The FX market has gotten boring. The intra day moves are smaller and there is not much real direction that I can see. To get the money flows moving again we need a crisis. There is no crisis in our headlines. So FX traders go to the South of France or the Hamptons. They will be back in a month or so and so will the next crisis.

I try to stay away from FX markets when I don’t have a strong conviction of where the next 5% move will come from. I also try to stay away from FX when the markets have moved 10% in a short period of time.

I’m not sure what the next 5% move for the EUR/DLR will be. We could drift back up over 1.30 or some of the old fire will come back and we could get a move lower to 1.20. For me it’s not a question of who looks better. It is a question of who looks worse. If I had to roll the dice right now I would say that the US could very well win the UGLY competition between now and year end. In spite of the big bounce off of the lows a month ago the market is still overbought dollars. The natural position is short, so we are in an interesting position.

Should a weaker dollar trend emerge the Fed would be delighted. They want inflation so bad they would cheer any source. Charles Engle who works for the Dallas Fed wrote a paper "Exchange Rate Policies" last November that I think represents the broader thinking of the Fed Governors. The full link is here. Some cut and pastes:

A debate has continued over many years on the desirable degree of foreign exchange rate flexibility. One side of the debate has made the case that the exchange rate should be freely determined by market forces. This argument takes the stance that the market can best determine the appropriate level of the exchange rate.

From the standpoint of modern macroeconomics, particularly from the view of New Keynesian economics, that stance is potentially self-contradictory.

Oh boy! First, what exactly is New Keynesian economics? I think this is “Inflate at all cost!” But I am not sure. Essential what is being advocated is a managed exchange rate regime. That’s interesting. Isn’t that what we have been beating the Chinese up over? It must be different.

What is clear is that the proponents of this believe that floating exchange rates will eliminate large current account deficits or surpluses.

However, there is very little empirical support for this notion.

He has a point with this. The US has been wracking up current account deficits for three decades. There is nothing in the current FX market that is going to change this. To achieve a turnaround in the US current account would take years. It would also take an exchange rate that was 50% lower than where it is today.

Macroeconomic theory does not support the claim that a policy that allows a fully flexible exchange rate with complete hands-off by policymakers will deliver an efficient market outcome.

I think this is the New Keynesian thing. It is a strong argument that what we are doing and what we have been doing is not supported by the facts. Interesting that we have been doing “this” since 1971.

An exchange rate or a currency is misaligned when the exchange rate change has led relative prices internationally to deviate from the efficient levels that represent underlying costs. External balance means the currency is not misaligned. This is a notion of external balance that is not arbitrary and simply assumed, but rooted in economic logic.

Read this to mean that the US dollar is overvalued. The imbalances prove that. Important point.

The renminbi cannot be efficiently priced against both the dollar and the euro when the dollar is out of line with the euro. So the amount of trade between the U.S. and Europe is not a sufficient statistic to capture the possible losses from a misaligned dollar/euro exchange rate.

Hmmm. What is suggested is that Purchasing Power Parity with the Euro could result in a mispriced Yuan/Dollar. Yet another good excuse for a weak dollar versus the Euro.

To the extent that policymakers rely on sterilized intervention to control exchange rates, the exchange rate policy contributes less to the credibility of monetary policy.

There is significant discussion of sterilized currency intervention in the paper. I kept looking for the section about Un-sterilized intervention. There was none. The foregoing sentence is vague on this. I read it to be saying that FX intervention must be supportive of monetary policy. Unsterilized FX intervention certainly would do that. The Fed would sell dollars and buy other currencies. The end result will be that the supply of dollars out there will be increased. The fed loves it when they can do that. Especially when all of their other policy options have been exhausted. Which is today.

Unperturbed free markets in foreign exchange cannot be relied upon to arrive at exchange rate levels that deliver terms of trade and real exchange rates that reflect the underlying economic productivity, efficiency, and competitiveness of economies.

Well that is the end of free market economics. We have intervened in every other aspect of our economy. Why not FX?


I think the odds of the Fed actually doing something in the market under the current conditions are close to zero. But current conditions will not be sustained. Something new always comes up. A new crisis will emerge. Should things turn bad for the US I don't think the Fed will hesitate to do whatever it can to avoid a decline in economic growth. That includes some self-serving FX intervention. This wild card has always made me leery trading the dollar from the long side.

Lost in this report was the following sentence. It is presented as an “axiom”. I would disagree. It is most Un-natural for a country to borrow purely to sustain consumption. It is a dead-end policy that will have a very messy final chapter. But don’t doubt for a minute that this is exactly what the Fed believes. We should spend money on our CC because our card has no limit. Nothing could be farther from the truth.

It is natural for some countries to borrow to finance consumption.