Recovery Worries Weigh on USD

The US dollar continued to fall after disappointing December employment numbers were released on Friday morning. Analysts on both sides of the border who were expecting a return to positive job growth were disheartened, as 85,000 jobs were lost in the United States and 2,600 in Canada during a month normally boosted by holiday spending. These numbers caused a general reassessment of the recovery’s strength, and led many traders to conclude that the Federal Reserve would keep interest rates in neutral for longer. As of this morning, the USD had posted its largest weekly loss since November, down against every major currency.

The Canadian dollar has moved in the opposite direction to within clear striking range of par. The CAD is currently range-bound above a key technical barrier at 1.0250. Without intervention (or the threat of it) from the Bank of Canada, momentum looks ready to push the CAD even higher. Further direction depends on both commentary from the Bank and on commodity prices, and traders will be watching both very carefully over the next few days.

Crude oil hit a 15-month high over the weekend, close to $84 a barrel, as cold weather created demand for heating oil and the USD decline supported prices. Gold prices also gained, rising above the $1150 range this morning.

Currency Paths Diverge

The dollar hit a three-week low against the euro, although the euro zone statistics agency said on Friday that unemployment in the single currency zone had reached 10%, the highest since the EU was created. Wide disparities exist between countries within the EU: German unemployment is sitting at 5.8%, whereas Spain is registering 19.4% (43.8% for those under 25). In comparison, unemployment rates currently stand at 8.5% in Canada, 7.8% in the United Kingdom, and 10% in the United States.

Sterling regained some of its losses after a survey was released indicating that the Conservative Party has a good chance of forming a majority government when elections are held in June. This point is crucial for the currency markets because a hung Parliament would put fiscal measures in jeopardy, prolonging and possibly increasing the UK’s budget deficit.

The Japanese yen gained ground after the new Finance Minister Naoto Kan retracted his statements calling for a weaker currency, saying that exchange rates would be determined by the markets. After a long series of currency blunders by Kan and his predecessor Hirohisa Fuji, speculation is rife that he was told to make the correction by Prime Minister Hatoyama.

The Aussie dollar marked up the best performance among major currencies, having gained almost 3% over the last week, after the Chinese customs bureau published positive export numbers, showing that shipments had risen nearly 18% over the last year. The New Zealand dollar gained as well, up almost 2% over the week.

Traders attempting to evaluate the pace of the recovery have a busy week ahead, with the calendar full of data releases: tomorrow brings trade balances for the US and Canada, both of which could move markets; the Federal Reserve’s Beige Book survey of regional economic growth is released on Wednesday; and, finally, Thursday’s release of US Retail Sales numbers may have a decisive impact on currencies by outlining the strength of holiday spending.

Withdrawal Symptoms

During the financial crisis, interest rates were pushed down to zero by most major central banks in the hopes that lending would recover and economies would benefit. When this did not occur to the desired degree, central banks turned to another tool, which has become known as quantitative easing. In essence, central banks created new money, which was used to purchase assets such as government and private sector bonds. This artificial demand caused prices to rise and yields to fall. With falling yields available in the bond markets, large banks were encouraged to lend money to businesses and individuals. Investors were induced to move funds into more attractive instruments such as equities, helping businesses obtain capital. Finally, the additional money supply caused inflation expectations to rise, creating another short-term incentive for individuals to spend money.

As the world economy recovers, both of these types of central bank stimulus must be carefully withdrawn from the financial system in order to prevent inflation from rising, while maintaining the strength of the recovery. Benchmark interest rates are highly visible and widely followed variables in the financial markets, so an increase has an immediate and dramatic effect within the general economy. Changes in money supply are far more difficult to detect, and can be more finely adjusted to policy requirements. Therefore, it is widely expected that the quantitative easing measures implemented over the last two years will be removed long before benchmark interest rates themselves begin to rise.

A logical first step in removing money from the system is to simply stop purchasing new assets. As currently scheduled, the Federal Reserve, European Central Bank, and the Bank of England are all due to wind down their large bond purchase programmes over the next few months. Unless economic conditions take a turn for the worse, policymakers are not intending to renew these policies.

After the flood of new money has ceased, central banks will need to actively withdraw funds from the economy. To do this, a wide variety of tools have been proposed. Central banks may decide to pay interest on bank reserve balances, creating an incentive to leave the funds on deposit rather than lending them out. They may also perform temporary asset sales through arrangements known as reverse repurchase agreements, whereby intermediaries will purchase the assets and sell them to the markets, and the central bank will then repurchase them at a higher price. Ultimately, the banks will need to sell most of the acquired assets to the markets, and will engage in outright sales to do so. When this is done, the banks will need to ensure that appropriate demand levels exist, and that the sales do not spook the bond market unduly.

Foreign exchange movements are driven by the differences between economies. Although the downturn was globally synchronized between countries, the recovery will not be. Differences between growth rates among the developed economies have already begun to emerge, and will define the paths of central banks as they attempt to chart their exit strategies. With a feeble recovery highlighting differing growth rates among EU members and a rigid job market contributing to escalating unemployment levels, the European Central Bank is not expected to begin active removal of liquidity until late 2010. Benchmark interest rate increases are not probable until well after the Federal Reserve has moved. Consequently, the euro will remain under pressure.

The Monetary Policy Committee in the UK has debated the extension of quantitative easing policies at its last few meetings. Inflation is returning to target levels, but unemployment numbers are persistently high. The signs of a recovery are not yet clear enough to indicate when liquidity will be removed, and interest rate differentials are not yet favouring the sterling. Japan remains entrenched in a slump that has lasted almost two decades. Quantitative easing has been a constant component of monetary policy since its invention in 2001, and there are few signs of a reversal. For Australia and New Zealand, high interest rates have long supported currency strength, and quantitative easing has not been employed. This means that, unless rates go higher, these currencies should suffer from slight negative demand as other markets become marginally more attractive.

For the Canadian dollar, the picture is highly uncertain. While quantitative easing was never expressed as a clear policy objective by the Bank of Canada, money supply appears to have been increasing at a steady clip. Additional restrictions on mortgage lending may be needed to slow the appreciation of asset prices. That being said, it does not look as if specialized measures will be required to drain liquidity from the broader Canadian economy over the next year. An interest rate hike ahead of the Federal Reserve remains unlikely, so interest rate differentials should have a neutral effect. The outlook for the Canadian dollar depends on the wider dynamics affecting the Greenback.

Although December’s employment numbers were certainly a disappointment to the financial markets, a steady decline in new jobless numbers began in both Canada and the United States during August last year. Historically, central banks have tended to begin tightening monetary policy within six months of a peak in the unemployment rate. Anticipating a liquidity contraction, US short bond yields have risen over the last two months, contributing to a halt in the broad dollar depreciation that has prevailed since the crisis. As yield differentials recover, particularly in comparison with the euro area and Japan, demand for US dollar assets may improve.

While this has been the most damaging and widespread financial crisis in a generation, markets are already shifting focus towards the inevitable withdrawal of central bank liquidity. The next year may offer opportunities for both hedgers and investors alike. Close attention to the (admittedly boring!) pronouncements of central bank officials will be crucial as the status quo which has held in currency markets for the past year and a half begins to shift.

By Karl Schamotta, Market Analyst
Send a message