The Euro, Oil and March

March 4, 2011

Investors learned several important facts this past week. 

It’s going to take more than Middle Eastern unrest, a healthier U.S. labor market and rising Treasury yields to forge a stronger dollar.  The U.S. currency isn’t depreciating across the board, but my two favorite barometers of dollar sentiment, EUR/USD and gold, touched 1.4000 for the first time since November and exceeded $1440 for the first time ever.

The dollar has historically benefited from most event surprises that put a greater premium on getting a return of one’s investment than a return on investment.  However, geopolitical risk that also lifts oil prices, is a distinct case that warrants different conclusions.  Revolutions in North Africa and the Middle East caught everyone by surprise but have intensified upward pressure on oil prices, which have climbed above $100.  The last spike of oil prices into triple digits crested at $147.91 per barrel on July 14, 2008, and EUR/USD peaked a day later at a record high of $1.6038.  That juxtaposition of turning points doesn’t appear to be mere coincidence.

The rise of ten-year Treasury yields hasn’t led to a wider premium vis-a-vis German bunds.  The former are 80 basis points above levels six months ago, while the latter have climbed by 93 basis points.  Strengthening economic activity and the prospect of an end to quantitative easing have produced rising long-term interest rates and the whiff of inflation.

Knowledgeable economists can honestly disagree over how worried to be about future inflation.  Food and energy price pressures have been exacerbated from both the supply and demand side.  The spike in overall commodity prices is already pretty impressive, and monetary policy stances in the advanced economies remain quite stimulative.  However, this is also an age of massive deleveraging, a process that will suppress money and credit growth for considerable time longer.  High rates of unemployment are meanwhile suppressing wage inflation.  Real estate prices are still falling.  The spread of commodity price inflation to the broader pool of all goods and services will not happen easily or quickly.

Even if the danger of future inflation is exaggerated by some, currency holders would rather see policymakers take out insurance to prevent second-order price and cost mark-ups from a commodity price spark.  ECB President Trichet suggested that the bank’s Governing Council is very close to raising its interest rate next month, if for no other reason than to stop an easing of real interest rates that would otherwise occur with steady nominal interest rates but a temporary rise of inflation.  In contrast, Fed Chairman Bernanke implied that credit policy in the United States would be tightened if and when evidence of rising inflation is detected.  The 3.3% annualized rise of total U.S. consumer prices in the seven months from mid-2010 to January apparently doesn’t count because core inflation of 1.0% remains too low. 

Interbank and currency market day traders noticed the contrasting central bank reactions, and so probably did managers of large sovereign reserve asset portfolios.  Amidst uncertainty regarding future inflation, it would make sense if all central banks seemed evenly predisposed to avoiding a rate increase to give a greater benefit of the doubt to those monetary authorities with the best long-term track record of delivering low inflation.  These would be the ECB, Bank of Japan, and Swiss National Bank rather than the Fed and Bank of England.  It would have worked to the euro’s disadvantage if the ECB were girding for a rate increase clearly before sustainable economic recovery seemed secure, but that isn’t the case.  Activity and demand trends look sound on both sides of the Atlantic, and Japan also seems to be emerging from a setback in the latter months of 2010.

A further evolution has occurred in how fiscal policies are viewed.  European officials have been grappling clumsily with their sovereign debt problems, and markets since November 2009 have shown a lack of confidence in various policy solutions.  The Greek, Irish, Portuguese, and Spanish bond yield premiums are unsustainable, and the first two of such have worsened significantly during the past month.  But this saga is an old story now and, until something changes dramatically, priced into currency relationships.  Meanwhile, concern about the U.S. budget deficit and the long-term threat of such is not a theme that was vented in 2010 as much as Europe’s fiscal situation.  The United States has more to lose than Euroland from fiscal failure: a superpower military status, the current standard of living, and all the benefits of having the world’s main reserve currency.

Some pundits warn about this time each year to watch out for an appreciating yen on the strength of repatriated capital ahead of Japan’s fiscal yearend on March 31st.  These pronouncements are not supported by the yen’s historical performance during the month of March.  At best, March is a marginally supportive month for the yen, and the performance in April, when some of the yearend accounting-inspired flows presumably reverse direction, has been a better one.  Over 21 years from and including 1980 through 2000, the yen rose 11 times and posted an average rise of 0.5% between end-February and end-March.  During the ensuing nine years to 2009, the split in USD/JPY was five to four of years when the yen rose versus fell, and the average yen movement for March in those years was a minuscule uptick of 0.3%.  In March 2010, the dollar and euro respectively appreciated by 5.2% and 4.3% against the yen.

Because of monetary policy implications of the New Zealand earthquake on February 22, the kiwi was last week’s softest currency among the major relationships followed regularly by this weekly column.  In a world where interest rate cutting is in the rear-view mirror just about everywhere else, speculation picked up this week that the Reserve Bank of New Zealand may cut its 3.0% Cash Rate soon.  Such had been sliced from 8.25% to 2.5% between September 2008 and April 2009 and then raised by 25 basis points each in June and July of 2010.  Expectations had been reasonably strong at the start of the current year that more moderate tightenings would occur in 2011.  That possibility ended with the earthquake, and now just the opposite action seems plausible and appropriate.  In 2010, the kiwi fluctuated between a low of USD 0.6563 in May and a high of USD 0.7979 in early November.  From a high this year of USD 0.7830 about a month ago, it is now down a nickel or 5.8% and set a 19-year low this past week against the Australian currency.

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


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