Weekly Foreign Exchange Insights: September 12, 2008

September 12, 2008

The dollar correction moved into a new phase this past week.  In prior weeks, the rally had closed with upward momentum, but action on September 12th saw the U.S. currency fade off its highs.  The dollar ended the week of September 5th within 0.3% of its period highs against the euro and Swiss franc and just 0.6% below the peak against sterling.  At noon today, it was below the week’s highs by 3.1% versus the Australian dollar, 2.7% against the kiwi, 2.4% relative to sterling, 2.0% against the euro, and 1.9% against the Canadian dollar.  The backward step in the dollar as the weekend approached might be nothing more than some profit-taking especially with Japan closed for three days, or this might be a sign that the dollar rally is running out of steam. I cannot find a fundamental economic basis for a multiyear appreciation of the U.S. currency, since the economy still has significant imbalances and reduced options for achieving trend growth without first correcting those imperfections.  If this past week proved anything, it is that the buyout of Fannie Mae and Freddie Mac did not enable the financial sector to turn the corner.  However big the revelations, there always seem to be more troubled institutions waiting in the wings.  While risk aversion associated with the credit crisis gives rise to waves of repatriated capital that lifts the dollar from time to time, the final destination of a much more heavily indebted U.S. government and a central bank that will find it harder to pursue price stability is not a backdrop that supports currency strength.

It remains unproven if the dollar truly began a prolonged reversal this summer.  It’s not even clear whether currency markets have been dollar-centric.  One fact suggesting dollar centricity is the similarity of gains from its 2008 lows: 17.7% against the Swiss franc, 14.0% against sterling, 13.2% relative to the euro, and 12.4% against the yen.  Among the commodity-intensive dollar relationships, the U.S. currency scored larger moves against the kiwi (24.0%) and Australian dollar (20.6%) but a shallower 9.2% rebound versus the Canadian dollar.  So the dollar has strengthened in a broad and somewhat similar way.  The gains exceed 10% for the most part and 20% in a few instances.  That clearly constitutes a correction and an overdue one at that, but the size of the advance does not qualify yet as a change in long-term trend.  Moreover, recent trade-weighted currency movements raise doubts that a change in dollar sentiment is the main theme.  From their post-midyear extremes, the trade-weighted dollar has appreciated 10%.  That is about twice the size of trade-weighted declines in the euro (-6%) and pound (-5%).  Most peculiar of all, the trade-weighted yen (+7.5%) has climbed almost as much as the dollar. 

Contrary to one school of thought, the dollar does not seem to be simply following moves in the price of oil.  Between March 24 and September 12th, oil prices firmed 0.4%, while the dollar advanced 10.1% against the euro on balance, and from March 24th to July 15th, the dollar slid only 2.8% while oil prices soared 45.5%.  The typical expectation on oil asserts that the downward move may run further, but not by much compared to the near-$50 decline seen thus far.  The fact is hardly anybody holds a short-term view on oil with strong conviction after the volatility we’ve been through, but I doubt that better foresight on this point would be very helpful in predicting the dollar’s behavior over the coming six months.

In the coming week, not a huge amount of data arrives to gauge the relative strength of the U.S., Japanese and European economies.  The list includes Germany’s ZEW index, Japanese consumer confidence, British unemployment, Italian orders, Japan’s service-sector index, and some U.S. housing sector measures.  There is likely to be greater market focus on inflation, with labor costs and consumer prices due from Britain and Euroland, producer  and import prices from Germany, and consumer prices from the United States.  Also, the Fed and Swiss National Bank hold interest rate policy meetings, and minutes from the Bank of England’s meeting last week will produce a third written document for market analysts to compare.  None of these central banks has or will change rates in September, but their discussion about competing priorities of promoting growth and restoring price stability may provide valuable clues about the timing of future interest rate changes.  The Fed reacted differently from most central banks when the credit crisis broke, leading to an erosion of the dollar’s interest rate support.  Until and unless weaker growth in Europe and Japan pushes interest rate spreads back toward pre-August 2007 widths, the cyclical case for a much stronger dollar is not going to hold up over a long time.

So what is going to move the dollar?  I would expect concerns about asset safety will continue to be paramount in currency, as well as stock, bond and commodity trading.  When funds seek security above all else, the dollar tends to look attractive and to be a residual beneficiary of liquidating market activity.  If in the end, U.S. problems have to be monetized away because there is no alternative policy solution, the dollar will lose its safe-haven image.  It remains very difficult to pinpoint the timing even to within three to five years when such a watershed might be crossed.


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