Currently, the case for an interest rate hike (as the Fed confirmed this week) remains weak: “They will need to see a lot more, better numbers consistently, not just for one or two months, before they would start to genuinely be talking more hawkish…I think the markets may be disappointed if they’re looking for hints of hikes coming soon,” said one strategist. While the data continues to improve – witness last week’s miracle jobs report – it has not yet been demonstrated convincingly and unequivocally that the economy has exited the recession. There are too many contingent possibilities that could send the economy into relapse for the Fed to even consider acting. As I said in my last post, I don’t personally expect a rate hike until next summer.

Still, the markets are alert to the possibility. And where perception is reality, any sniff of rate hikes is enough to send the Dollar soaring; it has risen an impressive 5% against the Euro over the last couple weeks. That investors are acting so early to protect themselves against a possible rate hike shows the precariousness of the foundation on which the Dollar’s rise has been predicated.
What I’m talking about here is the Dollar carry trade, in which investors borrowed in Dollars at record low rates, and invested the proceeds in riskier currencies and assets. It wasn’t so much the interest rate differentials they were chasing (only a few percentage points in most cases, hardly enough to compensate for the risk), but rather outsized returns from currency and asset price appreciation. In other words, while the S&P has risen by an impressive 50% from trough to peak (providing a handsome return to any investor smart enough to have foreseen it), stock markets outside of the the US have performed just as well. Factor in currency appreciation, and in some cases you are talking about gains of around 100%.

But we all know that volatility is the enemy of the carry trade, and volatility is slowly creeping up. First, there was the Dubai debt crisis, then came the downgrading of Greece’s sovereign debt. With talk of interest rate hikes, it’s no wonder that investors are becoming jittery. Bloomberg News reports that, “The so-called 25-delta risk-reversal rate, which was flat as recently as October, hasn’t shown such high relative demand for dollar calls since hitting a record 2.595 percentage points in November 2008….[and] JPMorgan Chase & Co.’s G7 Volatility Index rose to 14.43 last month from the low this year of 12.32 in September.”
The consensus remains that neither the Dubai nor Greece episodes signals broad systemic risk, and that the Fed probably won’t hike rates for a while. Still, investors must brace themselves for the possibility of surprise on one of these fronts, or from a completely unsuspected “bolt from the blue” as one analyst put it, because of what happened to the Dollar after Lehman’s collapse in 2008. As evidenced by the Dollar’s sudden turnaround in the last couple weeks, this kind of uncertainty is self-begetting. As some investors get nervous and begin to unwind their carry trade positions, other investors also begin to move towards the exists, lest they get stuck short the Dollar after the music stops (or when it starts, depending on how you look at it.)

In that sense, the best paradigm for analyzing the Dollar is the end of the carry trade on one hand, weighed against the possibility of interest rate hikes on the other hand. “The dollar will depreciate to $1.55 against the euro by March from $1.49 last week, and to $1.62 by June, according to JPMorgan,” which is betting heavily that investors will remain clear-headed about interest rate differentials. Those that are looking at the Dollar from a risk-aversion/carry trade standpoint have slightly different projections: “I wouldn’t surprised if the euro makes it to $1.40 before the end of the month without much trouble, maybe a little bit lower.”

In short, in forex, it’s never enough to be able to predict the economic future. Instead, you must be able to predict how these predictions will be syncretized into currency valuations by the markets. In this case, that means you need not necessarily be able to accurately predict when the Fed will hike rates; rather you need only be concerned with how other investors view that possibility, and whether that makes them feel more or less confident about holding certain currencies.

That is why small business operators should heed a few strict rules about using credit cards in their daily business activities.

Pay Quickly and Often

Since businesses use credit cards to manage cash flow they should be willing to make payments as soon as the money is available. Managing cash flow means watching income from accounts receivable and being able to allocate that income right away. This will also help prevent interest from accumulating on the credit card balance.

Actively Manage Account Online

Small business credit card account managers should make use of online access to manage their credit card accounts. This will also help them to monitor charges that occur on a daily basis.

Pay Fees and Charges Monthly

Do not allow fees and charges such as annual fees to stay on the account past the month in which they occur. If there is a dispute, it is best to pay the charges and then start an inquiry regarding the charge with the intent of having it reversed.

Watch Your Credit Limit

Credit card companies are doing crazy things with accounts these days that are designed to help them remain profitable. One such action is the lowering of credit limits. This is ok if your balance is paid off every month, but you need to be aware of your limit before you use your card again. If your balance is not high enough to absorb the charge for your purchase, then you will be charged an over limit fee. You might also incur an interest rate charge, too.

Limit Card Holders

In small businesses, usually only one or two people have company credit cards. The challenge that having multiple cards spread among several employees causes is in the management which becomes a larger business activity. The way to minimize this is to minimize the number of cards and accounts that are in use. Close some if necessary.

Limit Card Uses

Placing strict rules on the use of credit cards for specific purposes will help keep that use from getting out of control. In fact, some credit card companies allow businesses to restrict the usage of accounts to certain categories of purchases which not only helps in managing use, but also helps from a security standpoint.

Manage Money Float

Everyone does it – using that day or so between when a payment is made and when it is late, and how long it takes to clear the banks. It’s a part of wise money management because the more your money stays in your account, the more interest you earn on it. But, running on the ragged edge like this can lead to some sleepless nights wondering if and when your money is going to be where it needs to be in the morning.

Having to pay for credit in the form of interest and other charges just to help your business manage cash flow should force you to become good at minimizing the cost of using that credit. Ideally, using credit cards in a business setting is not something that you intend to do for major purchases, but during tough economic times, you have to do what you can to remain profitable.

Using the principles above will help you stay on track and keep credit cards in their proper place – as a business management tool.

This point is further illustrated by the fact that, “the decline in turnover of spot and forwards occurred somewhat later than that in foreign exchange swaps and derivatives….Spot turnover reported in October 2008 was likely to have been supported by large cross-border capital flows as investors sought to reduce risk by repatriating foreign investments. In addition, the high frequency and impact of news at the height of the crisis would have generated the need for investors to frequently adjust their positions.”

The final revelation is that the change in forex volume was not always commensurate with changes in trade volume. A general relationship between trade and forex turnover has been observed, although speculators ensure that currency is exchanged much more frequently than actual goods and services. The two currency pairs registering the greatest unbalance are the CHF/USD and CAD/USD. Forex volume for the former fell much more sharply than trade, while the opposite is true of the latter. One can only speculate as to why this is the case. As for the CHF/USD, forex volume probably suffered disproportionately more because both the Swiss Franc and US Dollar were perceived as safe haven currencies, in which case it would be relatively less useful to exchange them for each other. In the case of the CAD/USD, meanwhile, it makes sense to view the imbalance in terms of the spectacular decline in trade, which was largely a product of declining commodity prices.
It’s impossible to predict whether forex volume will remain depressed. Given the efforts underway to increase regulation and curtail leverage, I don’t personally expect volume to recover for a while. As for the implications, the less might be to stick to the majors. If volume is declining, it will probably affect emerging market currencies most. Lower liquidity might translate into higher volatility. However, it’s worth pointing out that volatility has been declining ever since it skyrocketed after the collapse of Lehman Brothers last fall. In that case, it might be that investors are behaving more prudently with less funds to trade with.

Admittedly, the risk of inflation in the short-term is still low: “With so much of the world ensnared by the economic downturn, demand for goods and services is weak, which tends to push down prices. Amid high unemployment, workers are in no position to demand wage increases.” Still, the Consumer Price Index (CPI) is already creeping up. The Fed’s “core” measure, which excludes food and energy prices, rose 1.8% from a year ago. If commodity prices continue to rise, the total CPI could soon become positive. (It currently stands at -1.3%).

Among academics and economists, the discussion is being framed relative to the Fed; specifically, can it - and more importantly, will it - move to unwind its quantitative easing program when the time comes? “If it acts prematurely to reduce the money supply, the Fed could stifle the recovery. If it waits too long, it could contribute to a jump in inflation. Its timing is going to have to be perfect,” says a former Fed economist.

This question remains divisive, as evidenced by the ongoing feud between the chief economist at Morgan Stanley and his counterpart over at Goldman Sachs. MS is concerned that the Fed will leave rates too long. According to one of his supporters, “The Fed absolutely has the tools and know-how, but the question is, will they have the guts to use them? I don’t think there is a snowball’s chance in hell they will be willing to tighten to slow inflation down.” Counters the GS camp: ““The Fed will be able to contain inflation pressures through a combination of raising interest rates and unwinding its balance sheets.”

That was until this week, when the SNB sprung into action, buying Euros on the open market. “The franc slid as much as 2.4 percent versus the euro and 3.3 percent against the dollar, the biggest declines since…March 12.” It’s not clear why the SNB suddenly intervened after months of inaction. The Central Bank didn’t hold a press conference to “celebrate” its intervention, and the only indication was a vague declaration last week that “policy makers will act to curb any ‘irrational appreciation’ of the franc.”

swiss-franc-rises-after-snb-intervention

Analysts have speculated that the SNB is (arbitrarily) targeting the exchange rate of $1.50 Francs/Euro, which is plausible given that the intervention occurred very close to that level: “They’re trying to put a line in the sand at 1.50. There’s a big debate as to whether they will continue doing this, and for how long they will remain successful.” After all, the idea of intervention is more effective than intervention itself. The SNB can only buying so many Euros; the real value is in the threat to continue buying, which keeps investors from building up speculative positions.

While the SNB has been criticized as “protectionist” for its actions, its premise for intervention is well-grounded. According to the OECD, “Switzerland should keep interest rates close to zero well into 2010 and mull more fiscal stimulus to fight a deep recession and the risk of deflation.” Modest deflation has already set in, facilitated by a collapse in aggregate demand. Varying forecasts are calling for an economic contraction in 2009 equal to -2.5%-3%, and even a modest contraction to follow in 2010. Q1 GDP growth was negative and the consensus is that Q2 will prove to have been more of the same. If this trend continues, 2009 will be the worst year economically in over 30 years. Still, economic indicators suggest the bottom is soon approaching, and the overall picture is consistent with the rest of Europe.

The real concern is that other Central Banks will imitate the Swiss approach. “In the past couple of weeks we have had five or six central banks, including the Bank of Canada and the Bank of England, talking down their currencies. Like Switzerland, they are fearful that currency appreciation could offset the stimulus to the economy,” noted one analyst. Monetary and economic conditions remain abysmal worldwide, and most banks have already exhausted the tools available to them. Interest rates are universally close to zero; fiscal “stimuli” will push the OECD debt/GDP ratio past 100% in 2009; quantitative easing has given rise to wholesale money printing. Currency devaluation may be the only option left.