Weekly Foreign Exchange Insights: February 27th

February 27, 2009

Risk averse markets continue to push equities lower and the dollar higher.  Risk aversion is no longer supporting the yen, indicating that carry trades are at long last unwound. In January, the dollar had eased 0.8% against the Japanese currency but advanced at least 8.0% against the euro, Swiss franc, Ozzie dollar and New Zealand dollar.  By contrast, the dollar had appreciated 8.8% against the yen in February through 16:30 GMT today but risen just 1.4% relative to the euro.  In addition to fading carry trade reversals, Japan’s recession has stood out as more severe than others, with its real GDP plunging 12.7% last quarter at a seasonally adjusted annual rate and corporate production plans pointing to more than a 60% annualized plunge of industrial output in the present quarter.

The yen’s erosion against the euro seems unlikely to extend for much longer.  Japan’s currency had become very undervalued last year in a general sense but especially against the euro as the latter soared to a peak of $1.6038 in the summer.  The euro still looks pricey against the yen in light of its vulnerability to Eastern European debt problems.  Japan’s fiscal year ends in a month.  Analysts often start warning of capital repatriations around this time of year.  In fact, the yen tends to be strong in April rather than March, so it may take a couple of weeks before a yen turnaround occurs.

After suffering losses in December, the U.S. dollar appreciated against most currencies in both January and February, doing best this past month against the currencies that had been comparatively resilient in January.  Besides the yen, the dollar gained some 2% against sterling this month after a 0.5% uptick in January and rose over 3% against the Canadian dollar after just a 1.0% uptick in January.  Likewise, the dollar had climbed at least 8.5% against the kiwi, Ozzie dollar, euro and Swiss franc in February but did not extend its uptrend by as much as 2% against any of the four other currencies this month.  From its cyclical lows, the dollar has risen 21% against the Swiss franc, 27% against the euro, 40% against the Canadian dollar, 54% relative to the Ozzie dollar and 64% against the kiwi.  This impressive rally should help contain the uneasiness of major holders of U.S. currency as a reserve asset.  I say contain, not eliminate, intentionally because the explosion of deficit spending to a post-WW2 high of more than 10% rightly concerns investor.  So will the rapid rise of the Fed’s balance sheet.

Continuing dollar appreciation would be a counter-productive development.  The sequence of asset market bubbles over the past generation was a result in large part of an unresolved polarization between regions with excessive spending and others that saved excessively, and this is a view shared widely.  The financial crisis has demonstrated yet again the inability of other nations to power the world economy when the U.S. engine throttles down.  By design or force of circumstances, the United States is headed toward a state that must be more reliant on net exports and less so on consumption than used to be the case.  Excessive dollar appreciation will thwart that process

The cause-and-effect response of commercial and capital flows to shifting exchange rates is far from instantaneous .  Waiting for the dollar to peak by natural causes could involve too much appreciation for the world economy’s own good.  In the emerging new policy paradigm that says asset bubbles should be pricked before they get too large, an early test-case may indeed involve the dollar.  It boils down to whether G-20 officials remain on the sidelines if the dollar keeps climbing on capital inflows inspired by risk aversion, not superior U.S. economic fundamentals.  I suspect we are instead entering a period of more pro-active currency management.  This hands-on approach could take two very different forms, and it isn’t clear which will be most embraced.  One would entail an upsurge in beggar-thy-neighbor politics in which weak currency policies becomes the cutting edge of protectionism.  A different cooperative form, which would be far preferable, is that governments coordinate currency policies more closely, not to impart a directional bias but rather to impose less volatility than the market’s invisible hand can deliver.

Copyright 2009 Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.


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