Forex Investment and Currency Trading

There is usually a fair amount of discussion in advance of G7 finance minister meetings about major outcomes that could be announced at such gatherings. While there have been notable exceptions – particularly the Dubai G7 gathering in September 2003 – for the most part the volume of speculation usually exceeds the concrete outcomes by a meaningful multiple. It appears that will be the case later this week.

A number of issues have interested market participants in recent weeks. The fall in the USD back toward record lows in late March rekindled talk of potential intervention. However,the US position is likely to remain staunchly against intervention to support the USD, for four main reasons: 1) it is not clear the Administration believes a stronger USD is in the best interests of the economy at this time (with real export growth accounting for about 40% of real GDP growth over the last two years); 2) the need for ongoing Fed easing would undermine efforts to strengthen the USD; 3) the USD remains overvalued relative to many Asian currencies, and intervention to strengthen the USD would send an inconsistent message and; 4) a philosophical aversion to intervention.

To be sure, there is likely to be ongoing concern expressed about the burden-sharing of the weak USD. Euro zone authorities appear split over the ongoing strength of the EUR as the trade-weighted EUR rises within 0.5% of its October 1992 record high. While Finance Ministers appear concerned about its impact on competitiveness and future growth, the ECB appears more
content to let the strong EUR moderate the impact of the strong rise in USD-denominated commodity prices that push headline inflation higher. But with EUR/CNY within 3% of its record high in January 2005 despite accelerated CNY appreciation versus the USD, calls for more rapid currency appreciation in Asia and a broader sharing of the weak-USD “burden” is likely to remain a major thrust of the G7 statement.

More recently, the focus has shifted to the stress in the financial system and housing sector, US-led problems that have impacted global markets and have become a focus of the IMF and policymakers. One of the options that has gained market focus is the potential for government entities to buy up troubled mortgages, limiting downside risks at the heart of the problem for many financial institutions and structured products.

The actions by US authorities to address the strains in the mortgage market have focused primarily on financing capability. Changes in regulatory constraints and official lending facilities are estimated to have increased mortgage capacity for qualified borrowers by about $300bn, sufficient to bring spreads narrower for good quality borrowers. However, it remains unclear that more aggressive action for a broad set of mortgage holders will be implemented, with significant political opposition to what many believe would amount to a bailout for imprudent borrowing activity.

To be sure, there are a number of reasons to push for such action. Stability in the US economy would enhance global economic stability, improving the outlook for continued export growth. Moreover, a more aggressive fiscal approach by US authorities would likely limit the need for additional monetary policy easing, easing that appears to have contributed significantly to the recent weak performance of the USD. To some international policymakers, therefore, a different US fiscal/monetary policy mix could help support the USD and eliminate some of the competitiveness concerns emanating from the extremely undervalued USD.

Given these likely developments – or lack thereof – later this week, what are the potential implications for currency markets? First, the lack of discussion of potential intervention is likely to remove one impediment to a weaker USD, and cyclical forces continue to suggest new lows for the USD during the weeks ahead. Second, the expected lack of agreement over aggressive fiscal action to directly support the mortgage market could also be a minor negative for the USD. That is not to suggest that some form of fiscal support for the housing sector is unlikely this election year, particularly if the downturn in housing continues. However, that is expected to come via Congressional action already underway, and a G7 gathering is not the forum for the US to make assurances of new policy initiatives, particularly in light of international pressure. In this environment, no news from the G7 is likely to imply continued bad news for the USD.