While some progress on European sovereign debt problems may have slowed or halted the decline of the euro for now, uncertainty on a fundamental level predominates in currency markets, leaving traders and technical factors in control and possibly less volatility in the outlook.
The dollar recently has seen some signs of strengthening while the yen has resumed weakening as central banks in the United States and Japan have taken different tacks on quantitative easing and currency traders and analysts are looking for more of those trends in the coming year.
Among factors affecting currency prices are recent crude oil price spikes as well as hard assets, which weigh particularly on the “commodity currencies,” such as the Canadian and Australian dollars.
Mark Frey, vice president of corporate payment and risk solutions for Cambridge Mercantile Group, says that following the Greek bailout deal many currency market participants believed the rebounding euro would challenge the $1.35 mark, but when that failed in the wake of the European Central Bank’s long term refinancing operation, thinking on the euro changed.
“The market is going to be able to focus a little bit more on the euro fundamentals,” he says. “The euro fundamentals at this time are obviously not that robust. We’ve got some significant concerns from an employment point, from a GDP contraction standpoint. As the various austerity measures get pushed through across Western Europe, it’s going to have a more negative impact on the overall euro and the economy.”
This is likely to lead to more economic contraction in Europe with the euro again heading downward. “It’s no secret that 2012 is going to be a difficult year for the Eurozone with austerity measures going into place,” says Greg Michalowski, vice president and chief currency analyst with FXDD. He notes that continued problems with the smaller European countries like Greece, Spain and Portugal are weighing on growth prospects of the Eurozone and that currency markets have that idea priced in.
“You can see it in some of the volatility in the euro. Last year the average daily range for the euro was about 157 pips and that fell to 121 pips in February,” Michalowski says (see “Euro takes a chill pill,” below). “The volatility has come down and that is a reflection of this idea that we know what’s ahead.”
At least for now, prospects of a breakup of the Eurozone are seen by most observers as having been put on hold. “In the short-term the euro will continue, but I can’t say what will happen in the long-term,” says Thomas Molloy, chief dealer at FX Solutions. “It’s possible that eventually at least one of the nations in Europe will not necessarily have been kicked out but will have chosen to leave (see “Jamie Thorsen: Enjoying the action of forex”).”
He and others say that increasingly stronger nations in Europe are more likely candidates to leave the monetary union. “The big risk to the euro is that Germany exits, and if Germany exits, it basically falls apart,” Frey says. “Whereas you could lose Greece, and while that would be messy and it wouldn’t be that convenient for anyone concerned, the euro could still survive. But at some point down the road in the very long run, if Germany were to exit, that marks the end of the euro for sure.”
Kathy Lien, director of currency research at Global Futures & Forex Ltd., also expects the euro to continue but adds, “Unfortunately I do not believe that a second bailout of Greece will be the end of the Eurozone’s troubles,” she says. “Greece was never the main problem — it is contagion. As a result, expect more volatility in currencies this year.”
Differing outlooks also are seen for the U.S. dollar in light of European developments and recent Congressional testimony by Federal Reserve Chairman Ben Bernanke. “The dollar is much lower than it was three months ago and also the prospects of easing have soured sentiment toward the dollar index,” says Andrew Wilkinson, chief economic strategist for Miller Tabak & Co. LLC. “I would say that the stage is set for a weaker dollar and a stronger euro.”
But he adds that fears of a weaker dollar should not be overestimated and that the euro does not deserve to be fundamentally much higher. “It’s really a question of positioning at this point. A lot of people are losing money from failing to adjust to the reality of the ECB wrapping its arms around the Eurozone financial system.”
Frey notes that the prospects for the dollar began to change with Bernanke’s testimony. “There were a great number of participants that were banking on seeing some form of QE3 relatively soon and Chairman Bernanke poured cold water on that idea,” Frey says. “He really gave us the sense that there is no further monetary stimulus coming our way and, if anything, we likely will continue to maintain low interest rates at the current level until 2014, which already has been forecast in the market and already has been very well communicated.”
In light of the market’s prior expectations for further monetary easing, that is a positive development for the dollar, Frey says. “If the overall economy begins to firm and the U.S. economy gets on the right track again, if the unemployment rate [continues] to dip down and the housing market begins to firm, those are big positives for the overall economy and big positives for the dollar” he says. Frey adds that if the Fed also doesn’t continue to expand its balance sheet, that is positive for the dollar as well.
“I am still looking for further gains in the greenback as a gradual U.S. recovery makes the dollar more attractive than the euro, which will experience ongoing strains in the coming year,” Lien added.
Election year trends
Another potential positive for the dollar is that 2012 is an election year and Lien’s analysis indicates that the dollar tends to rise during election years. Using the Deutschmark as a proxy, Lien analyzed data on the EUR/USD for nine election years in the U.S. going back to 1976. “Don’t vote against the greenback” (below) shows that the EUR/USD weakened eight out of the nine election years by an average of 6%. In other words, the U.S. dollar tends to perform well against the euro in election years. No consistent election year patterns were found in USD/JPY or the Dollar Index. “The EUR/USD has performed extremely well in the start of the year, but eight out of nine times are very high odds. For this reason, we would not be surprised to see the EUR/USD reverse trend as the year progresses,” Lien says.
Less positive is the outlook for the yen. “There are a couple of things that have really changed in terms of the backdrop for the Japanese yen and that means that it’s on its way back toward 100 per dollar,” Wilkinson says. ”We’ve seen a significant turning point for the yen and we’ll increasingly see investors turn bearish on it.”
Among the problems antipated for the yen are increasing risks for energy prices driven up by the conflict with Iran. “[Japan is] a big importer,” Michalowski says. “[Japan] imports all its oil and the idea that the yen is a safe haven has kind of been washed out of the market over the last month and we’ve seen a nice steady rise in the dollar vs. yen.”
The dollar may be the only safe haven left as the Swiss National Bank’s decision last September to peg the Swiss franc at SF1.20 to the euro effectively devalued the currency and left very few options in terms of a safe haven.
Also benefiting to some extent from higher oil prices are the commodity currencies. “Overall, things like the Aussie dollar and the New Zealand dollar tend to have higher interest rates, the advantage of commodity prices and the advantage, hopefully, of China in their region,” Michalowski says.
Even better results are expected for the Canadian dollar. “The Loonie should outperform the Aussie because there will be more latitude to the upside and it stands to benefit more from the direct impact of over-the-border strength of the U.S. recovery,” Wilkinson says.
