Surprises for Currency Traders to Consider

February 3, 2012

2012 hasn’t played out quite as expected.  First, the euro debt crisis has been less intense than in late 2011 in response to s big infusion of three-year liquidity  by the European Central Bank and because various talks to bail out Greece and to tighten fiscal discipline made greater-than-expected progress.  Second, U.S. and European data showed unexpectedly better growth.  European GDP will either contract much less sharply this quarter than in 4Q11 or even eke out a marginal increase.  Improvement in the U.S. labor market is unmistakable.  Third, Fed policy has even looser than anticipated despite signs of more solid production and demand.  The Fed is doing its utmost to promote faster economic growth, and it’s becoming clearer that two of the intended results of its effort are stronger share prices and a soft, if not softer, dollar.  Fourth, gold prices have soared more than $200 per ounce since late December after falling quite sharply in the final month of 2011.  Fifth, Chinese authorities have not shown any urgency to shift policy gears or to commit resources to Europe.  China’s economy appears likely to grow at a considerably slower pace in the first half of 2012 than it did in 1H11 or even the second half of last year. 

The currency implications of these developments are varied.  Europe remains a time bomb that could explode next month.  The boost to the euro from lessening strain has been mitigated by continuing uncertainty surrounding euro debt negotiations and the possibility that the recent signs of progress could yet unravel.  The worst case scenarios surrounding Greece would see the euro depreciate substantiallyBetter economic news in the United States is dollar positive, but support is mitigated by a more stable European economy, too. 

The current policy of the Federal reserve is a dollar depressant currently.  Should greater-than-assumed U.S. growth lead investors to distrust the conditional forecast of the Federal Reserve to maintain for two more years near zero short-term interest rates, the dollar conceivably might perform better, but whether it does so would hinge critically on how monetary officials guide expectations.  The dollar will climb if policy tightens in the face of strengthening aggregate demand, fewer excesses of productive resources, and continuing contained inflation.  If the Fed is perceived to fall behind the curve, that is responding to higher actual and expected inflation rather than in a pre-emptive manner before such happens, the dollar actually ought to drop.  A sharp advance so far this year in the price of gold is consistent with concern that excessively loose Fed policy for too long is a strong possibility. 

The China factor has been mystifying.  The likeliest economic evolution in that economy is a soft landing, but a more abrupt downshift of that economy is not being ruled out because of the frothy housing market and the persistence of inflation that prevents a more single-minded policy that ensures continuing economic growth of 8.5% or more.  Uncertainty related to China ought to restrain demand for gold and commodity-sensitive currencies, but those are the monies that have been most heavily bid.  The dollar shows comparatively large year-to-date declines of 6.9% against the kiwi and 5.1% against the Australian dollar.  It has fallen but no more than 2.5% against other key currency units like the euro, loonie, Swiss franc, and sterling.  Chinese behavior is potentially critical to currency developments as an engine of global demand but also as a source of dollar buying thrrough the purchase of U.S. fiscal debt.  The recycling of China’s net export earnings into the Treasury market has tapered off, and that is reflected in a dollar that has stabilized this year around 1.30 per euro instead strengthening sharply further.

Dollar/yen hardly moved in the first five weeks of 2012.  Japanese officials seem very motivated to resist appreciation but, unlike their Swiss counterparts, do not have the consent of other governments to do whatever it takes to prevent additional appreciation of their currency.  The yen is a special case, and prospects for keeping it capped seem reasonably good because of Japan’s vanished trade surplus and fragile economy.  Tokyo officials merely need to convince investors that their currency still has the proper credentials for funding carry trade investments.  For years, no other currency was seen as more ideally suited for that purpose, but the dollar is now honing in on that role because Federal Reserve officials have done their best to convince markets that their policy will remain ultra-accommodative just as long as the Bank of Japan keeps such a stance, and perhaps for even longer.

By midyear and at least the end of 2012, the dollar could indeed have appreciated extensively, particularly against the euro.  Many analysts believe this has a very high probability.  If the early market action of 2012 sheds any constructive guidance, however, it is that a diverse array of factors are interacting in the currency marketplace, and the net impact on major dollar pairs is unlikely to be uniform or intuitive.  The best tactical way to play this game is to think short term and not get wedded to any preconceived notion of a destination some six or twelve months from now.  To the extent that one must take a long-range view, it never hurts to remember that the dollar with rare exception has been unable to sustain multi-year upward movement over the past 40 years.  The burden of proof therefore rests with the dollar bulls, not bears. 

Copyright 2012, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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