The final weeks of 2009 have brought a sense that tides may be turning in the foreign exchange market, reflecting broader developments in the global economy. The predominant changes relate to the dollar.
December’s 5 percent recovery in the dollar index is linked to a better outlook for the US economy. There are risks to this optimism but short-dated US yields have pushed higher since late November, allowing the dollar to shrug off the downtrend that characterized it during 2009 and potentially embark upon a recovery against some currencies.
Better US economic data in early December could not have come soon enough for the Japanese authorities. In late November dollar/yen had fallen to a 14-year low. Having proclaimed the economy to be in deflation, the Japanese government openly pressured the Bank of Japan to take further supportive measures.
The Bank announced an emergency credit facility and subsequently stated it will not tolerate a negative inflation rate. This, combined with a rise in short-dated US yields, has allowed the yen to take back the mantle of favored funding currency from the dollar. The downtrend in dollar/yen, in place since mid 2007, may be turning.
In view of weak domestic growth prospects, there is much political will in Japan and the euro zone for a stronger dollar.
During 2009 euro/dollar was driven almost exclusively by the pros and cons (mostly cons) of the dollar; euro zone fundamentals were decidedly in the back seat. Over the past couple of weeks, there has been an increase in the negative press surrounding the fiscal difficulties of some euro zone members which has pressured the currency.
No doubt there is more bad news on budgets waiting in the euro zone’s wings which could come from Greece, Ireland, Spain or Portugal. Austria, the Baltics and Iceland may also have nasty surprises up their sleeves.
While there appears to be no real risk of the European Economic and Monetary Union breaking down, there could be sufficient bad news to highlight the inadequacies of EMU’s budget criteria and bring a rocky ride for the euro.
December’s 2.9 percent drop in cable is more moderate than the 4.8 percent decline in euro/dollar. The euro’s underperformance reflects its sovereign deficit problems. The outlook for Britain remains mired by its own weighty problems.
Despite decent labor data in Britain, issues surrounding the budget deficit, slow growth and the upcoming general election are likely to weigh on sterling. With the euro under pressure, cable is likely to reflect this weakness.
It is feasible that the dollar will maintain a better tone against the euro, the yen and the British pound while still underperforming higher yielding currencies.
The Australian dollar/dollar has moved off its recent highs on fears that having tightened policy three times the Reserve Bank of Australia may leave rates steady for an extended period.
While the dollar’s downtrend may persist against some currencies, dollar appreciation against the yen and the euro would likely be sufficient to keep the dollar index trending higher.
This would relieve immediate pressure on China to revalue its effective dollar peg. Once China is confident that external demand has strengthened a revaluation of the yuan will become more likely, meaning a move is possible in the second half of 2010.
