ECB TALK HAS SLOWED FALL IN THE BUCK
JANE FOLEY
RESEARCH DIRECTOR, FOREX.COM
THANKS to a healing of risk appetite, a sharp deterioration in the American fiscal position and the perception that US monetary policy will stay loose potentially until the latter part of 2010, further losses could well be ahead for the US dollar.
And with euro-dollar rising towards, and potentially through the psychologically important $1.50 level, the Europeans are starting to get worried about their competitiveness.
Unsurprisingly, therefore, there has been plenty of verbal intervention in support of the US Treasury’s strong dollar policy. And coming from European Central Bank (ECB) President Trichet, calls for a stronger buck are a thinly veiled complaint about the strength of the single currency.
While European officials have not exclusively complained about US dollar weakness – there have been references to other currencies including the weak Chinese yuan – the level of euro-dollar is important because the US is the Eurozone’s second most important trading partner after the UK. The rise in euro-dollar has thus had a significant influence in pushing the nominal effective euro higher and to within a whisker of the December 2008 high.
LONG MEMORIES
But to those with long memories, verbal intervention may be stirring up memories of actual invention in the FX market. But while it would be foolhardy to completely disregard that risk, it is not an obvious threat. Firstly, the US and Eurozone authorities have steered clear of actual intervention in favour of oral communication since the mid-1990s.
And secondly, ECB research has shown that oral intervention has the effect of reducing volatility in a currency pair whereas actual intervention can increase it, which may ensure that this political tool remains on the shelf.
Another factor arguing against the use of actual intervention at this time is the weight of the poor US fundamentals weakening the dollar. Intervention in the foreign exchange market is likely to have greater success when the economic fundamentals support the central bank’s actions.
This appears to have been the case when the ECB intervened in late 2000 in support of the euro.
In hindsight it appears that the ECB’s decision was correct – at that time the euro-US dollar pair was close to a turning point anyway. The pair did, having bumped along the bottom for much of the following year before embarking on an uptrend.
While the oral communications supporting the dollar from the US Treasury and the ECB have not managed to turn the currency pair around, they have arguably had some success in slowing down the pace of the dollar’s fall and limiting the pair’s volatility.
FIERCELY DEBATED
And political will to slow down the pace of the dollar’s decline undoubtedly reaches well beyond the Eurozone. While the dollar’s standing as the leading global reserve currency has been fiercely debated, the consensus is that there is currently no clear alternative and so there can be no quick change in the makeup of FX reserves around the globe.
With this in mind, creditor nations such as China – which itself holds $2.3 trillion in its foreign exchange reserves – have a vested interest in not allowing the value of the dollar to fall at an aggressive pace.
Oral communication supporting a strong dollar and continued buying of US Treasury debt by central banks suggest that further declines in the value of the dollar are expected to remain orderly. This should cap any rapid and decisive move above $1.50 in euro-dollar.
There are two clear scenarios which could lead to a turnaround in the dollar’s prospects. The first is an improvement in US fundamentals. Should the US economy start to grow strongly, it is feasible that by the second half of 2010 US rates will be projected to rise at a faster pace than ECB rates. This would support the greenback as FX traders looking for yield differential will move into the dollar.
And second, fears of a double-dip recession in the US cannot be disregarded. This would lead to a retrenchment in risk appetite and benefit the buck. Combined with the reining in of fiscal incentives next year, this could undermine the global recovery and result in a surge of dollar interest.