Nominal and real exchange rates

• The nominal exchange rate e is the price in domestic currency

of one unit of a foreign currency.


• The real exchange rate (RER) is defined as , where P is the

domestic price level and P * the foreign price level. P and P * must have

the same arbitrary value in some chosen base year. Hence in the base

year, RER = e.


The RER is only a theoretical ideal. In practice, there are many foreign

currencies and price level values to take into consideration.

Correspondingly, the model calculations become increasingly more

complex. Furthermore, the model is based on purchasing Power Parity

(PPP), which implies a constant RER. The empirical determination of a

constant RER value could never be realised, due to limitations on data

collection. PPP would imply that the RER is the rate at which an

organization can trade goods and services of one economy (e.g. country)

for those of another. For example, if the price of a good increases 10% in

the UK, and the Japanese currency simultaneously appreciates 10%

against the UK currency, then the price of the good remains constant for

someone in Japan. The people in the UK, however, would still have to

deal with the 10% increase in domestic prices. It is also worth mentioning

that government-enacted tariffs can affect the actual rate of exchange,

helping to reduce price pressures. PPP appears to hold only in the long

term (3–5 years) when prices eventually correct towards parity.
More recent approaches in modelling the RER employ a set of

macroeconomic variables, such as relative productivity and the real

interest rate differential.

Free or pegged

If a currency is free-floating, its exchange rate is allowed to vary against

that of other currencies and is determined by the market forces of supply

and demand. Exchange rates for such currencies are likely to change

almost constantly as quoted on financial markets, mainly by banks, around

the world. A movable or adjustable peg system is a system of fixed

exchange rates, but with a provision for the devaluation of a currency. For

example, between 1994 and 2005, the Chinese yuan renminbi (RMB)

was pegged to the United States Dollars at RMB 8.2768 to $1. China

was not the only country to do this; from the end of World War II until

1966, Western European countries all maintained fixed exchange rates

with the US dollar based on the Bretton Woods system.

Week of April 6, 2008

Highlights:

1. Rebound in risk appetites looks set to falter
2. EU Finance Minister meeting this weekend; G7 next Friday
3. BOE and ECB interest rate decisions
4. Key data and events to watch next week

Rebound in risk appetites looks set to falter


Friday's NFP report provided further evidence that the US economy remains on weak footing, as if any more were needed. But a strange thing happened on the way to the recession. Market sentiment appears to have embraced the view that the US downturn will be relatively manageable, if not downright mild. I'm not about to embrace that view, but I can understand where it's coming from. In the Week Ahead of March 21, I suggested that risk appetites (and USD/JPY and JPY-crosses) were set to rebound after aggressive Fed actions significantly reduced the potential for a US financial system failure. Indeed, since then risk appetites have come back, with JPY crosses up roughly 8 yen since March 21. Stock markets have recovered and commodities are stabilizing after sharp corrections.

But the horizon for the financial sector is far from clear and many risks remain. Inter-bank lending rates (LIBOR, EURIBOR) are actually making new highs since the credit crunch began last summer, suggesting the root problem—confidence between financial firms based on transparency (who's sitting on what size losses)—has yet to be remedied. Looking ahead, major US banks are set to begin announcing 1Q earnings after the middle of April and there are likely to be additional sizeable losses and disappointments, potentially rekindling fears over financial sector solvency. As a reminder of the potential for unwelcome surprises, as I'm writing this on Friday afternoon, Fitch ratings has just cut its AAA rating on the largest US bond insurer, which only recently avoided downgrades from other rating agencies by raising additional capital. At the minimum, then, I suspect the rebound in risk appetites has likely run its course already and is more likely to fade than extend. In currencies, the proxy for risk appetite is USD/JPY and JPY-cross strength. If USD/JPY falls back below 101.20/50 key support zone (EUR/JPY equivalent support is 159.00/30), it's a good indication risk aversion is re-surfacing and that carry trades are headed south again, pulling stocks and commodities down with them.

The financial sector is only one of the patients in the Fed's emergency room, the other being the broader US economy. Recent data (Chicago PMI and ISM sentiment) have given the 'glass half full' crowd reason to celebrate and expect that the US downturn will be both brief and relatively shallow. Even a larger than expected decline in March NFP jobs was greeted with the view that it was "bad, but not 'that' bad." To me, the market reaction looks more like wishful thinking, and probably a fair amount of willful denial. The headwinds facing the US consumer economy are substantial and show no signs of abating—high energy prices, falling home values, restricted credit, and now rising unemployment. As much as I would like the US downturn to be brief and mild, I have to reckon with further weakness in the immediate future. Perhaps a weekend spent digesting the implications of the NFP report will see a more realistic reaction in markets early next week.


EU Finance Ministers meeting this weekend; G7 next Friday

Eurozone finance ministers are meeting this weekend in Ljubljana, Slovenia for their regular monthly conclave. But this weekend's meeting comes just a week before the G7 quarterly meeting of finance ministers and central bank heads in Washington, DC. Recent comments from European finance sources suggest Eurozone officials want to raise the strength of the Euro as an issue in discussions at the G7. In the run-up to the last G7 meeting in February, US officials effectively refused to even discuss currency issues outside of Asian currencies needing to appreciate. That rebuff was at least partly responsible for the EUR blasting off from around 1.45 through 1.50 up to where we are today. I do not think the US Treasury has changed its stance, so Eurozone officials are left hollering into the wind. Traders should not expect the G7 communiqué to include any new language on currencies.

That the G7 is unlikely to address what is arguably excessive EUR strength does not mean that Eurozone finance ministers are powerless to express dissatisfaction with the strength of the Euro. On the contrary, I get the sense that Eurozone officials might finally embark on a rhetorical campaign to limit additional EUR gains. If this materializes, I would expect comments from key Eurozone finance officials to materialize over the weekend, seeking a 'shock-value' to start the week off in FX. Likely candidates are German Finance Minister Steinbrueck and Bundesbank Pres. Weber, who are scheduled to hold a press briefing on Saturday around 0600ET. Unilateral market intervention still does not seem likely at this stage; further EUR gains above 1.6000 would be needed to trigger that.


BOE and ECB interest rate decisions

The Bank of England (BOE) and the European Central Bank (ECB) are set to deliver interest rate decisions on Thursday of next week, with very different outcomes expected. The BOE is widely expected to cut its benchmark rate from 5.25% to 5.00%, though there are a few dissenters who expect a steady rate. The UK economy is undergoing a similar housing-led downturn, which is already spilling into the broader economy. The credit crunch is also fully evident as UK banks have actually raised mortgage lending rates to cut back on loan demand and preserve capital. GBP should remain on the defensive going into the BOE decision and is most likely to weaken on the GBP-crosses, rather than against the beleaguered USD. Should the BOE hold the line and keep rates steady, I would expect GBP to briefly rally, only to later come under even greater pressure, as continued high rates would be seen as potentially tipping the UK into a deeper slump, requiring even larger rate cuts down the road. I favor selling GBP on rallies, and with positioning likely to tilt toward short-GBP, a short squeeze higher would provide just such a rally to sell into.

The ECB rate decision is expected to see the benchmark rate held steady at 4.00%. With inflation running at 15-year highs and growth holding up for now, there is little else the ECB can do. M. Trichet has been adamant that fighting inflation is the sole task of the ECB and he is likely to retain a hawkish tone in his press conference following the announcement. His comments on the economic growth outlook will be significant, and may undermine his hawkish inflation rhetoric if he expresses a sense of alarm. He is also likely to be grilled by the media on his thoughts on EUR strength. When questioned at the last press conference on March 6, when EUR/USD was around 1.5300, he avoided making any criticism of EUR strength, triggering a rally to 1.5900 over the next 2 weeks. If he decides to take a stand, he may use the term 'brutal' to describe the Euro's gains, and the EUR should weaken. But if he demurs and sticks with the G7 language and refers to the US strong dollar policy, it's another green light for the market to take EUR/USD to 1.6000 and beyond.


Key data and events to watch next week



US data next week kicks off on Tuesday with Feb. pending home sales and April IBD/TIPP economic optimism index in the morning, followed by the minutes from the March 18 FOMC meeting in the afternoon. The minutes are likely to reinforce the notion that additional aggressive easing from the Fed is less likely in the future, but otherwise keep the focus on US weakness ahead. Wednesday sees weekly mortgage applications and Feb. wholesale inventories. Thursday's highlights are the Feb. trade deficit and weekly initial jobless/continuing claims. Friday concludes with March import prices and the preliminary April Univ. of Michigan consumer sentiment survey. US Treasury Sec. Paulson is speaking on Monday and will provide a G7 briefing after the close on Friday. Fed speakers on the US economic outlook include Vice Chairman Kohn on Monday; Dallas Fed's Fisher (dissenter at 3/18 FOMC) on Wednesday; and Fed Chairman Bernanke on Thursday.

Eurozone data sees the April Sentix investor confidence on Monday along with Feb. German industrial production. Wednesday sees German Feb. trade and current account balances and final 4Q Eurozone GDP. Thursday sees French and Italian Feb. industrial production prior to the ECB rate announcement. Friday finishes out with German March wholesale prices and Feb. OECD Eurozone leading indicators.

UK data will see March HBOS house prices sometime during the week, but no fixed time has been established yet. The March Nationwide Building Society consumer confidence index will be released at midnight on Tuesday night UK time. Wednesday sees Feb. industrial/manufacturing production and the March BRC shop price index, a private gauge of retail inflation. Thursday sees the Feb. trade balance report prior to the BOE's interest rate announcement.

Japanese data begins on Monday afternoon Tokyo-time with the preliminary Feb. leading economic index. Tuesday afternoon sees the March Economy Watchers survey. Wednesday afternoon is expected to see the BOJ hold rates steady at 0.50% when the MPC concludes its meeting. Thursday morning sees Feb. machine orders, bank lending data, and the Feb. current account report. Friday sees only the March domestic corporate goods price index (CGPI).

Week of March 30, 2008

Highlights:

1. The Commodity Trend Is Your Friend
2. Is Anybody Home?
3. Singing The Blues or Show Tunes?
4. What’s On Tap For Next Week?

The Commodity Trend Is Your Friend


Last week we saw massive reversals in the two hot commodity markets, gold and oil, as the leverage hedge fund community unloaded massive long positions to book profits as global risk aversion increased. Spot gold put in a $1032/oz high before shedding over $125/oz into the end of the week. NYMEX crude put in a similar 'slide' from $111.80/bbl down to $98.65/bbl. Now because the commodity markets are a natural hedge against the falling value of the USD, rapidly falling commodity prices sent the dollar shorts running for cover sending the USD higher against the G-7. At the start of this week, many traders were expecting this theme to carry into this week. But it's amazing how quickly the old adage 'the trend is your friend' is forgotten by the markets. Starting Sunday night we were in mostly a holding pattern until the underlying themes began to reassert themselves.


Is Anybody Home?


Monday morning saw an unexpected 2.9% increase in February's Existing Home Sales numbers after 6 consecutive monthly declines. The markets took it to heart as the S&P broke the 14-day 1342 resistance level to print the intra-week high on opening trading session. But Tuesday morning's Case Shiller Index brought the bottom-fishing real estate bulls back to earth by printing a 10.7% Year over year decline; the biggest decline on record. The very next day February's New Home Sale saw 578k New Home Sales sold, just below the 590 expected with a 588k prior for January. The most interesting part of this report was the inventory of unsold homes is the highest since 1981. After Monday's 1359 high in the S&P, it was a steady stair step lower for the rest of the week. The bloated inventory of unsold homes combined with depressed consumer confidence is very likely to sustain this economic downturn for sometime to come.


Singing The Blues or Show Tunes?


Speaking of Consumer Confidence, Tuesday morning's reading of 64.5 handily missed the surveyed expectations of 73.5 with a prior reading of 76.4. 64.5 is the lowest reading of Consumer Confidence since March of 2004. To further confirm that the US consumer has the blues, today's University of Michigan Confidence report printed the lowest reading in over 8 years! The reading was expected to come in at 70.00 with a prior reading of 70.5, but also missed the mark by a half point at 69.5.

While the US consumer is signing the blues, we found out that for the 3rd month in a row the Euro Zone business owner is singing show tunes. If you recall last February's IFO reading of 104.1 that beat the expectations of 102.9, you might remember EURUSD breaking free from significant 1.4950 resistance to trade 1.5000 for the first time ever in the product's history. On Wednesday we got the March IFO Business Climate index that again beat the 103.5 survey with a 104.8 reading. And again, EURSUD caught a huge bid to approach the 1.5905 March 17th highs, but failed at 1.5858.

The major theme of the week is that while the Fed is focused on easing monetary policy and preventing further effects of the credit crisis in the financial markets, the ECB is more focused on pricing stability and inflation concerns. On Wednesday Jean Claude Trichet noted fundamentals are "sound" while the labor markets remains strong. EURUSD will do well against the low yielders such as the USD and CHF on higher risk appetite, but faces downside risk from hedge funds de-leveraging out of commodities should global markets shown further signs of slowing as a result of the US sub-prime meltdown.

Once we hit the mid-point of last week, we began to see that the outlook for the global economy is still positive as the underlying themes I mentioned in the first paragraph began to take hold. Gold and Oil slid into Monday's session as a result of carry over from weakness seen last week, but quickly regained footing at the 50% retracement in oil after clearing stops blew $100/bbl and the 61.8% retracement in spot Gold. Crude dealt to a weekly high of $108.22/bbl today as Gold set in a $954/oz on Thursday. In response to firming commodity prices Australian and Canadian Dollars were both strong against the USD and will look for this theme to continue into next week.

Risk aversion has been driving the Yen higher as those who have borrowed cheap Yen to fund speculative positions in global markets area closing those positions. But now, there might be actual value seekers flowing into Tokyo after Thursday's CPI showed inflationary pressures most likely as a result of increasing energy costs for the highly oil-dependant nation. Lastly, Japan's fiscal year is coming to a close as local investors repatriate Yen back home to close outstanding positions.


What's On Tap For Next Week?


Looking ahead to Sunday night, we have Japanese Industrial Production for February expected to come in at -2.0% M/M and 2.9% Y/Y. On 3/31 we'll get the Euro-Zone Consumer Confidence reading expected to come in at -12 with a prior reading of -12. Then Monday morning in Canada look for the GDP surveyed to come in at 0.5% with a -0.7% prior, followed by the Chicago Purchasing Manager Index at 9:45 AM EST expected to come in at 46.0 with a 44.5 reading from February. But that night in Tokyo at 7:50 PM EST is the big one. We are expecting the Tankan report that will be very telling to learn just how much the strengthening Yen, as well as higher energy costs, have affected Japanese businesses. Tuesday morning in Germany we are expecting February's Retail Sales and the Euro Zone's Unemployment Rate expected to come in at 7.1% with the a Jan reading of 7.1%. Tuesday morning in NY at 10:00 AM EST is ISM Manufacturing expected at 47.5 for March with a prior reading of 48.3. Wednesday afternoon at 5:00 PM EST we get valuable pricing data in the Euro Zone with Feb PPI expected at 0.6% M/M and 5.2% Y/Y with prior readings of 0.8% and 4.9% respectively. Back in the Euro Zone on Thursday we get Retail Sales for Feb, which sets up the big one on the first Friday of every month: the US Employment Situation numbers Non-Farm Payrolls and Unemployment Rate for March. As of now, economists are expecting us to lose 40k jobs after last month's loss of 63k jobs. Of the last 52 months there has been only one negative reading, and last month was it.

With Consumer Confidence so low in the US and Euro Zone growth and inflationary pressures ever present with strongly rebounding commodity prices, we look for EURUSD to achieve 1.6000 while 1.5400 supports the market. USDJPY has a bit of its own wood to chop to break through 98.50 support and then on down to 98.00, which would bring an all but certain test of the mid-March lows of 95.50. If both EURUSD and USDJPY head towards these levels, that will most likely leave the cross, EURJPY, flopping around in the 153.00-159.00 range while the focus shifts away from carry trade/risk aversion theme, and towards the commodity/USD theme