Continuing Choppy Forex Conditions Fed by Uncertainty

October 19, 2012

Market noise continues to drown out an sense of cumulating trend.  Key dollar pairs against the euro, yen, Swiss franc, sterling, Australian and New Zealand currencies are each trading presently less than 2.0% from their year-to-date average levels.  The same is even true of the euro-yen relationship in spite of its 18.5%-wide 111.435 to 94.075 high-low range.  The big surprise of the year has been the resilience of the euro, which is a dime stronger than its low of $1.2041 hit on July 24 when that currency’s very short-term survival prospects were considered dubious by many.

High levels of uncertainty have deterred dollar swings from cumulating in 2012, and uncertainty will persist over coming months on several matters.

The fear of a euro break-up has not disappeared entirely.  Structural imbalances within the single monetary union remain severe, and the officials who represent the different participating nations still squabble publicly on many issues.  Nevertheless, September, which had been viewed for a long time as breaking point for the common currency, has come and gone, and the euro still stands with all 17 members inside.  In the 1990s, it was doubted that the Ezone would ever happen until investors appreciated the purely political motivations that were driving the project.  The political commitment to preserving Euroland has again been underestimated recently. 

The ECB’s bailout plan could still be exposed if Spain doesn’t apply for aid, but for now investors are leaning toward the view that Spain’s leaders will not let that happen if other ways to service debt prove inadequate.  Peripheral bond yields versus Germany remain uncomfortably wide but not in crisis territory. 

Just over two weeks remain before the U.S. election, yet the outcome remains in great doubt partly because of the state-by-state method of electing a president.  Investors seem to be leaning narrowly toward assuming that Obama will win because the economy has performed marginally better and a variety of slim advantages exist in areas that are not directly related to the economy.  If Romney wins, the new policymakers seek to implement profound sea changes affecting taxes, entitlement spending, the dual mandate of monetary policy, financial market regulation, and trade. 

An even greater uncertainty than the winner of the presidential election involves the subsequent fiscal cliff.  This hinges on the congressional contests as well, and a great number of plausible scenarios exist between the extremes of nothing getting done and producing a comprehensive bipartisan accord that waters down near-term fiscal drag substantially while steering the long-term budget outlook to a satisfactory trajectory.  Washington in eleven weeks from Election Day to January 20 will be a two-ring circus.  In one ring, a lame-duck congress will attempt to dampen or at least push back the full brunt of the fiscal cliff.  In the second ring, the staggered announcements of the president-elect’s cabinet appointments will drive sentiment about the future.

The road to China’s political transition, which is almost at hand, has not gone smoothly.  It may take quite a while for a coherent Chinese economic policy strategy to emerge.  China’s economic slowdown appears to have flattened, but the shape of the growth profile in 2013 and 2014 remains uncertain.  If Romney wins and fulfills his pledge to declare China a currency manipulator, a trade war between the world’s two largest economies could ensue.

Japanese officials continue to threaten currency intervention to dampen yen strength.  This risk has been waved around for months without any action being actually taken.  A semi-annual full policy review by the Bank of Japan at the end of October presents an opportunity to walk the talk.  Market players are wary of the possibility of actual intervention but lean in their thinking to the view that such will either not occur or at worst be a single-day event.  A further expansion of quantitative easing in Japan is considered the likelier action.

Asset markets until today had been in a generally risk-positive frame of mind, which on balance helps the dollar.  This respite may be ending, because quarterly corporate data on earnings and sales have been more disappointing than expected for the most part.  The coming two weeks before the U.S. election will be especially difficult for currency market participants to sort out, as political polls and domestic financial markets influence one another.  It will not be easy to separate cause from effect.

The euro is prone to sustained depreciation only in the face of clear and present danger to its existence.  The euro’s rise since July sheds light on the previous depreciation, which it turns out was more speculative than realized.  Much of Euroland is in recession, and even the German and French economies have weakened recently without hurting the euro.  Those analysts that were predicting a euro brush in 2012 with $1.10 or possibly even parity based that view on the projection of deficient European growth compared to U.S. growth, as well as the possibility of a full or partial break-up of the Monetary Union.  All that’s been reduced since July is the high perceived chance of a split-up.  Even in July and August, the region’s balance of payments was healthier than generally imagined.  The seasonally adjusted current account recorded a surplus of roughly EUR 17 billion over the two months, and the unadjusted “Basic Balance” that includes long-term capital flows as well as the current account posted a two-month surplus of EUR 38 billion.  Although the euro has some very weak components, these are offset by some of the developed world’s best running economies.  The logic that a chain is only as strong as its weakest link is not an appropriate way for assessing the euro.

The potentially most influential developments in foreign exchange next week are the FOMC decision, the release of preliminary estimates of third-quarter U.S. and British GDP, and revelations that might be found in preliminary euro area, German, and French purchasing manager surveys.  Fed easing of some sort  seems likely but can take many forms.  Whatever central bank officials decide, one objective will be to edge the dollar lower or, at worst, not encourage the currency to rise.  Analysts expect the U.S. and British GDP figures to be positive.  The PMI data will confirm that Euroland’s recessionary trends in the third quarter carried into the autumn and, moreover, whether the downturn is flattening or picking up momentum. 

The final U.S. presidential debate on Monday and string of opinion poll results will be closely watched but are likely to exert significant influence on the dollar only if and when a likely winner emerges in public opinion.  Based on the party platforms, I would expect the dollar to trade on a lower plane over the course of 2013 if there is a change in the presidency than if Obama gets a second term.

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

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