Weekly Foreign Exchange Insights: March 20th

March 20, 2009

The dollar experienced heavy selling pressure this week but has recouped some losses today in mid-day New York trading.  Price action on a Friday can be misleading especially if not associated with a data shocker that day or if significant change during the week is simply getting trimmed.  Both of these qualifying conditions apply to today.  The U.S. didn’t release any new economic figures, and the dollar at 15:15 GMT had still booked weekly declines of 6.3% against the kiwi, 5.1% against the Swiss franc, 4.7% against the euro, 4.5% against the Australian dollar, 3.1% versus sterling, 2.6% against the Canadian dollar, and 2.2% against the yen.  Even before the beginning of this week, the dollar had moved off its highs, and U.S. stocks had rebounded from their lows.  Nascent trends were established, and then the Fed introduced a huge surprise.  A considerable sum of money will be created by the Fed’s new initiative, and when investors hear the words “printing money,” they are conditioned to assume “higher inflation” and “weaker dollar.”  The dollar fell, and gold rose, dragging the currencies of commodity-sensitive economies with it.

Investors may have over-reacted.  Whether the creation of a lot of money proves inflationary depends on what is happening to money demand.  The worst recessions in history followed breakdowns in the financial sector.  The U.S. recession is already fast approaching the the severity of the largest post-WW2 downturns.  Global economic trends have not looked as bad as now since the 1930’s.  In very severe economic recessions, the demand for money leaps, and the Fed’s failure to see that happening in the early stages of the Great Depression was a critical policy mistake that Chairman Bernanke is attempting not to repeat.  If money demand expands much faster than its long-term trend, a comparable spike in the stock of money by central banks will not be inflationary.  In fact, the failure by central banks to react in kind would prove deflationary, but there’s a catch.  It’s very hard to gauge the optimal amount of liquidity to provide, and indeed money demand is apt to behave erratically in these uncertain times.  Dollar sellers and hoarders of gold are betting that monetary officials will over-correct the economy.  They may suspect, too, that one of the policy objectives is dollar depreciation.  The economies whose currencies weakened first in the depression generally had milder and shorter-lasting contractions.

The obvious precedents for judging contemporary monetary stimulus do not suggest that the major risk is higher inflation.  Japan also combined considerable deficit spending with zero interest rates and eventually quantitative easing.  Money and bank lending growth never rose back to normal trajectories, and Japan hasn’t escaped deflation more than fifteen years after deflationary seeds were sown.  The Great Depression also was a period of deflation, not inflation.  Global demand is falling so sharply that the level of GDP in many economies is dropping far beneath long-term trends.  So long as actual output is well below potential production levels with fully utilized labor and capital resources, market pressure on inflation will be pressing downward, not upward.  Put differently, the notion of a non-inflationary speed limit on economic growth only comes into play when excess labor and capital approach zero.  Economists call this differential the output gap, and it is currently expanding rapidly, not shrinking.  For this story to end with an inflation problem, central banks would have to either ignore warnings well in advance that policy gears need to be switched or lack the political ability to restore a neutral or even restrictive stance.

An unstable political landscape in the United States provides an altogether different rationale for selling the dollar.  The Obama administration will not complete its first 100 days until the end of April yet is already getting vilified on talk radio and in some key financial newspapers like the Wall Street Journal for virtually everything that is said, proposed, and done.  Egged on by self-appointed critics, voters have turned angry against all figures of authority from the cabinet  to the Congress to Wall Street executives.  The collective behavior of any mob is scary and tends to produce bad decisions.  When  Premier Wen raised concerns recently about the security of China’s vast holdings of U.S. securities, he was not only talking about risks associated with festering banking system problems, printing money, and an exploding budget deficit.  In a society where law and order are the paramount priorities of the government, increasingly polarized U.S. politics has to be unnerving.

Fortunately, Chinese leaders cannot match their bark with their bite.  Analogous to the too-big-to-fail logic that has infused the banking crisis, China is too deeply involved in U.S. financial markets to walk away.  It would not be possible to sell a major part of China’s dollar-denominated assets without depressing prices.  China would be one of the biggest losers of wealth even if it made a decision to modify the deployment of incremental wealth in a significant way, and it would also suffer a blow from reduced flows in commercial trade.

Movements of the dollar this past week merely nudged the U.S. currency closer to the center of its 2009 high-low ranges.  In the cases of sterling, the Canadian dollar, and the Swiss franc, it is now very close to those mid-points.  Where it looks relatively weaker, for example compared to the Australian dollar, kiwi, and euro, it still remains above the lowest quadrant of those high-low bands.  The major dollar pair where the U.S. currency appears most firm is against the yen.  The 95.87 spot quote on dollar/yen at this writing sits at the 69.6 percentile of this year’s 87.15 to 99.67 per dollar trading range.  A weaker yen is actually a hopeful sign of a step back from the ultra-risk averse conditions that prevailed earlier this year.  A more straight-forward way to gauge the pendulum on risk aversion will continue to be the behavior of equities.  It will be crucial whether the S&P climbs back above 800 before in sinks under 700 and alternatively if the DOW returns to 8000-something or sinks anew below 7000.  Stocks and the dollar are presently in a demilitarized zone of limbo.  The dollar may not trade tick for tick in inverse relation to stocks, but a decisive shift in equities is likely to produce an opposite impact on the dollar.

Copyright 2009 Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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