Dollar Ranges Intact Midway through the First Quarter

The price action against the euro and yen in recent days reinforces the US dollar’s trading ranges. After testing the strong side of the ranges recently, the risk is that the greenback now slips toward the lower end, which comes in near $1.4900 for the euro and toward JPY106 against the yen.

Euro

For more than three-months now the euro has been largely confined to a $1.43-$1.49 trading range, with most of the activity taking place between $1.4500 and $1.4800. This range has persisted despite a plethora of negative dollar developments, like the aggressive Fed rate cuts, fiscal stimulus pending, an economy which appears to have ground to a halt or worse, and the ongoing paralysis in the capital markets, morphing like the common cold, first hitting SIVs and the conduits, then commercial paper, sub-prime mortgage derivatives, leveraged loans, and more recently auction rate bonds and tender-option bonds. The fact that the euro has not been able to make a new high since late Nov 07, speaks to the US dollar’s general resiliency.

After ECB President Trichet apparently announced a shift toward a more neutral stance, though no change of rates has taken place since June last year, the euro completed its decline of the first half of the month, which took it from $1.4950 to $1.4440. It closed below the 100-day moving average against the dollar on the day of Trichet’s press conference (Feb 7) for the first time in about six months.

A number of factors, however, in recent days have conspired to lift the euro off its lows and likely propel it back toward the upper end of its range. Fundamental considerations seemed to play a role. In recent days, several ECB officials protested the market’s move to discount a rate cut near midyear, warning that this was not consistent with the central bank’s efforts to anchor inflation expectations.

Even though Trichet had made it clear that, unlike past ECB meetings, no one sought a rate hike, neither he nor Bundesbank President Weber can feel comfortable given the status of the current wage round. Significant wage increases have already been conceded in Finland and German unions have engaged in a full court press for a substantial increase in wages. In recent days, there have been warning strikes by the pubic sector workers seeking an 8% pay increase.

From a purely economic point of view, it is not immediately obvious why the ECB should be favoring capital so clearly and consistently over labor in the distribution of gains from productivity. It could be one of the factors that has restrained household demand during the business expansion. Retail sales in the euro-zone for example, fell each month in Q4 and were 2.0% lower in Dec 07 than Dec 06. By depressing domestic demand, it also increases the region’s reliance on exports for the critical impetus to growth. This could contribute to the region’s vulnerability to a slow down in the US and UK, its biggest trading partners this year.

There are several reasons for the ECB’s reluctance to ease policy. There seems to be an ideological component. Trichet specifically articulated this, for example, when he opined that “activism on rates is improper”. The Federal Reserve clearly does not believe this and sees the cost of inter-meeting activism or the cost of possibly needing to reverse itself later this year as being marginal. There also seems to be a structural difference in how the ECB and Fed are organized. Over time, the Federal Reserve has weakened the power of the regional presidents, who get to vote on policy on a rotating basis, while the permanent core of the Federal Reserve Board always enjoys a comfortable majority. The ECB has a significantly smaller core and a greater voice for the regional presidents (member central bank governors).

Observers typically play up the fact that the ECB has a single mandate, price stability, while the Fed has two masters, price stability and full employment. Yet in practice, it is not clear that this explains the differences. As we have noted, the ECB has overshot its self-defined inflation target (2% for consumer prices) since 1999. The overshoot has been marginal and did not prevent the ECB from easing earlier this decade. At the same time, Fed officials appear to conflate their two objectives by accepting that price stability helps sustain growth and full employment over the long run.

In any event, the ECB’s hawkish stance contrasts with the signals from the US Federal Reserve which has validated the market expectations that it is prepared to cut rates. This has been reflected in a widening of interest rate differentials against the US. For example, when the market had been bringing forward the time frame of the first ECB rate cut, the spread between the June Euribor futures and Eurodollar futures narrowed to about 130 bp in Europe’s favor and now it is just shy of 150 bp.

Yen

For the past month, the dollar has been largely confined to a JPY106-JPY108 trading range. It has poked through the JPY108 level in recent days, but offers from Japanese institutional investors and exporters are believed to have helped cap the greenback in front of JPY108.60, which roughly corresponds to a 38.2% retracement of the dollar’s decline from the JPY114.65 high seen shortly after Christmas.

On Feb 8th, the dollar’s 5-day moving average against the yen crossed above the 20-day average for the first time this year. While these moving averages have whipsawed in the euro, they have caught the big moves in the dollar-yen rates since last October, with no false signals. Technically, the dollar appears to be tracing out what technicians call a “rounded bottom”, with a convincing move now above JPY108.60 opening the door for a recovery toward JPY110.

The yen barely derived any benefit from news that the economy expanded at twice the pace the consensus had forecast (3.7% annualized rather than 1.7%). Nor did it benefit from the continuing narrowing of 2-year interest rate differential with the US. The 2-year spread stands near 130 basis points currently, down 55 bp in the past month and 6 bp over the past week. This is the smallest premium the US has offered in 3 ½ years. Some of the dollar selling in recent days was linked to Japanese institutional investors repatriating their part of the US Treasury’s large semi-annual coupon payment (paid Feb 15).

Many observers, it seems, continue to talk as if yen’s movement can be explained by yen-carry trade strategies, but this seems to miss the fact that for the past two weeks the net speculative position in the yen futures has exceeded 50,000 contracts long, which has only happened on three periods in the past decade. And data from the Financial Futures Association of Japan indicate that Mr and Mrs Watanabe have record short dollar positions.

As the dollar has chopped between JPY106 and JPY108, the implied volatility has fallen from near 14% to near 10%. Volatility has generally moved opposite the dollar against the yen. That is to say that implied volatility has been trending higher as the dollar has been trending lower against the yen since the end of H1 07. Implied volatility is finding support ahead of 10%, which if sustained, would suggest the dollar may not make much headway against the yen.

The Range Can be Your Friend, Until It’s Not

The dollar has been confined to fairly well identifiable ranges and the odds favor their continuation. This requires not only buying dips but selling rallies. The price of such a strategy is that that eventual break out may be missed. At the same time, a convincing break of the range would likely be sparked by fundamental news. Two such potential developments come to mind. The first is a resolution of the monoline insurers’ woes—the race is between potential downgrades (ostensibly bad for the dollar) or the rating agencies finishing their analysis and affirming their AAA status, likely with some new capital infusions (ostensibly good for the dollar). The second is economic data that eases US recession fears and this could come in the form of the next employment report on March 7th.