Weekly Foreign Exchange Insights: May 29th

May 29, 2009

The dollar fell substantially in the second half of May but against a different backdrop from the prevailing metric of the last two years in which the ebb and flow of risk aversion had been the dominant Forex determinant.  Stocks also looked fragile this week, a factor previously associated with dollar strength, and the yen has moved in tandem with the dollar rather than depreciate against it as it had done at prior times when the dollar fell against European monies.

Confidence in the dollar continues to be jolted by perceived excessive U.S. deficit spending and signs that Washington officials are not worried about recent dollar movements or perhaps even welcome the recent depreciation.  Big holders of dollar-denominated assets like China have expressed uneasiness about their holdings and reminded Washington about its responsibility for keeping the dollar stable and strong.  Massive dumping of dollar wealth would be self-defeating, but a compelling incentive persists to diversify increasingly away from the dollar into other currencies.

The dollar’s drop has not been disorderly in spite of developments one would expect to see in a crisis.  Gold, a bellwether of dollar sentiment , is back in position to challenge $1000, and oil has soared.  If investors concluded that the dollar could only go south, Treasury risk premiums would be driven much higher.  The yield on 10-year notes had in fact climbed from 3.21% at mid-month to an intra-day peak yesterday of 3.76% before settling significantly back today.  Market chatter has been focused on the dollar weakness, not the strength of other currencies.  The dollar hit new 2009 lows against the euro, sterling, Canadian dollar, Australian dollar, kiwi and rand,  and as of 15:15 GMT it had approached to within 50 pips of its low against the Swiss franc.  Nevertheless, market conditions do not exhibit the typical trappings of a crisis, such as widening bid-ask spreads, the inability to lay off large transactions without moving rates, a loss of price resiliency, or great difficulty conducting commercial business.  The Swissy and euro are not leading the charge against the dollar, as one would expect in an overly speculative market.  Treasury yields are climbing for the same reason the dollar has been falling — concern about the budget — and not primarily in reaction to the depreciating dollar.

Except in instances of natural disaster or war, currency crises do not begin with a bang but rather germinate as part of the normal market ebb and flow and only later evolve into self-feeding and unstable storms.  That is unlikely to occur soon.  The world economy is still fighting off a serious illness, and central bankers and government politicians remain at their battle stations and in close contact.  Fireworks in the currency trenches tend to occur after long periods of policy neglect, not times of tight surveillance and management.  I agree with the view of those like Harvard Professor Feldstein that additional dollar depreciation will be needed and is in fact inevitable by design or force of circumstances to promote Teutonic shifts in economic behaviors and flows.  The question is when.  An optimal process should be gentle, not as a rush to the exits now.  A significant appreciation of the euro, yen, sterling, and commodity-sensitive currencies would hurt competitiveness in the affected countries much more than a sharp drop in the dollar would boost U.S. growth.  Any chance of global recovery in 2H09 could be dashed.  Dollar depreciation will be on a shorter leash in the near future.  So after the frenzied dollar sell-off in the second half of May, it would not at all be surprising to see the market pendulum swing partly back in the dollar’s favor even if the respite prove brief.

Medium-term constraints on further dollar depreciation are a different story.  The euro is not far from its three-year average of $1.3794, so European companies should be able to cope with a significant, but gradual dollar loss over the next year or so.  For the yen, whose three-year average is 109.68 per dollar, the dollar looks too pricey only because the yen had been undervalued for a considerable period previously.  Treasury Secretary Geithner’s trip to China is not expected to turn the thinking of Beijing officials into engineering a resumed rise of the yuan against the dollar.  Without that cover, Tokyo officials will find yen appreciation against the dollar most unwelcome. 

One of the big lessons of the Great Recession is the continuing failure of most advanced economies to de-couple their business cycles from the United States, and an inference of that reality it that it is easier to achieve significant dollar depreciation during periods of sustainable growth than at times like these.

Copyright 2009 Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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