Currency Reflections on a Wintry Day

January 23, 2014

Optimism about U.S. growth prospects continues to mount, and many currency watchers have been awaiting just such a sign as the needed catalyst for a significant rise in the dollar against its main rival, the euro.  Canadian monetary officials just raised their projected 2014 U.S. growth rate by a half percentage point to 3.0%.  That would constitute the strongest calendar year pace since 2005, exceeding the rate of potential GDP growth and therefore alleviating disinflationary price pressures.  There would be little reason for the Federal Reserve not to proceed steadily with a drawdown of quantitative stimulus at no less than the current rate, or perhaps a faster one, and this would progressively differentiate U.S. monetary policy from the stances of other more cautious central banks.  U.S. growth of 3.0% would also nearly match the likely expansion rate of non-advanced economies excluding China and would be more than two percentage points faster than growth in the euro area and over a percentage point above likely Japanese growth.

Three weeks into 2014, however, finds the euro trading as high as $1.3674 today, near the upper boundary of its 2013 range of 1.3893 to 1.2744. The correlation between relative growth and the dollar’s value against the euro (or mark before 1999) has never been as intuitively straight-forward as myth would have one believe.  The euro’s Achilles heel is the possibility of the common currency breaking apart.  Such a risk has receded partly, but investors have for the most part abandoned efforts to trade on that factor because the timing cannot be determined.  Euroland’s greatest economic danger — sliding into Japanese-like deflation — wouldn’t necessarily be a bad thing for the euro, as the yen’s experience in the late 1990s and first decade of the 21st century surely attest.  Among aspiring reserve currencies, the dollar’s king-of-the-hill status is well-secured, but that role doesn’t assure appreciation.  The dollar has lost considerable ground since the international monetary system left fixed exchange rates and adopted flexible market-determined parities. The balance of payments matters.  While the U.S. current account deficit has narrowed to less than 3% of GDP, the euro area’s balance has swung from deficit into surplus, rising 80% to EUR 211 billion in the first eleven months of 2013 from EUR 117 billion a year earlier.

Foreign governments are watching the yen like a hawk, limiting that currency’s potential for additional depreciation.  This is a trust-but-verify situation.  Japanese Prime Minister Abe and Bank of Governor Kuroda were given a green light to implement a very loose monetary policy to end deflation, even though it’s acknowledged by all that the policy will likely depress the Japanese exchange rate.  Most, but not all, of the currency’s losses were front-loaded.  A present level of 103.60 yen per dollar lies 4% below the mean value of 99.6 over the second half of 2013, but it’s also 1.7% above last year’s low-point of 105.4.  Japanese officials continue to express satisfaction that monetary policy has probably been eased enough already and have rejected calls for more monetary stimulus as soon as March or April.  110 per dollar would seem to offer the limit of how far the yen might weaken during 2014 — a worst-case scenario if you will rather than a most probable outcome.

The Swiss franc has been shadowing the euro since a cap of 1.2000 francs per euro was imposed by the Swiss National Bank on September 6, 2011.  The current cross rate of 1.2311 is very close to the 2013 average level of 1.2335.  Sometimes a fixed exchange rate imposed by officials offers a target to topple that proves too enticing to refuse like sterling membership in the old ERM that George Soros famously ended in September 1992.  Other times, a pegged exchange rate succeeds beyond anyone’s imagination like the Hong Dollar’s parity of 7.76 per USD since October 17, 1983.  Until Swiss monetary officials decide that its current policy to guard against deflation is no long self-serving, the strategy looks more like the second above example than the first, that is free from serious speculative challenge.

Sterling’s value of $1.6622 today is already above its 2013 high of $1.6578 and represents an 11.4% advance from the 2013 low of $1.4919.  By coincidence, however, the pound is trading almost spot on its average value over the interval since the onset of the global financial crisis on August 9, 2007.  It’s been my experience of nearly 40 years as a currency market watcher that sterling is among the most difficult currencies to predict future movement.  The recent uptrend makes sense since few economies performed better relative to market expectations than Britain’s during the second half of 2013.  But viewed from a broad perspective, the pound has merely returned to its center of gravity.  Early in the financial crisis, sterling was as strong as $2.1160 on November 9, 2007.  Unlike the United States, British GDP hasn’t fully recovered its pre-crisis level, and the British current account deficit relative to GDP is about 50% larger than America’s.  The Bank of England’s attempt at forward guidance seems even more confusing and snake-bit than the Fed’s.  More fiscal austerity is on the way in the U.K. but letting up substantially in the United States.  Sterling’s uptrend could hit diminishing returns.

The Australian and Canadian dollars are 17% and 12% below their 2013 highs.  Central banks in those countries have been outspoken in proclaiming their currencies to be overvalued.  Yesterday’s statement released by the Bank of Canada declares “inflation is expected to remain well below target for some time, and therefore the downside risks to inflation have grown in importance.”  Officials then go on to suggest for the first time in over three years that the next interest rate change in Canada could be a reduction:  “the timing and direction of the next change to the policy rate will depend on how new information influences the balance of inflation risks.”  The baseline forecast projects on-year core CPI averaging 1.1% in the first half of this year and 1.4% in 2H14 versus a target of 2.0%.  As late as the final quarter of 2015, core inflation rises to only 1.9%.  The recent depreciation of the C-dollar is being counted upon to lift exports, business confidence, and investment.  Officials in Canada and Australia would no doubt welcome more depreciation and are using rhetoric to get results.  Failing that, each central bank will resort to more concrete measures.

Copyright 2014, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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