Foreign Exchange Insights

June 27, 2008

Net oil-consuming nations face a common enemy in soaring energy costs, which lift inflation and cut economic growth.  Since the end of the first quarter, oil prices have advanced 38%.  The weakest major currencies since end-March have been the yen and Swiss franc, the historic financing vehicles in carry-trade investments.  The strongest currencies in 2Q08 were the Australian and Canadian dollars, whose movements tend to correlate positively with commodity price trends.  The dollar is little changed on balance since the start of the second quarter against the euro and sterling but has performed poorly lately across the board.  This past week through 14:15 GMT on Friday saw the greenback slide by 2.5% against the Canadian dollar, 1.2% versus the Swiss franc, 0.8% relative to the euro, yen and Aussie dollar, and 0.6% against sterling.

For now, rising oil prices will do more harm than good for the dollar.  The U.S. economy was already more fragile than others.  The United States needs capital inflows to finance a current account deficit that edged up to 5.0% of GDP last quarter.  Fed officials have escalated their hawkish rhetoric, where “hawkish” as used here is meant to imply a predisposition to raise interest rates, but persistent housing market strains, weakening labor market conditions, and plunging consumer sentiment mitigate the threat of any bite behind the bark.  The European Central Bank, by comparison, will be raising its key interest rates next Thursday despite data suggesting that regional growth is slowing more abruptly than that central bank had assumed.

Next week will feature a number of potentially market-moving weak economic reports.  On Tuesday, the Bank of Japan’s quarterly survey of business conditions and expectations, known as the Tankan, will fan fears of a possible recession, but with a central bank rate of just 0.5%, the Bank of Japan will not introduce new stimulus in response.  The United States reports the PMI-mf’g survey results on Tuesday, followed by its service-sector counterpart on Thursday along with the monthly labor market survey that same day.  These numbers will be weak.  So will Euroland and Britain’s monthly PMI’s.  Preliminary Euroland readings announced last Monday unexpectedly revealed a trio of sub-50 scores for the overall economy of 49.5 versus 51.1 in May and 57.8 in June 2007, 49.1 in manufacturing, down from 50.6 in May and 55.6 in June 2007, and 49.5 in services after 50.6 in May and 58.3 a year earlier.  A score below 50 implies contracting activity, while readings above that level point to expansion. The overall score is at a five-year low.

Having escalated their protest against dollar depreciation, U.S. and other G7 officials have their credibility on the line.  This is not quite as significant as it seems.  Policy credibility can be built back up with good, consistent behavior, but the process can be difficult.  If the dollar weakens and oil strengthens from here, it is unlikely officials will stay silent.  Beyond talk, however, policy options are limited.  The ECB may curb its enthusiasm for additional rate hikes, but the main gesture has to come from the Fed.  With dollar depreciation feeding the oil market frenzy, a rate hike by the Fed from a very accommodative stance currently could have a net stimulative effect.  Oil might stabilize, and equities, U.S. housing, and consumer confidence could hardly do worse than they are performing already.  Another possibility to consider is currency market intervention, in which the G7 buys dollars against other currencies.  Such options will come into play only if the atmosphere surrounding the dollar takes a dramatic and sustained turn for the worse.  The most important dollar relationship is its value against the euro, and that pair barely moved on net during the second quarter.  So the flash-point for policy surprises, if such come sooner rather than later, is likely to arise from other financial markets — soaring commodities, sinking equities, or rising long-term interest rates — and not from foreign exchange movements per se.

The coming business week ends early with the 18:00 GMT U.S. Treasury market closure on Thursday ahead of the Independence Day holiday.  At times when the U.S. has a major holiday not shared elsewhere, currency movements become listless.  Other times, trading gets erratic.  On Friday, July 6, 1973, less than four months into the experiment of floating dollar rates, world foreign exchange markets suffered a near-complete seizure, with very wide bid-ask spreads and a free-falling U.S. currency.  The rupture was so severe that a decision was made that weekend to re-introduce a role for currency market intervention (the original dollar float did not envisage any intervention) to be decided when the situation warranted it.  The Fed, as agent for the U.S. Treasury, thereafter was entrusted with the responsibility of “countering disorderly market conditions,”  and the definition of a disorderly market was framed in terms of the conditions that had been seen on July 6, 1973.  As the third quarter begins, market participants should watch out for the unexpected (for example, the sub-prime credit crisis burst onto the scene last August) and understand that market moves in summer-thin volume may not be indicative of underlying supply and demand. 


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