Forex : Currency Trading : Brokers : Pips

Rumor has it that the Dollar is about to make a run. As the credit crisis slowly subsides, (currency) investors are once again looking at the long-term, and they like what they see when it comes to the Dollar.

For those that care to remember, 2008 was a great year for the Dollar, as the credit crisis precipitated an increase in risk aversion, and investors realized that despite its pitfalls, the Dollar was (and still is) the most stable and really the only viable global reserve currency. [This reversed a trend which had essentially been in place since the inception of the Euro in 1999]. In 2009, meanwhile, the Dollar resumed its multi-year decline, and many analysts were quick to label the rally of 2008 as an aberration.

Then came the debt crises, first in Dubai, then in Greece. Suddenly, a handful of smaller EU countries appeared vulnerable to fiscal crises. Japan officially became the first of the Aaa economies to receive a downgrade in its credit rating. The British Pound is dealing with crises on both the political and economic fronts. According to Moody’s, “The ratings of the Aaa governments — which also include Britain, France, Spain and the Nordic countries — are currently ’stable’…But…their ‘distance-to-downgrade’ has in all cases substantially diminished.”  Suddenly, the Greenback doesn;t look so bad.

I want to point out that in forex, everything is relative. (Novice) forex investors are often baffled by how sustained economic and financial crises don’t immediately result in currency depreciation. The explanation is that when the crises are worse in (every) other countries, the base currency still looks attractive.

This is precisely the case when it comes to the US Dollar. To be sure, the economy is still flawed, financial markets have yet to fully to recover, the federal budget deficit topped $1.8 Trillion in 2009, and government finances seem close to the breaking point. Moody’s has also identified the US as a candidate for a ratings downgrade. And yet, when you look at the situation in every other currency that currently rivals the US for reserve currency status, the Dollar still wins hands down.

Its economy is the world’s largest. So are its financial markets, which are also the deepest and most liquid. Its sovereign finances are still manageable from the standpoint of debt-to-GDP and interest-to-revenue ratios. It is the only currency whose circulation can even come close to meeting the needs of global trade. Summarized S&P – when it confirmed the AAA credit rating of the US, “The dollar’s widespread acceptance stems from the U.S. economy’s fundamental strength, which in our view comes from the economy’s size and the flexibility of labor and product markets. We view U.S. banking and capital markets to be dynamic and unfettered relative to their peers.”

That’s why auctions of US Treasury bonds remain heavily oversubscribed (demand exceeds supply), despite the rock-bottom interest coupons. China has reaffirmed its commitment to Treasuries (what other choice does it have), confirmed by some forensic accounting work. Gold might continue to rally. So will other commodities, for all I know. Emerging market currencies are still in good shape as well, but none of these will seriously rival the US Dollar for a long-time, if ever. In short, when it comes to the other majors, the Dollar is still King: “You can say whatever you want, but the dollar is the currency of last resort It’s the currency people want in a crisis.”

Following up on my last post, I want to use this post to write about the long side of the carry trade- specifically the Australian Dollar. The Bank of International Settlements (BIS) observed in a recent report that, “The role of short-term interest rate differentials in both the deprecations and their reversal has grown over time.” When you consider that the benchmark interest rate in Australia is now 4% and that interest rates in every other industrialized country (including Japan) or close to 0%, it’s not hard to connect the dots.

Earlier this month, the Reserve Bank of Australia (RBA) raised the benchmark by .25% for the fourth time since it began tightening. In an accompanying press release, the RBA stated that “The board judges that with growth likely to be close to trend and inflation close to target over the coming year, it is appropriate for interest rates to be closer to average. Today’s decision is a further step in that process. It’s worth noting that the Australian Dollar barely budged, because investors had expected the move. The larger question was, and still is, the ultimate extent of RBA rate hikes and how soon it will get there.

Glen Stevens, Governor of the RBA, has himself indicated that ”rates are still 50 to 100 basis points, or hundredths of a percentage point, below normal.” If you do that math, that means that the RBA will hike rates to 4.5-5% before stopping. Other more bullish analysts think 5-6% is a more realistic expectation because it is closer to the long-term average of Australian rate hikes.

As to when the benchmark will reach that point, it’s anyone’s guess. Going forward, analsysts have pegged the lilihood of an April rate hike at 40%. Said one analyst, “It’s now a line-ball call; indeed, if you put a gun to my head . . . I’d guess that the RBA is going to hike again by 25 basis points in April.” Still, most think that the RBA won’t hike again until May. Added another analyst, “They are not indicating any urgency. We think they will go again in a couple of months. It could be three months, it could be two, our formal view is two, that may depend on how the inflation numbers look.” It’s too early to project when the next next (after the next one) hike will take place, because it depends on the timing of the first one.

At this point, most Australian economic data is trending steadily in the right direction. “Australia’s economy is starting a new upswing…Unemployment fell to 5.3% in January, not far above levels considered full employment for the economy…A rebound in construction and an investment splurge in the mining sector are expected to restore growth in the economy back to historic averages by the end of 2010. The RBA has indicated it expects inflation to remain within its 2%-3% target band.” Without drilling too deeply into any of the other numbers, there’s very little reason to doubt that the Australian economic recovery is genuine, which reinforces the notion that it is only a question of when – not if – the RBA further hikes rates.

In fact, the picture surrounding the Australian Dollar is almost a mirror image of the Japanese Yen. While the Yen looks destined to fall irrespective of the carry trade, the Australian Dollar looks destined to fall. While further monetary easing in Japan will give the Yen a second life as a funding currency, higher rates in Australia will once again make it a popular long currency. In short, “With commodity prices likely to remain strong and the spread between Australian and US interest rates likely to widen further its only a matter of time before the Australian dollar breaches parity against the US dollar.”

In fact, the Australian Dollar just touched a 13-year high against the Euro – though that is as much due to the Greek debt crisis and Euro problems as it is with Aussie strength. Meanwhile, the Australian Dollar has zig-zagged against the US Dollar, and is now in a rising trend following a recovery in risk sentiment. Whether it sustains this momentum depends largely on whether the RBA hikes rates next month.

I can’t remember how long it’s been since I was hyping the Yen carry trade (though a browsing of the ForexBlog archives indicates 2 years). Upon the outset of the credit crisis, forex markets went haywire, and one of the main “beneficiaries” was the Yen, which soared as carry trades were unwound. Now, however, a similar set of circumstances that made the Yen carry trade attractive from 2006-2008 have re-appeared, and it looks like the trade could be on the verge of making a big comeback.

Practitioners of the carry trade understand that it has a few pre-conditions. The first is low interest rates. In this case, the benchmark Japanese interest rate is only .1%. While that would have meant something a few years ago, however, it no longer counts for much, since benchmark rates in other industrialized countries are just as low. Where Japan has the edge is in market interest rates. Long-term rates have historically been well below the global average, and short-term rates are finally following suit after a 3-year hiatus. In fact, for the first time since August, the 3-month Japanese LIBOR rate – a lending benchmark – fell below its US counterpart: “On Thursday, the yen Libor JPY3MFSR= was fixed at 0.25063 percent — its lowest level since May 2006 — and the dollar USD3MFSR= rate at 0.25219 percent.” In short, the Japanese Yen is once again the cheapest currency in the world to borrow.

In addition, interest rates in Japan will probably remain low for the immediate future, as the Bank of Japan is actually looking to make its monetary policy even more accommodative (I didn’t think this was possible with a benchmark rate of only .1%!), in order to further stimulate the economy and alleviate the risk of deflation. This contrasts with Central Banks in other countries, which are already contemplating interest rate hikes.

The second condition is low volatility. ” ‘Realized trading vols has not been so low for many years.’ For example, three-month implied vols in the euro have slipped from a 25-plus high at the peak of the subprime crisis to levels around 10.68 currently…’As volatility goes down,’ the FX market tends to move toward a ‘classic carry trade environment.’ ” Low volatility is important because it enables investors to make low-risk bets on interest rate differentials without worrying too much about currency fluctuation. However, it doesn’t hurt that aversion to risk is also trending lower, such that investors can borrow in Yen to make higher-risk bets. According to the Bank of International Settlements, “The carry-to-risk ratios, a measure of the appeal of carry trades, have ‘been steadily rising over the past 14 years, consistent with an increasing attractiveness of the yen-funded carry trades for Australia and New Zealand.’ ”

The pickup in risk aversion – as a result of the Greek debt crisis – may have delayed the return of the Yen carry trade. In January, volatility rose slightly and the Yen rallied as the safe-haven mentality set in. Personally, I find this somewhat ironic, since Japan’s debt problems are even more pronounced, and unlike Greece, it can’t count on a bailout from Greece if things really get rough. Still, the markets work in strange ways, and the fact that the Yen has benefited from the crisis is probably due to the fact that traders can’t short all currencies simultaneously.

The third condition is really an outgrowth of the first two: belief that the funding currency will remain stable, or even decline. In this regard, the Yen is still hovering near an all-time high against the US Dollar, and given the confluence of bearish economic and political factors, it would seem to ne headed downward irrespective of the carry trade. For those looking for specific reasons to short the Yen, there are plenty from which to choose: low economic growth, dismal performance in finance markets, high public debt, dwindling savings and an upcoming retirement boom. As one analyst argued, “Tokyo is due to announce its medium-term fiscal plans in June. ‘Either this will mark the start of a prolonged period of fiscal restraint, weakening the economy again and requiring further monetary loosening, or the plans will lack credibility, in which case Japan’s financial markets would be hit hard. In either scenario, the yen looks vulnerable.’ ”

I don’t mean to get excited, but it’s hard to state a better case in favor of an imminent return of the Yen carry trade.

One of the pitfalls of forex blogging (or all financial reporting for that matter) is that it’s inherently after-the fact. In other words, any information about the past – while relevant – is inherently useless, since it has theoretically already been priced into the asset (or currency in this case). Before I begin my post on the Pound’s recent decline and the factors that wrought it, then, I wanted to offer the caveat that in analyzing past events, we must simultaneously look to the future.

Anyway, for anyone watching the Pound Sterling over the last month, its performance has been startling. It is down 7.5% for the year already (we’re only in March!), and has fallen 12% from its August peak of 1.70 USD/GBP. This represents an unbelievable about-face, as the Pound spent much of 2009 floating upwards following its lows from the credit crisis.

What’s behind the decline? In short, economics and politics, or more precisely, the junction of economics and politics. As the British economy began its recovery from recession, analysts began to turn their attention to UK government finances. Another way of looking at this would be to say that analysts have shifted their gaze from the positive effect of government intervention (i.e. economic recovery) to the many lasting negative effects. Inflation and government solvency, of course, are the two most pernicious of the bunch.

The Bank of England’s quantitative easing program was comparable to the Fed’s program in relative terms, and in the aftermath of all of that money creation, inflation is slowly creeping up. The government’s free spending also contributed, and now, so is the sinking Pound, as prices for commodities and other imports are rising fast in local currency terms. Speaking of government spending, the UK government budget deficit is projected at 12% for 2010, slightly higher than 2009. You can see from the chart below that budget deficits are forecast to remain large for the next few years. Expectations are so low, in fact, that a reduction in the deficit to 3% of GDP by 2014-2015 would be viewed as a victory.

Naturally, the UK government feels some pressure to reduce its deficit, both for the sake of financial solvency and to control inflation. The problem is that an election must be called before June, and until then, there is natural pressure to continue operating the money printing presses 24/7 in order to appease the voting public. The same goes for the Bank of England; it can’t be expected to tighten monetary policy and/or reverse quantitative easing until after the election.

I’m not going to pretend that I understand British politics, but from what I’m hearing, it seems the problem is that the election polls are now very close. Previously, a major victory by the Conservative Party was seen as inevitable, and this was viewed positively by financial markets because of the expectation that they would rein in spending. Recently, the incumbent Labour Party has closed the gap, to the extent that a hung Parliament is now a likely outcome. This would be even less desirable than an outright Labour victory, because the sharing of power would make it unlikely that reforms of any kind would be enacted. With regard to forex, some have posited an inverse correlation between the rising popularity of Labour and the falling Pound.

With the crisis in Greece still unresolved, analysts are also making comparisons to the UK. Some have suggested that if Greece were to receive a bailout, then, investors would turn their attention to the UK, whose finances are in equally bad shape. Without the protection of the Euro, the Pound would be open to speculative attack. On the other hand, that the (declining) Pound is independent from the Euro could become in advantage, if it boosts exports.

Going forward, it’s difficult to make any predictions until after the elections and/or the government makes a firm commitment to reduce spending and lower its deficit. Some analysts think that regardless, the Pound is doomed to continue falling, perhaps all the way to the $1.40 mark. Others see the current decline as the “darkness before the dawn.” As I noted in the introduction to this post, the latter could certainly be right. Besides, most of the uncertainty has probably already priced in. While most of the factors currently weighing on the Pound are bearish, some contrarian investors might see this as a good opportunity to buy. And who’s to say they’re wrong?

Since most emerging market economies and financial markets are fairly small, their currencies are subject to the whims of international investors, moreso than is the case with major currencies. For that reason, when I research emerging market currencies as a whole, I often like to focus on what investors are saying are saying about their stocks and bonds.

According to one columnist, “For an asset class once considered a snake pit of risk, emerging market sovereign bonds have become remarkably popular among investors. So popular, in fact, that even the most cautious of institutions have developed an appetite. Indeed, US pension funds are poised to pour almost $100bn (£65m, €74m) into emerging market debt in the next five years…potentially helping push yields relative to US Treasuries to a record low.” The popularity of emerging market debt is pretty incredible in the context of the Greek debt crisis and the consequent spike in risk aversion. At the same time, emerging market countries have been lauded for their sound finances and low debt-to-GDP ratios, so perhaps it’s no surprise that investors remain willing to continue lending them money. “More and more investors are looking to emerging market local bonds as an alternative to standard global bond allocations, as the problems in Greece and the European periphery highlight the credit risks of that market that have been long underpriced.”

The same is basically true for emerging market stocks, as “A recovery in economic growth and exports in developing nations is boosting the outlook for…company earnings.” Added another analyst, “When you look at the most recent financial crisis, one of the key features has been that emerging market countries weathered the storm extremely well.” Going forward, the consensus expectation is that emerging markets will soon account for the lion’s share of global growth.

For the most part, investors are still quite bullish on both stocks and bonds, despite – or perhaps because of – their amazing performances in 2009. The MSCI emerging market stock index has doubled over the past year, and the JP Morgan EMBI+ bond index rose 28% in 2009 en route to a record high. Still, there is concern that since emerging market stocks and bonds are basically in line with fundamentals, a further inflow of capital would push them into bubble territory. “Jerome Booth, head of research at Ashmore Investment Management, reckons that currency appreciation will be the main source of return for local emerging market debt portfolios in the medium term. ‘The only questions are when it starts and whether it happens fast or slow: with old world currency crashes or managed adjustment.’ ” This is problematic because it means at this point, investors may be chasing currency appreciation rather than direct asset appreciation.

Some investors have started to talk about bubbles, but these appear to be more regional in nature, and the handful of bears point to specific countries rather than dismiss emerging markets outright. For example, it’s now clear that there is a bubble in China’s property market, but not necessarily in the country’s stock market. The South African Rand, meanwhile appears to be overvalued, but the Central Bank of South Africa has announced that it will allow the Rand to continue appreciating. The Chilean Peso, meanwhile, is also poised to appreciate, ironically because of the recent earthquake, as Billions of Dollars aimed at relief efforts are already pouring into the country.

There’s much else that can be said about emerging market currencies at this point, and the near-term will depend largely on if/when/how the Greek debt crisis is resolved. While emerging market investors like to pretend that this is irrelevant, the fact is that they are still somewhat skittish, and even a minor crisis would send them running towards the exits.

It’s still anyone’s guess as to if and when China will allow the Yuan (RMB) to continue appreciating. You can see from the chart below – which shows the trading history for the RMB/USD December 2010 futures contract – that expectations of revaluation have eroded steadily since December 2009. At that time, it was projected that that Yuan would finish 2009 at 6.57 RMB/USD, 4% higher than the current level. Fast forward to the present, and investors now only expect a modest 2% appreciation rise on the year.

What’s behind the change in expectations? The answer is a combination of economics and politics. On the economic side, China’s trade surplus is much smaller than in recent years, as import growth outpaces export growth. “Double-digit annual growth in exports is all but assured in coming months due to a low base of comparison in early 2009, but…sequential growth momentum went into reverse in January, with exports down 16 percent from December.” Moreover, while GDP growth appears strong, it appears tenuously connected to exports and fixed-asset investment. In addition, if the Central Bank of China raises interest rates to counter property speculation, it will have even less room to maneuver in its forex policy if it wishes to maintain high GDP growth. In terms of politics, the CCP doesn’t want to lose a crucial bargaining chip in international relations, and it also doesn’t want to mitigate the threat to its political legitimacy posed by a prolonged economic slowdown.

On the other hand, China still desires to turn the Yuan into a global reserve currency, again both for economic and political reasons. In order to accomplish such a feat, one of the prerequisites would be dual convertibility. Financial institutions and foreign Central Banks are still extremely reluctant to hold RMB currency since it’s difficult to convert into other currencies. “Citing data from the Bank of International Settlements (BIS), it [Citigroup] said the renminbi’s share in the global foreign-exchange market turnovers was only 0.25 percent in 2007, ranked 20th in the world and fifth among Asian emerging-market currencies.” This is pretty incredible considering that China’s economy is the world’s third largest, and will only change when the exchange rate regime is loosened.

While some analysts predict that the Yuan will continue rising as soon as next month – and at least by a slight margin for 2010 – the modest pace of appreciation will ensure that China’s foreign exchange reserves continue to grow. They are currently estimated at $2.4 Trillion, and while their composition is largely a secret, analysts estimate that more than 2/3 is denominated in USD-denominated assets. Recently, there was a perception that China had begun to diversify its reserves out of Dollars, as US Treasury data indicated that its Treasury purchases had all but stopped. As it turned out, China had merely moved to conceal its purchases by conducting them through a UK Bank.

The biggest threat to the USD posed by China is not an end to the RMB peg – for such is unlikely – but rather a change in its structure. Currently, the RMB is pegged directly to the Dollar, which means that the Bank of China MUST stockpile its trade surplus in USD-denominated assets, namely US Treasury securities. If the peg were to shifted to a basket of currencies, however, it would have more flexibility in the denomination of its reserves. Until then, China’s forex policy will continue to favor the Dollar.

It’s still anyone’s guess as to if and when China will allow the Yuan (RMB) to continue appreciating. You can see from the chart below – which shows the trading history for the RMB/USD December 2010 futures contract – that expectations of revaluation have eroded steadily since December 2009. At that time, it was projected that that Yuan would finish 2009 at 6.57 RMB/USD, 4% higher than the current level. Fast forward to the present, and investors now only expect a modest 2% appreciation rise on the year.

What’s behind the change in expectations? The answer is a combination of economics and politics. On the economic side, China’s trade surplus is much smaller than in recent years, as import growth outpaces export growth. “Double-digit annual growth in exports is all but assured in coming months due to a low base of comparison in early 2009, but…sequential growth momentum went into reverse in January, with exports down 16 percent from December.” Moreover, while GDP growth appears strong, it appears tenuously connected to exports and fixed-asset investment. In addition, if the Central Bank of China raises interest rates to counter property speculation, it will have even less room to maneuver in its forex policy if it wishes to maintain high GDP growth. In terms of politics, the CCP doesn’t want to lose a crucial bargaining chip in international relations, and it also doesn’t want to mitigate the threat to its political legitimacy posed by a prolonged economic slowdown.

On the other hand, China still desires to turn the Yuan into a global reserve currency, again both for economic and political reasons. In order to accomplish such a feat, one of the prerequisites would be dual convertibility. Financial institutions and foreign Central Banks are still extremely reluctant to hold RMB currency since it’s difficult to convert into other currencies. “Citing data from the Bank of International Settlements (BIS), it [Citigroup] said the renminbi’s share in the global foreign-exchange market turnovers was only 0.25 percent in 2007, ranked 20th in the world and fifth among Asian emerging-market currencies.” This is pretty incredible considering that China’s economy is the world’s third largest, and will only change when the exchange rate regime is loosened.

While some analysts predict that the Yuan will continue rising as soon as next month – and at least by a slight margin for 2010 – the modest pace of appreciation will ensure that China’s foreign exchange reserves continue to grow. They are currently estimated at $2.4 Trillion, and while their composition is largely a secret, analysts estimate that more than 2/3 is denominated in USD-denominated assets. Recently, there was a perception that China had begun to diversify its reserves out of Dollars, as US Treasury data indicated that its Treasury purchases had all but stopped. As it turned out, China had merely moved to conceal its purchases by conducting them through a UK Bank.

The biggest threat to the USD posed by China is not an end to the RMB peg – for such is unlikely – but rather a change in its structure. Currently, the RMB is pegged directly to the Dollar, which means that the Bank of China MUST stockpile its trade surplus in USD-denominated assets, namely US Treasury securities. If the peg were to shifted to a basket of currencies, however, it would have more flexibility in the denomination of its reserves. Until then, China’s forex policy will continue to favor the Dollar.

The Wall Street Journal’s coverage of the Greek dent crisis has focused less on the crisis itself, and more on the markets’ reaction to it. With headlines like “Hedge Funds Try ‘Career Trade’ Against Euro” and “Speculators Bet Record Amount Against Euro For 4th Week” and “Europe Trouble, U.S. Opportunity” – among others – the WSJ has identified a collapse in the Euro (mainly against the Dollar) as one of the most prominent (and profitable!) strategies for exploiting the crisis.

As I mentioned in the last post (”Understanding the Greece Situation“), the debt crisis has become self-fulfilling, not only for Greece, but also for the Euro. In other words, as perceptions abound that Greece is insolvent and the Euro is doomed, Greek bonds and the Euro have lost value, which only makes the crisis worse. It seems that speculators are taking advantage of this phenomenon by making large bets against the Euro. In fact, large is an understatement, as the net short positions against the Euro now total a record $12 Billion, according to the closely watched Commitment of Traders report.

Some analysts have taken such information at face value, noting that “The fact that the shorts got even shorter when they were already at extreme levels highlights just how negative the sentiment is toward euro.” On the other hand, there is evidence (and some degree of admission) that large speculators are now acting in concert to bring down the value of the Euro. The WSJ reports mention private meeting between hedge funds managers and investment banks helping their clients bet against the Euro using derivatives. For those that are skeptical that speculators could really influence currency markets, consider that one man – George Soros – single-handedly forced a devaluation of the Pound in 1992, and made $1 Billion in the process. While the Euro is certainly bigger than the Pound ever was, there are more people watching it than ever, and when there is money to be made -  hundreds of billions of dollars in this case – it isn’t inconceivable that the Euro could suffer a similar fate.

Already, there is evidence that this strategy is working, as the Euro has fallen 10% in less than three months, which is unbelievable for a currency whose daily trading volume is estimated at $1.2 Trillion. In fact, one popular options trade is based on the the Euro falling to parity against the Dollar. Once unthinkable, such a possibility now faces odds of “only” 1 in 14 (based on options premiums), compared to 1 in 33 in November. On the one hand, it’s frustrating to accept the market power that these speculators have. But emotion has no place in (forex) trading, and standing in the way of momentum would be costly.

On the other hand, Euro fundamentals remain strong. To be sure, a currency is only as strong as its constituent parts, and the fact that a handful of EU member states have shaky finances certainly cannot be dismissed. At the same time, the fact that such currencies have no direct control over the Euro is just as important. Before the inception of the Euro, currency traders would be justifiably concerned that a country in a similar position to Greece would deliberately devalue its currency (by printing money) in order to devalue its debt and make it more manageable.

Now, this would be impossible, since the Euro is controlled by the European Central Bank, over which Greece has no power. The current crisis in Greece notwithstanding, “The European Central Bank’s (ECB) resolve to maintain sound money is…important. This is especially true for the ECB, which has a single mandate—price stability—unrelated to fiscal problems.” While there is legitimate concern that the ECB will be forced (or voluntarily) print more money to fund bailouts of bankrupt EU member states, this doesn’t seem very likely, given the history of the ECB. Its monetary policy has always been quite conservative, and it’s no wonder that the Euro has come to be seen as a viable alternative to the Dollar.

In my opinion, the decline in the Euro is mostly baseless, and if it were to continue, it wouldn’t represent the prevailing of logic. Then again, logic is not exactly a word that I would apply to the forex markets, now or ever.

With this post, I want to try to clarify the Greek fiscal crisis. The problem is that it’s not clear exactly how serious the problem is, because most of the media coverage of the crisis has been directed towards the financial markets’ perception of it, rather than its underlying fundamentals. In the end, I think it’s important to understand both.

The Financial Times published a great timeline that shows perception and reality side-by-side. While there were certainly other important developments that bear in Greece’s fiscal position (in addition to those listed below), you can see that financial markets are basically making their own reality. For example, there was hardly a response to the October announcement that Greece’s budget deficit would be 12.7%, which was 5% higher than earlier estimates. In fact, the markets only became bearish on Greek debt after it the government announced that it would try to bring the debt down to 9.4% through various measures.

Apologists for the markets would be right to wonder why investors should be inclined to believe the government of Greece when it said it could control the budget deficit. Fair enough. Still, one has to wonder why the markets suddenly started worrying about Greece’s fiscal problems, when only a couple months ago, the possibility of a whopping 12.7% budget deficit barely caused investors to blink. Besides, the credit crisis has been raging since 2008, which means the markets have had plenty of time to digest the implications of recession for Greece’s fiscal position.

These days, where is a financial crisis, chances are derivatives are not far removed. As credit default swap spreads (i.e. the cost of insuring against default by Greece on its loan obligations) have risen, so have concerns that this is a bona fide crisis. “It’s like the tail wagging the dog…There is a knock-on effect, as underlying positions begin to seem riskier, triggering risk models and forcing portfolio managers to sell Greek bonds,” said one portfolio manager. From this perspective, it almost looks like this “crisis” is being completely manufactured by speculators for the sake of profit. Summarized another analyst, “It’s like buying fire insurance on your neighbor’s house — you create an incentive to burn down the house.”

To be fair, Greece also played a role in derivatives speculation, and on some level, it was even more nefarious than the speculators. Assisted by Goldman Sachs (who is now betting on Greek default [how un-ironic that is!]), Greece entered into a series of swap agreements last decade, which it used to conceal its true debt burden. “By using an historical exchange rate that didn’t accurately denote the market value of the euro, Goldman effectively advanced Greece a €2.8 billion loan. Under EU accounting rules—which were tightened in 2008—Greece wasn’t obliged to include the loan in overall public debt on its books.” Now that those transactions have been uncovered and the truth is coming to light, financial markets are rightly re-evaluating the risk of further lending to Greece.

There is no question that Greece’s debt problems are serious. As to whether labeling it a crisis is necessary, that depends on your standards. Greece ranks near the top of the list on a variety of individual “debt sustainability” criteria. At 94.6% of GDP, it’s net debt is among the highest in the world. Its projected 2010 budget deficit is also high, though not the highest. Its cost of borrowing is also significantly higher than projected GDP growth, which means that net debt will continue to grow until a budget surplus can be produced. When you average these measures together, it appears that Greece’s debt problems are the most unsustainable of any country in the world. But this is hardly news.

On the other hand, the weighted average of the maturity of Greek debt is 7.7 years, well above average, and plenty of time (relatively) for Greek to sort through this mess and secure new lenders. Towards the latter end, it has hired a former bond trader to head its debt management agency. In order to improve its fiscal position, it has announced a series of austerity measures, including budget cuts, tax increases, wage cuts for public-sector employees, and stricter laws against tax evasion.

At this point, a ratings downgrade looks inevitable, and some analysts think the crisis has already become self-fulfilling. As borrowing costs rise, it only makes it more likely that Greek will default, which causes rates to rise further, and so on. On the other hand, Greek politicians are being forthright about their position (”Greece’s finance minister, George Papaconstantinou, remarked this week: ‘People think we are in a terrible mess. And we are.’ “) and have a plan for rectifying the situation. There is cause for skepticism here, but also for hope. And that goes not just for Greece, but also for the Euro.

Last week, the Fed raised the discount rate by 25 basis points, to .75%. Investors have consistently focused the brunt of their collective monetary attention on the Federal Funds Rate, and the markets (forex included) barely registered a response to the move. Regardless of whether apathy in this particular context was justified, investors who turn a blind eye to changes in Fed monetary policy do so at their own risk

The direct implications for the discount rate (the rate at which depository institutions borrow short-term funds from regional federal reserve banks) hikes are admittedly hazy. Some economists analyzed the move in and of itself as a signal that the Fed wants banks to borrow more from each other, and less from the Fed. Others saw it as a political move, designed to appease both inflation hawks and an angry public that is dismayed over the massive profits that banks have earned from this prolonged period of easy money. If the former are right and the move has an economic basis, then the discount rate will probably have to be hiked at least once or twice more in order to have any kind of measurable impact. If it was indeed political, then another rate hike in the near-term is unlikely.

As I said, investors remain focused on the Federal Funds Rate (the rate at which banks borrow directly from each other) as the crux of the Fed’s monetary power. In this context, the discount rate hike didn’t move the markets because the Fed, itself, cautioned investors from inferring a connection between the discount rate and the federal funds rate. Nonetheless, some analysts posited a connection anyway: “The Fed can talk all day about how the discount rate hike is technical and not a policy move, but the market sees it as a shot across the bow. Not tomorrow, or the next day, but soon, they will be lifting the Fed funds rate target as well as the economy is starting to regain momentum…” Whether this represents the mainstream perception, however, is debatable.

On the one hand, investors have been talking about a (ffr) rate hike for more than six months now. As the above analyst pointed out, the economy is growing (5.7% in the fourth quarter of 2009…not too shabby!), and most other indicators (with the notable exception of housing) are trending upwards. On the other hand, expectations for timing continue to be pushed back (the current consensus – via interest rate futures – is that there is a 70% chance of a 25 bps hike in September).  This is due in no small part to the Fed itself, whose “emissaries” are doing their best to dispel the possibility of a near-term hike.

Some samples: San Francisco Federal Reserve Bank President Janet Yellen said the economy “will continue to need ‘extraordinarily low interest rates.’ ” Dennis Lockhart, the president of the Atlanta Federal Reserve Bank, conveyed that, “If his forecast of slow growth proves accurate, Fed monetary policy will have to hold rates low for longer.” Federal Reserve Bank of St. Louis President James Bullard Thursday said “speculation of an imminent hike in the Fed’s target interest rate was ‘overblown,’ calling an increase in the short-term federal funds rate ‘just as far away as it ever was.’ ” There’s not much ambiguity there.

Analysts also continue to look for clues as to when the Fed will begin to reverse its quantitative easing program. “Bernanke said such steps could be taken ‘when the time comes.’ Given the weakness of the economy, Bernanke signaled that that time was still a long way off.” This kind of procrastination is not being met well, and there is concern that “the Fed will misjudge the situation and wait too long to tighten monetary conditions.” In the end, this is perceived as more of an inflation issue, and it is of secondary importance to interest rate policy for the capital markets.

Forex traders, however, would be wise to focus on both aspects; inflation erodes the Dollar over the long-term, while higher interest rates make it more attractive in the short-term. For the time being, both remain low. In the not-too-distant future, either inflation and/or interest rates must rise. If/when the markets get over their sudden fixation on the debt crisis (a long-term issue) in Europe, they will return their attention to the Fed, probably just in time for the start of some big changes.