Currency Wars, Fiscal Cliff And Central Banks

Includes: FXA, FXC, FXY
by: Luca Avellini

As part of what I do as manager of a Global currency-only multi-strategy fund, I go to conferences. It's very rare to come across revolutionary ideas, and conferences are most likely not the place where one may experience the exception to that rule. If you are familiar with the movie "Margin Call," it's more, like Jeremy Irons puts it, about trying to hear the music (or lack of) that will lead the market over the next few months. But sometimes I hear comments worth writing down, and this is what happened at a recent event in New York. I thought I'd share some of them with you. I apologize in advance for the synthetic style, but I wanted to cut right to the chase.

The Fed vs. the ECB, and their view of the crisis

The most interesting part here is not what the Fed and the ECB say: we have heard it a million times. It's in how differently they are looking at the present situation.

According to the head of the risk analytics group of the Federal Reserve Bank of New York, Joshua Rosenberg, the main issue remains Europe. In general, emergency measures created in 2008/09 are relaxing across the board and the few outstanding loans will be repaid within a few years. When pressed by the audience that asked him why on earth they are so relaxed when we are still in the middle of uncharted (financial) territories, he admitted they, at the Fed, are still working on updating their models to reflect those changes that characterize the post 2008 era.

It was then the turn of Lorenzo Bini-Smaghi, who served on the ECB (European Central Bank) board from 2005 through 2011. In the view of the ECB, the crisis is linked to excess debt, both public and private. Conventional monetary policy alone is not enough to solve the issue. It requires a political intervention. The ECB is very frustrated by the ineptitude and lack of commitment shown by European political leaders in countries like Spain and Italy. The OMT (Outright Monetary Transactions) program was the answer to such frustration.

I thought the contrast in the positions of the Fed and the ECB on the nature of the crisis was puzzling. I wonder whether the Fed, besides blaming Europe for the current global economic situation, may be fighting the crisis of the past instead of the current one. The various QE, including the latest so-called QE infinite, all address a liquidity problem, not a credit one. Well, that problem no longer seems to exist, at least in its original form. And in any case, it is no longer the main issue. Sovereign credit is the next ticking bomb! After all, nobody can deny that the level of debt is definitely also an American issue, and not only European.

The rest of the conference took the format of round tables, with mostly hedge fund managers and bank strategist challenging one another on various topics.

Fiscal cliff

On the U.S. fiscal cliff, there are three positions:

  1. Some believe that Washington will be able to turn it into a non-event. This camp argues that we have already seen the results of the real cliff in 2011 with the downgrade of the U.S. debt.
  2. Others are convinced that the U.S. will be able to avoid the cliff, but this will turn into a fiscal drag in 2013. This means higher taxes and lower spending, which will deduct about 1% from GDP growth, thus leading the country to a very slow economic recovery.
  3. Finally, it's worth noting that one of the panelists, someone very familiar with what happened at Lehman before and after it went bust, well that person believes that the combination of the European debt crisis and the fiscal cliff will have consequences that may surpass in magnitude the market panic of 2008.

Most panelists agreed on one point: the U.S. dollar is likely to appreciate. The reasons: if there is no fiscal cliff, and in particular if there is a real agreement on cutting the U.S. debt, growth prospects in the North America would improve, interest rates may possibly rise, and the dollar would benefit. If on the other hand there is no agreement, we are in for significant market turmoil and the U.S. dollar would appreciate in virtue of its safe-haven nature.

Housing market

Before its collapse, Lehman and the others were creating about $600 billion a year of mortgage securitizations. That money was pumped into the system and boosted the housing market until the bubble burst. Now, on the other hand, we are witnessing the death of the securitization market and banks are holding on to loans. Some argue the housing market is healthier because speculators are left out in the cold, others simply see this as keeping the value of houses low. As for capping mortgage deductions (from taxes) as some Republicans suggested, one panelist noted that some housing markets such as Canada and Australia, are among the most vibrant despite mortgage interests not being deductible.


Currency wars (the practice to devalue a currency to stimulate exports) are the modern equivalent to the protectionism of the 1930s. As a result, in an environment that is more and more dominated by headline risk (unexpected statements issues by politicians) rather than economic fundamentals, managers are tempted to focus more on tactical (short-term) trading than longer-term investing.

Which currencies could appreciate the most in the future

Panelists like the Mexican Peso, the Canadian dollar and the Australian dollar. The Mexican peso and the Canadian dollars are seen as well positioned to take advantage of the higher U.S. economic growth relative to the rest of the world, without the risk of fiscal cliffs. The most disliked currency seems to be the Japanese yen. The Swiss franc was not included in the conversation because it's effectively pegged to the euro.

Ways to play the currency market

There are several ways to play the currency markets. The most liquid one is probably through cash interbank spot transactions. There are many good platforms offering competitive pricing to both private and institutional clients. If you agree with the panelists' view and want to trade the spot market, you may then want to consider buying Australian dollar vs. yen (buy AUDJPY), Canadian dollar vs. yen (buy CADJPY) or Mexican peso vs. yen (buy MXPJPY through the use of crosses such as USDMXP and USDJPY).

Alternatively, one can use ETFs. To replicate the above positions using ETFs instead of cash spot, an investor could buy CurrencyShares Canadian Dollar Trust (NYSEARCA:FXC), CurrencyShares Australian Dollar Trust (NYSEARCA:FXA) and CurrencyShares Mexican Peso Trust (NYSEARCA:FXM), while perhaps selling short CurrencyShares Japanese Yen Trust (NYSEARCA:FXY).

There are many other exchange traded vehicles that give access to the currency market. I invite you to always keep in mind the difference between ETFs and ETNs. They may behave similarly in terms of price changes, but they receive a very different fiscal treatment and create an equally different set of counterpart's risk.

And remember to pay attention to liquidity. If nobody trades it, you don't want to be in it.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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