A Telling Week in Foreign Exchange

September 14, 2012

Market reactions to the ECB and Federal Reserve monetary initiatives this month have clarified why the euro fell earlier this year and exposed underlying vulnerability in the dollar.  Euro weakness reflected the perceived imminence of a breakup among common currency users and not very much else.  In turn, dollar sentiment appears more fragile than comparisons of economic growth, productivity, demographics and banking system health would lead one to expect.

Financial market commentaries about the ECB and Federal Reserve policy announcements have not been particularly positive.  The latest central banking offers of stimulus are not considered panaceas addressing the root of U.S. and European economic troubles.  Nor has uncertainty been materially lessened.  Defections from the euro within several quarters are still very plausible.  The fiscal cliff deadline is looming closer, with no clear path to resolution.  A great deal hinges on the outcome of U.S. presidential and congressional elections that remain too close to call.  In other respects, generalized uncertainty has swelled.  U.S. relations with the Middle East took a nasty turn for the worse.  China’s political transition is not going smoothly, and economic prospects in that and other emerging economies look worse than had been hoped.

A variety of market reactions to the ECB and Fed have been quite electrifying despite the persistence of a very great amount of uncertainty about critical matters.  Let’s put aside the movement of currencies for a moment and focus on other areas like stocks, bonds and commodities.  In each of these instances, it is clear that the summer is ending with investors in a different frame of mind than when it began. 

  • The Dow, S&P, Dax, and Nikkei each rose a further 2-3% this week, but the rally in equities actually dates back to the final week of July when hints of a dramatic ECB change began to surface.  Since July 24, the Nikkei has recovered about 8% and is again above 9K.  The S&P 500 as of this writing has gained about 10%, and the German Dax has soared nearly 16%. 
  • 10-year Treasury and German bund yields advanced nearly 20 basis points this week and have leaped almost 50 basis points since late July, but the yield spread between U.S. and German sovereign debt remains essentially unchanged.
  • 10-year yield spreads versus German bunds have dived by nearly 700 basis points in the case of Greece, over 350 bps for Portugal, some 200 bps for Spain and around 175 bps in Italy’s instance.
  • Oil and gold prices are each roughly 12% higher than on July 24.  Other commodities have been well bid, too.

The euro has strengthened impressively against the dollar and its major cross relationships. At today’s high of $1.3170, the euro had reversed 78% of its 2012 peak to trough decline.  The common currency was 9% above its lifetime mean and just 5.4% below its average level in 2011.  Euro/yen this week has virtually matched the appreciation vis-a-vis the dollar, and the euro outpaced rises of the Swiss franc, sterling, and Australian dollar. 

Taking a longer perspective of the movement in major currencies, however, one finds a stratification that places the Swiss franc and yen high on the totem pole and the dollar and sterling on the bottom.  A meaningful frame of reference for such an examination is the end of 1998 when eleven European currencies as charter members married into the family of euro.  Foreign exchange trading changed fundamentally at that moment just as such had when flexible exchange rates replaced a regime of fixed parities in March 1973.  The lifetime average levels of the Swiss franc and yen against the euro of 1.4971 and 126.89 are roughly 19% lower than the current cross rates in those key relationships.  Prior to 1999, the franc, yen, and mark had been grouped together by analysts and called “hard currencies” because of their tendency to strengthen on the basis of certain economic fundamentals like low inflation and chronic current account surpluses. 

The Swiss franc and yen now occupy a higher rung than the euro, which makes intuitive sense because the euro is a watered-down mark.  While Euroland shares and even surpasses Germany’s former track record of low inflation, other traits of the European monetary union are not as stellar as the Germany-backed D-mark.  Growth and the current account are two examples.  That being said, the dollar has not overtaken the euro in the pecking order.  Even with Euroland singled out for the past three years as the epicenter of the world’s greatest downside growth risk, the euro has stayed above its lifetime average level against the dollar.  The same can be said about the euro’s cross rate against sterling, which is currently more than 10% above the post-1998 mean of 0.7125, so sterling too is well down in the currency standings. 

Sterling shares a key characteristic with the dollar besides the commonality of language, and that is the tradition of having been a predominant international reserve currency.  Along with advantages of having a reserve currency like the ability to borrow one’s own money abroad, easy opportunities for shorting reserve currencies develop.  At the same time, depreciation in a reserve currency has less dire consequences for the host country than does eroded external value of currencies that are not a current or former reserve asset.  The operative word from the pound’s perspective is “former.”  After a currency has relinquished the role of reserve currency hegemon, it continues to exhibit chronic heaviness that transcends what fundamental economic trends would otherwise suggest.

Commodity-sensitive currencies have outperformed the U.S. dollar over the past two years.  In that period, the Australian and New Zealand dollars have risen about 13%, and the loonie has climbed by a smaller 6%.  A direction of appreciation is hardly surprising given net gains of 40% in gold prices and 29% in oil.  What’s less obvious is why commodities continue to rise amid softer global economic growth and subdued core inflation.  One explanation rests on the exponential growth of world population, which is making greater and greater demands on all kinds of resources.  This strain will persist near the surface regardless of how the euro debt crisis and U.S. fiscal cliff stories unfold. 

The officials of commodity-sensitive economies face different circumstances than do those in Switzerland and Japan.  Upward pressure on commodity currencies is warranted by improved economic fundamentals.  The strength of the yen and Swissie, however, stems from adverse circumstances happening elsewhere and their natural appeal as a refuge to park wealth.  It’s been a year and a week since Swiss National Bank authorities declared “enough already” about the franc’s then-relentless and punishing appreciation.  Thursday’s quarterly review of Swiss monetary policy concluded that the franc remains far too strong, which is dampening growth prospects and sustaining a deflationary threat to the economy.  For now, the franc’s ceiling against the euro stays at 1.2000, but notice was served that officials will take new steps if the currency does not weaken eventually on its own.

Japanese officials are clearly losing patience with the yen’s excessive strength.  Verbal intervention is only managing to keep the yen steady against the dollar near historical record highs.  Japan’s economy has lost considerable momentum, with revised data putting GDP growth last quarter at merely 0.7% versus 1Q at an annualized rate.  The Bank of Japan meets next week for the first time since the ECB and Federal Reserve presented stimulus packages.  Those gestures ought to give Japan’s central bank authorities new motivation to expand Japanese quantitative easing, but messy domestic politics may dissuade them.

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

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