Currency Thoughts

EUR/JPY Reversal

February 17, 2012

The recent choppiness of currency market price action obscures some important trend reversals.  In the two years between end-2009 and end-2011, the dollar climbed 10.6% against the euro but dropped 17.4% against the yen, and Japan’s currency had accordingly appreciated about 34% against the euro.  So far in 2012, a period comprising just over an eighth of the year, the dollar has slipped 1.8% against the euro but recovered 3.1% on the yen.

The euro debt crisis has followed an uneven path toward intensification since late 2009 and continues to dominate daily currency trading.  The crisis most likely with continue to be a top storyline way past Greece’s March 20 large debt service deadline.  There have been days when progress toward a resolution was reported but just as many times when the news grew more ominous.  On the whole, prospects have become more uncertain and potentially dangerous because the option of a near-term default is not a taboo subject anymore.  Furthermore, peripheral sovereign bond yields remain at dangerously high levels, and a great deal of time has been squandered when action should have been taken to fortify the ability of European financial institutions to withstand a default and contagion to larger economies.  The risks associated with the debt crisis haven’t changed sufficiently to justify a trend reversal of EUR/USD or EUR/JPY, yet an incipient turnaround of those key currency pairs has nonetheless begun. 

Other developments in 2012 underscore continuity rather than reversal.

• Commodities are still cresting.  WTI oil prices rose 24.5% in the two years to end-2011 and an additional 4.0% up to now in 2012.  Gold prices soared 42.7% from end-2009 to end-2011 and show a further 10% advance so far in 2012.  The Canadian, Australian and New Zealand dollars — each sensitive to what’s happening to commodity prices — appreciated against the greenback in both periods, with the loonie moving less sharply than the two Southern Hemisphere units.

 

• Equities continue to strengthen impressively yet unexpectedly.  The S&P 500 advanced 12.8% over 2010-11 and roughly 8% in 2012 as of this writing.

 

• Sub-trend economic growth continues to be experienced in advanced economies.  Although U.S. GDP rose 2.8% at an annualized rate last quarter, much of that gain reflected inventories rather than final demand, and on-year growth amounted to just 1.6%.  Real GDP last quarter in the euro area (minus 1.2%) and Japan (minus 2.3%) both contracted and recorded respective on-year changes of +0.7% and minus 1.0%.  Annualized growth over the five years to 2011 amounted to 0.5% in both the euro area and United States and negative 0.2% in Japan.  None of these areas performed close to adequately.

 

• Monetary policy hasn’t shifted gears away from extreme accommodation.  Central bank rates have stayed very low and will continue there for a period of years, not months or quarters.  Fed officials expect to keep a near-zero interest rate policy until at least late 2014.  The Bank of Japan Policy Board intends to retain its stance of virtually zero interest rates until deflation has been eradicated and CPI inflation has risen to 1.0% and no longer faces significant downside risk.  The ECB refinancing rate has been cut since November from 1.5% to 1.0% and faces continuing downside risk.  The Fed’s Operation Twist attempts to lend particular support to the U.S. housing market.  The ECB through its LTRO program is extending to banks unlimited sums of money for three years at 1.0%, and the Bank of Japan again boosted its asset purchase program this past week.

But a few currency influences are in transition.  One is the configuration of current accounts.  While America’s remains in chronically large deficit and Euroland’s hovers near zero, Japan’s surplus plunged 44% last year, and its trade balance has swung already into deficit and will likely get larger.  A second matter concerns policy tolerance for currency levels.  Japanese officials escalated their drumbeat of complaints against the elevated yen this month after it strengthened to within a half-yen of its all-time peak against the dollar, and the Bank of Japan’s recent policy changes seem intended for the yen rather than to influence inflation in general.   In contrast to Tokyo’s angst about an overly strong yen, European officials are not protesting the euro’s value.  The market, too, seems comfortable with a $1.30 handle, which has been restored after a brief dip to $1.2974 yesterday.  A third change concerns U.S. Treasuries, whose multi-year bull market may finally have ended.  The 10-year yield declined 195 basis points between end-2009 and end-2011 but, since touching a record low of 1.67% last September 23rd, rose to 1.88% by yearend and 2.02% currently.  And a fourth matter involves Chines currency management.  The U.S. dollar was allowed to fall 3.5% against the yuan in 2010 and 4.5% last year but has been kept essentially steady this year. 

Sterling has recovered some ground against the dollar, but Cable remains a comparatively stable relationship.  The dollar rose 4.1% against the pound between end-2009 and end-2011, which is a trivial two-year swing, and has given back about half that move so far this year. It’s been feared that the British economy might get walloped severely in 2012 due to domestic fiscal restraint and Euroland’s recession.  However, several economic indicators for January like retail sales and the purchasing managers indices surprised on the upside.  Evidence continues to pile up confirming that U.K. inflation is falling pretty sharply, and that improvement enables the Bank of England to provide a monetary counterweight against the very tight fiscal policy.

The Swiss franc now moves in lock-step with the euro against the dollar.  Swiss central bank officials last September called an end to the franc’s out-performance.  The franc’s climb (10.3% against the dollar in 2010-11 when EUR/USD was dropping by 9.6%) exacted a painful toll from the standpoints of weak economic growth and intensifying deflation.  One of the big uncertainties in the remainder of 2012 concerns the Swissie-euro cross rate and how it will react to the unfolding Greek debt drama.  If default occurs whether in the spring or later, the Swiss policy commitment will be tested severely.  Conversely, if the Swiss economy doesn’t improve later in the year, officials will be tempted to take additional action to weaken the currency.

Other issues that figure to play prominently later in 2012 are the French elections on April 22 and May 6, the Republican primaries, the U.S. general election, and further budget fights in Washington.  Military action against Iran seems only a matter of time, and that possibility could potentially lead to a substantial spike in oil prices.  Yet another factor to watch are the U.S. and European business cycles.  I tend to doubt that the better-than-anticipated U.S. data reported recently will be maintained over the balance of 2012.  I also think Euroland will indeed experience a declared recession even if positive growth is recorded this quarter after the contraction in 4Q11.  In the recession of 1973-75, U.S. GDP rose in the fourth quarter of 1973 after falling in 3Q73, and positive growth occurred again in the second quarter of 1974.  Likewise, the 1981-82 U.S. recession was interrupted by GDP increases in 3Q81 and 2Q82. 

First-quarter currency market price action doesn’t always set the pattern for the remainder of the year.  One blatant exception in 1985 saw the dollar climb against the mark by 10% as of February 26 but end the year with a net loss from end-1984 of 22%.  And in 1980, the yen lost around 9% from January 1 to very early in April, but it closed in the following December with a net 18% advance for the year as a whole.  2012 has seen some interesting changes in key currencies, but the landscape remains fraught with uncertainty and the potential for further twists and turns is high.

Copyright 2012, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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This entry was posted on Friday, February 17th, 2012 at 12:18 pm and is filed under Foreign Exchange Insights and Next Week. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.