Dollar Emerges Strong after Two Mistrusted Deals

July 16, 2015

The first of two agreements reached this week pitted the Greek people against the country’s creditors.  It avoided the feared precedent of a member leaving the currency union but did so at enormous cost to the euro’s reputation.  To Greece’s partners, the struggle ended with victory for the principle that rules governing common currency area must be followed, regardless of circumstances.  Otherwise, an ensuing contagion of rule-breaking will destroy the arrangement.  But to the world financial community, the latest chapter in the five-year Greek debt crisis revealed a very dark side of the Economic and Monetary Union, demonstrating that political imperatives will always take precedence over economic sanity.  Confidence in the long-term survival of the euro took a big step lower.  A common currency in Europe built to solidify economic and political integration is doing just the opposite by depriving nations like Greece of breathing room and sovereignty over their own destiny. Even the IMF smells a rat in the deal’s failure to reduce Greece’s debt, and may abstain from a third bailout without that element being added.   While the Germans, Dutch and Finns are hailing the result as triumphal for rejecting blackmail has been seen differently by investors.  The euro weakened against the dollar and key crosses like sterling.  British politicians are looking brilliant for steering wide of the euro.

The second historic agreement of the week  also set off a storm of misgivings.  Nobody seems to know the whole truth about the merits of the Iran nuclear deal versus a scenario where no deal is made.  President Obama is in a bind.  Like Woodrow Wilson’s inability to achieve U.S. ratification of the League of Nations, it will be humiliating to the power of the presidency if a treaty supported by a broad cross-section of allies is rejected by the Congress.  But if Obama prevails without bipartisan support on such an important piece of foreign policy legislation, the victory will damage the U.S. political climate.  The Iran nuclear deal may ultimately prove to be an historic misjudgment, but that will not be apparent for many years.  The Greek agreement solved a more urgent crisis than an Iran deal, so the two events do not cancel each other out from the standpoint of currency market effect.

Three other developments this week favored the dollar.  Janet Yellen’s congressional testimony strengthened speculation that the Fed will soon raise interest rates.  I expect the first increase nine weeks from today.  Second, concern keeps rising that the progressive slowdown in Chinese economic growth is not done, and confidence is eroding that Chinese officials will find the wherewithal to manage the future path of their economy.  China is so important from an economic as well as foreign policy standpoint that high uncertainty over its direction arguably constitutes the greatest risk that markets need to hedge.  As a safe haven, the dollar naturally benefits.  Third, the credibility of Abenomics is low.  The Bank of Japan’s upbeat statement following this month’s Policy Board meeting was widely panned as too optimistic on growth and inflation, and the only way seen for achieving the central bank’s goals is for the yen to weaken further. 

The likeliest currency outlook at any given time generally seems to be an extrapolation of what’s been happening recently.  If that were always correct, however, there never would be trend reversals.  That said, the case for continuing broad-based dollar appreciation still seems reasonable.  At a 2015 high against the euro of $1.0459 hit exactly four months ago today, the dollar ran out of steam.  In less than three months since end-2014, the dollar had advanced 15.7% against the common European currency, a decent high-low trading range even by whole year standards.  As the dollar relinquished about three-fifths of that advance over the two months to mid-May, more and more market observes came to the view that the dollar’s 2015 high against the euro had been seen in March.  From this vantage point in mid-summer, with one of two Fed rate hikes juxtaposed against Bank of Japan and European Central Bank quantitative stimulus, that pronouncement that the euro will not get any lower than its March low is looking doubtful again, and if 1.0459 gets taken out, a challenge of parity would be certainly possible.

Another reason for optimism about the dollar’s outlook in the second half of 2015 stems from the broad nature of its gains.  It’s not just the euro.  The Canadian dollar hit a six-year low this week.  Canadian, Australian and New Zealand officials all would welcome weaker currencies and expect such to happen.  A weaker trend of growth in Chinese demand has adverse implications for a lot of other emerging economies and well as commodity-sensitive advanced ones.  The drag on the U.S. recovery would be comparatively less significant.

As a final thought of the week, it’s always important in summer to be cognizant that market action in this season can be less representative of underlying economic fundamentals than what happens during other parts of the year.  Don’t always believe in summer what your eyes see and ears hear. 

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

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