Weekly Foreign Exchange Insights — October 17th

October 17, 2008

The dollar consolidated its prior gains over the past week in continuing, albeit marginally less, volatile trading.  Against the currencies of other developed economies, almost all dollar pairs saw lower highs and higher lows than in the week before.   From 2008 highs against the U.S. currency, the Aussie dollar, New Zealand kiwi, Canadian loonie, and euro were down by around 30%, 25%, 17%, and 16% in late morning today on the U.S. east coast.  The yen continues to enjoy favor, too, because Japanese rates have less scope to fall and because of comparatively good Japanese bank balance sheets.  Nonetheless, the dollar recouped 1.3% against the yen this week after the latter stalled at the 100 level.   The dollar sank no further than 99.28/$ versus a low of 97.92 last week, and it currently is trading above the Y 101.00 level.

Firmness in the U.S. currency appears to stem from asset liquidations, not a comparison of economic fundamentals.  The recession is global, and stock markets, although not moving in tandem on a same-day basis, have recorded similar sharp declines since September 26th in the United States, Britain, Germany, and Canada.  The Nikkei (off 27%) has dropped slightly more sharply than the others.  For numerous hedge funds, the fiscal year ends in October, not September or December, so major currency pairs are likely to encounter continuing turbulent days.  Strains in money market conditions, evidenced by wide Libor premiums are diminishing at a very slow pace despite frantic efforts by G-7 officials, escalating concern that the patient may not hold out for the cure.  Unless the speed of progress in reliquifying money markets accelerates, investor anxiety may hit another air pocket next week.  The dollar has handled such panic attacks well, and conversely gold — the quintessential bet against the dollar and U.S. macro-economic policy — has performed poorly.

Gold may yet have its day, but only if the goal of price stability is severely compromised.  Gold performed well in the 1930’s, when prices for goods and services tumbled, a condition of rampant deflation, which should not be mistaken for the moderately falling prices that Japan experienced earlier this decade.  Gold also soars at times of accelerating inflation, such as in the late 1970’s and earlier this year.  In between those extremes, gold is not the optimal place to invest.   G-7 economies are now transitioning away from an inflationary threat.  The leading edge of this shift occurred in housing prices and then commodities like oil and gold, and it is now spreading to a wider range of goods and services.  Disinflation, lower but upwardly trending prices, is a reasonably good backdrop for the dollar.  It is not clear how medium-term price expectations will develop, as such could slump on fears of severe and prolonged recession or climb in response to massive government deficit spending and runaway money stock creation.  As a result, medium-term prospects for long-term interest rates run a full spectrum of possibilities in this age of high uncertainty.  In Japan, where the central bank implemented a quantitatively-driven accommodative credit policy for five years but not until prices were actually falling, officials were unable to reinstate normal growth in lending and money, and long-term interest rates remain very low even now.  One can hope that the errors of procrastination by Japanese officials will not be repeated on a broader global scale.

A number of currencies of developing countries and non-G7 advanced economies have been hammered.  The Mexican peso sank to 13.63 per dollar yesterday, some 20% weaker than its value at the start of October.  The South Korean won is about 30% weaker than a year ago.  The Icelandic krona has declined even more steeply and likely faces more depreciation now that the central bank is cutting interest rate to sub-inflation levels.  Hungary’s forint, Turkey’s lira, and Sweden’s krona were recent objects of selling pressure.  The krona climbed above the psychological 10 per euro level, and the lira slumped more than 5% against the dollar yesterday.  A common thread in some of these speculative attacks is worry about the health of local banks after excessive lending in the go-go global expansion prior to mid-2007.  The attacks on certain developing currencies belies the complacent attitude that healthy growth will persist outside of the United States, Euroland, Japan, Canada, Australia and New Zealand, and that their resilience will blunt the synchronized recession in other economies. 

In the past, sharp runs on developing country currencies have spelt trouble for growth in those economies.  Depreciation is a sign that capital is draining, and it boosts the service burden of foreign currency-denominated debt.  The Asian crisis of 1997-8 was triggered by a devaluation of the Thai baht.  Before long, many currencies were tumbling in the region, and levels of real GDP plunged later.  If emerging economies do not hold up, the recessions that are under way already in the G-7 will turn out much worse than currently imagined.

It continues to be very hard to match up the dollar’s performance with reported net U.S. capital flows.  The table below is based on net flows reported by the  U.S. Treasury and expressed on a monthly basis.  The so-called TIC data present three aggregated definitions of flows: 1) long-term movements excluding stock swaps, 2) long-term movements including such swaps and 3) most long- and short- term international financial flows but not any direct investment.  The two right-most columns averaging May and June of this year and then July and August show first levels of long-term inflows comparable to those in 2007 even though the dollar remained near historically low trade-weighted levels but later a big deterioration in capital flow support in July-August when the dollar began to recover.  Since closing at 1.4672 per euro and Y 108.86 in the end of August, the dollar has extended its recovery by a further 9% and 7% against those rivals, and the two-way liquidation of assets, which can be observed in the negative cell entries in July-August for foreign buying of U.S. securities and U.S. purchases of Foreign securities, has escalated to a much higher frenzy.

Billions of USD per month 2006 2007 May-June July-Aug
Fgn Buying of U.S. Securities 95.3 84.7 86.3 -17.2
U.S. Buying of Fgn Securities 20.9 18.7 17.8 -28.5
Long-Term Net Flows (def #1) 74.4 66.0 66.8 11.3
Net Flow, Definition #2 59.8 46.4 47.7 -2.5
Net Flow, Definition #3 88.5 52.7 19.0 -17.0


Whereas next week’s U.S. data calendar is very meager and the FOMC is not scheduled to meet until later in October, plenty of important information will  emerge elsewhere.  China, will be one spotlight.  Third-quarter growth there will drop into single digits and, I suspect, be closer to 9% than 10%.  September retail sales, industrial output, business investment, CPI and PPI data are also due from China early in the week.  Preliminary PMI estimates for the month of October from Germany, France, and Euroland as a whole will no doubt all have sub-50 scores, conveying a picture of recession, and a potential exists for big drop-offs given the shut-off of financing spigots.  French business sentiment and consumer spending, Italian business and consumer confidence, and British growth in 3Q , which ought to be down 0.2% or more, also arrive.  Japanese September customs trade figures will enlighten traders further about the erosion of export demand that is pinching manufacturers in that economy. Canadian figures covering retail sales and wholesale turnover and Japan’s all-industry index will each be weaker than for the prior month, but these releases are for August, which is before the world’s financial architecture changed.

Central banks will remain in the forefront next week, as several implement newly minted reforms in a race to reduce money market interest rates and encourage banks to start relending.  The Bank of England releases minutes from the meeting that cut rates 50 basis points on October 8th in conjunction with six other central banks.  It would not be surprising if Professor Blanchflower argued for a deeper rate cut.  He’s been far ahead of his fellow committee members on pressing for aggressive rate reductions.  Three central banks with policy meetings scheduled next week are the Swedish Riksbank, the Bank of Canada, and the Reserve Bank of New Zealand.  In New Zealand where the cash rate remains at a surreal 7.5%, a cut of 100 basis points is possible and appropriate.  The Canadian rate is at 2.5% after a 50-bp reduction on October 8th but remains a percentage point above the 1.5% Fed funds target. Another 50-bp move downward is therefore possible, and at least 25 basis points is certain.  The Riksbank also cut rates on October but included a sentence in its explanation that left open the chance of not cutting again as soon as next week:  “Although developments in Sweden to some extent differ from those in other countries…” which went on to proclaim the virtue of showing support for the joint action of the other central banks nonetheless.

Post-debate opinion polls suggest an upward bump for McCain.  If later polls confirm a tighter race, there might be an effect on the dollar as well as other markets.  Obama and McCain have different policy intentions on practically every imaginable issue.  While market realities will narrow the feasible differences concerning economic policy, their stylistic differences are so far apart that the future will inevitably be affected by who wins.  Whether investors can surmise the implications for the dollar and other key currencies at this stage is dubious, however, so I doubt that a tightening race would be a market-mover.  The one constant is that a new administration is coming to Washington. That much we know, and early mistakes in dollar management are more common than not when the cast of policymakers changes.


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