EUR/USD and Dollar/Yen Just Drifting Around

May 4, 2012

Real economic growth is one of the first factors generally mentioned when analysts list influential determinants of currency market movement.  The United States is enjoying one of the largest growth advantages vis-a-vis Europe in a very long time, but you wouldn’t know that from the recent steadiness of the euro.  The common currency is quoted currently at $1.3167, not far from previous monthly averages of $1.315 in April, $1.320 in March, $1.323 in February, $1.290 in January, and $1.316 in December.  In the fourth quarter of 2011, U.S real GDP advanced 3.0% at an annualized rate, whereas the euro area slipped into apparent recession with GDP in the bloc sliding 1.2% at an annualized rate.  U.S. GDP grew for an eleventh straight quarter in 1Q12, rising 2.2% annualized from 4Q11 and 2.1% from a year earlier.  First-quarter GDP in Euroland hasn’t been released yet but likely was flat to negative.  Moreover, early signs point to quickening recessionary momentum at the start of 2Q12.

The characterization by ECB policymakers that their economy stabilized and soon will commence a gradual recovery appears too optimistic.  The region’s retail purchasing managers index plunged from a reading of 49.1 in March, which implies a near-sideways trend, to a decisively recessionary 41.3 score in April, implying the fastest rate of contraction since late 2008.  A manufacturing PMI reading of 45.9 reflects the sharpest rate of decline since mid-2009 and was 8.9 points below the comparable U.S. score, which by contrast hit a 10-month high.  Euroland’s service-sector PMI scored a 46.9, 2.3 points less than in March and 6.6 points lower than the comparable U.S. figure.  ECB policymakers are counting heavily on strengthening export demand to restore positive growth later this year, along with short-term interest rates that are very low in nominal terms and negative when adjusted for inflation.  One flaw in their logic is that Europe mostly trades with itself where growth is weakening, not strengthening.  Not only were most of the euro area PMI readings below 50, implying a contraction of activity, but so were most European economies that do not share the euro.  The manufacturing PMI scores of Britain, Sweden and Switzerland last month were 50.5, 50.2, and 46.9.  Also, while short-term interest rates are historically soft, they have been depressed for years already in Europe and elsewhere without giving the economy any discernible significant lift.  Why should that disconnection change now when its’s been three years since the refinancing rate was cut?

America’s faster growth isn’t limited to comparisons with Euroland.  In the first quarter of this year, British GDP fell 0.8% annualized and was unchanged from a year earlier compared to on-year U.S. growth of 2.1%.  Japan’s GDP dropped 0.7% annualized in 4Q11 and by 0.6% from 4Q10.  Japan’s manufacturing PMI reading in April of 50.7 was 4.1 points lower than the U.S. score. 

A disadvantageous growth comparison is not the only reason why one might think the euro ought to be trading at a lower level.  Following the massive infusion of liquidity via LTROs from the European Central Bank in December and February, three-month money market rates in the euro area have declined 75 basis points since end-2011, 64 basis points more than the drop in 3-month U.S. rates.  U.S. unemployment has fallen 1.9 percentage points from the cyclical peak, while 10.9% joblessness in the euro area is still cresting, and in Spain such has climbed even with the U.S. peak in the depths of the Great Depression some 70 years ago.  The 10-year U.S. Treasury minus German bund spread is likewise 26 basis points more dollar-advantageous than at the start of this year.  The Fed is not chomping at the bit to undertake a third round of quantitative easing.  For that to happen, the U.S. economy would need to perform worse than policymakers expect for a second straight year during the middle quarters of this year.  Most curious of all, a renewed rise of euro sovereign debt tensions has failed to buoy the dollar as such did last autumn. 

Taken as a whole, it would have seemed sufficient for new euro debt strains, painfully high peripheral bond yields, a rebellion of European voters fed up with austerity, dim growth prospects in the region, and the rapid expansion of the ECB balance sheet to have established a new euro trading range centered in the mid $1.20s or even closer to the June 2010 high of $1.1878.  That’s not to say that the dollar lacks baggage of its own, but most negative factors for the dollar  were already present when the dollar climbed last autumn.  America has a chronic current account deficit, as well as big fiscal problems complicated by the uncertainty of this year’s presidential and congressional election.  The external deficit hovers around 3% of GDP, and the relative size of this year’s budget deficit is similar to Japan’s and about twice as great as the collective budget gap of all 17 nations in Euroland.  The price action of EUR/USD outweighs fundamental economic developments that support a different equilibrium.  Market behavior leads one to conclude that underlying dollar equilibrium isn’t as strong as imagined.

In a matter of speaking, the yen also is meandering around but not making any dramatic directional changes.  Dollar/yen averaged 77.54 in the second half of 2011 and 77.69 in January-February of this year.  The mean for March-April after a surprise extension of quantitative easing by the Bank of Japan was 81.92, representing a yen retreat to the vicinity of the 81.95 average seen in the first half of 2011.  At 79.87 now, intervention-inspired weakness in Japan’s currency has seemingly run out of steam.  The BOJ’s late-April quantitative easing announcement was smaller than feared, and the market again seems predisposed to keeping the yen well bid.

The euro’s main downside risk scenario involves the defection of one or more countries.  The euro is priced at a level that implies great doubt that such a split-up will happen before end-2012.  The dollar’s downside risk involves the uncertain outcome of the November election.  Whether the Democrats or Republicans win — however slim the margin — will have enormous consequences for fiscal and regulatory policies.  A break-up of the euro in 2012 would be a bigger event than a power shift in American or even the repercussions of fiscal drag next January.  While America is definitely holding an election, Euroland probably will not break apart this year, and that different degree of probability is why the dollar hasn’t appreciated more sharply thus far.

Several other currency relationships bear watching.  One has to wonder how much longer the Canadian dollar will hover so close to par with the greenback.  It’s been near unity since the middle of last October.  The Swiss franc keeps sitting at the edge of the Swiss National Bank’s ceiling rate of 1.2000 per euro.  If the dollar fails to break convincingly into the 1.20s against the euro, it will become harder for Swiss authorities to defend their exchange rate target.  Sterling, which is not tethered like the franc, has been edging upward against the euro.  Gains have been gradual, relentless and a bit surprising in light of weaker U.K. growth than expected.  Support for sterling has emerged because Bank of England officials have become less convinced that low growth will eventually depress U.K. inflation to and below the 2% medium-term target. 

Some of the most volatile day-to-day foreign exchange foreign exchange movement involves the Australian and New Zealand dollars.  At central bank meetings during the past ten days in both “down under” countries, officials have expressed concern about the strength of their currencies.  Australia’s cash rate was lowered by a larger-than-anticipated 50 basis points to 3.75% and accompanied by downwardly revised forecasts for growth and inflation.  New Zealand monetary authorities warned that “should the exchange rate remain strong without anything else changing, the Bank would need to reassess the outlook for monetary policy settings.”

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

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