Foreign Exchange Insights

July 25, 2008

The U.S. dollar rose against a broader array of other currencies and by greater amounts this past week than in the previous week to July 18th.  Its gains even included a minuscule uptick against the Chinese yuan.  As of 14:45 GMT, the dollar had advanced 2.5% against the New Zealand currency and by between 1.0% and 1.7% relative to the Swiss franc, Australian dollar, Canadian dollar and euro.  It was up 0.9% against the yen and 0.4% stronger versus sterling.

Market confidence in the dollar’s outlook also appears much sounder than prior to midyear.  It’s been quite a while since the U.S. currency’s lowest points were set against many other currencies:  more than 250 days in the case of sterling and the Canadian dollar, 149 days vis-a-vis the kiwi, 130 days each against the yen and Swiss franc — a natural tandem since each is used to finance carry trades.  Only the euro and Australian dollars hit new peaks this month, ten days ago to be precise.  From its lows, the dollar shows double-digit recoveries of 12.2% against the Canadian dollar, 11.3% against the yen and 10.7% versus the kiwi.  It has risen by 7.8% relative to the Swiss franc and by 5.9% against the pound.  Not surprisingly, the smallest rebounds have been against the currencies that peaked on July 15, 3.1% against the Aussie dollar and 2.3% against the euro.  Traders no longer wonder if the dollar will stage a correction in the short term.  Such a move had seemed well overdue, increasingly likely as other markets became highly frothy, and indeed already apparent in the currency charts.  The questions now are these: how long will the correction persist, how far will it go, to what extent will the euro join in, and might this correction evolve into a full-blown true trend reversal?

Although U.S. GDP  in 2Q08, which will be released on July 31st,  expanded two to three times faster than in the first quarter, newborn optimism in the United States is not the main reason for the dollar turnaround.  The beginning of an enduring U.S. convalescence will not take hold until housing prices bottom, and that point is still quite some distance away.  Although the boost from Fed easing in 1Q08 will continue to nourish the economy, the only way to stave off recession will be with additional timely doses of major fiscal support.  In any case, the deepening impression among analysts that the U.S. will muddle along perhaps into 2010 is unlikely to be quelled by forthcoming data.  The figures will ebb and flow as they always do and as we saw this week between the contrasting reactions to existing and new home sales, but their overall appearance will not be especially supportive of the dollar.

The dollar doesn’t need such help to correct upward further.  Its improvement rests on two pillars.  The most important of these can be found in non-U.S. data.  Oil prices at this writing have retreated 16.5% from their July 11th peak but are still more than 140% above their  cyclical low in January 2007 and 70% greater than their 2007 mean level.  A substantial further retrenchment is suggested, but not guaranteed, by these comparisons and by the softening tone of the entire global economy.  The possibility of a coming recession in Japan and many parts of Europe is mainly responsible for the stronger dollar recently and for the likelihood of a continuing bid-tone for the U.S. currency in the near term.  Foreign exchange markets tend to be most sensitive to new ideas.  Investors have long become accustomed to the fragile U.S. economy and all the event risks that such entails, but they are still coming to grips with a broader global slowdown, which in fact could yet spread more deeply into even the go-go emerging market economies.

The cusp of every month is a period when many economic indicators get released.  German consumer confidence arrives Monday, an otherwise slow day.  On Tuesday, Japan releases labor statistics, retail sales and household spending.  We also get French consumer confidence and housing starts, as well as Italian wages and British monetary growth, retailer conditions, and mortgage approvals.  Wednesday sees the release of Japanese industrial output and worker confidence at smaller firms, German retail sales, and Euroland business sentiment and consumer confidence.  Thursday is another crowded day: Japanese housing starts and construction orders, euro area and German labor market figures, British consumer confidence, a whole bunch of price figures, Canadian GDP and U.S. GDP.  All eyes on Friday, August 1st, will be watching the U.S. monthly labor force report, but U.S. and European manufacturing PMI’s that same day will afford a reality check to compare trends in the two economies directly.  If both foreign and U.S. data next week exude weakness, it will not be a wash in the currency markets.  All that’s required is that Japanese and European figures not consistently outperform expectations.  U.S. growth above 2.5% saar will be icing on the cake.

Investors like to find theoretical reasons to support what they see in data trends.  A rationalization for why U.S. economic weakness that is now making the rounds is that policymakers in Europe and Japan failed to match the stimulative acts of the Fed and Congress, and such logic seems to support the possibility that Europe and Japan will be under-performing the United States for the next year.  Eventually, the ECB and BOJ will be cutting rates, perhaps at the same time that the Fed is looking ahead to economic recovery and tightening.  All of these developments encourage investors into thinking much more dollar appreciation lies ahead, and that’s a very positive dollar backdrop for the very near term.  Here’s where the second pillar of major dollar support enters.  The meeting of G7 finance ministers and central bankers sharply escalated verbal support for the dollar when they met in April, and the Tokyo summit of G8 leaders reinforced that momentum.  At the same time, Beijing officials are believed to be transitioning toward a slower pace of yuan appreciation against the dollar.  The U.S. currency could climb considerably from current levels without arousing protest from any officials.  Even if currencies that are already significantly below their cyclical highs against the dollar only move gradually, the euro should indeed participate more fully in this correction.  It may be a while before the ECB cuts rates, but soft Ezone data will embolden the investment community to count upon the next European rate move being down, not up.  Euroland growth in the fourth quarter will have to conform much more closely to ECB expectations than the softer trajectory anticipated by private analysts to dissuade the market of such thinking.  Half a year remains before that data is known, so plenty of time remains just ahead for euro to settle back.

I use the term dollar correction to connote an observable movement in time and size that is opposite in direction to a surrounding movement that is much more profound.  The length of corrections vary greatly.  During a dollar strengthening period during the first Reagan term, there were three distinct counter-trend declines of more than 10% that lasted from between two and four months.  On the other hand, the dollar’s post-Y2K swoon that began early in 2002 was interrupted for almost the whole calendar year of 2005 by a period of appreciation.  The present dollar correction does not fit easily into either of these patterns.  It’s length has exceeded four months against most currencies and already exceeded 10% against some.  However, the most important dollar relationship is the EUR/USD, which hit its peak just ten days ago.  If the dollar ever squanders its reserve asset hegemony, it will be ag
ainst the euro.

The U.S. economy has more fundamental imbalances than Euroland’s with a potential to impact long-term currency trends.  I agree with Robert Reich (see previous posting) that the United States is out of options for sustaining good growth in spite of lagging real wages and that the rebuilding process will take a long time regardless of which party wins the presidency.  The dollar’s long-term trend since the late 1960’s has been downward, a fact alone which puts the burden of proof for long-term dollar prospects on the optimists.  I therefore doubt the dollar is in the early stage of a 2-5 year uptrend.


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