Weekly Foreign Exchange Insights: Shifting Themes as Yearend Beckons

December 18, 2009

The dollar experienced a third straight well-bid week, shrugging off a seasonal tendency in many previous years to swoon in late December.  The U.S. currency had weakened during the bulk of 2009, posting peak-to-trough declines of 20.7% against sterling, 17.7% against the euro and 17.1% relative to the Swiss franc.  The depreciation had been characterized by some as a reversal of the dollar’s rise during the prior intense portion of the global financial crisis and by others as an acquired carry trade funding role for all sorts of transactions not limited exclusively to pure currency transactions.  The improved dollar tone came after grousing by major holders of dollar reserves and European leaders about the dollar’s losses, as the U.S. economy escaped from recession more quickly than anticipated, and amid central bank preparations for winding down unconventional stimulus facilities.  As everybody’s favorite carry trade, the dollar may be stepping aside now for the yen, which had held that role during most of this decade.

Whereas the U.S. and European recoveries are making forward progress, Japan’s has stumbled.  With deflation back and deepening, fear is rising about a second leg of Japan’s recession.  The anxiety has many elements, but the yen’s appreciation against the dollar and relative to the yuan which since mid-2008 has been moving in tandem with the greenback, has drawn considerable attention as an urgent problem that can be remedied by policy.  The 150-day moving average of dollar/yen had been above 110 (that is a weaker yen and stronger dollar than that level) from mid-December 1996 until April 2008.  The average is now at 92.6, less than 4% from its all-time peak of 89.3 in September 1995.  (A sharp but short-lived shift in currencies isn’t going to impact economic activity as much as a long-enduring move, which is why I look at 150-day moving averages to gauge the potential effect of the present bout of yen strength with what caused renewed recession in the mid-1990s.)  The yen has been stronger than 110 for the past 20.5 months versus a span of 39 months from September 1993 to late 1996.  It’s been stronger than 100/$ for the last 10.5 months compared to an interval of 15 months in the mid-1990’s.  Back then, spot yen peaked at 79.85 per dollar just four months after the 150-day average first crossed below 100.  If the recent yen high of 84.83/USD turns out to be its cresting point, it will have taken a longer 10.5 months to get there after the 150-day moving average first strengthened through 100.  While the yen’s earlier spike still looks like a more serious growth killer, the current episode is fast approaching the same magnitude.

The epiphany of the dollar rescue package of November 1978 was to realize that currency depreciation and domestic U.S. inflation were intertwined symptoms of the same problem and feeding one another.  In a similar vane, Bank of Japan officials seem to have concluded that Japanese deflation and yen strength are likewise linked.  Japanese officials are notorious for inconsistent verbal messages and for poorly executed policy changes.  That said, investors who disregard the determination of the central bank to push the yen lower do so at their own risk.  At 90 per dollar, a long way remains before officials will feel a sense of mission accomplished.

The dollar actually rose more strongly over the past week against the Australian and New Zealand dollars than against the yen.  To their surprise, markets learned that Reserve Bank of Australia officials believe that three 25-basis point increases of the cash rate to 3.75% from 3.0% constitute enough restraint to return policy to normal settings for now.  Most interesting was the signal from the central bank’s deputy governor that because of residually tight lending standards, an Australian central bank rate of 3.75% is now akin to 4.75% before the global financial crisis.  This belief might have applicability to a whole range of central banks, suggesting that policy neutrality will be achieved at lower central bank rate levels than what had been considered neutral in prior business upswings. 

The dollar’s rise this past week was also stronger against the euro than versus the yen.  The EUR/USD pair is the best bilateral gauge of general sentiment toward the dollar and U.S. economy.  The rise from an intra-week low of $1.4685 to a high beyond $1.4300 is notable because dollar seasonal softness tends to be recorded most prominently at the expense of Europe’s major currency.  Assuming that late-December seasonal weakness doesn’t return in the next two holiday-interrupted weeks, it will be interesting to see if an opposite seasonal bias toward dollar strength in the first trading days of January also fails to show up or whether such does occur and add momentum to the dollar’s reversal.  The key U.S. data release, as so often is the case, will be the December jobs report.  Fed officials have conspicuously singled out labor market conditions as crucial to guiding their views on future consumer spending and inflation.  But data will not be the only force in play.  Geopolitical risks in the middle east and between China and the United States seem to be moving back to the fore, and that tends to favor the dollar.  On the other hand, the approaching anniversary of the Obama presidency may invite reflections on the administration’s stumbles, reduced voter ratings, and potential future pitfalls, and that process could be a dollar negative.

Dollar gains last week were smaller relative to the Swiss franc, sterling and the Canadian dollar have been comparatively small.  The Swissy’s euro cross rate moved to the strong side of 1.50, penetrating the Swiss National Bank’s line in the sand since last March.  The quarterly policy review in December reiterated that policy commitment, but a return to positive Swiss on-year inflation has investors wondering just how dedicated officials really are to a 1.50 or weaker parity, since the stance was introduced as an attack against Swiss deflation.  Sterling can be a very fickle currency, but it’s latest move makes intuitive sense.  While Britain has terrible fiscal problems because of decimated tax revenues from the financial services sector, the deficits of Greece and other vulnerable members of the European Monetary Union are getting more acute currency market press coverage because they have revived the misgivings from the late 1990’s that a common European currency without a common fiscal policy would not succeed in the long run.  Canada’s trade position improved far more than predicted from deficits of C$ 1.95 billion in August and C$ 0.85 billion in September to a surplus in October of C$ 0.43 billion.  Caution should be exercised here, however, because the Canadian dollar was quite weak during the dollar’s revival in the late 1990’s and only began appreciating in 2002 when the dollar in general turned southward.

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

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