From the March Special Report issue of Treasury & Risk magazine

Dollar’s Swings Could Continue

Europe’s fiscal crisis, Japanese monetary policy fuel FX volatility.

The dollar has undergone some big moves against the euro and yen in recent months, and foreign exchange analysts say there could be more swings in the months ahead given continued uncertainty about Europe’s fiscal crisis, changes in Japanese monetary policy and the U.S. federal budget deficit.

“Global geopolitical maneuvering and central bank thinking has certainly allowed volatility to make [foreign exchange] trading very interesting,” said Dean Popplewell, director of currency analysis and research at OANDA, a provider of online foreign exchange trading.

The ups and downs in the foreign exchange market have led to talk that central banks are embarking on a global currency war, in which countries try to boost their exports by devaluing their currencies. But analysts said central banks are aiming to revive their sagging economies with their monetary policy moves, not devalue their currencies.

The biggest move has occurred in dollar/yen, with the yen weakening about 20% against the dollar since September. The Japanese currency slid as Shinzo Abe campaigned for prime minister with a promise that he would rescue Japan from its prolonged bout of deflation, in part by having the central bank target 2% inflation. That level, double the previous target, suggested an aggressive easing in monetary policy. Abe was elected in December.

The Bank of Japan “somewhat reluctantly signed on to the new government’s higher 2% inflation target,” said Peter Buchanan, senior economist at CIBC. “But until they get their new governor on board, we’re not sure how aggressive they’ll be.” Bank of Japan Governor Masaaki Shirakawa steps down this month and Abe has nominated Haruhiko Kuroda, the head of the Asian Development Bank and a long-time advocate of an inflation target and easier Japanese monetary policy, as his replacement.

Meanwhile, the euro gained about 10% against the dollar over the last five months amid perceptions that European leaders were making progress in halting the eurozone’s sovereign debt crisis.

“Some sort of calmness back in the markets and some better data out of mainland Europe, especially Germany, which is the backbone of Europe, have allowed the euro to bounce back,” said OANDA’s Popplewell. “The market’s been giving up some of that insurance premium that has been built into it the last 18 months.”

Popplewell notes that the euro rallied from a very low level. “On a trade-weighted basis, the euro is still 8% below the 10-year average,” he said. And he blames some of the dollar’s weakness on the U.S. balance sheet. “Europe is getting cash inflows and paying down its deficit. The U.S. is doing the opposite, the deficit is rising to a certain extent.”

Tod Van Name, global head of FX, economics and commodities at Bloomberg, argued that as concerns about Europe subside, “the focus is going back to what’s really going on in the global economy.”

“When investors have a greater appetite for risk,” Van Name said, and as the attraction of U.S. currency’s safe-haven status wanes, “there’s a tendency for the dollar to weaken.”

The Fed has made it clear that it will keep rates low for quite some time, and “investors are basically chasing yield,” he added. “So you’re going to see investors move out of the dollar and into higher-yielding currencies.”

Van Name argued that the dollar is also likely to suffer from the Fed’s easing moves in the wake of the financial crisis. “[The federal government] flooded the market with liquidity, which the market expects will impact the economy’s performance,” he said. “That’s a scenario where you would tend to see a gradually weakening dollar.”

The optimism fueling the euro’s gains was tempered by the results of the Italian elections in late February, in which voters rejected austerity and no single party emerged a clear winner, leading to fears of a prolonged political stalemate.

And there are still plenty of other problems that could arise in Europe, starting with the possibility that the euro’s gains hamper the eurozone’s economic recovery.

In Spain, another Eurozone nation that’s still in shaky condition, the party of Prime Minister Mariano Rajoy was recently accused of operating a slush fund to reward its politicians. And Mike Dueker, chief economist at Russell Investments, said that it’s worrisome that Spain has yet to signed a memorandum of understanding to participate in the European Central Bank’s Outright Monetary Transaction program, which involves ECB purchases of sovereign debt. “Now it looks as though Spain won’t sign anything until there’s a crisis,” Dueker said. “To me, that’s a policy miscue.”

Amid the swings in dollar/yen and euro/dollar, there have been increasing complaints that nations are manipulating their currencies to boost their exports.

“The yen’s sharp slide has raised some hackles among Japan’s trading partner,” CIBC’s Buchanan said, noting criticism by German Chancellor Angela Merkel. “While they do want a softer currency to support growth, they don’t want one that’s so weak that it causes friction with their trading partners.”

But economists said central banks are just going about the business of trying to get their economies growing again.

“We essentially have the three biggest central banks in the world pursuing monetary policy for their own domestic policies,” Dueker said. While news articles may dub that a currency war, “in fact the monetary policies are very much tailored to domestic economic situations and not designed to really drive the exchange rate per se,” he said. “If each country is pursuing a nominal GDP growth policy in the central bank, then that’s the driver, not the exchange rate itself.”

CIBC’s Buchanan notes that central banks are stepping up partly because many governments are hesitant to use fiscal policy to stimulate growth. “There’s a great deal of concern about debt levels and deficits,” he said. “That has thrown more of the burden on the shoulders of central banks. If you have central banks doing more of the work, by extension you’re going to see greater potential for currency volatility.”

 

Read the March Special Report on Hedging and Forex.

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