Weekly Foreign Exchange Insights: October 24th

October 24, 2008

In this mother of all liquidating markets, anything is possible. Economic fundamentals impose no constraints, and the myriad of policy initiatives have lacked sustaining potency. Foreign exchange is just one of many financial markets to exhibit historic volatility, and one theme has risen to the top: sell everything.

The EUR/JPN cross rate captures the unwinding of yen carry trades, which were a centerpiece of the hedge fund casino. EUR/JPY is now perhaps the best single indicator for monitoring the global deleveraging crisis. The euro’s all-time peak against the yen of 169.98 was touched only three months ago and represented a 91% appreciation over nearly eight years from the record low of 88.98 set on October 26, 2000.  Sixty-nine percent of that advance has been erased since July 23rd, proving the axiom that objects fall faster than they rise. For every loser, there is a winner in foreign exchange, and the yen has soared 49.3% against the euro and is now even 13% stronger than its average level of 113.8 per euro since the launch of the common European currency nearly ten years ago. Even after Friday profit-taking, the yen at 19:25 GMT today showed a 7.5% advance against the dollar for this week. It’s strongest level of today, 90.95/$, was just 14% shy of the all-time peak of 79.85/$ hit briefly in Asia on April 19, 1995. In the currency market jungle of 2008 where fundamental economic comparisons have no connection to capital flows, the only force standing between a revisit of Y80/$ would be massive intervention. Japanese reserves now total a politically awkward $995.9 billion. However, an urgency now exists to inject, not withdraw, dollar liquidity, and intervention buying of euros would draw the wrath of European officials, who for years had complained about an excessively weak yen. With no end in sight to the global flight from risk, it seems very probable that the yen will take out its record high against the dollar. Y60 or even stronger yen levels against the dollar are not unthinkable.  Such an appreciation would weigh heavily on Japan’s economy, which is now in recession, and could force a return to quantitative easing by the Bank of Japan.

The next most-favored currency has been the dollar. The cumulative dollar appreciation has now exceeded the threshold against numerous other currencies for classifying its advance as a major trend change and not a short-lived, albeit sharp, counter-trend correction. Many kudos go to those deserving analysts, who from the start predicted the upturn to be genuine and long-lived. My main reservation against the view that six years of dollar famine will now be followed by six years of dollar abundance is that the currency’s reversal reflects atypical market conditions to a larger extent than positive economic fundamentals. When America emerges from recession, a whole new paradigm for building wealth through deferred consumption will need to be relearned, and that process will prove easier if the dollar is depreciating, because growth will be heavily dependent on exports. Besides, thinking ahead to the post-recession era is getting ahead of the story. Based on the precedents of the 1930’s and Japan in the 1990’s, the onset of recovery even in the United States seems more likely to arrive later than mid-2009.

Dollar strength in the meantime should feed off various elements of the global recession, including plunging share and commodity prices. Oil fell more than 10% this week, and gold lost more than 5%. The Nikkei closed today just 0.6% above its cyclical low of 7604 in 2003. Japanese stocks have been hammered by the implications of extreme yen strength, but strong downward momentum suggests that the DOW and Ftse will plausibly fall under than multi-year lows of 7197 and 3276, respectively.

This week was just as historic for the dollar as for stocks. Upward dollar momentum was remarkable both for the breadth and magnitude of the advances. Commodity currencies were special victims. At mid-afternoon on Friday, the U.S. dollar showed weekly gains of 11.1% against the Australian dollar, 10.0% against the rand, 9.7% against the kiwi, and 7.6% against the Canadian dollar. The dollar had also risen 8.8% against the pound and 6.2% relative to the euro but only 2.7% against the Swissy, another traditional financing currency when carry trades used to be in vogue. Some emerging market currencies took a bath, as speculators took note of depleting reserves needed to defend them. The dollar appreciated 9.4% against the Hungarian forint despite a 3 percentage-point leap in Hungary’s central bank rate and by 14.2% versus the Ukrainian hyrvnia. It went up 5.2% against the already-weak Icelandic krona, 4.7% against the Swedish krona where interest rates were cut, and 4.1% relative to the Indian rupee.

Although the main engine of dollar strength continues to be revolutionary change in the international monetary system, investor expectations of staggered business cycles are another important underlying factor. Whether Fed officials had an inkling back in January about where the banking crisis would be heading, they followed a better course than the ECB and other central banks, where officials priortized upside inflation risks above downside growth risks. Back in 1H08, it seemed that one could argue that both the Fed and ECB stances were correct, since much more powerful unions in Europe and the prevalence there of wage indexation posed far greater second-order price risks than faced in the United States. It is now apparent that the banking crisis became so severe and so contagious that it would have been impossible for the spike in European inflation to have become entrenched. It was a huge mistake in hindsight to have been intent on repeating the mistake of overly accommodative monetary policy in the 1970’s. There was no banking crisis then. Indeed, financial market strains in 2008 swallowed the upward pressures on commodity prices, which had caused the spike in inflation. By easing long before Europe or Japan, the Fed has less rate cutting to do now, and the U.S. will presumably escape recession before other regions. Like so much else about 2008, this logic may prove incorrect. Being driven by financial market strains, the U.S. recession may not respond to monetary policy support. Moreover, the significantly imbalanced U.S. economy and the dollar’s sharp appreciation of late may delay the onset of economic recovery past that in Europe. Rates will drop further during the next six months in Europe than the United States or Japan, but rates in Europe also are likely to be rising in the next cycle as soon, if not sooner, than the upturn of U.S. rates. Until such surprises occur, however, the dollar ought to remain generally well-bid.

Investors are overwhelmed with what they do not know about the future. One of the big uncertainties is the outcome of the U.S. election and how that result leads to policy change and perhaps a new national psychology. In years following a U.S. election, the dollar has undergone quite a few major directional shifts.


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