Weekly Foreign Exchange Insights: May 22nd

May 22, 2009

Dollar karma has deteriorated sharply since the last Insights piece two weeks ago.  The U.S. currency lost more than 4.0% this past week against many currencies, including the pound, euro, and several commodity-sensitive units.  More importantly, market chatter is warning of a potential large depreciation, and the dollar has dropped in spite of wobbly equity markets, which previously had correlated with a rising dollar and investor risk aversion.  Fear that Treasury debt might be downgraded has tarnished the dollar’s safety appeal.  Other pundits have piled onto the dump-dollar bandwagon with reminders that a weaker U.S. currency will be needed eventually to promote an inevitable swapping of roles between world savers and spenders.

Coincidentally or not, negative dollar psychology crystallized at the cusp between the first and second of three currency market seasons, covering the interval between the U.S. Memorial Day and Labor Day holidays.  Summer has a wholly different feeling than the winter/spring or autumn seasons because of the coming and goings of vacationing dealers.  Volume is less steady, depriving the market of the depth, breadth and resiliency found in the first and final periods of the year.  Do not mistake these characteristics for an indication that nothing much ever happens during summer.  Quite the opposite.  Many of the biggest currency market events occurred in summer: Nixon ending dollar/gold convertibility, Iraq invading Kuwait, the onset of the financial crisis in 2007, and the abrupt and sharp reversal of oil prices last year.  Some of the dollar’s most important directional shifts and several intra-European currency crises started in summer, and the grand-daddy of equity bear markets began on the Wednesday after Labor Day in 1929.

In the ten prior summers since the euro was launched, the dollar in summer rose five times, including a gain of 7.4% last year, and fell an equal number of times.  Most of the moves were small like a drop of 0.8% in 2006 and an uptick of 0.3% in 2005, and the average dollar change was an insignificant net gain of 0.5%.  Dollar/yen tends to be more volatile in summer than dollar/euro, averaging a drop of 1.1% over the past ten years.  Strangely, dollar/yen often moves toward 110-120 during the summer season.  The range of closes on the Friday before Memorial day was 103.35 to 124.63 during the last ten summers, whereas the range of pre-Labor Day closes was tighter at 108.86 to 118.67.  Presently trading at 94.8, the historic pattern would suggest that the dollar should climb pretty sharply this summer versus the yen, but such a move flies in the face of the darkening general sentiment that now surrounds the U.S. currency.

The table below compares dollar changes thus far in 2009 to those recorded after Labor Day of 2008 and during last summer.  The dollar performed better than expected in the final two seasons of 2008 and had retained a resilient tone until recently.  But it has dropped suddenly to multi-month lows, including its weakest 2009 quotes hit earlier today against the kiwi, Australian dollar, Canadian dollar, and even sterling.  Britain shares many of the same imbalances as the United States and has a rotten political climate to complement the bad economy, which contrasts with the strong popularity of President Obama.  Unlike the dollar, sterling has done very well lately, outpacing the euro this past week to move at one point within 1% of its 2009 high against the common European currency.  As the table shows, sterling had previously fallen sharply last summer and even more after Labor Day.  The pound’s recent appreciation needs to be understood in the context of exaggerated previous losses.

Dollar versus Year-to-Date Autumn 2008 Summer 2008
Euro -0.5% +5.0% +7.4%
Yen +4.1% -16.7% +5.3%
Pound -8.2% +24.7% +8.6%
Swissy +1.0% +20.0% +12.1%
C-dollar -7.9% +0.7% +7.4%
A-dollar -10.0% -2.7% +7.5%
Kiwi -6.1% +21.3% +11.9%


Whenever the dollar has been well-bid, strength tends to be attributed to relative high U.S. growth and attractive interest rate spreads.  The problem with the correlation of relative growth and currency movement is that many exceptions exist such as right now.  One drawback of a theory that sees interest rate differentials as the main currency market driver is that it too has many exceptions such as 1994, when U.S. rates were rising sharply but the dollar fell.  More broadly, interest rates, capital flows, and exchange rates are determined simultaneously in the marketplace, so isolating one of the three legs of the stool as a cause of the other two is not conceptually elegant.  The last two quarters saw GDP contract less sharply in the United States than in Japan, Euroland, Britain and many developing economies in Eastern Europe and Asia.  The United States retains a growth advantage, while long- and short-term interest rate differentials are likely to remain narrow.  The dollar has marched mainly to the ebb and flow of risk aversion in a metric that now seems to be breaking down.

The influence of risk aversion has faded because of several unproven investor premises:

  • Financial markets will continue to mend slowly.
  • The recession reached its greatest intensity in the prior two quarters.  The current quarter will see much lower rates of contraction, and a recovery will begin in many economies sometime during 2H09.
  • Central banks will wait considerably longer before lifting interest rates.  Risks will be taken with inviting inflation, not deflation. 
  • No major geopolitical shock is likely to occur.  The rise of oil prices, higher long-term interest rates, and the flu scare do not overtake forces pointing to a recovery.
  • If the worst of the recession is over, stock and housing prices should avoid major new setbacks.

Risk aversion is still very prevalent but has changed nature significantly.  It is no longer dominated by the dangers of depression, big financial institution bankruptcies and a complete meltdown of financial markets.  The great concerns now relate to government debt, loose monetary policy, and how the exit from stimulative economic policies will play out.  The first set of worries h
elped the dollar, but the second set are hurting it.  The connection between risk aversion and currency movement has not changed.  That only appears to be happening, because risk aversion itself has been transformed.  The dollar’s best chance this summer lies in scenarios in which the financial and economic problems of last autumn and early this year return to the fore.

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


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