Currencies Dancing to the Beat of News Headlines

November 11, 2011

Intra-day volatility continues to dwarf any sense of purposeful direction in the arena of foreign exchange.  News headlines related to the euro debt crisis are producing wild swings in equities as well.  The dollar at 16:00 GMT today was a mere 0.4% stronger against the euro than its closing value last week.  It had fluctuated in a 2.1%-wide range during the week between 1.3858 and 1.3578 after occupying even wider high-low real estate bands of 4.1% in the week of November 4 and 3.3% in the week of October 28.  Against the dollar, sterling recorded similar sequential weekly highs during each of the past three weeks ($1.6152, $1.6166, and $1.6129) and similar lows of $1.5890, $1.5875 and $1.5866. 

Currency and equity swings are derived from gyrating risk aversion, marching to the sequence of headlines from Europe with randomly yet widely different implications.  News reports land on the marketplace like scud missiles.  They reflect political responses to a tightening economic noose.  Unlike economic data, headlines do not conform to a prearranged release schedule, and there’s no scientific way to anticipate what’s going to be reported next. 

Some truths moved into sharper focus in the second week of November regarding the chaos in Europe.  Foremost, the main barometer to watch is not the euro or equities but sovereign debt yields.  Once such reach unsustainably high levels, the experiences of Greece, Ireland, and Portugal suggest that yields will not drop back enduringly to safer heights without a bailout.  Second, the long-term interest rates are more sensitively influenced by debt/GDP ratios than the size of the deficit-to-GDP ratios.  Third, Italian yields crossed the Rubicon this past week, and a sense of contagion to France deepened.  These two economies are way too large to be bailed out by available in-regional tools, so the potential downside negative consequences in the euro debt crisis have climbed substantially.  A fourth truth is that the stakes for economies not in the euro area or even Europe have risen, too, and more and more central bank authorities around the world are factoring that danger into their baseline assumptions.   Fifth, investor confidence is fading that this crisis will be somehow capped.  Without a lender-of-last-resort role from the European Central Bank or the International Monetary Fund, it seems impossible to defuse the crisis.  Even under such possibilities, most thought experiments point to a break-up of euro membership.  Whereas such a result used to be qualified by “probably later than sooner,” pundits and investors are increasingly speculating “sooner rather than later.”  Lastly, Chinese officials are not inclined to gun their economy or commit huge resources to preventing a breakup of the euro. 

U.S. economic data are meanwhile looking better.  I do not expect this step back from imminent recession to be the last word.  The good news reflects some temporary U.S. factors. Fiscal policy will be tightening, and an intensifying European crisis would slam world financial channels, much as the Lehman bankruptcy did in 2008.  The most useful information for Forex trading is often found in how currencies react to news rather than the content of the news.  Present dollar values underscore a persistent pessimism about the dollar.  In spite of all that has happened to tear European Economic and Monetary Union (EMU) apart, the euro remains 15.6% stronger against the dollar than its 2010 low.  It also retains an appreciation of 2.6% from the end-2010 level.  The dollar is near its historic low against the yen and would be weaker if not for the threat of Japanese intervention. 

Three drags on the dollar are

  • The mix of tight fiscal policy and ultra-loose monetary policy.  When the macroeconomic mix was opposite from now, the dollar doubled in value between end-1980 and February 1985.
  • The perception that U.S. politicians and monetary authorities each prefer a softer dollar and are pursuing actions consistent with that goal.
  • A view that America is moving in the wrong direction justifies prudently steady reserve currency portfolio diversification into non-dollar assets.  Strong gold prices reflect a vote of lessening confidence in the U.S. economy and the dollar.

The impact of these adverse dollar factors would lessen after the European crisis experiences a Lehman moment.  During the extreme spike of risk aversion in the autumn of 2008, the dollar rose strongly but did not hold onto the gains in the long run.  Commodity-sensitive currencies at that time were especially victimized and therefore bear special scrutiny in the period ahead.  if the euro comes under much greater peril, the Swiss National Bank’s enforced franc ceiling might get tested.  So far it has held up very comfortably, and investors are in fact inclined to believe that the franc faces more downside than upside risk. 

The resumption of quantitative easing by the Bank of England and downward revisions of projected British growth by numerous forecasters haven’t hurt the pound.  Sterling has been steady against the dollar and has advanced about 6% against the euro since midyear.

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

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