In the year-to-date, the Chinese Yuan has already appreciated 6.5% against the USD, the fastest pace since the currency was famously revalued three years ago. This upward pressure has been built largely on the continuing inflow of speculative "hot money," which was itself built on the expectation of further interest rate hikes, ostensibly needed to tame inflation. However, the Central Bank of China recently indicated a slight shift in its monetary policy, backing away from fighting inflation in favor of promoting economic growth. At least until after the Olympic Games conclude, China will henceforth ignore inflation, so as not to precipitate a slowdown that could jeopardize the Games. The Futures markets have been quick to react, and the consensus expectation for 1-year RMB appreciation has fallen from 10% to 5.4%. Bloomberg News reports:

Once the Olympics are out of the way, the vigil on inflation may have to resume. But unless China gets flooded by speculative flows, a one-shot revaluation will remain off the table.

Read More: China Won't Stamp Out Inflation, Revalue Yuan

Leading up to last week's G8 summit in Japan, it was rumored that "volatility" in forex markets would be a hot topic of discussion. Thus, it came as quite a shock to analysts and investors that the final declaration failed to name any specific currencies. Politicians, especially those representing EU member states, seemed equally surprised. Many of them had hoped to at least come to a rhetorical consensus that the Euro was overvalued relative to the Dollar and Chinese Yuan, and perhaps also the Pound. Given that currencies are evidently not as much of a concern outside the EU, it seems unlikely that any kind of coordinated forex intervention will take place in the near-term. Bloomberg News reports:

Exporters in Germany, Europe's biggest economy, are grappling with the euro's 15 percent appreciation against the dollar and an 18 percent gain against the pound in the past year. That's eroding competitiveness just as a U.S.-led global slowdown and record oil prices cool the world economy.

Read More: Merkel Regrets G-8 Failed to Address Currency Swings at Summit 

The narrative in forex markets had recently become so cut-and-dried, that investors may have forgotten that in the long-term, a variety of factors weigh on currencies. Last week, they were sternly reminded of this fact when tensions in the Middle East boiled over and sent the Dollar racing downwards. An Iranian missile launch sparked the initial uproar, but was quickly followed by unrelated violence in Turkey and Iraq. First, the price of oil skyrocketed, and then the Dollar fell, consistent with the inverse correlation which has been observed between the two commodities. It is unlikely that geopolitical tensions will supercede the macroeconomic situation; investors continue to monitor the credit crisis and interest rate differentials with vigilance. Nonetheless, the events in the Mid East served as a warning against tunnel visions when trading forex. Reuters reports:

Analysts said geopolitics could soon take a back seat again once macroeconomic newsflow picks up after a lack of first tier economic releases from U.S. or euro zone.

Read More: Dollar knocked by geopolitical tensions, oil

2008 has witnessed an explosion of volatility in emerging markets, affecting both debt and equity securities. Fluctuations have been especially dramatic in the forex markets, compounding the turmoil and skewing returns for foreign investors. The South African Rand and Brazilian Real, for example, have moved so violently that for both countries, a 10% gap distinguishes the returns earned by local and foreign investors. As a result, some institutional investors are re-examining their hedging strategies with regard to emerging markets. According to experts, currency hedging among equity investors is still rare because it is expensive and often complex. If hedging is undertaken at all, it is usually outsourced to a third-party. Some investors are quite dogmatic in their insistence that hedging is a complete waste of money, and argue instead that diversification (into different countries/currencies) represents a "natural" hedge. Since, the net change in exchange rates must ultimately be zero, a diversified, long-term approach to investing in emerging markets may automatically mitigate against currency risk. The Guardian reports:

"Currency movements tend to be noisy but over the long term they are just reflective of the economy and not the driver of economic performance."

Read More: FX swings wreak havoc with emerging equity returns

When one hears the phrase "housing crisis" uttered, the US immediately comes to mind. Not without reason, of course, since the US housing market is the largest in the world, and the scope of any US housing crisis is sure to dwarf a comparable crisis in any other country, in absolute terms. At the same time, let's not forget that prices in the UK, for example, began to decline earlier than in the US. In addition, as one columnist points out, the impact of the UK housing crisis may be relatively greater on the UK economy. While some of the statistics he quotes are dubious, housing and consumer debt (on a per capita basis)  may in fact be larger in the UK than in the US. As a result, the ongoing correction in housing prices would be expected to punish the UK more than the US. The story could be the same for the Pound, vis-a-vis the US Dollar. Money & Markets reports:

[One analyst] is...a long-term bear on the British pound and believes any rallies in the currency represent an opportunity to enter short at a better price. Selling the pound against the dollar with a 10-12 month time frame may present one of the best opportunities in the currency markets today.

Read More: UK Housing Bust Spells Trouble for Pound

In a bid designed to placate skittish investors, America's Federal Reserve Bank announced that it will extend the duration of its liquidity facilities at least through 2008 and possible into 2009. It is hoped that the continued enabling (which began several months ago) of certain Wall Street firms to borrow on especially favorable terms will prop up faltering credit markets. Given that both credit conditions and the economy at large continue to flounder, this move seems more symbolic than anything. Analysts are divided about whether this increased liquidity will serve as a complement or a substitute for a near-term interest rate hike. Futures prices had previously reflected a 65% chance that the Fed would hike rates in September, but the bet is now closer to even money. Reuters reports:

Others...think liquidity problems and inflation concerns are two separate issues. [One analyst] believes that the Fed is still on track to raise rates in September.

Read More: Dollar rises as Bernanke calms financial markets

Global capital markets remain caught in a tug of war between inflation and economic growth. For most of 2008, the economic growth story prevailed as the Federal Reserve Bank cut interest rates aggressively to cushion the blow from the housing crisis. However, the pendulum soon swung to inflation and the Fed began to worry that perhaps it had lowered rates too far and may in fact need to hike them in response to surging food and fuel prices. In fact, the European Central Bank recently hiked its benchmark interest rates. Now, a slew of negative economic data threatens to shift the rhetoric back to the other corner. Securities and currencies have fluctuated wildly over this period, and investors remain unsure about which side the world's Central Banks will err on. Currency traders need to look no further than credit markets for a snapshot of the current consensus, which often presages changes in currency valuations. A quick and dirty analysis would place American and Euro-zone short-term bonds side by side and compare the yields (or prices), as a proxy for the EUR/USD exchange rate. The Wall Street Journal reports:

Two-year yields in all three markets have been on a wild ride in June, driven up by tough inflation rhetoric from central banks, then down again by renewed worries about the credit crisis and the state of financial markets.

Read More: Inflation and Growth   Compete for Attention

In what some analysts have termed 'an act of desperation,' Vietnam has devalued its currency, the Dong, by .5%. Negative pressure had been building above the Dong for months, due to a burgeoning trade deficit, sagging stock market, and a stratospheric inflation rate, most recently clocked at 23%. Unfortunately for Vietnam's economic planners, the black market exchange rate remains nearly 5% below the official rate. In addition, futures prices reflect the expectation that the Dong will lose 30% of its value over the next twelve months. At this point, Vietnam is simply trying to forestall a full-scale economic crisis. This will probably involve further devaluations of the Dong. The Times Online reports-

Analysts said that the rising risk of a sudden and crippling depreciation comes as the cracks in Vietnam’s vaunted “economic miracle” have grown too large to ignore.

Read More- Markdown of dong, the Vietnamese currency, seen as act of desperation

In the context of fundamental currency analysis, we usually talk about inflation, interest rates, economic growth, politics, etc. But perhaps these variables mask some deeper "truth" in forex, specifically that there is some ultimate "force" guiding the decision-making processes of forex traders. What we are really talking about here is comfort with risk. Especially in the medium-term (the short-term consisting of hours and defined by randomness and the long-term consisting of years and defined by relative changes in the money supply), investors are constantly re-evaluating the level of risk that they want to assume.

To make this idea more concrete, let's look at how the credit crisis has impacted forex markets. In general, it has favored major currencies, such as the Dollar and the Euro, although sometimes one more than the other. This is to be expected since the capital markets of the US and the EU are the most stable and in times of uncertainty, investors seek out stability. Likewise, the Japanese Yen has fared well. Despite a continuation of its easy money policy, investors have unwound their Yen carry trade positions, ever-fearful that a spike in volatility could cost them dearly. On the other end of the equation are emerging market currencies and beneficiaries of the carry trade, which have faltered as investors pare their exposure to risk. The underlying narrative is the same; only now, investors are willing to accept lower returns in exchange for proportionately lower risk. 

In a move that will shock some investors but please others, the European Central Bank has raised its benchmark interest rate by 25 basis points, to 4.25%. On several recent occasions, Jean-Claude Trichet had alluded to the possibility, in connection to soaring inflation. Critics, including several politicians, have countered that the ECB should also be cognizant of the macroeconomic picture in Europe, which is faltering amid the global credit crunch. But such naysayers should remember that the ECB is mandated to maintain price stability, rather than to explicitly facilitate economic growth. In any event, this move certainly throws a wrench into the forex markets. The Dollar had rallied over the last couple months, as traders had prepared for a narrowing US-EU interest rate differential in the medium-term. So much for that theory, reports The New York Times:

But the sharp rise in inflation has put Europe’s bank into a policy bind because it has been accompanied, in recent days, by evidence that the economy here is deteriorating much like that of the United States.

Read More: Eyes on Inflation, European Bank Raises Rate