This Year’s Paradox of Foreign Exchange

October 12, 2012

Managing risk in this year of daunting uncertainty has been extremely difficult.  The paradox is that key currency pairs have been comparatively stable. 

I submit that it is reasonable to presume that uncertainty would correlate positively with cumulating currency movement.  This certainly happened after the October 1987 single-day 22.6% crash of the U.S. stock market.  A big drop in the dollar ensued.  The dollar also adjusted significantly after Iraq invaded Kuwait in 1990 and following the 9-11 attacks in 2001.  My favorite example is from 1973-74 when, for example, dollar-mark whipped from 2.90 early in 1973 to 2.20 by July and back to 2.90 by late that autumn.  In 1973-74 investors grappled with the implications of many shocks:

  • The Watergate scandal.
  • The Yom Kippur War.
  • A transformation of the international monetary system via the introduction of flexible dollar exchange rates when the U.S. suspended intervention.
  • A subsequent decision by the U.S. government to intervene when necessary to counter disorderly market condition but not to reestablish fixed rates.
  • Sharp oil production cutbacks and and a nearly fourfold jump in prices engineered by OPEC over the space of two months.
  • The acceleration of U.S. CPI inflation from 3.4% at end-1972 to 12.2% two years later.  Steep increases in inflation in other countries, too.
  • A severe and prolonged year-and-a half recession shared by many economies.
  • The elimination of U.S. capital controls in January 1974.
  • The revelation of heavy FX losses at Franklin National Bank and the collapse of Herstatt Bank also related to currency trading losses.
  • Britain’s first withdrawal from the EC “snake” and a series of other stochastic changes in intra-European currency parities.

Those were chaotic times, but so is the current period.  In America, whose economy is performing better than Europe’s or Japan’s, a fast-approaching fiscal cliff could prove catastrophic.  The election just over three weeks from now presents voters with the vastest choice in a lifetime on almost every imaginable matter.  The European Central Bank’s insistence on the irreversibility of the euro remains a slogan that lacks real credibility, and this vulnerability is apparent in sovereign debt spreads but not the exchange rate.  Japan has experienced two decades of disappointing politics and economics.  The only remaining powerful aspect of Japan is its currency, much to the the chagrin of Tokyo officials who with increasing stridency are hinting of drastic action to weaken the yen.  The problems of the developed economies are seeping into emerging markets, and the most important of these, China, faces a once-in-a-decade change in political leadership.

Key currency pairs, such as the four in the table below, have nonetheless been remarkably stable.  To be sure, euro/yen has ranged this year in an 18.5% high/low band.  The width of the dollar’s 2012 trading bands against the euro and yen have been 12.0% and 10.2%.  However, what sticks out about these relationships is their value at this writing in comparison both to quotes at the start of the year and to their year-to-date averages.  The width of the dollar’s high/low ranges over the first two weeks of October has been 2.1% against the euro and 1.0% versus the yen.  The Australian dollar is virtually unchanged from its end-2012 level against the greenback, while sterling and the Canadian dollar show year-to-date advances of only 3.5% versus the U.S. currency.  All things considered, this been a rather trendless year, and stability continued to be observable in the first two weeks of October.

  October 12, 2012 2012 AVG January 2, 2012
EUR/USD 1.2944 1.2824 1.2931
USD/JPY 78.35 79.30 76.92
EUR/JPY 101.42 101.73 99.49
EUR/CHF 1.2087 1.2044 1.2162

In the week ahead, the IMF/World Bank meetings in Tokyo have the potential to generate market-moving comments.  Restlessness about the integrity of the euro will likely increase if this opportunity passes without discernible evidence of further progress toward implementing mechanisms for resolving the region’s crisis.  The week will be a light one from a data-release standpoint for the euro area and Japan.

Some important U.S. economic data are due such as retail sales, industrial production, and housing starts but these are likely to be overshadowed by Tuesday’s second debate between Obama and Romney.  The first debate reset the campaign back to “too close to call” status. If Obama doesn’t win in the second debate, investors will increasingly decide that huge changes are coming in U.S. health policy, tax policy, foreign policy, and social policy on a scale comparable to those experienced in 1913 and 1933.

A third area of keen interest in the coming week is going to be China, which is scheduled to release its monthly price, money, trade and activity indicators plus third-quarter GDP.  The government and central bank have thus far implemented less stimulus than market participants were assuming, and China has led a slowdown among emerging markets that has been sharper than what markets anticipated.  With such an array of distractions from the United States, Europe and China, it may be an opportune time for various players elsewhere to seize the initiative.  New headlines from the Middle East or Japanese FX intervention are two possibilities.  The combination of America’s fiscal cliff, Europe’s political disunity and structural vulnerability, weaker developing country growth prospects, and event risk will test the stability of currency markets.  But if currency stability manages to withstand substantial shifts in the global political and economic landscape, it may be that the answer to this riddle lies in the evolutionary changes in how foreign exchange trading is conducted.

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


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