Reflecting on Currency Prospects after the EU Summit

December 9, 2011

The agreement reached by EU leaders in Brussels is neither as impressive as market participants had wished nor the kind of utter failure that would have broken the common currency within weeks.  The plan hardly constitutes a bazookette, let alone the big bazooka that was promised last summer.  It is not a recipe for short- or long-term restoration of competitiveness and growth to the common currency area’s weakest members.  It does not assemble sufficient resources to handle bailouts of Italy and Spain should that be required.  The timetable for implementation is still too drawn out and uncertain, particularly since a credible popular mandate from the people continues to be missing.  Enforcement may not prove ironclad.

The super game changers in currency trading have been few and very far between.  The Fed’s monetarist switch in October 1979 from targeting interest rates to targeting the stock of money was one.  The Plaza Summit where the United States, Germany, Japan, Britain and France agreed to macroeconomic policy adjustments with the intent of weakening the dollar was another.  These book-ending events created profound fallout, one promoting a doubling of the dollar’s value and the other more than reversing those cumulative gains.   From today’s vantage point, today’s pact isn’t in the same class partly because the ultimate impact depends on many other interested parties.  Will the credit rating agencies downgrade regional sovereign debt, and how soon might such decisions be announced?  What is the ECB prepared to do following this commitment to greater fiscal unity?  The central bank made no follow-up promises beyond changes announced yesterday, and monetary officials made those decisions with the knowledge that a plan along its actual lines could emerge.  Political leaders in Spain, Italy, and Greece will need to rally public enthusiasm for actions that offer endless austerity, and Germany hasn’t indicated a willingness to run things any differently from before.  Political change works too slowly to accommodate the quick gratification required by the financial community. 

The immediate victory of the summit is that it bought some more time for euro area governments.  The option of putting the euro down was not chosen, and markets in December are probably not inclined to test if the emperors are wearing clothes.  It will be easier to close books and call it a year.  The ambivalence of the mood is reflected in surprisingly stable currency price action over the past two weeks

  • The euro had a handle of $1.34 or $1.35 at some point on each of the ten trading sessions, even though it sagged as low as $1.3210 briefly.  EUR/USD at this writing is only about 4% weaker than its 2011 average level and remains about 15% above its 1999 starting point.
  • Despite Britain’s isolated status after opting out of fiscal unity, cable (sterling versus the dollar) has traded in a narrow 1.3%-wide high-low range since November 28 and lies just 2.7% under its 2011 mean of $1.6065.
  • The euro’s sterling and Swiss franc cross rates traded in narrower-than-2% high/low ranges over the past two weeks.
  • Dollar/yen since November 28 has traded between 78.27 and 77.13. 

It’s easy to imagine broader currency swings given other recent developments.  The stability of the dollar in fact contrasts with swings in other comparative criteria.  The OECD is projecting that U.S. GDP will expand 2.0% next year, far more than in Switzerland (0.8%), Britain (0.5%) or the euro area (0.2). Share prices in Japan and Germany have fallen about four times greater than those in the United States since the previous EU debt agreement in July. Ten-year sovereign yields in that same span have dropped about 90 basis points in the U.S., more than Germany’s fall of 63 bps or Japan’s dip of just 7 bps. 

The Fed and Bank of England since 2008-9 have been readier to intervene quantitatively in big volumes than central banks in the euro area and Japan.  In inflation-prone times, it would be a slam dunk to conclude that accommodative monetary biases would favor the yen and euro at the expense of the dollar and sterling, but the correct lesson to draw in disinflationary or deflationary ones like the present is a much more complicated matter. 

Sometimes that invisible hand imposing currency market equilibrium has little to do with the interplay of private supply and demand.  The Chinese yuan’s trend against the dollar over the past four months has been essentially flat because of government forex intervention by Beijing.  Japanese reserves shot up by a record $94.88 billion in the latest reported month because of nearly $120 billion of intervention sales of yen.  Chatter among analysts and traders has persisted that the Swiss National Bank’s quarterly policy review this month may shift the targeted minimum for the euro to CHF 1.2500 from CHF 1.2000.  The franc in 2011 has ranged from as weak as 1.3381 per euro to as much as 1.0075, but its mean for the whole year of CHF 1.2333 is paradoxically and ironically near the present level. 

Slower global growth may exert a drag on general prices and those for commodities.  Whereas indicators of activity and demand in the United States have tended to surprise on the upside over the past month, the opposite has been true elsewhere.  A full convergence of business cycles isn’t going to happen, but on balance global activity should slow and weigh on commodity-sensitive currencies.  During the past two weeks, the kiwi and loonie traded in wider high-low bands of 5.5% and 4.0% than the aforementioned currency relationships.  The central banks in New Zealand and Canada did not change their low interest rates at policy meetings held this past week and are not predisposed to abandoning wait-and-see mode soon.  Moving in a 6.1% range, the Australian dollar traded almost symmetrically around par since November 28, appreciating as high as USD 1.0378 and dipping as low as 0.9786.  The Aussie currency’s year-to-date mean of USD 1.0146 is a mere half percent from the present level.

Economic fundamentals favored the dollar to a greater extent in 2011 than was reflected in currency prices.  A top suspected reason is the ever presence of portfolio diversification.  That force will continue in 2012.

Finally with December winding down, remember that the dollar often exhibits a seasonal bias of softness against the euro and the D-mark before that during the second half of the month.  The U.S. currency does not drop every year, but losses outweigh rises by a significant margin.  The dollar’s movement between December 15 and December 31 for all the years from 1973 through 2010 has been an average decline of 0.9% per year.  In 2010, for one example, the dollar lost 1.2% against the euro after a drop of 1.7% in the first half of that December.

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

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