Currency Crystal Ball Gazing: December 2010

December 17, 2010

The tempting prediction for next year is that the dollar will appreciate against the euro, especially since it remains roughly 10% weaker than its life-time average value of 1.1891 per EUR.  The timing and end of the euro’s identity crisis remain unclear.  Against the yen, the dollar touched sequentially lower calendar year highs and lows in 2008, 2009, and 2010 but has so far stubbornly resisted sinking below its all-time trough of 79.85 in 1995.  That’s impressive, and  I suspect the dollar may perform better against Japan’s currency in 2011 than it has since 2007.  I also like the Swiss franc, Chinese yuan, Canadian dollar, and even sterling in 2011 but warn that year-out forecasts, which are given out with great frequency each December, need to be taken with a grain of salt.

Economic forecasting can be humbling even for the best-endowed think tanks.  One has to anticipate shocks and other unknowns and then correctly infer how governments and markets might react.  The financial crisis was sparked by a U.S. national housing market collapse that began innocuously enough in the first half of 2006.  The Federal Reserve first mentioned a gradual cooling of the housing market in the FOMC’s May 2006 statement.  The qualifying adjective gradual was dropped four months later and replaced with the word substantial in December of that year.  As late as the statement of August 7, the day before the onset of the money market crisis and just four months before the United States would slip into recession, Fed officials were projecting continuing moderate economic expansion over coming quarters and identifying their primary policy concern as the “risk that inflation will fail to moderate as expected.”  Three years have now passed since December 2007, half of which has been on the other side of the recessionary tunnel.  A housing correction regrettably persists, and unemployment is painfully elevated at 9.8%.  All that, and the U.S. economic prognosis is considered brighter than many.

A starting point for forecasting what currencies might do in 2011 is to get ones hands around what happened in 2010.  Several key themes to emerge this past year have storylines which seem incomplete, such as

  • Whether the declining housing market finally bottoms.
  • If labor markets improve at a more acceptable pace.
  • Whether and how Euroland leaders fashion a way to manage the needed debt restructuring of several members that keeps the euro intact and ultimately reduces their cost of finance.
  • Who gets appointed to serve the next eight-year term as ECB president and what that choice will say about the common currency union’s longevity.
  • Whether Europe’s crisis simply festers for another year, combusts into a global mega-crisis, or is resolved locally.
  • How much longer investors hold the U.S. Treasury market to a weaker standard than European markets.
  • Whether the recent rise of bond yields even in the United States and Europe represents normalization associated with strengthening global growth, which is a good thing, or a premature trend that will extend to levels that weigh unduly on economic growth in 2011. 
  • How China interfaces with the rest of the world as an economic and foreign policy competitor and the holder of enormous financial assets that need to be invested some place to achieve growth, income, and safety. 
  • How long markets tolerate the lack of a medium-term legislated framework for reducing the U.S. deficit, and how well other economies are able handle fiscal austerity.
  • Whether inflationary or deflationary concerns that surfaced in 2010 prove better grounded.
  • Whether currency warfare escalates or fades.  Alternatively, are other forms of trade protectionism kept in check?
  • The extremes that emerging market governments will go to dissuade inflows of hot capital.
  • Whether U.S. Republicans and members of the tea party prove as capable at policy governance as they’ve been in the role of political opposition.
  • Where Japan fits into the new world economic order that seems focused on emerging markets, the United States, and Europe.
  • Whether the upward trend in commodities continues.  Does oil crack $100?  What about $1600 for gold?
  • Whether acts of terrorism escalate, diminish or stay on a plateau.  Do Middle Eastern politics remain as toxic as ever?
  • Whether cyberspace continues to be exploited as the new frontier for geopolitical warfare.
  • Whether the Fed, ECB, BOJ and Bank of England finally begin raising interest rates as many other central banks have been doing.

It would be nice to stare into a crystal ball and learn how different economies will perform relative to present expectations, but that will not necessarily provide useful currency clues.  According to one gauge of consensus growth expectations, the monthly survey published in The Economist, forecasters in December 2009 were anticipating U.S. GDP growth in 2010 of 2.7%, and one year later have a similar 2.8% growth expectation about the year that was. Assumed growth for Euroland, by comparison, has been revised upward by a half percentage point to 1.7% including a doubling in Germany’s case from 1.6% projected a year ago to 3.4% assumed now.  In spite of the different magnitude of these revisions, the dollar is 9.3% stronger now against the euro than a year ago.  Dollar/yen, on the other hand is 6.5% weaker than a year ago, which seems intuitively sensible in light of the revision in views about Japanese 2010 growth, which a year ago was projected at 1.5% but is now assumed likely to be 3.2%.  Sweden also performed considerably better in 2010 than expected initially, and the pleasant surprise of an upward revision to 4.6% from 1.9% assumed a year ago is reflected in the krona, which is more than 6% stronger against the dollar than at this time last year.

The more currencies one examines, the more 2010 emerges as a year of euro weakness than one of dollar strength.  Against its year-earlier value, the U.S. currency also rose against sterling (4.3%) but shows losses of 7.3% against the Swiss franc, 10% against the Australian dollar, 5.7% against the Canadian dollar, 3.3% versus the kiwi and 2.6% relative to China’s yuan.  The dollar depreciated relative to many other emerging market currencies like the Korean won, Brazilian real, Thai baht, and Indian ruppe.  Most governments are reining in fiscal policy.  Washington is swimming against this tide, which points to a growth advantage in 2011.  However, America’s edge stems from just the kind of irresponsible government behavior for which Euroland’s peripherals are being punished, so the medium-term impact on the dollar is ambiguous.

A safer bet on 2011 concerns currency volatility rather than direction.  An unstable financial and economic landscape has promoted wider currency swings.  The financial crisis began in August 2007, a year that saw high-low spreads of 14.1% in EUR/USD, 15.8% in USD/JPY, and 13.3% in EUR/JPY.  Those three major currency relationships traded during 2008 in ranges that were respectively 30.1%, 27.0% and 49.6% in width.  Their width in 2009 was 21.6%, 19.6%, and 24.2%, and the band widths so far this year have been 22.8%, 18.4%, and 27.4%.

For now, markets are in the yearend lull.  While the forecasting industry delves into longer horizons, it actually is not a bad time to focus on a short time frame.  One of the strongest seasonal patterns in the dollar happens in this period, a drop in the second half of December followed by a tendency to appreciate in the first half of January.  The December part of this phenomenon is examined in an article I posted this past Monday.

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

Tags: , ,


Comments are closed.