Yen Intervention Just One of Several Currency Market Themes

March 18, 2011

Using many arguments, analysts like to downplay the usefulness and effectiveness of currency market intervention whenever that policy tool is employed. They say central banks lack the firepower to move a market with daily volume that exceeds $4 trillion, that intervention gives speculators an opportunity to book profits, and that only intervention that is done by many central banks together and allowed to affect money growth has any chance of working.  Most intervention is done unilaterally and sterilized by other offsetting money market operations.

Over thirty-five years as a currency market observer have convinced me that intervention is for the most part a more effective tool than appreciated, but today’s coordinated sale of yen is probably not going to be one of the effective instances.  For openers, this operation appears to be a one-time event, not the start of days or weeks of joint intervention.  The last time the Group of Seven intervened together was also a one-day operation done to support the beleaguered euro on September 22, 2000, which like today fell on a Friday.  The 10+ year interval since then underscores the reluctance of officials to intervene in tandem, and today’s statement from the G7 explicitly mentions today’s date only just as the statement in September 2000 also referred to intervention on a single day.  That statement said the initiative was taken at the request of the ECB, and today’s statement said today’s operation was undertaken “at the request of Japanese authorities.”  Such gratuitous information suggests some lack of shared purpose.  The euro was trading at $0.8581 on September 22, 2000 and depreciated further over the ensuing month to an all-time low of USD 0.8228 on October 26.  By the end of 2000, the euro had rebounded to $0.9306, but at the end of January 2002 — sixteen months after the joint intervention — it was trading at $0.8580, unchanged on balance from the level at the time of the joint intervention.

It seems that the intent of today’s yen intervention is to stop yen appreciation, not to reverse Japan’s currency’s gains from period averages of 83.99 in the second half of 2010, 91.46 in 1H10, or 103.32 in full-2008.  At least that’s how market chatter is interpreting the initiative.  History suggests that is not the best message to send if officials really want intervention to succeed.  Last year’s intervention by the Swiss National Bank was framed as a “line in the sand” operation also, and it failed ultimately.  Interventions that take the premise that the status quo is unacceptable and out of line with fundamentals, like that which accompanied the “strong dollar” doctrine in 1995,tend to work better by creating prospects for a continuing reversal of a currency’s direction.

The effort to stabilize the yen by Japanese officials is one of several developments vying for market dominance.  Other influences are upwardly-pressured oil prices, the likelihood of a number of interest rate hike by the ECB, the Fed’s greater reluctance to do the same, Europe’s sovereign debt struggles, a series of natural disasters, Chinese official steps to cool down domestic demand, and geopolitical turbulence in the Middle East.  The strain on oil prices should persist.  Many countries are reviewing nuclear power programs, increasing their potential dependency on fossil fuel energy sources.  Revolutions in the Middle East are curbing sources of production.  Emerging market demand, in spite of tighter macroeconomic policies, will continue to grow briskly, fanning demand for imported oil.  U.S. growth prospects have improved as well.

In past years, expensive oil has tended to weigh most heavily on currencies associated with excessive current account deficits like the dollar.  The dollar’s all-time low of 1.6038 per euro was set one day after the all-time record high in oil prices in July 2008.  The euro posted progressively weaker average levels of  $1.4707 in 2008, $1.3942 in 2009, and $1.3298 in 2010 but has thus far averaged $1.3603 this year and at $1.4161 has reversed 61.2% of the loss between its 2008 and 2010 mean values.  That reversal is very similar to the turnaround in oil prices since their drop from $147 to a February 2009 low of $34 per barrel. 

Britain has large current account and fiscal deficits  Their sum in 2011 will be only about 1.5 percentage points less as a percent of GDP than America’s.  British and U.S. monetary policies have been similarly loose, but interest rate increases are likely to begin sooner at the Bank of England than at the Fed because the U.K. has a more serious inflation problem and less stable expected inflation.  Britain’s economy, partly as a result, will grow more slowly than the U.S. economy.  The premium of ten-year British gilt yields versus German bunds is much smaller than those for countries within the euro area with sizable fiscal imbalances, and the U.K./U.S. sovereign debt differential is fairly insignificant as well at some 25 basis points.  Politics will be a larger constraint this year in the United States than in Britain.  On paper, the pound’s fundamentals look similar to the dollar’s but weaker than the euro’s.

The euro is not the D-mark, being a hybrid of hard currencies like the German, Dutch, and Austrian units and currencies that historically performed much more weakly like the peseta, drachma, escudo, lira and punt.  Euroland’s sovereign debt crisis, now entering its 17th month, has made many analysts bearish toward the euro.  How can one feel otherwise about a currency whose very ability to stay forever intact lies in doubt?  The answer is twofold.  First, the will of politicians to preserve the union is extraordinarily strong.  Second, while the euro is a hybrid, ECB policy inherited the body chemistry of its hard currency forebears.  The euro area economy chronically grows more slowly than U.S. GDP.  But so did the region’s economy before the common currency era, and one ought to expect that from a place with slower population growth.  ECB policy moreover takes its cue from inflation, not growth, and price pressure has resurfaced sooner in Europe than North America.  In spite of that, investors are more confident about the long-term preservation of price stability in Euroland than in the United States.  The euro is presently 18.5% stronger against the dollar than the average value of that pair over its entire 12+ years, a sign that price stability and solid current account balances feature more heavily in deciding a currency’s strength than relative economic growth or whether a currency holds the largest share of reserve asset portfolios.

That said, one has to like the Swiss franc even more.  The Swissy shares the euro’s advantages but not its imperfections and is associated with a substantial current account surplus in contrast to Euroland’s nearly balanced external account.  In times of heightened geopolitical risk around the world, Switzerland’s neutrality also boosts the franc’s appeal.  When gold and other precious metal prices are well-bid, so usually is the Swiss franc.

This past week’s softest currencies were those sensitive to commodity prices, a group that previously had done well.  It remains to be seen if this just happened to be a bad time for them, or if a more significant turn for the worse is happening.  Australia and New Zealand depend on Chinese demand, and the People’s Bank of China continues to tighten its monetary policy vice, turn by turn.  New Zealand’s central bank made a 50-basis point reduction of its key interest rate in the wake of its February earthquake, and the whole Asian region feels a closer affinity to Japan’s disaster than do the United States and Europe, which are farther away.

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

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