Weekly Foreign Exchange Insights: September 18th
September 18, 2009
The dollar in most cases has declined quite sharply in the two weeks since the Labor Day weekend, depressed by rebounding investor risk taking, the likelihood that very low short-term U.S. interest rates will remain so for considerably longer, and concerns about U.S. fiscal policy and the possibility that the dollar will not continue to dominate the international monetary system as it has done since the Second World War. At this writing, the amount of depreciation in these two weeks had exceeded 1.5% against the yen and Canadian dollar and surpassed 2.5% in the case of the euro, Swiss franc, kiwi, and Australian dollar.
Cable, which is what dealers call the sterling/dollar relationship, did not fit the broad pattern. The pound spiked upward in the week to September 11 but relinquished all of its gains this past week. The euro touched 0.9038 per pound today, equivalent to D-mark 2.164 per Gbp. That happens to represent sterling’s weakest-ever value against Germany’s former currency, which was reached in mid-November 1995. Between then and late October 2000, sterling rose almost 57% against the mark, and that entire advance has now been squandered. Britain and the United States have four factors in common that link their currencies.
- Before the dollar, sterling was the hegemonic currency in the international monetary system. Sterling’s experience serves as a lesson that the international monetary system is not as static as it seems. Big changes do not occur easily but they happen eventually if currency fundamentals fail chronically to deliver what investors expect from the preeminent paper currency. Enormous offshore holdings of dollars and pounds now exist.
- The Fed and Bank of England engaged in extensive quantitative easing. Investors believe these central banks will not be among the first to exit their ultra-loose stances. The three-month interest rate differential between U.S. Libor and Japanese Libor interest rates, which favored the United States by as many as 70 basis points early last March, has turned marginally negative this month, lending credence to the growing dollar image as a highly suitable carry trade funding currency. Money growth has been much more rapid in Britain and the United States than in Euroland or Japan. Whereas other central banks are starting to posture for a policy shift, the Bank of England is apparently considering a cut in the interest rate it pays on bank reserve deposits.
- Fiscal deficit and debt projections for the coming five or more years have exploded upward more powerfully in the United States and Britain than elsewhere. The early 1980’s demonstrated that expansionary fiscal policies will boost a currency if counter-balanced with very restrictive monetary policies and sharply improving inflation. Currencies tend to perform poorly, however, when both fiscal and monetary policies are extremely loose. A risk-aversion tsunami in late 2008 and early 2009 over-rode that tendency but only for a while.
- The United States and Britain run chronic current account deficits. Although the U.S. shortfall last quarter was only half as large relative to GDP as it had been a year earlier, much of the improvement was caused by the deep global recession, and the gap now seems to be heading higher. An economy with a current account deficit needs to attract capital inflows, and its currency becomes vulnerable in the presence of comparatively low interest rate returns. Net long-term U.S. capital movements in the portfolio and direct investment items of the balance of payments shifted from a $134.8 billion inflow in 4Q08 to an outflow of $54.9 billion in 1Q09 and of $119.7 billion in 2Q09. The U.S. current account and dollar are getting support from less reliable, more erratic short-term capital flows. Monthly capital flow figures compiled by the Treasury Department suggest even further erosion in the quality of U.S. capital flows occurred over this past summer.
Scheduled economic data releases are relatively light next week. The main ones are U.S. new and existing home sales, Euroland flash PMI scores and industrial orders, and Japan’s monthly all-industry index. Trading volume next week could be restrained by the closure of Japan’s market for holiday until Thursday and the observance of the Jewish High Holy Days. That’s a poor backdrop for a major and sustaining shift in currency market momentum. The upbeat mood that is promoting investor risk-taking needs several negative data surprises to get buried, and next week just doesn’t have enough stuff coming out.
The week’s two main attractions do not involve economic data, but they also do not shape up as events to break the dollar’s downward momentum. One is the FOMC meeting and statement. Remarks from Fed officials continue to accentuate the fragile state of the recovery and a need not to rush into a premature removal of stimulus. It seems unlikely that the FOMC would depart radically from that message which implies no rate increase in the next several months. A more plausible surprise would be a reference to the recently soft dollar, however subtle. The other key event will be the summit of G-20 leaders late in the week, which is expected to address the issue of an exit strategy but to urge continuing fiscal support for now.
All this does not mean the dollar downtrend sails automatically onward. The movement seemingly needs a phase of consolidation. So too does the recovery of equity prices, which has been well correlated with dollar depreciation. From 677 on March 9th just over six months ago, the S&P 500 climbed to 798 by end-March, 873 by end-April, 919 by end-May, 987 by end-July, 1021 by end-August and 1067 at 16:30 GMT today. The pace of revival — 136% annualized for the whole period and an even faster 144% annualized for the portion so far in September — cannot be sustained forever. Action in June saw a pause but only a tiny dent relative to the whole move. A bigger setback would not be surprising even if there were no immediate economic or news to trigger it.
The yen bears special attention because of its inability thus far to punch through the 90 per dollar barrier. Dollar/yen set a lower weekly low for a fourth straight time this week of 90.13 following lows of 90.18 in the week of September 11, 91.93 in the week of August 28, and 93.40 in the week of August 21st. The new Finance Minister, Hirohisa Fujii, has made contradictory remarks on the yen, sometimes welcoming its rise and other times stepping back from that role. The coming three trading days present investors with the opportunity to bid the yen into the high 80’s without worrying about what Japanese officials might say, because Japan will be on holiday. If by Thursday the yen still hasn’t broken past the big figure, conditions will be ripe for it to retreat for a while.
The euro, which is some 18.5% stronger against the dollar than last March and at its best levels since August 2008, is also getting near to levels where real damage to the region’s recovery might result. Swiss authorities just reiterated their resolve to subordinate domestic credit policy to the goal of preventing any further franc appreciation against the euro, so that currency is no more ideal than the euro for testing just how low the dollar can go. Reluctant to press their luck against the dollar’s relationships with the currencies of other advanced economies, investors may focus instead on emerging markets at least so long as gold and oil stay above $1000 and $70, respectively. The kiwi, Aussie dollar, and Canadian dollar thus could play lead roles in any furthe
r dollar drop. But if the dollar were to turn up against the majors, it will be a general dollar correction, and commodity-sensitive currencies would follow the trend.
Copyright Larry Greenberg 2009. All rights reserved. No secondary distribution without express permission.
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