To What Drum Will Major Currencies March?

April 6, 2012

A special report on foreign exchange in the April 5th edition of the Financial Times presents two competing currency market drivers, mood swings between risk aversion and risk appetite and conventional cyclical discrepancies between key economies.  It is asserted that risk on/risk off swings dominated market behavior last year, preventing significant directional movement and ultimately leading to a stronger euro than orthodox forecasting models seemed to suggest.  A second point is made that 2012 will likely yield greater dollar strength as the contrast between U.S. growth and European recession becomes a more dominant market mover.

I believe that surprises unforeseen at the present will in fact provide the market’s loudest beat.  With 20-20 hindsight, this is not a novel idea.  Currency activity in 2011, for example, was heavily influenced by the Sendai earthquake, the deficit showdown in Washington last summer, the twists and turns of the euro debt saga, winds of revolution in North Africa and the Middle East, and the interventionist policies of the Japanese Ministry of Finance and Swiss National Bank.  2011 was not really an aberration in delivering unplanned shocks.  In an era of global warming, greater income inequality, rapid technological innovation, unsustainably huge economic imbalances, and shifting importance between the long-time industrialized world and emerging nations, it would be strange if markets weren’t bombarded with game-changing surprises on an uncomfortably frequent basis.

The two competing currency models of risk on/risk off swings and unsynchronized business cycle strains moreover fail to answer the ultimate question of where the dollar, euro, yen, Swissie, and other major currencies are ultimately headed.  A risk on/risk off view of the market is simply an argument for lots of volatility.  As the FT notes, that’s not conducive to a reliable carry trade strategy of borrowing in low-interest rate currencies and investing in denominations whose assets offer high yields.  All it tells the investor is that whip-sawing price action will be common and that market noise will drown out any tendency for a trend to take root.  This is a playbook for day traders but ignores the reality that trend moves happen more times than not if one gives the market a little time.

The shortcoming of trading on cyclical economic disparities is that such oftentimes yields totally misleading information.  Compared to their levels against the dollar exactly ten years ago, the yen has strengthened 60.3%, and the euro has appreciated 48.6%.  Over the ten calendar years between 2001 and 2011, real GDP expanded at annualized rates of 1.6% in the United States, 1.1% in the euro area and 0.6% in Japan.  In other words, the ordinal ranking of economic growth was inverse to the performance of the currencies. The 10-year sovereign debt yield spread between America and Germany is merely 20 basis points wider now than it was on the first April Friday of 2002, hardly enough to suggest that a near 50% swing in the exchange rate would be warranted to clear the market.  Currency trading is loaded with such anomalies.  For another example, the Federal Reserve doubled the Federal funds target rate from 3% to 6% during the year to January 1995.  Treasury yields shot up even more sharply in response, yet 1994 was an awful year for the dollar.

From where might big surprises arise in the rest of 2012?  Rounding up the usual suspects, the next acute phase of the euro debt crisis centering on Spain and Italy as well as Greece and Portugal seems likely to happen sooner rather than later.  China, which influence currency markets as a key engine of world growth and mover of enormous sums of wealth, is in an unpredictable transition year for both its political leadership and economy.  Israel could make good on its threat of acting self-defensively with an attack on Iran’s nuclear facilities, which in turn would likely trigger a spike in oil prices and the kind of geopolitical chain reaction that precipitated the First World War.  Contrary to the perception that oil prices have been spiking continuously since mid-2010, such rose by just 3.9% in the first half of 2011, 4.1% in the second half, and 4.5% so far this year.  A leap of more than 20% as happened in the second half of 2010 would exert a much bigger drag on world recovery than the recent gradual incline because the change in energy price is more pertinent than its level.

Another danger is the possibility that America’s political polarization takes a violent turn.  Civil disobedience, which has become a more common sight in much of Europe in protest against fiscal austerity, could spread to the U.S for reasons that are both similar and quite different.  Escalating frustration and anger might even give vent to assassination as it did 50 years ago and 150 years ago.  The ancient Mayans singled out 2012 among all possible choices for Armageddon.  Although the correctness of that forecast is extraordinarily unlikely, the possibility that the Mayans were right about the event but wrong about the year appears much higher, and so does the chance of 2012 becoming a year of momentous events to be recorded in history books.

Currency markets have found several comfort levels — in the low $1.30s for the euro and the 80s on the yen.  I suspect cyclical disparities and risk on/risk off swings are not going to be the catalyst to produce changes of 20 cents or more in the euro or 10 or more yen against the dollar, but I wouldn’t be terribly surprised if such was caused by a shock not yet seen on the radar.

That’s the big picture.  The immediate market challenge ahead concerns the Swiss franc.  This past week’s wave of euro-centric risk aversion lifted the franc past the 1.20 per euro ceiling, and today’s disappointing U.S. jobs report will keep investors in a pessimistic mood once trading resumes after the Easter break.  The Swiss authorities would be wise not to see if their policy constraint can be held with a threat or actual intervention.  It’s time for the Swiss National Bank to preempt all that with another big infusion of banking reserves.  In light of continuing deflation in Switzerland, the downside risks of such an action do not outweigh the risks of falling behind the curve in defending the currency policy.

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

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