Economic Indicators

If you chart the course of the Australian Dollar over the last twelve months alongside the S&P 500, the overlap is jarring. You can see from the chart below that the two lines zig and zag in almost perfect unison. It would seem that there was a slight break in the second quarter of 2010, but even this is an illusion, since the Aussie and the S&P continued to rise and fall in the same patterns over that time period, differing only in degree of fluctuation.

I shouldn’t have been so complacent in declaring the paradigm shift in forex markets, whereby risk aversion had given way to comparative growth and interest rate differentials. While such a shift might have been present – or even dominant – in forex markets over the last couple months, it appears to have once again been superseded by the so-called safe haven trade.

I must confess: I never expected the Greek debt crisis to reach such a dire threshold in such a short time period. Over a matter of mere months, the Euro has fallen 15% against the Dollar. That’s the kind of drop that you would have expected from the Greek Drachma, not from the Euro!

One of the cornerstones of exchange rate theory is that currencies rise and fall in accordance with inflation differentials. All else being equal, if US inflation averages 5% per annum and EU inflation averages 0% per annum, then we would expect the Euro to appreciate (or the Dollar to depreciate, depending on how you look at it) by 5% against the Dollar on an annualized basis. If only it were that simple…

One of the main themes (even if not always overt) of my posts recently has been the revival of the carry trade, if not the already extant revival than at least the imminent one. In this context, there is no better candidate than the Brazilian Real.

After a stellar 2009, the Brazilian Real opened 2010 in much the same way that most emerging market currencies did: down. In the month of January, alone, it fell almost 10% against the Dollar, as fears of a widespread sovereign debt crisis took hold in currency markets. Its modest recovery since then, is not so much due to a decreased likelihood of such a debt crisis, but rather to a shift in the markets’ perspective away from long-term fiscal problems and back towards short-term economic and monetary conditions.

In January, the Canadian Dollar (aka Loonie) registered its worst monthly performance since June. Many analysts pointed to this as proof that its run was over, after coming tantalizingly close to parity. Others insisted that the decline was only a temporary correction, a mere squaring of positions before the Loonie’s next big run. Who’s right? Both!

Many analysts are pointing to Friday, December 4, as the day that logic returned to the forex markets. On that day, the scheduled release of US non-farm payrolls indicated a drop in the unemployment rate and shocked investors. This was noteworthy in and of itself (because it suggests that the recession is already fading), but also because of the way it was digested by investors; for the first time in perhaps over a year, positive news was accompanied by a rise in the Dollar.

As I outlined in my last two posts, the Dollar could witness a rapid appreciation if/when the Fed finally raises interest rates. Given Chairman Bernanke’s frequent erring on the side of inflation, however, it could be months (at the earliest) before the Fed actually pulls the trigger. With forex markets guided by interest rate differentials, and traders’ uncertainty about the timing of interest rate hikes, its fair to say that the Dollar is at a crossroads.

It’s been a while since I last wrote about the Euro (October 26: Euro Optimism (And not just Dollar Pessimism)). That’s because my perspective recently has been mainly Dollar-centric; I continue to believe that much of the recent movement in forex markets (with the exception of certain cross rates) can best be explained by the Dollar. Nowhere is this more evident than the Euro, whose rise should really be thought of in terms of the depreciation of the Dollar. It’s no surprise then that yesterday’s Euro decline – the steepest in months – was the result not of internal European developments, but rather of the US jobs report.

Last week, I opined on the official US forex policy (“Strong Dollar” Policy is a Joke). Most of my analysis was directed towards the lackluster efforts of US policymakers in failing to execute this policy, and I paid short shrift to the policy itself. With this post, then, I would like to address whether a Strong Dollar is, on balance, actually good for the US economy, specifically as it bears on the balance of trade.