Officials Likely to Tolerate a Rising Dollar

January 13, 2015

Sure things do not exist in currency forecasting.  That said, the likeliest year-ahead prognosis implies more of the same, that is a rising dollar, falling European currencies, further weakness in a wide range of emerging market monies, and additional yen depreciation.  If these scenarios indeed pan out, it’s only a matter of time before market watchers talk about the risk of trade warfare.  Protectionism, which encompasses currency manipulation as well as the use of tariffs and other direct barriers to commerce, was one of the most toxic elements of the global economy in the late 1930s, and it has reared up from time to time in recent decades.  For various reasons, damage from protectionist tactics is likely to stay contained.

The dollar is not currently at extreme levels.  Although 19% stronger against the euro than its 2014 low of $1.3993 last May 8, the dollar is just 4.3% above its post-1998 average level against the common European currency and could rise another 43% before matching its October 2000 peak.  Dollar/yen is now trading 13% from its post-1998 mean of 105.3 per dollar but only roughly equidistant from than average and its post-1998 high of 135.15.  In light of Japan’s prolonged bout with deflation, it’s not unreasonable to expect the yen to be trading above its long-term mean, but the Japanese expected current account surplus in 2015 lies only marginally above 1.5 and well below the highs during the past couple of decades. 

The trade-weighted dollar has not risen nearly as sharply as dollar/yen.  On September 12, 2012, two months before the general election that brought Prime Minister Abe and the LDP party to power, the dollar was trading at JPY 77.12.  Since then, it has risen 54% against the yen but just 25% on the Bank of England’s trade-weighted dollar measure.  The trade-weighted yen over the same period fell almost 32%, implying a a 46% appreciation of other currencies against the yen.  So the cumulative trade-weighted changes in the yen and dollar over this period are close to mirror images, and their movement has been considerably less than that of the bilateral dollar/yen relationship.  In any case, Japan’s current account surplus (1.6% of GDP) and the U.S. deficit (some 2.3% of GDP) remain easily manageable in size.

The case of EUR/USD is somewhat different from that of dollar/yen.  The euro peaked at $1.604 in 2008, a level called brutal by then-ECB President Trichet.  But just eight months ago, the euro hit a 2014 low of $1.3993 last May 8.  The shift over those six years had been a dollar rise averaging only around 3% per year, which is also quite tolerable.  Unlike dollar/yen, moreover, shifts in EUR/USD correspond to more skewed movements in their respective trade-weighted effective exchange rates.  The dollar is 19% stronger now than last May 8 against the euro.  While the trade-weighted dollar has climbed 15%, the trade-weighted euro has dropped only 5%.  Euroland is running a considerably bigger relative current account surplus than Japan, equal to 2.6% of GDP, although such masks vast intra-EMU imbalances between the very large surpluses of Germany and the Netherlands on the one hand and substantial deficits at several other economies using the euro.  The disparity of circumstances within the common currency area makes it very difficult to forge a consensus view on the euro.  While politicians may employ verbal rhetoric to influence the foreign exchange market, their lack of influence over pan-Ezone monetary and fiscal policy will mute the effectiveness of such efforts. 

Central bankers in general and those at the European Central Bank in particular have philosophical qualms against currency manipulation.  The age of tightly coordinated forex policy is over.  Nations like Germany greatly regret the collateral damage of such exercises in the past.  It is the exception like Switzerland, rather than rule, where domestic monetary policy has been subordinated to an exchange rate objective.  In the ECB’s case, quantitative easing now appears unavoidable, and it will amplify the euro’s current downtrend. 

China will be an important player during 2015 in currency policy cooperation or hostilities.  The yuan depreciated against the dollar last year but rose against the euro, yen and many other currencies.  Although China posted only a $16.6 billion trade surplus in the first quarter of the year, such ballooned to an average monthly surplus of $46.3 billion in the second half.  The Obama administration has two opportunities each year to declare China a “currency manipulator” but has always refrained, and 2015 will be no different.  Such a designation would be a highly provocative gesture, whose potential risks far outweigh potential gains.  Trade frictions that might arise are far likelier to involve China and other Asian countries than U.S.-Sino relations.

Some of the greatest reversals in the dollar resulted from deliberate policy initiatives.  At this early stage of 2015, the stars are not aligned for such a surprise in 2015.

Copyright 2015, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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