Three Weeks is One Thing; Three Years Is Quite Something Else
November 24, 2010
Fed officials understood the risks to the dollar from quantitative easing when its Federal Open Market Committee agreed three weeks ago to buy an additional $600 billion of longer-dated Treasury securities over eight months. They also appreciated that risks are simply this: possibilities rather than a fait accompli. The chance of a dollar decline was deemed worth taking. If the risk proved correct and if it created an unacceptable problem, that could be dealt with down the road. Three weeks into the QE2 experiment, the dollar is doing much more than holding its own.
Since the dollar floated in 1973, currency matters almost never have influenced U.S. domestic monetary policy, and a major reason for this is the extreme difficulty of predicting where the dollar will go next. Dollar price action over the last three weeks provides a sober reminder not to take short-term dollar forecasts too seriously. When the dollar rose initially after the FOMC meeting, appreciation was passed off as a “sell the rumor, buy the fact” circumstance, but three weeks is more than enough time for such a sequence to have come and gone. From the daily low against the euro on November 3rd to its high today, the dollar rose 6.8%. That’s a 211% jump if extrapolated for a whole year. In similar three-week comparisons, the dollar also climbed by 3.8% against the yen, 3.5% relative to the Australian dollar, 3.2% versus the Swiss franc, 3.0% against the kiwi and 2.8% against sterling.
Second-guessing Fed policy was overtaken by fears over the spreading European sovereign debt crisis. Geopolitical tensions in the Koreas and a string of better-than-expected U.S. data releases buoyed the dollar as well. Misgivings over Fed policy remain as strong as ever, but other issues have intruded. But isn’t that the point? Currencies react to an infinite and never-ending flow of news surprises. One can’t isolate this factor or that one in making a short-term call. Even if doing that were a more precise science, the effect of a single factor is influenced by the context of all other factors, so 20:20 foresight is required in all cases, not just for the factor that is assumed to dominate market action.
Accusations of dollar debasement continue, so we’re in one of those instances when dollar direction is not consistent with market perceptions about monetary policies around the world. These periods tend to occur more seldom than times when dollar moves consistently with chatter about Fed policy. Here’s a news flash: dollar debasement is hardly new. It’s been going on for decades, with some notable interruptions. In the thirty years from 1968 to 1998, the dollar on balance depreciated 3.9% per annum against the Swiss franc and Japanese yen and by 2.9% per annum against the Deutsche mark. An era ended in 1998 when eleven European currencies including the mark were blended into the euro at fixed parities. Five currencies subsequently joined the common currency, notably some of the troubled peripherals like Greece, Portugal and Spain. In the near dozen years that followed the euro’s launch, the Swissy rose 2.7% per annum against the dollar, and the yen climbed by an almost identical 2.6% annualized. But the euro appreciated just 1.1% per annum.
More sense can be made of longer-term dollar changes than short-term ones, and the price movement presented above yields a number of inferences.
- The dollar fell in the long run both before and after the creation of the euro.
- The dollar has declined more slowly, however, during the last twelve years.
- The Swiss franc and yen outperformed the Deutsche mark prior to 1999 and the euro since then.
- The dollar’s improved relative performance since 1999 was more pronounced against the euro than the other two traditional “hard” currencies.
- Point four makes intuitive sense. The euro is a hybrid of currencies which previously represented a wide range of economic fundamentals. Germany had excelled then, as now, in terms of maintaining low inflation and producing solid growth with a strong balance of payments. The mark appreciated routinely against many of its current euro partners during the 1960s, 1970s and 1980s.
- Point three also seems predictable. Before 1999, the Bundesbank on a de facto basis acted as the ECB does now, setting the framework for regional monetary policy, not just German credit policy. Periodic revaluations of the mark and devaluations of other European currencies were not a perfect adjustment mechanism for the multi-speed range of economic fundamentals in the region.
The dollar is not built for a marathon race course. The Fed has greater tolerance for inflation than central banks like the European Central Bank, Swiss National Bank or Bank of Japan. The United States runs a current account deficit unlike Germany, Japan, or Switzerland. As a watered down unit of account, the euro cannot perform as well as the mark even though the European Central Bank emulates Bundesbank behavior quite well. The euro may not survive at all or as configured currently, but any residual that retains Germany will benefit. Japan and Switzerland have high-octane currencies in spite of policy efforts to contain appreciation. Moreover, the strength of those hard currencies hasn’t depended on fast economic growth. GDP growth in those economies averaged only 0.9% per annum and 1.5% per annum, respectively, over the last twenty years.
The dollar reaps only temporary benefit from geopolitical event risk. The history of floating exchange rates is filled with such crises from the Mayaguez incident off Cambodia in 1975 to the assassination of Egyptian President Anwar Sadat in 1981, the liberation of eastern Europe later that decade, the invasion of Kuwait in 1990, the Al Qaeda attacks in 2001 and this week’s flare-up in Korea. The currency market effect of these kinds of situations never endures. Korea and European debt pack a two-fisted punch that should support the dollar and maybe even lift it sufficiently to defy seasonal yearend headwinds. But after three years, five years, or ten years, I would be surprised to see the dollar stronger than it its now.
Copyright Larry Greenberg 2010. All rights reserved. No secondary distribution without express permission.
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