Weekly Foreign Exchange Insights: December 5th

December 5, 2008

One needs to look no further than today’s data releases to see that forecasts remain behind the curve of a rapidly deteriorating global economy. Just about every observation of demand, production, and sentiment has been worse than expected and substantially so in most cases. Investors are gloomy, and they are being continually surprised with reports that reset the bar of worst-case possibilities. That’s a recipe for getting out out of the marketplace, and trading volumes have been light. But the backdrop also seems conducive to volatility. Play the markets right, and there’s opportunity for profit, so one would think.

The greatest swings have been in commodities. After peaking at $147.27 per barrel on July 11th, oil prices fell 15.7% over the rest of that month, 6.9% in August, 12.8% in September, 32.7% in October, 19.5% last month and 24% so far in the first week of December to $41.34 at this moment. A shift to mostly better-than-forecast data or even just plain better economic figures does not appear on the horizon, so the impulse to drive oil prices lower keeps firing away. Monetary policy, that is rapidly falling central bank rates, has provided atypically ineffectual support, the main proof that many economies are collectively in an old-fashioned liquidity trap. Fiscal policy initiatives have been coordinated sloppily and opaque in terms of the amount of real new monies to be spent.  Fiscal action will not be much helpful before next spring, if then. Some of the billions of authorized support for banks seems to have been used wastefully. The clearest lift in sight comes from the commodity-induced rapid decline of inflation, but that is not going to stabilize the oil market soon. At $41/barrel, the move looks way overdone, but that’s what markets do. Based not on rigorous statistical testing but rather on how the wind is blowing, I attach 75% probability to seeing oil fall to $30, 30% probability to an eventual drop to $20, and a 15% chance that it dips under $10 as happened in late 1998 during the Asian crisis.

Commodity-sensitive currencies and developing economy currencies continue to be at great risk. At 16:00 GMT today, the dollar showed weekly advances of 4.8% against the kiwi, 4.7% against the Canadian dollar, and 3.2% against the Australian dollar. The Ukraine hryvnia, Icelandic krona, Russian rouble, Turkish lira, Indonesian rupiah, and South Korean won are some of the currencies that have required support because of exposure to a combination of global financial turmoil and downwardly spiraling trade flows. Geopolitical risks in South Asia pose an additional potential problem for currencies in the region.

Among major currencies used by the advanced economies, two developments are striking. The first is the relative resilience of the euro. Through early afternoon in New York today, the dollar had recorded a scant weekly advance of 0.3% against the euro, less than its 0.8% rise against the Swiss franc and substantially less than a 5.3% spike against the pound. EUR/USD is the world’s most influential bilateral currency pair, pitting the top two forex reserve assets. In currency market chatting circles, the mantra all week was that currency markets were taking their cue from stocks, which dived by some 7% in the United States, Japan and Australia, about 6% in Germany, and over 5% in Britain. Plunging stocks and pricey bonds are signs of risk aversion — flight to quality if you will — and that is what lies behind the dollar’s bid tone in 2008. Only the euro has stopped falling just shy of $1.25, and as a consequence the common currency was rising against a number of its cross rates. Indeed, the synthetic D-mark yesterday came within 4% of its all-time high against sterling, which was set in November 1995 when the pound’s euro cross hit a record low yesterday of 0.8725. The trade-weighted euro today clocked in at 107.92, 2.1% stronger than its value a month ago on November 5th despite two rate cuts by the ECB in that span totaling 125 basis points and no rate change by the Fed since October. The euro’s levitation is not a matter of a relatively shallower recession than the United States is experiencing. The two recessions appear comparable; in fact, I expect Euroland GDP in the fourth quarter to contract as much, if not more, than U.S. GDP. After plunging 14.9% saar in 3Q08, German industrial orders in October were another 10.4% (not annualized) below the third-quarter level.

The other observation, the yen’s relentless rise, is more intuitive. As the financing currency for carry trades, the yen thrives on risk aversion. It touched dollar highs of 91.6 this past week compared to 94.6 in the week to November 28, 93.6 in the week to November 21, 94,5 in the week to November 14, 96.8 in the week to November 7 and 91.9 in the week to October 31st. The record yen high of 79.85 per dollar was touched for only an instant in the Far East on April 19, 1995, and it traded more strongly than 90/$ in that episode for just 4-1/2 months. That was enough to produce a pretty nasty recession, but it is already apparent that Japan is succumbing now to an even more severe downturn, the depth of which is being magnified by the yen’s appreciation and the unwillingness of Beijing officials since mid-2008 to allow the yuan to rise any further. The yuan just posted its biggest weekly drop since the authorities began a controlled rise of the currency in July 2005.

Western authorities have praised the virtues of market-determined exchange rates over and over again in recent years. In basic way, however, free-floating foreign exchange trading has led the yen repeatedly into counter-productive situations. Carry trading kept Japan’s currency excessively depressed earlier this decade and at times in the 1990’s, which contributed to widening current account surpluses. And now when Japan needs a weaker currency to fend off a return of deflation and to mitigate what could be its worst postwar recession, the yen is the world’s strongest currency. In fact, all three of the G-3 currencies — the dollar, the euro, and the yen — are moving in the wrong direction from the standpoint of acting as automatic stabilizers. Each of them has appreciated in trade-weighted terms, and real GDP in each of their economies is slated to tumble in the half-year to March 31st, if not beyond.

If ever there was a time when currency intervention might be a policy tool to consider, it would seem to be now. From the standpoint of market conditions are orderly or not, which since 1973 has been the most consistent test for justifying intervention, the call for intervention has not been met. Other asset markets are not being destabilized or even inconvenienced by forex developments. The damage that’s being done threatens future economic activity, not present market functionality.


One Response to “Weekly Foreign Exchange Insights: December 5th”

  1. Simon says:


    Many say that the USD will sink in 2009 because of the trillions of debt and expected issuance. That Gold is the place to combat hyper-inflation. If America is going into a depression how will hyper-inflation take root?

    Is it not safe to think that in a Global depression the economy that is most flexible and fast moving is the more likely to recover or stop collapsing. Is not America and USD more likely to go into a long U shaped depression, whilst scelrotic Europe goes into an L shaped depression?Could this not lead to parity for USD/Euro?

    The UK I see going into an L but slowly recovering before the Eurozone.

    China could be a long U.

    I can’t see any V’s in the industrial world.

    My fear is that the UK goes to B before L due to a run on the pound. If the economic data from the UK becomes really dire what probability do you put on a run on the pound, say a 30% to 50% fall in the value of Sterling?

    Martin Wolf at the Financial Times reckons there is a 1 in 5 chance of a 50% fall in Sterling against USD and Euro.

    I am interested to read your perspective.

    Thank you