Currency markets continued to be gripped by an obsession with interest rate differentials as 2006 began to unfold. The dollar merrily followed the path of US short-term rate expectations higher, while the yen remained in the doldrums as even the growing band of optimists about the state of the Japanese recovery saw no sign of Tokyo scrapping its zero interest rate policy for another 12 months or so.
Matters are rarely that simple in the currency market, however. The dollar actually endured a poor start to the year, slipping to four-month lows against the euro ($1.23), sterling ($1.792) and Swiss franc (SFr1.257) in late January. The sell-off was largely attributed to a rise in risk aversion, with UBS reporting that its risk index rose to its highest level since Hurricane Katrina in September. Concerns over the nuclear stand-off between Iran and the West appeared to encourage some to cut their exposure to the dollar, while a renewed spurt in oil prices, partly caused by the Iran effect, led to further jitters.
However, a settling of nerves at the end of January allowed the market to refocus back onto yield differentials, allowing the greenback to recover. This neatly tied-in with a study by Goldman Sachs, which concluded that interest rates matter most for foreign exchange strategy when liquidity is abundant and both risk aversion and volatility are low.
The dollar’s rally was driven by both hawkish rhetoric and a series of solid US economic reports. Labour market data signalled both accelerating wage growth and a slide in unemployment to 4.7%, the lowest rate since mid-2001. Industrial production data indicated capacity utilisation has risen to 80.7%, its highest level since November 2000, a factor sure to attract the interest of the Federal Reserve. The housing market, which many analysts predict will soon begin to buckle, heralding a wider consumer-driven slowdown, managed to hold up. Even a disappointing GDP report for the fourth quarter of 2005 indicated that the core personal consumption expenditures deflator, the Fed’s preferred measure of inflation, rose to 2.2%, above the central bank’s target range.
Perhaps not surprisingly, The Fed’s widely expected January 31 rate hike was accompanied by the suggestion that further tightening “may be needed”. Come February and Michael Moskow, president of the Chicago Fed was calling further rate rises “appropriate”. The upshot was predictable. Back in mid-January, the futures market was pricing in little more than a 50% chance of rates being raised to 4.75% in March. By mid-February this probability had risen to 94%, with the market even having gone a long way towards pricing-in a hike to 5% by summer.
Equally predictably, the dollar rose to $1.191 against the euro, 2% above its mid-January levels, 1.9% to $1.742 against sterling, 2.5% to SFr1.307 versus the Swiss franc and 3.1% to Y117.75 against the yen.
“The pendulum of market sentiment is swinging back in favour of Fed tightening, and that is helping the dollar,” said Marc Chandler, head of Global currency research at Brown Brothers Harriman, who foresaw US rate peaking anywhere between 5 and 5.5%, allow the dollar to re-test its November high of $1.166 to the euro.
The yen was the month’s other main talking point, selling off sharply into early February, before a modest recovery kicked in. With interest rates still at virtually zero, the yen remains the favoured funding currency for the infamous carry trade. Indeed, with much of emerging Asia witnessing strong equity markets and currencies (the South Korean won hit an eight-year high of Won957.4 to the dollar in early February). Hans Redeker, head of currency strategy at BNP Paribas, saw the yen becoming the victim of a new Asian carry trade, in which borrowed yen are recycled into the equity and bond markets of its neighbours.
The release of data showing core Japanese prices edged up 0.1% in the year to December, the first time Japan has posted two successive positive inflation readings since April 1998, might have been expected to provide some relief. But policymakers remain determined to move at their own pace. Toshiro Muto, deputy governor of the Bank of Japan, warned that conditions were not yet right to end quantitative monetary easing, in which additional liquidity is pumped into the banking system. The consensus view is that the first interest rate rise will follow a year or so after the scrapping of this easing.
“An end to quantitative easing will be announced in April or May, but the Bank of Japan is likely to maintain the overnight call money rate near zero for some considerable period beyond then,” said Paul Chertkow, head of Global currency research at Bank of Tokyo-Mitsubishi UFJ. “We expect a continued widening of the US-Japan short-term interest rate differential to drive the yen weaker.”
The yen did sustain a modest recovery in February as a build-up of short-yen positions prompted a short-squeeze, and a double salvo of strong data showed wholesale prices are rising at their fastest rate for 16 years and that machinery orders are at a five-year high.
“Such was the strength of the figures that one can imagine the hairs rising on the neck of any inflation-fearful central banker,” said Neil Mellor, currency strategist at the Bank of New York. Despite this, the yen still fell 1.2% to Y140.23 against the euro in the month to mid-February, 1.3% to Y205.33 against sterling and 0.9% to Y87.07 to the Australian dollar.
Most other major currencies were little changed on the month as the market lacked clear direction. The Australian and New Zealand dollars, off 2.3% and 2.9% at $0.7392 and $0.6794 respectively against the greenback, were a little weaker than most. Both countries reported some soft data as high nominal interest rates worked their way through their economies. Monica Fan, Global head of FX strategy at RBC Capital Markets, also saw weakness being driven by selling of Japanese banks as uridashi bonds – foreign-currency denominated debt aimed at Japanese investors – matured.
European currencies were essentially flat against each other as expectations for the future path of interest rates remained unchanged. The European Central Bank, as expected, held rates in March. But equally expectedly, Jean-Claude Trichet, the bank president, dropped heavy hints that eurozone rates will head up to 2.5% in March.
The Bank of England also surprised no one by staying on hold in February. More importantly the release of the minutes of January’s gathering, at which the monetary policy committee voted 8-1 against a rate cut, allied to better-than-expected GDP growth data, gave the impression that rates will not be coming down in the near future.
Not for the first time, however, the Brazilian real bucked the trend, jumping 5% to R$2.163 to the dollar. Foreign investors continued to pour money into the Sao Paulo stock market, sending it to a record high, while the central bank cut back on its issuance of currency swaps, which allow investors to benefit from Brazil's 17.25% interest rate without having to buy the real.
