Currencies to be Less Exciting in Second Half

By: Chip Hanlon | Sat, Jul 23, 2005
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With the Chinese calling Congress' bluff yesterday and moving the Yuan's peg to the Dollar, the focus of the investment world will once again be back on the world's currencies. Ironically, they may disappoint.

There will certainly be plenty of conjecture about the balance of currencies in China's new "basket," but since China hasn't released the details of that basket's make-up (and likely never will), we will all be left to sift through any clues we can find in time through market action in these currencies.

Aside from the initial trading spasm following the announcement, the reaction has been remarkably quiet, which suggests this is merely the first step in a long, slow process in which the world's central banks try to manage their way out of today's fiscal imbalances. If so, then it makes sense to simply take our cues from continued market action, so a look at recent currency action will likely be our best guide as to what comes next.

First, the U.S. Dollar:


www.stockcharts.com

It can be seen in the chart above that the Dollar recently reached not only an overbought state, but an area of measurable chart resistance in the 90-area on the USD Index. In addition, the greenback was also extremely overbought recently according to point & figure 10-week trading bands (not pictured), a useful short-term gauge. Because other foreign currencies remain oversold and the Dollar has not yet become so, a further correction from its recent highs remains in order.

One positive for the Dollar: while it has clearly been working off its overbought state, it hasn't declined measurably from those recent highs, a sign of strength. Since there isn't a great deal of chart support until down below at 85, a pullback to that level is a possibility, but for now it appears to be a time, not a price correction for the USD.

Having been underweight foreign currency exposure since the fourth quarter of last year (and having first written about it in December of '04), I'm comfortable in cautiously nibbling on a few select foreign currencies at the moment, slowly raising non-Dollar exposure for clients back to more "normal" levels (but by no means overweight). Here, however, is a picture of a currency that is still to be avoided, in my opinion:


www.stockcharts.com

A 1-year look at the Euro paints nearly the opposite picture one sees in the Dollar; while the Single Unit has for weeks been trying to work higher from a very oversold condition, it has gone essentially nowhere during that time. This is a flashing yellow light of caution, if not an outright red one. The British Pound has been under such awful pressure lately (partly due to the terrorist activity we've seen there) and remains much more oversold, so perhaps a bounce in the Pound could help carry the Euro a bit higher in sympathy (the increasing possibility of a rate cut in the U.K., by the way, wouldn't make this idea one to bank on), but on its own the XEU continues to look very weak.

Further, the chart shows that each time the Euro's short-term momentum indicators have rushed from oversold from overbought in 2005, the currency has had a hard time making any headway on the upside, a poor sign. In this light, the current attempt at a bounce looks no different.

Those hoping for a rally in the Euro will learn a lot more on its next pullback; if it can move back to an oversold condition without making a lower low (which looks unlikely at the moment, but we'll wait and see), that would be the first positive divergence the currency has seen in some time and might finally signal that the Euro was ready to move higher on a sustained basis.

Although the Fed's raising rates (which, despite what you may hear, is indeed one key driver of a currency's movement against others - see the chart below for a simple, long-term picture that while the correlation between interest rates/currency strength or weakness isn't perfect, there's strong enough correlation there to be compelling),


www.decisionpoint.com

it is appearing more and more that the next couple of hikes are likely priced into the Dollar. On the other hand, while downside risk to the Dollar remains visible, technically, it has proven quite resistant to such pressure of late.

Interestingly, now that the Chinese have re-valued, we may witness a prolonged period without much in the way of market-moving currency news. The second half of 2005, therefore, may see little more than a digestion of the first-half move, a period of technical consolidation that allows us to better determine the next trend in the world's currency system.

A Word about the Yuan

Yesterday's revaluation should set off fireworks from the Dollar perma-bears. While many of the arguments of these types are correct (that fiat currencies assess a hidden tax on savers, that they provide the basis for the runaway welfare state, that we're sadly witnessing a massive wealth transfer from America to Asia, etc.), you're also likely to hear many forceful prognostications that this marks the beginning of the end for the US Dollar.

In fact, yesterday's move wasn't the beginning of anything; it was simply another move by one of the world's central banks, one certainly acting in its own interest, but also doing its part to work slowly out of these massive global economic imbalances faced by all economies. It's a process that is almost certain to take place at a glacial pace, regardless of financial accidents along the way (risks for which are indeed present currently). The Dollar isn't going to collapse tomorrow. The end of American Empire isn't upon us. The financial world is evolving, in a precarious manner, to be sure, but slowly.

Here are a few things to keep in mind about the Yuan revaluation you're unlikely to hear from many writers on the subject:

  1. While the Yuan revaluation is highly significant and it does highlight that the world is trying to slowly move away from a system in which one currency is the global standard, it was also an open admission by the Chinese that their financial markets are not nearly mature or healthy enough to withstand a fully floating currency, despite their manufacturing prowess and recent rate of growth.

  2. The idea of the Yuan as a threat to become the world's reserve currency is fantasyland anytime in the near future. The country has none of the 4 main attributes the brilliant folks at Gavekal Research, for example, suggest is necessary to issue the world's reserve (financial, agricultural, military and technological dominance), let alone a legal system the rest of the developed world would put such faith in.

  3. It is China that is now on the hot seat to get its own fiscal house in order; planning to liberalize its capital account in 2008 as part of its ongoing reforms, which would open up financial flows into and out of the country, the Yuan could then be the currency under siege if it hasn't cleaned up its banking system and equities markets by then.

I'll have more to write in-depth very soon on the outlook for global currencies, but in the meantime, keep your wits about you and remember that despite the fact we live in truly historic economic times, the financial world continues to evolve slowly in front of us. And in the second half of 2005, there may be a lot more smoke than fire as far as currency fluctuations go.


 

Chip Hanlon

Author: Chip Hanlon

Chip Hanlon
President
Delta Global Advisors
800-485-1220
info@deltaga.com
www.deltaga.com

Currently the President of Delta Global Advisors and the founder of Green Faucet, Chip Hanlon is regularly featured in the national media for his global economic viewpoints and is a contributing writer for Real Money, the subscription service from TheStreet.com. Previously, Hanlon has served as the C.O.O. at Euro Pacific Capital, as the President of Unfunds, Inc., and as Vice President of Investments and Syndicate Manager with Sutro & Co.

Copyright © 2005-2009 Chip Hanlon

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