Major Currencies at Mid-March

March 16, 2012

Currencies did not share in the high dramatics of sovereign debt yields, equities and gold prices this past week.  The dollar has so far risen just over 1.0% against the yen and sterling but dipped 0.3% or less against the euro, Swissie, kiwi and Australian dollar.  The Canadian dollar’s unchanged, and the Chinese yuan is marginally weaker.

The most remarkable currency development of 2012 involves the yen/euro relationship.  It’s turning point occurred on January 16, the same day that the Nikkei bottomed out.  Since the yen peaked against Europe’s common currency on that day at 97.05, the euro has risen 13.3% to a high earlier today at 109.99, and the Nikkei has advanced 20.9%, thus meeting the rule of thumb for designating a bull run.  Japanese officials complained loudly for months about excessive yen strength, and Bank of Japan officials surprised investors last month with a rather aggressive extension of quantitative easing and a vow to continue a very accommodative stance to eliminate deflation and promote a more fundamentally appropriate level of the yen.  The ECB also has a very stimulative policy but is more conflicted about that stance because it faces higher-than-targeted inflation. 

Currency analysts are widely divided about the likeliest 3-6 month direction of EUR/USD. Whether the euro weakens to $1.20 – $1.25 as some project or finds new strength in a $1.35 – 1.40 range as others believe, the yen’s retreat seems likely to persist.  In the decade from 2001 to 2010 when Japan unlike now ran a chronic and large current account surplus, the euro’s average value of JPY 137.8 was some 20% stronger than today’s yen low.  As for EUR/USD, a credible argument can be made that such appears more comfortable near current levels than either significantly above or considerably below below these levels

The euro against dollar relationship is a much truer barometer of dollar sentiment than yen/dollar.  The problem in forecasting where EUR/USD is likeliest to settle in the second and third quarters of 2012 is that there are a number of critical influences.  These forces are not necessarily pointing in the same way, nor is it apparent which will exert the greatest dominance over the marketplace.

The past 2-1/2 years have taught investors not to assume that the euro debt crisis is over.  At some future time, the dangers will get acute again, so the question to ask now is how long a respite should be reasonably expected.  Much can and will still go wrong especially since peripheral bond yields vis-a-vis German bunds remain problematic.  It will be surprising if the situation doesn’t get very dicey again before midyear.  French presidential and then parliamentary elections pose a potential flashpoint given the possibility that political power in Euroland’s second largest economy may change.  The first and run-off rounds of the presidential contest are scheduled for April 22, just five weeks away, and May 6.  At their worst, euro debt difficulties tarnish the region’s image, promote risk aversion, and support the dollar.

A second big area of uncertainty concerns the evolution of the U.S. recovery from here.  Labor market conditions have provided the main cause for optimism, but other data have been inconsistent and/or disappointing.  The past few weeks have seen considerable euphoria.  Considering that a 3.0% growth rate last quarter was the best pace since the spring of 2010 and that GDP in the United States expanded just 2.5% annualized over the whole ten quarters since the recession’s end, it’s become apparent that investors have lowered their perceptions of what’s acceptable and that deleveraging is continuing to exert a significant drag on demand and makes the economy vulnerable to shocks, of which there are some, for instance elevated oil prices.  Much tighter fiscal policy at the end of this year will be another.  A possible third is the widening trade deficit caused by weaker demand from China and Europe. 

This week’s spike in Treasury yields is a sign that a multi-decade trend of higher prices and lower yields may be over.  It’s said often that significantly higher long-term interest rates both absolutely and relative to comparable rates elsewhere promotes currency strength, but the truth is that it depends on why interest rates are climbing and the broader economic context in which the development occurs.  1994, when the 10-year Treasury yield shot up from a low of 5.54% to an intra-year high of 8.02%, was an awful year for the greenback virtually from the start of the interest rate trend.  Investors were irrationally worried about inflation in 1994 and very uncertain about how much the Fed was going to tighten.   Investors this week didn’t know how to handle the dollar as interest rates climbed, but the setback in oil prices is an auspicious start for those bullish on the U.S. currency. 

A change in Fed policy during 2012 seems very remote, but the debate now concerns whether future rate guidance will change noticeably as soon as June.  I suspect not, and an absence of such rhetoric might weigh on the U.S. currency.  The stronger the dollar around midyear, the less likely becomes a less dovish tone from the Fed.  Part of the central bank’s hidden agenda is to run a policy that promotes a weak exchange rate and thereby stronger export competitiveness.

Next let’s consider some of the aforementioned possible growth shocks, starting with elevated oil prices that remain in low triple digits.  A near-term climb based on seasonally strengthening petroleum usage seems probable.  Regarding tensions with Iran, history tends to support worst-case scenarios more than best-case ones, so it’s a better-than-even bet that crude and pump prices will each move even higher by May.  Greater disagreement among analysts tends to revolve around the U.S. and global economy’s tolerance thresholds.  History here suggests the frog-boiling analogy.  The sensitivity of economic growth to oil is much more dependent on the rate of change in price than to the level of price.  So far, the rise in prices falls well short of what has caused past recessions.  If oil manages to knock growth off its present path, the dollar probably would face more downside risk than the euro because the United States has a weaker current account than the euro area, although America’s relative energy independence would be a mitigating factor in perceptions.

It remains in doubt whether Euroland’s fiscal crisis hurt the euro mostly because of the size of the deficits or the negative growth implications of imposed fiscal austerity that was mandated subsequently.  I suspect the latter, and the same pattern could hurt the dollar later this year.  Higher taxes and less spending await America in 2013, but the signaling effect on the dollar could become very prominent by 3Q12.  Because of their big run-up since last November, equities may react even before currencies.  Since the financial crisis began, the dollar has done well in times of falling equities, but the reverse (as observed this past week) has shown much less pronounced negative correlation.

The U.S. trade and current account deficits are a stealth factor.  Markets seldom react after such data are announced, even when the results fail to meet expectations more or less closely.  But over the long run since 1970, the dollar has lost substantial ground in spite of benefits such as America’s faster growth, dominance in reserve asset portfolios and wide usage as a currency in which trade is conducted and valued.  Traders like to denigrate the euro and the perceived deficiencies of capitalism in Europe while acclaiming as a foil the more market-oriented brand of capitalism practiced in America.  Forty-plus years of tug-of-war against other widely traded currencies like the D-mark, euro, yen and Swiss franc have left the dollar with net losses, nonetheless, and persistent trade deficits are one reason why.  The disadvantage persists to this day as attested by the respective sizes of trade deficits last year —  $738.3 billion in the United States and EUR 9.8 billion (equivalent to $13.6 billion) in the euro area.

A final area of uncertainty, the strength of China’s economy is hardly the least significant one in contemplating how EUR/USD might perform over the rest of this year.  More and more analysts are concluding that Chinese growth is going to slow enough to constitute a socially, economically and politically disruptive hard landing.  China holds almost $1.2 trillion of U.S. Treasuries and its continuing appetite for foreign currencies remains a crucial determinant of how they perform against one another.  U.S. politicians, who threaten retribution for unfair Chinese protectionist policies including complaints about yuan undervaluation, are playing with fire, given China’s potential influence on U.S. interest rates and the fact that 2012 is a transitional year for China’s ruling communist party leadership.

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

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