Foreign Exchange Insights
May 30, 2008
The dollar continues to march inversely to the beat of oil prices. A sharp 4.7% advance in oil costs during the week to May 23rd had been associated with across-the-board dollar declines. Oil reversed course this past week, and the dollar followed. Both oil and the dollar are now near their levels of two weeks ago. At 15:00 GMT today, the dollar had accrued weekly gains of 2.0% against the Swiss franc and yen and 1.4% against the euro. These are the three traditional hard currencies, which have perennially been well-bid against the dollar whenever accelerating inflation was a global problem. Hold that thought just one moment. Appreciation last week in the greenback was more limited against other currencies like the Aussie dollar (0.6%), Candian dollar (0.5%), kiwi (0.3%) and sterling (0.2%).
What I find striking about this past week’s action is that a group of currencies that usually do well when, as now, investors worry about future inflation are the ones that performed worse. In any given week, many forces push and tug at the currency markets, some fundamental but many of a technical and transitory nature. This week opened with holidays in both the U.S. and British markets. It was the final week of a calendar month and the first week of the summer trading season. An enormous whip-saw occurred in the oil market these past two weeks. The surprise in such circumstances would frankly have been not to have experienced considerable market noise. If inflation remains a predominant market concern in June, as I believel, historical patterns argue against sustained weakness in the euro, yen and Swissy in the period ahead.For May as a whole, the dollar did not register significant net movement, rising as of 15:00 GMT by 1.5% against the yen, 1.0% against the Canadian dollar, and 0.5% each against sterling and the euro but falling by 1.3% against the Canadian dollar, 1.1% against the Australian dollar, and 0.1% relative to the kiwi. High/low dollar boundaries in May were 105.87 – 102.58 against the yen, 1.5287 – 1.5818 against the euro, 1.0622 – 1.0217 against the Swiss franc and 1.9366 – 1.9909 against the pound. The action in foreign exchange was less remarkable than in oil, which still managed to post a net advance of about 10%, or in sovereign fixed income securities, where 10-year yields recorded net increases of 31 basis points in Britain and more than 20 bps in the United States, Germany and Australia. 10-year Japanese Government bond yields (JGB’s) touched a ten-month high in the month of 1.81% and closed 13 bps higher on balance. Most importantly, a dollar crisis was avoided in May.
Will June play May’s tune? Not only were price data throughout the world uniformly disturbing in May, but also indicators of expected inflation crept upward at a faster pace in many places. A shift in market anxiety away from deficient growth and toward excessive inflation helps the dollar in the short term, convincing investors that the more hawkish tone of remarks by Fed officials is not mere lip service. Only the most diehard U.S. economic bears think a Fed pause will last through only a single policy meeting. I believe that the Fed stopped easing at a 2.0% Fed funds rate not only because of more even-sided perceived risks between growth and price stability and that it will take more than weaker growth than Fed officials are imagining to tip the FOMC back into rate-cutting mode. Although not emphasized in the FOMC minutes, the possibility of a dollar crisis was lurking in the background. Greater dollar stability since the rescue of Bear Stearns in mid-March doesn’t remove that risk. The EUR/USD relationship, which is the best gauge of general dollar sentiment, as recently as May 27th was merely 2 cents below its March peak, and as I mentioned before, the dollar tends to run into trouble when global inflation becomes a pressing concern. The Fed funds rate moved below 2% earlier this decade only because of deflationary fears. The landscape now is entirely different. Even with a U.S. recession, a fed funds rate of 2.0% looks too loose with CPI inflation at 3.9% and with evidence mounting that expected inflation is coming unglued.
Any dollar appreciation or even a stable dollar going forward is going to stem from signs that the Japanese and Euroland economies cannot handle the currency market status quo. Weaker growth in those economies will not be a sufficient condition, as that is already expected by private analysts and central bankers. Inflation must start move convincingly lower, and signals of coming rate cuts in those economies will need to be sent by the central banks.
ECB Governor Trichet speaks publicly three times next week, culminating in his monthly press conference on Thursday, which will mark the anniversary of the bank’s last rate change. Trichet will be wearing his anti-inflation hat, however. Tough, hawkish rhetoric is very likely from him. He will be speaking after both the ECB and Bank of England announce unchanged benchmark rates, and analysts will find scant hope in anything he says for a rate cut anytime later this year. Fed Chairman Bernanke also has multiple speaking opportunities next week. His message might prove more nuanced than Trichet’s, first becaust the Fed has dual mandates of both growth and price stability, secondly because the possibility of a recession remains real, and finally, because he will not want to unduly jeopardize the Republican election prospects in November.
The Reserve Bank of Australia also meets next week to set interest rate policy. The economy has slowed sharply in some respects. As in Canada, first-quarter growth may even have dipped into the red. But monetary officials remain more worried about inflation than growth and will not cut their 7.25% cash rate. A rate hike later in 2008 still remains possible. If oil and gold ride a new wave upward, so with the Aussie dollar.
Next week’s data calendar features PMI readings in Europe and the United States, revised Euroland GDP, Australian and Swiss GDP, Euroland retail sales, British banking statistics and consumer confidence, German industrial orders and production, Euroland producer prices, Canadian labor statistics and, most awaited of all the U.S. May labor market data. As weeks go, this non-exhaustive list is reasonably substantive. Nonetheless, I suspect the dollar’s direction over this very short time horizon will take its major cue from oil, just as it did this past week. If I had to bet, I think we shall see $130/barrel again before the price dips below $120.
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