Currency Words

February 7, 2013

Currency market participants spend considerable time waiting for uncertain areas of interest to become better clarified.  By the time that happens, other mysteries overtake investor psychology, and the market moves on to another issue.  At this moment, attention has been captured by the attempt of several governments to manipulate exchange rates in the hope of attaining cheaper and more competitive currencies.  This is a competitive game.  If a government succeeds in strengthening its currency, the difficulties of other economies tend to mount.

The currency wars of the past few months have been fought primarily with words, not deeds.  Just about every developed economy has an accommodative monetary policy.  Interest rates are near zero, and many central banks have expanded balance sheets sharply.  A new government in Japan has been the most aggressive verbal combatant, and markets are trained to react to passive signals like hawkish Governor Shirakawa’s announcement that he will step down a few weeks before his term expires.  The element of surprise can be a powerful weapon.  ECB President Draghi merely had to suggest that a stronger euro could hamper Ezone growth and that ECB officials would continue to monitor market developments to push the currency somewhat lower today.  I expect the euro to regroup and remain buoyant.

Next week, markets will get an important cue from the Bank of Japan on Thursday, but the most awaited event is the gathering of G-20 central bank leaders and finance ministers in Moscow on Friday and Saturday.  Important moments for the BOJ are coming soon but will not happen at the February meeting.  Governor Shirakawa’s big concession was his announced plan to step down in mid-March when the terms of the two deputy finance ministers expire.  Prime Minister Abe by the end of this month but not as soon as next week is expected to announce his chosen replacements for all three key influential positions, which comprise a third of the BOJ Board.  Shirakawa’s visible discomfort shows that he already has agreed to more easing than he feels comfortable doing.  It will be up to the new masters of the BOJ to take things from here. At the meeting in Moscow, criticism will be directed at the Japanese for breaking the code not to engage in currency manipulation.  Like the BOJ meeting, however, this event is likely to resolve less than market participants would like to see. 

The large G-20 is an unwieldy body for coordinating currency market policies and peer review.  The G-20 has done a weaker job of communicating policy intentions and inspiring market confidence than did the G-7.  Japanese delegates will explain that their actions are consistent with the domestic anti-deflation goal and will probably escape the meeting without conceding any modification of policy.

To a degree, the mounting saber-rattling among governments over currency valuation comes at an unexpected time.  Ordinarily, one expects this kind of trouble to arise after sharp cumulative one-way currency swings or when trading conditions are behaving in a disorderly fashion marked by abnormalities such as atypically wide bid-ask spreads.  That really isn’t the case in the present instance.  The year-to-date averages in dollar bilateral relationships are less than 4% away from their 2012 means in the case of the euro, sterling, Swiss franc and the Canadian, Australian and New Zealand monies. 

Viewed from a wide-angle lens, the three strongest widely traded freely convertible currencies in the flexible exchange rate era have been the Swiss franc, the Deutsche mark and the Japanese yen.  Back in the 1970s, they acquired the label “hard currencies” because of their battle-tested toughness.  The table below documents long-term changes in the dollar against each of these by comparing ten-year to 25-year averages (25-10), three-year to ten-year averages (10-3), current levels to their three-year averages (3-Now) and 25-year means to current levels (25-Now).  Note that

  • In all the cases, the hard currency’s 10-year mean was more than 10.0% stronger against the dollar than its 25-year mean.
  • The 3-year average of the yen and Swissie show an even sharper appreciation between their 10- and 3-year means than between their 25- and 10-year averages.
  • But in the synthetic mark’s case, the pace of rise between the 10- and 3-year average is only half as much as that between its 25- and 10-year means.  Since the mark’s has but one of many currency DNA’s that were combined to form the euro, it makes sense that the euro would perform less strongly than the mark over long stretches of time even if inflation under the ECB has been more consistently low than it was in Germany under Bundesbank management.
  • The yen is presently weaker against the dollar than its 3-year averages but shows a sharper gain versus the 25-year mean than the synthetic mark.
  • Dollar-Swiss and EUR/USD, which moves in lockstep with the synthetic mark, are less than 4% from their three-year averages. 
  • The Canadian and Australian dollars also are presently less than 4% from their three-year average values.
  25-10 10-3 3-Now 25-Now
DEM 10.6% 5.6% 2.0% 12.1%
JPY 11.5% 22.5% -11.9% 20.3%
CHF 17.7% 18.6% 3.5% 44.6%

The yen’s roughly 12% depreciation against the dollar from its three-year average is justified by Japan’s weak fundamentals.  The current account surplus is now only around 1% of GDP, and it’s still narrowing.  GDP in Japan remains well below its level before the world financial crisis.  So how did the yen manage to stay so strong until the recent election of a new government committed to its future depreciation?  The answer lies in Japan’s macroeconomic policy mix.  Deficit spending is abundant.  But monetary policy did not shift toward greater accommodation to the same degree as the central bank stances of the Fed, ECB, or Bank of England.  Under Prime Minister Abe, that’s now going to change.  Domestic monetary policy and exchange rate management are finally going to be coordinated in an all-out effort to end deflation.  A similar epiphany linking exchange rate conditions to domestic price behavior occurred in the United States in November 1978.  In a mirror image of Japan’s present circumstances, a package was unveiled that hiked the federal funds rate by 100 basis points and allocated resources to fund massive intervention support for the purpose of boosting the dollar and reducing inflation.  And nobody then accused the United States of currency wars.  Rather, it was understood that the Treasury and Fed were merely taking care of domestic business.  U.S. inflation wasn’t going to stop rising in the late 1970s unless the dollar stopped falling, and Japanese deflation isn’t going to go away now if the yen has an upward instead of downward bias.

Copyright 2013, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.



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