Weekly Foreign Exchange Insights: March 27th

March 27, 2009

The dollar performed impressively both in the first quarter of 2009 and during this past week.  Barring an enormous setback before Tuesday, the dollar will have recorded a quarter-end to quarter-end rise against the euro for the fourth straight time, the first time it will have done that since the four quarters of calendar 2005.  It also will have posted a net advance against the yen for the third time in the past four quarters.  At 15:40 GMT, the greenback showed year-to-date advances of 5.0% against the euro and 8.1% relative to the yen.  Splicing dollar/mark into euro/dollar for pre-1999 history, there has not been a quarter when the dollar rose by at least those respective amounts since the first quarter of 1982, which ironically also fell in the middle of a severe recession.  The dollar has thrived from a risk averse psychology, which bolsters demand for Treasury securities.

The past week’s gains of 2.1% against both the euro and yen, 1.5% relative to the Swiss franc and 0.9% versus sterling did not occur in a week with the other trappings of high risk aversion.  Equities rallied sharply in all regions.  Sovereign bond yields climbed too, and so did commodity prices and commodity-sensitive currencies like the New Zealand and Australian dollars.  The Canadian dollar strengthened in tandem with its U.S. counterpart against traditional hard currencies like the euro, yen, and Swiss franc.  U.S. dollar strength against those bastions of stability withstood loose talk by Treasury Secretary Geithner about China’s call for a global currency and escalating worries that massive deficit spending funded by Fed currency printing might boost inflation and debase the dollar in the medium term.

Except mainly for the heavily hit U.S. labor market, the U.S. economy seems to be weathering the recession better than Europe, Japan, or most export-dependent emerging economies.  Investors and analysts, who openly disapproved of less aggressive monetary and fiscal support from European and many Asian authorities than what U.S. officials implemented, undoubtedly feel vindicated.  All economies, including America’s, were hammered hard last quarter and will contract substantially further in the quarter now ending.  But concurrent and forward-looking data suggest that the severity of the recession seems to be lessening sooner in the United States than elsewhere, just as forecasters thought would happen.  The dollar’s buoyancy is consistent with a marketplace that is again trading expected near-term cyclical trends.  Many may even perceive the dollar to be in a win-win situation.  If the optimism that has been reflected in higher stock prices unravels, the dollar would be positioned to benefit from another spike in risk aversion.  Alternatively, any winding down of recessionary forces will lend the dollar cyclical support, as U.S. interest rates lead rates elsewhere in returning to normal settings.

Bear with the following digression because I believe it is central to the present cross-roads in world economic development.  The market’s focus on a short time horizon produced a set of incentives and behaviors that helped put the world economy into the present plight.  Current confidence in the dollar likewise rests on weighing up the range of possibilities of what might happen in the coming six months.  Trading strategies that guard against much more U.S. debt in the future, higher inflation to reduce the real burden of those liabilities, or a redesigned international monetary system that replaces the dollar standard will not be profitable.  The primacy of short-term considerations over long-term ones is hard-wired into the collective marketplace, and officials are powerless to change that fact.  Market mechanisms react to long-term misalignments only when they become so exaggerated and so unsustainable that they spawn near-term changes that land on the investor’s radar.  By then, it’s too late to avert wrenching adjustments.  This is the great drawback of an economic system that rests on the discipline of competition and individual pursuit of self-interest.  The great disadvantage of a command economic system that involves government in property ownership, regulation, and decision-making in production and distribution is that consumer preference ends up playing a less central role that it should.

Great experiments in the 20th century that promoted top-down economic management collapsed under the weight of increasingly complex decisions that they failed to perform efficiently.  Subsequent rapid advances in world population, technology and globalization also outstripped the processing capacity of capitalism, and a series of ruptures occurred culminating the present world recession.  In this context, the G-20 summit next Wednesday will be an early effort to find a third way, not just a compromise that takes elements from each extreme but a whole new organization of activity that embodies truly fresh concepts.  Exchange rates will not survive this process in their current form.  Exchange rates are the most important prices in the international economy.  The dollar has anchored the world monetary system since the Second World War via a web of fixed relationships at first and la combination of fixed and floating parities since 1973.  The merits of floating versus fixed exchange rate parities were hotly debated in the 1960’s and early 1970’s, and the pro-floaters won that early debate. Market-determined exchange rates are still a shared goal of G-7 officials.  In practice, however, exchange rate trends have displayed a tendency to overshoot and to promote other financial market excesses.  Chinese officials have opened an issue that would have surfaced sooner or later.  These are early times.  The G-20 summit is unlikely to produce a dramatic currency market initiative.  In fact, that goal is not on the agenda, but I expect a time will come when the world international monetary system indeed looks profoundly different from now.  Change is moreover likely to involve a weaker, not stronger dollar.

The dollar has derived unanticipated strength from a major U.S. economic setback that morphed into a synchronized global recession.  The downturn defines the market’s short-term time horizon, and it is likely to persist for all of 2009.  Actual appreciation could stall.  A four-quarter advance already stretches historical limits.  And the dollar’s support beyond the recession looks even shakier, both because its long-term trend has been mostly downward since the late 1960’s and in light of possible evolutionary changes in the international monetary system.

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


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