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Thursday February 23, 2006 - 17:27:48 GMT
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Next Big FX Move Structural, Not Cyclical...April

I am sorry but nothing Fukui said Thursday in parliamentary hearings qualifies in my book as a shift in policy. Indeed the Governor seemed to try and check press reports that something new and different is afoot at the Bank of Japan when he told Dow Jones Newswire that he emphasized nothing in his remarks...in other words Fukui was surprised by the hullabaloo in the financial markets.

To begin with Fukui said the Bank is prepared to end quantitative easing immediately once conditions for doing so are met - that core CPI stabilizes above zero. He said core CPI would be positive from January on. But Fukui and other Board members have been more explicit about ending quantitative easing...April to be exact, when the new fiscal year begins. This would provide a quarter's worth of CPI data and better basis to determine if assumptions are correct and inflation has stabilized above zero. Keep in mind the GDP deflator in Q4 was down 1.6% y/y...so not all inflation measures are aligned.

Markets also seemed to seize on Fukui's remarks about normalizing interest rates. Here he was repetitive...not immediate, but some point in the
future. There is no date attached to this the way there is the quantitative easing. And frankly I think the BoJ will be hard pressed to carve out one rate hike this year much less several.

Which leads me to the notion that the yen carry trade is dead. I don't think so. It is just not as frothy as it was a few hours ago. Risk aversion in FX land has risen this week, especially in the more exotic high yield currencies like the Icelandic krona, the Hungarian forint and the Brazilian real. And it is not surprising that the Kiwi has been hit hard against the USD, AUD, EUR and JPY...talk about a one-sided currency bet/market.

But shift up in risk aversion away from risk neutrality does not mean a whole lot for the US dollar and the euro where positions are reasonably balanced or markets two-way.

Furthermore I am not looking to a cyclical interest rate or growth story to drive the next big move in the euro, dollar or yen. Central bank policy in the respective locals are somewhat if not entirely offsetting (least so in Japan, today's noise notwithstanding).

In a similar vein I believe the German IFO index gain today does little to alter the outlook for ECB rate policy. My stomach gets knotted up every time I read that the report secures an ECB rate hike next Thursday. Was there ever a doubt before IFO? How many ECB officials does it take to say there will be a rate increase in March before the market believes it? Clearly more than is needed to screw in a light bulb based on market commentary today.

The cyclical theme of competing interest and growth rates is not the pathway to the next major move in FX full stop.

The next big move in FX land for the triad currencies and namely the dollar will come when the market focus switches back to the structural imbalances that demand a lower dollar. I think April is the month where this theme reemerges. US Congress is moving on protectionist legislation to protest China's meager currency policy reforms, the US Treasury, in its April FX report to Congress, is compelled to name China a currency manipulator for failing to let the yuan move more freely (higher), Chinese President Hu is in the US for a state visit and G7 meets ahead of the World Bank/IMF meeting April 21-22. G7 can no longer put off the adjustment process without securing a disorderly adjustment with its current de facto benign neglect approach.

A more significant revaluation by China in April (maybe late March) could well be the key to the structurally weak dollar door. If China does do what no one thinks it will based on official rhetoric from its political leadership, then Europe and Japan will be far more inclined to accept the inevitable - a broad US dollar decline, and advocate one. It is worth noting that most major turning points in the dollar (Plaza, Louvre, Rubin strong dollar...to name a few) were led by G7 officials. This is somewhat to be expected given that markets are prone to overshooting and undershooting. Maybe I am giving G7 and China too much credit here. But the fact is the longer adjustment process is delayed the more severe the process will be when it comes...and it will come, dark matter or no dark matter.

David Gilmore
FXA
www.fxa.com

 

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