Foreign Exchange Insights

May 16, 2008

The dollar is wrapping up the the second full week of May on a soft note but shows mixed changes for the week as a whole. The balance of weekly dollar gains and losses suggests a further lessening of risk aversion. The greenback as of 14:50 GMT had posted gains against carry trade funding currencies such as the yen (+1.2%) and Swiss franc (+0.6%), but it lost ground against high-yieliding commodity-sensitive currencies like the Australian dollar (minus 1.0%), Canadian dollar (-0.9%) and kiwi (-0.4%). EUR/USD firmed 0.5% on balance and had a stronger low this past week of $1.5367 than in the previous week ($1.5287). The euro is currently near its high for the week. Although closing with a net decline, dollar/yen traded within similar boundaries as those in the prior week. Oil and Gold were volatile and higher on net.

Whereas U.S. GDP crawled along at a tepid 0.6% saar pace last quarter (+0.1% not annualized), growth in Germany of 1.5% not annualized and Japan of 0.8% (3.3%) surpassed expectations by a significant margin. Business spending was the major engine of German growth last quarter, whereas a 0.9% drop in Japanese non-residential investment (-3.4% saar) signals trouble ahead. European growth also has slowed sharply since the winter quarter. The dollar’s continuing sharp decline in 1Q08 was consistent with fundamental economic trends then, but the present quarter shows considerable convergence in growth and world-wide difficulties in containing commodity-driven inflation. The likelihood and likely depth of a U.S. recession will continue to arouse a spectrum of viewpoints amid both pleasant and unpleasant U.S. data surprises. Housing starts and permits and consumer confidence figures today gave a sampling of both types. It is the nature of economic statistics to bounce around. The safe assumption looking to the rest of 2008 is a landscape with weaker growth, uncomfortably high inflation, and central banks that lack an inflation comfort level to cut interest rates. That may spell a rather prolonged period of dollar consolidation around present weak levels. If commodiy prices keep firming, dollar risk should skew to the downside.

The U.S. Treasury’s semi-annual report on international economic and exchange rate policies released on May 15th contained some surprising revelations. As part of the G7, U.S. Treasury officials agreed in a statement released on April 11th that “there have been at times sharp fluctuations in major currencies, and we are concerned about their possible implications for economic and financial stability.” But the Treasury’s more recent review observes, “the currency market has been orderly and has experienced substantially less volatility than other asset classes.” And the report goes on to say, “EUR/USD has at times experienced sharp fluctuations, but in general volatility throughout 2007 and 2008 has been near the norm.” It is noted too that the euro has strengthened much less on a trade-weighted basis than bilaterally against the dollar, that bid-ask spreads for the euro have been normal, and that Euroland’s current account remains near zero despite euro appreciation against the dollar. These comments tend to undercut the oft-repeated reminder by ECB President Trichet that he takes Bush Administration assertions at their word that a strong dollar is in the U.S. best interest. European politicians have been blunt in protesting dollar weakness against the euro, with the French finance minister this past week implying that an appropriate range for the key euro/dollar relationship is $1.20 – $1.30, not $1.50 – 1.60 as now exists.

The U.S. Treasury report likewise does not complain about dollar depreciation against the yen since mid-2007 when the pair was at 123.2. By pointing out that Japan’s current account share of GDP at the end of 2007 of 5.0% was no smaller than in the middle of last year, the Treasury indeed appears to endorse the yen’s gains. Harshest complaint was reserved for Chinese offiicials, who continue to “manage tightly” movements in the yuan. In the Treasury’s opinion, the yuan remains substantially undervalued, and the faster pace of rise in 1Q08 needs to be continued. This has not occurred, however. Over the first half of the second calendar quarter, the yuan rose only 2% at an annual rate against the dollar, only about a ninth as fast as its rise in the first quarter. Not by coincidence, voiced objections to yuan appreciation within China’s business community had intensified earlier this year.

The week to May 26th has a light U.S. data calendar, highlighted by producer prices and existing home sales, plus last month’s FOMC minutes get published. Euroland releases German business sentiment and PPI, Italian GDP and, most tellingly, flash PMI readings for May. Japan’s all-industry index for March comes out but has been superseded by this week’s quarterly GDP release. A BOJ policy meeting at the start of next week will again rubber-stamp the 0.5% overnight money target rate. British retail sales, GDP, and Bank of England minutes will hold interest. The April central bank meeting had produced a rare three-way, 6-2-1, split among policymakers. In light of horrendous inflation data since then, I expect that May’s decision to leave the Bank Rate at 5.0% enjoyed greater consensus than seen at the April meeting.


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