Foreign Exchange Insights

June 6, 2008

The leaders of the world’s two most influenctial central banks served up major, and more importantly, conflicting surprises to the currency marketplace last week. Bernanke went first and lent the dollar a substantial boost. Trichet had the last word, sending the dollar to a net weekly loss of 1.1% against the euro as of 16:15 GMT on Friday and to within three cents of its all-time low. The order of scheduled speeches reverses next week, with Trichet talking on Monday and Bernanke on Tuesday. Bernanke and Trichet are responding to the same problem. Commodity-led inflation has persisted longer than anticipated and reached uncomfortably high levels that threaten to unglue expectations of low and stable prices in the medium-term.

Bernanke addressed an important element of U.S. inflation, the weak dollar, in as explicit language as I have ever heard a Fed Chairman, or Treasury Secretary for that matter, speak on this issue, leaving no doubt that future monetary policy will try to do nothing to promote continuing dollar losses. Other parts of Chairman Ben Bernanke’s speech, however, made it quite clear that U.S. monetary authorities are not prepared to begin raising interest rates yet. Today’s jump in the U.S. unemployment rate to 5.5% from 5.0% in April underscores that impediment. We are left to conclude that the Fed’s interest rates will remain on hold for at least several more months but that currency intervention is a policy tool that may be gaining favor inside the U.S. administration. Most market observers were already migrating to the view that additional U.S. rate cuts were unlikely. The tone of recent remarks by Fed officials had promoted such beliefs, and so too had a string of better-than-feared U.S. economic data. The main effects of Bernanke’s words was to highlight a shift away from benign neglect of a weak dollar and to establish a credible motivation for that shift based on a perceived link between dollar depreciation and accelerating domestic inflation.

Trichet’s message is more action-oriented than Bernanke’s. Although ECB officials and politicians in Europe share the same foreign exchange market hopes as Bernanke and Treasury Secretary Paulson, the worsening inflationary environment has crossed over the line of tolerance, compelling the ECB Governing Board to abandon its wait-and-see approach that’s been in effect since last September. Trichet warned that a rate hike is possible, although not certain, on July 3rd. I take that to mean probable and likely to be followed up with at least one additional increase by end-year. The ECB’s refinancing rate of 4.0% is already twice the Federal funds target rate of 2.0%. The 200-basis point spread between them is headed for 250 bps or wider. Just as Bernanke’s remarks put to rest the thinking of some analysts that rate cuts might resume in late summer or in 4Q, Trichet has poured cold water on the view that the ECB was going to ease once or twice later in 2008. In a single week, a reasonal expectation of movement in the U.S./Euroland central bank spread has shifted by more than a 50 basis points.

Under the circumstances, the reaction of currencies was guarded. For the whole week, the dollar closed with mixed changes, increases of 2.5% against the Canadian dollar, 2.1% against the kiwi, and 0.7% against sterling but with losses of 1.8% against the Swiss franc, 1.1% against the euro, and 1.0% versus the Australian dollar. The market is probably not ready to challenge $1.60/euro, and other key dollar relationships remain well shy of their cyclical lows of 0.9630 Swiss francs, Yen 95.77, $1.9183 per pound sterling, C$ 0.9061, or 0.9466 per Aussie dollar. One deterrent to unhibited dollar selling is that growth in Europe seems to be slowing faster than officials believet. Another is the extensive drop of the dollar since 2002, making it look very competitive against the euro and some other currencies. A third factor mitigating dollar bearishness is the possibility of coordinated interevention. Bernanke’s dollar remarks were truly extraordinary and did not get said without considerable forethought about how to handle renewed dollar depreciation in the future.

The annual summit of G7 leaders in Japan on July 7-9th is but a month away, and currencies are likely to be discussed. So far this year, the dollar is down 9.7% against the Swissy, 8.9% against the Aussie dollar, 7.2% against the euro and 5.5% against the yen. On the other hand, the dollar has risen by 0.9% net against sterling and 2.5% relative to the Canadian dollar. It’s no coincidence that outside of the Fed, the central banks in the U.K. and Canada are the two that have also cut interest rates.

A large number of economic indicators will be released during the week to June 13th. Japanese data include revised GDP and industrial output, machinery orders, consumer confidence, the economy watchers’ index, revamped money aggregates and corporate goods prices. China releases CPI, PPI, trade figures, money and lending growth, and retail sales. The yuan has climbed so far in 2008 at a 13% annualized rate against the dollar. From Euroland, traders will be learning the results of German trade and Ezone industrial production as well as quarterly growth in jobs. British producer prices, house prices, unemployment, wage earnings, trade figures, and a central bank survey of expected inflation are due. The U.S. calendar is topped by consumer prices, the Fed Beige Book, consumer sentiment, and pending home sales. A slew of ECB officials besides Trichet will participate in public speaking opportunities including Weber, the Bundesbank’s hawkish leader. Several Fed officials also have speaking engagements.

Both the Bank of Canada (Tuesday) and Bank of Japan (Friday) announce rate decisions. News of negative GDP growth in Canada last quarter and a small 8.4K rise in Canadian jobs last month appear to cement the likelihood of a 25-bp Bank of Canada rate cut to 2.75%. Previous rate reductions were made on December 4th (25 bps), January 22nd (25 bps), March 4th (50 bps) and April 22nd (again by 50 basis points). In explaining the rate cut of April 22nd, Canadian monetary officials warned that “some further monetary stiumulus will likely be required..,” which added the qualifying word “some” to its conclusion in the March 4th statement. The Bank of Japan has not changed monetary policy since February 2007. The target is very low at 0.5% but may have to be cut later in 2008, if Japan’s seemingly stalled economy fails to perk up.


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