Currency Thoughts

Betting Short Term and Long Term Against the Dollar

October 15, 2010

Currency market sentiment can change radically in a hurry.  Traders were extremely pessimistic about the euro in the spring of 2010, not merely predicting extensive depreciation but also the end of the common European currency as we know it, with both the peripheral members and Germany speculated objects of defection.  By early June, the dollar had recovered to 1.1878 per euro, 35% stronger than its record low.   Predictions of a 1:1 exchange between the euro and dollar as soon as this year’s fourth quarter were being taken seriously.  But with two and a half months left in the year, it is the U.S. dollar, which everyone wants to dump.

Negative dollar momentum is already pretty extreme.  In each of the past seven calendar weeks, the U.S. currency has set a lower low than reached in the prior week against the euro, Canadian dollar, Australian dollar and kiwi.  The streak of lower lows is up to nine weeks in the case of dollar/Swiss franc.  For sterling , the run of lower dollar lows is at five weeks. 

Continuing dollar weakness looks about a sure a thing as there is in foreign exchange.

1. The silence of U.S. officials has convinced market participants that the Obama administration wants a softer dollar.
2. Even if that were an untrue accusation, the 2.5 weeks remaining before congressional elections makes this not a politically correct time for Democrats to impose a floor under the dollar. 
3. The U.S. trade and current account deficits are once again rising, and external trade is affecting U.S. GDP adversely.
4. Officials in plenty of other governments are unhappy about the weak dollar but powerless to take effective action against the problem without the cooperation of the United States.
5. Emerging market currencies have been especially well bid.  These economies have experienced dramatically stronger economic growth than the U.S. and other advanced economies.  The desperate search for a decent return on investment is redirecting a big part of liquidity created by G-7 central banks during the Great Recession to these less developed but more dynamic economies.
6. Efforts by South Korea, Brazil, and China to slow down the appreciation of their currencies has fostered a build-up in dollar reserves.  China reported a $194 billion rise of its reserves last quarter to $2.65 trillion.  The diversification of that wealth into other reserve currency denominations weakens the dollar against the euro.
7. The Swiss and Japanese experiences with intervention embolden speculators to sell dollars.  Intervention provides opportunities to take profits on short dollar positions, and the persistent strength of the franc and yen suggest officials are fighting a dollar battle they cannot win.
8. If one takes relative inflation rates into account, the yen is significantly undervalued relative to the last time it traded in the low 80s against the dollar. Japan, Germany, and Switzerland have large current account surpluses in spite of the rise in the yen, euro and Swiss franc.
9. When the euro was taking shots in the spring, a sliew of risky European banks was a key depressant.  The mortgage robo-signer scandal has turned the spotlight back to the plight of the major U.S. money center banks.
10. The Federal Reserve has been about as clear as Fed-speak allows in signaling that a second round of quantitative easing is coming very soon.  Only the size is in doubt.  The bottom line for U.S. monetary officials is avoiding deflation and promoting job growth to reduce the unemployment rate.  The on-year rate of U.S. core consumer price inflation was 0.8% last month, down from 1.5% in the year to September 2009 and 2.5% in the year to September 2008.  Core CPI was unchanged on month in both August and September and rose at only a 0.7% annualized rate between June and September.  Unemployment has been 9.4% or above since May 2009 and isn’t projected to dip below 9% for many more months.
11. Investors noticed that the Fed conspicuously had virtually nothing to say about collateral damage to other economies that continuing its extremely accommodative policy stance might cause.  The problems that other policymakers have are not going to influence Fed policy.  As former Treasury Secretary John Connolly famously advised European leaders, “the dollar is our currency but your problem.”
12. The Fed is now more dovish than any other advanced economy central bank.  The ECB is pursuing an exit strategy of its unconventional liquidity-enhancing measures.  The Bank of England is equivocating on whether it should tighten or ease next.  Central banks in Australia, Sweden, Norway, New Zealand and Canada have already lifted their key interest rates.
13. The euro area has reported some encouraging above-consensus economic indicators, such as a 1.0% on-month rise of industrial production in April, Germany’s 40K drop in unemployment last month, and a further 0.9-point rise in Euroland economic sentiment to a 32-month high.
14. The yuan’s sharpening rise has plenty of disbelievers in the marketplace, who doubt the shift will persist once the upcoming G-20 meetings are over.  In any case, a rise of 2.5% by China’s currency against the dollar since the Labor Day weekend alleviates only a tiny part of the currency misalignment.
15. The dollar has historically had a bias toward weakness in the final calendar quarter.  The non-seasonally adjusted U.S. trade deficit tends to be larger at this time of year than the adjusted deficit.  Unadjusted flows are the ones that pass through the marketplace.

With so many negatives in place, investors are unlikely to let today’s rise of the dollar in North America stop a short-term trend that still appears to have plenty of life.  When speculation on a directional movement becomes a big force in the market, it often takes coordinated policy efforts to stabilize conditions.

Although the dollar is presently 15.5% and 26.5% below its average euro and yen levels since end-1998, I remain bearish about the long-term fate as well.  For more time than I have been a currency market watcher, the dollar has trended downward on balance.  There have been numerous multi-year intervals of depreciation and just two such periods of dollar strength.  Both of those instances were defined by pretty unique circumstances, which underscore their exceptional nature.  The early 1980s saw the Fed engage in quantitative tightening, the United States reassert its military strength, a substantial decline in U.S. inflation, and a large federal deficit that also elevated real long-term interest rates.  The late 1990’s saw a big improvement in U.S. productivity, strong U.S. real growth with price stability, the unexpected emergence of a large fiscal surplus, and an interlude of peace between the stresses of the cold war and the war on terrorism.  Like the early 1980’s, it was a time when U.S. officials genuinely seemed to prefer a stronger dollar to a weaker one without any hesitation.

The consistency of dollar softness over four decades has become a reason in itself for being long-term bearish.  From DEM 3.992, JPY360 and CHF 4.373 in 1969, it has depreciated by 65% against the mark, 77% against the yen, and 78% against the yen.  Oftentimes it is very difficult to discern a near-term trend, but a rule I maintain has stood me in good stead of putting the burden of proof about the dollar’s long-term outlook on why it might strengthen.  History shows that the default setting for dollar movement has been downward since the 1960s.  At a conference sponsored by Columbia University in February 2009, another person attending asked my opinion on the dollar.  A flight to safety had been boosting the U.S. currency at that time, and the recession was at its most intense part.  I replied that the dollar’s rebound might be overdone but unsure where the business cycle and therefore the dollar were heading over the next few months.  Then, I added that I was much more confident that in the long run the dollar would fall because that was what it does when given enough time.  She was naturally unconvinced.  A forecast that the dollar will lose value eventually because it usually does is hardly rigorous proof.  Yet sure enough, the dollar since that conversation has on balance lost 34% against the Australian dollar, 32% versus the kiwi, 17% against the Swiss franc, 12.5% against the yen, 10% relative to sterling, and 8% against the euro.

The dollar’s weakest levels prior to the euro’s launch in 1999 were touched in the March-April 1995 at DEM 1.3450 and JPY 79.85.  Fifteen and a half years later, the synthetic mark and yen are close to those peaks, and one question to ask is whether the United States is sounder now, about as sound, or not as sound at as it was then.  Opinion polls point to a significant drop in the nation’s sense of well-being, and that’s why anger is so widespread.  The debt machine, which fueled household spending, business investment, and public sector programs, is no longer functional.  Unemployment is rampant, retirement savings are insufficient, homes continue to get abandoned, and the government and private sectors are finding promises made in the past to be no longer affordable.  Economic expansion is much slower and sporadic, and extraordinarily low interest rates signify fear of deflation.  Experts differ on what should be done, and the political process is too disabled to respond if the experts managed to agree on a course of repair.  Europe and Japan share many of these problems, but the emergence of a new generation of economic engines has seen the torch of policy coordination passed on to the Group of Twenty from the Group of Seven.  To the extent that the dollar embodies the present value of America’s role in the world, common sense implies that the dollar ought to work its way below its lowest levels in 1995.

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

Tags: Dollar, Euro, Yen

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