G7 FX Communiqué Papers Over Large Differences on Dollar

As Reuters points out below, the G7 agreement to change the language in the communiqué on FX allegedly followed 2 hours of heated discussions to iron out and represented a concession to European officials, especially France (no wonder Lagarde is all over the wires calling the change significant), by the more laissez-faire US, UK and Japanese officials who are inclined to let markets set exchange rates. As Reuters points out below, the G7 agreement to change the language in the communiqué on FX allegedly followed 2 hours of heated discussions to iron out and represented a concession to European officials, especially France (no wonder Lagarde is all over the wires calling the change significant), by the more laissez-faire US, UK and Japanese officials who are inclined to let markets set exchange rates. The statement noted that exchange rate movements in major currencies (read dollar, euro, yen, C$ and pound) had recently become excessive and a threat to financial and economic stability. Well looking at a chart of any of these major currencies versus the dollar, the volatility really was compressed to the first half of March in and around the collapse in Bear Stearns and the Fed’s response (75 basis point rate cut as well as extraordinary liquidity measures including opening the discount window to primary dealers – security houses – for the first time since the Great Depression). I would be shocked if major currency pairs were not volatile in this period of time in light of the significance of the news and the broader market uncertainty. What is not particularly excessive is the pace of appreciation since the February G7 meeting – more like a steady but orderly dollar retreat outside the first half of March.

It is worth noting that G7 always states that currencies should reflect fundamentals and unless I am half baked on this, there is no suggestion in the G7 communiqué that current levels do not reflect fundamentals. If markets do not have the levels way out of whack with fundamentals – IMF is still calling the dollar overvalued – what is G7 talking about?

I also find it incongruous that the ECB is alarmed about inflation but does not want a stronger euro…and in a period when commodity prices (dollar priced) are the main source for inflation. It seems to me that the ECB is looking for more free put options on a recession from a lower euro…if only the market’s bought the inconsistency. The other free put option on growth that the ECB enjoys in its cult-like fight against inflation is the fact that the Fed easing to date is an offset to a sharper US slowdown which would drag Europe’s economy down more than if the Fed were easing less aggressively. Again it is a free pass on growth to battle inflation only. ECB’s Mersch today said he did not expect a rate cut this year. No kidding, why should he if the Fed takes the funds rate to 1-2% range soon?

I would argue that the change in language in the G7 statement demonstrates weakness not strength on signaling opposition to the dollar decline much less arresting the currency’s decline.

From what I have heard and read there was no appetite at G7 for currency intervention. And European authorities are no fan of unilateral currency intervention. So the new language reflected a compromise and again highlights dysfunction not coordination.

Is it any wonder that China only came around to letting the yuan rise at a faster pace when it was clear that inflation was becoming a growing problem and China’s interest rate (capital market) is not an effective policy transmission mechanism. G7 impact on China? I wonder who is laughing.

I don’t want to be totally dismissive of where G7 is unified on the dollar…no one wants a freefall and with the US current account deficit in the danger zone on absolute and relative comparisons, this outcome is not easily dismissed, especially in light of the spate of events hitting credit market assumptions (models).

I find little surprise in the reversal in dollar gains at the London open and expect to see euro/dollar trade above 1.60 soon as markets test G7 commitment to stabilizing the dollar. Frankly I don’t see it until it is clear the Fed is done easing and the ECB is ready to cut and saying as much. That could be late summer before this unfolds.

David Gilmore

Foreign Exchange Analytics has it's roots in both the emerging information technologies and the global economy that characterized the last two decades.  As currency transaction volumes soared in the wake of the 1985 Plaza accord, the need for timely concise information on what forces were driving and would drive exchange rates became critical.   David Gilmore was one of a new breed of analyst that saw a void of relevant, market moving... More