From the April 01, 2010 issue of Futures Magazine • Subscribe!

World rattles on wobbly euro/dollar axis

The IMF has projected Japan’s gross debt for 2010 at 227% of its annual GDP, reflecting continuation of a trend that’s kept the country in a deflationary period for years.

“The Japanese have said over and over again that they’re committed to battling deflation,” says Hoversen. “Whether that means increasing their QE (quantitative easing) program or deploying another round of emergency policy tools I can’t say, but their rhetoric indicates they’re very much ready to do both.” She points out that the recent Economy Watchers Survey of business-cycle sensitive workers showed optimism, but not enthusiasm, and that Finance Minister Naoto Kan has repeatedly harangued the Bank of Japan for failing to take action despite projecting another two years of deflation at least.

The government set a target of 2% real annual GDP growth over the next 10 years, and Kan says that plan is contingent on an inflation rate of 1%. Neither he nor Prime Minister Yukio Hatoyama has called for an outright inflation target, but pressure to take action is mounting.

With its key interest rate at 0.1%, the BOJ’s options are limited. It has, however, twice conducted massive infusions of three-month funds to ratchet up liquidity — once in December, and once in March. The bank accepted bonds as collateral in both of those actions, and also has promised more stimulus to come. The next step might be an outright buy-back of bonds, says Holger Schindler, who manages currency risk for Hanseatisches Logistik in Hamburg.

“The BOJ really prefers to let things ride,” he says. “They want to act gently to prevent being given a mandate to set an inflation target. So, you’ll see little nudges and maybe intervention when we get above a certain level, but they don’t want to do more.”

Those interventions may not be far away. The country recently announced it would raise its borrowing limit to raise its war-chest for market interventions, a practice it gave up six years ago. The BOJ will be reviewing its long-term strategy on Apr. 30, and rhetoric surrounding that meeting will begin jostling the yen more and more as the date approaches.

China may be the world’s largest exporter, but Germany is number two, and China is one of Germany’s largest non-EU export destinations. Furthermore, Germany’s exports to China are high-end goods and services such as factory machines and engineering expertise.

Unlike its neighbor, France, Germany hasn’t managed to create the kind of domestic demand that will sustain it in bad times. Indeed, Chancellor Angela Merkel has openly expressed an unwillingness to try and do so.
That leaves the euro at risk of further depreciation if China slows — a risk that also extends to the Australian, New Zealand and Canadian dollars. These commodity currencies have remained strong at the end of 2009 and beginning of 2010 despite the surge in the dollar. But if Chinese demand for commodities slows, these currencies will take a hit.

The United Kingdom is gearing up for a general election to be held on or before June 3, and you can bet markets will be watching carefully as the pound continues to struggle back from a two-year slide that bottomed out in early 2009.

“As the polls get a little bit closer, anything under a 10% lead for the Conservative party is moving into hung parliament territory, and the latest polls are showing just a 5% lead, which is well within that range,” Furness says. “At the same time, there is an awful lot of M&A activity in the background, and whilst equity markets remain volatile, plenty of hedge adjustment currency trade by UK fund managers, which could mean UK buying.”

Furthermore, he says, central banks tend to buy sterling as it falls to keep their reserves diverse, a fact often lost on the market at large.

So at least some of that bodes well for the pound, but the downside isn’t difficult to see: the country has the highest budget deficit of the G7 nations, and when former IMF Chief Economist Kenneth Rogoff warned that a default in Greece could set off a chain of sovereign defaults across the developed world, many eyes turned to the UK. Indeed, as Greek woes intensify, the pound has been suffering.

Furness sees a rocky mid-term for the pound, and advises anyone looking to capitalize on the weakening euro to stick to the long dollar, although his favorite cross has been the euro/Swedish
krona cross.

“The krona is part of the dollar index, so it’s used in arbitrage trade,” he explains. “We’re forecasting higher interest rates for Sweden, and the Swedish central bank has been great at keeping the market fully in touch with where they think the interest rate picture is going.”

The euro has been sliding against the krona since early last year when it peaked at 11.71. At the beginning of this year, Furness’s company recommended adding to short euro/long krona at 10.30, with an objective of 9.60 by the end of 2010.

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