Weekly Foreign Exchange Insights: November 6th

November 6, 2009

The deep recession last year and this produced a perverse inverse correlation between the dollar and the tone of economic news.  When conditions were bleakest, haven-seeking capital inflows lent unexpected support to the U.S. currency.  This relationship appears to hold only in extreme circumstances and is unlikely to resume if economic recovery is merely slow by historical standards and weaker than markets have assumed.  A full-blown double-dip downturn is probably required.  I draw this inference based on a cursory look at month-end to month-end changes in the trade-weighted dollar, but the conclusion also makes conceptual sense.  The backdrop to a strengthening dollar last autumn was a stampede of wealth away from risky assets into U.S. government securities.  Such a response isn’t caused merely by sluggish or even negative growth.  The fear factor needs to be rampant, causing investors to settle for a return of their investment rather than a return on their investment.  Conventional wisdom a year ago was that the banking system might have to be nationalized and a depression might prove unavoidable.

Stock markets, another handy barometer of risk aversion, bottomed out after the first week of March.  Prior to then, the trade-weighted dollar had risen during the second half of 2008 by 1.1% in July, 4.6% in August, 1.4% in September, and 7.8% in October.  After some calm following the U.S. election that saw a small dollar uptick of 0.5% in November and a decline of 4.1% in December, the dollar advanced by a brisk 2.4% in January and 4.5% in February.  Over the last eight months, however, the dollar only performed really decently in June when the trade-weighted dollar rose 2.2%.  Otherwise, the U.S. currency notched losses of 2.0% in March, 2.2% in April, 6.6% in May, and 3.6% in July.  Conflicted investor convictions have been evident more recently with the dollar edging up 0.1% in August and then falling 0.9% in September and 0.3% last month.  Two other explanations for this inflection point in the steepness of the dollar’s fall seem more compelling than emerging doubts about the pace of recovery.

One of them involves the protest of officials in countries with appreciating currencies.  Amid disinflation, substantial unused resources, and very depressed domestic demand, rising currencies only create more economic drag and anxiety over whether economic recovery can be sustained.  Warnings by Bank of Canada officials that a pricey currency might offset all the other forces promoting recovery have helped depress the affectionately known loonie 6% from an October high of 1.0207 per USD to a low of 1.0869 this past week.   Officials in New Zealand have also been successful in escalating their complaints about excessive kiwi strength.  Japanese and euro area officials have protested, too, and the Obama Administration has vocalized the words that “a strong currency is in America’s interest.”

By itself, verbal rebukes might not be especially influential with the marketplace.  However, reasonable doubt exists that officials may not stop with words alone in their efforts to end dollar depreciation.  Foreign exchange policy coordination is no longer a strictly G-7 matter, but rather has been transferred along with many other surveillance responsibilities to the wider Group of Twenty, where countries like China have policy traditions that favor top-down management.  Japan hasn’t intervened in 5-1/2 years but did forcefully enough before then.  Markets still pay attention to comments about the yen by Tokyo officials.  So long as the dollar drifts lower in an orderly way, currency intervention seems improbable, but the global economy remains too fragile to think governments would sit on the sidelines and not respond to a dollar rout.

The second factor promoting stable currencies is the present proximity of many major forex relationships to big round figures.  The dollar has found support at 1.50 per euro and Y 90, staying near to each of those key levels.  The Canadian dollar at a recent low of 1.0207 and the Swiss franc at 1.0035/USD each stopped short of rising through par against the U.S. currency.  The Australian dollar is pivoting $0.90, and the kiwi has settled back closer to 70 U.S. cents after climbing as high as $0.7635 in October.  While sterling is trading mid-way between $1.60 and $1.70, the euro has remained very close to 0.90 against the pound in recent weeks.  When currency relationships settle into a tight orbit around big figures, trend movement is impeded.

Still, there is no hint in the air of a multi-year dollar rally like its climb from DEM 1.70 to DEM 3.47 in the early-to-middle 1980’s or from DEM 1.345 to DEM 2.38 in the late 1990s.  Market chatter about the dollar has a perennially bearish tone these days, and the currency’s changes are mostly negative whether one compares current levels from when the DOW peaked at 14165 on October 10, 2007 or just changes over the past 12 months.  In the first grouping the DJIA shows a net loss of 29.5%, a sign of risk aversion, yet the dollar is lower except against sterling and the Canadian dollar.  In the second instance from a year ago, the DOW shows a net advance of 14.9%, and that is associated with broader-based and, except against the yen, larger drops of the dollar.  One again is left to conclude that negative forces on the dollar outweigh positive ones.  An extreme capital flight can distort this picture but only to a degree and only temporarily.

Dollar versus Since 10/10/07 Since 11/06/08
Euro -4.8% -14.4%
Yen -23.4% -8.1%
Swissy -13.8% -13.5%
Pound +23.3% -5.8%
Aussie-$ -1.9% -27.5%
Canadian $ +9.3% -10.4%

As the global portfolio manager’s new favorite funding currency for carry trades, any developments that point to Fed interest rates staying low for longer are likely to magnify the dollar’s difficulties.  In that regard, this past week’s election resulted in a the swing in support away from the Democratic Party, revealing general dissatisfaction with the direction of the economy and specific uneasiness with larger government and mounting deficits. That’s going to make prospects for additional fiscal support dimmer.  If fiscal levers cannot be used and the economy grows slowly with unacceptably high unemployment, monetary policy is going to have to shoulder a disproportionately larger reflationary burden.  And in fact, orderly dollar depreciation is likely to be one of the intended mechanisms for delivering ongoing stimulus if that happens.

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


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