Many observers are having a difficult time offering a cogent explanation of the recent moves in the foreign exchange market. They want to talk about the dollar doing this or doing that, but its divergent performance against the Japanese yen and the complex of European currencies has been one of the distinguishing features in the foreign exchange market this entire year and especially since the summer. Over the past year the dollar has risen about 7% against the euro and has fallen more than 20% against the yen.
It doesn't make sense to talk about the dollar in the abstract. Take last week, for example. The U.S. reported third-quarter
gross domestic product
rose 4.8% while the
employment cost index
In knee-jerk fashion, the dollar was briefly bid higher across the board. However, this quickly gave way to the more common divergent performance. The dollar continued to strengthen against the yen, but gave back all of its gains plus some against the euro. Suggesting the dollar rose on the favorable mix of economic data is meaningless. A dollar-centric view right now hinders rather than helps our understanding of what is going on.
Let's start with the yen. The yen's strength has been largely, although not exclusively, a function of Japan's institutional investors' and multinational corporations' money management. Among the largest Japanese multinational companies,
offers an arguably representative case in point. When earnings were released last week, Masayoshi Morimoto, Sony's senior executive vice president, was quoted by the
as saying, "For every yen the currency moves against the dollar we lose or gain 6 billion yen in operating profits." He revealed that Sony has now hedged 90% of its exposure against the euro and dollar for the second half of the financial year, which ends March 31, 2000. Deploying resources overseas and then hedging the exposure seems to be a better explanation of the vagaries of the yen than citing fairly stable macroeconomic fundamentals.
Over the past couple of years and in recent months, Japanese institutional investors have increased their purchases of European bonds and stocks in absolute terms and relative to U.S. assets. As the hedging program unfolded, it ought not to be too surprising to learn that the yen has appreciated more against the euro than the dollar. To be perfectly clear, Japanese investors are not repatriating their foreign investments. They are simply hedging (or offsetting) some of the currency risk.
Just as the yen has been strong across the board, the euro has been weak. In part, the euro's weakness reflects the strength of the yen. In part, it reflects the net capital outflows from the eurozone in the form of direct investment both in the U.K. and the U.S. In part, it reflects the underperformance of European asset prices. On the fixed-income side, eurozone bonds have fallen more than U.S. Treasuries since July as the U.S.-German 10-year spread has collapsed from 180 basis points to around 85 basis points currently.
The poor performance of European asset markets, however, is even more obvious in the equity market. A dollar-based investor has done better in the Brazilian equity index, suffering through the large currency devaluation at the start of the year, than investing in most major European bourses, with the exception of France and Sweden.
Next week, the
European Central Bank
will likely take a page from
playbook. Recall that as chairman of the
in the early 1980s, he wanted to squeeze inflation from the U.S. economy. But given the high levels of unemployment, the kind of rate hikes that plan would have entailed were politically unpalatable. He needed cover and found it by becoming an "opportunist monetarist." That is, he used the money supply growth to justify what he wanted to do in any event.
Nearly everything I have read and heard suggests the ECB has decided to raise rates at the Nov. 4 board meeting. The consensus calls for a 25-basis-point hike, but don't be surprised if they do 50 basis points and sit tight until after the wage round in the first quarter next year.
On one hand, ECB officials have said their money supply target is not really a target but a reference range, and that they cannot be sure the introduction of the euro has not distorted the demand for money. On the other hand, many ECB members, even the perceived doves, played up the significance of the recent money supply report, which showed acceleration in the growth rate. With double-digit unemployment rates throughout most of the eurozone and average inflation shy of its 2% pain threshold, the ECB needs to offer some justification for its hike.
ECB President Wim Duisenberg has tried to spin the likely rate hike as taking one's foot off the accelerator rather than hitting the brake. But a simile is not an argument and the risk is that the ECB begins with Volcker's playbook but ends up with a Japanese play. Recall that Japan raised its retail sales tax in 1997 just as the economy appeared to be recovering and this sent the economy spiraling lower. The risk is that the ECB takes away the proverbial punch bowl too early and curtails the already painstakingly slow recovery. A trajectory of less accommodative monetary policy and restrictive fiscal policy tends not to be associated with strong asset markets.
Marc Chandler is the chief currency strategist for Mellon Bank. At the time of publication, he held no positions in the currencies or instruments discussed in this column, although holdings can change at any time. While he cannot provide investment advice or recommendations, he invites you to comment on his column at email@example.com.