Euro Surprising the Pessimists

February 24, 2012

The better recent performance of the euro is subject to varying interpretations.  The EUR/USD is the best currency-against-currency barometer of sentiment toward the U.S. economy and dollar, so euro appreciation can simply reflect a vote of lessening confidence in the United States.  Or because the dollar is the most favored safe haven in the family of paper currencies, the euro also tends to rise when investors become more predisposed to risk taking.  In the wake of last weekend’s euro group accord on a second Greek bailout package, a third inference to draw is that investors on balance accept the admittedly blemished deal as an opportunity to cover euro shorts that had hedged the now doubtful possibility of a euro breakup in the very near term.  A fourth explanation might attribute the rise to better economic data reported by the group’s core members and to feelings that ECB President Draghi is handling the euro crisis better than his predecessor and with much needed flexibility and creative thinking.  A fifth concludes that EUR/USD has risen not because of what’s happening on either side of the Atlantic but rather as a result of two Asian developments: more aggressive Japanese steps to weaken the yen and slower growth and smaller external surpluses in China that are curtailing that nation’s bidding for U.S. financial assets.

The euro is not the only currency to rise recently.  At a high earlier today of $1.3475, it was 2.3% above this week’s low of $1.3172 and had gained 6.4% from a low of $1.2623 reached six weeks ago when S&P downgraded its country risk ratings for the EFSF and nine euro-sharing governments including France, Italy, Spain and Portugal.  The Swiss franc high earlier today of 0.8935 per dollar was 2.7% stronger than its lowest level of the week and constituted a 7.4% advance since January 9.  The Australian and New Zealand dollars have also done well, respectively climbing against their U.S. counterpart by 12.0% and 14.4% since late November.  Sterling is about 3.5% stronger against the greenback than six weeks ago, but a comparatively stable currency has been the Canadian dollar, which has traded exclusively between 0.9900 per USD and 1.0100 since January 26.

The weakest industrial currency of late has been the yen.  Japan’s currency had not been as soft as 80 per dollar since July 11 and today touched 80.79, 6.5% from its record peak on October 31.  At 108.9 per euro, the yen has retreated 4% from this week’s high of 104.66 and 11% since January 16.  On the eve of a meeting of Group of Twenty central bankers and finance ministers in Mexico City, Japanese officials are wasting no opportunity to convey displeasure over the strength of the yen and plant suspicion that covert intervention may underlie the currency’s recent move south.  An elevated yen contributes to deflation, depresses growth, and has developed in spite of an end to Japan’s chronic trade surpluses.  While other government’s have complained about Tokyo’s high-handed interference in foreign exchange markets, the actions are consistent with worsening yen fundamentals.

Recent currency movements fly in the face of some other market developments such as advancing oil prices and continuing high bond yields among Euroland’s high debt members.

The fingerprints of high and rising oil prices have been found at the scene of every recession of the past forty years.  The oil factor tends also to be present at economic slowdowns that fall short of recessions.  One only has to go back a year in time to find an example.  Decent economic data were generating optimism among G7 economies at the start of 2011 even as WTI oil prices had risen 22.4% from $79.49 on October 19, 2010 to $97.28 per barrel on February 24, 2011.  The price continued to climb and eventually crested at $113.93 on April 29 for a punishing gain of 43.3% in the space of six months.  That increase resulted in an unforeseen loss of momentum in 2011 versus 2010 among most advanced economies.  Flashing forward a year, the economic data from various purchasing managers surveys to U.S. labor statistics are again upbeat but juxtaposed against a backdrop of appreciating oil import costs.  West Texas Intermediate oil has climbed 4.9% in the past week, 12% since February 2, 18% since November 1, and 43.6% since October 4.  In under five months, the late 2010 to early 2011 increase that took a half year to play out has been matched entirely. 

To the extent that a softer dollar reflects growing economic optimism, the market’s desire for riskier investments may be misplaced.  Coincident data suggest that recovery from the Great Recession has finally found its stride.  Oil suggests that it may be still premature to draw such a conclusion.  If global growth looks worse than now in late spring, safe haven dollar demand might stage a comeback.

Euro strength based on relief after the Greek bailout also could be misplaced.  Market commentaries on the deal continue to accentuate its shortcomings and potential pitfalls, and a better market barometer of the mood than foreign exchange, namely peripheral bond yield premiums over German bunds, tells a different story of widespread dissatisfaction.  The Greek spread is more than 230 basis points wider than a week ago.  The Belgian, Portuguese, and Irish spreads are moderately greater now, too.  Italy’s hasn’t narrowed but remains dangerously large.  Spain’s differential is somewhat smaller but also exceeds 300 basis points in width.  Currencies aren’t alone in their upbeat response.  Share prices have been buoyant.  Both vehicles convey the message that it doesn’t matter that an end is eventually probable to the euro as a shared money for 17 countries.  Instead, investors merely want a reason to believe that a breakup isn’t lurking around the nearest corner.  With central banks making life very difficult to meet targeted returns on the safest investments, the urge to take risks will arise if given a scrap of reassurance.  It is equally true, however, that it will not take much to touch off a stampede back for cover.

In this era of never-ending uncertainty, currency direction is not exempt.  But until the next major reality check, the trends of the day support the currencies of Europe and down under relative to the dollar and yen.  One last point to make as we approach the final month of Japan’s fiscal year is a warning to treat talk about Japanese capital repatriations with more than a grain of salt.  Year in and year out, analysts cite this point to highlight the likelihood of a fillip for Japan’s currency in late February and March.  Count me out on that call.  After discovering many years ago that the yen in fact does much better on average during April than March, I switched to the other side and since have not seen contradictory empirical evidence to reverse that move.

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

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