Dollar in Favor, Euro Not

January 29, 2010

Market confidence continues to build that 2010 is going to be a good year for the dollar.  The U.S. currency clawed through several big figures this past week such as 1.40 per euro, 90 on the yen, 90 cents per Australian dollar, and $1.60 per pound sterling and 70 cents on the kiwi appear on the brink of getting taken out.

European and Japanese officials are praising the virtues of a stronger dollar for the U.S. and global economies, and no complaint has been heard from the Obama administration about the greenback’s better tone.  During 2008, Swiss authorities adopted the most blatant hands-on currency management, halting with intervention when necessary all further franc appreciation against the euro beyond 1.50/EUR.  That stance abruptly ended about six weeks ago, symptomatic of a greater willingness by all governments to let markets determine exchange rate values without policy interference.

The downturn in equity prices, evidence of returning risk aversion, has lifted the spirits of dollar holders.  We see in this latest market turnaround that the inverse correlation between the dollar and stock prices persists strongly.  Given how far stocks climbed after bottoming last March, a downward run now would appear to have a considerable additional distance to run, especially since equities have repeatedly exhibited an inability to benefit more than fleetingly from favorable economic news such as today’s better-than-forecast U.S. GDP and other data.  That’s a hallmark of bear market behavior and suggests that the upturn of the dollar also may be only in its infancy.

U.S. news has been mostly dollar-supportive.  Chairman Bernanke was finally confirmed for a second four-year term, removing one uncertainty, and the healthcare debate, no matter what happens from here, will not conjure up as much fear about a ballooning fiscal deficit as before.  Economic data, although mixed, on balance point to continuing expansion, and Fed plans to normalize policy continue to grind forward.  Quantitative easing is getting shut down, and the inclusion of the word “recovery” in the FOMC’s latest statement suggests that the central bank will begin lifting rates before, not after yearend and indeed closer to July than December.

For people betting on a rising dollar, the euro’s identity crisis couldn’t have come at a better time.  Because the directional default in the dollar since the late 1960’s has been downward, any cumulating advance of the dollar needs to draw energy from more than positive U.S. circumstances.  The European Monetary Union never ideally fit the blueprint for a suitable currency union, and early misgivings about the lack of a common fiscal or foreign policy have returned with a vengeance.  The safest bet remains that the EU will bail out Greece when push comes to shove, but similar logic led analysts to assume a bailout of Lehman brothers in 2008.  Moreover, a speedy resolution of the Greek debt saga does not appear likely, so this euro-corroding factor isn’t going away quickly.  After that specific national problem is addressed, other peripheral euro area members like Portugal, Spain and the numerous central European nations requesting permission to join will cause continuing investor anxiety.

In the really significant historical dollar rallies, the greenback climbed against both the yen and euro.  That pattern has become rarer, since as carry trade funding vehicles, both the yen and dollar have benefited at times of spiking risk aversion.  Early in January, the dollar posted successive losses against Japan’s currency of 0.4% in week one, 2.0% in week two, and 1.0% in week number three to the 22nd.  At mid-morning today, the dollar had accrued this week a gain against the yen (0.9%) that rivaled its 1.0% advanced against the Swissy and was respectable compared to a 1.5% move relative to the euro.  But later in the day after equity markets headed sharply south, the dollar’s rise lengthened against European currencies but was halved against the yen.  Although very severe headwinds perpetuate deflation in Japan, magnify the economy’s enormous fiscal imbalances, and limit the potential for future economic growth, the truth is that export demand has recovered decently.  In that regard, a 3.2-point drop in the export orders component of the economy’s factory PMI report this month bears watching. In the long run, Japan is unlikely to handle a 90 per dollar yen rate despite a more competitive cross rate against the euro.

A shift in Chinese currency policy could modify currency market dynamics yet again, mitigating positive dollar sentiment.  Beijing remains the great currency manipulator.   Over the three years between July 2005 and July 2008 when CNY/USD was previously allowed to rise, the dollar also lost 7% against the yen and 24% against the euro.  It may actually not be much longer before a controlled yuan appreciation against the dollar resumes to complement other monetary tightening gestures.  Alternatively, the time interval before the yuan is again unpegged could drag out more deeply into this year than most analysts are predicting.  At the end of the day, the policy change will be a political, not economic, decision.  Investors aren’t going to sit around waiting for that Godot but rather will deal with the consequences when the policy change is made. 

A second U.S. dip into recession could also knock the legs out from the dollar by dashing hopes of Fed tightening later this year.  Resumed recession remains a minority assumption among analysts.  A relatively greater number would agree that a stock market decline of more than 20% from peak is quite plausible, thus meeting the definition of a bear market, and I believe that a future quarter of negative economic growth would almost certainly occur if equities perform that poorly or worse.  The debate over banking reform legislation also could prove unsettling to the dollar, if investors come to fear that such as a path will disadvantage the ability of U.S. financial institutions to compete internationally and therefore persuade the banks to relocate their operations abroad.  Event risk in this century, the omnipresent and multi-faceted geopolitical risks that can command center stage without warning is yet another potential game changer.  But all these caveats are just that, exceptions to the most likely outcome.  Right now, the most probable possibilities point to further dollar appreciation.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.

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One Response to “Dollar in Favor, Euro Not”

  1. Jimbo says:

    “The Federal Reserve will also be working with its central bank counterparties to close its temporary liquidity swap arrangements by February 1”

    This was in the FED December Report! Care to comment? Seems very important yet it in the last paragraph and Feb. 1 is Monday.