Foreign Exchange Insights

May 23, 2008

The global economy needed this past week’s 5.6% additional rise in oil prices like a whole in the head. The threat of a recession induced by inflation creates a more difficult task for policymakers than a downturn caused by a banking crisis. By answering the first challenge, moveover, the Fed has little left in the tank with which to resist new headwinds.

The dollar fell last week in spite of mounting evidence of weakening growth prospects in Japan and Europe. Investors do not expect the Fed to resist inflation as vigilantly as the ECB, and the United States has a chronically large current account deficit in contrast to Japan’s surplus and Euroland’s near-zero external balance. Stagflation is not a good backdrop for the dollar. As of 14:00 GMT today, the greenback was showing weekly losses ranging from 0.5% against the yen to 0.7% against the Australian dolar, 1.0% against the euro, 1.3% against sterling, 1.5% against the Canadian dollar, 1.8% against the kiwi, and 2.0% against the Swiss franc. The Chinese yuan, whose climb had been stalled for several weeks, advanced at a 48% annualized rate this week and promoted the biggest drop in Chinese equity values in five weeks. The euro was not the most well-bid currency against the dollar but for a second straight week posted higher highs and higher lows than in the prior week. Advancing back to $1.60 and beyond will not be easy, however, amid escalating complaints about the euro’s strength from Ezone politicians and in the teeth of mounting ware and tear on the regional economy from high raw material costs and an uncompetitive exchange rate.

The first season of the currency calendar’s three natural seasons ends today. We now move into the summer period, lying between the U.S. Memorial Day and Labor Day weekends. The dollar declined 7.3% against the euro in the first season of 2008 on top of a 9.5% drop in full-2007. The U.S. currency fell by an almost identical 7.2% against the yen on top of a 6.3% slide last year. Against the third traditional “hard currency” — the Swiss franc — the dollar slumped 9.4% thus far in 2008 compared to a fall of 7.0% between end-2006 and end-2007. Against all three of these rivals, dollar weakness intensified in the winter-spring season. In contrast, last year’s strongest currency, the Canadian dollar, shows a year-to-date rise of just 0.9% versus a 17.4% jump in 2007. Canadian officials have not just observed the negative effects of appreciation on growth. They are doing something to mitigate those effects. Interest rates have been cut by a third to 3.0% from a 4.5% level at the start of December.

What most differentiates currency trading in summer from the rest of the year is the comings and goings of vacationing traders. Volumes ebb, and there tends to be more discontinuinty in the flow of market life, resulting in less depth, breadth and resiliency to the marketplace. This doesn’t mean that nothing happens in summer. Far from that. Some of the biggest foreign exchange milestones occurred in summer: the initial severing of dollar/gold convertibility, Iraq’s invasion of Kuwait, and last year the start of the still-evolving global credit market breakdown. Many dollar corrections began in summer, and when Europe had many more currencies than now, the vulnerabilities of the weakest ones were often exposed in late summer.

During the nine summers since the euro was formed in 1999, dollar/euro has declined five times, risen four times, and on average posted a net dip between Memorial Day and Labor Day of just 0.3%. Last summer’s 1.4% dollar decline was atypical, following moves of -0.8% in 2006 and +0.3% in 2005. Dollar/yen was considerably more volatile in the past nine summer seasons, dropping by 1.8% per year on average. In six of the years, the dollar recorded a change against the yen of at least 4.0%, including a 4.7% drop in 2007. One other peculiar characteristic of the yen’s shift each summer has been the tendency to gravitate toward somewhere between 110 and 120 per dollar by Labor Day. The range of the dollar’s pre-Memorial Day Friday levels ran from 106.96 to 124.63, but the range of values on the Friday before Labor Day was considerably narrower at Y 109.63 – 118.67. The big mysteries of the coming summer involve the continuing evolution of oil and other commodity prices and how dramatically the economies of Europe and Japan soften. The latter issue should lend the dollar support and prevent a hard landing. The currency that lagged most in the first season of 2008, the Canadian dollar, may be ripe for a better performance this summer.

Next week, the last one of May, has a thick slate of data to be released, and the pace of news will be compressed by closures on Monday in both the United States for Memorial Day and Britain for a bank holiday. It’s a four-day week for all intents and purposes yet one jam-packed with new information. Japanese arrivals will include corporate service prices, the Shoko Chukin index, labor statistics, real household spending, retail sales, industrial production, housing starts and consumer prices. The United States reports house prices, consumer confidence, new home sales, durable goods orders, and revised real GDP. From Europe comes detailed breakdowns of GDP growth in 1Q, business and consumer sentiment, labor statistics, and consumer prices. Foreign data should have more influence than U.S. data over currency markets because nothing is going to happen as soon as this week to change the fact that the Fed is for now keeping its interest rate structure steady. The ECB and BOJ are also in a wait-and-see mode, but perceptions about how long such will remain the case will be in a greater state of flux than the perceived timetable for Fed policy. The Norges Bank of Norway holds a policy meeting this week.


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