Weekly Foreign Exchange Insights: November 7th

November 7, 2008

The dollar’s steep uptrend through much of October broke down in the final days of last month and was not restored in early November. Strong advances were limited to gains through noon on Friday of 2.0% against sterling and 1.5% against the Swiss franc, but such were balanced by weakness against commodity-sensitive currencies. The Canadian dollar rallied by a further 2% and  at noon had recouped 9.8% since bottoming on October 28th. The U.S. currency also was showing losses for the week of around 1% against the Australian dollar and New Zealand kiwi. Net changes against the yen and euro since end-October were insignificant. Historic political developments in the United States were drowned out by portents of deep recession in the United States and Europe. A somber data tone was set early in the week by a slew of falling and sub-50 readings in purchasing managers’ October surveys and later amplified by several poignant statistical developments and a scramble by central banks to cut interest rates.

  • Germany reported September monthly declines in industrial production and orders of 3.6% and 8.0%, which as a result fell by 5.0% and 14.6% in the third quarter at a seasonally adjusted annual rate.
  • British factory output fell from a year earlier by 2.2% in September and 1.9% in the third quarter. The sum of the U.K. manufacturing and service-sector PMI scores fell to 83.8 in October from 95.1 in July, 104.8 at the end of 2007 and 113.9 when the financial crisis began in August 2007. Home prices, which are down 15.7% from peak, are likely to double that drop eventually.
  • Concern about the outlook for emerging markets continued to mount. Quite a few analysts think Chinese GDP will expand less than 8% in 2009, down from 11.9% in 2007, and some are warning that growth might even turn out slower than 7%.
  • U.S. nonfarm payroll jobs dropped at an average of 217K per month in August-October, the largest three-month decrease since the three months to April 1991. By comparison, the worst 3-month average declines in the 1980’s and 1970’s were respectively -271K in the three months to January 1982 and -447K in the three months to February 1975.
  • The main central bank shock was a 150-basis point cut by the Bank of England. Other reductions of 75 bps in both the Czech Republic and Australia, 50 bps in Euroland, Switzerland and Denmark, and 25 bps in Korea also underscored the severity and dispersion of the global recession.
  • U.S. stocks coughed up a big chunk of the prior week’s price gains even with their rally today. So much for political honeymoons.

One theory about the dollar’s reversal in 2008 attributes the main cause to the bursting oil bubble. I tend to view the negative correlation between a rising (falling) dollar and falling (rising) petroleum prices as interesting but not very useful. The only major currency pairs whose reversal coincided with the July peak of oil were EUR/USD and USD/AUD. The Canadian dollar peaked last November, the Swissy turned last March, and the yen reached its high-point two weeks ago. Even if correlation is established, the direction of causality, and even whether there is any causality, can be debated. One has to ask too how enduring this correlation is. I’m thinking of 1985-6, when the dollar and oil prices collapsed in tandem, and analysts were writing about a positive correlation between oil and the dollar. A final reservation with the concentration on oil is that knowledge about the relationship between the dollar and petroleum and about which one of them is the dependent variable still leaves the analyst with a daunting task, since forecasters have been just as wrong in predicting oil as the dollar. Few saw oil prices surpassing $100, let along $145/barrel, and when prices began falling, the $80-90 range was considered the lowest we might see.

One central uncertainty in the present economic environment is that medium-term scenarios of high inflation, low inflation, or even deflation all seem possible. Central banks have cut interest rates sharply, and some will be doing much more. But the focus of stimulus is already transitioning toward fiscal policy. As the private sector scrambles to cut debt loads, public-sector deficit spending is poised to rocket upward to mitigate the drop-off in aggregate demand. Such a textbook remedy addresses the immediate crisis but is unlikely to end it within a timely period. This is not a do-over of the early 1980’s when a mix of tight monetary policy, expansionary fiscal policy, and sharply falling inflation lent the dollar considerable support. Nor will the situation replicate the yen’s strengthening backdrop in the early 1990’s, because BOJ officials did not tolerate negative interest rates and thus ran a tighter policy than the Fed is now doing. One relevant lesson from Japan, nonetheless, is that extremely heavy deficit government spending did not create an inflation problem. Japan’s greatest threat to prices remains deflation. If in fact we are in the early stages of a U.S. recession that will be sharper than the average downturn and last much longer, inflation is likely to surprise on the downside, despite a tremendous amount of stimulus. This time, both arms of policy will be loose as in the 1970’s when the dollar was weak, but the missing ingredient from that era will be an absence of inflation.

Another complication for forecasters and investors is that right now the dollar looks pretty well valued in most of its relationships. The 1970’s followed a period of fixed dollar rates, setting the stage for very big currency adjustments, which were amplified additionally because of much wider inflation differentials than exist now.  Excessive dollar strength already was eliminated between 2002 and the end of 2007. Powerful forces will continue to be unleashed by massive debt downsizing around the globe, and that may tend to keep the U.S. dollar choppy and prone to wide weekly or even monthly high-low trading bands. By starting at a fairly well-valued point, large cumulating dollar changes are not apt to result, and that is how officials would like currency markets to behave. The Bush administration never intervened in the currency markets — not once in eight years. The same cannot be said about any of its predecessors, and it would be surprising if intervention remains locked up in the tool shed during the Obama years.

The data calendar next week features several statistics from China, Euroland third-quarter GDP, Japanese machinery orders, British labor statistics, and U.S. trade figures. There are no scheduled interest rate-setting meetings among the major central banks. The G-20 summit in Washington, news from Obama’s transition team, and equity market movements will be the main preoccupations of foreign exchange market participants next week. The yen will be judged by its placement relative to the 100 per dollar level. The ECB is likely to be second-guessed for not cutting rates by more than 50 basis points this month, and so the euro is more likely to weaken at times below $1.25 than to strengthen above $1.30. Sterling took a hit against the dollar and euro after the Bank of England’s mega-rate cut, but continuing losses may be constrained by investor feelings that its approach is more appropriate for current conditions than the ECB’s.


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