It’s Complicated

December 3, 2010

Currency market dynamics have become more complicated and less predictable turning into the homestretch of 2010.  Discerning trend in December will not become any easier because December is a quirky month.  The closing of 2010 books elevates the importance of accounting considerations relative to decisions based on investment, trade, and speculation.  Trading volume thins around the holidays, and the end of December sees a lot of big-picture thinking about possible major issues and trends in the following calendar year.  A tendency has been observed in the past for the dollar to soften in the second half of the second half of December but to re-strengthen in early January, although this seasonal pattern is not a fool-proof guide.

Politically driven currency trading can be some of the hardest forex markets to predict.  Euroland’s debt problems, for one example, are more political than economic, namely a failure to integrate fiscal policy or to abide by enforceable budget constraints.  Fiscal coordination must be secured if a currency union is to benefit its members in the long run.  The framers of European Economic and Monetary Union did a poor job on this score but an excellent job of creating a pact that would be extremely painful for everybody and any nation trying to leave the group.  Many members would be better off if they had never joined, but that is no longer an available option.  The choice now is between the economic pain of staying and the political and economic pain of leaving.  A fairly  infinite number of conceivable compromises exist to resolve the crisis, and no solution exists that will minimize the costs borne by each and every member.  The gaming considerations governing every stakeholder in the effort to defuse Europe’s debt crisis are constantly shifting.  Investors want to see a fast, comprehensive, and credible resolution, but acting with dispatch rarely rewards negotiators.  No leader wants to commit early.  By holding back, however, Europe’s dysfunctional leadership has fashioned a crisis that increasingly resembles the U.S. banking crisis of 2007-8, when policy response after policy response secured only temporary relief, and the length of the respites shortened progressively as investors became increasingly distrustful of the entire process.  ECB President Trichet’s ironic observations that America’s bond markets are better behaved than Europe’s despite a significantly larger deficit/GDP ratio and bigger planned fiscal cuts in Europe underscore the political rather than economic core of Europe’s problem.

Analogously, it has taken until the final month of the final year of the Bush tax cuts for the U.S. Congress to address what will be a huge increase in taxes if no extension is passed.  This matter is essentially political.  Predicting economic data is more art than science as today’s U.S. labor force survey demonstrated, but at least the timing of the news is known in advance with certainty, and forecasting methods follow consistent and statistically rigorous standards.  In political markets, the timing and content of market-moving information is a crap shoot. 

Geopolitical event risk looms more heavily in the background.  President Obama’s domestic political difficulties will continue to encourage America’s enemies to test Washington.  If the war on terrorism ended now, Al Qaeda would be declared the winner notwithstanding the inability to deliver a follow-up blow worthy of the 9-11 attacks.  Creating death and property destruction is only a means to the goal of weakening the U.S. economy and thereby its performance as the defender of western capitalism and democracy.  America’s reason for fighting back is not to disable each and every terrorist on the planet but to preserve a free society for Americans, their advanced standard of living, and the opportunity to pursue economic reward and other means for greater happiness.  A comparison of the growth of U.S. employment and GDP in the second half of the 20th century with the much weaker trends since Y2K provides all the information one needs to know about who’s winning the war on terrorism. 

Neither the dollar, euro, nor yen offer real intrinsic attraction.  Japan is the ghost of Christmas past, a morality play on the fate that may befall the United States if it fails to fix its imbalances and adapt to the more competitive and faster-moving global environment.  Japan next week is expected to revise 3Q GDP growth upward from the brisk 3.9% annualized figure reported last month, but Japan’s story is told through the central bank interest rate that hasn’t exceeded 0.5% since September 1995 and real GDP growth of 0.9% per annum over the twenty years between 3Q90 and 3Q10.  The bungling of Euroland’s debt crisis for the past thirteen months will leave enduring scars.  Even with weaker trend growth than the United States, the euro was decently positioned to appreciate in the long time as big reserve asset holders try to diversify their portfolios. So long as a chance of the euro splitting apart exists, the euro will not be perceived as the potential challenger of the dollar in those portfolios in quite the same way that it was from 2002 until 2009

The dollar remains the straw that stirs the global international monetary system.  It’s dominance has been overwhelming since the end of the the Second World War even after the system changed fundamentally and unilaterally by U.S. degree in 1971.  Talk will continue about a second Bretton Woods summit, but the leap from talk to action seems far away.  That said, the dollar has demonstrated that it can be the kingpin of the monetary system yet still trend lower over the long run against other freely convertible currencies.  The first condition does not preclude the second.  The two prominent weaknesses in the U.S. economy — a reeling housing market and soaring unemployment — remain far from fixed, and that’s very troubling. 

Safer bets can be made on commodity-sensitive and emerging market currencies.  The two groups are related.  World growth figures to eclipse the growth of the advanced economies again in 2011 and beyond. World growth is what drives commodity prices and, in turn, currencies like the Canadian dollar, Australian dollar and kiwi that march to a commodity beat.  The dollar’s losses since end-2009 range only from 4% to 9% against those three units, hardly enough to constitute an overdone move.  While the governments of several emerging economies are imposing capital controls and other barriers to limit upward pressure on their currencies, those efforts are unlikely to halt appreciation entirely.  Given the great difficulty for savers in advanced economies where interest rates are extremely low, incentives are likely to climb for diversifying into emerging markets in spite of associated risks. 

To conclude, here’s a final note regarding key advanced forex relationships.  After hitting an air pocket late this week, the dollar is near the mid-points of its November high-low ranges such as JPY 82.23, CHF 0.9801, and 1.5893 per GBP.  It is more distant from the November mean of $1.3625 per euro, but the November mid-point in EUR/JPY of 111.68 is also reasonably close to where things stand today.  That neutral signal and the high level of unpredictable short-term political parameters suggest that two-sided risk among the major currency relationships will prevail in choppy trading during the next few weeks.

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


One Response to “It’s Complicated”

  1. Jimbo says:

    Excellent article. You are one of the few folks who I read who understands international currency. Are you going to do both a year in review and a prediction of possible things to come in 2011?