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Friday September 5, 2008 - 17:18:45 GMT
Larry Greenberg -

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Foreign Exchange Insights

The dollar recovery continues, feeding in part off the failure of the economies of Japan and in Europe to withstand a U.S. slowdown.  Several better-than-expected Japanese monthly indicators point to a better-than-expected start for that economy in the third quarter, but second-quarter growth is likely to get revised to negative growth in excess of 3.0% and maybe even as much as -4.0%.  The plainly bad situation in Europe is less ambiguous.  Just about every data point in both the European Monetary Union and Great Britain is arriving weaker than forecast, so much so that the anti-inflationary biases of monetary policy at the ECB and Bank of England has stopped lending discernible exchange rate support.  From its August lows to September 5th highs, the dollar recouped 12% against sterling, 10% versus the euro, and 7% against the Swiss franc.

Two major currencies against which the dollar is not appreciating are the Chinese yuan and Japanese yen.  The yuan’s circumstances reflect a policy decision.  That currency only moves when Beijing officials want such, and they exert pin-point control over when change occurs and how rapid it is.  Official concern has grown over Chinese export prospects amid weakening global demand, while inflation has subsided more than expected, further shifting policy priorities.  The yen’s resilience cannot be entirely explained by better data from Japan than Europe.  As the financing currency for enormous carry trade holdings of once-hot commodity currencies, the yen does well when investors bail out of the latter. From August lows to its highs this past week, the U.S. dollar appreciated over 17% against the Australian dollar, more than 11% against the New Zealand kiwi, and 5.4% relative to the Canadian dollar.  The greenback also reached a 2-month high against the South African rand.  From weekly highs of more than 110 yen in each of the first three weeks of August, in contrast, the dollar fell to as low as 105.55 earlier today.  And from a 2008 low against the euro of Y 169.98, the yen climbed 12.9% to a high this past week of 150.62.  Somewhat simplistically, it’s not unreasonable to assume that the farther that oil and other commodity prices decline from here, the better the yen is likely to perform.

As noted, the yen’s resistance to a dollar resurgence does not seem to be a function only of softer commodity markets and even worse news from Europe.  A look at all global financial trends — stronger bonds, weaker equities, weaker commodities, and a healthier yen — reveals a deepening aversion to risk.  An essential condition for carry trades — borrowing low-yielding currency and investing in the assets of higher-yielding currency — is the tolerance for risk.  Another beneficiary of risk-averse markets tends to be the dollar.  In the land of the blind, the dollar gains respect as the one-eyed king.

The year 2000, when the dot-com boom unraveled, provides a classic example of this pattern.  From early-2000 peaks to the year’s lows, the Nasdaq and DJIA fell by 53.8% and 17.0%, while 10-year Treasury yields sank as much as 177 basis points.  However, the era of dollar hegemony kept going, confounding market pundits.  From lows early that year to its highs in 4Q00, the dollar rose 26.6% against the euro and 13.5% against the yen.  Like now, other developed economies could not decouple from the U.S. business cycle’s turn for the worse in 2000.  The Japanese Nikkei, German Dax, and British Ftse dropped by as much as 35%, 23%, and 13% in 2000, while yields on 10-year Gilts, Bunds, and JGB’s fell by as much as 103 basis points, 80 bps, and 43 bps.  Then, too, holders of the dollar did comparatively well in an otherwise unfriendly financial and business environment.

Year 2000 was like 2008 in another sense.  The U.S. elected a new president with different personnel to manage the economy in a fresh direction.  The winner this coming November remains a huge question mark.  From an economic standpoint, neither choice evokes great inspiration.  The criticism of Senator Obama’s untested experience in an executive capacity has a ring of truth, and Senator McCain’s intent to take America further down the path of tax cuts that was fully explored over the past eight sub-trend years also carries risks.  U.S. stocks, growth in jobs, growth in GDP, and the Federal budget did not do well in most of the Bush43 presidency.  Neither did the dollar, which fell by as much as 48% against the euro, 47% against the Swiss franc, and 44% against the Canadian dollar.  However, these losses did not begin racking up from day one after the power handover.  The dollar’s surprising buoyancy in 2000 lingered through much of 2001, and the currency posted net end-year to end-year gains in 2001 of 14.8% against the yen and 5.8% against the euro.  2002 saw a considerably weaker record, with losses of 9.7% and 15.1% against those two currencies.

The global economic outlook for the next six months is worrisome, and that includes the prognosis in America.  With eight straight monthly declines in U.S. jobs averaging 76K per month, the ability for GDP to expand decently  on the back of brisk productivity, as attested in yesterday’s revised data, will get harder and harder to sustain.  I have doubts about a continuing U.S. dollar recovery based on relative growth trends and central bank interest rate responses.  But I do believe that there will be many more days ahead characterized by high risk aversion than by low risk aversion, and that factor should be enough to extend the dollar’s bounce.  None of these dollar supports is likely to be sustained over many years.  The analogy to 2001 is not perfect.  History repeats exactly hardly ever, and the future course of oil prices and the ability of China and India to carry global demand injects a key new dimension to consider.  That said, my reading of why the dollar has done well recently and the analysis of its experience in 2000-2002 argue against the view that the dollar may have embarked on a five- or six-year period of cumulating strength.

The week ahead features many trade reports, which usually cause little market stir but may attract atypical interest for information such shed on the spread of recessionary and inflationary forces from one region to another.  Some data highlights will be Japanese machinery orders, Economy Watchers’ index, and revised 2Q GDP; Euro-zone industrial production plus German and French trade; British producer prices and trade figures; Canadian trade and productivity; Chinese retail sales, consumer prices, and trades; and U.S. producer prices, trade, and retail sales. The difficulty of running monetary policy in stagflationary times will be underscored by a likely juxtaposition of at least one rate hike (South Korea) and at least one cut (New Zealand) during the week.  The week just ending also saw central bank rates increased as well as cut.


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