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Over the last year, declines in imports and commodity prices have contributed to a veritable collapse in the US trade imbalance. While the deficit increased to $27 Billion last month, the general trend is definitely still downwards. Since the inception of the credit crisis, US imports have fallen by a record 40%, on an annualized basis. In March, “Imports decreased 1 percent to $151.2 billion, the fewest since September 2004. Demand fell for industrial supplies such as natural gas and steel and for capital goods such as engines and machinery, reflecting the slump in U.S. business investment.†Lower commodity prices have also played a role on the imports side of the equation. In fact, if not for a slight uptick in energy prices, the deficit probably would have declined further this month.
Economists remain divided as to whether the trade deficit will continue to decline: “The low-hanging fruit has been achieved, and it will be difficult to narrow the trade deficit by much more going forward, especially if the vicious downturn in the economy seen in the fourth quarter and first quarter has begun to abate…..Once the economy begins to return to health in earnest (mainly a 2010 story), the trade deficit will likely begin to re-widen.†But a competing view expects “drooping consumer demand to weigh on imports and keep the trade deficit on a narrowing trend in the coming months,†in which case the deficit could fall to $350 Billion by the end of the year. Compared this to the record $788 Billion deficit of 2006! While the balance of trade doesn’t figure directly into GDP (although it confusingly is incorporated into the expenditure method), a declining trade balance is generally reflective of a healthier economy. It implies that either exports are growing relatively faster than imports, and/or consumers are diverting more of their relative spending towards domestic consumption, both of which should contribute positively to GDP. Summarizes one economist, “If the current account did move towards balance, then it would allow the U. S. economy to probably grow at a more sustainable rate in the long term.†The idea of sustainability (not in the environmental sense, unfortunately) is also connected to the US Dollar. Generally speaking, it is the Dollar’s role as the world’s reserve currency which has enabled the US to run a trade imbalance almost continuously for the last 30 years. In other words, trade surplus economies are willing to accept Dollars because they can be stably and profitably invested in the US. In this regard, one commentator hit the nail right on the head: “When it comes to the U.S. trade gap, how many refrigerators the U.S. sells overseas is far less important than how many dollars the rest of the world wants.â€
Note: Both Charts courtesy of International Business Times.  According to a recent Reuters poll, investors are increasingly bullish on emerging market Asian currencies, including the Taiwan dollar, Indonesian rupiah, Singapore dollar, Malaysian ringgit, Philippine peso, South Korean won, and Indian rupee. The Thai Baht wasn’t covered by the poll, but given its strong performance over the last few months, it seems safe to include it in the bunch. This uptick in sentiment is somewhat unspectacular, since “The Bloomberg-JPMorgan Asia Dollar Index, which tracks the 10 most-active regional currencies,†has now risen for almost three consecutive months [See chart below]. Leading the pack are the Taiwan Dollar and South Korean Won, which recently touched five-month and seven-month highs, respectively. “The Korean currency has climbed 28 percent since reaching an 11-year low of 1,597.45 in March.â€
Investors are now pouring money back into Asia at rapid clip. “Asia ex-Japan received $933 million in the week ended May 20, the most among emerging-market stock funds, bringing the total this year to $6.9 billion.†Meanwhile, the “The MSCI Asia Pacific Index of regional stocks climbed 22 percent this quarter†while Chinese stocks are up 45% since the beginning of 2009. But it’s unclear – doubtful is a better word – whether this rally is supported by economic fundamentals. One commentator summarized this contradiction as follows: “Improved sentiment has led to a massive resurgence in flows to emerging markets, irrespective of the underlying data, which remains weak. Investors are going out of dollars to riskier markets, riskier currencies.†Let’s drill down into some of the data. Chinese exports fell 15% in April. Japan’s economy contracted 15% in the most recent quarter. Singapore’s exports are down 20% on an annualized basis. The South Korean economy is projected to shrink by 2% this year. The Central Bank of Thailand just cut its benchmark interest rate to an unbelievable 1%. The only bright spot economically is Taiwan, which is benefiting both from improved economic ties with China and a healthy current account surplus. I suppose everything is relative, as “developing Asian economies will grow 4.8 percent in 2009, even as the world economy contracts 1.3 percent†according to the International Monetary Fund. The notion that the rally is not rooted in fundamentals is shared by the region’s Central Banks, which clearly realize that economic recovery will be much more difficult in the face of currency appreciation. One analyst argues that, “Until the signs of global economic recovery become more convincing, central banks will unlikely tolerate significant currency appreciation.†The Central Banks of South Korea, Taiwan, and Indonesia have already actively intervened to hold their currencies down, while Malaysia and Singapore (discussed in a Forexblog post last week) have also intervened for the sake of stability. As a result, this rally could soon begin to lose steam. “A â€کcorrection’ in regional currencies is â€کappropriate’ following recent gains,†said one analyst. Another has called the rally “overdone.†Still, Central Banks and economic data pale in comparison to capital flows and risk/reward analysis. In short, these currencies (and other investments) will continue to find buyers for as long as there are those hungry for risk. Citigroup, whose “Asia-Pacific foreign-exchange volume may rise about 10 percent from the first quarter,†is bullish. A representative of the firm declared: “Fund managers are still ’sitting on lots and lots of cash’ so the pickup in volumes will continue.†Over the last couple months, the Euro has thoroughly outperformed the Dollar, which recently fell to a five-month low on a trade-weighted basis. Over the same period, global stock and commodity prices have also risen quickly, which is not a coincidence. Meanwhile, “Implied volatility on major currencies, which reflects investors’ expectations of currency swings, fell to 13.96 percent yesterday, from…17.22 percent at the end of March. A drop in volatility tends to signal less demand for options to protect investors from currency swings.†This indicator is now at its lowest level since the days preceding the Lehman Brothers bankruptcy and subsequent stock market collapse. One would normally expect a correlation between risk and return, but in this case, rising returns have been accompanied by lower risk. Even more unbelievable is that this decline in risk is taking place against the backdrop of declining economic fundamentals. “Risk appetite in the currency market is nothing short of impressive considering the fact that the Fed reduced their growth forecasts,†said one analyst. However, “The euro-area economy will contract 4.2 percent this year, according to the International Monetary Fund, more than the projected 2.8 percent contraction in the U.S. and 4.1 percent slump in the U.K.†If investors were focusing on this divergence in economic growth, one would expect the Euro would be falling. One hypothesis is that inflation-conscious traders are flocking to the Euro, since the ECB remains vigilant about fighting inflation, even in the face of declining prices and aggregate demand. After cutting rates to a record low 1% earlier this month, the ECB unveiled its own version of a quantitative easing plan, involving the purchase of 60 billion euros worth of low risk securities. But this is a pittance, both relative to the size of the EU economy (it represents a mere .6% of GDP) and compared to the Trillion Dollar Fed program. This led one analyst to call the ECB’s plan “chicken feed.†While all of this is noteworthy, it’s unlikely that this is having a meaningful effect on forex markets, which still remain focused on (avoiding) deflation. If the Euro is to continue rising, it must overcome some technical obstacles. “The euro could hit a ceiling if the recent resilience of U.S. stock markets faces headwinds. â€کAt some point…stronger nongovernment growth has to show up to sustain and justify these moves in equities.’ †It’s interesting that the fear of Euro bulls is not that the EU economy won’t recover, but rather that US stock prices are overvalued. Given recent market movements, however, their concerns are reasonable, and “any disappointment [in corporate fundamentals] could provide an excuse to take profit [this] week — benefiting the dollar.†I found this great tidbit of info this morning. The past 4 highs in the EUR/USD have occurred within 2 days of an FOMC meeting. The sell-off after-wards has been sharp, leading me to wonder whether today’s reversal is foreshadowing a larger decline ahead. Click on the chart for a zoomed in view 
Source: Bloomberg London markets are closed today for May Day while Japanese Markets are closed for Greenery Day. The most recent IMM Commitment of Traders report shows that USD longs were cut back substantially. This suggests that traders are starting to turn dollar bearish which is in line with the recent improvements in risk appetite. 
source: Deutsche Bank There is also an article in today’s NY Times that suggest better than expected results from stress tests based upon quotes from a “senior official.†Tests of Banks May Bring Hope More Than Fear The central question in the financial markets right now is whether the global recession is nearing an end. In addition to the U.S., improvements were also seen in the Chinese and the U.K. manufacturing sectors. The price action of the currency, equity and bond markets suggest investors believe that the worst is over. The U.S. Treasury yield curve is steepening, which means that longer term rates are rising. This is a reflection of the market’s optimistic outlook for the U.S. economy. However we are only cautiously optimistic because it is far too early to label the recent improvements a new trend. Wad of Cash One of the primary arguments for a recovery and further gains in equities is the wad of cash sitting on sidelines. According to JPMorgan, close to $700 billion is parked in bank accounts and money market funds in the U.S. alone and therefore deployment of these funds could pave the way for a stronger recovery in currencies and equities. If you remember, the recession was triggered by a crisis of confidence and if confidence is restored, the money sitting on the sidelines may move back into the markets. We will be watching closely to see if the recent stability can turn into sustainability here in the U.S. and abroad. In the meantime, it is encouraging to see currency, equity, commodities and bond traders all price in a greater chance of a recovery. article from kathylien |
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In other words, investors are allocating capital on the basis of risk, rather than in accordance with (economic) fundamentals. For example, “ICE’s Dollar Index and crude oil have a correlation of minus 0.61 in the past two months, compared with minus 0.26 since the start of the year,†as rising oil prices and the declining Dollar feed back into each other.