With an estimated daily turnover of $1.5 trillion, foreign exchange may be the largest of the world's capital markets. Yet it seems as if the foreign-exchange market can only sustain one major dollar trend at a time.
In the first half of the year, the dollar trended higher against the euro and mostly sideways against the yen. In the third quarter, the dollar stopped appreciating against the euro and trended lower against the yen. Thus far, for two thirds of the fourth quarter, the dollar has traded broadly sideways against the yen and has trended higher against the European currencies, including the euro.
The market is unlikely to reverse these trends in the run-up into the end of the year. Activity is winding down, and short-term traders are looking to protect this year's earnings and bonus. They are increasingly averse to the risk implicit in reversing market trends. There seems very little to prevent the euro from slipping still lower. The break of parity ($1.00), successfully avoided in July, is looking ever more likely. The euro has already fallen to new lows for the year against the major foreign currencies (the dollar, the British pound and the yen).
However, the critical question is whether these trends reflect short- or long-term considerations. Most of the major investment houses forecast the euro to be higher than the prevailing spot rate for every quarter over their rolling one-year time horizons. Recall that as recently as the start of this month, the much-watched
survey of 260 fund managers found the lowest support for the dollar in 2 1/2 years.
Yet conventional wisdom has not proved very useful in the foreign-exchange market this year. And each one of the euro bulls' arguments has appeared to weaken over the last couple of weeks. First, recent data from the three major eurozone economies (Germany, France and Italy), which account for around 75% of the region's GDP, have disappointed expectations. It is true that the peripheral countries like Spain, Portugal and Ireland are enjoying robust growth. But, to a large extent, this reflects the convergence process that allowed these countries to enjoy much lower interest rates than they previously experienced.
The U.S. economy may be the most-analyzed country, but the number of eyes poring over the data has not prevented surprises. And the U.S. economy has surprised most economists again by producing greater growth and lower inflation. Recall that a year ago, with Asia's ongoing woes, Japan's recession, Russia's devaluation after receiving billions of dollars in international assistance and
Long Term Capital Management's
demise, many feared a recession in the U.S.
On the inflation front, despite the predictions of the nervous Nellies, the core rate of consumer prices has risen at a slower pace this year than last year. The rise in commodity prices this year, including oil, can be traced more to supply-side fundamentals than demand. Supply has been restricted in oil through
agreements, in gold through an agreement among major central banks in Europe, in copper through mergers and acquisitions, and in coffee by both floods and droughts in Mexico and Brazil.
Many observers and participants believe the U.S. equity market is a bubble. This was the year the bubble was to pop. And surely there have been a number of events that could have pricked the bubble, especially in recent months. Some thought that the antitrust action by the U.S.
, one of the largest U.S. companies, would be sufficient to sour investors. Some recalling the old "three-steps and a stumble" rule of thumb thought that the tighter U.S. monetary policy and the backing up of bond yields would end the bull market.
Nor has the U.S. current account been much of a nemesis for the dollar. And for good reason. In the world of highly mobile capital, trade flows are less important. Private capital flows (direct and portfolio investment) are more than offsetting the U.S. current account deficit and the eurozone surplus. Consider, as
economists have observed, that
, are equivalent to a full two-thirds of the eurozone's current account surplus.
One of the distinguishing characteristics of this year's capital flows has been the surge in crossborder direct investment. This activity appears to be having a greater impact in the foreign-exchange market this year than in the past. First, in sheer size, it is running at new record levels. European companies are modernizing and restructuring in part through purchases of foreign management and technology. Long-term direct investment flows are financing the lion's share of the U.S. current account deficit for the second year running. Second, other significant players have pulled back from the foreign-exchange market, like hedge funds and risk-takers at the investment banks. And this gives the "real money" flows greater impact in the market.
Where does this leave the dollar and the euro? The thinness of the year-end market may be contributing to the exaggeration of the euro's weakness. Europe in general and Germany in particular are more committed to reform than the recent pronouncements of
would suggest. Moreover, talk is one thing; action is another. And thus far the German government has not formally acted against the hostile bid for Mannesmann. Similarly, many market participants lampooned the French commitment to a 35-hour work week. And contrary to expectations, rather than lead to more rigidities, the bold French move has actually spurred greater restructuring.
Finally, although they're obscured perhaps because of Y2K preparations, there are some preliminary signs of a slowdown in the U.S. economy. The interest-rate-sensitive sectors are beginning to feel the bite, job growth is slowing from the average seen last year and earlier this year, and durable goods orders have declined for two consecutive months for the first time in several years.
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