Dollar Winning the Currency Wars

October 8, 2010

A strong correlation exists between currency expectations and recent forex movements.  Market players like to run in herds.  The dollar at 15:15 GMT today had recorded across-the-board losses for the first week of October.  Declines over the past four weeks had built up to 8.8% against the euro, 5.9% relative to the Australian dollar, 5.7% versus the Swiss franc, 3.6% against the pound, 3.4% relative to the kiwi, 2.8% vis-a-vis the yen, 2.0% against the Canadian dollar, and even 2.0% relative to the Chinese yuan.  One can think of many explanations for the dollar’s weakness, and most of the depressants remain in place.  The bet on a dollar rebound doesn’t rely on economic fundamentals but rather would need the help of market technicals or coordinated government manipulation.

The Federal Reserve appears poised to initiate a second round of quantitative easing.  U.S. monetary officials make the argument that new stimulus would be appropriate unless the U.S. economy improves.  It hasn’t and in certain key respects like the labor market has suffered a setback.  In size, Fed stimulus is expected to surpass what the Bank of Japan offered this past week.  The ECB has, in contrast, put a more upbeat spin on economic prospects and is taking steps to shrink, not expand, its balance sheet.

The dollar has lacked its traditional interest rate support for some time, and the new circumstances are likely to persist.  The yen carry trade, which kept the Japanese currency undervalued for years prior to the world financial crisis, was predicated on very low interest rates in Japan but not elsewhere.  Investors borrowed comparatively cheap yen and parked the money in higher-yielding other denominations including the dollar.  The table below expresses in basis points the calendar year average differentials for three-month libor deposits and 10-year sovereign bond yields since 2006.  Year-to-October 7 are used for 2010 comparisons.

Spreads, Bps 2006 2007 2008 2009 2010 10/08/10
  U.S.-Ezone 212 102 -171 -51 -33 -61
  U.S.-Japan 490 450 199 21 12 9
  U.S.-Germany 103 40 -36 -3 48 8
  U.S.-Japan 240 255 251 193 159 147


An inverse relationship between stocks and the dollar persists.  Most economies, including the United States, have avoided a second distinct recession and a return to severe financial market dysfunctionality.  Both changes encourage investors to make risk-on trades even though the speed of growth among advanced economies is constrained by ongoing balance sheet adjustments.  Labor markets still exhibit recessionary properties, but governments have turned to fiscal restraint rather than stimulus.  Households face a daunting challenge rebuilding their retirement nest eggs.  Cash and fixed income assets do not offer a means toward that goal.  Financial returns are too low.  By process of elimination and the fact that corporate profits are outperforming revenues, stocks have performed quite well over the past six weeks.  As we’ve seen in recent years, the dollar thrives on risk aversion and flounders when investors take on riskier assets.

The unpopularity of the Obama Adminstration is another dollar depressant.  To be sure, voters in other advanced economies also dislike their political leaders, but the mood of U.S. voters dwarfs political developments elsewhere as a factor influencing the dollar.  The U.S. currency has weakened 7.0% against the euro and 9.5% against the yen on balance since President Obama was sworn in.  The greenback fell over 20% against both the common European and Japanese currencies during the eight-year stewardship of Obama’s immediate predecessor, who also became very unpopular.  Four-year presidential administrations by definition were distained.  The Obama presidency has a four-year sheen at this point still shy of two years.  Against the mark, the dollar dropped 13.2% during the first Bush presidency and 16.6% when Jimmy Carter was President.  Both administrations lasted only four years.

Recent market chatter is full of speculation that the Obama Administration wants a weaker dollar.  The term for such predispositions is benign dollar neglect.  The accusation of benign neglect was made against the Carter Administration in 1977-78 and Bill Clinton’s people because of the way they talked about dollar/yen during 1993-94.  Dollar depreciation is a way to promote export-led growth when interest rates cannot be cut, and fiscal reflation is not the will of the land.  When deflation is a more pressing risk factor than accelerating inflation, a weakening dollar helps by lifting import prices.

The dollar has been victimized too by reserve asset diversification.  China and other Asian central banks that buy dollars in intervention to influence theirtparities relative to the U.S. currency have reportedly been exchanging part of those dollars into other currencies.  Beijing has reportedly acceded to Tokyo’s request that it curb its voracious buying of Japanese government bonds, but many other countries are practicing the same kind of yen-boosting behavior. 

Diversification is a sensible practice simply from the standpoint of the dollar’s long-term history.  Since the late 1960s, the dollar has dropped from 4.00 per mark to an implicit value of 1.40, and the yen has soared from 360 per dollar to 82.  Slumps in the dollar recur again and again in a pattern that tempts reserve asset managers to ensure that portfolios are diversified into other denominations.

The dollar’s losses in this latest episode do not look overdone.  As noted, they amount to less than 10% relative to the euro and yen since Obama took office.  When officials have come together to reinvent the world monetary system such as the Bretton Woods agreement of 1944, the scrapping of fixed dollar parities in March 1973 or the Plaza Accord of 1985, a greater consensus existed for change than seems apparent now.  Among advanced countries, French President Sarkozy and Japanese Prime Minister Kan have taken the main initiative in urging concerted action lately, which is ironic because France and Japan were the two countries where politicians most resisted the abandonment of fixed exchange rates nearly 40 years ago.  Leaders in many developing nations also want change, but a new currency order without the full cooperation of the United States and China is going to be very difficult to engineer.  Investors would be wise not to count on a sea change from either of those governments, let alone both of them. 

While I do not anticipate dramatic concerted action by political leaders to control currency market movements better, I do agree that volatility has been excessive to the detriment of GDP growth in many countries as well as the health of the world economy since 2007.  I submit the examples of three commodity-sensitive currencies to illustrate my point.  When the financial crisis began in August 2007, the Australian, New Zealand and Canadian dollars were trading at USD 0.8636, USD 0.7665 and 1.0482 per USD, respectively.  At first, all three currency units were bid higher, climbing 14.0% to USD 0.9849 by July 2008 in the Aussie instance, 7.1% to 0.8213 in February 2008 in the kiwi’s case, and 15.7% to CAD 0.9061 in November 2007 for the C-dollar.  When risk aversion then sky-rocketed,  the U.S. dollar soared by 63.8%, 67.7%, and 44.2% against these respective commodity-sensitive currencies.  The Aussie dollar bottomed in October 2008 at 0.6014.  The kiwi hit bottom at 0.4896 in March 2009, the same month that the Canadian dollar stabilized at a floor of CAD 1.3064.  That was hardly the end of the story, however  This past week’s highs in those currencies of USD 0.9919 for the A-dollar, USD 0.7594 for the kiwi, and 1.0063/USD for Canada’s currency represent respective appreciations from their lows of 64.9%, 55.1%, and 29.8%.  Those swings represent an incredible amount of noise to produce net movement since the onset of the financial crisis of +14.9%, minus 0.9%, and +4.2% in the Australian, New Zealand and Canadian dollars.  Such instability no doubt takes quite a toll on numerous aspects of all the economies, especially business planning and confidence.

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

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