Currency Markets Head into the Home Stretch of 2011

December 16, 2011

Currency trading has unique properties in the final weeks of the calendar year.  Market professionals will be closing their books, taking some days off, and generally become less responsive to the flow of fundamental economic and political news than in the other fifty weeks of the year.  This is more true of the week before Christmas than of the final week of the year when people sometimes try to get an early start on the coming year.  As reviewed in an earlier update, the dollar through the years has demonstrated a moderate bias toward depreciation against Europe’s main currency between mid-December and the end of the month.

In the subset of this period, specifically between December 15 and December 23, the dollar fell against the mark and, after 1998, the euro in 23 of the last 38 years since currency floating began in 1973.  The dollar’s average movement, including the 15 years when it rose, was a net drop of just 0.3%, and it traveled less than 1% in twenty of the thirty eight years.  In the dozen Decembers since the euro’s creation, the dollar rose five times between mid-December and the 23rd of the month, posting a net slide of 0.2% per year.  Two of greenback’s five rises occurred in 2009 (1.4%) and 2010 (0.7%).  Given Europe’s economic and political struggles and the likely possibility of a region-wide credit rating downgrade, chances look good that the U.S. currency will post its third straight pre-Christmas advance, but it will need to bust through the psychological and now technical 1.3000 per euro barrier.

In any case, 2011 is probably going to be the fourth consecutive year with a endyear to endyear change against the euro of less than 7.0%.  At this writing, the euro shows a net drop for the year of less than 3.0%.  It also fell in 2008 by 4.3% and 2010 by 6.6% while rising 2.5% in 2009.  Such small calendar year movements in EUR/USD didn’t used to be the norm.  The euro tumbled 13.9% against the dollar in its first year of 1999.  After smaller drops of 6.7% in 2000 and 5.5% in 2001, EUR/USD moved on net more than 10.0% in five of the ensuing six years:  up 17.8% in 2002 and 19.9% in 2003, down 12.9% in 2005, and then back-to-back advances of 11.6% in 2006 and 10.7% in 2007.  The sole sub-10% change in this sequence, a gain of 7.9% in 2004, was still greater than any of the past four yearend-to-yearend swings.  Currency market volatility remains high, but swings have gravitated to vastly shorter durations.

Another way to look at the evolution of the EUR/USD is to subdivide the entire post-1998 life at the start of 2004.  In the five prior calendar years, the euro recorded an average value of $0.9922, and in none of the years did it average stronger than $1.1321.  From the beginning of 2004 through the end of last month, the euro’s mean value was $1.3374, not far from its current quote.  The weakest calendar year mean of $1.2439 occurred in 2005, and the strongest of $1.4707 happened in 2008.  2011, like 2010, 2009 and 2007,will show a mean of $1.30-something.  Some twenty-six months into the euro’s crisis of a lifetime, the common currency is still trading within the orbit of its latter years, not that of its first five formative years, and the big question is whether that bias of firmness is about to collapse.  One year ago, several analysts incorrectly thought it would happen in 2011, predicting a fall to near parity. 

A related question asks why the euro isn’t much weaker already.  One answer is not to look at the dollar to find demonstrable euro weakness.  The common currency has dropped some 40% against the yen and 27% versus the Swiss franc from highs versus those other European monies reached respectively in July 2008 and October 2007.  A second explanation lies in the different orientations of the European Central Bank and Federal Reserve.  ECB officials still worry about inflationary implications of excessively growing its balance sheet either through quantitative easing or embracing the role of lender of last resort that other central banks accept without a second’s thought.  The first president of the ECB, Wim Duisenberg, was less adept than Draghi or Trichet at communicating a consistent straight-arrow policy of unqualified support for delivering price stability, and it’s not coincidental that the euro performed better under those latter leaders. 

A third euro support is that because it remains the main rival to the dollar, EUR/USD is the quintessential currency barometer of general sentiment toward the U.S. currency.  U.S. politicians are suspected of limited tolerance for currency appreciation.  Europe’s game of chicken may kill the euro as we know it, but proposals to abandon central banking have not been submitted.  In contrast, Republican presidential candidate Ron Paul, who chairs the House Financial Services Subcommittee on Domestic Monetary Policy and Technology, wants to shut down the Fed, and all the candidates from his party, especially front-runner Newt Gingrich, advocate replacing Fed Chairman Bernanke even though America has a record of low core inflation.  If price stability is the ultimate prize, history suggests the best institutional start is found by granting monetary authorities maximum insulation from the inherent corruption of politics.  As long as benign neglect is possible, diversification away from the dominant reserve currency will be an appealing strategy at the margin.   Fourth, European institutions have been forced to repatriate wealth home to cover domestic losses.  This process unavoidably creates new demand for the euro.

This is not a time that inspires strong confidence in any currencies.  Policies in Switzerland and Japan have been modified to counter the strength of the franc and yen.  Britain has become more isolated from the rest of Europe than before, and its influence on regional policies is diminished.  The U.K. has the same conundrum as European peripherals.  When every government is deleveraging, austerity depresses growth but not the relative burden of the fiscal deficit. 

Commodity-sensitive currencies behave cyclically, and are presently endangered not only by Europe’s recession but also signs of a slowdown throughout the developing economy world.  Planning for the long term has become increasingly unfathomable.  Market players have little appetite for looking beyond what’s just ahead.  For now, that’s the simple matter of whether this weekend will bring news of new credit rating downgrades for the euro-17.

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

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