The Arcane World of Commodities & Currencies
Every business day, an estimated $3.8 trillion is changing hands in the vast network of the world’s foreign exchange markets, which never sleeps and is growing by leaps and bounds. The foreign exchange market is the first port of call for global investing and trading volume has nearly doubled from five-years ago, reflecting the rapid expansion of the world’s money supply engineered by central banks.
London is the global hub of currency trading, with daily turnover, including over-the-counter swaps and options, at $1.8 trillion in April, up 54% from a year earlier. Turnover in New York and North America, the second largest hub, rose to $715 billion in April and is up 15% from a year earlier. The most heavily traded currency pair is the Euro/dollar, with $665 billion changing hands in London and New York each day. Worldwide, the daily volume in the Euro /dollar might be approaching $1 trillion.
It has been suggested that one way to shore-up the value of the US dollar is through coordinated intervention by central banks by purchasing large sums of dollars on the open market. To be sure, a knee-jerk reaction to a surprise attack could jolt the US-dollar higher against the Euro, but the size of the intervention would have to be very large and sustained on a daily basis in order to have a lasting impact.
The most recent example of central bank intervention is the Bank of Korea’s attempt to shore-up the value of the Korean-won against the US-dollar, which is 8% lower from a year ago. A weaker won, combined with sharply higher import prices for crude oil and raw materials, has turned Korea’s trade surpluses into deficits, and import prices were 49% higher in June from a year earlier, the biggest increase since a 54% annual gain in February 1998. South Korean consumer prices in were galloping 5.5% higher in June from a year earlier, marking the fastest inflation rate in 10 years. Factory prices were 12% higher, but might be topping out soon.
Korean President Lee Myung Bak says fighting inflation is his government’s top priority, and sacked Vice Finance Minister Choi Joong Kyung, the scapegoat for the devaluation of the won. Lee instructed the Bank of Korea (BoK) to begin selling US-dollars from the country’s $258 billion foreign-exchange stash to bolster the won and contain inflation. The BoK dumped a record $5-billion on the FX market on July 9th, knocking the dollar 4% lower to 995-won, its biggest intraday loss in a decade.
Dealers estimate that South Korean authorities have sold about $20 billion to prop-up the won, between 1,057-won and 930-won/dollar so far in 2008. But the dollar has since recovered to 1,010-won, fanning speculation that the BoK might need to hike its interest rates on August 7th to support the Korean-won. The Finance Ministry has also lifted controls on overseas borrowings by foreign bank branches hoping to revive the “yen carry” trade, and strengthen the Korean-won.
Yet it wasn’t the BoK’s intervention in Seoul’s currency market that was responsible for knocking the dollar lower against the won. Instead, buy and sell decisions by traders in the Korean-won/dollar rate are based upon expectations about the direction of crude oil and other key raw materials. The dollar’s plunge from 1,050-won to 995-won was linked to expectations of a sharp drop in crude oil prices, a key indicator used to gauge Korea’s trade balance and inflation rate.
The Korean central bank has often promised to keep inflation between 2.5% and 3.5% on average, but failed miserably. Instead, the BoK has held its policy rate steady at 5% for 11-months, while Korea’s M2 money supply has exploded to a 14.5% annualized rate. Korean Finance minister Kang Man-soo is opposed to raising interest rates to fight inflation. “Money supply growth isn’t an issue that can be solved with an interest rate increase,” he said on July 23rd. Still, the odds favor a quarter-point BoK rate hike on August 7th.
In contrast, the European Central Bank understands that managing exchange rates requires more than verbal threats, and open market intervention in the $1 trillion per-day Euro/dollar market is useless unless backed-up by interest rate adjustments. For the past-year, the ECB has dealt with the historic run-up in energy prices by guiding the Euro above $1.5400, and lifting benchmark German schatz yields to +180 basis-points above the comparable US 2-year T-note yield. Whereas currency traders in Korea are currently fixated on oil prices, traders in the Euro/dollar are tracking interest rate differentials between the two currencies 24-hours per day.
The ECB hawks shocked the global stock markets on June 5th by signaling a baby-step rate hike to 4.25%, the first increase in a year. The ECB hawks refuse to be bullied by Euro-zone politicians into a series of rate-cuts, or join the Fed’s money printing orgy. Instead, the ECB held its repo rate steady at 4% through the first-year of the global banking crisis, then guided German schatz yields to a six-year high.
If the historic rise in crude oil to $150/barrel was driven by speculators, then the world needed a powerful central bank to go against the “Big-Easy” at the US Treasury and the Fed, and the “yen carry” traders at the Bank of Japan, in order to deflate the oil and commodity “bubble” with a classic dose of higher interest rates. “The simple fact is that there is nearly $250 billion in America’s commodity futures markets that wasn’t there just a few years ago,” said CFTC chief Bart Chilton on July 22nd.
The ECB’s rate hike on July 3rd to 4.25% might have taken the steam-out of the Dow Jones Commodity Index, which peaked at a historic high on the very same day, and subsequently has plunged 15%, led lower by a stunning $20/barrel drop in crude oil, and double-digit losses in the agricultural sector. German 2-year schatz yields slumped to 4.25% this week, dousing ideas of another ECB rate hike this year.
The ECB hawks disregarded the advice of the ultra-inflationist Frederic Mishkin, a top advisor to “Helicopter” Ben Bernanke at the Federal Reserve. “Just as doctors take the Hippocratic Oath to do no harm, central banks should recognize that trying to prick asset-price bubbles using monetary policy is likely to do more harm than good. Interest rates are too blunt a tool for targeting specific asset prices, and attempting to prick an asset price bubble should be avoided,” he said on May 15th.
However, the ECB’s baby-step rate-hike to 4.25% was partly responsible for knocking the commodities markets lower and taming inflation pressures. But it carried a very expensive price-tag. Global stock markets lost $3 trillion in value over the past two months. And the Euro zone economy could grind to a halt by the third quarter. The Spanish economy could suffer a hard-landing with its jobless rate spiking up 0.6% to 10.4% last month. New home building permits in Spain plummeted 57% in May from a year earlier, derailed by a housing bubble bust.
The recent sharp run-up in the price of crude oil, gold and grains sparked a debate over whether supply-demand fundamentals or a piling-on of new investors into the commodities markets were behind the boom in prices. Some research showed that 35% of commodity investors were active in the markets for less than three-years. Pension funds, European banks, and hedge funds were the three biggest players, helping to drive tens of billions into commodities.
The Socialists on Capitol Hill in Washington tried to tighten position limits on energy and agricultural futures contracts with an anti-speculation bill but were defeated, lacking the required a two-thirds majority, or 291-votes, to override a presidential veto. An anti-Speculation bill wouldn’t be a topic of debate today if the Federal Reserve hadn’t slashed its interest rates far below the US-inflation rate.
The impact of the ECB’s baby-step rate hike to 4.25% rippled across the Indian Ocean to the shores of Australia, and blunted the historic surge of New-Castle Coal at a record high of $224/ton. Australia is counting on record high prices for coal and iron ore, its two biggest exports to add A$45 billion to A$55 billion to its export earnings in the year ahead, and potentially wiping out the country’s trade deficit.
Australian exports had climbed to a record A$21.9 billion in May, and the April trade balance was revised to a A$12 million surplus, the first in six years, as miners BHP Billiton and Rio Tinto agreed to price increases with Chinese steel mills of up to 96% for iron ore with a 12-month contract. Strong global demand and tight supplies also saw coal prices triple, and Australia is the world’s largest exporter of coal.
However, a subsequent downturn in global commodity prices, following the ECB’s hike, has knocked Aussie coal prices 15% below their all-time highs and is causing currency traders to lighten-up on over-extended positions in the Aussie dollar. The Reserve Bank of Australia (RBA) is a routine seller of Aussie dollars each month, attempting to build-up its foreign currency reserves.
RBA intervention hasn’t altered the currency’s trends, but regular sales can smooth out sharp or erratic price swings. Still, the RBA stepped up its Aussie dollar sales in June, dumping A$875 million, its biggest sale over the past 12-months. Traders are also penciling in RBA rate cuts later this year after retail sales took their biggest fall in six years last month, stirring fears the economy is slipping into recession.
About Gary Dorsch
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