Weekly Foreign Exchange Insights: November 14th

November 14, 2008

Recent foreign exchange movements have exceeded what fundamental economic discrepancies justify. The biggest winner in this reconfiguration has been the yen followed by the dollar. Commodity-sensitive currencies and sterling are the main losers. Since September 12, the Friday before Lehman’s failure, the yen as of 15:50 GMT today had had advanced 39.6% against the Australian dollar, 35.3% against sterling, 25.4% against the euro, and even 11.6% against the dollar. On a trade-weighted basis from September 12, the yen and dollar are up by about 20% and 10%. Trade-weighted sterling is down10%, and the euro is off 4%. For just this past week, the dollar rose 5.8% against the pound, 5.3% against the New Zealand kiwi, and 2.6% versus the Canadian dollar, but it fell 1.5% against the yen.

As my previous post observes, every country is experiencing escalated economic strains, even China relatively speaking. Among major economies, its difficult to rank the degrees of stress. It is accepted that the British recession will be the most severe among G-7 economies, but nobody will be spared. Stock market declines both this past week through 16:25 GMT today and since the September 12th closing have been similar. Everybody is in the same boat, and it’s taking on water as policymakers bail away.

Changes DJIA NASDAQ NIKKEI FTSE DAX
Week -3.8% -6.4% -4.0% -4.5% -4.2%
Since 9/12 -24.6% -31.8% -32.6% -23.0% -24.1%

 

Excessive currency movements are often detrimental to the goal of sustained growth with low and stable inflation. Forex volatility could be particularly counterproductive in the global economy’s present fragile state. Wide forex swings, either up or down, inhibit investment decisions. An appreciating yen will amplify Japan’s susceptibility to deflation and dampen Japanese exports. Sharply declining currencies create the threat of capital outflows. Britain can ill-afford that extra problem, and officials there are being counseled to stimulate fiscally in a way that is impermanent. Currency depreciation can be crippling for economies with large foreign currency-denominated debt. This may be a huge problem for many developing economies. Since September 12, the dollar has risen over 20% against the Mexican peso, Korean won, Icelandic krona, Ukrainian hryvnia and Turkish lira.

The United States faces one of the biggest economic renewal project, needing to rotate growth away from domestic demand and toward net exports. In that process, the savings rate will climb and current account deficit will diminish. 28% of the dollar’s trade-weighted decline from a peak of 120.76 on July 6, 2001 to a low of 69.28 on March 17th of this year has been reversed in just two-thirds of a year. That’s much more than was necessary to restore two-way dollar risk and prevent diversification into other reserve currencies. The pace and amount of dollar appreciation will impede the economic overhaul that is required especially if it is extended.

The euro has been comparatively stable since backing down from $1.60 to the mid-$1.20s. Since the ECB has underestimated Euroland’s recession, officials will cut interest rates more quickly and by more deeply than they had been planning. It will be easier to proceed aggressively if additional euro depreciation is orderly and limited.

Foreign exchange intervention occurs when a consensus exists against the outcome that currency markets are producing and when currency swings exceed what economic fundamentals seem to warrant. The present would seem to be a candidate for joint or unilateral intervention on both scores, and the G-7 has already issued a statement implying no objection should Japan attempt to cap yen strength unilaterally. At the same time, three factors may yet sustain the hands-off stance that officials have so far taken on foreign exchange policy. First, Beijing has reverted to a mercantilist currency policy, halting yuan intervention in order to support exports and overall economic growth. Chinese cooperation promotes G-7 cohesion, and vice versa. Secondly, the U.S. federal government is in transition, and the outgoing team is ideologically predisposed not to intervene. There has been no U.S. currency market intervention since September 2000, covering the entire Bush era including the period right after the 9/11 attacks. Finally, attention is not focused on currencies but rather on the banking system, fiscal policy, and cutting interest rates. Intervention may be viewed by some as a distracting sideshow until and unless it becomes apparent that forex issues are impeding the other policy goals. That’s what happened in the 1970’s before officials realized that dollar depreciation and domestic U.S. inflation were two sides of the same coin.

Left to its own devices, the market should sustain the main currency trends that we have seen lately. At EUR/GBP 0.903, sterling will be back to the equivalent of its record D-mark low of November 1995. If and when sterling challenges this barrier, the euro will likely be closer to $1.20 than $1.25. Meanwhile, the Australian and New Zealand dollars should fall additionally even if commodity prices stabilize, because benchmark interest rates of 5.25% and 6.5%, respectively, remain much too high in present global and domestic circumstances. Canadian dollar risk also seems skewed somewhat to the downside, while the Swiss franc, which benefits for many of the same reasons as the yen, ought to out-perform the euro.

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