Easter Holiday 2010 Finds Key Currencies Marching to Different Beats

April 1, 2010

The euro’s first-quarter range of $1.4882 – $1.3268 lay entirely within calendar 2009’s high-low boundaries of $1.5144 and $1.2458.  Until a week ago, euro momentum had been adverse.  It subsequently rallied 2.4% to $1.359 but remains 3.5% below the mid-point of this year’s trading range.  At times, perceptions that the euro area’s growth prospects are weaker than America’s and that interest rate increases by the ECB will lag those by the Fed weighed on the common European currency.  The spread between the ten-year U.S. Treasury yield and ten-year German bunds is 33 basis points wider now than at the end of 2009.   But the main problem for the euro this year and the greatest threat of renewed weakness in the second quarter is essentially political.  Investors are unsure that EU leaders will bear any burden and do whatever it takes to preserve their monetary union and prevent the exodus of Greece or any other present members.  And even if they do, a collateral concern is the drag on the region’s growth for many years ahead that preserving the euro might entail.

A European shared currency with a single independent central bank in charge of monetary policy was achieved by legal means but lacked conditions that would have bestowed real legitimacy.  As the details of EMU were being worked out, economic feasibility often got subordinated to political expediency.  The cold war, which had prevented a real war in Europe for 40+ years, was ending, and the leaders of France and Germany in particular believed it was imperative to take the next giant leap in European integration, a common currency, to make unthinkable armed conflict in the region like what had occurred over and over through the centuries. People in Europe were promised economic stability from the euro, but the driving goal was peace, not greater prosperity.  Critical steps like integrating fiscal and foreign policies were not addressed properly, and admission to the EMU club was based on meeting certain economic conditions for a relatively brief period, which governments managed to do.  Penalties were designed in a separate agreement to promote continuing responsible public finances after the adoption of the euro.  While that arrangement was made at the request of Germany and intended for governments with checkered histories of managing their fiscal affairs, Germany and France were among the first countries to break the rules.  When the penalties were waived in their cases, everyone else knew that the rules would never be enforceable for anybody.

An equally severe failure of the Maastricht Treaty that created a currency union was that ratification was not subjected to stricter standards worthy of such a profound transfer of sovereignty.  Most countries approved the euro by a majority vote of legislators.  Three countries held voter referendums but did not require two-thirds or three-fourths majorities to pass.  After the Danish people voted against ratification by a slim 50.7/49.3% margin in June 1992, the fate of EMU literally came down to a French referendum in September 1992 that squeaked through on a 51.04/48.96% “yes” majority.  Such was hardly the kind of overwhelming vote of confidence that ought to have been mandated.   European currency union was a worthy idea executed in a half-baked way that lacked key ingredients to ensure long-term viability.  Those omissions are now resurfacing and creating enormous uncertainty.  Investors are not satisfied with assurances given about Greece, which can be seen by that country’s undiminished bond premium, and Greece is small change compared to bigger fiscal scofflaws that could become speculative targets in the near future.  The euro’s future performance thus depends largely on political decisions over how to share fiscal burdens and how to create a truly enforceable single fiscal policy.

The euro was not the weakest major currency in March.  From a low of JPY 119.66 on March 2, the euro has recovered 6.5% against the yen yet is only back in the middle of this year’s 134.38 – 119.66 corridor. Japanese officials, who’ve demonstrated a consistent bias for currency softness, no doubt welcome the yen’s setback, which also took it above 94.0 against the dollar at one point today.  Japan’s short-term interest rates are seen staying at present ultra-low levels longer than the ECB or Fed benchmark rates, and it’s long-term rates are considerably below those in Europe, Australia or North America.  As recoveries churn away in emerging markets and broaden in the advanced ones, investors are tiring of the missed opportunities of holding safety-only portfolio positions.  Japan offers the perfect funding currency for those willing to accept risk.  That said, one needs to acknowledge the tremendous inertia of the yen most of the time.  90 per dollar has served as an equilibrium, pulling the yen back whenever it strays too far.  The Japanese currency’s strongest level of 2010, 88.15, was seen in March.  Last year’s high-low range had a mid-point of 93.14, very close to the present spot level, and the yen never got weaker than 101.44 per dollar.  Unless Japanese growth halts anew, 95/$ or even 90/$ look more appropriate than 100/$.

Britain will probably hold elections five weeks from today.  The outcome is uncertain, and so is the path that political expectations take over the period ahead.  One thing is clear:  the pound has performed poorly oin Prime Minister Brown’s watch.  Sterling responded well when former PM Thatcher initially imposed fiscal austerity, but David Cameron, the Tory leader, is no Margaret Thatcher.  Even if he could lead as she did, it would not be conveyed with the same sense of righteousness and assertion when she repeated “there is no alternative” so often that TINA became a common acronym.  Sterling also performed decently when Tony Blair was prime minister, but there will be no turning back of the clock.  Britain has suffered a structural shock, having put many eggs in the basket of financial services and government services and now saddled with the legacy of a monster fiscal deficit to be cut for many years to come.  Prudence suggests that monetary policy should provide a counter-weight of support.  One risk is that inflation doesn’t give the Bank of England the luxury to do that.  Most imaginable scenarios appear unfavorable for the British currency.

With today’s intervention, Swiss monetary authorities declared “enough already” in a metaphorical way, having previously tolerated a 6.1% appreciation from the old 1.50/euro line in the sand, which was abandoned in December, to 1.4140 this morning.  Or did they?   The Swiss economy has been improving as attested by a big improvement in its manufacturing purchasing managers index.  If the Swiss franc’s strength were too burdensome, it should be apparent in data such as that.  The defense of 1.50 was sustained for nine months. I think officials will be more flexible at this time in letting the Swissy gain ground in an orderly way, but that flexibility may not be tested or become apparent right away.

The Australian central bank rate never got lower than 3% compared to near-zero levels in many other places, and it has already been raised four times by a total of 100 basis points.  More increases are coming, and investors in the meantime can settle for the hawkish rhetoric that the Reserve Bank keeps tossing out.  Australia benefits from Asian demand for its commodities and the higher prices such are fetching.  All things considered, the 2.4% rise of the AUD from end-2009 looks understated, but maybe that’s the point.  Australia has a current account deficit, which ought to be a greater currency liability in the new global financial environment.  Often the most useful information comes from the behavior of the market to economic news, not the news itself.  Before the AUD can make a run at parity, it has to eclipse $0.9405, the 2009 peak that is not too far above the present level.

Everybody believes a rise of the loonie through U.S. dollar parity is a matter of when, not if.  Count me in that group, although I get nervous when every pundit shares my thinking.  As pointed out in an update yesterday, Canadian real GDP on an industry-by-industry basis advanced at a sizzling 6.2% annualized pace in the five months between August and January.  The U.S. has done reasonably fine, but Canada’s economy is performing betterCanada has less financial market baggage than the States.  It’s current account will likely head out of the red, something that cannot be said about its southern neighbor.  Canada is more sensitive to commodity prices than the U.S., meaning that holding Canadian currency is one way to bet on continuing solid growth in emerging economies.  Canadian central bank interest rates will begin to rise sooner than the Fed’s, and they will increase more quickly. 

This time after the CAD breaks $1.00 will not be like the last such experience.  In 2007, the Canadian dollar broke par on September 20 and rolled all the way to $0.9061 within seven weeks.  The timing for such an appreciation was awful, as the pieces of a world recession were then just falling into place.  The Canadian dollar’s subsequent retreat was even more violent than its inclining phase.  It took just 20 days to return to parity.  For a while it seemed to stabilize but as the global recession hit commodities, a new tumble ensued, depressing the CAD to $1.3017 by October 28, 2008.  The 2009 low of $1.3064 was reached on March 9, the same day that global stock markets bottomed.  Like AUD, buying Canadian is a vote against a double-dip world recession, only without the baggage of a chronic current account deficit.

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

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