Weekly Foreign Exchange Insights: April 10th

April 10, 2009

The dollar retains a bid tone.  So far in the second quarter, the dollar has advanced moderately against the three traditional hard currencies: the yen, the Swiss franc and the euro, which is the heir to the Deutsche mark.  Currency market specialists use the term “hard” to denote currencies that have trended upward in the long run and ones, not surprisingly, that have been associated with chronically low inflation and strong current accounts.  In 1968, a dollar could be exchanged for roughly 4 marks (compared to 1.49 now), 360 yen (versus about 100 at present), and 4.37 francs (compared to about 1.16 today). 

Also this quarter, the U.S. dollar has lost ground against currencies that had previously been hammered by a spike in risk aversion.  Dollar losses this quarter against sterling, the Canadian dollar, the Australian dollar and the kiwi are compared below to net appreciation since September 12, 2008 (the Friday before the Lehman failure) and August 8, 2007 (the start of the financial crisis). Dollar losses against currencies that were especially victimized by falling commodity prices and extreme aversion make sense.  So does a slight rise against the yen, but concurrent recent advances against the Swissy and euro is quite impressive and somewhat counter-intuitive.

US$ versus C-Dollar A-Dollar Kiwi Sterling
since 3/31/09 -2.6% -3.6% -3.4% -2.1%
since 9/12/08 +15.7% +14.6% +22.4% +22.5%
since 8/8/07 +17.2% +20.2% +36.3% +38.4%


Diminishing current account imbalances are an important X-factor that helps to explain the dollar’s continuing resilience.  Convergence has been more pronounced than most analysts had imagined.  As a percent of GDP, the U.S. current account deficit topped out at 6.4% in the third quarter of 2006 and averaged 6.0% that year after 5.9% in 2005.  Such was still 5.7% of GDP in 1Q07 and at 5.3% in 2007 as a whole.  Imbalances of this size had never been sustained in the past.  The same can be said about the deficits in the first three quarters of 2008, respectively 5.0%, 5.1%, and 5.0%.  But the U.S. current account then abruptly dropped to 3.7% of GDP in 4Q08.  A sharply diminished trade deficit in January and February suggests the current account ratio will be no larger than 2.5% in the first quarter of this year, and that looks manageable.

The trend is just the opposite in Japan and Euroland.  Japan’s current account surplus narrowed from Y 24.8 trillion in 2007 to Y 16.3 trillion in 2008 and Y 5.6 trillion at an annualized rate in January-February of this year.  Euroland’s current account swung from a 31.7 billion euro surplus in 2007 to a 67.3 billion euro deficit in 2008, and the common currency bloc recorded a 12.7 billion euro deficit on a seasonally adjusted basis in the first month of 2009.  These levels are sustainable, too, but their rapid rate of deterioration strikes a disadvantageous contrast with the U.S. pace of improvement.

Net exports are also supporting U.S. growth in contrast to hugely adverse contributions of net foreign demand to Euroland, and Japanese GDP growth.  At an annualized rate, such boosted U.S. GDP by 1.1 percentage points (ppts) in 3Q08, exerted an insignificant drag of 0.2 ppts in 4Q08, and appears likely to enhance growth last quarter by more than a full percentage point.  Euroland growth was depressed by 2.6 ppts in 3Q08, an even larger 3.9 ppts in 4Q08, and will be hurt substantially again in 1Q09 and coming quarters.  In Japan, net exports subtracted 0.3 ppts from growth in 3Q08 and then a whopping 10.8 ppts in the final quarter of 2008.  Like Europe, Japanese growth will continue to get battered by deteriorating net trade.  Not only do current account changes support a firm dollar, but so does the way those trends are impacting growth.

Dollar bears continue to warn that the dollar is newly vulnerable because of exploding government deficit spending, the Fed’s quantitative easing that is financing such, and low inflation-adjusted interest rates that will decline further when U.S. inflation heats up.  The Fed is not the only central bank easing quantitatively.  The Bank of England and Bank of Japan are also at that stage, and the ECB will be joining the club soon as well.  Even if that were not the case, the U.S. macroeconomic mix would threaten the dollar only if truly inflationary, and that is a hypothetical possibility but not a proven fact.  Right now, inflation is too low, not too high, and the Japanese experience for one example sheds doubt on the certainty that quantitative easing and fiscal reflation guarantee much higher future inflation.

Market players are always uneasy with currency projections that rest on current account arguments.  A cottage industry of current account refuters in fact developed in the 1990’s and this decade that maintained that current accounts are no more than the residual of net capital flows, a much larger gross figure.  These experts felt the whole notion of an unsustainable current account position was bogus.  They are the same people who argued against the possibility of a national bear market in real estate.  On the contrary, unsustainably large current account imbalances rooted in the dangerously skewed dichotomy between net savers in some regions and net spenders in others was the single most central cause of the present financial crisis and world recession.  Current accounts and their shifts matter a great deal in the determination of market-clearing exchange rates.

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


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