Ignore the back-seat drivers
Much has been made of the new foreign exchange market paradigm that has been unfolding since the birth of the euro, but really has all that much changed?
Proponents of this doomsday scenario point to four indicators that these are lean times for the foreign exchange markets. Citing an initial 15% decline in the euro as proof that major concerns still exist over the long-term viability of the concept, they also refer to the loss of liquidity, the paucity of jobs in the area and the overall lack of confidence of the world’s political lobbies. But are these concerns grounded in reason, or are they a reaction to misinfomation? While it might make great copy to proclaim the demise of the euro, it is naïve to ignore the plethora of variables at work. It might just be that the recent bout of mergers amongst financial institutions is causing a temporary shrinkage, it might be that, heaven forbid, we are going through a lull. It might also be that the birth of the euro coinciding with these conditions is just that – a coincidence.
But let us deal with each criticism in turn. Regarding the euro, we must draw a distinction between a currency’s strength and a currency’s success. Despite what the sensationalists in the financial media would have us believe, they are not one and the same thing. The media miss the point when they interview politicians looking for long-term directional views on the euro. The armchair currency managers should be ignored. Long-term forecasting of the financial markets is haphazard at best, and any active participation in forecasting must be on a dynamic basis. When Duisenberg et al spoke of their hopes for the euro, they used phrases like ‘widespread adoption’ rather then talking about particular levels that they would like to see within six months. Indeed, a clearer indication of the success of the new currency would surely be the fact that some 80% of all former Deutschmark- denominated business was done through the euro in the first week of January. Its direction relative to a specific currency, such as the US dollar, is reflective of too many other variables to be an equitable measure of the world’s reaction to the new currency. If the euro had appreciated 15% against the dollar in the first six months, but in thinner volumes, would that have been considered to be a more successful launch? Probably not. Much of the pessimism surrounding the currency’s direction stems from the back-seat drivers in Whitehall and Brussels.
The next jab taken at the currency markets relates to the loss of volume since the financial turmoil of the third quarter of 1998. 1, the market has lost some liquidity since the global crisis. But are these facts indicative of the end of foreign exchange markets as we know them, or are they simply another trough in the ongoing cycle that is the foreign exchange market? Those who remember the drought of 1994 will remember an environment where volumes fell off in choppy markets. Rather than panic and dust off their college resumés, the major players rode it out and enjoyed the fruitful markets between 1995 and the end of last year.
The loss of volume has been gradual and the euro cannot absorb all of the blame. Six months of data is probably not enough to suggest a drastic change to 25 years of activity. And while it is true that major markets such as the dollar/yen have been somewhat apathetic recently, it is only 10 months since the most volatile week in the history of foreign exchange. We must also acknowledge that the market is operating in a more efficient manner since the merger mania of the last two years. Once again, we must be careful to distinguish between a short-term reaction and a fundamental, seismic shift in the way the market conducts itself.
So what is the prognosis for foreign exchange in general, and for the euro in particular? It would seem too early to call time on the practice of foreign exchange just yet. For all the whispers of managed floats, there is still more than enough justification for a very real currency policy. The level of liquidity has fallen in the short term, but this is not an unusual occurrence, and should not in itself change our views on the long-term health of foreign exchange. The industry’s ‘shrinkage’ is the result of the rationalisation that any healthy industry experiences periodically. As for the euro, we should not preoccupy ourselves with predictions of its value for the next 12 months. For one thing, this is an extremely difficult and usually inaccurate exercise.
But more importantly, we must remember that judging the success of its launch solely by value relative to the dollar is a misinformed philosophy that has been getting too much airtime recently.
David Walsh is general manager and chief investment officer at Gaiacorp Ireland in Dublin