Many Uncertainties For Currency Traders to Sift Through

March 19, 2010

February 5th has become an important reference point for world financial markets.  For one thing it was a Friday.  Because currency trading is a 24-hour per day game, Friday closing levels provide a convenient opportunity to get a still picture of what’s happening.  Also in early February, stock markets bottomed after a long-overdue, but comparatively short-lived, corrective move.  U.S. healthcare legislation looked like it might not pass.  Greece’s debt problems took center-stage and the possibility of aid from other EU governments gained some traction.  U.S.-Sino relations soured over the contentious issue of Beijing’s management of the renminbi, and British opinion polls suggested that no party might win a clean majority in upcoming elections.  Not least in importance, the U.S. Labor Department on February 5 reported a drop in jobs of only 20K along with a three-tenths percentage point decline of the jobless rate back to a single-digit 9.7%.  Talk heated up over how soon the federal funds rate might rise, and Fed officials responded swiftly to reassure investors that such a point likely remained a half-year away, if not longer.  Indications of inflationary pressure remained very subdued, and economic recovery prospects appeared delicate.  Atypically for world business cycles, emerging Asian, and not the United States, was and continues to power this upturn.

Amid all these facts, the trade-weighted values of the dollar, euro, and yen are each slightly lower now than six Fridays ago.  The euro was the clear-cut least-favored currency this past week, but its six-week net change against the dollar has been actually smaller than that of the stable yen. The biggest winners during that somewhat longer period have been the Canadian dollar and other commodity currencies and, within Europe, the Swiss franc.  Oil (up almost 13%) and gold (up 4%) have enjoyed a good run, but so too have equities with the Nikkei, DOW, and Dax each rising at least 7%.  The table below documents changes in the dollar against selected other key currencies (as of 17:00 GMT on March 19) from closings a week earlier and six weeks ago.

USD since March 12 February 5
EUR +1.7% +1.0%
JPY -0.1% +1.3%
Gbp +1.2% +4.2%
Chf +0.3% -1.0%
CAD -0.4% -5.3%
AUD -0.1% -3.1%
NZD -1.0% -2.7%

The big issues of the last six weeks are fraught with continuing uncertainty.  With U.S. legislators down to the eleventh hour, it’s not clear if the dollar will perform better or worse if the Democrats pass a healthcare law.  Failure would deliver an enormous political blow to the White House, never a good sign for the currency.  However, stocks have seemed to trade inversely with healthcare reform prospects, and buoyant equities now, unlike during the financial crisis, ought to promote dollar firmness by helping the economic recovery and bringing the onset of tighter Fed policy closer.

Twice a year, the Treasury issues a report on the currency markets and U.S. trade relationships in which it is obligated to identify any foreign governments that it deems under narrowly defined guidelines to be guilty of currency manipulation.  Republican and Democratic administrations have repeatedly refrained from placing China on that list of scofflaws, in spite of Beijing’s habitual forex interference to override market forces and prevent a global adjustment needed critically to avoid a future financial crisis.  Domestic political pressure this time on the Obama administration has been enormous to declare China a currency manipulator in April’s report.  If that happens, an already frosty relationship between the two countries will turn extremely icy.  Beijing will not comply in such circumstances, and open trade war between the two countries will likely ensue.  In trade wars, deficit-country currencies usually weaken.

A Chinese interest rate hike meanwhile looks imminent in the wake of today’s rate increase in India, making that the biggest economy from a still-short list of central banks that have raised interest rates.  Even as the central banks in advanced economies do no more than unwind emergency unconventional credit market enhancements, monetary policy tightenings in India and China will represent a watershed in the evolution of recovery from the global recession.  These countries will be test cases for other central banks to watch to gauge the tolerance of economic activity as interest rates rise.  Judging from Australia’s experience, China and India will require much more aggressive policy removal to dent growth.  What is observed as Asia leads the world in raising interest rates will encourage market players to expect earlier, rather than later, policy moves in the advanced economies.  But officials at the Fed, ECB, Bank of Japan realize what a leap of faith it will be to start withdrawing policy support from economic recoveries that would not have started without those heroic lifelines.  India caught analysts by surprise with today’s hike when a policy meeting wasn’t scheduled for another month.  The danger is small that western central banks will similarly act sooner than investors expect.

Europe has a problem bigger than Houston’s.  Greece is a small player in a big-stakes game of brinksmanship that challenges the whole process of European integration.  The Papandreou government will do what it must to get through its crisis and cannot be concerned with how its financing problems threaten monetary union.  It boggles the mind to think a continent that has been fighting wars for centuries to settle its disputes over the region’s balance of power could mutually vest sovereignty in an outside body.  That’s why analysts, like myself, were so skeptical when the EMU project of a single currency and single monetary policy was proposed.  Most countries agreed to monetary union by processes that lacked the mandate that such a revolutionary change should have required.  A U.S. constitutional amendment mandates approval of two-thirds of the members of each house of congress and three-quarters of state legislatures.  EMU was accepted by simple majorities, mostly of elected parliamentarians and in a few cases, razor-thin simple referendum majorities.  Monetary union was not matched with a political union that would have produced a single fiscal mouthpiece.  Previous currency unions without fiscal unification have not survived indefinitely.  Litmus tests to allow only worthy economies into the union and to constrain them to responsible fiscal paths thereafter have now been exposed as a toothless fudge.  Germany, without whose lead support monetary union would never have happened and whose future non-participation would render the arrangement pointless, has turned hostile to the whole experiment.

The euro continues to trade firmly for a currency whose future integrity in its present form is not assured.  Either, investors believe that a break-up of the currency union is impossible are are treating the euro as cocktail of assets that will never be entirely written off.  If liquidated, the Greek drachma and other PIIGS might get marked down but the D-mark could advance against the dollar and yen, and it will not be alone in doing so.

The Swiss franc performed at a level above other so-called “hard currencies” in the 1970s.  Those were wild days for currencies in the brave new world of floating exchange rates.  Switzerland had all the good economic characteristics of Germany, like a big current account surplus and manageably low inflation, without any of the political baggage.  With EMU under the microscope and the Swiss recovery and price data even better than imagined, the franc’s historic special status has returned to some extentBritain, on the other hand, has regressed.  The new new Labour Party, distinct from Tony Blair’s New Labour, is the old Labour as next week’s budget will attest, and David Cameron, the Conservative Party leader, isn’t Margaret Thatcher.  The wisest reason for keeping sterling independent from European Monetary Union is that the pound time and again has been found to lack the right stuff for participation in any joint float with other currencies or as a component of a common currency.  After softening to $1.4874 and 0.9150 against the euro earlier in March, sterling  enjoyed a respite, helped by better poll numbers for Cameron.  It’s faded today, a likely sign of more trouble ahead.

Long positions in commodity sensitive currencies are essentially a bet on the vibrancy of emerging markets and their ability to withstand lessening policy support.  The lead role of emerging markets will distinguish this and future global business cycles from those of the past.  The Canadian dollar is knocking at the door of parity with its U.S. counterpart.  Canadian officials were very upset when the CAD soared to a high of 0.9061/USD in early November 2007 just as the United States was slipping into recession , but Canada’s economy will now be better able to handle levels stronger than par against the USD.

I’ve become increasingly suspicious of yen stability.  The Japanese currency has traded not far from 90/USD since last August. In the far past, Japan’s government employed various under-the-radar methods to influence the yen.  It also conducted massive and highly visible above-board intervention, a tool last used in the first quarter of 2004.  The stability of the yen over the past seven months suggests the influence of something beside private market forces.

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

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