Groping for a Compelling View on the Dollar

January 8, 2010

September and January are two times when investors take a fresh look at currency market prospects.  It often takes a while in January for solid convictions to emerge, partly because December trading can give a distorted picture and partly due to weather-related noise in data that are released in the winter.  2010 seems to be having one of those Januarys.  So let’s see what we do know.

The dollar tends to falter in late December more times than not but in 2009 advanced by 1.5% against the euro and an impressive 3.8% against the yen during the second half of the month.  That momentum did not carry into the new year, but neither did the dollar unwind its prior gains.  At 16:30 GMT today, the greenback showed minuscule year-to-date dips against the three traditional hard currencies: 0.3% against the Swiss franc, 0.2% against the yen and 0.1% relative to the euro.

The first U.S. jobs report of 2010 was a clunker, but the dollar held its ground.  That resilience is less meaningful than one would think.  As my post of January 7 documented, the dollar has done quite well since late 2008 on job report days, regardless of whether the details were better or worse than predicted.  Handling the employment reports with stride did not prevent the dollar from depreciating during much of last year.  From a policy standpoint, the January labor market data push expectations about the onset of Fed tightening further out into the future.  That’s consistent with how economists had been thinking, but the markets were anticipating an earlier start.  On balance, this ought to be a dollar negative.

The extreme risk aversion of a year ago seems to be still fading.  Commodity currencies continue to trade firmly.  Since end-2009, the dollar is down 1.8% against the Australian dollar, 1.1% against the Canadian dollar and 0.8% against the kiwi.  Stock market indices have risen further since late November, especially in Japan and other parts of Asia.  Ten-year Treasury and gilt yields are 56 and 44 basis points higher than they had been on November 25, while bund and JGB yields have increased but much more moderately.

Dollar gains since November 25th of 6.3% against the yen, 5.6% against the euro, and 4.6% against sterling  are not consistent with the picture of fading risk aversion.  The old paradigm of inverse dollar movement compared to the trend in equities may have broken down, but investors are unsure what new rules might be taking command of the marketplace.  Either general indecision or a whole spectrum of opinions leads to choppy trading with no cumulating trend as we saw in the first week of the year.

After falling during much of last year and over most of the naughties, it’s reasonable to wonder if markets may perhaps have overshot and that the dollar is now overdue for a rebound.  The bounce late last year did not endure long enough or go far enough to complete an offsetting correction.  Dollar depreciation since 2002 has been associated with an extensive reduction of the U.S. current account deficit and a rough halving of it as a percent of GDP.  Purchasing power parity, the theory that currency movements in the long run offset inflation disparities between countries, only holds when those price performances are materially different.  That was true in the 1970s but does not warrant chronic dollar depreciation now.

Investors are increasingly demanding a premium for fiscal laxity above and beyond the widely shared rising in budget deficits caused by the global recession.  Eastern Europe, Great Britain, and the United States fall into this group.  So do some euro area peripherals, especially Greece.  Although Japan’s public finances are as bad as anyone’s, it does not fit into this category because its fiscal deficit has been huge for a long time and so does not represent a new development.  One way to hedge fiscal risk is by higher long-term interest rates, but another possibility would be by debasing the currency.  Britain holds parliamentary elections in the spring, and U.S. mid-term elections will occur next November.  Each of these events has a strong chance of changing the political and policy landscape.  Currencies do not handle uncertainty well.

Event risk is back in the market’s face.  This does not necessarily imply a stronger or weaker dollar.  Both positions can be argued, as the transmission of event risk into investor behavior is multi-dimensional and complicated.  The prolonged war on terrorism has produced a higher trajectory for oil prices and contributed to a lower rate of U.S. trend growth in the noughties than in any earlier decade since the 1930s.  Although oil payments continue to be invoiced in dollars for the most part, the last decade was not a good one for the U.S. currency, either.

The currency policies that governments adopt matter greatly.  This inherently obvious statement has been actually attacked, taking the form that intervention is pointless given the limited resources of central banks compared to the enormous volume of daily currency market turnover.  I disagree with those who argue that policy doesn’t impact currency movements and submit several case studies as evidence.  The Chinese yuan is not a fully convertible currency, and Beijing officials have demonstrated an ability to move and halt its external value at will.  Because China’s economy is growing about four times faster than the United States, U.S. monetary policy is way to loose for China, so there will be internal incentives to modify yuan policy before the end of 2010.  Such decisions will be dictated by China’s leaders, not market forces, and they will greatly affect monetary policy and currency policy in other countries as well.  As another example, the Swiss franc only moved past 1.50 per euro after central bank officials in Switzerland indicated a less airtight opposition to any further gains in the Swissy.

Currency policy is extremely important in Japan.  Former Finance Minister Fujii entered office espousing a strong yen policy, and markets ran with his cue to bid the yen higher.  The new chief of the Ministry of Finance has adopted an opposite approach, and the yen’s retreat does not appear complete.  For the record, it has been the view of U.S. governments since 1995 that a strong dollar is in the best interest of the economy, but that view has been accompanied by vastly shifting body English over the past fifteen years.  The Obama administration did little to dissuade market cynics from believing it sought gradual depreciation.  Now that Treasury yields are trending up, that may change, but it’s also true that these are fertile times for trade protectionism.  The Doha Round of multilateral trade talks is stuck in a ditch, and the most powerful and insidious barrier to trade is currency manipulation.

Currency levels will also have a role to play.  Nobody seems to like sterling’s prospects.  The pound clings precariously to the $1.60 level.  A shock to that foothold could send the British currency tumbling several notches.  The Canadian and Swiss currencies continue to hover above dollar parity, which has huge psychological importance, and three important pairs — the Aussie/USD relationship, dollar/yen, and sterling’s euro cross — remain near to 0.9 in the first and third examples and 90 in the yen’s case.  As a general rule, such round figures make bad anchors for market equilibrium.  By contrast, EUR/USD looks more comfortable nestled in the low $1.40s but comfortably away from 1.4000.  The last seven monthly U.S. monthly jobs reports were released with the EUR/USD printing between $1.40 and $1.50.

Investors have a lot to ponder as they grope for a compelling view on the dollar’s outlook against key European currencies.  A downward trend in the yen and upward movement in commodity currencies like the Canadian dollar seem to be more intuitive forecasting calls than taking a stand on EUR/USD.  Then again, currency market behavior is notoriously counter-intuitive.  Traders can sometimes do quite well always acting against the market consensus.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.

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