European Currencies Carrying a Downward Bias into Summer

May 28, 2010

The dollar recorded gains of more than 10% against the euro, sterling and Swiss franc from the start of 2010 to this Memorial Day weekend.  The main development of the period was a loss of confidence in the short-term and long-term prospects of the euro area.  This happened in spite of evidence that an economic recovery that began in 3Q09 was continuing in 2010.  European leaders did not handle their sovereign debt crisis well but eventually showed strong resolve to avoid a near-term break-up of the euro.  EMU’s long-term survival is still not assured, however, and that will only happen if a way is found to restore some of the eroded relative competitiveness of the peripheral economies like Greece, Portugal, Spain, Ireland and Italy.  Unpopular fiscal austerity has been difficult to approve and will be even harder to sustain for as long as it’s needed.  Fiscal austerity will not be enough, moreover.  Alternative sources of stimulus will be necessary.  A loose monetary policy is a given. Since interest rates have no room to drop, currency depreciation becomes the primary channel for promoting more accommodative monetary conditions.  A successful plan to preserve Europe’s common currency and to make it worthwhile for its members needs to involve a depreciating currency.

The euro is not at present excessively undervalued.  One could even argue that its not undervalued at all.  Although moderately weaker than when the financial crisis began in August 2007, it’s about 4.5% stronger than its long-term mean value against the dollar and less than 1% from its ten-year trade-weighted average.  A little more than eleven years have passed since the euro replaced the mark as Europe’s leading currency.  The DEM-translation value of the euro is presently 1.583 per dollar, 5.2% stronger than the mark’s average value over the eleven years prior to the birth of the euro.   Similar comparisons find the present synthetic mark to be 20% stronger than its 1987-98 average value against sterling but 22.5% weaker versus the yen.  A spontaneous euro recovery engineered by the market sensing an extreme misalignment is not in sight at present levels. 

European officials understand that euro depreciation in the long run is desirable and will act against such a directional move only if market conditions become disorderly.  The speed of the euro’s drop is not the main criteria for determining if currency trading is disorderly.  A drop of as much as 25% against the dollar was already tolerated since late November, and officials have expressed almost no concern about that slide or the euro’s  level.  They want to avoid the collateral damage that a free-falling euro might cause: overly wide bid-ask spreads, illiquid trading conditions, excessive imported inflation, rising expected inflation, and climbing long-term interest rates.  Ten-year German bund yields are presently down by 50 basis points from April 18, 71 bps from end-2009, and 41 bps from the 2009 average level.  Although German import price inflation of 7.9% constitutes a 20-month high, total CPI inflation in Euroland’s largest economy was just 1.2% in May, and non-energy CPI inflation in the entire area printed at a mere 0.7% in April. 

U.S. officials will not complain if the euro continues to drop.  America’s current account account deficit is presently more manageable in size, and less than 11% of the first-quarter deficit was at the expense of members of the European currency union.  Washington supports European Monetary Union because of favorable geopolitical benefits.

The high level of financial market anxiety about Britain prior to May 6 elections has dissipated significantly.  Opinion polls pointing to a minority government were on the mark, but the often heard expression, hung parliament, far overstates the extent of dysfunction in government.  Britain’s new leadership has made a good first impression, tackling the deficit with a greater emphasis on spending cuts than higher taxes.  A stronger sense of teamwork permeates the Conservative-Liberal Democratic coalition than the previous Labour regime, and monetary policy has less leeway in the near term for further loosening because of higher-than-assumed inflation.  Sterling should continue to look less vulnerable than the euro.

Both of those currencies lack the current luster of the Swiss franc, which needs periodic central bank intervention to temper upward pressure and to control its movement.  If the euro works its way below $1.20 and beyond as seems probable, the Swissy should in time get the green light to strength past the 1.40 per euro barrier.

A long tradition exists in the halls of Japanese government to favor and promote a softer yen than the equilibrium that private market pressures otherwise would dictate.  Tokyo officials were among the last to give up the fight to preserve fixed dollar parities in the early 1970s.  Given enough time, market pressures have triumphed.  From 360 per dollar prior to 1971 and 307 in December 1975, the yen soared to 176 less than three years later and to 79.85 per dollar in April 1995.  Japan since 1991 hasn’t resembled the powerhouse of previous decades.  The Bank of Japan’s interest rate has been 0.5% or less since 1995, long before other central banks moved their rates to such low levels.  As the funding currency in carry trades, the yen retreated and spent quite a few years above 100/$, but the unit’s predisposition for strength was not killed.  Japanese officials sold enormous sums of yen in the early years of the last decade to quell appreciation, and even though the Nikkei-225 stock market index is now 75% lower than its end-1989 peak, the yen has been stronger than 100/$ since late 2008.  It helps to be located in Asia, the most dynamic economic region on the planet, and export volumes were over 42% above year-earlier levels in the first third of 2010.

Japanese authorities have effectively managed to keep dollar/yen stable.  Such has averaged 91 these last nine months, staying stronger than 88 but weaker than 95 for the most part.  EUR/JPY will continue to be a popular vehicle for shorting the euro.  So long as Japanese government bond yields are very low in spite of very high debt, the yen should be able to project a bid tone.  Covert or threatened overt intervention may keep the yen from escaping its orbit around 90/$, but more appreciation against the euro is probable.

A vote for commodities or commodity-sensitive currencies is a vote of confidence in future world growth.  The dollar fell over 1% against the Canadian and Australian currencies this past week.  Central banks in those countries meeting next week are expected to begin a tightening cycle in Canada but underscore that policy for now is on hold in Australia.  The problem with commodity currencies is that these are truly perilous times.  While a semi-annual forecast from the OECD sees world growth in 2010 surpassing 4%, part of that gain constitutes a dead-cat bounce, and all forecasts, however optimistic, have to be hedged with caveats stressing all the things that can go wrong.The Aussie and New Zealand dollar are both more than 5% weaker than their end-2009 levels, and the Canadian dollar hit an air pocket earlier this month.  Good timing is always important but will be especially so to make long commodity-currency positions profitable during 2H10.

The chronologically middle trading season each year, lying between the U.S. Memorial and Labor Day weekends, does not lend a directional bias to the dollar, which over the last eleven years fell in that period six times apiece against the euro and yen.  Only in 2005 and 2000 did the dollar move in different directions against the euro and yen during the same summer.  Dollar changes in summer against the euro ranged from a loss of 5.7% in 2001 to a gain of 7.7% in 2008 and from a drop of 11.2% against the yen in 1999 to a rise of 5.4% against the Japanese currency in 2008.  In the summer of 2009, the dollar fell by a similar 2.1% against the euro and 2.0% versus the yen.

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



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