Foreign Exchange Insights
July 31, 2008
The foundation of a dollar correction dried further during July. Based on quotes at 15:35 GMT on the 31st, the dollar was higher across the board for the month against the Australian dollar (+7.1%), New Zealand dollar (+3.6%), Swiss franc (+2.6%), Japanese yen (+1.8%), euro (1.0%), British pound (+0.6%) and Canadian dollar (+0.4%). In addition, depreciation against the Chinese yuan slowed to an annualized pace of 4.0% in July from 13.5% in the first half of 2008. In order of importance, the correction has been promoted by a surprisingly abrupt and sharp deterioration in European and Japanese data, investor relief that the U.S. financial system will avoid a worst-case scenario, a drop in oil prices in the last two weeks, and better-than-feared U.S. economic data. Since the middle of 2008, the DJIA has recovered 1.2%, but it remains 13.4% lower than at end-2007. Yields on two- and ten-year Treasury notes slid another 9 and 1 basis points to 2.53% and 3.96% in July. If not for support from net foreign demand, U.S. real GDP would have declined 0.5% saar in 2Q instead of rising 1.9%. The U.S. growth outlook remains precarious, but prospects elsewhere now look just as bad, if not worse.
| Dollar against | Euro | Yen |
| January | -1.7% | -4.5% |
| February | -2.2% | -2.6% |
| March | -3.8% | -3.8% |
| April | +1.0% | +4.2% |
| May | +0.5% | +1.6% |
| June | -1.2% | +0.6% |
| July | +1.0% | +1.8% |
Month-end to month-end dollar changes against the euro and the yen, shown above, were sharply negative in the first quarter but with one exception positive in each of the subsequent four months. The EUR/JPY relationship has been a more consistent relationship to trade than either of the two dollar pairs. From a low of 151.73 yen per euro on March 20th, the euro advanced 12.0% to a high of 169.98 on July 23rd. It is no coincidence that the yen peaked in mid-March, as that trend reversal coincided with the news of the Fed-assisted buy-out of Bear Stearns. Based on currency market behavior, that action ranks in importance above all other monetary or fiscal steps to add liquidity, safeguard the financial system, and aid ailing homeowners and consumers. The rescue of Bear put a bottom under the dollar and under the economy. Without that triage, nothing else would have mattered. In the long run, the dollar will need much more than first aid to prevent renewed slippage.
Opinion is split over whether the yen continues to lose ground against the euro. Support kicked in when the 170 level was threatened, so technical resistance would need to be overcome. On purely economic considerations, both regional economies have hit the skids. It’s hard to distinguish which region faces more difficulty. Neither the BOJ nor ECB is likely to change interest rates over the rest of this year. However, the rise of EUR/JPY was powered not merely by economic comparisons but also by the return of a modicum of risk taking. Before the rescue of Bear, investors lost all confidence in the financial system. The appetite for risk is as essential to carry trading as oxygen is to life. Carry trading, in which investors borrow low-yielding yen or Swiss francs, and invest in higher-yielding assets denominated in other currencies, only works when risk appears manageable. The weakness of the Swiss franc in July was a further sign that some carry trading has resumed. Unless the euro backs sharply down from Yen 170, a successful move through that barrier ought to occur later in the third quarter. On a period average basis, the pair’s average level so far in 2008 of 161.7 is very close to the full-2007 mean of 161.3. The point there is that some further euro gains against the yen are not going to be calamitous to the Euroland economy.
Few economies have had worse economic news for a backdrop than sterling, yet cable (trader talk for its value against the dollar) continues to hover close to $2.00, meaning the pound outperformed the yen, euro, and Swissy this past month. In its favor, sterling has a 5.0% central bank rate, compared to 4.25% in Euroland, 2.75% in Switzerland, 2.0% in the United States, and 0.5% in Japan. None of these central banks seem poised to make a policy change, so that advantage isn’t going away quickly. All the same, sterling assets ought to carry a warning. The pound has a history of over-electrified movements, many of which were southward like its exit from the ERM in September 1992 and also sixteen years earlier when sterling lost a quarter of its value in seven months, sinking from $2.0250 on March 4, 1976 to $1.85 a month later, $1.7020 by early June and an eventual low of $1.5550 by October.
The summer Olympic games in Beijing begin on August 4th and run thorough the 24th of the month. Associated local currencies slid mildly during the past three summer games. While the Atlanta games were being played between July 19 and August 4, 2004, the dollar eased 0.9% against the Deutschemark. Over the course of the Sydney games (September 15 – October 1, 2000), the Australian dollar fell 1.2% against the U.S. dollar on balance. And four years ago when the games were played in Athens from August 8th to August 24th, the euro declined 1.4% against the dollar. Chinese officials already have signaled growing reservations against continuing yuan appreciation amid a slowdown in economic growth and a downturn in inflation.
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