Midyear Reality Check of the Currencies

July 2, 2010

At the very least, the dollar is in a pause.  During the week that bridged the second and third quarters, the dollar hit its weakest levels against sterling ($1.5231) and the Swiss franc (1.0581 per USD) since early May.  The euro posted a high today of $1.2613, its best level since May 21 and 6.2% stronger than the low for the move of $1.1878 on June 7.  Having dropped 27.5% from  a low of $1.5149 around Thanksgiving in just over six months, the euro certainly warranted a period of consolidation. 

The juxtaposition of the dollar’s setback with mounting concerns about global growth, plunging stock markets everywhere, and generalized risk aversion nonetheless strikes a departure from established patterns since the financial crisis began nearly three years ago.  A number of factors could explain a shift.

For starters, it no longer seems likely that the Fed will be raising interest rates before the ECB or Bank of Japan do.  It’s going to be a long, long time before any of them make such a move — too far away to have any confidence in a view about which bank will lead.  Monetary conditions in the meantime can be influenced by the central banks in the way that liquidity-supporting measures are withdrawn.  Because the ECB can do this passively by just not fully replacing loans that mature and shortening the maturity of its refinancing tenders, it has a mechanistically less challenging task than the Fed.  This past week’s considerably smaller three-month ECB tender revealed fewer banking strains in Europe than feared, and money market rates there should continue to edge up.

The firmer euro in the last couple of weeks is not just about Europe and perceptions of future monetary policy.  Doubts about the United States economy have deepened.  Some of the angst is short term in nature and being driven by a string of weaker-than-expected U.S. indicators, including housing starts, retail sales, the trade deficit, pending home sales, existing and new home sales, construction spending, consumer confidence, weekly chain store sales, auto sales, factory orders, unemployment insurance claims, and growth in private jobs.  Until now, it had not been assumed that the United States would suffer as pronounced an economic slowdown in 2H10 and early next year as Europe.  After all, the main global economic risk factor is excessive European debt and the need for many governments there to tighten fiscal purse strings sharply despite fragile recoveries or, in some cases, continuing recessions.  But a lesson of the sub-prime mortgage meltdown and subsequent recession is that the source of a risk factor does not necessarily bear the heaviest cost.

The U.S. economy’s longer-term economic image has also taken more than a few knocks.  Ronald Reagan famously asked the American people in 1980 if they were better off than four years earlier.  A decade-long comparison provides an even better span of time for answering such a question.  In spite of low inflation and incredible changes in applied technology where U.S. companies have provided leadership, these have not been prosperous times.  Stock prices according to the DJIA, are 8.6% lower than on July 2, 2000.  Extraordinarily low returns of bank deposits and Treasury notes are further frustrating efforts to build savings.  There has been a net loss of 1.369 million jobs in an economy that created them at an average rate of 2.2% per annum over the previous fifty years.  Real GDP growth over the past decade averaged 1.8% per annum, only half as much as during the prior half century.  Large budget and current account deficit remain chronic.  The U.S. government is doing less than its European counterparts to devise a plan of deficit reduction in the long term, while the external deficit is again widening.

The Toronto summit of Group of Twenty leaders ended with the release of another disappointing statement.  No mention was made about foreign exchange policy coordination, a boiler-plate pledge until the Group of Seven was neutered.  More worrisome, no cooperation or forethought seems to have been given to choreographing the sequence of how monetary and fiscal policies are to be tightened.  Every country is on its own, and little thought seems to be given to identifying countries where  it would be better to adjust fiscal policy before tightening monetary policy and where to do the reverse. 

The U.S. healthcare and banking reforms may also be culpable in the dollar’s pause.  These huge pieces of legislation introduce yet more uncertainty into the trading landscape.  Although history may ultimately judge these initiatives as constructive, uncertainty looms now and may depress confidence in the dollar.  President Obama didn’t get a boost in the polls from healthcare, which instead gives opponents a rallying cause for the fall election campaign.  A regulatory overhaul of financial institutions could rein in a sector that accounted for a disproportionate share of U.S. growth prior to the recession. 

No major traded currency has performed better than the Swiss franc.  Having taken 4-1/2 months to strengthen from slightly weaker than 1.50 per euro to 1.40, it moved another ten centimes to 1.3074 in less than a month.  There’s a Swiss-centric reason for this appreciation.  Swiss National Bank officials concluded that their economy no longer faces a deflationary risk and indicated in public that intervention would no longer be necessary to contain upward pressure on the franc.  That pledge may have to be rescinded, at least for a while, in light of the market reaction.  Having said that, a tradition exists of the franc leading many of the biggest dollar downtrends. One of the best positions over the past three weeks would have been a long franc/short Canadian dollar, which rose marginally over 11% to return to near parity for the first time since February 10.

The one bloc that continues to do poorly even against the U.S. currency has been the commodity-sensitive currencies.  At 14:30 GMT today, the greenback had recorded gains from a week earlier of 3.2% against the Australian dollar, 2.9% versus the kiwi and 2.7% relative to the Canadian dollar.  These movements seem to corroborate that investors are scaling back their expectations of world growth.  A slowdown would stem from three primary sources that are independent of one another.  In addition to fiscal austerity being implemented in Europe, the slowdown experienced so far in the United States has exceeded what analysts had been projecting, and Chinese data indicate that austerity in that country is already achieving results.  The concern is that while each of these headwinds seems manageable, the total impact of these fairly simultaneous depressants on world growth could exceed the sum of their parts.

The recent currency movement that seems most dangerous is the strength of the yen.  It is no coincidence that Japan has suffered the sharpest equity price losses even as the yen rose near to a 15-year high.  Japan’s fiscal imbalances continue to mount, appearing unsustainable.  Prime Minister Kan could be the last best hope for a designed correction of the problem.  Meanwhile, the economy remains overly reliant on foreign demand for economic growth.  A fiscal crisis at these yen levels would be a devastating one-two punch.  A pre-emptive resumption of Japanese intervention is an ever-present possibility.

The Chinese renminbi rose more sharply against the dollar in these first two weeks of allowed appreciation than analysts expected and is on a pace to advance about 22% over the course of a full year.  Beijing still completely controls day-to-day movements.  The dollar’s decline against other major currencies means a bigger dollar/yuan advance can be accommodated for any given acceptable trade-weighted rise of China’s currency.  If the dollar were to resume rising in general, the yuan’s gains against the U.S. currency would likely diminish.

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

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