Investing in the foreign exchange market is like judging a reverse beauty contest, that is to say, trying to select the currency that looks the least ugly at any given moment in time. Almost every major central bank is trying to devalue its currency to gain a competitive advantage for their local exporters, either through direct market intervention, jawboning, or adjustments of short term interest rates.

Seldom does a central bank decide to go against the grain of competitive currency devaluation, and instead, take action to strengthen its currency, to combat inflation even at the expense of a possible economic slowdown. But such was the case of the Bank of Brazil, which has earned the reputation as the world's toughest inflation fighter, after jacking up its overnight Selic loan rate in half-point increments, from 16% to as high as 19.75% in the summer of 2005.

The Bank of Brazil tackled inflation head-on last year, even at the expense of contracting the local economy -1.2% in the third quarter. The central bank reined-in consumer price inflation from as high as 7.9% in April 2005 to as low as 4.5% in December. The bank's bravado was rewarded with an astounding drop in Brazil's 2040 benchmark bond yield from 13% in early 2004 to as low as 6.25% last month. Lower Brazilian bond yields sent the Bovespa stock index through the roof.

Brazil 's currency appreciated by 34% to 2.1 reals per US dollar on March 17th, its highest level in 4-½ years, and has remained strong despite the central bank's efforts to slow its advance through heavy intervention. The "Commodity Super Cycle" has boosted Brazilian exports and trade surplus to record highs, enabling its economy to withstand the real's surge against the US dollar and Argentine peso.

The history of Brazil's real is a long story, but South America's largest economy has gone from the brink of default on $332 billion of local debt, its benchmark bond trading at 49 cents on the dollar to yield 26%, and its currency plunging 23% in the third quarter of 2002 toward a record low of 4 reals per US dollar. Today, Brazil's real is the world's reining beauty queen and everyone wants to own its debt.

In 2005, the Federal Reserve abandoned its cheap dollar policy, and tried to defend the greenback against the Euro and yen through a series of baby-step rate hikes, without puncturing the US stock market rally or the US housing bubble. The Fed achieved its twin objectives, because Asian central banks and Arab oil kingdoms were heavy buyers of US Treasury bonds, keeping US mortgage rates low.

The most notorious Asian buyers of US debt were China and Japan, which recycled hundreds of billions of US dollars acquired through foreign currency intervention back into the US debt markets. All told, Asian central banks hold a whopping $2.75 trillion of foreign exchange reserves, led by Japan's $851.7 billion, China's $818.9 billion, Taiwan's $257.3 billion, and South Korea's $217 billion.

Beijing is on course to top $1 trillion in FX reserves this year, and wants to diversify this year's build-up of cash away from the US dollar. Beijing's satellite colony, Hong Kong, owns another $127.8 billion of foreign currency reserves. Therefore, the US Treasury is afraid to identify China as a currency manipulator, even after the US rang up a $202 billion trade deficit with China, due to fear that Beijing and its satellite could retaliate by selling US bonds, and driving mortgage rates higher.

To discourage Asian central banks from dumping their US dollars, the Greenspan Fed engineered a 15% counter trend rally for the US dollar against a basket of major currencies, including the Euro, British pound, and Japanese yen. Higher Fed rates were required to prevent the US dollar from falling under its own weight, due to a rising tide of current account deficits. Despite a sharp 26% devaluation of the dollar from its highs in 2002, the US still posted a record trade deficit of $723.6 billion in 2005, and started 2006 with a record $68.5 billion shortfall in January.

The Fed's rate hike campaign failed to slow the US appetite for foreign made goods, as Americans extracted $600 of home-owners equity to meet their expenditures. Also, Washington is on track to borrow $364 billion in 2006, more money than any other government in the world, or 34% of gross global government borrowing, up 14% from 2005, according to Standard and Poor's. And greater amounts of US debt held in foreign hands will require larger interest rate payments abroad.

Thus, the US dollar's rally in 2005 was quite pathetic, given the magnitude of its interest rate advantage over the Euro and yen. Unless the US dollar index can eclipse the 92.00 level on a sustained basis, its 2005 rally could stall out, and become nothing more than a counter-trend rally in a longer-term bear market.

Yet the series of 14 baby-step rate hikes by the Federal Reserve to 4.50%, and the widely telegraphed rate hike to 4.75% on March 28th, was able to achieve what the Bank of Japan could not accomplish in 2003 and early 2004. The BOJ made history after it sold 35 trillion yen and bought $300 billion US dollars from 116-yen down to as low as 106-yen, peppered with countless jawboning sessions, in a determined effort to prevent the dollar from falling below 100-yen.

The US dollar was under heavy speculative attack as the Greenspan Fed pegged the federal funds rate at 1% in a desperate attempt to re-inflate the US equity markets, following the Iraqi war and the bursting of the Nasdaq high tech bubble, amid a sludge of high a rising budget and trade deficits. The BOJ was holding a paper loss of $73 billion from its massive intervention in January 2005. Yet the ruling LDP elite in Tokyo approved another 40 trillion yen for intervention in the 2005 budget.

However, once the Federal Reserve lifted the fed funds rate above 2.50% in the second quarter of 2005, traders began to cover their short dollar positions, and the US currency managed to climb as high as 121.50-yen in December 2005, much to the satisfaction of Japan's financial warlords. The weaker yen helped ignite a 42% rally for the Nikkei-225 stock index to as high as 16,800, the highest in 5-years.

But Japan's ministry of Finance must borrow yen for its foreign exchange intervention account by issuing short-term finance bills. With the BOJ dismantling its five year ultra easy money policy in the months ahead, Tokyo will have to start paying interest on past and future interventions it conducts on behalf of the dollar. Moreover, PM Koizumi is keen on limiting the government's budget deficit to 30 trillion yen this year, to limit the damage to the longer term JGB market, in the face of a tighter BOJ policy. That could limit the scope of BOJ intervention in 2006.

Under its five year old policy of "quantitative easing" the BOJ flooded the banking system with 30-35 trillion yen ($255-$297 billion) of deposits, about five to six times the legally required reserves. But with Japan's consumer price index moving into positive territory for the first time in eight years, the BOJ has announced that it will abandoned its cheap yen policy, and gradually drain 26 trillion yen ($220 billion) out of the Tokyo money markets towards the legally required amount of 6 trillion yen.

The BOJ, which has been buying 1.2 trillion yen of long-term Japanese government bonds (JGB's) each month under the quantitative easing regime, said it will eventually lower the amount of monthly purchases, tightening the supply of yen in global markets. Thus, the BOJ must try to match the wizardry of the Greenspan Fed, by tightening rates without disturbing the re-invigorated Nikkei-225 stock index, nor snuff out a new born recovery in Japanese real estate prices.

So with the BOJ on track to tighten its monetary policy in the months ahead, San Francisco Fed chief Janet Yellen put the dagger in the US dollar on March 13th, when she hinted that the Fed rate hike campaign was reaching a dead end. "I think we're in a range where Fed decisions have become quite data-dependent and there does need to be sensitivity to the possibility of overshooting," she warned.

Then on March 16th, US Labor dept apparatchnicks told the mainstream media that consumer prices were only 0.1% higher in February, taming fears of a tighter Fed policy on Wall Street. Fed chief Ben Bernanke has a reputation of a radical inflationist in the gold market, and is anxious to shed some of his dovish feathers with a quarter-point rate hike to 4.75% next week. But he could point to the February inflation report as justification to halt the rate hike campaign at ay moment.

And without the crutch of higher interest rate expectations, the US dollar could tumble against currencies with trade surpluses, such as the Euro, Korean won, Japanese yen, and eventually, the Chinese yuan. Japan in particular, earned a trade surplus of 7.6 trillion ($64 billion) last year, and its income surplus from dividends and interest rose to a record 11.4 trillion yen ($97 billion) last year.

Looking forward, the Bernanke Fed is likely to continue the "Easy" Al Greenspan policy of "asset targeting." "We probably do need to see some cooling-off in the housing sector," said SF Fed chief Yellen said, adding that despite the Fed's lifting of short-term rates, relatively low long-term rates meant there had been only a limited tightening in financial conditions. "We won't get a slowdown in the economy, I think, unless there is at least some moderation in the pace of house price increases."

The Bernanke Fed could aim for a fed funds rate that neither stimulates a speculative run-up in housing prices, nor triggers a bursting of the housing bubble. The neutral fed funds rate would keep average US home prices steady. "As financial markets continue to broaden and deepen, the behavior of asset prices will play an important role in the formulation of monetary policy going forward, perhaps a more important role than in the past," said New York Fed chief Timothy Geithner on January 11th.

Sales of new US homes fell 5% in January to a 1.233 million unit pace, their slowest pace in a year while the number of homes on the market hit a record high, according to a government report on February 27th that signaled a further cooling in the housing market. The number of new homes available for sale at the end of January rose to a record 528,000. At the current sales pace, that represented 5.2 months' supply, the largest inventory since November 1996.

"The substantial uncertainty about the path of asset price movements going forward necessarily reduces the case for altering policy in advance of the move. Instead, when policy makers have already witnessed a significant move in asset values, and are confident in what that move means for the outlook, it should be prepared to adjust policy accordingly," Geithner said.

The Fed could follow in the footsteps of the Bank of England, which has championed "asset targeting" since 2001, when its slashed its overnight base rate from 5.50% to as low as 3.50% in 2003, in an effort to cushion the decline the British stock market. By slashing its base rate, the BOE inflated the average UK home price from 180,000 British pounds toward 310,000 pounds by October 2004. The BOE began a series of baby-step rate hikes in late 2003 to rein in the UK housing bubble it created, which expanded by as much as 26% annualized in 2004, but then flattened out in 2005.

When it appeared that UK home price might actually fall on a year-over-year basis, the BOE panicked and quickly lowered its base rate a quarter-point to 4.50% in August 2005, and sent signals that rates could fall further. But the Bank of England kept its benchmark interest rate on hold for a fifth month on January 12th, 2006, and Deputy BOE chief John Gieve ruled out a rate cut on January 26th, "Over the last 18 months we've seen a fair degree of stability in house prices," he said.

With the FTSE-100 climbing above the psychological 6000 level and British home prices moving into new high ground, the next shift in the Bank of England's base rate is likely be to the upside. However, the doves outnumber the hawks at the BOE, and asset inflation is likely to run rampant in the months ahead in the UK, before the central bank reverses its rate cut of August 2005.

And while Japanese traders were unloading the US dollar for yen last week, they were also unwinding long positions in the New Zealand kiwi. Japanese investors became addicted to the "carry trade" or borrowing in yen at zero percent and locking in higher yielding deposits in other foreign currencies, such as New Zealand kiwis, which currently yield around 7.25% for short term deposits.

The Reserve Bank of New Zealand lifted its cash rate nine times by a combined 2.25% since January 2004. The last hike was on December 7 th, when the central bank raised rates by 25 basis points to 7.25 percent. Japanese traders maintained their love affair with the kiwi to as high as 87-yen from 48-yen in 2001, tracking the path of rising kiwi interest rates.

But the kiwi/yen bubble began to burst in mid-December, when BOJ chief Fukui said Japan's core consumer price index was likely to show a clear year-on-year rise in the January-March quarter, and a high chance of a rising prices beyond that period. "Now we know that the core consumer price index for October was zero, everyone expects that the end of fulfilling our commitment is near," Fukui warned.

Attempting to jawbone the kiwi lower on November 3rd, RBNZ chief Bollard said a high New Zealand dollar was a major factor behind a worsening NZ current account deficit, which stands at 8% of gross domestic product (GDP), the highest level for two decades. "We now see the exchange rate as exceptionally high, and in some respects this is unjustifiable; in time it will fall," he said.

"The decline in the currency would be either gradual as domestic spending eased, or abrupt if global investors withdrew from New Zealand assets. Either way, those investors who think that the New Zealand dollar only goes up will be set up for disappointment," Bollard correctly predicted on November 3rd.

The New Zealand dollar plunged to 20-month lows against the US dollar on March 20th, amid a shrinking interest rate gap and bearish comments from Prime Minister Helen Clark, who said a lower kiwi exchange rate was good for exporters. Trade minister Phil Goff also jawboned the kiwi lower on March 16th. "The forecasts suggest the NZ dollar will settle somewhere between 59 and 65 US-cents. I think that most New Zealand companies would find that to be a reasonable level to operate from."

"We have a strong economy, but we have a large current account deficit and the fall in the New Zealand dollar is going to be good for exporters, and it will bring our current account back into balance. From a level that was perhaps unsustainably high, we believe it will come back to a more comfortable level, but still a level above where it was five years ago," Goff said.

RBNZ chief Alan Bollard said he is unlikely to cut the cash rate from a record 7.25% this year because a slowing economy has yet to reduce inflation risks. Bollard said inflation will remain near the top of his target rate of between 1% and 3% for at least another year. Consumer prices rose 3.2% last year. "Inflationary risks mean we won't be likely to cut rates this calendar year. We don't have a recessionary picture."

But because 64% of New Zealand government bonds are owned by foreigners, the RBNZ can't afford to see the kiwi unwinding turn into a rout. That could result in heavy foreign sales of NZ bonds, putting upward pressure on long term rates, and damaging the local economy. So with the kiwi falling below 76-yen, Bollard ruled out a rate cut for all of 2006, hoping to put a floor under the kiwi. But as history shows, the currency market doesn't always obey orders from the RBNZ.

The end of the BOJ's quantitative easing might impact the fortunes of the Australian dollar, which has served Tokyo traders as a high yielding proxy for gold. Booming commodity exports are not delivering an improvement in Australia's external balances. The deficit on goods, services and investment widened to AD$14.45 billion ($10.7 billion) from AD$13.67 billion in the third quarter. A widening trade shortfall has subtracted growth from Asia-Pacific's fifth-largest economy for over four years.

"In consequence, Australia's current account deficit has remained high at around 6% of GDP recently," RBA chief Ian Macfarlane said on February 17th. "Still, the market hasn't been concerned by the size of the deficit. If people were really disturbed about the shortfall, then the exchange rate would plunge," Macfarlane said.

The deterioration in Australia's current account was driven by a net outflow of dividend and interest payments abroad of $AD10 billion. Since Australia is a net debtor and foreigners own large slices of its biggest companies, a big chunk of the profit windfall from the commodity boom is going offshore. Australians are paying more to service their A$472 billion of net foreign debt. In contrast, the Japanese are major creditors and bought 16.6 trillion yen ($141 billion) of foreign bonds in 2005.

Still commodity export earnings by Australia, the world's biggest shipper of coal, iron ore, alumina and wool, may rise by 7.4% to A$134.2 billion in fiscal 2007 to a third-straight record driven by China's demand for raw materials, the government forecast on February 28th. But Australia also imports more than it exports, particularly capital equipment for investment, leading to a AD$4.37 billion deficit on the goods and services account for the fourth quarter.

The gap between Australian and US Libor rates is the smallest in almost five years, knocking the Australian dollar to a 17-month low of 72 US-cents. While the Reserve Bank of Australia has signaled it will hold rates steady, US interest-rate futures show the Fed will hike the fed funds rate to 4.75% on March 28th. The odds of another quarter-point hike at its May 10th meeting are narrowing to 82%.

Australian raw materials, such as copper, uranium, zinc and gold which comprise about 60% of exports, and contribute about 13% to the economy, are soaring to stratospheric heights. But while metal prices are rising, Australia's interest rate advantage is narrowing, and is out-weighing the effect of higher metals prices. Much like his New Zealand counterpart, the RBA's Ian McFarlane tried to put a floor under the Aussie dollar to promote a two-way market on February 17th.

"It is more likely that the next move in rates would be up rather than down. It's far more likely upward pressure on inflation will prevail and we will have to react to it. It's not meant to say we have a plan to increase rates," McFarlane said. The jawboning did unwind Australia's inverted yield curve, and the ASX-200 stock index jumped above the psychological 5000 mark, celebrating the weaker Aussie dollar.

Japanese traders have been reluctant to part with the Canadian Petro-dollar until last week, when the Canuck buck fell to 100-yen from 102.5-yen the previous week. Canada enjoyed a record current account surplus of CD$30.2 billion in 2005, as record energy prices bolstered oil and natural gas exports, allowing Canada to extend its economic expansion to nine straight quarters.

The strength in exports reinforced the Bank of Canada's assessment that the country has shrugged off a rising Canadian dollar and is operating at full capacity. However, after lifting its overnight interest rate a quarter-point to 3.75% on March 7th, the BOC suggested its current tightening cycle may be drawing to a close, and noted the Canadian dollar rose more against the US dollar than expected. "Consistent with this view, some modest further increase in the policy interest rate may be required to keep aggregate supply and demand in balance and inflation on target over the medium term," sounding less hawkish while jawboning its currency lower.

The Bank of Canada's rate hike to 3.75% marked the fifth increase in a row since September, and dealers are looking forward to the next rate-setting meeting on April 25th. The BOC might decide to peg its overnight loan rate at a one-percent discount to the US fed funds rate, and wait for the Fed to reveal its next move in May. In the meantime, Loonie/yen traders could keep their eyes focused on Japanese interest rates and gyrations in the crude oil market.

The Euro jumped above the $1.20 level last week, on speculation that the Fed's tightening campaign would wind down at 4.75% or 5.00 percent. The ECB prefers the Euro at the sweet spot of $1.20, which help European exporters, while holding down the escalating cost of dollar denominated raw material and crude oil imports. Still, German producer prices were 5.9% higher in February than a year earlier.

But the United Arab Emirates, which includes Dubai, said it was looking to move one-tenth of its $23 billion of US dollar reserves into Euros. The governor of the Saudi Arabian central bank, Hamad Saud al-Sayyari condemned as "discrimination", a decision by the US Congress to block a Dubai company from buying five of its ports. Also, Iran will begin trading its crude oil exports, estimated at $45 billion per year, in exchange for Euros as of March 20th.

So with the Euro looking a little less ugly than the US dollar in the Middle East, traders bid the Euro higher to $1.22 on March 17th. In a real struggle for competitive devaluation however, the ECB has expanded its Euro M3 money by 7.6% from a year ago, while the US M3 growth rate is 8.7% higher. Both central banks aim to inflate their equity markets higher with explosive money growth, while the ECB is nurturing mergers and acquisitions, the big energizer on Europe's stock exchanges.

The US M3 money supply stands at a record $10.34 trillion and is $827 billion higher from a year ago, and has become such an embarrassment, that the Federal Reserve will cease publishing its growth rate after March 24th. However, the decision to abandon M3 reporting could create widespread mistrust about the Fed's custodianship of the US dollar, and persuade many foreign central banks to diversify their reserves into gold, silver, commodities, or even foreign equities.

And Trichet doesn't want the Euro to spiral higher against the US dollar either, which could hurt the earnings of European multinationals and exporters. "Our monetary policy is accommodating. We have real short-term interest rates that are very close to zero, nominal short-term interest rates are the lowest in the Euro area since the Second World War. There is abundant liquidity," noting that Euro M3 money supply is growing at four times the pace of the Euro zone's economic output.

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