Weekly Foreign Exchange Insights: October 2, 2009

October 2, 2009

It’s striking that the dollar did not climb more sharply this past week as concern mounted that global and U.S. growth prospects may be much weaker than assumed not long ago.  Should not a return to risk aversion lend the dollar and yen clear support as such did in the autumn of 2008 and winter of 2008-9?  Well for one thing, the data do not suggest a new severe implosion of economic activity as occurred a year ago but rather a growth recession in which advanced economies experience very modest positive GDP growth and further job loss.  Central bank rates were lowered sharply and repeatedly a year ago, but money markets kept on misfiring.  Inflation too sank like a rock; when price pressures receded rapidly in the early 1980’s, the dollar also performed very well.  Central bank rates have now bottomed.  The fear of a total meltdown of the financial system is not present, and inflation is more likely to edge higher than keep falling during the coming year.  So the current and future  environment will be distinctly different from the one that lent the dollar substantial safe-haven support.

One can still not dismiss the symbiotic behaviors between the dollar and stock markets for more than a year.  Although it is difficult to conjure up a return to an economic backdrop like ones that have lent the dollar support in the past, a drop in stock prices of more than 10% and perhaps more than 20% is not an unreasonable possibility.  Equities have in fact been more responsive than the dollar to the string of worse-than-forecast economic indicators, yet stock prices remain far above their March lows and too high if the U.S. economy expands less than 2% next year, which is the IMF’s view, instead of the 2.5% consensus view of private forecasters.

Market pressures on equities are not just responding to the economic outlook and what that implies about corporate earnings.  Monetary policy will remain ultra-loose for quite a while longer, maintaining abundant liquidity and extraordinarily low interest rate returns.  The stock market beckons, if not for worried families then to institutional funds that promise their clients a minimum return.  In a somewhat analogous trade-off, the dollar will be tugged this way and that by shifting speculation about the strength of the recovery and timetable of central bank exit strategies. The volatility of stocks and ebb and flow of investor risk aversion will also enhance week-to-week choppiness.  All of the above complexities point to considerable market noise in the U.S. currency, and this volatility may deflect a lot of attention to cross rates.

Two separate issues involve the ability of certain economies to cope with greatly appreciated currencies as foreign trade picks up and how governments will protest “abnormal” currency swings. 

  • The yen averaged 117 per dollar in 2006-2007 and 120 per dollar in 1987-2007, each some 25% weaker than now, and that currency remained on the strong side of 90/$ even after Japan’s fiscal half ended this week.  Unlike most dollar pairs, the yen is very close to its strongest level since the end of 2007, and concern is high in trade-dependent Japan about the damage this may cause.  Finance Minister Fujii is talking often but without a clearly understood message about currencies.  That’s a bad combination.
  • Euro strength has likewise spooked European officials.  Euroland’s PMI-manufacturing index was close to but slightly below 50 in September, connoting a marginal contraction of activity, and the rise in the index slowed amid signs that the strengthening euro is now exerting a drag on export demand for euro area goods.  ECB President Trichet noted that it was very important [i.e., constructive] that U.S. Treasury Secretary Geithner continues to publicly endorse a strong dollar position.
  • Swiss National Bank authorities will continue their policy of intervention to keep the franc weaker than 1.50 per euro for the foreseeable future. While that goal has not been successfully challenged, the Swiss franc remains very close to the target ceiling
  • Appreciating commodity-sensitive currencies like those of Australia, Canada, South Africa and New Zealand have elicited verbal intervention by officials, too.  It takes a very long time for excessively uncompetitive exchange rates to damage an economy sufficiently to produce an endogenous reversal in the exchange rate.  The purpose of verbal guidance by officials is to kick-start such a reversal or at least slow the undesirable market trend.
  • Continental European officials have been critical of Britain’s hands-off management of sterling, which has lost about 25% on a trade-weighted effective basis since the outbreak of the global financial crisis in August 2007.

G-7 currency policy coordination served a useful purpose, which I believe will be missed.  Without the framework of a written shared creed of principles that governments can agree upon regarding currency trading, confusion develops, and markets become more predisposed to disorder. In many way, the more inclusive G-20 forum for international economic diplomacy is preferable to the antiquated G-7.  In the area of currency policy coordination, the inclusion of Beijing in regularly scheduled meetings will be an improvement if peer review has any teeth in affecting Chinese policy. That remains to be seen, and from the standpoint of a workable-sized committee to monitor currency market conditions, a committee of seven seems better than a goup of twenty representative economies.  It would be constructive for the G-20 to arrange for finance ministers and central bankers to gather at least three times each year as their G-7 counterparts have done for the past two decades.  I have not seen that intent spelled out explicitly, and even if it were enacted, a committee of at least 40 people meeting for about six hours probably cannot lend the marketplace the kind of structure that is needed to avoid chaos.  I’m reminded of the March-June 1973 period, the first four months of floating dollar rates which the Nixon Administration entered with no established legal mechanism to use FX intervention.  Not only did the dollar sink in increasingly one-way trading, but inter-bank trading become increasingly dysfunctional and eventually broke down almost completely.  The launch of enhanced G-20 powers in an international monetary system with un-repaired fundamental shortcomings is going to create inevitable growing pains.

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

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