U.S. asset prices and the dollar took a drubbing in the second half of last week, and this is likely to spill over into the early part of the week ahead.
Despite the chart's ugliness, however, this is not the beginning of a dollar crisis; by the second half of next week, the dollar is likely to begin recovering. Look for the dollar to finish next week near 106.50 against the yen with the euro finishing near $1.08.
Many participants will worry that the distortions seen in the September
Producer Price Index
data released last Friday will get duplicated in the
Consumer Price Index
data to be released Tuesday. And on Wednesday, the market will be reminded -- as if this is necessary -- that the U.S. trade deficit continues to grow, even though world growth is improving.
Assuming the world survives these developments (I have it on good authority that it should), the outlook for the dollar may brighten. On Thursday, the
European Central Bank
meets. Recent comments, even from some of the more dovish board members, and the ECB's monthly report emphasize that inflation risks need close attention despite the relatively subdued current readings. Speculation of a rate hike at this meeting, however, is likely to prove premature.
Admittedly, trying to anticipate what the 10-month-old ECB will do is a bit like playing in a new poker game: You're not really sure of everyone's style. You can't be sure, for example, that a cough is just someone clearing his throat, and not signaling. There are, however, some clues. ECB officials, for example, have indicated it will not be an activist central bank. That means interest rates will be adjusted less frequently than say the
Bank of England
, but implies the magnitude of changes might be greater.
Also, the ECB has been criticized for its lack of transparency. To ensure that the logic behind a decision to hike rates is perfectly clear, the ECB needs data releases that demonstrate its case to market participants. There simply have not been enough significant data releases since the last ECB meeting to justify a reconsideration of the judgment made then.
However, by the next meeting on Nov. 2 (or the following meeting on Nov. 16), sufficient data will be available to provide the ECB with reasons for a rate hike. It is almost as if the ECB will take a page from
playbook and use the data as cover to do what it wanted to do in the first place. The ECB has acknowledged that its target for M3, the broadest gauge of money supply, is a reference point, not a policy determinant. It has also acknowledged that the introduction of the euro may distort the demand for money.
When the ECB cut key rates by 50 basis points in April, it indicated the move was an insurance policy because of the downside risks to the eurozone economy. Now it is clear that the downside risks no longer exist. The insurance policy will likely be taken away in full in November. However, some players will be disappointed if the ECB does not move this week, and this could help fuel the pullback in the euro. With momentum indicators getting overextended, the technical condition is also consistent with a dollar recovery by the second half of the week.
Many market participants remain skeptical of the significance of the BOJ's decision this past week to use additional instruments in its open-market operations, provide extra liquidity to pre-empt higher rates caused by Y2K positioning, and lastly, to purchase short-term government paper directly. Details about the last point remain sketchy but should be clarified at the next BOJ board meeting at the end of the month.
There are two significant aspects to the BOJ's decision. First, changing instruments used for its operations will likely enhance the effectiveness of its liquidity provisions. It means that not only will overnight rates hover just above zero, but other money-market rates, through the two-year sector, will also see rates decline. The subsequent steepening of the yield curve is a good thing insofar as it will help the banks strengthen their balance sheets. That said, the greater problem in Japan lies with the demand for money, not the supply, and the most recent evidence on bank lending suggests the liquidity trap is as potent as ever.
Second, with the BOJ demonstrating the meaning of its commitment to flexible monetary policy (within the context of zero overnight interest rates) in such a concrete fashion and the Japanese government preparing a supplemental budget in excess of 10 trillion yen (about $95 billion), the political conditions for coordinated intervention appear enhanced.
For the record, I have yet to see any evidence that the U.S. is really pressing Japan for quantitative easing. Officials are often more concerned about the pace of change of foreign exchange prices rather than a particular level. This implicit threat should discourage the market from aggressively pushing the dollar below the 105-yen level in the coming sessions.
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.