Currencies More Sensitive to Global Growth Than Growth in Particular Economies

July 9, 2010

A more resilient euro has coincided with better-than-expected European data, but the rise from $1.1878 in early June doesn’t reflect strong confidence the short-term to medium-term economic outlook for the region.  Industrial production during May recorded monthly advances of 2.6% in Germany, 1.7% in France, 1.0% in Italy, 2.6% in Sweden and 0.7% in Britain.  All these gains were larger than predicted, but sovereign debt strains in the region and their uncertain consequences continue to weigh on investor minds.

Less fear surrounds the consensus view on the world economy.  Recently released GDP forecasts from the IMF upgraded projected global growth to a robust 4.6% in 2010 and look for such to be only slightly softer at 4.3% in 2011.  For China where policy restraints to forestall inflation had aroused considerable concern, the IMF still see GDP growth averaging about 10.0% per annum in 2010-11.  Indian growth will average marginally more than 9.0% for the two years, and all emerging markets are seen humming along at 6.8% this year followed by 6.4% in 2011.  In North America, growth is projected to average 3.2% per annum in Canada and 3.1% per annum in the States, while Japan manages to expand at a 2.1% per annum pace.  Euroland will trail badly with growth of 1.0% in 2010 and 1.3% in 2011, and growth in Britain, where some of the heaviest policy austerity is to be felt, GDP is only projected to climb by an average of 1.6% a year.

If relative growth prospects were the main currency market driver, the euro would be on the ropes, and forecasts do exist that project its value falling over the coming months to less than $1.10 or even possibly par.  But if global growth holds the key as I believe, the sharp correction in bond yields looks overdone.  So do equity market losses since early May.  Even if benchmark central bank rates stay on hold longer as most will, scope exists for short-term market rates to drift higher as enhanced credit support measures get reversed.  There is hope, too, that published European stress test results at the end of July, as the U.S. experienced in the spring of 2009, will remove an important weight on the euro, revealing a system that hasn’t collapsed and only a minority of institutions that must take remedial action.

Support for EUR/USD also derives from an appreciating Swiss franc.  This is a role the Swissy played often in the 1970s.  The franc in October 1978 was 185% stronger against the dollar than in 1970.  It had appreciated twice as rapidly as the mark.  Both units were considered hard currencies, underpinned by very low and stable inflation, decent economic growth, and large current account surpluses.  In times of dollar depreciation, the franc usually assumed the role of market leader, lifting other currencies in its wake.  From 1.5141 per euro in mid-December 2009, the franc had risen nearly 16% to 1.3074 on July 1.  The upward path has not been smooth, as central banking authorities vacillate between currency market intervention and holding their fire.  In June, Swiss deflationary risk was declared mostly extinguished, while a $43 billion increase in reserves was a mounting concern.  A more recent drop in CPI inflation from 1.1% in May to just 0.5% in June revives the case for intervention, which when done involves extra buying pressure on the euro.

The yen hasn’t traded as weakly as 90 per dollar since June 24.  90 yen per dollar is a pain threshold, and that three-week span of uninterrupted extreme strength matches the longest such stretch since 1995.  There was a similar interval in late November/early December of last year.  It is no coincidence that the Nikkei has been pounded especially hard or that 10-year government bond yields recently traded below 1.10%.  Foreign orders for Japanese machinery fell 3.7% in April and then plunged 17.9% in May.  By design or force of circumstances, Japan cannot tolerate present levels indefinitely, let alone absorb significant further currency appreciation from present levels.

The United States and China seems to be moving closer to a showdown on Beijing’s management of the yuan.  The U.S. Treasury finally released its semi-annual report to Congress on currency market conditions, which originally was scheduled for mid-April.  The next report will arrive in early autumn, and officials now say that they will be monitoring the behavior of the yuan very closely until then.  The uncoupling of China’s currency against the dollar three weeks ago was hailed as a potentially significant step, but “what matters is how far and how fast the renminbi appreciates.”  Future determination of whether China is a “currency manipulator,” a status that would open the gates to broader trade restrictions, will be made on other criteria as well.  This past week’s document complains about the still-big Chinese purchases of foreign currency in 2009, equaling 8.1% of GDP and the small 6.8% real effective trade-weighted rise of the yuan from its 1998-02 average level during a time of stronger export productivity growth in China than its trading partners.  Reserves, which have swelled to 54% of GDP and to 2-1/4 years’ worth of imports, are another criteria that will be under tight scrutiny in Washington.

In the two months since the Conservatives were put back in power in Britain, sterling has advanced just over 2% against the dollar and euro.  Investors like right-of-center politics. Undesirably high British inflation attaches a credible likelihood to the possibility that the Bank of England raises interest rates before either the Fed or ECB.  Tight fiscal policy is usually a recipe for a softer exchange rate.  Boosting interest rates in the present British context would not be supportive, as such would be reactive to higher-than-expected inflation rather than preventive in nature.  I do not see substantial upside scope for the U.K. pound.

Commodity-sensitive currencies fluctuate with shifting confidence in world growth.  This past week was a good one for them, as equities enjoyed their best performance in many weeks.  The Australian, New Zealand and Canadian dollars each set 2010 lows on May 25 at USD 0.8068, USD 0.6563, and CAD 1.0851 per U.S. dollar but had respectively recovered 9.0%, 8.4% and 5.3% at this past week’s highest levels.  Canada’s labor market report for June was excellent.  Jobs expanded at the U.S.-equivalent pace of 573K per month in the second quarter without benefit from a temporary surge in census workers.  Commodity currencies remain far from peaks reached between November 2007 and July 2008 and would need to advance by a further 12-15% to scale those heights.  The pendulum of confidence in the global economy will be swinging the other way in due time, and I doubt the commodity-sensitive currencies will revisit 2007-8 highs before mid-2011.

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

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