Weekly Foreign Exchange Insights: January 2nd

January 2, 2009

Seasonal distortions are often pronounced in late December (dollar down) and early January dollar up). The dollar fell 2.0% against the euro between mid-December and the end of last month. That was the sixth decline in seven years, eighth drop in ten years, and somewhat greater than the 1.3% average depreciation in the second half of December for all ten years. During the 23 years to and including 1999, the dollar rose against the D-mark and/or euro nineteen times between endyear and mid-January, with an average change of +1.4%. However, since 2000, the dollar has not exhibited a bias in the first half of January, falling against the euro five times, rising four times, and recording an average uptick of 0.2%.

The dollar experienced a good first day of trading day in 2009. At 17:50 GMT, it had strengthened 1.7% against the euro, 1.6% against sterling, 0.8% relative to the Australian dollar, and 0.6% against the yen. If dollar gains get extended in coming days, it may reflect no more than a flash-back to the seasonal pattern of strength in much of the 1980’s and 1990’s and should not be interpreted as necessarily heralding another buoyant year like 2008. Alternatively, if the dollar falters later this month, one similarly should not read to much into that. One of the most historic dollar reversals was the peak of DEM 3.478 and JPY 263 on February 26, 1985, which marked the end of a multi-year period of appreciation including 9.5% against the mark in the first two months of that year.

Convictions about the dollar’s direction are all over the map. No solid consensus seems to exist. 2008 was the dollar’s best year in over a decade despite sharply lower U.S. interest rates. But December saw the U.S. currency slide 11.6% against the Swiss franc, 10.3% in against the euro, 8.0% relative to the Australian dollar and 4.9% versus the yen. The dollar during much of last year was lifted by a capital flight to safe Treasuries, which suppressed the responsiveness of currency values to economic news and shifting interest rate differentials. Capital swings in 2009 are likely to be inspired also by transactions made under duress to escape danger, cover losses, and ameliorate damage sustained by balance sheets. If a semblance of a U.S. and global economic recovery does not commence until 2010 or later, the dynamics of trading in 2009 will contain some of the same elements of extreme risk aversion found in 2008, but the years will be different in key respects. Here are two:

  • Other central banks will be cutting interest rates more than the Fed, which has run out of room to reduce them. But the Fed is embarking on a policy oriented around expanding its balance sheet. U.S. money growth should accelerate, possibly by leaps and bounds. A school of analysts are accordingly bracing for the possibility of a major dollar debasement to result from this unorthodox loosening of monetary policy.
  • U.S. political power changes on the 20th of this month. Democratic Party majorities in both houses of Congress will be expanded. The Obama Administration plans to hit the ground running, with a massive fiscal stimulus and numerous other huge changes, many of which do not require legislation. Foreign exchange policy is its own entity. Every administration eventually adopts a stance on dollar management, but oftentimes when a new party with new policymakers comes to Washington, it takes time for officials to stumble upon a consistent dollar policy. Rhetoric may be loose, as the new people do not anticipate the currency market’s sensitivity to what is said and done.  Volatility results. Much of this is inadvertent. Some of it may be designed, however. In a deflation-prone world and U.S. economic environment, a falling dollar mitigates price deflation and enhances export competitiveness.

In the vernacular of currency market analysis, a falling currency is said to be weak. The inference that depreciation is to be avoided is misleading. For the United States, whose foreign debt is denominated in dollars rather than foreign currency, a rising exchange rate has worse implications in the present situation than a declining one. That’s why the Rubin mantra that “a strong currency is in the best interest of the U.S. economy” is not getting said these days by either Presdient Bush’s outgoing economic advisors or President-elect Obama’s incoming team. Not all currencies would fall even if every government engaged in activities to promote depreciation. Economists call such strategies “Beggar Thy Neighbor” policies, and we’ll be hearing that expression increasingly in 2009. The United States is in a unique position in this regard, which is why it should prevail in any currency depreciation wars. The foreign debt of other nations is denominated in non-local currencies. If their currencies fall, the burden of repaying and servicing such debt increases.

Since the late 1960’s, the dollar has trended unevenly downward. Sure, there were two period of multi-year substantial dollar appreciation in the early 1980’s and the latter 1990’s. But a comparison of the dollar’s values before August 1971 with those today reveals the soul of a currency that falls more than it rises. In making any long-term currency forecast for speculative or planning purposes, the burden of proof lies with making a case for a strengthening dollar. We face great uncertainty in 2009, 2010 and beyond. The uncertainty itself does not have an inherent bias favoring dollar appreciation or depreciation. The lack of a compelling reason to anticipate significant dollar gains this year is enough to convince me that the likeliest dollar scenario is the one it has followed most often, and that is a downward path.


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