Currency Prospects in the Final Eighth of 2010
November 12, 2010
Many key events have played out. U.S. voters vented extreme displeasure, shifting government leadership sharply away from the Democrats and toward Republican rule. The FOMC unveiled details of a controversial second round of quantitative easing. The British government spelled out what programs will be cut in a dash for deficit reduction. China made an initial interest rate increase and launched other steps to contain inflation, which is accelerating. G20 leaders met in Seoul, South Korea and released a statement of largely unenforceable plans such as these of special interest to currency market dealers:
We will move toward more market-determined exchange rate systems and
enhance exchange rate flexibility to reflect underlying economic fundamentals and
refrain from competitive devaluation of currencies. Advanced economies, including those
with reserve currencies, will be vigilant against excess volatility and disorderly
movements in exchange rates.
And
In circumstances where countries are facing undue burden of adjustment,
policy responses in emerging market economies with adequate reserves and increasingly
overvalued flexible exchange rates may also include carefully designed macro-prudential
measures.
And
These indicative guidelines composed of a range of indicators would serve as
a mechanism to facilitate timely identification of large imbalances that require preventive
and corrective actions to be taken.
Not all unknowns have been removed, however, as the market heads into the second half of the final quarter of 2010. One huge shoe still to drop is what action the lame duck U.S. congress takes on the Bush tax cuts, which will expire entirely at yearend if no agreed compromise is reached. Investors will be looking for speedy resolution, as only a couple of weeks remain before the typical yearend thinning of trading volume begins. Another question mark surrounds European sovereign debt market strains, which have been intensifying especially in Ireland’s case. If a rescue package for that country along rumored lines is indeed fashioned, will the euro soon find a better footing as it did after the Greek crisis was stabilized last spring? History never replicates exactly, and perhaps the initial hit to the euro will endure longer this time because of quicker contagion to other exposed EMU sovereign debt. A third area where investors will be seeking clarification concerns the strength of U.S. data. Awkwardly for the Fed, a string of stronger-than-expected indications of activity and demand has followed the decision to do more asset buying. Will positive data surprises persist, or will new indications of struggle in the recovery return?
The dollar is coming off one of its best recent weeks. This turn for the better occurred just when market pessimism had reached a very profound point and it came ahead of the G20 summit and right after the U.S. election and FOMC meeting. None of these juxtapositions should be considered coincidental, nor should it be assumed that the dollar’s reversal will endure. The contrarian reputation of foreign exchange is well earned. Many times when a dollar trend becomes sufficiently noteworthy to head the business news or, better yet, general news, the currency suddenly changes direction. Long anticipated events like the election and the unveiling of QE2 details give markets plenty of time to price in the news, such that the events themselves simply offer a convenient time to book profits.
The dollar’s corrective rally was itself trimmed today. From lows earlier in November, the dollar at this week’s highs had rebounded most sharply against the euro with an appreciation of 5.0% from 1.4247 to 1.3574, and the U.S. currency also recorded gains of 3.6% against both the Australian and New Zealand dollars, 3.2% relative to the yen, 2.5% against the Swiss franc, 2.2% versus the pound, and 1.6% against the Canadian dollar. At 14:30 GMT earlier today, those advances remained well intact, over 70% so in the case of euro, yen, Swissy, kiwi, and Australian dollar. Sterling has proved most resilient of the bunch and at $1.6131 was back above the key $1.60 level and within 1.0% of the November peak.
From the broader perspective of dollar movement during the first seven-eighths of 2010, the U.S. currency remains quite weak. The table below contrasts dollar levels earlier today with a) its 2010 highs and b) its November lows.
| % Chg in Dollar | Versus 2010 Highs | Versus Recent Lows |
| EUR/USD | -13.6% | +3.7% |
| USD/JPY | -13.3% | +2.6% |
| USD/CHF | -16.9% | +2.1% |
| GBP/USD | -11.8% | +1.0% |
| USD/CAD | -7.1% | +0.9% |
| AUD/USD | -18.7% | +2.6% |
| NZD/USD | -15.6% | +2.5% |
The Fed’s return to quantitative easing looks even more isolated than a week ago. U.S. monetary stimulus was then assumed likely to be joined soon by similar proposed action by the Bank of England, but minutes from that central bank seemed to put that likelihood to rest at least in the near term. Previously, British officials had seen a greater risk that inflation would be below 2% in two year’s time than the possibility of above-target inflation. They now consider those scenarios equally likely. Moreover, the scheduled increase of British valued added tax by 2.5 percentage points to 20% in January will probably lift inflation in the short term to higher levels. Meanwhile in Euroland, ECB will pursue a steady policy course on rates and may in fact take further steps to tighten unconventional liquidity-enhancing measures. China’s inflation, money and credit growth data announced Thursday surpassed expectations, setting the stage for a possible second rate hike as soon as this weekend.
The inverse relationship between the dollar and stock prices continues for the most part. Share price prospects, unfortunately, look as uncertain as do currencies. Technical signals in stocks have weakened as prices have flattened, while technicals in the dollar appear inconclusive. The big event for stocks will be the decision, or non-decision, on U.S. taxes. If nothing gets done, there could be a stampede for the exit in order to book capital gains in 2010 rather than 2011, and that would bode well for the dollar. If all the Bush tax cuts are preserved at least for now, stocks could get a relief lift, and that might segue very nicely into the historic pattern of seasonal dollar weakness in the second half of December.
A final big shoe to fall will be what happens to the Chinese yuan. That currency’s rate of appreciation picked up pace in the run-up to the Seoul G20 Summit, but the yuan fell today. Cynics will note that this pattern of movement seems to happen around every face-to-face negotiation involving Chinese leaders. For now, the yuan’s movements are entirely under the control of Chinese officials, so the currency’s trend in coming weeks depends on political decisions, not economic forces. Those kind of markets are toughest to trade and forecast. In China’s case, the stakes are high because the movement of the yuan and shifts in Chinese interest rate policy have enormous consequences for other economies in Asia.
Copyright Larry Greenberg 2010. All rights reserved. No secondary distribution without express permission.
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