Europe, Japan and the Dollar

The euro has failed to hold on to even modest upticks in response to stronger than expected euro-zone growth. This is important. It is among the conditions we anticipated would help reverse the trends that have emerged in the foreign exchange market over the past several weeks.

During this time, when the euro strengthened from $1.1877 to $1.3334, investors recognized that EMU would survive, but also the plethora of upside surprises in the more high frequent data. We have argued that the markets priced in a great deal of good news, leaving the euro vulnerable. We also identified as a key factor the swing in short-term interest rate differentials. Using the 2-year US-German spread, we note it has tracked the euro-dollar exchange rate fairly closely, especially recently. The spread went from 62 bp in Germany’s favor last Nov to almost 34 bp in the US favor by late May. It then swung back in Germany’s favor by about 25 bp. We argued that a swing back in the US favor would likely point to a greenback recovery. The spread is just below 13 bp today.

The market had been selling the dollar off on disappointing US economic news, as one would expect. However, for the dollar to recover, we thought either the data would begin getting better or the markets would show in how it responded to economic data that the poor news had been discounted. This is last piece may not have yet convincingly fallen into place. On one hand the bad news has gotten worse. With this week’s data, it now appears that Q2 US QDP may be cut by around half from the preliminary 2.4% pace and weekly initial jobs claims continued to tick up. On the other hand, the market has generally shrugged it off.

Finally, we also noted that the technical condition needed to improve to become more confident that the dollar was poised for recovery. On Wednesday, the dollar’s 5-day moving average against the Swiss franc crossed above the 20-day average for the first time since June 11. The same moving averages are crossing to the downside today for the euro.

The euro is flirting with its 100-day moving average that comes in just above $1.28 today. This week’s price action breaks the relentless buying of the foreign currencies. The shallowness in magnitude and brevity in duration this week suggests that there is likely to be follow-through on this week’s price action.

Even separate from these considerations, tensions have flared up again in the European bond markets. Ireland was the focus for much of the week and credit default swaps for it are trading at their higher than earlier this year. The markets also learned this week that even after the stress tests, peripheral countries’ banks have increased their borrowings from the ECB. In the month of July, Greek bank borrowings rose 2.5%, Spain 3%, Italy 12% and Portugal 20%. Market talk suggests that the ECB also stepped up its purchases of sovereign bonds this week and verification will available at the start of next week when the ECB announces the size of its term deposit facility.

The other major market theme that grew this week was the discomfort that the yen’s rise is causing for Japan. Verbal intervention has largely been ratcheted up. Today’s developments include an indication that the Prime Minister Kan will meet with BOJ Governor Shirakawa next week to discuss it. In addition, news wires report that a faction within the ruling DPJ are to formally call upon the MOF to order BOJ intervention.

It is clear, however, that there is not much sympathy for the Japanese position either in Europe or the US. That means that intervention, if it were to take place, would be unilateral. This would seem to undermine its chances for success and as officials may have learned in the 2003-2004 experience, ineffective intervention may be worse than no intervention if it emboldens speculators.

This does not mean that Japan needs the US and/or Europe’s permission to intervene. It is simply that their cooperation could increase the odds of success. Perhaps in the background discussions, the most Japanese officials might hope to secure is that US and European officials do not comment on their action. An off-the-cuff criticism could undermine what even little success unilateral action. At the same time, there are numerous other measures, outside of intervention, Japanese officials can consider. This is likely to be the subject of the Kan-Shirakawa discussions, as the intervention decision is the MOF’s call and if Kan wanted that he would be meeting with the finance minister.

Also, intervention on dollar-yen may exacerbate the pressure on the euro-yen cross, which given the magnitude of the move, may be more costly for Japanese businesses than the dollar-yen. The bottom-line is that there is increasing pressure on Japanese officials to do something, but the bar to intervention still appears higher than current conditions.