Weekly Foreign Exchange Insights: October 23rd

October 23, 2009

The dollar had a better week, gaining against the yen and Canadian dollar and closing with little change relative to sterling and a manageable loss against the euro.  Wire services and the written press carried fewer dire warnings that the dollar may be heading for a rout, and foreign official complaints about the weak dollar seemed to simmer down.

The backdrop remains unfavorable for the dollar.  A tightening of Fed policy well in advance of rate hikes in Europe seems doubtful.  The global economic recovery has been fairly synchronized and continues to gain traction.  Financial markets are better, but a full restoration of normal functionality remains a ways off.  The consensus of officials and private sector analysts anticipates an atypically slow rebound from a very low level of activity.  Inflation is weak and not a pressing issue despite worrisome fiscal deficits everywhere.  A sustained pullback in stocks is not thought to be likely until monetary stimulus starts to be withdrawn, even though many investors believe equity gains are overdone and not justified by the tepid economic outlook.  Dollar depreciation has been caused by its widespread use to finance carry trade investment, not feared inflation.

China stands apart from the pack in being ahead of other economies in the business cycle and closer to the re-absorption of excess liquidity and an increase in interest rates.  Beijing officials have so far not acquiesced to foreign calls for yuan appreciation to resume, but a shift in Chinese monetary policy is likely to happen before the Fed, ECB, or Bank of Japan undertake their first rate hikes.  Leaving aside Japan, other Asian economies and their currencies have benefited from brisker Chinese demand.  So have commodity-intensive countries like South Africa, Australia, Canada and New Zealand.  In this year’s first two currency trading seasons, end-2008 until the U.S. Memorial Day weekend in late May and then the interval between the Memorial Day and the Labor Day holidays, the Australian dollar posted successive gains against its U.S. counterpart of 10.6% and 8.8%.  The kiwi rose 6.3% and then 10.9%, and the Canadian dollar advanced 8.7% and 3.2% in those successive periods.  Compared to closing levels before the Labor Day weekend, the dollar has lost a further 9.1% against the kiwi, 7.9% against the Australian dollar and 3.1% against the Canadian currency.

Officials have done little to reverse the dollar’s losses.  The threat of intervention is not taken seriously, and only unilateral responses of any sort have been effective.  Chinese officials froze the yuan in July 2008, and Swiss officials have been targeting the franc’s euro cross since last March.  A rumor surfaced this past week that officials in South Africa may be contemplating pegging the rand, which has risen about 27% against the dollar so far this year after dropping 27% in 2008.  Canadian dollar appreciation was trimmed this past week by forceful verbal warnings that net exports will again be a huge drag on growth during 2010. The Canadian dollar had risen 28% from a low last March of 1.3063 per U.S. dollar to a high of 1.0207 earlier this month.  Unless Canadian authorities back up their words with actions, which I doubt will happen, it seems only a matter of time before Canada’s currency again makes a run at parity.

The Obama administration shows no inclination to intervene in support of the dollar.  The last time any U.S. government intervened was  more than nine years ago in September 2000, and that operation was undertaken to cap dollar strength.  U.S. stocks have rallied, bond yields remain low, and inflation is not a policy concern.  From the many comments by Japan’s new and former Finance Minister Fujii, markets are confused about the governments intentions regarding the yen, and officials are probably pleased with the ambiguity because the yen has not been stronger than 88/$ since January even though it has often straddled the 90 per dollar level.  Unilateral intervention by the ECB seems doubtful, first because that central bank has never favored currency manipulation as a policy tool but, most importantly, because of the lack of evidence that the pricier euro is stifling regional exports.  The region’s composite purchasing managers indexreached a 22-month high of 53.0 in October with an export orders sub-index of 51.5 after 50.0 in September.  The total PMI has improved from 41.1 six months ago and a low of 36.2 in February.  Meanwhile, industrial orders in the euro area, which tend to have a large import content, soared 33.5% at an annualized rate between April and August.

The major potential movers among scheduled data next week will be the slew of end-month Japanese statistics due primarily on Thursday and Friday, business sentiment in Euroland due Thursday, and the market’s first glimpse of U.S. GDP growth in the third quarter due also on Thursday.  However, these are not likely to produce game-changing surprises.  Figures in each instance should support the reassuring view that advanced economies are transitioning into expansionary phases of their business cycles.  The yen, euro, and various commodity currencies are at levels that a year or two ago would have evoked fear of coordinated action to promote a trend reversal.  That’s not happening now.  Collateral damage in other financial markets from a lower dollar is minimal, and a conspicuous effort to lift the U.S. currency or even halt its erosion as G-7 officials attempted in 1987 could inadvertently overturn the decent performance of equities.  With yuan appreciation and central bank tightening remaining a medium-term likelihood but not an imminent possibility, the dollar will continue to serve the role of funding currency for carry trades in search of higher yields.  To be sure, trading remains two-sided.  There will be weeks when the dollar mostly gains and other, like the past one, when the dollar rises against some currencies but drops against others.  More likely than not, the dollar will close 2009 at a softer trade-weighted value than now.

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


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