Relative growth and interest rate differentials

(08.02.2011) The euro weakened versus the US dollar yesterday, but has regained strength during the night. The Norwegian krone has lost some value versus both the euro and the dollar since yesterday’s morning, while the Swedish currency has strengthened. In general, it appears that relative growth and interest rates differentials have been important in FX recently.

By Anders Grøn Kjelsrud, Analyst at DNB Markets

illustration euro cc DNB marketsThe euro weakened sharply versus the dollar throughout the day yesterday, but bounced back during late trade. EURUSD is currently traded around 1.363 – about the same level as yesterday morning, but down from above 1.38 as late as Wednesday last week.

It is always difficult to pinpoint causal relationships in FX. Still, it appears that relative growth and interest rate differentials have been one of the main drivers lately. One indication of this is that monthly macro figures/events at times have created substantial market movements – stronger-than-expected key figures have often led to a stronger currency.

During the time period between the ECB's first (Jan 13) and second (Feb 3) policy meeting this year, EURUSD rose from 1.30 to 1.38, implying a 6 per cent stronger euro versus the dollar. Much of the euro strengthening was probably caused by what was interpreted as a hawkish European central bank, prepared to move against rising consumer prices.

On the monetary policy meeting last week, however, Mr. Trichet’s discussion of the inflation outlook was perceived as more balanced than expected, reducing the belief in interest rate hikes any time soon.

The euro has weakened versus most major currencies since then, especially versus the US dollar. The later is not solely due to European circumstances, but also due to several encouraging US macro figures, which has lifted the USD yield curve recently. Much of the euro depreciation throughout yesterday, however, could probably be attributed to disappointing figures for German industrial orders, which indicated a decrease of 3.4 per cent from November to December.

Elsewhere, we notice that the Chinese currency, the yuan, once again has strengthened slightly versus the US dollar during the night. The Chinese authorities have faced strong criticism for its regid currency regime - especially from US authorities, but eventually also from countries such as Brazil.

China was apparently also a topic during Tim Geithner’s visit to Sao Paulo and Brasilia yesterday. Yet, the focus and attention on the Chinese currency must be said to have declined since the most intense period late last fall, which in turn is related to the fact that the recovery has improved in several countries. And after all, the Chinese has allowed their currency to strengthen by almost 4 per cent since last summer.

Late Friday, the US Treasury finally issued their semi-annual report, where they are required by law to report on whether any of the countries major trading partners manipulates their currencies to achieve an “unfair competitive advantage”.

The report was originally scheduled to be published in October last year, just before the US Congressional elections, but was postponed with the explanation that they would await the outcome of the upcoming G20 meeting.

The real explanation for the postponement, however, was probably that it was both politically impossible, right before the election, not to declare the obvious, namely that China is manipulating their currency, while on the other hand it was not desirable to stir up the already existing international friction (or the so-called currency war).

With the election as history and the economic recovery gaining strength, it was much easier now than it would have been in October to not label China as a currency manipulator. Instead, the Treasury gave the Chinese a softer form of criticism, as to point out that the yuan is "seriously undervalued". Still, a potential trigger for escalation of the so-called currency war seems to be called off for now, but the discussions about the Chinese currency regime will not disappear anytime soon.

New figures from the Statistics Norway, released yesterday, suggest that manufacturing production fell by 1 per cent from November to December. According to Reuters, consensus expected a positive growth of 0.5 per cent, ie. the figures were weaker than anticipated in advance. It is worth noting that these production figures fluctuate significantly from month to month and the main picture is still that the manufacturing sector is improving, albeit at a very moderate pace. Yet, yesterday's figures seemed to weigh on NOK in a short period after the announcement. EURNOK is currently traded around 7.85, up slightly from the same time yesterday.