The Hindu Business Line : Dollar on a cyclical upswing?

GIVE a forecast but do not give a date. That is an unstated rule in the business of forecasting the financial market. Well, if the volatility seen in the major global financial markets — foreign exchange and interest rates — in the past few months is any indication, one would recognise that the unstated rule is actually a realisation born out of humility.

Such has been the major turnaround in the markets. The US dollar, defying all predictions of a disruptive breakdown, is up at least 10 per cent against the euro in the past six months — rising from the 1.36 levels of December 2004 and breaking the 1.20 barrier in the past week. There has been a broad-based dollar rally also against all of important US trading partners.

On the interest rates front, while the short-term dollar interest rates are being pushed up by the US Federal Reserve, the medium/long-end is reacting differently. Even the Fed acknowledges that longer-term inflation expectations are well-contained. Long-term dollar rates have, therefore, swung from a high of 4.69 per cent to a low of 3.9 per cent and a sustained move above 4 per cent again is facing resistance.

We, therefore, now have a situation where the overnight US interest rate is 3.25 per cent and the 10-year interest rate is 4 per cent. Even if the 10-year rate rises to 4.5 per cent in the ensuing period, the US term structure would be almost flat. This has implications from a systemic risk point of view as well.

Forecasting, the name of the game

The unstated rule given above is more a reminder of the need for humility when forecasting the markets. It does not preclude forecasting. Indeed, financial markets participants have to take a call on various variables day in and day out in the course of their operations.

This piece attempts to do the same. So, here is a paisa's worth of a forecast on the major currencies. The US dollar is possibly at the start of a cyclical upswing against major global currencies such as the euro, the yen, the British pound and the Swiss franc, which could persist for at least a couple of years. Even here, while the dollar/yen could broadly move in tandem with the overall strength of the dollar, it may also be subject to more volatility than the other pairs.

Economic, social and political developments also seem to be combining to support this uptrend prognosis about the dollar. The key point here is that economic and non-economic forces seem to be playing a supportive role only in explaining currency movements and are not the fulcrum or pivot on which the bullish dollar story primarily rests.

Cyclical patterns in currencies

The uptrend theory about the dollar basically draws its support from the evidence thrown up by movements in the dollar's exchange rate over the past 30 years or so — that is, almost from the advent of free floating itself. A study of the dollar's exchange rate movement over the past 30 years indicates a broad pattern of alternating uptrends and downtrends in the currency every five years or so.

Consider the following average exchange rates of the dollar vis-à-vis the Deutsche mark and the euro over the past 30 years. These are yearly averages which are averages of the daily closings.

The dollar seems to rise and fall every five years. From an average level of 2.45 DM in 1975, it fell to 1.82 in 1980 but rose again strongly to almost the 3 DM level by 1985. The next five years again marked a fall to the 1.60 levels which persisted even further into the mid 1990s when the dollar touched a low of 1.37 DM. From thereon, it was all the way up for the dollar as it roared upwards to the 80 cents level against the euro by 2000. The next four years up to late 2004/early 2005 again saw the US unit take a nosedive as it sank to the 1.35 levels against the euro.

With the latest five-year period over now, we are possibly at the commencement of a new block of five years. And sure enough, we seem to have seen the first stirrings of a broad dollar rally as it has risen almost 11 per cent in the past five months — and more than 50 per cent of that rise has come in just in the period of a month and a half — from around mid-May 2005.

Supportive economic/political environment

It is pertinent to note that the alternating pattern in the dollar has been experienced irrespective of the economic and non-economic environment attending currencies. In the event, economic/other factors seem to have played only a supportive role in explaining currency movements and have not been, by themselves, fundamental to the same.

An example will illustrate this point. One of the prime reasons for the dollar's weakness over the past five years was the high level of trade/current account deficits the US was running.

Now, has there been such a turnaround in the US trade/current accounts to warrant the 10 per cent-plus appreciation in the dollar in the space of a few months now? One has not seen even preliminary indicators of the US external imbalance on the path towards adjustment. Indeed, the external imbalance will adjust only over a period of time even if corrective fiscal/monetary measures are put through.

What is more relevant is understanding correctly how the market interprets the underlying economic environment. If a particular economic condition such as a trade/current account deficit is seen as negative for a currency in one period, the same issue is not interpreted in the same way in a different period. Also, other factors with positive implications for the currency (for instance, the dollar's current and expected interest rate differential against the other major currencies) come into focus when viewed in relation to other countries/currencies even as the original `malady' of stubborn trade deficits persists.

In fact, the above argument would seem to apply broadly over the past 30 years also. This period has seen alternating and differing interpretations by the market of a particular set of economic conditions in various sub-periods of time. And, following those different interpretations, currencies have also alternately risen and fallen. One example is the differing treatment meted out to the US' external imbalances over the past two decades or so.

The immediate future

The immediate future appears quite bearish for major currencies such as the euro or the British pound. In the case of the euro, not only could a historical pattern of currency alignments be working against it. The underlying economic/political environment in the Euro zone also seems greatly capable of scoring same-side goals against the common European currency.

(The author is Associate Vice President — Treasury — ING Vysya Bank Ltd. These are his personal views and do not represent those of his employer.)

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