Weekly Foreign Exchange Insights: December 11th

December 11, 2009

Taking a cue from increasingly positive technical market support, the tone of chatter about the dollar’s near-term prospects has become palpably more bullish.  Since recording a 2009 low against the euro the day before Thanksgiving, the dollar has recovered 3.6% including a gain of 1.6% this week as of 15:40 GMT. Dollar-Swiss has rallied 4.3%.  Commodity currencies, which frequently spearheaded the weakness of the dollar since last March, seem to have run out of momentum as well.  Their last big fling into new ground came in September and early October, and resistance held at CAD 1.02, AUD 0.94, and NZ$ 0.765.

When technical conditions shift, analysts naturally fish of fundamental economic explanations, and the recent period has been no exception.  Some key U.S. data, for example today’s retail sales report and the November jobs report a week ago, were much better than forecast, generating speculation of an earlier onset to Fed rate increases, and this was not dispelled by many comments by Fed officials that gave scant credence to such a view.  The government deficit problems of Greece, Spain, Britain, Japan and Portugal are meanwhile impacting currency market sentiment more directly than Washington’s deficit, and much weaker-than-assumed German, French, Italian and Dutch industrial production in October suggests that a sustained $1.50 per euro level may be more than Euroland’s economy can bear.  The Japanese economy’s ability to cope with a 90 per dollar yen is even more suspect.  Analysts had been prepared for a downwardly revised estimate of third-quarter Japanese GDP growth, but the 3.5 percentage point revision to 1.3% from 4.8% reported a month ago was still a shock.

Foreign exchange market behavior is infamously contrarian.  When everybody is jumping on the same bandwagon — in this case promoting the view of a dollar rally through yearend and into early 2010 — it’s time to check if there’s pertinent information that has not been considered.  It so happens that the dollar has a pretty compelling history of softness against European currencies during the second half of December.

  • This is the eleventh December for the euro, which was launched at the start of 1999.  The dollar fell against the common European currencies in six of the last seven years and posted an average drop between mid-December and end-year of 1.3% in those seven years.
  • In the second half of December, the dollar lost 2.0% against the euro last year, 1.2% in 2007, and 0.8% in 2006.
  • Among all ten years beginning with December 1999, the U.S. currency fell eight times and also by an average 1.3%.
  • There has so far been no year in which the dollar advanced on balance against the euro in both the first and second halves of December.
  • Starting in 1974 and running through 1987, the dollar fell in the second half of December against the D-mark in 13 of 14 years, with an average drop of 1.7%.
  • The negative dollar bias in late December was not observed from 1988 through 1998.  Over those eleven Decembers, the dollar actually rose against the mark six times during the second half of of the month and posted an inconsequential net average dip of 0.1%.  The weak behavior of the dollar against the euro in late December thus represents a reversion to an older pattern that had seemed to fade in the 1990s.

One would expect increasingly positive dollar technical forces to trump seasonals, but if that is not the case, the technicals will not be as dollar-supportive at the end of this year as such appear now.  Since the dollar has a seasonal bias toward strength in early January, trading over the coming month could prove very choppy.

From a fundamental standpoint, the case for dollar appreciation over the next three to six months rests ultimately on how economic activity evolves in the U.S. vis-a-vis other regions, the performance of global growth as a whole, and how the latter impacts risk appetite.  The dollar was strengthening sharply in late 2008 and early this year when risk aversion was extremely elevated.  It would probably take a double-dip recession or a renewed financial market crisis to return investors to a mind-set of unconstrained fear, and that’s not the most likely path.  A more probable adverse landscape would be a growth recession, when activity remains positive but not enough so to improve labor markets or to give central bankers at the Fed or in Europe enough confidence to start readying markets for rate hikes or actually starting the cycle of rate tightening.  The communication that central bankers must do before lifting their rates is a very delicate process especially as the removal of unconventional and quantitative measures is being taken first.  The last FOMC meeting of 2009 this Tuesday and Wednesday could give the dollar a boost if officials modify the phrase “likely to warrant exceptionally low levels of the federal funds rate for an extended period,” but more likely officials will merely upgrade the economic assessment.

A really important monetary policy question that will only be settled by empirical observation will be whether the various economies that have experienced near-zero overnight money rates for “an extended period” can tolerate a return to positive rates.  Has financial market functionality changed in a more permanent and profound way because of that crutch?  It was never the Bank of Japan’s intent to practice zero rates for a long period, but all attempts to return Japan to a normal monetary policy were undermined because the economy couldn’t handle it.  The last full month to see Japan’s overnight money rate target exceed 0.5% was August 1995.

The return to more neutral and more normal monetary policies in all countries may reveal similar inherent obstacles.  Like Japan, a complicating factor is that fiscal policies are also expansionary and will need to be reined in.  Advanced economies in the West have caught a break from well-behaved bond markets, but the run out of Greek debt highlights the risks.  Fifteen years ago when the Federal funds rate doubled from 3% to 6% in the space of twelve months, long-term rates soared, and U.S. real GDP slowed abruptly from 4.8% annualized in the first half of 1994 to the near-stalling speed of 0.9% in the first half of 1995.  Deciding when to start tightening rates is only the end of the first stage of what’s likely to be very complicated process. The premise, based on some better-than-expected recent data, that the Fed will be raising rates sooner and push the dollar higher is overly simplified.  By the way, 1994 was a very tough year for the dollar even though the Fed was tightening.

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

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