Weekly Foreign Exchange Insights: October 30th

October 30, 2009

At least four different forces are converging upon the currency markets, so last week’s mixed dollar performance was unsurprising and liable to continue.

The most widely identified pattern is the risk trade wherein the dollar moves inversely with stocks in response to the waxing and waning of investors’ appetite for risk.  The dollar was well-bid during the darkest parts of the recession but started to trend downward with the first spring sighting of economic green shoots.  So accustomed have currency traders become to the dollar gaining on bad economic news and vice versa that the pattern has become a pavlovian response as individual indicators get released one after another.  Data bounce around, and so will the dollar.  Ultimately, I expect a 2% or lower trend rate of U.S. growth to emerge, which would be significantly poorer than normal and lend the dollar support assuming this currency market factor persists.

Investors in foreign exchange eventually buy and sell value, but the directionality of fundamentals is a more powerful short-term determinant of currency movements. That’s why markets overshoot.   Microeconomic textbooks depict equilibrium as a point that equates quantity sought with quantity offered for any set of fundamentals.  In reality, currency market equilibrium in the short run gets manifested as a price direction.  So long as fundamental conditions remain supportive, a currency continues to drift higher even if the economics that predispose traders toward that currency are not becoming increasingly positive.  As with equities and commodities, a times comes when the market collectively says enough already.  The dollar posted sizable gains last week against commodity currencies largely because of such value considerations.  From their lows in the first quarter, the New Zealand, Australian and Canadian currencies had climbed by 55.9% from USD 0.4896 to 0.7635, 49.3% from USD 0.6250 to 0.9329, and 28.0% from 1.3064/USD to 1.0207.  Compared to those recovery highs earlier this month, the three currencies at 14:25 GMT today had depreciated 4.8%, 2.8% and 5.6%.

Seasonal tendencies are a third kind of market force.  Over 35 years, the dollar has exhibited a predisposition toward depreciation in the final currency trading season between the U.S. Labor Day holiday and yearend.  That doesn’t mean the dollar drops every year during the autumn, only that it does so to a significant extent more often than not.  A related distortion last week was that the period comprised the final five trading days of October, bringing month-end transactions into play.  The beginning of a new month next week will liberate markets from month-end impediments that constrained transactions during this past week.

A final issue concerns perceived likely disparities in the monetary policy cycles of different central banks.  Central banks already have begun to raise rates in Israel, Australia, and Norway.  Although New Zealand no longer has an easing bias in its monetary policy, the first tightening appears far away there, and the central bank benchmark rate of 2.5% is already 75 basis points lower than Australia’s benchmark.  Consistent with this contrast, the Australian dollar retreated only about half as much as kiwi in late October.  The Norwegian krone advanced against the euro by almost 1% in October and is up 4.5% since Labor Day and around 9% against the common currency since mid-2009.  Notably, the Australian dollar fell against the U.S. dollar last week despite the risk of a second interest hike next week.  In that instance, the collective slide of all commodity currencies trumped considerations related to Australian and Fed future policies.

Other countries particularly in Asia will be soon joining the rate-hike bandwagon, but central banks in advanced countries are likely to end up lifting rates later and in a slower and more synchronized fashion than now generally assumed by private analysts or policymakers.  Global economic recovery has been highly reliant on fiscal and monetary support.  Removing such will have to be handled very delicately.  Japan’s experience from the past decade and a half suggests that economies lose resilience after a long period of intensive care and are vulnerable to significant setbacks when the crutches are removed.  From the monetary side, rewinding will in most cases begin with the phased termination of unconventional measures as the Bank of Japan announced today.  It will be hard for investors to react to such initiatives, other than by handicapping what is implied about the timing of actual increases in benchmark interest rates.  We’ve seen too that labor markets are not turning as well as GDP.  Some of that is cyclical; unemployment tends to be a lagging indicator of the business cycle. 

Much of the labor market difficulties stems from structural problems, however.  The baby boomer generation (people born from 1946 to 1960) carry that distinctive name because there are considerably more of them than in the nearest younger and older age groupings.  Boomers still with jobs but eroded savings are keeping them, thus crowding out new labor forces entrants seeking work.  Boomers, who lost jobs, have a hard time getting back on the merry-go-round because of the lack of new skills and the ever-present issue of age.  If a major recession had occurred 15 years ago instead of during the past year, that is in a time when technology evolved more slowly, globalization was not so far advanced and a smaller segment of the labor force was older than 55, the labor market would face a less precarious outlook, and prospects for personal consumption would appear better than such do.

The risk trade appears likely to remain the most dominant of the four cited market forces.  Based on an erratic recovery since spring, the euro has risen progressively, the Swiss franc has shadowed the euro, and sterling also climbed until August but subsequently faltered on disappointment over British data and speculation that quantitative easing will be retained longer in Britain than elsewhere.  The yen has not conformed to the pattern of other major currencies like the euro, Swissy, or pound because it has carry trade appeal, like the dollar.  The euro has now encountered resistance at $1.50, an obvious psychological milestone and magnet, and dollar/yen has neared 90.0 asymptotically, creating another barrier that will influence trading challenges in November.  The table below of period averages illustrates how these four currencies moved against the dollar in 2009.  Note that for policymakers, comparisons of period averages are more relevant than point-to-point changes, because the former are the ones that will influence future trade flows and economic growth. 

$ versus Euro Swissy Pound Yen
1Q09 1.3043 1.1486 1.4345 93.64
2Q09 1.3614 1.1141 1.5502 97.42
July 1.4092 1.0794 1.6368 94.45
August 1.4263 1.0689 1.6531 94.87
September 1.4548 1.0413 1.6321 91.44
October 1.4884 1.0220 1.6192 90.41

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


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