Weekly Foreign Exchange Insights: December 26th

December 26, 2008

Investors typically approach the final calendar week with a forward-looking mind-set, opening positions consistent with how currencies are expected to perform in the coming year. Such a strategy would work if practiced by only a minority but often backfires when everybody does it. The week between Christmas and yearend is driven by psychology, not data, and the market tendency to get ahead of itself all too often sets up a dollar reversal in January. Usually, the dollar falls late in December and rebounds after New Years Day. Because of this propensity for what traders call a whiplash, this is a time of year when one needs to be careful. Traders have grown accustomed to expecting a surprise with the global economy is in such very rare circumstances, it would not be terribly surprising if the cusp of the calendar year behaved somewhat differently from in a typical year.

The end of 2008 finds market sentiment towards the dollar appearing newly fragile. The U.S. currency experienced a surprisingly strong upward run through much of 2008 after the first quarter, buoyed not by relatively strong U.S. economic fundamentals but rather by an outlook so ominous that risk aversion and a stampede of flight capital into Treasuries overwhelmed all other considerations. What began as a U.S.-centric housing and financial market problem has spread to all sectors and all economies. Japanese industrial production will likely have fallen around 40% at a seasonally adjusted annualized rate in 4Q08. Industrial orders in Euroland fell over 11% in the three months between July and October. On-year growth in Chinese corporate earnings swung from a rise of nearly 20% during the first two-thirds of 2008 to a drop of about 30% in the ensuing three months. A big element of market uncertainty reflects the difficulty of reconciling the sheer momentum of the global recession with unprecedented fiscal and monetary stimulus that has been elicited.

Currency market movements in December and especially last week imply lessening risk aversion, suggesting that investors are looking past an awful first half of 2009 to some semblance of improvement in the second half, even though the direction of activity then may still be flat to downward. The dollar rose 1.4% against the yen so far this week and is trading above 90, the benchmark against which investors are judging that currency pair. More tellingly, the Swiss franc has been the currency in greatest demand since mid-December, gaining some 8% against the dollar.  The Swiss franc was a carry trade financing currency, but it also has a history of performing well when the dollar is weak. When flight into the dollar was occurring earlier this year, commodity currencies like the Canadian, Australian, and New Zealand dollars fell particularly fast. These currencies have been comparatively steady this past week, by contrast, with the dollar firming 0.5% and 0.1% against the Loonie and kiwi, while slipping 0.3% against the Aussie. Finally, the euro has acquired a better tone, advancing since mid-month by 2.6% against the dollar, 2.5% versus the yen and 6.8% to a series of new record highs against sterling. ECB officials in deed and word have been more reluctant than other central bankers to cut interest rates, but an upwardly-trending euro is a development that will probably force the ECB’s hand next month.

Sterling is just the most notable of several currencies, whose depreciating trends could turn into a rout. 2009 figures to be an extension of 2008, with growth risks skewed to the downside. Any currency that exhibited bouts of weakness in 2008 is a candidate for continuing and possibly bigger difficulties in 2008. Compared to a year ago, the Icelandic krona is down 51%, the Ukraine hryvnia has plunged 37%, the South korean won has lost 29%, the Pakistan rupee is off 23%, and the Turkish lira has fallen 21%. Russia’s ruble (-14% and a heavy drop in reserves), Mexico’s peso (-19%), Poland’s Zloty (-15%) and Hungary’s forint (-7%) also bear watching. Meanwhile, the focus for sterling is parity with the euro.

In early 1985, a similar vigil surrounded the pound/dollar relationship, also known as “cable.” Cable fell to as low as $1.0375 on February 26th of that year but was saved from the ignominy of par by a 3-step 450-basis point increase to 14% in the Bank of England benchmark rate compressed between January 11th and January 28th. The pound’s failure to sink beneath $1 in retrospect proved a catalyst in ending the dollar’s five-year-long bull run. In current circumstances, Bank of England officials have cited the possibility of a disorderly drop in the pound and collateral damage to other markets as the main reason why interest rates have not been reduced more sharply this year. A big change between the present and circumstances in early 1985 is that the back of inflation has already broken this time. British consumer prices ended 1984 with 12-month 4.6% rate of increase that swelled to 7.0% by May-June 1985. With a different script in 2008/9, British interest rates are headed closer to zero, and a EUR/GBP quote above 1.0 is a better than even bet.

As for the key dollar/euro pair, the present fixation with $1.40 as representing neutrality is unlikely to be long-lived. $1.45 per euro will probably get visited before $1.35.


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