Weekly Foreign Exchange Insights: December 19th

December 19, 2008

‘Twas six days before Christmas and oil’s free-falling,

Shoppers are broke and the economy’s appalling.

The dollar has stumbled, China’s yuan is stalled,

The yen’s on the high road, but sterling’s been mauled.

Last week saw the most volatile currency market price action since right after the Plaza Accord of September 22, 1985, when G5 officials agreed to promote a weaker dollar. At the week’s lows, the dollar had plunged 15.6% against the Australian dollar, 11.5% against the Swiss franc, 10.2% against the kiwi, and 9.1% against the euro, which otherwise showed gains of more than 5% against sterling and the yen. A subsequent short-covering dollar rally was almost as violent as the initial depreciation and and by 15:00 GMT on Friday had trimmed U.S. currency’s maximum losses by a half or more against the euro, Swissy, kiwi, sterling, Canadian dollar, and yen. The most dramatic of these reversals came against sterling where the pound’s 5.5% rise from $1.4955 to $1.5723 got transformed to a net dip of 0.9% from the close on December 12th.

Like the dollar, equities and bonds were exceptionally volatile, but the trend that stood out above all others belonged to oil, where a drop to $33.26 early on Friday constituted a 28% plunge for the week up to that point and a 77.5% loss of value from mid-July’s high. In reverse, that’s a greater movement that the infamous fourfold oil price shock of 1973-4 and just as compressed in time. Ironically, each of these polar-opposite events will be associated with severe recessions, the former as a cause and the latter as an effect.

Three buzzwords for foreign exchange participants over the balance of December will be diversification, intervention, and quantitative easing. Rumors flew earlier this week that heavy Chinese diversification demand for euros lay behind the stampede out of the dollar. The adage, where-there’s-smoke, there’s-fire probably applies to diversification. Bulking up on euros, which comprise a substantially larger share of world foreign exchange reserves than in 1999, makes long-term sense, and this week’s currency market action suggests that Beijing officials have the sophistication to move large lots of funds into Europe’s common currency in ways that hit prices sharply but mostly temporarily. A presumed deterrent to diversification has been that China cannot engineer a meaningful shift of its portfolio without unduly jeopardizing the value of its extensive dollar holdings. This week somewhat discredits that fear.

Japanese officials do not want to resume intervention for the first time since March 2004 but seem fully prepared to do so if the yen moves too rapidly or too high or if it stops responding to the threat of intervention alone. A perception exists that intervention is a futile policy tool unless utilized under ideal conditions, namely when fundamentals support the goal of intervention and when operations are coordinated with other central banks. In Japan’s case, I disagree with that consensus. Unilateral Japanese intervention has worked pretty well in the past, and I believe it will be used as a first resort in the next month or two, rather than go back to the kind of quantitative easing that the Bank of Japan employed for the five years to March 2006.

Quantitative monetary easing, that is targeting the stock of money or money reserves rather than its price, comes in many shades. The Fed is already well down that road in the sense that its actions are ballooning its balance sheet, but the Fed, unlike the BOJ of yore or Fed policy of the early 1980’s, has not shifted to specific numerical targeting. Whether quantitative easing translates into currency depreciation depends on context. The yen did weaken earlier this decade, and the dollar strengthened in 1980-84. Exchange rates are the price of an economy’s money expressed in how much of another money it exchanges for. Like other market prices, exchange rates equalize supply and demand, and if the stock of money is raised much more rapidly than demand, its price will drop. But what if rapid growth in other national monies is also being promoted? What if market players think the policy will be short-lived and reversed just as quickly as it was imposed? What happens to inflation matters too? Dollar strength in the early 1980’s was partly a response to the very extensive decline of inflation. U.S. inflation is now very low at 1.1%, but downside risks appear greater than upside ones for the short term because of the severity of the recession now and in coming quarters. Quantitative monetary stimulus gave Japanese inflation a surprisingly small boost. These caveats have not sunk into market thinking, and if the Fed’s balance sheet and the U.S. money supply do climb faster than foreign counterparts, the presumption that the dollar must depreciate in these circumstances may become self-fulfilling.

Even if shoppers aren’t buying, the holidays will go on, which means seasonally low market depth, breadth, and resiliency in the two weeks ahead. With Christmas and New Years Day landing on a Thursday this year, a strong temptation exists for back-to-back four-day weekends. Britain, Germany, France, Italy, Spain, Norway, Switzerland, Sweden, Canada, New Zealand and Australian in fact will be formally celebrating national holidays on Friday. Several countries in Europe are also closed on Wednesday, and Japan is shut on Tuesday to celebrate the emperor’s birthday. The point is that even by late December standards, this one could see less activity than average. Bear in mind, however, that low holiday-interrupted activity does not mean sedated currency price action. The last four years when Christmas fell on Thursday were 2003, 1997, 1986, and 1980. In the Christmas weeks of 1980 and 1986, the dollar fell over 2.0% against the mark. It dropped 2.5% against the yen in 1986 and almost 1% against Japan’s currency in 1980. In 2003, the dollar also fell against euro and yen in the coming equivalent week, although the size of decline was limited to about 1% in each instance. EUR/USD was generally flat in the week of Christmas 1997, and the dollar rose about 1% versus the yen that week.

Logic suggests that any significant currency swings next week will occur early, but markets have not been in a rational mood all year. It’s best to go into the week without major preconceptions in that regard. It’s a very light week for central bank policy meetings and not especially noteworthy from the standpoint of market-moving data releases. No preview of the week would be complete without a reminder of Christmas 1989. Japan is always open on Christmas, and that year the Bank of Japan under newly installed Governor Mieno hiked the discount rate on Christmas Day by 50 basis points for the second time in less than 7 weeks. Japanese stock prices peaked four days later and are currently 78% below that historic high of 19 years ago. Japan has never been the same again. The Bank of Japan presumably is done making news for the year, but on Friday morning (Thursday evening in the United States) when much of the world is on vacation, Japan will release numerous monthly economic indicators.


One Response to “Weekly Foreign Exchange Insights: December 19th”

  1. LG, I appreciate that you explain the nuances of the concepts you discuss. And I appreciate that you go a bit deeper than most and are concerned about context. I usually read pat definitions of quantitative easing in the blogosphere with glib or snarky commentary — but you’re up there with a select few who have experience and insight and who are willing to share it with the rest of us.

    Great education for me. Thanks.