So far, 2011 has proven to be the year of the European currencies, especially for the euro and the Swiss franc. When compared to the British pound, Japanese yen, Australian dollar, Canadian dollar and the U.S. dollar, the euro and franc have shown impressive gains year to date. Refer to Table 1 to see how the major currencies have stacked up next to each other. Also, refer to Table 2 to gauge how the ebbs and flows of the major currency combinations have played out for the year.
Throughout the year, currency traders and hedge funds have significantly increased their bets against the U.S. dollar. This reflects bearish sentiment against the U.S. dollar maintaining its status as the currency of choice around the world. Of course, there has been pressure on the U.S. dollar for years, but with the growing U.S. debt, increasing concerns about the fiscal competence of the current U.S. political system and rising eurozone inflation and interest rates; it is not surprising that the U.S. dollar has taken it on the chin. Even the geopolitical tension in the Middle East, which normally pushes a flight to safety in the U.S. dollar and assets, has not been enough to help the U.S. dollar. Thus, there has been a sharp reversal and a pointing of favorable sentiment towards the single euro currency, which faced major stability issues with the eurozone sovereign debt crisis in 2010.
In a recent press conference, Jean-Claude Trichet, President of the European Central Bank and the Governing Council decided to keep key ECB interest rates unchanged for June, but left the possibility open for a further rate increase in July. He also stated that because of increased energy and commodity prices, there is upward pressure on overall inflation. He also stated that the pace of monetary expansion is gradually recovering in addition to positive underlying momentum of economic activity in the euro area. The ultimate goal is to maintain inflation rates close to 2% over the medium term, which would maintain a favorable environment towards supporting growth and job creation in the eurozone. Chart 1 shows that so far in 2011, the euro interest rate has increased by 0.25%.
Chart 1
The other traditionally safe haven currency, the Japanese yen, has trailed the European currencies and Britain, Australia and Canada. It has only outperformed the U.S. dollar year to date. However, since the disastrous March 11th earthquake and tsunami, the yen has strongly outperformed the Canadian dollar, Britain pound and the U.S. dollar.
With or without earthquakes, the yen is still the currency of choice for traders as a funding currency. Traders want to take advantage of the low interest rates in Japan by borrowing the yen to buy other assets that give a better yield such as the Australian dollar.
Until rates rise in Japan and risk appetite is still in the air, one can expect Japan to serve as the funding currency for quite a while to come. The earthquake only insured that rates will be kept low indefinitely through its disruption of Japanese economic growth. However, when the quake hit, fear and panic set in, causing traders to unwind those positions and buy back the yen they had previously sold which caused the yen to strengthen.
Initially, after the earthquake, there were many bets that the yen would rally due to the speculation of repatriation. The thought was and still is that it will require yen to pay for the rebuilding of the stricken region of Japan. However, as an export-oriented country, Japan thrives on a weak yen. There are aggressive fiscal and monetary policies mapped out by the Japanese authorities, thus it appears that the yen could continue to be held down as we move from the date of the earthquake. Of course, in the event of another set of unfortunate events, you can expect the Bank of Japan to step in and boost liquidity injections to ensure financial stability. They did it after the March 11 earthquake, and they did it after the Kobe earthquake.
Going forward, there are profound global events, both self-inflicted and compliments of Mother Nature that could continuously throw curve balls in the direction of various currencies. It would not surprise me to see a see-saw effect of the euro versus the U.S. dollar. Like times I have written in the past for Forex Journal, I see the deterioration of the U.S. dollar through the unprecedented amount of debt and lack of fiscal leadership literally competing with the widening cracks in the foundation of the euro. Positive and negative news regarding either currency could pick up the volatility to the point of having more “trade food” to work with for short-term opportunities.
This is an excerpt from Jul 2011 issue of Forex Journal.
