Weekly Foreign Exchange Insights: Yearend Edition

December 30, 2009

The dollar is winding up 2009 on a bid note.  Except in the unlikely event of a major decline on the final trading day of the year, this will be only the second time in the past eight years in which the U.S. currency rose against the euro between mid-December and yearend.  The greenback’s firm tone surfaced earlier this month and also defied a decent performance by U.S. stocks, against which the dollar had previously traded inversely during much of the year.

Seasonal considerations usually favor the dollar in early January, reversing the bias of late December.  Among the 34 years to 2008, the dollar between December 31 and mid-January rose in 24 instances and posted an average change of +1.2% against the mark or euro including those times when the buck fell.  A 6.4% rebound against the euro at the start of 2009 was the second largest, topped only in the first half of January 1992.  The beginning of 2007 and 2005 also saw especially sharp rises against the euro of 2.0% and 3.7%.  Another quirk in the EUR/USD at the start of the year is the number of instances in that relationship’s relatively brief existence when a calendar year extreme, either high or low. occurred in the first few weeks of January.  That being said, it’s prudent not to read too much into currency market price action at this time of year.  It’s easy to get whipsawed because volumes can be thin and movements oftentimes are not especially representative of underlying speculator sentiment or fundamental economic trends.  Some of the dollar’s recent advances, moreover, have come in liquidating markets ruled by stop-loss triggers and divorced from economic news or expectations.  Finally, the case for an enduring dollar upswing rests mainly on two assumptions that do not seem especially compelling.

  • Investors think the U.S. will expand faster than Europe or Japan in 2010 and that the Fed accordingly will tighten sooner and more aggressively than other monetary authorities.  But a watchword of forecasters in 2008 and 2009 — uncertainty — remains in greater abundance than usual, so no scenarios should be held with great confidence.  I’m not anticipating any dramatic swings in short-term or long-term interest rate spreads during the first half of next year.


  • The dollar has been oversold and is therefore overdue to for a prolonged period of appreciation.  This is the biblical metaphor of seven years of plenty followed by seven years of famine with the implication that currency movements even out in the long run.  Some think-tanks were pushing the overdue- for-a-trend-reversal theory a year ago when the dollar was getting lifted temporarily by a flight to safety, but the U.S. currency sputtered anew in the spring. 

The dollar’s long-term trend after the 1960s was in fact downward-sloping, not steady.  The table below presents the dollar’s decade-by-decade mean values against the yen and mark (using the implicit DEM after 1998 when it joined the European Monetary Union at a fixed parity to the euro).  Dollar percentage movements from the prior decade are also indicated.

USD vs DEM % Chg YEN % Chg
1960s 4.0043 360.00
1970s 2.6325 -34.3% 283.47 -21.3%
1980s 2.2462 -14.7% 198.92 -29.8%
1990s 1.6395 -27.0% 118.18 -40.3%
2000s 1.6462 +0.4% 111.97 -5.8%

The table shows a significant flattening of the dollar’s trend in the noughties, and fundamental economic explanations come to mind.  In the case of Europe’s anchor currency, the mark is but one of many currencies that comprise the euro, and the strongest of them.  Before the European Monetary Union was launched in 1999, pundits thought it might not perform as well as the mark had, because other component currencies had poorer histories than Germany’s D-mark.  Additionally, concerns were raised that a monetary union without a parallel fiscal union might prove unmanageable.  These reservations remain valid ones.  Countries like Spain, Italy, or Greece that were no longer able to recoup eroded competitiveness via the old-fashioned route of depreciation have indeed become heavier drags on the whole EMU economy.  Although the euro survived the worst recession in 75 years, fiscal discipline was blown apart in the process.  In Japan’s case, the economy for nearly 20 years hasn’t resembled the one that earlier justified chronic yen appreciation.

A different interpretation of the flatter dollar trend in the noughties emerges if one looks at a year-by-year display of dollar ranges, where one discovers the decade dollar highs happened early in the period and the lows were reached much more recently.  From a low of $0.8228 on October 26, 2000 to a high of $1.6038 on July 15, 2008, the euro advanced 94.9%, and the common currency remains in the upper quadrant of its decade-long corridor.  From a low of 135.20 per dollar on February 1, 2002 to a peak of 84.83/$ hit just over a month ago, the yen likewise climbed 59.4%. 

  Euro High Euro Low Yen High Yen Low
2000 $1.0415 $0.8228 115.00/$ 101.35/$
2001 0.9595 0.8350 132.00 113.60
2002 1.0505 0.8565 135.20 115.45
2003 1.2620 1.0333 121.87 106.92
2004 1.3670 1.1756 114.92 101.83
2005 1.3581 1.1640 121.26 101.67
2006 1.3370 1.1812 119.88 108.97
2007 1.4966 1.2865 124.14 107.23
2008 1.6038 1.2331 112.10 87.15
2009 1.5144 1.2458 101.44 84.83

Another reason why the first table suggests a more stable dollar long-term trend could be reduced inflation differentials between the United States on the one hand and Europe and Japan on the other.  To keep price competitiveness stable, a country with relatively high inflation needs a weaker currency proportionate to the discrepancy in inflation rates.  All industrialized countries, not just the United States, experienced higher inflation in the 1970s and 1980s than more recently, and at higher levels, inflation spreads tend to be wider.

It is feared by many investors that runaway government deficit spending accommodated by loose monetary policy will prime inflation in the future.  Commodity prices already are moving higher.  Since the end of 2008, gold prices have increased 23.5%, and oil has shot up 77.2%.  Commodity-sensitive currencies were the best performers of 2009, with the Australian, New Zealand and Canadian dollar advancing some 26%, 23%, and over 15% against their U.S. counterpart.  If these concerns prove correct, purchasing power parity argues against an enduring rise of the dollar.  The worries could be overblown, however.  Japan’s lost decade, which had many similarities to current U.S. circumstances including ballooning government debt, led to deflation, not inflation.  The Great Depression also was a time of falling prices.  It may be that the dollar’s best prospects in 2010 lie in a double-dip downturn rather than the better-than-consensus recovery that dollar bulls are generally assuming.

In the United States, as elsewhere, one is struck by the fragility of the upturn and its dependence on supportive factors that could either reverse or fade.  Where would the U.S. economy be if not for the much stronger stock market rally than anyone imagined?  After posting losses of 7.1% in January and 13.3% in February, the DOW rattled off monthly advances of 7.7% in March, 7.3% in April, and 4.1% in May.  The market paused in June with a 0.6% net dip but then climbed 8.6% in July, 3.5% in August, and 2.3% in September.  After another pause in October, there was a 6.5% jump in November and what looks likely to be a rise of over 1% in December.  Amid rampant unemployment, the continuing weak housing market, and compromised incomes, the Federal stimulus would not have been enough to end the recession had the stock market not turned so dramatically.  And with fiscal support at its limit, there will be little defense from renewed recession if U.S. stock prices roll sharply downhill in 2010.

Currency markets have other things to watch as a new decade beckons.  When will China’s yuan be untethered from the dollar?  This is a great piece of unfinished business in removing a cause of the imbalances that set the table for the Great Recession.  Without a more flexible yuan policy, there will be more asset bubbles and further financial market upheavals.  I suspect Beijing will act much later than other countries hope and not merely because the rhetoric of Chinese officials remains deeply entrenched in preserving the status quo.  They want to avoid Japan’s experience at all cost.  Economically, Japan had behaved like a command economy, with government directing resources into highly competitive and leveraged sectors.  From the ashes of the Second World War, Japan grew very strongly much as China is now doing.  When fixed exchange rates collapsed in the early 1970s, Japanese and French officials were the most resistant to the new regime and, in Japan’s case, with good reason.  The sharply rising yen contributed to Japan’s transformation from G-7 powerhouse to the sick chain among major developed economies, and Beijing officials want no part of that evolution.

The noughties will be remembered as a decade when international trade stopped getting less impeded.  It may be that the teenies will see this regression extend into more toxic forms of trade warfare.  Governments will be tempted to manipulate their currencies.  The Hatoyama Cabinet in Japan came to office espousing a strong yen policy that has now been shelved.  Swiss officials instituted a policy nine months ago to halt the franc’s rise against the euro.  Just this month, however, a quarterly policy report from the Swiss National Bank introduced a more flexible approach, and now markets are probing to see how far upward the franc can be pushed.  It will be hard for Swiss authorities to strike a balance between a domestic monetary policy that keeps expected inflation anchored and a currency policy that is still needed.

Finally, there is the inscrutable British pound, easily one of the most counter-intuitive currencies.  Even though Britain suffered a very pronounced recession in 2008-9 and faces continuing difficulties because financial services are a big part of U.K. GDP, the pound rose over 9.0% against the dollar in 2009, outperforming the Swiss franc and euro.  Analysts expect sterling to do worse than other European currencies next year, but a spoiler to that view could be the election.  The likely return of the Tories to power should boost the pound.  That’s what often happens, as with the election of Margaret Thatcher in 1979, when the political pendulum swings to the right. 

Happy New Year Everyone!

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

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