Exchange Rate Moves and Currency News

So a week ago, I wrote that the US Non-Farm Payrolls was the event “for all the marbles.” That was true, and we have seen the US Dollar continue its rally through this week largely on the back of that news. However, within the span of one hour tomorrow, there are two news events that are likely to have a similarly large impact. Tomorrow two of the largest central banks in the world are announcing their interest rate decisions. The announcements by the Bank of England (7:00 AM EST) and the European Central Bank (7:45 AM EST) come at the end of a week with similar announcements of four major central banks, the other two being the Reserve Bank of Australia and the US Federal Reserve.

While neither is expected to make a move, the possibility exists for both, in particular for the ECB. Though it is possible that they may hike rates (and probably preferable if you ask people such as my colleague John), it is seen as unlikely. Growth throughout the Euro-Zone has been slowing rapidly, with some member nations (e.g. Denmark) already in a recession. As such, a move that could further damage growth rates is seen by most experts as unlikely, regardless of the ECB’s general tendency to focus on inflation.

Beyond the importance of the two decisions, their proximity in time should also prove for extremely volatile markets. The USD has witnessed an excellent rally for several weeks now, and with oil experiencing a coinciding plummet in price, that trend could very well continue. With many now predicting that the USD could break out of its trend with the EUR, a surprise move by the ECB could be just what the doctor ordered to bring back the status quo. However, given the resistance by European leaders to the last rate cut, it is within the realm of the possible that the ECB could witness a near coup d’état should they hike rates again.

Upcoming Figures
EUR German Trade Balance (Jun)
GBP Bank of England Rate Decision
EUR European Central Bank Rate Decision
ECB President Trichet Holds Public Press Conference

          The AUD has had a remarkable run for the past seven years, the AUD has appreciated from .48 to near parity over the past seven years.  The commodity boom has been very beneficial to the Australian economy.  Exports of iron and raw materials have caused the Aussie economy to boom.  The global slowdown will definitely hurt demand for raw materials from the land down under due to there elasticity.  This will hurt the value of the AUD which has broken the trend line and lost nearly 700 pips in the past couple of weeks.  The AUDUSD has approached the fib line of 38.2 and seems to have met a little resistance.  Consequently this Fib level was resistance in February of this year, and could become a support level.  If the AUD bounces off the Fib level then buy the bounce.  However if it goes 20 Pips past the resistance then sell the break.  The bounce will be short lived because of the macroeconomic deterioration of the Australian economy.  However for a short term range trader knowing the Fib level is crucial to trading your position.  In conjunction with the fact that the RSI is rebounding after coming very close to 30, this information would lead technical traders to be bullish AUD.  

The technical indicators all point to buy, however the long term picture is not bright.  The unemployment numbers come out this evening and any one who has traded the news knows that those releases tend to be very volatile.  If the Aussie economy surprisingly dumps jobs then expect the AUD to fall further.  For this reason I would stay out of the trade because the technical picture looks good while the fundamental picture is in divergence.  A short term trend occurred this afternoon, yet a long term reversal may be a foot.  Especially if the price of oil continues to plummet, expect the USD to appreciate across the board.  The demand slow down for Aussie raw materials comes from the global slow down of demand.  Consumption throughout the developed world has diminished because consumable income has been allocated toward energy costs.  This reallocation of consumption has forced demand for goods to decrease.  On the aggregate level consumption has not dipped but on a retail level excluding food and energy it has.  This information all leads to the conclusion that the world is headed for recession.  If the world is headed for recession it is a sufficient condition that Australia will face an economic slowdown.  The thought that the AUD could reach parity has been squashed and the recent sell off has proved this fact.  Any dovish statements from the RBA could send the AUD into a tail spin.  Given the fact that the interest rate is at 7.25% the RBA has a lot of room to cut in order to foster growth.  Even though the RBA has a target of 2-3 percent expect the Gov Stevens to become dovish and focus on growth in the time to come.

The theory of Purchasing Price Parity is hard to digest because of the fact that is so abstract and it does not apply non-tradable goods.  PPP is a theory that states all goods will cost the same across borders, because if one country charges more then consumers will change their spending patterns.  There are a number of assumptions perfect information, immediate capital flows, etc.  The theory does have relevancy in the currency market, because it can help traders distinguish over valued currencies.  The Big Mac index developed by the Economist magazine is a great way to explain the theory.  Essentially the Economist traveled the world and found out the price of a Big Mac in every country and expressed the price in dollars.  The current price of a Big Mac in America is $3.57 where as the Euro Area has a price of $5.34.  This gives the impression that the Euro is overvalued by 33 percent.  Norway has the bargain price of $7.88 for a Big Mac which is expected because Norway suffers form the Dutch disease because oil has risen so fast. 

On the other hand China, Malaysia, and Hong Kong all have Big Macs for fewer than two dollars.  Leading to the conclusion that the Yuan needs to appreciate 110 percent until equilibrium is reached.  The data confirms suspicion that Asian currencies are undervalued in order to promote their export sectors.  They do this by buying large reserves of U.S. Treasuries to increase the value of the dollar.  The Big Mac is a global commodity consumed world wide with the same ratio of pickles, onions, and ketchup which makes it a great example for PPP.  I would not base trades on Big Mac prices but it does confirm suspicions as to whether certain currencies are undervalued or not.  Thus the Big Mac index of 2008 concludes that the Euro Area is over valued and the Asian currencies are undervalued

Tomorrow is the one for all the marbles. The single most important economic announcement for the USD takes place tomorrow: Non-Farm Payrolls (NFPs). Despite today’s very important announcement of US GDP for Q2, the EUR/USD essentially stood pat around 1.56. What is special about NFPs is that, unlike announcements such as rate decisions or GDP results, predicting the outcome is often like finding a needle in a haystack. The unpredictability of this announcement, coupled with its importance, generally make it the largest “market-moving” announcement for the USD.

Given the hazy future of both the USD and the US economy, tomorrow’s results take on added importance. Good results could potentially enable the Federal Reserve to make market movements in the coming months. If, however, the news mirrors the tone of today’s disappointing results, then the Fed is likely to be stuck for the near future. The last time NFPs were announced, Bernanke pushed the results aside, as employment was not his paramount concern. However, should the numbers approach dangerously high levels, actions will likely need to be taken to curb rising unemployment.

The current expectations are around 75,000 new lost jobs. Should that number turn up around 100,000, there could be a rapid reaction by the government. If unemployment starts creeping towards 6% and beyond, we could witness a further crunch in the credit market, as the unemployed usually have more difficulties in repaying their debts. That problem would reverberate through the financial sector, weakening an already fragile industry. And as Bernanke has declared that the strength of that sector is his top priority, it would be in his best interests to do what he can to combat rising unemployment numbers in the coming months.

Upcoming Figures
USD Total Vehicle Sales (Jul)
JPY Vehicle Sales (Jul)
AUD RBA Commodity Index SDR (JUL)
EUR French Purchasing Manager Index Manufacturing (Jul)
USD Change in Nonfarm Payrolls (Jul)
USD Unemployment Rate (Jul)
USD ISM Manufacturing (Jul)
EUR Italian Budget Balance (Jul)

           Guns are dangerous so are pools, but which one is more dangerous?  Steve Levitt a Professor from the University of Chicago analyzed this question through economic analysis.  His results overwhelmingly supported the conclusion that pools killed 1000 times more children; yet pool control laws are not on the agenda for Congress.  In short expectations are every thing in terms of risk.  A gun is perceived to be dangerous and many are terrified by their existence.  Pools are more dangerous but no one runs for cover from a pool.  Rationale decisions are a major part of risk analysis apart from justifying banker’s salaries; it leads investors to prudent investments.  In order to judge whether the risk premium associated with an investment is worth the reward; models are employed.  The list of models is endless some of the simple familiar models are CAPM, MAR, VAR.  Almost all the models are constructed from data that uses correlations to construct portfolios with low variance returns.  Recently these models have failed to measure risk and the financial sector is suffering because of this failure.

Risk applied to the currency market can justify the Euro’s appreciation.  Central banks have decreased their exposure to the dollar by diversifying to the Euro and other major currencies.  This is theoretically in their best interest because by reducing their exposure to the dollar they are lowering the variance of their portfolio.  However by reducing their exposure they have flooded the market with dollars, thus a depreciation of the dollar has been occurring for the past seven years.  The question remains when will the diversification stop, and whether countries will start buying the dollar again.  We are no where close to the monthly simple moving average of the EURUSD, which suggests that we have a long way to go until equilibrium is reached.  I am not suggesting that a reversal is afoot, however I am hinting that the depreciation of the dollar has reached a peak, and the resistance at 1.60 may not been broken in the near term.  The risk of an undervalued dollar is beginning to outweigh the risk associated with dollar heavy portfolio.  Inflation has risen to alarming rates and the correlation between a 33 percent depreciation of the dollar and the rise in commodities is evident.  By acknowledging that risk influences Central Bank decisions a trader stands to gain.  The market for the EURUSD is range bound until it crosses 1.53, if it does then sell and hold on for the ride.

    “Human responses that result in swings between euphoria and fear that repeat themselves generation after generation with little evidence of a learning curve” 

                                                                                    -Alan Greenspan

           All major markets plunged on Monday, because of renewed fears of the credit crunch.  The Nikkei actually rose until the tsunami went across the world and crashed on the Nikkei on Tuesday morning.  Merrill Lynch just wrote off another 5 billion in mortgage related assets, which sparked fears that more are to come.  Expectations within all stock markets are shaky.  Investors see a global slowdown approaching juxtaposed with the fastest increase in prices in twenty years, which equals stagflation.  Currency markets reflect the uncertainty in the market place because they have been range bound for the last four months.  The only currency that is not range bound in the AUD which is still appreciating against all major currencies.  However Australia’s growth is correlated with the rise of Chinese GDP.  Australia is a commodity rich country that has provided the raw materials for China’s economic boom.  Iron ore mined in Australia costs 1/3 less than ore produced in Brazil, mainly due to transportation costs.  This has provided Australian mining companies with record profits, and an unemployment rate that is below natural unemployment. 

Once China slows down, which is not a certainty but highly correlated with the health of the U.S. consumer then Australia will slow down.  However due to the fact that most Chinese goods are inelastic trinkets the relation may not be as strong as expected.  The country that will lose the most in regards to a global slow down is Japan, because articles manufactured in Japan are elastic.  China produces GI Joes and Barbie’s which believe it or not are very inelastic.  They are inelastic because the purchase represents a small percentage of consumer spending, thus consumers don’t change their spending patterns dramatically.  Exporters such as Canon, Toyota, and Sony stand to lose the most because these big ticket items are not consumed when a recession hits.  The prediction of China’s demise does not apply unless a correlation is found between US consumer spending and Chinese exports. 

The Politburo wrote in the five year plan that they wish to augment domestic consumer spending.  This could be accomplished by allowing the Yuan to appreciate because the Chinese could afford international goods not found in China.  However this solution is highly unlikely because the PRC focuses on export lead growth.  The other option is to single handedly prop up the USD.  In order to do this the PRC must buy more US bonds, which would strengthen the dollar, but puts the Chinese in a bad situation.  The risk premium associated with U.S. bonds has risen, the U.S. will not default but the value of the dollar may be outside of China’s power.  If the dollar depreciates then the PRC stands to lose billions, from there 1.8 trillion dollar position in dollars.  Expect this to happen because it is a tricky way of augmenting exports.  It is not the prudent path but the PRC is known for the Great Leap forward and the Cultural Revolution.  By augmenting their dollar positions they are helping exporters at the expense of Chinese tax payers.  In short the global tsunami will first fall on Japan then on the Chinese tax payer.

One of the popular predictions of the past few years has been to declare China as the next world superpower. The most populated country in the world has experienced tremendous growth for some time, and given their size, growth, and stability, many view China as the United States’ next competitor for worldwide dominance. While I am not speculating as to China’s social or political future, I strongly believe that their growth-oriented policies will eventually – and inevitably – bring about economic consequences.

As children we all learned the saying “don’t put all your eggs in one basket.” By pursuing policies aimed at maintaining their meteoric growth, China has consistently cast inflation aside. With rates currently hovering around 8%, China will eventually have to work harder to contain this figure. Their growth of over 10% per quarter has been able to overshadow most other economic problems. However, in response to those numbers I’ll put forth another saying from childhood, “nothing lasts forever.”

China’s astronomical growth will slow, with some – including myself – believing that this slowdown will take place after the Olympics this summer. At that time, the following question will take center stage: will the Chinese economy be able to grow rapidly enough to make up for high inflation, an appreciating Yuan, and a swiftly rising standard of living? I predict no, and hence foresee and economic slowdown occurring in China by the onset of 2009.

Upcoming Figures
EUR German Consumer Price Index (Jul)
EUR German IFO Business Climate Survey by Industry (Jul)
USD Consumer Confidence (Jul)

With mixed news coming out of the world’s remaining superpower in recent weeks, the recent US dollar rally induced widespread befuddlement. With Europe suddenly looking economically worse-off than America, it is easy to understand why the USD has rallied against the EUR. However, the USD has rallied against many of the major currencies, including the JPY and the CHF. In other words, it is not only bad news coming out of the Euro-Zone that is fueling this USD rally. So, the important question is what exactly is causing this rally?

One obvious corollary is oil prices. Having fallen about $20 (or about 15%) in the past week or so, relaxed oil tensions have allowed the USD to achieve solid gains. However, the Forex market is rarely so simple in its explanations of cause and effect, so it would be unwise to solely attribute this USD rally to oil prices. However, the main theory that I am proposing is related very closely to oil prices, whose unprecedented levels are causing rising inflation all throughout the globe.

The hidden culprit, I believe, is foreign government entities. As the bulk of the commodity world – including oil – is priced in US dollars, the weakened state of the USD has been a primary component of the widespread inflation. The issue of permanently lowering oil costs (or oil demand) has not dissipated by any stretch. In lieu of a radical shift in the energy industry, however, is a simpler, temporary solution: a stronger USD. As countries have come to witness the terrible effects that the oil situation is wreaking on their economies, I believe that they are beginning to act in a manner to try to build up the USD.

It is unclear if the past few days are indication of any real changes or if they are just testament to the EURUSD being in a range-bound market. However, if the USD continues to rally and oil continues to fall, then perhaps we could be witnessing a long-overdue correction. Should that occur, inflation concerns could begin to lessen, and then central banks might be able to focus more on fixing other problems. As always, only time will tell.

Upcoming Figures
EUR German IFO Current Assessment (Jul)
EUR Euro-Zone Current Account (May)
GBP Retail Sales (Jun)
JPY Consumer Price Index (Jul)

          Congress is proposing legislation to restrict speculation on the oil market.  Is this beneficial to the American consumer, will it decrease the price of oil?  No, a recent paper written by Phil Abbott and Economics Professor from Purdue discusses in detail that speculation has not contributed to the recent surge in oil prices.  The paper underlines the correlation between the weakness of the dollar and the price of commodities.  Commodities are valued in dollars and a depreciation of the dollar makes commodities more affordable on the international market, thus increasing the demand for commodities.  Increased global consumption has increased the price of all commodities pork bellies and wheat included.  In short the decreased value of the dollar has contributed toward global inflation because it has fostered excess growth which has increased the price of commodities. 

            Over the past week oil has decreased by 15 percent, I doubt that Congress will blame speculators for shorting oil and forcing the price of oil down.  The dollar has consequently appreciated across the board.  The correlation between the price of oil and the strength of the dollar is undeniable, which gives the Fed another reason to raise rates.  By raising rates the Fed could actually help the economy, because the price of oil would fall dramatically.  The Fed’s current Dovish bias has done as much as supply and demand to raise the price of oil.  If the Fed could decrease both the price of oil and inflation, what is stopping them from raising rates?  Equities, unemployment, and the health of the financial sector are the only justifications for not raising rates.  The stock market seems to have stabilized and financial stocks have appreciated 30% across the board.  Banks are still fragile even though the FDIC claimed that Indy Mac would be the largest fatality of the credit crunch.  The question now becomes whether baby sitting banks is worth the weak dollar.  In the short run yes, but in the long run the Fed needs to take a more Hawkish tone towards inflation.  Will the Fed raise I doubt it, but the benefits could soon outweigh the risks.

The growth recession that is taking place has affected millions of Americans.  It was brought about by high commodity prices and the credit crunch.  Should the Government intervene?  Sometimes they should, but their intervention should be prudent and they should not waste borrowed money for political gain.  The fiscal stimulus that occurred seemed nice but at what cost, it was a three month shot in the arm that Americans will have to pay back in the future.  Now another round of stimulus is being planned and what will the Government do?  The Congress should not pan handle to voters, which is what politicians do, but it is not beneficial to the people.  If a stimulus should pass then it should be in the form of infrastructure spending.  This would put people to work and increase productivity.  However in doing so, the government borrows money from the private sector and corporations find it hard to find capital.  This is known as crowding out, which raises the interest rate.  This would be beneficial because it would slow down inflation.  Spending on infrastructure would not be reflected on Wal-Mart’s balance sheet, it would increase the productivity of the American worker, and decrease unemployment.

            It is estimated that traffic alone costs the American economy 25 billion in lost productivity.  Los Angeles was designed for 2 million people and the over crowding has forced Angelites to lose 3 hours of their day on the road.  This is disastrous to business and could easily be addressed by a 21^st century infrastructure plan.  I will not propose a solution, I’m not an engineer.  However as an economist I need to point out that productivity is being lost by out dated infrastructure.  This is an election year and the economy is in the doldrums, so another stimulus in imminent.  The responsible thing for Congress to do would be to increase government spending for infrastructure not stimulus checks.  The increase in interest rates would make American deposits desirable to foreigners and influx of foreign capital would drive up the dollar’s value.  Congress does not get many things right, however by funneling the stimulus to infrastructure instead of rebates they would kill two birds with one stone.  By increasing government spending on infrastructure, the Government would be able to decrease unemployment and decrease inflation.  The dollar would appreciate and oil would fall as a result.  These projects would take a long time and keep citizens employed for years.  In todays supply-side inflationary environment it is the only government intervention that I condone.  On the other hand they could do nothing but in an election year don’t count on it.

Upcoming Figures

EUR French Consumer Spending (JUN)

GBP Bank of England Minutes

CAD Consumer Price Index (JUN)

USD Fed’s Beige Book

NZD Reserve Bank of New Zealand Rate Decision

JPY Merchandise Trade Balance Total (JUN)