G7 meeting not a dollar positive

First, there was a new sentence: 'Excess volatility and disorderly movements in exchange rates are undesirable for economic growth'.

This was clearly meant to meet European concerns about the speed of the euro's appreciation, and add some two way risk to the market. It could also be taken as tacit support for the Japanese policy of massive intervention to prevent rapid moves in the yen.

Secondly, the sentence on flexibility was expanded to include '…we emphasise that more flexibility in exchange rates is desirable for major countries or economic areas that lack such flexibility to promote smooth and widespread adjustments…' (emphasis added).

This is meant to focus attention on those that have not allowed their currencies to adjust, particularly China. It probably also encompasses the other Asians who have been acting to prevent currency adjustment (Korea, Taiwan, Thailand).

How are the markets likely to trade in the weeks following this modified statement?

Euro: By giving some support for European concerns about the speed of the Euro's rise, the G7 may take some of the immediate upward pressure off the Euro. However, there is little prospect of either the European or US authorities actually doing anything to prevent further Euro appreciation as long as it is not too rapid.

Several European officials have emphasised that it is the speed of change, rather than the level of the euro which has been a cause for concern. Unless the euro moves rapidly above 1.30, intervention from the ECB seems very unlikely. We expect upward pressures on the euro to continue and for it ultimately to reach around 1.35.

Yen: Here the signals as rather mixed. The comment on volatility could be seen as support for Japanese policy, but the call for flexibility (aimed at the rest of Asia) could also apply to
Japan.

Finance Minister Tanigaki has already said that Japan is not a country that lacks flexibility, but the market may test the resolve of the Japanese authorities is coming weeks. We would expect continued intervention, so further moves down in dollar-yen are likely to be slow.

Non-Japan Asia: Here the pressures could become very intense. We do not expect any short term change in Chinese policy, but the NDF market may start to anticipate a change in the next few months. There could also be strong upward pressure on KRW, TWD and THB over the next few weeks.

Others: There seems nothing in the G7 statement to reverse the trend to dollar weakness seen in recent months. The market may thus return to recently favoured carry trades, which will put NZD, AUD and GBP under upward pressure.

Whatever the short term reaction to the G7 statement, the fundamental pressures for a lower dollar remain. The US external imbalance is unsustainable, and a lower dollar is increasingly accepted as an important part of the adjustment process.

In addition, the political linkage between the currency and job losses in the US is repeatedly made. In this election year, with the labour market still disappointing, it seems very unlikely that US policy makers will do anything other than welcome further dollar declines as a way (however misguided) of protecting US jobs.