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Friday August 29, 2008 - 18:51:38 GMT
Larry Greenberg -

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Foreign Exchange Insights

The dollar appreciated across the board during August, even against the yuan in China’s Olympic-hosting month.  However, dollar gains were not uniform in the month.  At 15:00 GMT today, the buck was showing a net rise against the yen since end-July of merely 0.6% but robust advances of 9.5% against the Australian dollar, 8.7% relative to sterling, and 6.0% versus the euro.  The U.S. currency performed much better in the first half of the month than in the second half but actually lost ground in the latter two weeks only versus the yen.  The dollar did very well in August against currencies associated with very high central bank rates and a mounting case for those rates to be cut.  Ten-year bond yields fell much more last month in Euroland and Great Britain than in the United States.  The Reserve Bank of Australia is expected to cut its cash rate on Tuesday to 7.0% from 7.25% and might even surprise us with a 50-basis point move.  The Bank of England does not appear prepared to cut its 5.0% Bank rate on Thursday, but many of us look at least for indications in September that such a move is already being more seriously contemplated.  In Switzerland and Japan, where local interest rates are too low to be cut, the franc slid just 0.2% since August 15, while the yen advanced against the dollar by 1.8% in those two weeks.

Two additional observations about the dollar’s better tone are the uptrend’s dependence on supportive commodity market developments and the fact that August in general and late August in particular constitute a time of year where market behavior may not be especially reliable as a guide to underlying sentiment.  Oil and gold prices fell on balance some 5% and 8% during August, preserving the inverse connection between the dollar and these commodities.  Compared to mid-month levels, however, oil is higher by 3.5% and gold by about 6.5%.  As for August, the world’s vacation month, many a trend that began then has endured into September and autumn.  Thin volume can intensify market price volatility, but that doesn’t necessarily invalidate the legitimacy of price direction

A summer rally is not hard to explain from a fundamental economic standpoint.  There has been an adverse shift in perceptions about growth outside of the United States, supported by a preponderance of weaker-than-forecast indicators.  After declining against the euro in five out of the six years to 2007, the dollar was ripe for a rally especially after G7 officials escalated their verbal warnings against those counting on endless depreciation.  Shifting trends in trade flows also seemed to justify a dollar correction.  Two years have now passed since the nominal U.S. trade deficit appeared to crest, and buoyant net export volumes were the main reason why forecasts of negative U.S. GDP growth in the first half of 2008 never materialized.  Meanwhile, balance of payments data from Japan and Europe show increasing signs of strain.

One cannot count on the  balance of payments backdrop for continuing dollar appreciation, however.  The current landscape has merely become less disadvantageous from the U.S. standpoint.  And opportunities for profitable investment in the United States, as elsewhere, are fraught with uncertainty.  Third-quarter U.S.  growth shapes up as weaker than in the second quarter.  The fragile balance sheets of financial institutions and still-declining housing market, where residential investment tumbled 15.7% at a seasonally adjusted annual rate in 2Q08, overhang the future.  The presidential election creates policy uncertainties.  The Dow Jones Industrial average eked out a 1.8% rise in August but remains below its peak in January 2000, more than 8-1/2 years ago.  The bull market of 1982-99 dawned in the midst of a recession but anticipated a quantum decline of inflation.  Nothing remotely so dramatic — such as a plunge of oil prices back to $40 or less — seems in the offing.

The scope for sustained and meaningful dollar appreciation thus rests on continuing bad news outside the United States rather than the U.S. economy really taking off, and invariably that opportunity leads markets to concentrate on central bank responses and a convergence of interest rates. Dollar bulls may be disappointed from both sides of this equation.  One risk is that anti-inflation rhetoric by Fed officials will not usher in an aggressive return to decently positive real interest rates.  A rate hike before end-2008 is iffy, and the possibility that officials will move soon  in increments of 50 basis points is even more dubious.  The other risk is the continuing reluctance of other central bankers to cut rates without clear evidence that inflation expectations are contained.  

Like last week, the first one of September offers a decent menu of economic news in terms of the number and importance of the releases.  But the array of central bank meetings may steal the show.  First up is Australia, where anything short of a 25-basis point cut with indications of much more to follow could disappoint investors.  A 50-basis point reduction is probably needed to boost sentiment in an electrifying way.  The Bank of Canada has already cut its rate from 4.5% to 3% but has made no moves since April.  Elevated inflation is a concern in Canada as elsewhere that probably will dissuade officials from reducing rates now, but a surprise ease cannot be ruled out.  I do expect that a growing inclination to reduce rates again will be conveyed.  Note that Canada’s rate announcement is scheduled for Wednesday, not the usual Tuesday, because Canada, like the United States, is closed Monday for Labor Day.  The Bank of England, ECB, and Swedish Riksbank announce decisions on Thursday.  The Riksbank is least likely to ease among the three, having hiked rates in July and indicating then that two more increases in 2008 are probable.  Despite weaker Swedish growth in 2Q08 of -0.1% saar than officials had assumed, central bank remarks since then have continued to warn of the risk of excessive inflation.  A Swedish rate hike is thus still possible next week, though the minutes of its July meeting revealed a split between hawks and doves. 

Britain arguably faces the starkest case of stagflation in the G7, and the Bank of England Monetary Policy Committee has a history of surprising markets more than other central banks with its decisions.  The consensus is for no rate cut mainly because no more than one committee member favored easing in August, and inflation is still rising.  The Bank Rate has been at 5.0% since April.  Most important is the ECB.  President Trichet indicated much more concern about weakening growth at his August press conference, but comments in the ensuing month by ECB officials dwelled mostly on the risks of inflation, not recession.  The Trichet-led ECB does not like to surprise investors, so odds-makers are not looking for a rate change.  The press conference will be scrutinized for signals about actions in the future, which can be conveyed directly or indirectly through new quarterly inflation and growth forecasts.  As in June, inflation will be revised up, and growth will be revised down.  The question in each case is by how much.

The three data releases  next week with the best chance to move markets are the U.S. monthly labor survey, a variety of PMI readings for both manufacturing and services, and Japan’s Ministry of Finance estimate of business investment during 2Q08, especially if the result suggests a possibly large revision to GDP growth.

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