Foreign Exchange Insights

August 8, 2008

Dollar strength intensified sharply over the course of this past week in increasingly heavy short covering, as participants sensed a major reversal of trend.  From lows during the week to August 1st to the dollar’s highs through 14:30 GMT on August 8th, the U.S. currency advanced by 8.2% against the Australian dollar, 6.9% against the New Zealand kiwi, 5.1% against the euro and Canadian dollar, 5.0% against the Swiss franc, 4.3% against sterling and 2.9% relative to the yen.  Talk has shifted from U.S. economic weakness to global economic weakness, with recessions likely or possible in numerous European economies, Japan, Australia, Canada and even some emerging markets.  A swing in asset preference away from commodities and equities and toward bonds also has buoyed the dollar.  The fear of inflation remains strongly in play but mostly as a potential major drag on future growth, rather than a development that will cause central banks to tighten monetary policy.  To be sure, central bank rates were raised this past week in South Korea and Belarus.  However, the Fed, Reserve Bank of Australia and, most importantly,  ECB flagged weak growth prospects in statements explaining decisions to leave their rates unchanged.  The Bank of England also did not raise interest rates even though inflation is expected to remain substantially above target for the rest of this year.

Market players will be fed a pretty heavy diet of soft economic data next weekJapan and much of Euroland release second-quarter GDP growth estimates.  This will be the week when most of China’s monthly data arrive, including exports, consumer and producer prices, fixed asset investment, money and lending, retail sales and industrial production.  Britain’s slate of economic indicators is also full: producer prices, trade, the CPI, average earnings, unemployment, the RICs housing price index, productivity, and the  Bank of England’s quarterly report unveiling new inflation and growth forecasts.  Australian monetary officials will publish their quarterly policy statement, which in the wake of last week’s shift to an easing bias will likely foreshadow a 50-basis point rate cut next month.  From Euroland arrives industrial production and consumer prices in addition to GDP.  Japanese trade figures, wholesale prices and tertiary index covering service-sector activity are due.  So are Canadian housing starts and monthly trade.  Last but hardly least, the United States releases trade data on Tuesday, import prices and retail sales on Wednesday, consumer prices and jobless claims on Thursday, and industrial production, capital flows, and consumer sentiment in Friday.  These releases are not expected to jar the growing perception that the U.S. is but one of many economies in a difficult situation and that several economies may perform significantly worse than the United States during the coming year.

A basis for a cyclical dollar upswing seems undeniable, but it takes a structural transformation to produce a major trend reversal like the dollar upswings that began in 1980 and 1995 or downturns that commenced in 1973, 1985, and 2001.  The currently improved dollar levels must be set against prior declines of 51% from 0.4785 per A$ to 0.9849, 44% from C$ 1.6194 to 0.9061, 49% from 0.8228 to 1.6038 per euro, 47% from Chf 1.8295 to 0.9637, 35% from 1.3685 per British pound to 2.1160, or 25% from Yen 135.15 to 101.67.  Those substantial dollar losses have recently been reversed by roughly 27% in the cases of sterling and the yen, 23% versus the Canadian dollar, 19% versus the Australian dollar, 14% versus the Swiss franc and 13% versus the euro.  In no instance has the first Fibonnacci threshold been approached.  Viewed over the past 40 years, the dollar performs like a soft currency, with exceptions occurring only under extreme circumstances like the mix of ultra-tight monetary policy and ultra-loose fiscal policy of the early 1980’s and the spike in U.S. productivity growth during the late 1990’s.

The dollar continues to carry much structural baggage.  The list of factors includes burdensome budget and current account deficits, excessive corporate and personal debt, a deficient savings rate, related housing and financial-sector problems, a lack of leadership in forging freer world trade, transportation and education infrastructure badly in need of repair, and a bias at the Federal Reserve to subordinate price stability to promoting growth even in the short term.  So enjoy the dollar’s short-term upward fling for what it is, a temporary but possibly sharp correction from undervalued levels against the euro in particular.  However, I would caution against reading too much into this move.  It’s doubtful that we at a significant favorable crossroads for the dollar like 1980 or 1995.  Until long-term charts suggest otherwise and until severe U.S. economic imbalances are enduringly on the road to being addressed, the burden of proof for any multi-year dollar forecasts rests with the optimists, not the pessimists.


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