Currency Outlook

Introduction

The US Dollar rose to 9-month highs against the Euro and British Pound this week, primarily on the back of sovereign debt problems in Europe. Only the fact that there may not be anyone left who has not sold the Euro can possibly help the European currency at this point, at least in the short-term. We look for the Japanese Yen to move lower but foresee continued strength in the Australian Dollar. Gold will continue in a trading range.

US stock markets chalked up their second consecutive weekly gain this week, the first such 2-week winning streak since December. The Dow Jones Industrial Average closed the week at 10,402.35, up 303 points (3 percent) for the week, while the S&P 500 Index ended at 1,109.17, up 33 points (3.13 percent). Investors were encouraged by strong corporate earnings, reduced concerns about sovereign debt defaults in Europe, and the Fed’s decision to raise its discount rate.

Meanwhile, the US Dollar rose to 9-month highs against the Euro and British Pound, as well as an 8-month high on a trade-weighted basis, before succumbing to some profit-taking late in Friday’s session.

The Dollar had been under heavy pressure for much of 2009, leading analysts to write off the greenback. However, to paraphrase Mark Twain, reports of the Dollar’s death appear to have been an exaggeration. Beginning in November, the Dollar began a remarkable recovery that has carried it to the afore-mentioned highs.

This article will look at where we think the Dollar can go from here, as well as examine the outlook for some of the other major currencies and gold.

US Dollar

US Dollar Index – 5-year Chart 021910

The Dollar’s decline for much of 2009 could be ascribed to several factors: a lingering hangover from the 2008 financial crisis with all its implications for US economic growth, an increasing appetite for risky assets, and the use of the Dollar as the new “carry” currency.

Between the Obama administration and the Federal Reserve, the US spent more than any other country in an attempt to stave off a depression or, at least, a severe recession. They succeeded in their objective but at the result of adding massive amounts to the country’s (in fact, the world’s) money supply while building a massive fiscal deficit. Investors became concerned about resurgent inflation because of both the magnitude of the money supply and the deficit.

As economies around the world began to recover in 2009, investors also redeveloped a willingness to take on risk. In addition to putting their money into the US stock market, they bought into developing-nation stock markets, as well as commodities, while selling Dollars.

Finally, because of low interest rates in the US, the dollar became the new carry-currency. In the early years of this decade, the yen-carry trade had become a popular investment vehicle. Investors would borrow Japanese Yen at low Japanese interest rates, convert the yen into higher-yielding currencies and reap the interest-rate differential. They received an added benefit: often when it came time to buy the yen back when they were unwinding their trade, the yen would have depreciated so investors were frequently able to buy the yen cheaper than when they put the trade on. As 2009 developed, low interest rates in the US allowed investors to replace the yen with Dollars. Again, with the Dollar depreciating throughout much of the year, investors also benefitted from the Dollar depreciation.

In the fourth quarter of last year, these factors began to shift. US economic growth in the third and fourth quarters of the year came in higher than expected, in fact outperforming many of the other developed nations, particularly in Europe. At the same time, inflation appeared to remain under control (investors were still concerned about inflation down the road, but many other developed nations seemed to be in the same boat, especially the UK).

There also began to develop some concern about the nature of growth in the developing nations, particularly in China. China’s growth was pushing an annual growth rate of ten percent, but it was coming on the back of what seemed to be excessive lending, possibly leading to a bubble in Chinese real estate and the Chinese stock market. On top of this, commodity prices began to level out. All of a sudden, risky assets didn’t look so attractive.

Third, as the US economy began to recover, and analysts began to focus on the specter of inflation, investors who had put on Dollar-carry transactions began to unwind some of those transactions, even though there was still no evidence of rates increasing in the US (until this week, that is).

These factors, along with some profit-taking by investors and traders that had been heavily short the Dollar, led to a shift in attitude regarding the US currency.

A fourth factor contributed to the shift. As investors began to search for new alternatives around the world, they also turned to the safe haven of the Dollar, a role the Dollar had assumed at the beginning of the crisis.

The strength in the Dollar wasn’t entirely Dollar-centric. Problems in the Eurozone and in the UK led to weakness in the Euro and the British pound, respectively. Concerns about sovereign debt default in several of the Eurozone’s peripheral countries along with economic weakness and fiscal problems in Britain caused investors and traders to buy Dollars at the expense of those currencies (more on this below).

Now, we appear to be at another crossroads. Can the Dollar continue its recovery or is it ready for another move to the downside?

In the past two weeks, five events occurred that we believe could have a bearing on the Dollar’s future course.

The first two concern China. Last week, the Chinese raised, by fifty base points, the capital reserve requirements that banks must maintain against outstanding loans. It was actually the second time the Chinese raised reserve requirements this year (the Chinese had raised requirements by 50 basis points in late-January as well). Some investors are concerned the two increases mark the beginning by China of a general move toward lending restrictions. If that is the case, it could be bearish for those countries whose economies are commodity-based, like Australia (tighter credit would cool the Chinese economy somewhat, possibly leading to reduced demand for raw materials). In fact, the Australian Dollar did fall on the news. There is a second school of thought, however, that maintains the reserve-requirement increase was strictly a technical maneuver by the Chinese. They point out that the announcement of the increase came on the eve of the Chinese New Year, to take effect on February 25, the day after the celebrations end. Each year, China adds reserves to the Chinese financial system because of the heavy demand for cash during the New-Year celebrations. Raising the reserve requirements would simply be a way of removing these reserves.

The second action by the Chinese was revealed this week in the Treasury’s monthly International Capital (tic) report (for December). In that month, China sold a net total of $34.2 billion worth of US Treasury securities (selling $38.8 billion worth of Treasury bills and buying $4.6 billion in Treasury notes). The sale dropped China into second place among the holders of US debt. (Japan holds $768.8 billion vs. China’s $755 billion.) China has sold a net total of $45 billion worth of Treasuries since last July. Should this trend continue, or possibly accelerate, it would pose a problem for the Obama administration and would certainly be bearish for the Dollar. China, however, could simply be moving out along the yield curve, lengthening the maturities of their holdings, which would then be bullish for the Dollar. But a net decrease in overall purchases is still a decrease. Net foreign purchases of US securities fell to $63.3 billion in December from $126.4 billion in November.

On a positive note for the Dollar this week were the economic numbers released on Wednesday. Housing starts jumped 2.8 percent in January, to an annualized rate of 591,000 starts, their highest level in six months, while industrial production rose by a better-than-expected 0.9 percent in January, its seventh successive monthly gain. But hanging over the economy is the continuing specter of joblessness. Unemployment remains near ten percent and this week new jobless claims rose by 473,000, erasing the euphoria created by last week’s decline in new claims to 440,000. Economists had predicted this week’s claims would also be in the neighborhood of 440,000.

Overseas economic numbers also supported the Dollar. The overall purchasing managers’ index for the Eurozone (comprising manufacturing and service industries) was a disappointing 53.7 for February, unchanged from January and down from December’s 54.2-level. Economists had predicted an increase in the index. The report on the index came on top of last week’s report that showed that overall Eurozone GDP had increased by only 0.1 percent in the fourth quarter, compared to 1.4-percent, quarter-on-quarter growth, for the same period in the US.

In the UK, the government reported that it ran a deficit of 4.3 billion pounds ($6.7 billion) in January, the first January deficit (January is traditionally a big cash month in the UK) since numbers began being recorded in 1993.

Adding to safe-haven buying for the Dollar has been the looming possibility of a sovereign debt default in Greece.(see below). At week’s end, Greece has apparently been given a month (to March 16) by EU ministers to enact needed reforms. So the jury remains out.

The biggest factor supporting the Dollar this week, however, was the announcement by the Fed that it was raising its discount rate to 0.75 percent, from 0.50 percent. While having little real impact, the increase was of symbolic importance, marking the first step in the Fed’s so-called “exit strategy.” The possibility of additional interest rate increases should also support the Dollar.

So where does the Dollar go from here? The biggest negative for the Dollar, as of this writing, is the possibility of a correction, especially against the Euro. The Chicago Mercantile Exchange’s Report of Large Trader Positions, a proxy for overall traders’ positions worldwide, has shown large increases the past two weeks, indicating that traders overall are overwhelmingly short the Euro, pointing toward a likely near-term correction.

We look for the Dollar to correct over the next few weeks. However, we also believe the Dollar can continue its upward run in the medium term.

Euro

Euro – 1-year Chart 021910

The decline in the Euro had two primary causes. First was the threat of sovereign default by one or more of the periphery nations: Spain, Portugal or Greece. All three were running huge fiscal deficits, which would make it difficult for them to repay or, even refinance, their debt. The second factor was a relatively weak economic recovery in Europe, especially among the larger countries.

The situation in Greece was the most disturbing to investors. Greece needs to refinance 53 billion Euros ($71 billion) worth of debt this year, including almost 5 billion Euros needed immediately. Public debt in Greece is running at 120 percent of GDP. Before the establishment of the Euro, a country could alleviate its debt-refinancing, particularly if the debt was denominated in its own currency, through inflation, by depreciating its currency. That option no longer exists for members of the EU. As a result, Greece is looking to the European Union for a bailout. It does not look, however, as if a bailout is in the cards. Germany, among the stronger nations, is especially adamant against providing aid to the Greeks. The main problem is the size of Greece’s budget deficit, a result of what Germany has determined has been Greece’s profligate spending.

The Stability and Growth Pact, which originally established the Euro, mandated that a country’s budget deficit could not exceed 3 percent of GDP. Greece’s deficit is well in excess of that figure, pushing almost 13 percent of GDP. The 3-percent limit was established to induce Germany to abandon its beloved Deutschemark in favor of the Euro. So now Germany wants Greece to be punished for exceeding that limit, drawing a so-called “line in the sand.” Unfortunately, however, since the Euro came into being eleven years ago, that 3-percent limit has been breached on a number of occasions, most notably by France, the other Eurozone leader.

As mentioned above, EU finance ministers met earlier this week and decided to give Greece one month, to March 16, to adopt fiscal measures to get its financial house in order. At that time the rest of the EU could decide to impose additional austerity measures on Greece, which could include increases in the Value-Added-Tax (VAT) applied to Greek purchases or higher taxes on energy products. The ministers were silent regarding any rescue operation. At week’s end, Greece was talking about applying to the IMF for a loan, willing to risk the austerity measures such a loan would carry.

The other factor weighing on the Euro has been European economic performance. As previously mentioned, Eurozone GDP rose only 0.1 percent, quarter-on-quarter, in the fourth quarter of 2009, compared to 1.4 percent growth in the US. Although French GDP grew by 0.6 percent, German GDP was stagnant in the quarter and Italy’s GDP contracted by 0.2 percent. So weak economic performance wasn’t confined to the smaller Eurozone members. Slow economic growth apparently continues in the current quarter as well. As we also mentioned, the Purchasing Managers’ Index for February, covering both manufacturing and service industries, showed no change from January, and was down from December.

Until the Greek crisis is favorably resolved, the Euro should remain under pressure. Only a technical rebound (because the world is running out of people willing to sell the Euro) can help Euro bulls at this point.

British Pound

British Pound – 1-year Chart 021910

The British Pound should also remain under pressure until its economy shows more signs of life. Sterling’s biggest problem remains its fiscal deficit. As we mentioned earlier, the UK ran a public-finance deficit of 4.3 billion pounds in January, the first January deficit in at least seventeen years. Investors have been steadily selling UK debt in recent weeks, with the spread between 10-year UK gilts and 10-year German bunds surpassing 100 basis points for the first time in four years. UK borrowing costs are now the same as Italy’s.

Japanese Yen

Japanese Yen – 1-year Chart 021910

Japan’s economy also outperformed its European counterparts in the fourth quarter, expanding by 1.1 percent (a 4.6-percent annual rate). So, a double-dip recession, which had been a concern, is unlikely. But the Japanese are worried about domestic growth. Net exports accounted for 0.5 percent of the 1.1-percent total growth in the quarter. Deflation, however, remains a major problem in Japan, with no sign of any further policy change by the Bank of Japan toward combating deflation.

If interest rates start to increase in the US, the Yen could resume its previous role as the primary carry currency, exerting downward pressure on the Yen. Given this possibility and the continued presence of deflation, we look for further depreciation of the currency.

Australian Dollar

Australian Dollar – 1-year Chart 021910

The Aussie has benefitted from several factors: relatively high interest rates (the Reserve Bank of Australia was the first central bank to raise interest rates in the face of the crisis), making it one of the prime beneficiaries of the carry trade; and Australia’s role as a primary-commodity exporter. Any kind of a slowdown in China could hurt the Aussie but the Reserve Bank has made it clear it will continue to raise interest rates this year, a factor which will support the currency.

Gold

Gold – 6-month Chart 021910

Gold appears to be in a trading range. Continued clarification regarding global economic growth could take some of the wind out of the gold bulls’ sails, but inflation worries will continue to support the metal. Of interest this week was the IMF’s inability to find buyers among central banks for the 193.1 additional tons of gold it plans to sell (the IMF sold 200 tons to India last October). The IMF’s announcement of its intended sale sent gold prices tumbling, but the subsequent failure to sell the gold allowed prices to bounce back. If the IMF can’t sell the gold, it will take some of the overhang out of the market and could prove bullish for the metal.