Foreign Exchange Insights: July 24th

July 24, 2009

Dollar movement has been dictated by shifting investor risk preferences since mid-September when Lehman Brothers failed, and equity markets have served as a gauge of attitudes toward risk.  The decline and subsequent rebound of equities has occurred on a global scale.  Since March 9th, the Dow Jones Industrials, German Dax, and Japanese Nikkei have climbed in tandem by 38.2%, 41.4% and 38.2%, and these advances reversed roughly 51%, 39%, and 53% of their respective plunges between September 12, 2008 and March 9, 2009.  The dollar appreciated when risk aversion overwhelmed all other incentives but has relinquished ground on risk assumption trades during the past 4-1/2 months.  Although stock markets remain 15-20% below pre-Lehman levels, the dollar is remarkably near its September 12th closing levels in many cases.  The key EUR/USD pair in fact is exactly unchanged, and the U.S. currency has risen just 0.9% against the Australian dollar and by 1.9% against the Canadian dollar and 1.8% relative to the kiwi.  Oil has doubled in price since bottoming early in 2009 but remains 34% below its level at the time of the Lehman bankruptcy.  Gold is roughly 25% stronger now than in mid-September.  The major net dollar movements since September are a 9% rise against sterling and a 12% drop against the yen.  An appreciating Swiss franc against other European currencies prompted Swiss monetary authorities to launch a successful intervention campaign to stop that trend, but the franc remains 5.7% stronger against both the euro and dollar than its September 12th levels.

The global economy is now hovering at the cusp between recession and expansion.  Many emerging nations in Asia appear to have recorded double-digit growth last quarter.  Japan also crossed the line into positive growth, while the U.S., British, Euroland, and Canadian economies remained in the red with the United States to a lesser degree than the others.  Britain today released preliminary data showing a still hefty and bigger-than-assumed 3.1% decline of real GDP at a seasonally adjusted rate, for example.  All of these economies, nonetheless seem poised for swing into the black in the current quarter.  Financial market strains have subsided, inventory cycles are turning supportive, and the impact of macroeconomic support will be felt more keenly.  Even in Europe, PMI trends document clear progress, with a score of 50 separating expansion from contraction.  1Q and 2Q PMI indications below are the period averages.  In only one cell of the matrix, French services in July, did the figure drop, but all of the levels remained shy of 50.

Composite PMI July 2Q09 1Q09
Euro area 46.8 43.2 37.6
Germany 48.9 42.7 37.6
France 47.2 46.1 39.1
Euro area 46.0 40.0 33.9
Germany 45.2 38.6 32.7
France 47.9 43.1 36.4
Euro area 45.6 44.4 42.9
Germany 48.4 44.7 42.9
France 45.5 47.3 42.1

The swings to risk aversion last September and back to risk assumption in March were motivated by extreme circumstances.  The period ahead will be one of greater muddle.  Positive growth will not return with a bang as it often does after past recessions and has done already in China for this cycle.  Officials are instructing markets not to be surprised by lagging personal spending.  The word fragile, a term that implies impermanence as well as weakness, is being used to characterize the next stage of the business cycle, and private analysts echo this diagnosis.  Business investment will not light any fires either despite promises by central banks to retain ultra-loose monetary policies.  Varied performances in net exports will be one segment that differentiates overall economic performances in the coming year, so it is not surprising to find authorities in countries like Switzerland, Canada, Australia, China, Russia, Japan, France and New Zealand paying close attention to forex developments.

The present attitude toward the dollar is distrustful in spite of substantially reduced trade and current account deficits.  Fears about medium-term inflation embody a weaker dollar prognosis as both cause and effect of that possibility.  Treasury capital flow data document a pronounced deterioration in the quality of current account funding away from long-term portfolio and direct investment and in the direction of hot money.  Chinese statistics suggest behind-the-scenes diversification.  The dollar is coming off a poor week even though equities have rallied strongly.  The DJIA posted its best nine-session rally in four months and one of the five best nine-session advances of this decade.  For anyone with a penchant for deja vu, it doesn’t help knowing that the dollar has a checkered history in years following presidential elections.

  • The U.S. currency devalued in February 1973 and was severed from its fixed parities one month later after which it tumbled another 24% by early July.
  • By end-October 1978, the dollar had lost 29% against the mark in the first 21 months of the Carter Presidency.
  • The dollar experienced a golden age in the first Reagan term, but a change of Treasury Secretaries at the beginning of the second term was associated with plunges of 30% against the mark and 24% against the yen in the final ten months of 1985.  By end-1987, the U.S. currency had lost over half its value against the mark and yen.
  • After peaking on June 15, 1989. dollar/mark fell 17%
    by the end of the year.
  • Verbal sparring over trade with Japanese officials during the first six months of the Clinton presidency caused the yen to soar nearly 25% against the dollar by July 1993.

Foreign officials are not waiting to see if their currencies climb excessively in the Obama Presidency.  I expect verbal rebukes of increasing intensity if the dollar drifts lower.  Japan probably gets a different political party to lead it after August 30th elections, so there is an opportunity for a clean slate on a whole range of issues.  German elections at the end of September should give Chancellor Merkel a second term and perhaps a friendlier junior partner with whom to govern.  British law doesn’t require elections until next spring, which creates problems for sterling because Prime Minister Gordon Brown is terribly unpopular and unable to take needed tough policy decisions.  Also, the Tories have been out of power since 1996 and represent a significant uncertainty.  In the United States, President Obama’s high popularity isn’t translating into a rubber-stamp government.  Key parts of his ambitious domestic agenda are in jeopardy, and the conflict and U.S. involvement in Afghanistan is heating up.  With politics entering a fluid period and the advance economies entering a delicate stage of the business cycle, this is no time for hands-off management of the currencies.  Market participants should stay alert to the possibility of an intrusive event risk or a shift to a different trading paradigm from the ebb and flow of risk preferences.

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


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