Times Are a Changing

February 4, 2011

Context is very important in foreign exchange trading.  The December U.S. jobs report released on January 7 and today’s January labor market report both surprised markets in pretty much the same way.  The unusual combination of weaker-than-needed jobs growth yet a big drop in the unemployment rate triggered a weaker dollar a month ago but promoted dollar demand today.  The euro’s 2011 low of $1.2907 occurred on January 7, after which the common currency rose 7.4% to a high of $1.3863 hit this past Wednesday.  The dollar subsequently recovered 2.4% to 1.3542 per euro.  From its January peaks, the dollar had also lost 5.4% against sterling, 3.9% versus the Swiss franc and Australian dollar, 3.5% relative to the kiwi, 3.1% against the yen, and 2.0% versus the Canadian dollar, and from lows a few days ago, the greenback has recovered at least 1% against the pound, yen, euro, Swissy, and kiwi.

Investors have had to deal with an unusually high degree of uncertainty for the past several years, and new areas of uncertainty keep arising.  A proliferation of strangely extreme weather in Europe, North America, and Australia is one of the new unknowns.  It makes little difference if this reflects global warming and has been caused by man’s use of resources.  What matters in the period immediately ahead is that bad weather is driving food prices up and depressing economic activities from construction to shopping and job hunting.  Data have become more volatile and harder to interpret, and the debate is intensifying over whether central banks should pay more attention to core inflation or less benign total inflation. 

Geopolitical event risk was in pretty deep remission a month ago but subsequently shot up to the top of the chart of uncertainties.   With global growth possibilities now at their best in nearly five years but still looking very polarized between advanced nations and emerging markets, capital had been drawn increasingly in the the latter category where real investment and financial market returns look brightest.  What’s happening now in Egypt may give pause to the the rush to park money in emerging overseas markets.  Since 2007, the dollar has often benefited from spikes in risk aversion even in response to weak U.S. data.

One of the factors behind the softer dollar/stronger euro much of last month was rising optimism that European leaders will find a way to protect the euro at all costs and to do so in a way that endows the monetary union with a greater degree of economic union including fiscal policy.  It takes a leap of faith to think that way, and it is based on the view that Europeans will act rationally in the end and that any imaginable compromise will prove less painful than abandoning the common currency altogether.  History has often not supported this conclusion, Argentina’s currency board system being a recent example.  However, a day of reckoning does not seem at hand, that is less than a year away, when the logic of an enduring euro being better than the alternatives might be tested to the breaking point.

The uncertainties associated with escalating and spreading geopolitical unrest and sovereign debt risk should not be rigidly compartmentalized.  The events in Africa have involved autocracies in emerging market economies.  But those characteristics do not define the limits of candidates for copy-cat crises.   The stabilizing advantages shared by democracies is a stress on the rule of law rather than rule of people and mechanisms that allow residents to change officials and policies when existing ones aren’t working.  In democracies, change happen by fair elections with real choices, not from the mobs of revolution.  This process allows maneuvering room for a nation’s people to find what does work and to vent frustration in peaceful ways.  However, the issues of massive unemployment and dire long-term fiscal possibilities in Europe, Japan and the United States and the elusive process of fixing such problems could test the immunity of democratic governments from spontaneous internal combustion. 

Relentless uncertainty shortens the focal depth of field for currency market participants, making long-term probabilities even more inscrutable because the activities done for short-term effect influence variables that shape the long term.  It’s not enough to infer when the ECB or Fed might raise interest rates and which institution moves first.  The path from point A at the start of 2011 to point B a year from now will be overwhelmed by things we now realize that we cannot know and other stuff that hasn’t even been imagined.  These weekly currency market essays were begun initially because Friday is the one time each week when the 24-hour trading clock of foreign exchange pauses for a commercial break and because the information flow contained in a single week seemed sufficient to warrant a review to see if longer-term pre-conceptions still look appropriate.  As uncertainty has climbed, this exercise has become more challenging and perhaps less useful for the purpose it was intended.

That being said, one can still glean insights by stepping back from the forest of trees.  The table below tracks the trend in a few dollar relationships, oil prices, ten-year treasury yields and their differentials to German bunds and Japanese JGBs.  Instead of plotting the hourly, daily, weekly, or even monthly twists and turns, the table simply presents calendar year averages for 2007, 2008, 2009 and 2010.  Current levels are also shown.  The dollar and sterling, the reigning and previous champions of reserve asset portfolios, have weakened against the yen, Swiss franc  and — to a lesser degree — the euro, which before the sovereign debt crisis had been depicted as the dollar’s main reserve asset rival in the future.  One lesson is that reserve asset properties do not promote currency strength.  A second message of the table is this:  having been eroded during the financial crisis, U.S. long-term interest rate differentials versus Germany and Japan are similar to their 2007 averages.  Finally, oil has bounced around from one year to the next, but it has settled at a much higher plateau than levels prior to 2003.  Calendar year averages between 1987 and 2002 of West Texas Intermediate ranged from a low of $14.49 in 1996 to 30.11 in 2000 and averaged $20.87 over all sixteen of those years.  2003, the year when America’s combat forces shipped off to Iraq, became a line of demarcation for oil prices as well as in the war on terrorism.

Averages 2007 2008 2009 2010 Now
EUR/USD 1.3716 1.4707 1.3942 1.3258 1.3573
USD/JPY 117.79 103.32 93.61 87.67 82.35
USD/CHF 1.2002 1.0828 1.0861 1.0428 0.9573
GBP/USD 2.0018 1.8521 1.5659 1.5448 1.6081
10-Yr 4.63% 3.65% 3.24% 3.19% 3.65%
– Bunds 40 bp -36 bp -3 bp 42 bp 38 BP
– JGBs 255 bp 251 bp 193 bp 160 bp 236 BP
Oil $72.44 $99.86 $61.98 $82.38 $89.07

We live in an era of perpetual, almost frenetic change affecting many areas.  Markets are assigned the role of dealing with ever-present uncertainty associated with a world in rapid invention and reinvention and weighing the probability of different possibilities.  The result of this process often looks chaotic and random when standing in the forest.  The above table covering the years since the onset of the financial crisis suggests that much of the movement from week to week is indeed noise but that the long and winding road has a real destination in certain instances.

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


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