A New Year but the Same Lingering Questions

January 7, 2011

Because of strong seasonal distortions, the weeks on either side of New Year’s Day are a difficult time to get an accurate pulse of currency market sentiment.  Against European currencies, the dollar shows a tendency to trade on the back foot in late December and with a renewed spring in its step once early January rolls around.  The pattern doesn’t happen always but frequently enough to be more than coincidental, and the sequence has played out again in the cusp between 2010 and 2011.  After falling against most currencies last month aside from the yen, the dollar climbed more than 6% against the Swiss franc and over 2% against the euro, AUD, and kiwi.  A gain of over 1% was achieved against the yen as of 15:30 GMT today, as well as fractional advances versus sterling and the yuan.  The start may foretell a better year than 2010 for the U.S. currency, but it as easily could reflect typical seasonal winds.

From a thematic standpoint, world investors will be chewing on the same fat as in 2010.

Like a year ago, the U.S. economy is beginning 2011 with an encouraging head of steam.  Market players wonder if the upturn has more stamina this time and how soon shifts might occur in U.S. inflation and the Fed’s policy predispositions.  Stronger U.S. growth and higher market interest rates are considered likely dollar support.  But doubt about the recovery lingers because of renewed troubles in housing and a labor market that has produced two weaker-than-expected job gains in a row.  The “fat lady” of the U.S. great recession was supposed to be healthier markets in jobs and housing, and she hasn’t really sung yet.

The euro’s aura was damaged severely last year, much more so than the 6.5% end-year to end-year decline against the dollar might suggest.  The coexistence of a single independent monetary policy with sixteen independent fiscal policies has ruptured the currency union’s credibility, but that isn’t the real source of the strain.  The central problem is widely diverse rates of economic growth and competitiveness between Germany and France on the one hand and the so-called peripheral economies on the other.  No socially tolerable means exist to rectify these imbalances, and they are likely to widen in 2011.  And yet, betting on a break-up of European economic and monetary union is very risky because of the immense financial costs such an outcome would entail and the demonstrably stubborn political will behind preserving EMU.  Movements in the euro have not been a good barometer of confidence in the common currency, so its resilience near $1.30 isn’t a sign that all is well.  Rather, sovereign debt yield spreads have taken on that role, and they indicate that a resolution to this crisis is far from over.  As long as the problem goes unsolved to the market’s satisfaction, member defections remain a possibility.  Any forewarning of such an event will be very scant, if at all.  This kind of monetary system change has to be made under the cloak of extreme secrecy to limit damage.

Emerging markets retain most-favored investor status.  The contrast between this segment of the world economy and the advanced economies of Western Europe, the United States, and Japan mirror the tension and strain within the European Monetary System.  Driving in the economic fast lane carries its own risks.  India and now China are contending with mounting inflationary pressures that are not easily addressed with selective administrative guidance.  Coarse monetary restraint, on the other hand, will subject emerging markets to added upward pressure on their currencies from ever-increasing inflows of yield-seeking capital.  Exchange rate appreciation and inflows of hot money are both unwelcome, and a wide range of governments in Asia and Latin America are undertaking counter-steps against these trends.  Such a regulatory approach can be a mixed bag from the standpoint of achieving the intended currency market result, and they can foster other unwanted market distortions. 

Europe and the United States are taking very different policy responses to their massive fiscal deficits.  Europe is attacking the problem directly with budget cutbacks.  U.S. President Obama’s adminstration considers ballooning fiscal imbalance to be derived from deep-seated private-sector imbalance and a shortfall of domestic aggregate demand that must be nursed back to health before tighter fiscal policy can be undertaken effectively.  The ideological arguments and planned policy paths of each side of the Atlantic were laid out in 2010, but 2011 will be the great test of whose ideas are better.  Britain offers the best example for watching this experiment unfold.  It will take a while but not the full year in order for cause-and-effect sequences to be revealed.  Currency markets will reward the economies that seem to be responding best.

The Australian dollar posted back-to-back end-year to end-year gains of 27% in 2009 and 14% in 2010.  It was supported by rising commodity prices, strong Chinese demand for Australian exports, comparatively high interest rates, and a relatively buoyant economy that was among the very few advanced ones not to experience a recession.  Severe floods have hit Australia, and China is escalating its effort to cap inflation.  Having risen nearly 7% against the dollar in just December, the Australian dollar gave back about 2.5% this past week.  More ground could be relinquished near term, but the full-2011 performance hinges on the global economy.  The A-dollar is one of three major U.S. dollar relationships hovering very close to parity, and its seems likely that it will spend more time above than below par in 2011.

The other pairs near unity are USD/CAD and USD/CHF.  Being so intertwined with the United States through economic and financial ties, Canada always seems to struggle when its currency is above its U.S. counterpart.  The Swissy has been compared increasingly to the Deutschemark of old as a tailor-made hedge for investors dissatisfied with what they see in the euro area as well as the United States.  Actually, the franc in the nascent days of floating exchange rates was a cut above the mark.  The franc took a big hit this past week, wiping out December’s advance.  If commodities like gold right themselves, so should the Swissy.  Swiss monetary officials are in no mood to resist appreciation forcefully in the wake of last year’s very costly intervention

Sterling traded in a comparatively narrow 15.6% band between $1.6457 and 1.4232 last year and is currently near the mid-point of that range.  It benefited from a government willing and able to make very large fiscal cutbacks.  2011 will tell if the Conservative leadership was courageous or foolish, and the pound will behave accordingly.  In advance of 2011, U.K. economic activity slowed appreciably in December.  The construction purchasing managers index slid 2.7 points to 49.1, the first sub-50 reading in ten months.  Then came news that the service-sector PMI also sank below the 50 break-even line for the first time since April 2009, printing at 49.7 after 53.0 in November. 

For all Beijing’s talk about a more flexible currency policy, the yuan rose merely 3.5% against the U.S. dollar between end-2009 and end-2010, and it gave back about a sixth of that advance in the first week of 2011.  Obama’s is a weakened presidency that will impede his maneuvering room in foreign as well as economic policy.  China’s currency policy lies at the intersection of both.  U.S. officials would like to see the yuan advance 10% or more this year but lack the leverage to make hope reality.  If it happens, it will be because China’s leadership decides the domestic inflationary threat of keeping the current policy exceeds the stress on net exports of a considerable quicker pace of yuan appreciation.

Copyright Larry Greenberg 2011.  All rights reserved.  No secondary distribution without express permission.

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