Weekly Foreign Exchange Insights: October 3rd

October 3, 2008

A recession is spreading rapidly across industrialized economies.  Trade flows account for only part of this contagion.  All regions were exposed to a rapid rise in commodity costs, especially for energy and food.  The breakdown of the U.S. sub-prime mortgage market created a liquidity shortage in most money markets that is transforming into more serious insufficiencies in solvency and inter-bank trust.  Big financial institutions are dropping off the radar screen.  The United States, Japan, Great Britain, Australia, New Zealand, and Euroland  as a whole and Germany, France, Italy, Spain and Ireland individually appear to be in recessions. Synchronization this complete happens very seldom.  Britain did not share in the U.S. recession at the start of this decade.  Germany continued to grow during the recession early in the 1990’s, powered by unification.  Japan missed the recessions of the early 1980’s.  To mitigate their slowdowns, leaders in the developed economies are counting on emerging market growth, a factor that wasn’t significant the last time there was such a simultaneous recession as now.  Around the past three U.S. recessions, the dollar performed better than expected in 2000-2001, traded weakly in the early 1990’s, and strengthened in 1981-2.  No two recessions unfold exactly alike.

In the current weak environment, which has slammed equities and commodities while encouraging the hoarding of cash, the dollar and  yen are thriving.  The Nikkei fell another 8.0% last week.  Prior to the New York open, the Dax and Ftse had weekly losses of 6.4% and 4.3%, while the DJIA was off 5% through Thursday.  Oil had plunged this week by some 13%, and gold was down 5% despite eroded confidence in paper money and macroeconomic policy.  The dollar’s biggest gains from the September 26 close had been 7.4% against the Australian dollar and 6.4% against the euro, but increases of 4% to 5% had been recorded as well against the currencies of New Zealand, Canada, Switzerland, and Great Britain.  The Australian dollar experienced its worst week of this decade, and the South Korean won lost about 5% during the week.  Conspicuously, the yen appreciated moderately against the dollar, despite a bunch of weak data released in Japan this past Monday and Tuesday.  Currency markets are not marching to the flow of economic news but rather to sudden needs to move large amounts of money into safe havens or to cover severe capital losses.  Sharp, abrupt swings in currencies back and forth are typical of liquidating markets.

Stepping back from the market noise, one nonetheless sees a significant improvement of the dollar, which has risen 11% on a trade weighted basis.  One finds that the trade-weighted yen has climbed almost as sharply as the greenback and in a shorter span, rising some 9% since August 7th.  The weakest major currency has been the euro.  G7 officials and central bankers will have many deepening problems to discuss when they gather in Washington later this month.  Policy initiative after policy initiative has failed to stop the financial market’s chain reaction, but one success has been the downturn of the euro, which was the main goal of tough currency policy language used in the fourth paragraph of the joint statement released after G7 finance ministers and central bankers last met on April 11th.  At that time the euro was trading at $1.5830 and Y 159.6, respectively 14.2% and 9.4% stronger than now.  From 2008 highs, the euro has also dropped more than 5% against sterling and the Swiss franc. Now that ECB President has fanned market hopes for a rate cut by November, additional euro depreciation seems likely before then.

Important fresh information about Germany will arrive next week.  Industrial orders and production are likely to post declines, and the trade surplus, which contracted 35% in July, will not snap back by much.  There is a risk also that revised euro area GDP figures could get bumped lower.  After a week that saw the euro drop as extensively as it has just done, however, it would not be shocking to see it pull back next week or at least consolidate those gains.  The big movers of currencies will not be data releases but rather developments in the global credit crunch — policy-wise and the reaction of other markets.

Three central banks holding monthly meetings next week will be the Reserve Bank of Australia, the Bank of Japan, and the Bank of England.  In Australia, the suspense is not over whether rates will be reduced a second time but whether the cut will be by 25 basis points or 50 basis point.  I lean toward the latter. Rates in Australia are very high at 7.0%, and it would take a long time to get such to an appropriate level in increments of 25 basis points per month.  The BOJ target rate, by contrast, is at 0.5%.  One can make a case for slicing that in half, but the cautious Policy Board will instead keep the rate steady.  The Bank of England is the toughest of the three calls.  British data have been awful, including today’s PMI services index, which was 46.0 after 49.4 and two points less than forecast.  The PMI-manufacturing was shockingly low at 41.0.  The sum of those two indices, 87.0, compares to a sum of 111.5 in September 2007.  British industrial output, monthly trade numbers and the Halifax price index will bring more bad news next week. The Bank of England should cut rates next week, and I think they will.  Central banks will have to keep injecting extra funds for the foreseeable future, and both Trichet and Bernanke have scheduled speeches next week.  FOMC minutes from last month’s meeting arrive on Tuesday.  In a light week for U.S. economic data, U.S. trade figures arrive Friday.

There was not much reaction in the dollar following House passage of the TARP bill.  At 14:10 EDT today (18:10 GMT), EUR/USD and USD/JPY were within 0.5% of closing Thursday levels, meaning the dollar will be booking its best weekly gains in a very long time.  U.S. stocks trimmed gains made before the House vote, and thus did not recoup the heavy losses last Monday after the first House vote failed.  There have been times when currency markets took their cue from equities.  The present clearly is not one of them.  If anything, causation is running from the dollar to equities.  The unexpected back-to-back readings of positive U.S. growth in 1Q08 and 2Q08 can be attributed more clearly to a very competitive dollar than to the one-time tax rebates.  A strengthening dollar juxtaposed against recessionary conditions overseas spells trouble for U.S. multinational corporations that rely heavily on export sales.


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