Weekly Foreign Exchange Insights: June 12th

June 12, 2009

All things considered, the dollar is proving resilient.  A test of the currency’s downside had been anticipated as investors transition away from extreme risk taking.  It hasn’t happened this month, even though confidence in a recovery has mounted.  Two weeks into June, the dollar is some 1.5-3% stronger against its three hard-currency rivals, the euro, yen and Swiss franc, as well as Canadian dollar, which is very sensitive to U.S. economic and commodity price trends.

As one might expect, dollar appreciation in June has been associated with higher Treasury yields and lower gold prices.  Politics has arguably supported the dollar, too.  The Obama Presidency has won applause, while several other governments have attracted negative press.  But stock market activity and the dollar have not traded consistently.   Equities in the U.S. were volatile but up on balance in the first two weeks of June, and Japan’s Nikkei closed above 10,000 for the first time since October 7th, suggesting a better appetite for risk.  The dollar has also withstood mounting worries about future U.S. inflation, a mood captured in a WSJ Op-Ed piece on June 10th by Arthur Laffer, a widely followed economist for over 30 years.

Dollar resilience may reflect the better tone of U.S. data compared to European or Japanese trends.  Net monthly losses in U.S. employment decreased progressively and by more than 50% in total from 741K in January to 681K in February, 652K in March, 504K in April and 345K last month.  By comparison, industrial output in the euro area declined more sharply in April (1.9%) than March (1.4%) and recorded an all-time 12-month plunge of 21.6%.  Total Japanese machinery orders dived another 12.7% between March and April including a 5.4% drop in core domestic demand.

Disbelief in the cup-half-full view of the world economy also fortifies the dollar.  Several factors may still delay or abort economic recovery.

  1. Crude oil prices have advanced more than twofold from a recession low of $32.40 to over $70.  That’s a pick-up of more than $10 compared to May’s monthly average of $59.29 and of more than $20 from April’s mean of $50.05 per barrel.  An oil price spike aggravated the present global slump and played a dominant causal role in America’s four previous recessions.  Yes, oil prices remain far beneath last July’s peak, but they are also back above every calendar year mean prior to 2007.  From 1987 through 2002, that is prior to the Iraq War, oil prices averaged $20.89 per barrel.
  2. Whereas the Fed ran out of room for cutting short-term interest rates in mid-December, the ten-year Treasury yield soared from 2.12% at the end of 2008 to 4.0% briefly during this past week.  All sorts of lending rates are influenced by Treasurys, including mortgage rates.  While not doubling since end-1998, ten-year yields in Germany, Britain and Japan jumped by 25-33%.  The point is that long-term interest rates have rebounded substantially everywhere, and this is a development that had not been foreseen, magnitude-wise, by analysts.
  3. Fiscal and monetary policies are in unchartered waters, which renders historical precedent an unreliable predictor of the future.  It’s not surprising really to hear heavyweights in the economics profession disagree about whether inflation or recession pose the greater risk.  It is easy to imagine an economic train wreck ahead and much harder to put faith in a gradual but multi-year period of sustained economic expansion with acceptable price stability.
  4. The recapitalisation process for banks will benefit from a steeper yield curve.  However, considerable doubt rightfully lingers about their ability to absorb major balance sheet shocks in the future and the accuracy of the government stress tests.
  5. The U.S. Federal government’s role as an economic player, rather than arbiter, is being ramped up.  This invasion is creating fear on two levels: a) that humongous and unserviceable debt will drive taxes and inflation upward and b) that public-sector technocrats will prove incompetent in performing their new responsibilities.
  6. The dark side of technology has been exposed.  The development and application of new technologies plays a key role in economic growth.  Capitalism is especially suited for promoting the risk-taking that drives the invention of technology.  When technology is in high gear, like during the industrial revolution and since 1975, rapid advances follow in productivity, economic growth, and the standard of living.  For the world to fall into its deepest hole since the 1930’s at such a time raises questions about whether technology is an entirely positive force, and I submit that it is not.  Without the revolutionary changes in data processing and communications, the excessive allocation of resources into finance and banking would not have happened.  More importantly, sweeping changes in technology have transformed politics into a wholly different and more dysfunctional form.  In the age of the sound bite and YouTube, elections hinge on different skills than before, and proper vetting of human resources cannot be achieved.  Partisan politics has run rampant in the system at the very moment that government is being asked to step up its game, not just in America but everywhere.

The private sector is unlikely to recapture the taste for risk that prevailed before the Lehman Brothers failure in September 2008 or the onset of the banking crisis in August 2007.  Too much can still go wrong economically or financially.  Risk aversion protected the dollar during much of the recession.  The suppression of animal spirits in the economy will be only partly lifted, suggesting that a dollar rout will be avoided.  The aforementioned Laffer article talks of future inflation that plausibly could be worse than what happened in the United States in the 1970’s and early 1980’s because greater monetary and fiscal stimulus is being administered now than before that earlier period.  If Laffer is correct — and bear in mind that his confident prediction that deep supply-side tax cuts would self-finance themselves and not lead to more deficit spending proved wide of the truth — the dollar surely will depreciate substantially.  Such an episode likely would deal a fatal blow tol dollar hegemony in reserve asset portfolios.

I’m comparatively optimistic that a crushing dose of inflation does not lie ahead.  First let’s see what happens to economic growth.  For the twenty years from 1Q53 to 1Q73, U.S. real GDP expanded at an annualized rate of 3.7% compared to a 1.6% pace of net real growth since the middle of 2000.  That’s a fundamental difference between the two periods and suggests there may be more danger in taking premeditative action now against inflation than in being sure that an economic recovery has really be secured even if that means delaying the first rate hike into 2010.  A vicious circle of dollar erosion and accelerating domestic inflation does not seem to be closely at hand.

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

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