Ah, if only it were that simple…
The year began as a continuation of 2008. Global capital markets were still in the throes of the credit crisis, and risk aversion was in vogue. Investors continued to remove funds en masse from virtually every economy – with an emphasis on emerging markets – and parked the proceeds in the US. More specifically, they put the proceeds in US Treasury securities. US corporate bonds and equities declined, as did interest rates, to such an extent that short-term rates briefly dipped below zero.
As this trend gathered momentum, the Dollar continued its rally against virtually every currency, with the notable exceptions of the Swiss Franc and Japanese Yen. For reasons related both to the unwinding of the Japanese Yen carry trade and the bizarre perception that Japan was also a safe haven against the storm of the financial recession, despite the fact that its economy contracted by the largest amount of perhaps any economy due to its reliance on exports. Against other currencies, the Dollar was nothing short of brilliant, surging 30% against many emerging market currencies, and 50% against the Korean Won, from trough to peak. Some analysts predicted that it was only a matter of time before the Dollar reached parity with the Euro.
But it wasn’t to be, as the Dollar never topped $1.25 against its chief rival. The markets pulled an abrupt about-face in March, and began a rally that would last 8 months (and might still be in progress, depending on who you talk to). The S&P 500 rose by more than 50%, impressive, but still paling in comparison to emerging market equity prices. As investors grew more and more comfortable with risk, they reversed the flow of funds, and bond spreads between the US and the rest of the world gradually declined. More importantly, so did volatility. For the forex markets, that meant a rapid appreciation in every single currency against the Dollar.
Around the same time, the Swiss National Bank (SNB) intervened for the first time (it would intervene again in June) in forex markets, ostensibly to guard against deflation. As a result, the Swiss Franc has largely been exempted from the forex rally which sent the Euro up 15%, the Brazilian Real up 35%, and the Australian and Canadian Dollars back towards parity with the the US Dollar.
After a modest rally, the British Pound stabilized around pre-bubble levels, due to concerns about the UK’s quantitative easing program (i.e. wholesale money printing), and consequent impact on inflation and the British national debt. Similar concerns have plagued the US Dollar, but interestingly have spared the Euro and Canadian Dollar, despite the fact that their respective Central Banks’ response to the credit crisis have largely mirrored that of the Fed. As a result, the Pound was quickly segregated with the Dollar as a fellow “sick” currency.
By the summer, currencies and asset prices had risen by such an extent that investors began to fear the formation of bubbles. Governments and Central Banks, meanwhile, grew concerned about the potential impact of expensive currencies on their nascent economic recoveries. A handful of Central Banks – many in Asia – intervened successfully to thwart the appreciation of their respective currencies, while Brazil resorted to taxes to try to stem the appreciation of the Real. The Bank of Canada threatened intervention, while the Bank of Japan was more ambiguous; investors ultimately shrugged off both, and the Japanese Yen touched an all-time high against the Dollar in November.
Towards the end of the year, the rally began to lose steam as investors began to fret that they had gotten ahead of themselves. In addition, the prospect of interest rate hikes was moved to the fore, thanks to early action by the Bank of Australia. While it’s clear that the Fed won’t be moving to tighten monetary policy anytime soon, investors have been forced to re-evaluate their short-Dollar carry trade positions within this context.
Meanwhile, a handful of credit market scares, first involving Dubai, and later, a handful of EU member countries, reminded investors that the recovery was both fragile and unequal. As a result of the renewed focus on fundamentals, commodity currencies and currencies backed by strong economic growth projections, continued to appreciate. The Dollar, despite comparatively weak fundamentals, also appreciated, due to its safe-haven appeal and perceptions that the Fed would be among the earliest Central Banks in the industrialized world to hike rates. Ironically, forex markets ended the year ironically just as they began (though for different reasons), with the Dollar in the ascendancy.
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