Important Week Ahead for Major Currencies

October 29, 2010

Currency market players long ago marked down the first week of November down on their calendars as one not to be missed.  Main events include 1) Tuesday’s mid-term U.S. election, 2) Wednesday’s meeting of the FOMC, 3) central bank meetings scheduled in several other countries, 4) the release of purchasing manager surveys and the monthly U.S. labor market figures, and 5) government posturing ahead of the fast-approaching G20 summit scheduled in Seoul, Korea on November 11.

The dollar has performed poorly since Obama was elected president, declining about 30% against the Aussie dollar, around 21% versus the kiwi, some 19% against the yen, 16% relative to the Swiss franc and some 8% versus the euro.  If relative growth dominated currency movement, the dollar would have done better over the past two years.  U.S. real GDP expanded 2.1% on balance between 4Q08 and 3Q10, or 1.2% per annum.  That’s not great, but many other advanced economies did worse.   Opinion polls point to a Democratic Party massacre next week and possible fiscal gridlock to follow.  But first the dust needs to settle, and two urgent issues to be decided are whether anything is done about the expiring Bush tax cuts and whether the administration chooses to chart a different course in the coming two years.  Conventional wisdom says that gridlock should be a better backdrop for the dollar because most government initiatives turn out poorly and because the dollar has performed okay during previous times when Congress and the White House were stalemated.

Since the possibility of QE2 was telegraphed in late August by Chairman Bernanke, markets have been steered increasingly to expect the unveiling of new quantitative easing at the November 3rd meeting.  Investors have devoted considerable attention to figuring out what the new measures will be, as if the terms and size of the operations make a huge difference in the market result.  From the dollar’s standpoint, it may not.  The main change will be that QE2 is being done at all.  Markets have already reacted to the symbolism of undertaking quantitative easing in response to deficient inflation.  The goal of reducing U.S. long-term interest rates is understood, and so is the fact that whatever the Fed offers will be more aggressive than what other central banks are now doing to stimulate growth.  In the 7 weeks since Bernanke’s speech on August 27, the dollar has lost over 5% against the euro, Australian dollar, yen and kiwi and has fallen 3-5% versus sterling, the Canadian dollar, and the Swiss franc.  Ten-year Treasury yield spreads versus German bunds and Japanese JGBs are 35-40 basis points less advantageous to the dollar now than then.  The incipient rally of equities last August has gone further, with the S&P 500 and DJIA up about 10% since Bernanke’s Jackson Hole speech and the Nasdaq more than 15% higher.  QE2 is meant to prevent the economy from stalling by keeping interest rates low and boosting competitiveness through a weaker dollar.  To some extent, these objectives are being met already, and a big part of the mystery that lies ahead concerns what might not yet be priced into the marketplace.

Central banks also meet next week in Euroland, Britain, Japan, and Australia. 

  • Euroland’s largest economy, Germany, has grown clearly faster since midyear than expected.  The region’s sentiment indices remain elevated, and PMI figures next week will be decent enough to forestall any serious debate on the ECB Council about fresh stimulus.  The choice instead is between status quo or resuming steps to dismantle unconventional liquidity-enhancing measures.  Officials will opt for the former at this time, preferring to synchronize policy announcements with  new forecasts that are routinely made in the final month of each quarter.  Also, the ECB would not want to be seen snugging policy at the same time that the Fed is announcing new quantitative easing, lest that disrupt currency markets unduly.  Finally, stronger-than-anticipated interest in the central bank’s three-month refinancing operation this past week indicated that banks are still under some stress.  The fiscal problems of Portugal, Ireland, Italy, Greece and Spain continue to trouble investors and pose an ongoing event risk that can sap euro strength.

 

  • This was to have been the week that the Bank of England might announce new quantitative easing of its own.  That was before this week’s surprisingly buoyant British GDP report showing economic growth of 3.9% annualized over the two quarter between 1Q10 and 3Q10.  That’s twice as fast as the U.S. rate of expansion over the same six months.  Sterling rose about 2% against the dollar this week, as investors adjusted their expectations about next Thursday’s Bank of England meeting.  The last meeting produced a three-way split among committee members, so it probably will take more definitive evidence of an economic slowdown to mobilize authorities into action, and that’s something that may not come.  So far markets like the Conservative governments decisiveness on the budget.  Good economic momentum in the middle quarters of 2010 are no guarantee against a stall in activity next year.  Sentiment could turn.

 

  • The Bank of Japan is the only central bank dealing with deflation rather than trying to avoid such, and yet the BOJ has acted more timidly than most central banks including the Fed.  The Bank’s logistical problem was that Japanese interest rates were already quite low when the financial crisis began in 3Q07 (1.76% on 10-year maturities and 0.83% on 3-month deposits).  Rates have fallen much less in Japan than in the United States or Europe since then, while Japan’s current account remained substantially in surplus.  World opinion has turned against intervention, so Japanese authorities can realistically use that tool only sparingly.  This is an ideal time for disguised covert currency market manipulation.  The BOJ moved forward its meeting to sooner after the Fed’s in order to permit a quicker tit-for-tat response, but it’s very unlikely that Japan will correct the great imbalance between how much quantitative easing the Fed and it are doing.  The yen strengthened 26% from an average value of 117.8 per dollar in 2007 to 93.6 in 2009 and moved up another 12.6% from 92.2 on average in the spring quarter of this year to 81.8 so far this month.  The overall move of 44% was almost as large as the 50% advance from a 1992 mean value of 126.8 to an average of 84.5 by the second quarter of 1995.  Damage to Japanese exports from the yen’s appreciation 15 years ago was mitigated by a sharp drop of the yen in the second half of 1995 such that its 101.5 per dollar mean in the final quarter of that year was weaker than its 4Q94 level of 98.9.  Not expecting the yen to collapse this time, Japanese officials will maintain a threat of intervention.

 

  • Lower-than-expected in-target Australian consumer price inflation last quarter is now seen likely to deter a rate hike next week by the Reserve Bank.  Partly in response, the Australian dollar continues to have trouble establishing a beachhead on the strong side of dollar parity.  It’s high for the move was USD1.0005 on October 15, and it touched USD USD 0.9975 this past week.  The last visit to such stratospheric levels crested just a penny and a half from unity.  I’m optimistic this time that the Aussie dollar is only in a pause and that its uptrend will resume.

 

Analysts want to find cause for celebration in a return to positive private-sector and total U.S. employment growth, but it’s doubtful that a better figure will lend much support to the dollar.  For one thing, the Seoul summit of G20 leaders on November 11 will be in sight by then.  For another, one month of jobs growth doesn’t make a trend, and the increases likely will be meager.  From a long-range standpoint, the hole in the jobs market is absolutely mind-boggling and it’s hard to find any cheer in a tiny uptick.  Consider these facts.  From a tiny base of 31.5 million, there were 12 million more jobs at the end of the 1940s than ten years before.  The next decades saw employment rise 10.7 million to 54.2 million at the end of the 1950s, another 17.0 million to 71.2 million at the end of the 1960s, 19.5 million to 90.7 million at the end of the 1970s, 18.1 million to 108.8 million at the end of the 1980s, and 21.7 million to 130.5 million during the 1990s.  Despite an increase in population of almost 38 million since 1999, the level of jobs last month was 130.2 million, a net loss of 331K compared to December 1999.  That kind of gap in the U.S. labor market will take a generation to make up, and Fed officials will not be deterred from a monetary policy stance consistent with low long-term interest rates and a collateral goal of more dollar depreciation.

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

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