Weekly Foreign Exchange Insights: September 25th

September 25, 2009

Currency movements continue to follow the cue of investor risk preferences, and stock prices provide a handy guide for shifting appetites between risk and safety.  It is the nature of economic data to become especially mixed when economies transition from recession to recovery.  As quarter-end approaches, numerous data reports have been weaker than forecast, a reminder of the fragile nature of the global economy and its reliance upon fiscal and monetary stimulus.  U.S. home sales and durable goods orders were weaker than forecast.  So was the growth of Euroland money and credit, and preliminary PMI readings in the common currency area exhibited a markedly slower rate of improvement.  Reported on-year declines in exports and imports of 36.0% and 41.3% remained huge in August, and an expected 0.7% advance in Canadian retail sales printed instead as a 0.6% decline.  Recovery may be at hand, but self-sustaining expansion remains illusive.

Investors had hoped to see the DOW close above 10,000 this week and the dollar slide further but experienced a reversal in both cases.  In the upside-down world of the dollar lately, weak economic news even from the United States hurts stocks but supports the U.S. currency and yen.  The greenback’s net changes against the euro, Swiss franc and kiwi were minuscule this week, but it has so far recouped 1.7% against sterling and 1.9% against the yen.  In its reincarnation as a carry trade funding currency — that is money that can be borrowed cheaply to be invested in higher-yielding currencies — the dollar got a lift from investor misgivings about economic prospects.  The yen, which has traded as a carry trade currency all this decade, performed even better, advancing 1.9% against the dollar and strengthening past 90 per dollar for the first time since February.  Speculative demand for the yen is being whipped up by verbal intervention from the new Japanese Finance Minister.  By frequently repeating his aversion to intervention, that is the government’s selling of yen in the market, Mr Fujii ironically transformed his own actions as a fresh and important force affecting the yen.

Finance Minister Fujii is not the only official with a currency agenda.  The Canadians have been outspokenly concerned that C-dollar appreciation might impede recovery, and their protesting comments seem to be tipping the market balance.  The  U.S. dollar climbed around 2% against its northern neighbor this past week.  Officials in other commodity-sensitive economies have voiced similar sentiments.  Beijing has not allowed the yuan’s appreciation to resume since stopping the managed gradual rise in July 2008, even though the yuan freeze stands directly in opposition to the global need for faster growth in Chinese consumption and less reliance on exports and investment to power the world’s third largest economy.  Switzerland has consistently kept the franc above 1.50 per euro since announcing last March that intervention would be undertaken when needed to stabilize the franc’s euro cross rate.  British and U.S. officials remain conspicuously quiet as their currencies fade.  From the very beginning of floating dollar rates in the early 1970’s, intervention has carried a disrespectful reputation of being costly and pointless in the face of irrepressible market forces.  In instances when market pressures are fundamentally appropriate, intervention has indeed been generally futile.  But all too often, a currency trend that is justified initially by economic realities becomes excessive and increasingly speculative, and intervention can indeed play a game-changing role in those instances.

Dollar movements this past week did not eradicate the picture of broad-based losses since the Labor Day weekend that launched the third and last trading season of the final year of the current decade.  The dollar has lost over 2% against the yen, euro, Swissy and kiwi during the past three weeks. Only sterling has been much weaker than the dollar, and the C-dollar has fallen only modestly.  Since the end of 1999, dollar losses surpass 30% against the euro and Swissy.  Depreciation against the Australian and Canadian dollars approximates 25% apiece, and even the yen has risen 13% in spite of sub-0.5% short-term interest rates for the whole period and a policy bias to keep the currency soft.  Sterling has also lagged the pack since Y2K, gaining just 1% on balance versus the dollar.

Even though the dollar tends to weaken in autumn more often than not, a reasonable case can be made for it to surprise on the upside in what remains of 2009.  The past week’s action demonstrates that an inverse relationship between the dollar and economic news remains pretty much intact.  The baseline forecast for U.S. and overseas economic growth calls for an uneven and weaker-than-normal recovery.  However, there are significant downside risks, one of which concerns a stock market that again looks frighteningly over-priced.  The DOW’s drop this past week was orderly.  In fact only two declines of as much as 100 points have occurred since July 8th.  If even a moderate correction of stock prices downward are associated with a better dollar tone, one can imagine the U.S. currency getting a pretty powerful boost if a substantial downturn in share prices were to occur.  If the DOW were to retreat 20% from this past Tuesday’s closing high, a move that would meet the textbook definition for a bear market, it would still be 20.1% above its close of last March 9.  A comparable 20% drop in the S&P 500 would leave that index 26.7% above its close from last March 9.  Equities were driven as high as they got by the extremely loose monetary policies, not the recession’s end.  When those policies get reversed, stock markets may become very vulnerable, and while the date of the first hikes in interest rates remain unknown, each passing day brings the day of reckoning closer.

Alternatively, the economic recovery could surpass expectations although  many analysts including myself attach lower odds to that scenario than to its converse.  Even if the economic news surprises on the upside, the associated additional rise in stock prices will not be nearly as substantial as the scope for stocks to fall in the face of disappointing news.  Put differently, the lower dollar and higher equities already price in an economic recovery that’s as good as it might get.  A path of lesser resistance would kick in if investors were to realize that the scenario they had discounted was indeed too good to be true.

I remain bearish long-term on the dollar, since further depreciation will be needed to promote sustained sufficient readjustments in global current accounts.  But events of the past week, namely the sensitivity of the dollar to stock prices and indications of Euroland’s difficulties coping with an expensive euro, have made me more hopeful about how the dollar with perform over the rest of 2009.

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


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