Currency Market Expectations Remain Fluid

January 14, 2011

After the first half of January, a time usually when currency views solidify, attitudes about how the dollar and other key currencies will perform in 2011 remain a work in progress and not backed by strong conviction or widespread consensus.

Last year was not an especially good one for the U.S. currency considering the euro debt crisis that festered all year.  True, the dollar ended December 7.0% stronger against the euro than where it started, while also rising 3.6% against the pound.  However, the greenback also posted losses of 12.2% against the Australian dollar, 11.9% against the yen, 9.8% versus the Swiss franc, 6.7% relative to the kiwi, 4.8% against the Canadian dollar and 3.5% versus the yuan.

Quantitative easing buoys equities but also by design depresses the dollar in the short- to medium term.  Even though long-term interest rates climbed unexpectedly over the twenty weeks since Chairman Bernanke broke the news that a second wave of quantitative easing was coming, the U.S. currency lost ground against all the above currencies, even 4.4% versus the euro and 2.2% against sterling.  In this period of nearly a half-year, the U.S. deflationary risk has diminished substantially, and it’s becoming quite clear that quantitative easing will not be extended beyond June when the second round is to be completed.  It may even be terminated sooner.  QE2 also helped lift inflation elsewhere.  Comparisons of present on-year CPI inflation to the level a year earlier show rises from 0.9% to 2.2% in the euro area, minus 1.9% to +0.1% in Japan, 0.6% to 5.1% in China, 1.9% to 3.3% in Great Britain, 2.8% to 7.0% in Indonesia, minus 0.7% to 1.8% in Sweden, 0.5% to 2.9% in Hong Kong, and minus 2.3% to 3.0% in Chile.

The expression “currency wars” became a part of the foreign exchange lexicon in 2010.  Governments and central bankers took action to limit upward exchange rate pressure, which was sapping growth prospects while offering scant collateral benefit because inflation wasn’t yet a concern.  The authorities in a number of emerging markets imposed controls to deter the inflow of yield-seeking capital.  Many central banks engaged in intervention.  Others have threatened to do so.  These deterrents remain in place and are intensifying in some places, but 2011 is shaping up as a different kind of year than 2010.  Because of the return of inflationary pressure, strengthening currencies may serve a constructive purpose, and central banks have less maneuvering room to forestall raising interest rates.  British inflation appears headed for 4%, twice its target, and euro area inflation surpassed its target in December for the first time in slightly more than two years.  ECB President Trichet addressed this shift, escalating that central bank’s level of vigilance against any breach of actual or expected price stability:

We see evidence of short-term upward pressure on overall inflation …that has not so far affected our assessment that price developments will remain in line with price stability over the policy-relevant horizon.  At the same time, very close monitoring is warranted.

The need for accelerating appreciation of the Chinese yuan keeps rising.  The goals of keeping yuan appreciation very gradual and reducing inflation are increasingly incompatible.  The use of administrative guidance and numerous increases of bank reserve requirements as a substitute for more forceful interest rate increases has not contained inflation or capital inflows.  Chinese reserves shot up an incredible $200 billion last quarter and, at $2.85 trillion, represent over $2000 per person in the planet’s most populated country.  Chinese bank lending again exceeded target last year, and so did M2 money growth, which rose 19.7%. 

Relative to monetary officials elsewhere, those at the Fed can more easily afford to keep credit policy extremely loose.  Reduced urgency to tighten stems in part from the Fed’s focus on core inflation rather than all prices as other central banks do.  It is to be expected that quantitative easing would impact commodity prices more quickly than other costs in the mainstream like wages, which are depressed by continuing high unemployment.  Core U.S. consumer prices in December were only 0.8% higher than a year earlier, and total CPI inflation of 1.5% was more benign than the level in many other regions.

The dollar defied a seasonal tendency to advance against continental Europe’s dominant currency in the first half of January.  Often, the U.S. currency falters in the final two weeks of December and recoups ground in early January.  The greenback fell 1.2% against the euro last month between mid-December and end-month but is currently unchanged so far this year.  Over 33 years from 1977 to 2009, the dollar rose in the first half of January 24 times and fell 9 times, with an average advance of 1.2% over all those years.  One has to wonder if the lack of a dollar rise in early 2011 might be foreshadowing further struggles.

And yet there are compelling reasons to like the dollar’s prospects this year.  Euroland’s status quo is untenable.  A big disruption seems to be a question of when, not if.  Peripheral bond spreads are punishingly wide even after welcome improvement between Monday and Thursday of this week.  Economic union, that is virtual fiscal unity and other structural convergences, aren’t complementing monetary union.  The peripheral economies can look forward to years of very harsh conditions, without relief unless a much greater degree of economic union is imposed and fast.  Their sacrifices will be much larger than what Germany endured in 2001-2005, and that dim future seems to be a recipe for blood in the streets and collapse of confidence in the euro. 

Investors already believe the experiment of a common European currency was a bad idea.  It didn’t reduce tensions between member governments.  It seems to have endured this long only because it was designed in a way that made defections extremely costly.  Currency market participants have already taken out insurance against worst-case scenarios.  One sees that mostly in bond spreads, but other evidence lies in the EUR/USD relationship.  Sequential euro highs were made at $1.6038 in 2008, $1.3064 in 2009 and $1.1878 in 2010.  The euro remains stronger than its lifetime mean value nevertheless, so a fourth consecutive higher calendar year peak in the dollar seems plausible during 2011.  But what about dollar/yen?

The dollar’s resistance to falling below its all-time low of JPY 79.85 have been very impressive.  Real GDP in Japan, like that in the euro area, is expected to expand only about half as fast this year as U.S. GDP, but that disparity is explained in significant part by population growth differences and will be much smaller on a per capita basis.  The dollar fell below 90 yen more than six months ago, averaging 86.5 in July, 85.4 in August, 84.5 in September, 81.8 in October, 82.5 in November, 83.3 in December and 82.9 so far this month.  Having come within half a yen of the 1995 low in the first week of November, the dollar seems to be holding its own, and investors see evidence that yen strength is hurting Japan’s export engine.  The Japanese government seems prepared to pop the markets with massive intervention again as they did in mid-September.

Last year, the Australian dollar appreciated 2.5 times faster against the U.S. currency as did the Canadian dollar.  Many think tanks, especially some analysts at Goldman Sachs, believe 2011 will be a year of payback in which the Canadian dollar outperforms the Aussie currency by a sizable margin.  Australia’s economy has been been slowed by seven interest rate increases thus far, actually and prospective further Chinese policy restraint, and the floods in the Northeast part of the country.  Canada, on the other hand, is positioned to piggy-back on a strengthening U.S. economy given the very close commercial and financial ties between the two neighboring economies. 

Swiss officials no doubt hope that a similar flip-flop occurs in the relative strengths of the franc and sterling.  A top Swiss National Bank official this week warned that franc strength may damage Switzerland’s economic growth.  But the central bank is in no position to resume intervention.  But with U.K. inflation well above target and amid signs of rising expected inflation there, the Bank of England seems likely to raise interest rates sooner than its Swiss counterpart.

Copyright Larry Greenberg 2011.  All rights reserved.  No secondary distribution without express permission.

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