Foreign Exchange Insights: August 15th
August 15, 2008
The dollar experienced another very strong week, reflecting increasing pessimism about other economies. Dollar strength and commodity price weakness were both cause and effect to one another. Although Russia’s incursion into Georgia underscored the limitations of U.S. diplomatic and military power, Europe and not the United States was put in greater economic and geopolitical peril, so that too helped the dollar. A feel-good wave of national pride in America’s early accomplishments at the Beijing Olympics appeared also to lift dollar sentiment, reminiscent of the favorable reaction to the successful Los Angeles Olympics in 1984. Dollar bulls were out in force on business radio and television, with some casting the dollar’s rise as the start of a significant and enduring recovery and the currency’s turnaround as an investor vote of no confidence in the ECB’s failure to anticipate how contagious the U.S. slowdown would be. The big surprise has been that U.S. GDP growth in 1H08 was better than growth in both Euroland and Japan. The rankings of growth compared to the first half of 2007 show the United State on top with 2.2%, followed by Euroland at 1.8% and Japan at 1.1%. Similarly, annualized growth rates in the two quarters between 4Q07 and 2Q08, while limp in all instances, ranked in descending order the United States at 1.4%, then Euroland at 1.0% and Japan with merely 0.4%. Today’s headlines in the Financial Times (Eurozone moving closer to recession) and Wall Street Journal (World Economy Shows New Strain) underscore how far economic anxiety has moved past its obsession with a dysfunctional United States.
The dollar plainly has a good head of steam right now. It’s recent climb has been so sharp that a setback period of consolidation would not be surprising to see in the coming week, but few investors would bank on this past week’s highs representing the end of the upswing. The most compelling reason for believing the dollar’s recovery has further life is that relatively high U.S. inflation justifies only a small fraction of the currency’s extensive net depreciation since 2002. An undervalued dollar and overvalued euro are one of the big reason why the U.S. has avoided negative growth thus far and Europe has not. Purchasing power parity calculations that indicate how currency relationships ought to adjust to offset internal inflation disparities suggest that the euro is still very over-valued. It’s already too late for any policy moves to prevent European and Japanese growth in 3Q from staying in the red. Next week is a lean one for data releases both quantitatively and qualitatively, but it doesn’t matter because the impression has hardened that economic conditions will be worse than thought two months ago. The three biggest releases in my opinion will be the Euroland Flash purchasing manager index due Thursday and the minutes of the last central bank meetings in Australia (Tuesday) and Britain (Wednesday). Authorities in both of these cases may cut interest rates this year even before inflation has crested. The Bank of Japan meeting on Monday and Tuesday will again leave its 0.5% target rate unchanged, underscoring the inability to escalate monetary policy support. A final event that will hold market attention is the annual Jackson Hole Fed Symposium, which perennially seems to generate the top business headlines that move markets.
I would be remiss not to point out that today is the 37th anniversary of step one in the breakdown of fixed dollar parities, when President Nixon severed the U.S. currency’s guaranteed convertibility into gold and let the dollar float temporarily. Two formal devaluations followed, one in December 1971 and a second in February 1973, followed by a permanent float in March 1973. Since August 15, 1971, which came at the end of a week of unprecedented heavy and ultimately ineffective intervention, the dollar has depreciation over 63% against the Deutschemark and nearly 70% against the yen, equal to per annum losses of 2.7% and 3.1%, respectively. Dollar/mark and/or dollar/euro fell on an end-December to end-December basis 19 times from 1973 through 2007, just a little more than half the time. However, ten of the years that saw net dollar gains came in two bursts (1980 through 1984 and 5 of 6 times from 1991 to 2001). In both of those periods the dollar had huge fundamental advantages besides the need to correct previous excessive losses. Because of this history, it is appropriate to hold arguments for a sustained and long dollar appreciation to very high standards of proof.
The first table below compares interest rate spreads and oil prices in the first two weeks of August to the six months through July. A second table ranks the latest on-year CPI inflation rates and the current account-to-GDP ratios that are expected in 2008-9 according to the latest Economist survey of forecasts. The data underscore that not much has changed on these vital criteria. Oil, by the way is not a misprint; it had an identical average price in both periods. Dollar support thus boils down to relative growth trends that are expected to modify interest rates that are very disadvantageous to the United States. But everyone’s growth is weak, and it will be a long time before interest rate spreads narrow appreciably.
| Period Averages | August 1 -14 | February-July |
| 10Yr Spread (U.S.-German) | -0.31% | -0.39% |
| 10Yr Spread (U.S.-Japan) | 2.79% | +2.65% |
| 3-mos Eurodollar minus Euribor | -2.71% | -1.93% |
| 3-mos Spread (U.S.-Japan) | 1.90% | 1.90% |
| Oil Price | $118 | $118 |
| United States | Euroland | Japan | |
| CPI (on-year change) | 5.6% | 4.0% | 2.0% |
| Expected Current Account/GDP Ratio | -4.6% | -0.3% | 4.2% |
The lack of a critical mass of factors to keep the dollar on a multi-year upward trend suggests a more limited correction in terms of duration and trough to peak magnitude. As of 14:55 GMT today, the dollar had advanced by 17.5% against the Canadian dollar and 13.6% against sterling from cyclical lows last November, by 15.4% against the yen and 13.8% against the Swiss franc from troughs last March, and by 9.2% against the euro and 14.0% against the Australian dollar from lows hit only a month ago. So the duration of the dollar upturn varies greatly depending on the currency in question. The previous dollar correction in 2004-5 took between 10 and 11 months against sterling (+14.4%), the yen (+19.3%), the euro (+18.3%), and the Swiss franc (+17.7%). The dollar rally relative to the Canadian dollar in 2004-5 was shorter (7 months) and smaller (8.3%). The current dol
lar upswing has not been as long as that one and seemingly has a decent chance to wind up bigger in terms both of duration and magnitude. The longer it persists, the more genuine it will seem to market observers, and even doubting investors may be anxious to participate, lest they miss a big move. At this point, I do not see enough support to declare that a probable multi-year advance is indeed in its initial year, but the situation requires continuing reassessment. European and Japanese officials will be more than happy to let the dollar reversal continue, despite some discomfort that such has promoted a leveling off of the Chinese yuan’s upswing. The U.S. election is a wild card. Neither candidate has a commanding lead, so the outcome is in doubt, and policy platforms have not been spelled out sufficiently to flesh out whether the dollar would do better with Obama or McCain. But both are novices in dollar diplomacy, so more likely than not, each will pose challenges for the dollar though for different reasons. A new presidency may test the dollar recovery if indeed it is still going at the start of 2009.
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