All Major Currencies Carry Negative Baggage

March 5, 2010

Currency movements continue to be choppy and mixed from the standpoint of a dollar holder.  So far this past week, the greenback recorded gains of more than 1.0% against sterling and the yen but also lost significant ground against the Canadian and Australian dollars.  In between those extremes, identically small net gains were posted against the Swiss franc, euro and kiwi.  Sterling had lost ground in both January and February, emerging as this year’s biggest loser, but the yen’s setback followed solid showings in each of the first two months of 2010.  The recent strengths in the Canadian and Australian dollars had begun in February but do not seem to represent a straight-up rush into commodities and commodity-sensitive currencies, since the kiwi shows a year-to-date decline.

Erratic trading patterns imply weak convictions.  Trading is often reduced to instant comparisons of actual data results against their predicted values rather than underlying trends and outlooks.  Since data embody a significant element of noise, so too do daily currency movements.  Moreover, it’s difficult to take a long-term view on any currency because they each carry negative baggage.

One can’t overstate the U.S. labor market problem.  True, the rate of decline in non-farm payroll jobs has improved considerably.  The monthly average drop in the three months to February was 57,000 compared to 126K in the three months to November and 358K in the three months to August; likewise, jobs fell by 93K per month over the past six months following a loss of 457K per month in the previous six months.  But U.S. jobs are currently 21 million short of where they should be.  Let me explain.  Job growth had traced a remarkably steady pattern of expansion until the last decade, advancing by 1.958 million per year between February 1970 and February 1980, 1.852 million per annum in the ten years to February 1990 and 2.091 million per annum in the ten years to February 2000.  To simplify, the long-term trend rate of growth should be two million workers per year.  Set against this rule of thumb and using February-to-February sequences of annual time, the level of employment fell below trend by 0.4 million in 2000, 4.1 million in 2001, 2.4 million in 2002,  and 1.6 million in 2003.  A hole of 8.5 million jobs was already dug in the first four years of the decade, and only 1.1 million of such was filled back in during the next three years to February 2007.  The negative deviation from long-term trend then ballooned to 1.3 million in the year to February 2008, 7.0 million in the year to February 2009, and 5.3 million over the past twelve months.

The United States quite plausibly will never return to the old jobs growth vector.  If jobs expanded 50% faster than trend, that is at 3K per year, it would take 21 years to return to the long-term trend, and there’s no imaginable way that such a long interval would not be interrupted by recession.  Short of a catastrophic drop in the U.S. population,  the jobless rate is likely to stay very elevated for the next generation, and that will aggravate many social and economic problems, including the sustainability of the government deficit in the long run whether or not spending discipline can be achieved.

The dollar faces other headwinds.  The trade and current account deficits are rising again.  Health care presents problems for the dollar regardless of what gets done.  If the Democrats manage to enact a bill, fear about its affordability will worry investors, but a failed gamble on heath care will leave the Federal government looking more grid-locked and the Obama administration more discredited and unpopular. Thirdly, the dollar has a flawed track record.  It lies presently 13% below its  euro mean value since the common currency was created at the start of 1999.  Compared to average levels over that same period, the dollar is presently 19-23% weaker versus the yen, Swissy, Canadian dollar and Australian dollar.  Fourth, a currency with vast off-shore holdings has to be a model student because it is an easy object of adverse speculation.  It is no coincidence that sterling is the one major fully convertible currency against which the dollar (with a rise of 12.5%)  is presently stronger than its post-1998 mean.  Although being a favored reserve currency bestows substantial economic advantages, there are no free lunches, and the penalties for former favored reserve currencies can be severe.

Sterling recovered about half of its March-to-date loss after touching a low of $1.4784 this past week.  Britain ranks unfavorably with many other countries in comparisons of public finances, current accounts, and inflation.On a fourth quarter-over-fourth quarter basis, British GDP fell 3.3% in 2009 compared to the U.S. economy’s 0.1% uptick.  Both economies fell 1.9% between 4Q08 and 4Q09.  I do not expect the 0.25% Fed funds rate to get raised this year.  I feel the same way about the Bank of England policy rate, and officials at that institution also continue to warn that they could be forced to do further quantitative easing.  Political uncertainty almost always exerts a negative influence on currencies, and Britain’s upcoming election is nearer than America’s and thus poses a a more present currency danger, especially since opinion polls suggest the next government will be  unable to get its policy manifesto transformed into law.

The yen’s fortunes lately have often dove-tailed with the dollar’s, each rising at times of diminishing risk aversion.  Japanese GDP in 4Q09 was just 0.4% lower than a year earlier according to preliminary data that will get revised next Thursday.  That was only a fifth as much as the 2.1% drop in Euroland GDP between the fourth quarters of 2008 and 2009.  Japan also holds an election this year that’s fraught with danger, and its economy cannot escape an unhealthy reliance on export demand or shake off deeply entrenched deflation.  But the yen’s most looming near-term downside risk is that officials are becoming more desperate about the exchange rate’s elevated level. Japan’s days of intervention abstinence may be numbered.  Each time the yen has strengthened past 90/$, it has fallen back toward that level.  Finance Ministry officials would rather see a range of 95-100 established.

European Monetary Union was a half-baked experiment.  The liability of having many fiscal policies might never have been exposed in its present severity if the world had not experienced a once-in-a-half-century economic disaster.  The Greek situation has been plugged, giving the euro a little respite.  However, Greece is not Euroland’s only weak link, and others will be more difficult to fortify. Greece accounts for just 4% of Euroland debt, about as much as Portugal and Ireland combined, but Spain’s 9% share and Italy’s 23% loom more problematically.  A separate euro problem developed during the Greek crisis, which was speculation that kept surfacing that hedge funds and other investors were reassessing the risk of their holdings of the common European currency.  On the economic front, the tone of activity data in Euroland has lately been softer than U.S. figures.  Although I expect growth in 1Q10 to be lower than in 4Q09 in the United States but stronger this quarter than last in Euroland, a much wider 10-year Treasury versus German bund spread of 53 basis points now compared to 5 basis points in the second half of last November constitutes another potential drag on the euro for now.

To many investors, the path of least resistance going forward lies with the Australian and Canadian dollars, two vehicles that do not match the breadth of opportunity of currencies discussed heretofore.  The Aussie and Canadian currencies rose against the greenback in February and the first week of March.  Commodity prices are firm because of a surprisingly robust recovery in emerging economies, which is unlikely to sputter suddenly.  Australian and Canadian GDP growth outpaced expectations last quarter.  The Reserve Bank of Australian has already raised its cash rate to 4.0% from 3.0%, and Canadian monetary authorities are ahead of other G-7 central banks in preparing markets for a rate increase.  It would be surprising if the Canadian overnight target rate isn’t lifted in July, and that will not be its only increase this year.  Fiscal consolidation plans in Canada are also ahead of other countries, and the Canadian current account may revert to surplus sometime this year after narrowing from 6.7% of GDP in 3Q09 to 4.7% last quarter.  Australia is benefiting from its location near Asia and its abundance of goods and services needed in the region.  So what’s not to like about these two currencies?  Technical resistance for one thing?  The loonie is hovering not far from parity against the U.S. dollar, and the Australian dollar has repeatedly encountered trouble trying to strengthen far from USD 0.9000.

The Chinese New Year holiday came and went without a change in the policy of linking the yuan to the dollar.  It had seemed like an opportune time for a fresh policy start.  I still believe China’s currency will rise this year against the dollar.  However, the timing of such will be politically determined and thus hard to trade.  Also, the rate of yuan appreciation will probably be too slow at the start to impact trading in other currency pairs.

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

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