Foreign Exchange Insights: August 22nd
August 22, 2008
The dollar’s summer upswing still has some life. It is ending this week on an up note, even though it showed modest to moderate net losses for the period against the euro, yen, Swissy, and key commodity currencies as of 13:30 GMT this morning. Those losses look trivial, juxtaposed against two-week prior advances between August 1st and 15th of 8.7% against the Australian dollar, 6.3% against the euro, 4.3% against the Swissy, 3.9% against the kiwi and 2.4% relative to the yen.
The extent of the slowdown in non-U.S. growth is shocking. In the second quarter, real GDP contracted at annualized rates of 2.4% in Japan and 0.8% in Euroland including 2.0% in Germany, 1.2% in France, 1.1% in Italy and 0.2% in the Netherlands. Growth was negative as well in New Zealand and Hong Kong and amounted to just 0.4% and 0.2% saar in Spain and Great Britain. In the U.K. where severely negative private domestic demand was balanced by an unplanned surge of inventories and a collapse in imports, scant doubt remains that a recession has begun. Japanese officials also concede a recession, claiming only that such will not be deep or long. That’s what officials say when they can no longer maintain the illusion that economic expansion has slowed but remains intact.
Sharply decelerating growth outside the United States has not been associated with central bank rate reductions. The ECB tightened in July, and the Bank of England has not followed reductions made last December, February and April. The Bank of Japan has not changed its monetary policy stance in a year and a half. Rates continue to rise in several emerging markets such as Vietnam this past week and almost certainly Malaysia in the week ahead. Analysts have been split over whether the Fed’s rapid response to worsening growth prospects or the conservative reaction of other central banks has been more appropriate. It’s not a fair comparison, because the Fed did not face the full brunt of inflation in 4Q07 and 1Q08 that exists everywhere now.
Currency markets are forward-looking, and the dollar’s better tone embodies the presumption that other central banks will eventually need to cut rates aggressively and perhaps at a time when the Fed is raising its rates. A 2% Federal funds rate while U.S. consumer and producer prices show 12-month increases of 5.6% and 9.8% looks risky if maintained and at first glance adverse for the dollar when contrasted with central bank rates of 8% in New Zealand, 7.25% in Australia, 5% in the U.K., and 4.25% in the euro area. The dollar has reacted more sensitively to the expectation of shifting monetary policies more than have long-term interest rates, where 10-year yields over the last three weeks are down by 26 basis points in Britain, 11 bps in Euroland, and 6 bps in Japan but also by 9 bps in the United States. Meanwhile, U.S. equity prices have lately outperformed those in Europe and Asia but not by a substantial margin.
Economic data from Japan and Europe will continue to accentuate the weakening trend, and this has been the single biggest driver of the dollar’s advance in 3Q08. Euroland industrial orders fell 6.0% at a seasonally adjusted annual rate last quarter, four times faster than in 1Q08, and the regions’s PMI scores for manufacturing and services were again both below a breakeven point of 50 in August. To be sure, U.S. economic prospects have darkened, too, because the main factor supporting growth, net exports, is likely to wilt under the strain of rapidly slowing global demand. But we are not at the point where quarterly U.S. GDP growth sinks below European or Japanese growth, and indeed such a cross-over might never occur. Considerable concern persists about the precarious state of U.S. financial institutions. Who’s to dismiss former chief IMF economist Rogoff’s prediction of failure by a major institution within a few months, with Fannie Mae and Freddie Mac reportedly headed for a taxpayer bailout? However, that is actually probably good news for the dollar, since it would replace a short-term source of risk and uncertainty with one of a long-term nature. It’s not just coincidence that the dollar’s lows in 2008 against carry trade-financing currencies like the yen and Swiss franc coincided with the Fed-assisted rescue of Bear Stearns in Mid-March.
The other principle driver of the firmer dollar this summer has been the downturn of oil and other commodity prices. It’s easy to be more confident that Japanese and European growth will stay very weak than in any forecast about the direction of oil prices, which continue to gyrate wildly from day to day. Commodity price gains had become extremely frothy by midyear, and even emerging markets are not growing as firmly now as they did. For these reasons, I doubt that declines in oil and gold prices in the three weeks since August 1st of 5.7% and 8.9% are simply the pause that refreshes. Continuing declines could promote additional softness in the dollar over the last week of August. As often happens just before Labor Day, some speculators may try to get the jump on the autumn season, deciding whether the dollar’s upswing was an overdue correction expedited by lighter and more erratic summer trading volumes or a reversal grounded in fundamentally-based economic trend changes. Most are likely to conclude the latter.
The overseas data calendar next week is a crowded one. Germany will release complete details of GDP growth in 2Q, the IFO business climate index, monthly labor market figures, and both consumer prices and import prices. For Euroland as a whole, scheduled releases include consumer and business sentiment, money and credit growth, consumer prices, and unemployment. From Japan on Friday comes the CPI, unemployment rate, industrial production, retail sales, household spending, housing starts, construction orders and small-firm sentiment. Canada reports quarterly current account and GDP figures, and Britain chimes in with its distributive trades survey and some housing market indicators. The U.S. calendar also includes a trio of housing market indications — the Case-Shiller price index, existing home sales, and new home sales — plus durable goods orders, an upwardly revised estimate of 2Q GDP, and personal income and spending growth.
The Democratic Party national convention will be watched to gauge if Obama can recapture momentum, or if we are witnessing another candidate from that party implode in mid-race. The first to do so was McGovern 36 years ago, and this pattern is partly related to changes in the selection process back then that ceded power in that role from party leaders to grassroots voters. Financial markets haven’t decided which candidate they prefer. Perennially, investors tend to signal a preference for the Republicans despite the fact that the economy since 1961 has consistently performed better with a Democrat as president, which I documented in my posting of August 19th. Because so many things went wrong under Bush43, I suspect that the investment community will be atypically ambivalent about the identity of the next U.S. president. Fact is that neither man inspires much confidence.
The release of many indicators means traders will have many opportunities to play the dollar, but how they play it will be determined more by their predispositions about the currency than by discrepancies between actual and forecast data. This market seems to want to take the dollar still higher, to plant the yen solidly beyond 110/$ and to see if the euro can be pushed past this week’s low of 1.4631 or even to less than $1.45. If those efforts fail, there is always sterling, whose fundamentals look simply awful. Cable (GBP/USD) has dropped 12.5% from $2.1160 last November to
a new cycle low of $1.8507 earlier today, but the pound’s value in euros has stalled shy of the 0.80 level, having only briefly penetrated that support to a low of 0.8098 last April 16th. Before the global downturn is over, the euro ought to move more convincingly and enduringly above that threshold.
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