Weekly Foreign Exchange Insights: January 9th

January 9, 2009

The dollar advanced against the euro today even though the U.S. Labor Department released data showing a double-digit 10.4% augmented unemployment rate, the highest regular jobless rate (7.2%) in 191 months, and employment losses of 510K per month during the fourth quarter.  At this morning’s euro low of $1.3471, the common currency had retraced 52.3% of its climb from $1.2330 on October 28th to $1.4719 on December 18th.  In fact, the major motif in this first full calendar week of FX trading in 2009 was not dollar strength but euro weakness.  At 15:40 GMT, the euro for the week had declined 6.7% against sterling, 4.9% versus sterling, and 2.9% against the dollar.  The Swiss franc moved closely in tandem with the euro and thus also lost considerable ground against the pound. 

The dollar is holding its own against the euro in spite of mounting market chatter that aggressive U.S. deficit spending and rapid money creation by the Fed will feed inflation in the long term.  Similar concerns were voiced in the early 1990’s in Japan.  Instead of inflation, Japan experienced disinflation, and the yen rose to a record high of 79.85 per dollar in April 1995.  Foreign exchange markets respond to short-term developments, not long-term possibilities.  U.S. macroeconomic stimulus is unlikely to weigh on the dollar until and unless accelerating inflation results.  For the foreseeable future, the immense momentum of the recession will trump any supply considerations.  Because other economies are also experiencing very negative growth, the U.S. recession is not clobbering the dollar.  Indeed, awful data trends in Europe and Japan, and many developing economies continue to elicit more surprise than the intensifying U.S. downturn.  Risk aversion will remain a powerful force and should lend the U.S. currency continuing sporadic support.  So too may perceptions that the new Obama Administration is being more responsive than other governments to the economic calamity.

The dollar has performed better when oil prices are low and falling than high or rising.  Geopolitical turmoil in the Middle-East (what else is new?) gave oil a good upward thrust, but the effect proved short-lived. Global recession has depressed oil back to its $40 pivot, and a drop toward $30 by end-March still seems more probable than a move above $50.  Commodity currencies were mixed this week.  The South African rand recorded the biggest decline since late October, and the Australian dollar eased about one percent.  In contrast, both the Canadian and New Zealand currencies closed higher against the greenback.

The future evolution of this global recession is unknown.  Considerable stimulus was introduced last quarter, and much more is on its way.  However, few people alive have any first-hand memory of a downswing as virulent as now exists.  One can only guess if, when, and for how long growth will respond positively to government support.  The pundits’ forecasts will rightfully be taken with a grain of salt.  For currency markets, a disconnection from cyclical trends is likely to persist well into 2009.  Comfort will instead be found in trading around key levels.  The most important of these is dollar/yen at 90, not only because that is a round figure but because sub-90 levels would greatly accelerate the falling trend of Japanese corporate earnings, exports and investment.  Tokyo officials are thought to be very sensitive to 90 and will continue to drop hints about the possibility of intervention to plant that seed in investors’ imagination.  The Ministry of Finance last sold yen in the marketplace in March 2004, and analysts differ over whether intervention has any residual effectiveness now, if ever.  Used in the right circumstances, I believe intervention is a useful tool.  Without it, the dollar probably would have dropped below Y 70 in 1995 and surely would have spend considerable time south of Y 100 earlier this decade.

EUR/USD 1.40 had acquired similar charting importance as Y 90 per dollar.  Neutrality has now shifted to $1.35, and that could quickly drop $1.30.  Beyond that level lies the October dollar high of $1.2330, but that’s getting far ahead.  The biggest event in the coming week will be the ECB rate announcement at 12:45 GMT on Thursday, and the euro is in a lose-lose situation going into it.  Recent Euroland data have, if anything, been more shocking than U.S. statistics in just about all respects except the labor market.  In retrospect, ECB officials have up to this point not  acted as forcefully as investors believe they should have done.  That perception includes the record 75-basis point cut last month.  Germany’s commitment to fiscal support has also been panned.  Whatever the ECB decides will be deemed too late, if not also too little.  Some of the dollar’s resilience against the euro reflects an intuitive belief that the United States will emerge from recession sooner than Euroland and more sharply.  Information to draw such an inference is too incomplete.  What the global recession has demonstrated so far is that  everybody sinks or floats together.  The policy actions of individual governments seem less influential in differentiating business cycles than the forces of globalization that promote convergence.

Sterling’s impressive rally from $1.4353 on January 2nd and EUR 0.9803 on December 30th shows how counter-intuitive currency trading can sometimes be and underscores the importance of psychological barriers in determining paths of least resistance.  As end-2008 approached, speculators in thin markets became obsessed with challenging sterling-euro parity. The pound came very close, but the barrier held, and sterling ricocheted so sharply that it even advanced beyond 2.164 per synthetic D-mark, which had been the all-time sterling low against the German currency reached in November 1995.  Bank of England officials have shown sensitivity to the sterling’s depreciation, whereas currency considerations are unlikely to exert any constraint on future Fed or ECB rate decisions. The pound is likely to be assessed in the future with respect to where it lies relative to $1.50 and 0.90 per euro.

Finally, a word of caution. the dollar tends to trade out of the yearend gate on a bid note against the euro and did so too against the mark more times than not prior to 1999.  This seasonal bias is the mirror image of some seasonal weakness in the second half of December.  The dollar’s resilience against the euro may not be entirely genuine.  The year is still young.  That being said, a trend sustained through the end of January is still no guarantee of how price action will play into the middle of the year. One of the major long-term dollar reversals from strength to weakness took place on February 26, 1985 after very sharp advances booked in the first eight weeks of that year.


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