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Weekly Market Update

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The BRIC who cried wolf

Tue, Jul 7 2009, 12:42 GMT
by Jeremy Cook

World First UK Ltd

The second half of 2009 started in similar fashion to the first, with equities, commodities and risky currencies retreating, and investor’s favourite safe haven, the US dollar, strengthening.

Sterling was undermined by a far weaker than expected revision of GDP for the first quarter of 2009, showing that the UK economy shrank by 2.4% (consensus was 1.9%). ISM services figures also revealed the first fall in seven months. The euro was steady, with the ECB holding interest rates, yet hinting towards a possible lowering of the benchmark rate to come in the future. Thursday’s nonfarm payroll figure, a broad measure of US unemployment, arrived over 125K worse than expected, providing a real shock to the markets, and some vindication to those opposing the theory of a ‘V shaped’ worldwide recovery. This saw the dollar strengthen, as investors once again looked for shelter from the economic storm.

But what is the long term future of the currency involved in 87% of all foreign exchange transactions, that has 22 currencies pegged to it, and is held as 65% of the world’s foreign exchange reserves? The voices continue to sound louder and louder for a replacement to the greenback as the current global reserve currency, particularly from the BRIC nations (Brazil, Russia, India and China) who have all been on record recently questioning its stability.

China first openly rocked the boat in 2008, as the People’s Bank of China, worried about the value of its dollar reserve holdings and the impact the dollar has on its important export driven economy, noted that there was a need for a global reserve currency “delinked from sovereign nations”. More recently the debate has intensified, with Russian president Dmitry Medvedev openly criticising the dollar system, repeatedly calling for a mix of currencies to be used as the global reserve. On Friday, India announced that it would look to diversify its near $300bn of foreign exchange reserves away from the dollar, and Brazil has been reported to be in support of a replacement.

Joseph Stiglitz, the Nobel Prize winning economist, is one who supports a new global reserve system, noting that economists have been discussing for decades the weakness of a single currency reserve system. He stated that the having the dollar as the reserve currency was “unstable, and had inequality associated with it”, and was in favour of using the already existing special drawing rights (SDR’s), a synthetic currency created by the International Monetary Fund (IMF). Yesterday, in the lead up to this week’s G8 meeting, France’s finance minister Christine Lagarde chimed in, stating that they must explore a new way forward given the “growing role of emerging countries”

However, it is somewhat of a case of ‘the boy who cried wolf’, with regards to the impact these statements are having on the markets. While earlier in the year, foreign exchange markets were reacting strongly and selling off the dollar after a mere hint of any comments from these BRIC countries, the markets are now largely ignoring them.

Until there is a clear movement towards a concrete resolution on the dollar debate, we expect this to continue, and while we concede that an eventual movement away from the dollar is increasingly likely, even the official Chinese newspaper, the ‘People’s Daily’, admits that “the evolution of the US dollars status will be a long drawn-out process”

Looking ahead for the week, the biggest bump on the horizon is the BoE interest rate announcement on Thursday, as we look for a possible change to the Quantitative Easing (QE) program. The euro zone backs up the UK’s disappointing GDP revision figure with their own, released at 10am on Wednesday, while the US has University of Michigan consumer confidence and trade balance figures.

Trade of the week

This week’s trade of the week is a strategy rather than an option, and is called the ‘ratio forward’. It is a synthetic combination of two existing strategies (the participating forward and convertible forward) that are weighted 50% each. For a seller of dollars a buyer of sterling, this client took advantage of a stronger dollar, hedging themselves over a six month period.

When combined, these strategies mean that the client was able to guarantee a worst case rate (WCR) of 1.66. If spot at expiry had never traded at or below 1.50, the client was able to benefit in 75% of the favourable movement. If 1.50 is ever touched then half of the exposure is reverted to a forward at 1.65, and you continue to benefit in 25% of any further favourable movement.

This strategy requires no premium, and is also relevant for sellers of sterling and buyers of other currencies. As there is a potential strengthening for sterling in the future, it provides a balanced upside for this potential, while guaranteeing a tight WCR.

Published on  Tue, Jul 7 2009, 12:46 GMT