Inspiration or perspiration in the currency markets

“The euro is an inspiring currency”
ECB President Jean Claude Trichet

The dollar is hitting all time lows and ECB is calling the Euro “inspiring”. One hopes that there was a misunderstanding in the choice of words or the translation because calling the Euro inspiring misses the important point.

A currency is the relative price of two monies, so it could be that the Euro is inspiring or it could be that there is a loss of confidence in the dollar. After the last week of Fed behavior, it is more likely that the Euro has appreciated because the market is less inspired by the choices of the Fed.

Most empirical evidence suggests that the Euro will have a stronger reaction to US announcements than with European economic announcements. The driver of the Euro exchange rate will always be the combination of economic behavior in both region, but the line of announcement effects usually moves from the US to the rest of the world. The dollar is declining because of bad behavior and news in the US. It is not an issue of being inspired by the European economy.

Nevertheless, a growing confidence in the Euro will have strong impact on the behavior of many countries and commodities which have been tied to the dollar. For countries closely tied to the dollar, there is internal inflation. For commodities priced in dollars, there will be less impact from price rises. Non-dollar buyers are purchasing a commodity whose price is not rising as fast as in the US. Demand will not be curtailed as much as expected by looking only at the dollar price. This is an equilibrium that cannot be sustained. There will have to be further shifting away from dollar assets which will lead to further declines in the dollar.

Canadian dollar commodity bandwagon not perfect

With the Canadian dollar reaching parity with the US dollar for the first time in over 30 years, there has been an increase in the number of stories about the high correlation between commodity prices and the currency increase. There is no denying the link between oil, gold and the currency, but this relationship does go through cycles.


The figure shows the 30-week correlation between these three markets. The evidence clearly points to a positive relationship but there are periods of these markets having no relationship or moving in opposite directions. The strength of the Canadian dollar is more than just a short-term commodity play, so anyone trying to track the Canadian dollar with the movement in oil or gold will have to occasionally suffer disappointment.

Looking for domestic bliss at the expense of the dollar

The cut in Interest rates by the Fed has lowered the Fed funds rate to 4.75. The two-year Treasury is at 3.99. The comparable short rate for Europe is 4.00 percent and the two year rate is 4.05 percent. There is little reason to hold dollar denominated assets from the bond side. Year to date equity performance has favored the US but when looked at on a risk adjusted basis the advantage is less. This gain for the US is all based on the reaction from the rate cut and not on improved earnings. On a forward basis, there is little advantage for holding US equities. The trend for the dollar is also not good. Simple momentum models all point to a negative trend.

The value of gold has trended higher on the latest down move on the dollar. Gold still serves as a store of value during periods of higher inflation or declining dollar. While the inflation story has been weaker because the range of inflation has been relatively tight for the last decade, the demand for gold as a substitute for dollar reserves has been a growing theme There is special interest by many of the traditional dollar reserve central banks of the Middle East and China. The reserve data from the IMF does not fully support this story at this time but it has gained more discussion in many financial circles.

Monetary policy is being eased even though it is well known that the dollar decline will be exacerbated. The dollar has not seen a significant volatile sell-off, so the thinking is that that the decline can be managed while trying to support domestic growth. The higher export numbers on the back of the declining dollar also support domestic growth. It is worth the chance of debasing the dollar if your objective is domestic growth. Unfortunately, there will ultimately be a financial cost with higher domestic rates. However, the financial community may prefer to take the risk of a declining dollar than be hurt with a credit woes.

Weak central bank parenting

Last week we outlined our parenting analogy for central banks. We focused on differences in approaches to the credit crisis by the Fed, Bank of England, and the ECB. This week we found that all central banks are behaving the same. Parenting is loose with little discipline of the market. Of course, there are consequences with "tough love" central banking, but it seems like these monetary authorities are unwilling to administer tight controls.

The Fed FOMC lowered rates by 50 basis points for both the Fed funds and discount rate. (I was in the camp for 25 bps on the Fed funds and 50 on the discount rate which was a more nuanced signal. This was based not on my preferences but the fact that a number of Fed officials were giving comments that were more hawkish.) The operative wording was that the Fed was acting to preempt a slowdown. Along with Fed, the Bank of England has moved away from its tough talk comments of just a few weeks ago to an announcement that they will be providing funds to help banks. So much for the tough parent. The ECB has already supported banks with added funds. It is hard to hold the line when all of the other monetary parents are lenient.

The reaction was as expected. Stocks went up, led by the financial sector. Bonds on the long-end sold off and the dollar declined. Prices of commodities tied to the business cycle climbed.

Of course, the hawks cannot have it both ways if the central banks took a hard-line position and we headed towards a recession. The economic data is turning down and some cut would have been necessary in 2007, but delaying the cut or making it marginal would have clarified the message that banks need to discipline themselves.