The euro’s rapid ascent beyond $1.30 was not simply the product of thin market conditions around Thanksgiving, but rather, the culmination of issues that have been growing in prominence for some time. Lying at the heart of the dollar’s problems is the enduring issue of ‘global imbalances’; and, as such, it is now difficult to see the dollar’s current weakness as a short-term phenomenon. Indeed, the fact that the dollar index now appears to be back on a downward trend that first got underway at the start of 2002 in itself points to this being the start of something important.
Perhaps the issue directly responsible for the timing of the dollar’s renewed slide, however, is monetary policy, and it is noticeable that the currency failed to derive support from hawkish comments (post-Thanksgiving) by Federal Reserve Chairman Ben Bernanke. We suspect that many traders were still nursing wounds from October, when a strikingly hawkish vocal campaign from the Fed preceded a Federal Open Market Committee (FOMC) statement that, if anything, conveyed a more dovish stance than its predecessor. This perhaps raises the issue of credibility. The FOMC is, of course, intent on maintaining flexibility and preventing market expectations from getting carried away (as was the risk in October); but then, it would appear that Mr Bernanke has fallen foul of crying wolf. Put simply, the prospects of tighter US monetary policy are considered to have diminished considerably – regardless of the FOMC’s expressed concerns over lingering inflation.
Just as the prospect of tighter US monetary policy has receded, so too has the potential threat posed to ample liquidity conditions across the globe. And in conjunction with the marked slide in oil prices through the autumn, and continued, optimistic official testimony on the US and global economic outlook, this has simply served to boost risk appetites and hence the fortunes of global stock markets, and emerging markets in particular.
Moreover, with recent data pertaining to reserves providing further evidence of the continued endeavours by central banks to stymie currency appreciation, we strongly suspect that foreign investors are once more being drawn to Asia-Pacific markets in particular, partly because of the effective subsidy to stock purchase that such intervention constitutes. With the endgame of US monetary policy now in play, this trend could well begin to intensify.
Perhaps the epitome of this concept is provided by investor interest in Hong Kong – which for 13 years has operated a currency board that maintains a fixed and ‘irrevocable’ exchange rate with the dollar; and the close association in the performance of the Hang Seng stock index and the net cumulative flows of foreign portfolio investment in the SAR (as measured by The Bank of New York’s iPFM data) as demonstrated in the accompanying chart. There is most certainly a speculative element to these flows amid renewed talk of the prospects of official linkage between the Chinese yuan and Hong Kong dollar (indeed, the discount on one-year dollar/Hong Kong dollar forwards has endured a steady rise since last autumn). The Hong Kong Monetary Authority’s refusal to countenance this idea is a threat to the forces that have kept one-year Hong Kong dollar interest rates at artificially low levels. But then again, we strongly suspect that the highly competitive Hong Kong dollar will remain ample reason to expect Hong Kong to retain the interest of foreigners while their current appetites for risk prevail.
Neil Mellor is a currency strategist at the Bank of New York.
Researched and published in association with the Bank of New York.
