In Search of Currency Direction

February 10, 2012

2012 is no longer a newborn.  The first eighth of the year will be completed by the middle of next week, yet investors are still groping for a sense of currency direction.  The dollar and yen have weakened somewhat despite the persisting euro debt crisis, better-than-expected U.S. economic data, and the Fed’s unwillingness to launch a third round of quantitative easing.  Typical of puzzling markets, rumors continue to surface such as ones today about an imminent shuffle of the Papademos cabinet in Greece and another that North Korea’s leader may have been the object of an assassination attempt.

Five broad factors command the currency market spotlight.   Foremost is whether Greece can avert a messy default on March 20.  A deal, in fact a series of agreements, has to be reached between Greece and its creditors before then.  Because the Greek government has repeatedly missed many fiscal targets and the enactment of promised reforms, doubts will rightfully extend past the March deadline no matter what eventually happens on paper.  The euro’s buoyancy above $1.30, however, suggests that investors have priced in a deal that enables Greece to meet next month’s debt servicing needs.  The key is whether a default is avoided then, not whether the agreed deal is seen to be ultimately sufficient.  Simply kicking the can down the road has up to now been enough to leave EUR/USD about 10% above its lifetime average level.  Given market expectations, the euro is likely to drop sharply if a March default of Greece is not avoided.  But little further appreciation should occur after the announcement of a successful bailout deal.

The second theme concerns the strength of the Chinese, U.S. and euro area economies.  The United States and Euroland have exhibited more resilience than expected lately, but Chinese data have fanned concern.  China is a commodity guzzler, so its economic health affects commodity-sensitive currencies like the Australian dollar keenly.  Signs of weakening or strengthening demand in any of the three broad regions are setting the market tone on a daily basis for whether risk trades are on or off.  Some of the key scheduled upcoming releases are Chinese retail sales, industrial production and fixed asset investment, British retail sales, euro area GDP and industrial production, Japanese GDP, Australian labor statistics, and U.S. retail sales, industrial output, and housing starts.  A wide divergence exists among analysts about future growth trends.  Convictions are not held tightly, so it does not take many data points of contradictory evidence to change expectations and shift currency momentum.

Ordinarily quantitative easing is perceived to pose downside risk to a currency at least in the short run.  When the Fed adopted a monetarist framework to slow money growth in late 1979, it engaged in quantitative tightening, and the dollar strengthened extensively.  Quantitative easing is the opposite operation, but the currency market result is complicated because several different central banks have used this tool.  The biggest practitioners since the Great Recession have been the Federal Reserve and the Bank of England.  The Bank of England expanded its asset purchase plan yet again yesterday.  Another GBP 50 billion worth will be done over the coming three months.  The Fed ended QE2 in the middle of last year.  It is currently lengthening the maturity of its balance sheet but no long increasing the size.  At the Bank of Japan’s meeting next week, a extension of its asset buying program seems probable, although a final decision may hinge on 4Q GDP data due on Monday.  The ECB has avoided undertaking any operation that it called "quantitative easing."  All of its unconventional measures are temporary and limited.  Framed in that way, the measures have nonetheless attracted controversy, for example when collateral rules were relaxed this past week.  The boldest ECB action, the 3-year RTRO in December, in fact preceded a period when the euro recovered, and a similar operation will be done late this month.

The fourth theme involves currency policy coordination in general and the yen and Swiss franc in particular.  Foreigners have publicly disapproved of Japan’s unilateral intervention sales of yen but find the Swiss National Bank’s imposed franc ceiling to be acceptable.  Since touching a record high of 75.55 per dollar last October 31, the yen has neither revisited that level nor strayed very far from it.  In the meantime, the yen’s fundamental current account support has eroded, and Tokyo officials have expressed dismay that the deterioraton hasn’t been reflected in a weaker yen.  A dramatic loosening of monetary policy via an increased asset purchase program would be well timed to promote a softer yen and combat zero inflation and excessively weak growth in money and bank credit.  When Swiss authorities established a ceiling an the franc’s euro cross rate at 1.2000 in early September, the action was accompanied by a dramatic example of quantitative easing.  The Swissie hasn’t crossed over the line in the sand, but it remains very close in spite of deflation.  Swiss consumer prices in January were 0.8% lower than a year earlier. 

Political uncertainties are the fifth and final factor that’s exerting major influence over currency markets.  The road to a Republican presidential nomination is proving longer, more winding, and more destabilizing than imagined.  The candidates in the race represent very different wings of the party.  Much like 1964, the campaign represents no less than a fight for the soul of the party.  The dollar would probably be doing better if U.S. politics were more certain.  A sweeping change also may be coming to France.  The first round of presidential elections there are just ten weeks away.  If held today, the incumbent would surely lose and might even place third, ensuring a regime change after the second round.  France’s claim to being part of core Euroland and not one of the peripherals may hang in the balance.  Within 18 months after the last time that a right-of-center president was defeated by a Socialist, the French currency had to devalue three times.

Examined factor by factor, the currency market story is at a complicated and uncertain juncture, much like the global economy.  What is known is that upward dollar momentum in late 2011 has partly reversed, but cumulative FX price action has not been substantial.  The verdict is out over whether the stall will be a temporary interlude or the start of a different chapter.

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

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