-Jane Foley is research director at Forex.com. The opinions expressed are her own.-

The discrediting of the efficient markets theory in the aftermath of the financial crisis appears to have been accompanied with growing support for the view that rather than efficient in nature, financial markets are predisposed towards the formation of bubbles.

A bubble can simply be defined as an occurrence that begins when the price of an asset has been driven significantly above it "fair" value. According to the efficient markets theory this would not happen.

If bubbles are a natural outcome of financial market activity it is relevant to ask whether the very loose fiscal and monetary policies of many central banks and governments are presently sowing the seeds of the next bubble.

Even though the real economies of the U.S., UK, Eurozone and Japan continue to be defined by expectations of rising unemployment and falling real wages, access to cheap money has already helped restore the profitability of many investment banks.

In turn, this has fed risk appetite which is evident in the rally in stocks since the spring, increased demand for "risky" currencies and a recovery in commodities prices. Brent oil has rallied by 128 percent from its 2009 low. The ability of oil to rally despite the existence of oil supplies well above the seasonal average suggests there is already speculative element in this market which could be in danger of driving prices above their fair value.

This week’s meetings of the Federal Reserve, the Bank of England and the European Central Bank have focussed attention not so much on rates, but on the extraordinary policy decisions taken by these central banks in the wake of the financial crisis and whether conditions are ripening in favour of a gradual withdrawal of some of these policies.

The Fed last week ended its $300 billion treasury bond purchasing plan, though it will carry on buying mortgage backed securities. The Bank of Japan last week announced that it will stop buying corporate bonds at year end. The Reserve Bank of India also removed emergency support measures last week.

This week there is speculation that the ECB could announce that it will hold no more 12-month cash tenders next year. By contrast the Bank of England is expected to increase quantitative easing at the November 5, Monetary Policy Committee meeting. Supporters of quantitative easing continue to stress that the lack of clear inflation pressures suggests there is room for these plans to be extended.

However, the lack of response in either money supply or inflation indices could equally be illustrating that these plans are not having a significant impact on the real economy and are therefore no longer appropriate. The paring back of these plans are likely to have an impact on the ability of some banks to turn an easy profit and thus should rein in risk appetite and limit speculative and "bubble" forming activity.

Unfortunately, a bubble can only be truly confirmed after it has burst; a characteristic with clear destabilising consequences. If bubbles are natural phenomena within financial markets, the need for tighter regulation and ongoing reviews of processes that oversee the financial system are absolutely necessary.

This conclusion, while in complete contrast to the implications of the efficient markets theory, ties in very well with the political desire to reform the banking regulatory framework in order to protect the tax payer from future hefty bank bail-out costs. The banking landscape, while already vastly different from just two years ago could continue its transformation for years.

researchEMEA@forrex.com

-Jane Foley is research director at Forex.com. The opinions expressed are her own.-

The U.S. dollar may have found support this week but the USD index remains at a 14-month low.

The impact of the financial crisis in drawing buyers to the "safe-haven" dollar has in effect been almost cancelled out by the healing in risk appetite. The dollar looks to have re-embarked on the downtrend that had been in place for more than two years prior to the start of the financial crisis, only now the U.S. fundamentals have arguably deteriorated further.  

Slow growth and a hefty budget deficit are likely to hamper the attraction of the dollar for some time.  That said, there is a huge invested political interest in ensuring that any further declines in the dollar remain orderly.

The weakness of the dollar has already prompted some Asian countries such as South Korea and Taiwan to intervene in order to prevent the appreciation of their currencies impacting competiveness.  This action can be viewed as a protest against the renminbi-dollar peg and a guard against losing competitiveness to China.

As the euro rises against the dollar, it is also rising against the renminbi and -- spurred on by the actions of other Asian central banks -- the chances are that it will continue to appreciate against a host of other Asian currencies.

Since the start of last year, the euro has risen by 37 percent against the South Korean won.  In recent comments, French Finance Minister Christine Lagarde stressed that she did not want to see the euro bearing the brunt of the downward adjustment of the dollar. 

The U.S. is still the Eurozone’s second largest trading partner after the UK suggesting that a move above EUR/USD1.500 cannot be welcome, but the pegging of the renminbi versus the dollar makes the downward adjustment of the dollar a far more painful experience for the Eurozone.

This is not the only objection to the renminbi-dollar peg.  The traditional objections relate to the huge US and Chinese imbalances which are evident in the ability of China to build-up huge foreign currency reserves largely denominated in dollars. 

Domestic policies which could lessen savings and promote domestic consumption are the usual prescriptions offered to China.  Higher government spending on social systems such as education and healthcare could offer part of a solution as this should limit the amount of savings viewed as necessary and boost consumption. 

Clearly a weaker exchange rate could be a significant part of the solution since this should limit export growth and promote demand for overseas goods.

Clearly China can not rush a move to a flexible exchange rate regime.  The Chinese authorities understandably fear that a quick move could prompt capital flight and undermine its banking system.  A fully convertible, flexible exchange rate must be a long term goal rather that a quick fix solution but China can expect to feel increased pressure to adjust its currency peg versus the dollar.

The renminbi and the dollar are of course linked in more ways than one.  China’s exchange rate regime can be blamed for exacerbating global imbalances which have undermined the value of the dollar.  It is ironic then that China, along with other creditor nations, now has an interest in supporting the value of the dollar in order to avoid a sharp depreciation in the value of its assets.  

Theoretically, the sudden, sharp rise in the U.S. budget deficit towards 11 percent of GDP this year, Obama’s difficulties in making progress with healthcare reform and projections for below trend U.S. economic growth at least through 2010 should be sending bond investors to run for the hills. 

The maintenance of good demand from overseas central banks for U.S. Treasury paper this year suggests that creditor central banks are continuing to play their part to ensure that the decline of the dollar remain orderly.  A move to EUR/USD1.55 may be further away than it seems.

-Jane Foley is research director at Forex.com. The opinions expressed are her own.-

If there is one foreign exchange story that will run and run it is the one about the U.S. dollar (USD) and its future as the world’s dominant reserve currency.  The discussions on this topic have at least brought some agreement, namely that there is no clear alternative and therefore there can be no quick fix change.  That said, much uncertainty remains as to what can, if anything, eventually replace the dollar.

The basis for questioning the USD’s position as global reserve currency stems from its declining value and its "poor" fundamentals.  The dollar index is currently trading close to where it was 14 mpnths ago, ahead of the financial crisis.  At that point the USD had been on a downtrend for over two years. The widening in the U.S.’s budget deficit this year has worsened the fundamental backdrop and drawn attention to its "twin deficits".  This has made creditor nations nervous. 

So, how bad are these fundamentals?

The U.S. current account deficit this year has actually improved.  However, once the U.S. recovery gets underway, many expect to see the current account widen again.  Textbooks suggest that a current account deficit should lead to a downward adjustment in the currency which will help address the imbalance.  This is not always the case.  Australia presently has a current account deficit of around 4.5 percent of GDP and the effective Australian exchange rate has rallied by 27 percent since January 1, 2009. 

Current account imbalances, while always a potential currency negative, only weigh if international savers become less keen to fund it.  Investment decisions will be determined by other factors such as relative growth and interest rates, political stability and fiscal coherence.   A huge USD negative this year has been the widening in the budget deficit to potentially 11 percent of GDP from 4.7 percent in 2008.   This implies huge bond issuance. 

To date, Treasury auctions have been well subscribed.  While supply has not caused the USD any clear problems, budget deficits of this size inevitably imply fiscal spending cuts which could weigh on growth for years.  This suggests limited growth in addition to low short-term interest rates which is a poor currency dynamic.

While a strong budget position is highly desirable for a reserve currency it is not the only factor.  Clearly a reserve currency needs to be fully convertible.  This requirement counts out the Chinese yuan (CNY).  The ability to cope with huge liquidity demands excludes currencies such as the Norwegian krone, Australia dollar and the New Zealand dollar.  The euro (EUR) fails the criteria insofar as there is no single sovereignty.  

Some argue that differing fiscal policies in the Economic and Monetary Union (EMU) have the potential to lead to friction, while others stress the geopolitical line that the absence of a single policy on defence would for some countries mean that the EUR would be an inadequate USD replacement.  This does not mean that the EUR will not take a greater role in the coming years.  There are signs that central banks have slightly increased their holdings of EUR along with the Japanese yen (JPY) this year and this trend may continue.

Looking forward, assuming U.S. fundamentals remain poor it is feasible that talk of a basket of reserve currencies will eventually become more relevant with the EUR and the JPY potentially playing a greater role and even the CNY playing a part in the next decade or so.  However, any adjustment in central bank currency reserves will be slow and is unlikely to lead to any tangible downward pressure on the USD particularly since creditor nations have an interest in protecting the value of their holdings.  As a result, any additional USD declines are likely to remain orderly.

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– Neal Kimberley is an FX market analyst for Reuters. The opinions expressed are his own –

Twenty-four years ago, major nations called for depreciation of the dollar to rebalance the global economy. Now, as another effort at rebalancing looms, the dollar will again bear the brunt — though officials will try to ensure its fall is less dramatic this time.

That’s the implication of President Barack Obama’s announcement this week that he will push world leaders for a new global “framework” in which the United States would cut its huge trade and budget deficits.

Agreeing on this framework would be politically difficult, since it would require policy changes by many countries — China, for example, would probably have to rein in its explosive export-led growth.

But as the euro’s climb to a new one-year high versus the dollar this morning shows, markets are starting to think the rebalancing process may start as soon as this week’s Pittsburgh summit of leaders from the Group of 20 nations.

The Plaza Accord of 1985 called for “orderly appreciation of the main non-dollar currencies against the dollar”; it was followed by central banks’ coordinated intervention to ensure that happened.

This time, with the world shakily emerging from a financial crisis, policymakers are likely to try to manage the dollar’s drop in a more low-key fashion.

They are unlikely to issue an explicit call for the dollar to fall. In fact, the U.S. Treasury may continue proclaiming its “strong dollar policy” in an attempt to keep the markets calm.

No one in the G20 wants to risk a freefall of the dollar that could disrupt global trade as it recovers from recession. And in contrast to the 1980s, developing nations such as China are now challenging the dollar’s long-term role as the world’s top reserve currency.

The dollar’s premier status helps the United States to obtain foreign capital and in order to keep that access, Washington is likely to encourage central banks around the world to continue holding dollars. This would require slow depreciation of the currency rather than a panicky slide.

So unless policymakers completely lose control of the forex markets — which cannot entirely be ruled out — the dollar’s slide is likely to be slower and smaller than it was after the Plaza Accord, when the currency sank about 50 percent versus the yen between Sept. 22, 1985 and the end of 1987.

The overall direction of the dollar does not look in doubt, however. Top presidential adviser Lawrence Summers has said he wants a U.S. economy that is “more export-oriented and less consumption-oriented”.

A lower dollar is a logical tool to achieve that goal, and letting the currency weaken would probably be faster and easier than most other big policy steps to reshape the U.S. economy, such as tax changes and health reform.

The International Monetary Fund, which is advising G20 nations on economy policy, is hinting heavily at the need for currency realignment.

In a report released this week, it said “current policies and the assumed constellation of exchange rates may not be sufficient for the needed rebalancing of demand.”

It added that policy reforms by the world’s big economies to restore growth “would be more effective if accompanied by a real effective renminbi appreciation, offset by euro and dollar depreciation”.

An international understanding on dollar depreciation may well not be reached in Pittsburgh. A French official said last Friday that Pittsburgh would merely set the stage for future talks on foreign exchange rates.

“At this stage there will not be currency discussions, but the framework that we hope to put in place…is a way of discussing later the question of exchange rates,” said the official, who declined to be named.

But giving China and other developing countries more power in the IMF and the World Bank could be part of an informal quid pro quo in which China quietly undertook to resume appreciating the yuan against the dollar.

The rise of the euro as high as $1.4821, breaking the December 2008 peak of $1.4719, is a technical signal that the market thinks the dollar is increasingly vulnerable.

For many traders, the break suggests a good chance of a rise to at least the psychologically important level of $1.50 in coming weeks or months.

The European Central Bank might seek to limit speculation against the dollar by expressing concern about such a move. But the market does not appear to worry that the ECB could actually intervene to support the dollar.

When the European Union’s Economic and Monetary Affairs Commissioner Joaquin Almunia said last week that excessive appreciation of the euro could hurt Europe’s economy, the euro fell back only marginally and briefly.

The market knows that even at levels just above $1.5000, the euro would remain well below its all-time high against the dollar of $1.6038, hit in July 2008.

And any rise of the euro against the dollar in the current circumstances would probably be seen by policymakers as the result of general dollar weakness, not excessive euro strength. When euro/dollar reached its July 2008 peak, euro/yen hit a similar high; now, euro/yen is a full 35 yen lower.

The Japanese may also be willing to see their currency strengthen. Before new Finance Minister Hirohisa Fujii took office this month, he said a strong yen was generally good as it boosted the purchasing power of Japanese.

Fujii subsequently backed away from that comment, but speculation will remain that after sweeping to power last month, the Democratic Party of Japan may try to shift the country away from its reliance on exports and its opposition to yen strength.

In the context of a G20 drive to rebalance the global economy, this could easily cause the market to think the yen should be trading stronger than 90 to the dollar.

– Agnes T. Crane is a Reuters columnist. The views expressed are her own –

It looks bad for the dollar, but looks can be deceiving.

Its sharp decline in the last week has pushed the euro to its highest level in a year and reignited fears that there’s only one place for the dollar to go, and that’s down.

Rhetoric from influential investors like Warren Buffett as well as big foreign buyers of U.S. debt like China and Russia has fed that sense of doom.

Then there’s the yen-like role of the dollar as the funding currency, which is casting a pall over the buck since the longer the Fed keeps a lid on interest rates, the longer the pressure stays on the currency.

Yet the dollar is still the No. 1 currency stashed in reserves around the world, by a long shot. International Monetary Fund data showed the dollar accounting for 65 percent of total allocated reserves in the first quarter.

That means there’s only so far you can push the currency before the self-interest of the world’s savers kicks in to support the buck.

First a little perspective. The dollar’s decline this year mirrors the rise in risky assets like U.S. junk-rated corporate debt that have returned to valuations seen before Lehman Brother’s implosion. Just as credit markets shut down and money poured into safe-haven U.S. Treasuries, the dollar soared as currency investors viewed it as a place to hunker down until the storm passes.

It may still be cloudy, but investors have been confident enough to venture back into riskier territory like emerging markets, which are booming.

That’s meant less money for U.S. assets. Recent data from the U.S. Treasury confirmed as much when it showed net foreign capital outflows of $97.5 billion in July, up from the exit of $56.8 billion in the previous month.

The Fed’s zero-bound interest rate policy has also turned the dollar into a funding currency, where investors borrow in the low yielding dollar and invest in nations that offer juicier returns.

“The dollar is selling off because we have low interest rates. That’s a macro fact,” said Marc Chandler, global head of currency strategy at Brown Brothers Harriman.

Yet, unlike the Japanese yen, which also served as a funding currency earlier this decade, the dollar, or rather dollar-denominated assets, continues to be sought after by nations with big reserves like China and Japan.

Brown Bothers Harriman notes that China snapped up $21.5 billion of such assets in July while Japan added $19.25 billion. Russia and Brazil, which are also sitting on stockpiles of reserves, trimmed their holdings by a relatively small amount.

This is significant. Earlier this year, China and Russia spooked currency markets when they began talking about the need for an alternative to the dollar for the world’s currency reserves.

Such an alternative would help savers like China better protect the value of their assets should the dollar fall out of favor, as it is now. Yet it could take years if not decades to implement.

That means the dollar is still the only game in town, rightly or wrongly, which should provide some comfort to those fearing the worst — a dollar in freefall without a net.