, executive board, European Central Bank, 10 December 2008

For too many years financial market participants were used to a macroeconomic environment with high global output growth, low inflation and very low interest rates. Macroeconomic policies led to global and domestic imbalances which became increasingly unsustainable with debt financed over-consumption in one region and high savings in other regions. An overall benign macroeconomic environment led to (i) a general carelessness or a tendency to under-price risks and (ii) to a search for yield which in turn accelerated financial innovation.

Lorenzo Bini Smaghi, member, executive board, European Central Bank, 9 December 2008
When analysing the current financial crisis the temptation might arise to attribute all the responsibilities to the excesses of the US financial system. I think this would be a mistake. While excessive debt creation and risk mispricing are clearly the root cause of the crisis, we should not forget that in order to make a market you need buyers and sellers. And this crisis is as much a crisis of sellers as of buyers.

This post can also be viewed on capitalspectator.com.

EU Leaves Interest Rates Unchanged In Risky Move

All over the world central banks are dropping key interest rates in an attempt to stimulate lagging economies. Why then would the head of the European Central Bank leave interest rates unchanged despite wide spread economic turmoil among EU countries? Kathy Lien shares her thoughts on Trichet's controversial decision, along with the potential impact to currency markets, in her blog post below.

Here is a snippet of my comments about this morning’s price action on FX360.com:

There has been a lot of action in the currency market this morning, mostly centered on the British pound and Euro.

ECB President Trichet is not buckling under pressure. After leaving interest rates unchanged at 2.00 percent, he refused to make any decisive comments on where interest rates are headed in March. Trichet is still buying time to see how the economy and price pressures respond to their recent rate cuts. The Euro has held steady because Trichet said he is not pre-committing or excluding anything. The zero interest rates that Prof Roubini is calling for is out of the question especially for a central bank that remains obsessed with inflationary pressures. Trichet acknowledged that inflation will continue to fall but he expects it pick up in the second half of the year and if oil prices rebound, the acceleration of price pressures could exacerbate. Rather than being completely downbeat about growth, Trichet said that even though the risks are clearly to the downside, there are signs of stabilization. By postponing rate cuts, Trichet is putting his credibility and reputation on the line.

The ECB cannot stop cutting interest rates at this time especially as we continue to see very weak economic data. German factory orders fell 6.9 percent in the month of December, more than double the market’s forecast. Trichet who is known for his candor has already admitted that 2 percent will not be the lowest level for Eurozone interest rates and the market may be right to bet on a 50bp rate cut in March. If he doesn’t plan to cut interest rates to 1.5 percent next month, he would not comment on the market’s expectations. Although zero interest rates is off the table, we do not think that the ECB will stop at 1.50 percent. Interest rates could fall as low as 1 percent, which is why we could see more weakness in the Euro.

EUR/GBP Crushed After BoE Rate Decision

EUR/GBP collapsed following the Bank of England’s decision to cut interest rates to 1 percent. Even though the yield advantage in EUR/GBP has increased from 50bp to 100bp in the Euro’s favor, the market is less focused on interest rate differentials and more focused on recovery. The pound is trading higher because the Bank of England and the UK are being rewarded for their aggressive monetary and fiscal stimulus. The Euro on the other hand is being punished for implementing sluggish monetary policy.

This post can also be viewed on kathylien.com.

What Does February Have In Store For Currencies?

January was a great month for the USD, and even better for the Japanese Yen, but what does February have in store for the currency market? Investors should pay close attention as currency expert Kathy Lien attempts to answer that question in her blog post below. Investors should know that past performance doesn't necessarily represent future performance, but it certainly can help investors make educated decisions.

In the beginning of January, I highlighted the effect of seasonality on the EUR/USD. At that time, I talked about how the EUR/USD has a natural bias to sell-off in the first month of the year as investors reverse their year end flows. Since 1997, the EUR/USD has sold off in the month of January 72.7 percent of the time. If we include the currency pair’s price action in 2009, the EUR/USD has now sold off 75 percent of the time in January. The combination of falling interest rates in the Eurozone, recession and a flight to safety into US dollars has led to the strongest January sell-off in the EUR/USD in more than a decade.

February Performance

Now that January is behind us, many forex traders may be wondering if there are any unique characteristics in the currency market for the month of February. Taking a look at more than 30 years worth of data, we have found that on average the trading range in USD/JPY tends to compress in the second month of the year. In fact, of all 12 months, the average trading range in USD/JPY is lowest in February. Lower volatility could mean stability for USD/JPY because high volatility hurts Yen crosses (A Turn in USD/JPY?).

Currency Performance Since January

The final chart (after jump) illustrates how all of the major currencies have performed against the US dollar in January. So far, the Japanese Yen has been the only currency to outperform the greenback.

This post can also be viewed on kathylien.com.

World Enters Recession: Time For Global Action?

So while the U.S. may not have officially entered into a recession, those who don’t realize a recession is among us are in denial. Recessions are always announced well after they actually begin, and you can bet the announcement will come soon enough. The U.S. isn’t alone, though; the Euro Zone and Hong Kong recently announced a recession, along with several other countries. This economic downturn is a global phenomenon and everyone is being affected. The Prime Minister of Britain, Gordon Brown, has even started campaigning for a global response to the economic problems plaguing the world. Even if Brown can convince all the developed countries to act in unison, will it be enough?

Brown is coming to Washington in an attempt to get the U.S. on board with his plan, but many of his ideas--such as creating so-called colleges of supervisors for the world's largest financial institutions, where regulators from the countries in which the firms operate would meet to swap information and coordinate responses in an emergency--have not been received well in the past, according to the Wall Street Journal. Brown is also trying to restart the Doha round of international trade talks that collapsed earlier this year. Maybe governments will change their minds and be more willing to make compromises considering the magnitude of the economic problems, but it is hard to say.

I like what Brown is trying to do, as it seems that the world working together would be able to fix the problem better than everyone working individually, but I doubt his success. Trying to get this many countries on the same page working together for one purpose is going to be extremely difficult. Obviously everyone is going to be looking out for their own best interests, and trying to weed through that to come to an acceptable compromise is going to require a lot of time and a small miracle. I just don’t think Brown is going to be able to pull it off. Even if he is able to do it, though, would it really fix our problems?

I doubt that it will be able to make everything better, however if anything is going to work, I suppose a major global effort would be near the top of the list. In my mind, though, there are too many problems that need to be worked out, especially in the U.S. Sure, we might be able to put a Band-Aid on the problems and stop the bleeding for a while, but the wound isn’t going to heal with just a Band-Aid. We really need to address the problems and take action, action that will require diligence and time. Unfortunately in our “now” society, we want the problems fixed right now, even if those fixes are only temporary.

British Pound Due For A Pounding

Last week the Bank of England surprised everyone by cutting their key interest rate by 1.5 percent. With their economy still struggling it seems like the rate cuts won't likely stop there either. This will have serious implications on the value of the British pound. Currency expert Kathy Lien evaluates the situation in her blog post below.

When the Bank of England cut interest rates by 150bp last week, I turned aggressively bullish EUR/GBP on the belief that interest rates are headed below 2%. The currency pair has now hit a record high as the market realizes that not only will UK interest rates fall below 2%, but could be headed to Japanese levels. Against the dollar, the British pound has fallen to fresh 6 year lows but the historically significant moves are in EUR/GBP.

According to the November Inflation Report, the monetary policy committee believes that inflation will fall below their 2 percent target with the potential of hitting 1 percent. With price pressures expected to ease significantly, the Bank of England sending a strong signal that interest rates will continue to come down.

There is talk that the recessionary conditions in the UK economy could turn the UK into the next Japan. Another 200bp of easing by the end of the first quarter has been priced into the markets, which would take interest rates to 1%. If the BoE chooses to overshoot monetary stimulus, UK interest rates could be at Japanese levels.

Mervyn King has become quite a maverick and we would not be surprised to see another large rate cut from the central bank.

When the dust settles, the UK’s aggressive monetary stimulus should turn their economy around faster than the Eurozone or the US, but in the meantime, more rate cuts mean more weakness for the British pound.

This article has been reposted from Kathy Lien. The full post can also be viewed on KathyLien.com.

Iceland’s Collapse: Magical Elves Lose Toyshop; Will Enchant For Food

Global credit crisis or not, I’m sick of reading (and typing) the words “crumbling” and “tumbling”, “freefall” and “meltdown”, and “bottomless pit of despair and agony”. So I’ll start this post by saying that I will use “Reykjavik” as a noun and verb to describe all of these concepts (and a few others), all in honor of Iceland: the first major casualty of this totally Reykjaviked financial situation on our hands.

Iceland has always been an insular place. The lush, little ball of lava was first colonized by Vikings and magical elves who didn’t much care for the stodgy mainlanders. Their tradition of aloofness and fondness for haddock has remained to this day. This aloofness survived even during the past few years as the island became a tourist spot known for its unique art scene, stunning natural beauty and lively nightlife. Meanwhile, the inflated economy and high interest rates drew millions in foreign capital from investors hoping for a better return on their deposits. This created two illusions for Icelanders: 1) the illusion of wealth and 2) the illusion that the rest of the world gave a Reykjavik about them.

Were Icelanders wealthy? Everyone seemed to think so because of the expansive assets that the three major Icelandic banks acquired throughout Europe over the last decade—Hanley Toys being one, because you know elves and toys are inseparable—all totaling 100 billion Euros. In a country whose GDP is less than 10 billion, that presents a slight problem when liquidity freezes: Like a shiny, spinning top, the tiny base that the government offered was only enough to support the floating island of wealth if enough hands kept it in motion. Those hands drew back very quickly when two of there three major banks, Glitnir and Landsbanki , were seized one after the other. Alas, no amount of geothermal hot springs and/or elf magic was enough to thaw the hearts of authorities in London and the Netherlands, who froze the assets of Iceland’s last major bank standing, Kaupthing, when it became clear that depositors from the two countries had no guarantee on their assets should the bank collapse. The move ironically sealed the fate of the institution, and perhaps of the country at large.

Icelandic PM Geir Haarde was less than pleased by this pre-emptive move, and it’s only by the good (and ever-sinister) graces of Vladimir Putin that Iceland has any continental support at all. The country received a four-billion Euro loan from Moscow, but with the value of the Krona now less than half of what it was at the beginning of the year, one must wonder how they ever intend to repay Russia. It may not be with cash...

Russia and Iceland do have one thing in common: a sense of isolation from the rest of Europe, though the Icelandic dislike of authority doesn’t quite mesh with war-mongering (and perhaps secret-assassination happy) Putin. Iceland’s isolation is a little more innocent. For example, their decision to remain outside the E.U. was largely motivated by the restrictions that inclusion would have placed on their fishing and whaling industry, which is one of their only major exports aside from twee, nonsensical music. Now some are suggesting that they be given a fast-track to E.U. citizenship to stabilize the country—Strike one against Iceland’s culture. Iceland’s decision to expand its assets into new territories allowed its young entrepreneurs—and louts, alike—to adopt the mantle of hip jetsetters and hypertrophic consumers without making cultural concessions at home. Now, in major debt to Mother Russia—and perhaps soon to the IMF as well, though Iceland has not yet officially requested aid from the Washington-based institution—the question is: What will be left of Iceland after the bill-collectors have taken their due?

Iceland has many natural resources, and Russia may find the prospect of tapping them increasingly attractive as Putin’s regime pawns off much of their own to China. However, sacrificing the island’s ecological integrity is in complete conflict with Iceland’s national pride as well as with their other major draw: eco-tourism. The pristine and dramatic landscape is home to the breeding grounds of many European birds, and spoiling the land would draw conservationist ire from around the globe. Despite clinging to their small and—I grudgingly admit—relatively responsible whaling industry, Iceland has until now been a beacon for environmental progressiveness. Sadly, sacrificing the land to save the economy may be unavoidable at this point, depending on how scrupulous the country’s saviors choose to be with their stake in the economy. An IMF loan would be the first offered by the agency to prop up the economy of a developed nation. As of Thursday morning (October 23) the rumored figure was in the area of 6 billion dollars, much of which would go towards loans held by banks in Japan. At least Japan—with their mutual penchant for whale meat, isolationism and living around active volcanoes—is a far better bedfellow for Iceland than Russia.

In short, Iceland’s tale is that of the classic, rakish decadent, who in a short time squandered his wealth, his reputation and perhaps his future for a few cheap thrills. And the worst is not over; the spending spree in the good times and the high interest rates at local banks encouraged the citizens to seek loans abroad, which they must now repay with a deeply devalued currency. Even the cheap labor force—Poles and Lithuanians—have packed up and left as they no longer profit by sending their meager paychecks home. There is no telling how Iceland will dig itself out of this fumarole, but one can be certain that the country will change dramatically as they dig and dig and dig—all on their own, for now. At least they’ll always have the Aurora Borealis—or perhaps it too will be blotted out by the smoke of industry that may yet be coming. That would be a Reykjaviking shame.

The European Central Bank's Balance Sheet Continues To Grow

The European Central Bank continues to pump money into the financial system in order to combat the financial crisis in Europe and the rest of the world. These measures are not without ramification, though. You can read the full blog post below, or you can visit The Prudent Investor blog for more information on the topic.

Politicians in the Eurozone are relieved these days as they see commodities and especially crude oil prices retracting to levels last seen a year earlier. But the improving outlook on the price front comes at the heavy price of monetary inflation.

The hope for a slowdown in price inflation is overshadowed by the terrifying numbers on the ECB's balance sheet that almost touched the €2 TRILLION level with a balance sum of 1,973 billion as of October 17. This is 57% more money YOY while the European economy started slipping into a recession.

Lending to banks immediately took off to never before seen levels since the ECB changed its rules and now takes more or less any crap paper as collateral.

Monetary inflation is now clearly written on the wall as the expansion of the ECBs weekly financial statement has become ballistic.

Within only one week the ECB's lending increased 4.8% overall, according to latest figures. The unlimited swaplines of the Fed begin to show up here without a doubt.

Banks Doubled Borrowing Within a Year
In a YOY comparison Eurozone bank lending more than doubled from €471 billion to currently €1.057 trillion. This comes hand in hand with a continuous flow of downgraded expectations for the Eurozone economy that may record a contraction in the last quarter of 2008.

The ECB's loose hand may have prevented a systemic disruption so far, but if the speed of money creation does not get reduced Europe could find itself saddled with runaway monetary inflation as there is an explosive lot of money sloshing around a steady pool of products and services.

IMF Warns of Sharp Slowdown
The IMF warns of a sharp slowdown as the financial crisis takes its toll on Europe. According to its latest outlook released on Tuesday,

Europe is facing its worst financial crisis in decades. Credit growth is slowing and domestic demand is weakening across the continent. At the same time, past commodity price increases have boosted headline inflation, depressing consumption.
In advanced Europe, a mild recession is expected in the near term. Real GDP growth is projected to drop to 1.3 percent in 2008 and 0.2 percent in 2009 (down from 2.8 percent in 2007). Growth is weakening in the emerging economies as well.

The IMF predicts a mild recession for Italy, Spain and the UK in 2009.

Latest forecasts for Europe from the IMF

In order to avoid a sharper downturn the IMF pledges for coordinated action of European governments. This call went so far unheard. European politicians may be setting up common meetings, but so far each country has taken its own way in order to end the credit crisis.

This article has been reposted from The Prudent Investor. The full post can also be viewed on The Prudent Investor.

Both Europe And Japan Economies Shrink: Emerging Economies Next?

In Q2 of this year, the Euro Zone saw its GDP shrink 0.2 percent and Japan’s GDP saw a decline of 0.6 percent, according to the New York Times. Since we have been focusing so much on the doom and gloom surrounding the U.S. economy, I thought it would only be fair to talk about the problems in the rest of the world, too.

This Euro Zone’s decline is the first quarterly decline that the group of nations has experienced since joining forces under the Euro in 1995, according to the New York Times. The Euro Zone’s two big economies, Germany and France, both contracted individually. Germany’s decline was more or less expected, and came in at 0.5 percent. On the other hand, France’s drop was a big surprise, according to the New York Times; it came in at 0.3 percent.

Japan, which represents another of the Group of 7 (G-7) economies, also has been hit hard. They reported a decline in their GDP of 0.6 percent. The G-7 consists of the U.S., Japan, U.K., Italy, France, Germany and Canada. When the group was formed, these seven countries represented the seven largest economies in the world. This make-up has changed thanks to China’s tremendous growth over the years, but these seven economies are still all toward the top of the list. Not one of these seven economies is doing well at this point, and it is possible that all of them could see economic contraction before the year is out. The U.S. has avoided one thus far, but let’s see how things look once the stimulus package impact wears out. The U.K. barely squeaked out gain in Q2 and many economists are predicting that their economy will contract in Q3. With the largest economies in the world all struggling, it seems we are set for a widespread global slowdown.

You can be assured that when all these countries slow down at the same time, the lesser economies of the world will suffer, too. No economy is completely shielded from all these economic powerhouses. Investors would do well to remember this, as well as that emerging economies, while offering diversification, are also much more volatile than developed economies. The biggest losses will likely be seen in the smaller countries. Don’t get me wrong--I’m a huge fan of emerging markets over the long term, but investors need to take proper precautions right now to protect themselves, because things are only going to get worse on the global scene.

Europe’s Economic Outlook Doesn’t Appear Much Better Than U.S.

Seeing how the U.S. dollar, along with most other world currencies for that matter, has fallen against the Euro, one would think that the Euro Zone (countries of the European Union which use the Euro) was in great financial shape, but that isn’t necessarily the case. Spain and Ireland in particular are suffering mightily as they were unable to control the booms (see One Interest Rate, 13 Economies article), and now busts of their economies. The two stalwarts of the Euro Zone, France and Germany, have been holding the Euro up thus far, but now even their economies are starting to feel the heat. Oh, and don’t forget about the U.K.--even though they are not part of the Euro Zone, they are one of the largest economies in Europe and their outlook looks especially grim.

The German ZEW economic sentiment indicator has plunged to a record low, French business confidence has dropped, retail sales are down sharply and European companies are starting to default on their debt at alarming levels, according to Money Morning, an e-mail newsletter from MoneyWeek magazine. These are all obviously negative signs that point to the fact that the Euro Zone is heading in the wrong direction economically.

The U.K. isn’t doing all that great either. The U.K. had the same sort of run up in housing prices experienced in the U.S., only their down cycle is just beginning. Furthermore, their economy is driven by two key industries, construction and finance, both which are doing extremely poorly right now.

Even with the troubles being experienced in the U.S. the dollar could regain some ground against the Euro and British pound. While this might please travelers who are looking to visit Europe in the near future, there is a big concern to keep in mind with all this. When we talk about struggles in the U.S. and Europe, we are talking about the largest importing countries in the world. You can bet that if all these countries struggle at the same time, it will be felt across the world. We very well could be headed for a serious global recession of sorts, and investors certainly should be keeping that in mind.

Fuel Strike In Spain

In response to high fuel costs truckers in Spain have decided to go on strike. The truckers want the government of Spain to pass a law establishing a minimum price for their services, and to make sure that their contracts better reflect the fluctuating cost of fuel, which has risen by more than 20 percent since the beginning of the year, according to BBC News.

This fuel strike, which involves around 90,000 drivers--most of whom are self-employed--has the potential to cause some serious problems for Spain and its inhabitants. Already people are lining up at grocery stores and gas stations around the country, trying to get as many supplies as they can before stores start running out of goods. The striking truckers have warned the public that stores will only be able to last a couple days, according to the BBC article.

The truckers know that the country can’t run without them and they are making their voices heard, but are they going to be successful in their campaign? Part of the problem is that the Spanish government has a limited number of options available to it thanks to its arrangement with the EU. For example, it is required by the EU that member countries place at minimum a 15 percent value add tax (VAT) on fuel. In addition, the EU restricts the use of certain fuel subsidies, according to the BBC.

What the truckers want is more money to account for the business cost increase of more than 20 percent, and one way or another, they are going to have to get it. "We have no more solutions. We can't afford diesel any more. It's as simple as that," Jean-Claude Ferrand told Spanish national radio, according to the BBC.

If the government can’t offer subsidies what they might have to do is help negotiations between the truckers and the suppliers. Ultimately, either the government offers a subsidy or the suppliers are going to have to pay more to have their goods delivered. Looking at the options available it appears that likely the suppliers will be the ones fronting the costs, which of course will be represented in price increases and in the end borne by the consumer. Either way, though, it was going to come down to the consumer; they were going to pay for it either through their tax dollars or through increased goods prices.

Spain is making the headlines now, but with the way fuel costs keep rising, they are unlikely to be the last ones with this problem. Look for more and more truckers to substantially raise their prices or go on strike--or else out of business. Either way, supply and demand pressures are going to push prices higher to account for the increase in transportation costs.

The Federal Reserve And European Central Bank: A Difference Of Opinion

The Federal Reserve and European Central Bank have a very different opinion when it comes to managing economic policy. This is especially apparent when one looks at how their respective currencies, the dollar and the euro, have performed against one another. It seems that every day, the euro is setting a new high against the dollar. There is a great article in The New York Times that talks about this very issue, but I will attempt to summarize it here. Let’s take a look now at how the two central banks ideologies compare.

The Federal Reserve’s number one priority is economic growth. Their thought is that if growth stalls, then so will demand and inflation. To the Fed inflation is simply a byproduct of growth, so they aren’t too concerned with controlling it directly. They would rather control growth, and thus indirectly control inflation.

The European Central Bank focuses on growth as well, but they are also very concerned with inflation. They do not necessarily agree with the idea that inflation can be controlled (at least to their satisfaction) solely by focusing on growth.

Growth has been slowing both in the U.S. and in the European Union, but the central banks have had very different responses. The Fed has responded with a series of rate cuts, and will likely make even more of them, while the European Central Bank has left their key interest rates in place. In the U.S., the drastic rate cuts haven’t had much effect in ramping up the economy, and growth has come to a halt. In addition, inflation has been increasing dramatically, inspiring some to proclaim that the U.S. is entering into a period of stagflation. Growth in the European Union has continued to slow and inflation is above target at around 3 percent, but on both counts they are doing a little better than the U.S.

It is extremely hard to compare economic policies in this way because the two subject economies are very different. It will be interesting though to see how the two differing policies turn out in their results. I’m not a big fan of how Bernanke runs things, and I’m leaning towards the European Central Bank working out better, but we will just have to wait and see.