Weekly Foreign Exchange Insights: August 7th
August 7, 2009
In the counter-intuitive universe of foreign exchange trading, one learns not to believe everything you hear or even everything you think. A lot of trading is done on faith, not reason, and profitable patterns get discarded only after their predictive value goes terribly awry. Collective behavior trumps independent thinking. The increased connection among currency market participants linked on a variety of cyberspace professional networks may be strengthening this herd tendency.
2009 trading has been explained by the simple relationship that good news for the global and U.S. economies spells bad news for the dollar, and vice versa. The Great Recession put a premium on asset safety and thus promoted Treasuries and the dollar. The downturn has ended, and investors are re-embracing risk, which strengthens equities but depresses the dollar. Now that conventional wisdom has accepted the premise that the recession is behind us, the long-held view that recovery will be gradual and fragile is being questioned by a rising number of market participants proclaiming the beginning of an old-fashioned V-shaped transition from recession to recovery.
While observing the increasingly upbeat mood of market analysts and traders, one inner voice advises caution, warning that when something looks too good to be true, that probably is a correct inference. Not quite six months ago, I heard a whole parade of experts from academia, business, journalism and government at a Columbia-sponsored conference of the Center on Capitalism and Society speak alarmingly about the global economic situation. They disagreed over causes and solutions to the crisis but agreed that the problem seen in 1Q09 would not fade without sweeping reforms and structural economic changes. The establishment of new paradigms would inevitably take considerable time to solidify. One point of pretty wide consent was that banking would have to change in radical ways, leaving the impression that nationalization would be unavoidable in many cases. I left discouraged and would have been even more so if I’d had the foresight to know how much resistance would surface to Obama’s policy agenda. Banking regulation and health care are stalled, and chances for additional fiscal stimulus if one is needed look dim. Global economic imbalances such as excess Chinese saving and too little U.S. saving are not converging in a sustaining way. Politicians in Japan are acting very irresponsibly, and their European counterparts are not much better.
Stock markets bottomed two weeks after that conference in late February. The Dow Jones Industrial Average soared16.2% over the balance of March, another 11% during the second quarter, and 11.6% additionally since midyear — 44% (141% if sustained for twelve months) in all! I had been very bearish about equities, predicting an eventual decline of the DOW to less than 6000 and possibly 5000. U.S. stocks seemed immersed in a multiyear bear market and not for the first time either. After 18 years, the DOW in May 1947 was still 57% below its 1929 peak, and after 20+ years, it showed a net gain in mid-1982 of just 5.7% from its December 1961 high. In a recent example, Japan’s Nikkei remains 73.2% below its end-1989 close nearly 20 years ago. And indeed, the Dow is still 19.6% weaker than its high in January 2000, over 9-1/2 years ago.
Economic revival reflects enormous Keynesian stimulus from the the fiscal and monetary sides, the surprisingly sharp revival of many emerging markets, and a favorable inventory upswing. Some gimmicks like the cash-for-clunkers program are unexpectedly effective. Just about everywhere, business and consumer confidence is improving, and that hopefully foreshadows strengthening private domestic demand because inventories and public spending are not bottomless reservoirs of support. It’s very difficult to separate cause from effect in the role of equity market reversal in this process, but avoiding a major relapse of equities seemingly is a crucial condition if a V-shaped recovery is to unfold. Market optimists claim the rally still has plenty of steam because economic recovery will be more robust than assumed, yet it’s not hard to argue that a buoyant economy will be possible only with a healthy restoration of wealth.
Where this leaves the dollar outlook depends on what currency relationship one considers. Assume the perpetual motion of reinforcing market and economic trends persists. In July that translated into strong across-the-board dollar depreciation even against the yen, which also has tended to trade inversely with economic news. But net dollar movements were contained in most cases during the first week of August , and the dollar actually rose over 3.0% against the yen. EUR/USD is already stronger than its $1.371 value at the start of the financial crisis exactly two years ago, and the current quote matches the average value of $1.424 over the span. Further dollar depreciation against the euro would serve no global economic need. A rise in the euro would also disregard the wider premium of Treasuries over bunds, which for ten-year notes is 34 basis basis points compared to spreads of zero two months ago and minus 40 basis points on April 4th. Dollar/yen, on the other hand, has not returned to its pre-crisis Y118.5 level of August 9, 2007. The first week of August may be a sign of what lies ahead. The dollar’s stability against most currencies in contrast to big gains in stocks suggests that the inverse equity/dollar pattern is a fading influence. However, the big setback in the yen suggests that flows are still leaving the yen, and that the haven play is becoming increasingly centered upon the euro – yen cross relationship. EUR/JPY has risen from from a euro low of 112.06 to 138.24 but that remains almost 20% below its 2008 peak and compares to an average level in 2007-8 of 157 yen per euro. Japan’s election at the end of this month could provide an excuse to sell yen.
The Swiss franc, sterling, and Canadian dollar each have special interest stories to follow.
- In March Swiss monetary authorities drew a line in the sand at 1.50 francs per euro. Intervention was threatened and indeed undertaken to keep the franc weaker than that level, that is in the 1.50s rather than the 1.40s. The strategy has not been fully successful, and after almost five months, the franc backed off a little further from the policy-enforced barrier. Currencies often follow laws of physics, seeking the path of least resistance. Dam up one direction, and trading eventually probes the opposite vector.
- Somewhat more optimism was voiced at this past week’s ECB press conference. Other central banks like the Reserve Bank of Australia have even more emphatically indicated that its next interest rate change will be a rise. The FOMC statement on August 12th should be more upbeat than the last one. One central bank that stood out from the pack this past week was the Bank of England, which expanded its program of asset purchases by 40% to Gbp 175 billion. The pound weakened after the unexpected announcement but showed not much net change for the week as a whole because it had been appreciating earlier. The week ahead is one in which Britain releases several important indicators and the Bank of England unveils new forecasts and a quarterly Inflation Report. I do not expect the pound to fall inordinately further this week, but the proof will be in the pudding whether the Bank of England’s separate path has a more enduring impact on the currency.
- The Canadian dollar has been extremely volatile this summer, declining 6.3% against its counterpart in June but then rising 7.9% last month. There was
little movement in the first week of August, but market chatter has been favorable toward the affectionately known loonie. Commodity-sensitive currencies are well-positioned for global recovery. The CAD should benefit as well from reviving U.S. auto and housing markets, and the Canadian currency remains some 16% weaker than its cyclical high against the USD in November 2007.
Important developments to watch for include the release of second-quarter GDP for Euroland on August 13 and Japan on August 17. U.S. retail sales, industrial production, and trade figures arrive next week, as does Japan’s economy watchers index and a month’s worth of Chinese statistics. It has been slightly more than a year since Chinese authorities threw on the brakes to their prior policy of carefully engineered yuan appreciation against the dollar. Compared to July 2005 when the yuan first moved higher, China’s currency is some 21% stronger versus the dollar. A global recovery and concerns in some Chinese circles that their economy may be heating up too rapidly create the possibility that the yuan will be allowed to resume its advance. But the operative word is allowed. As always, such will be a political decision and not market-determined.
Copyright Larry Greenberg 2009. All rights reserved. No secondary distribution without express permission.
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