Foreign Exchange Insights: June 19, 2009

June 19, 2009

Currency markets this past week conformed to a familiar risk appetite motif in which the yen and dollar correlate inversely with global share prices as investor tolerance for risk waxes and wanes.  Equities had a poor week in Asia, Europe, and North America.  The dollar at this writing has fallen about a percent against the yen, underwent little net change relative to sterling, and gained moderate ground against most other key currencies.  These movements imply second thoughts about taking on risk even though several promising bits of economic news continued to emerge.

  • A monthly proxy for the Bank of Japan quarterly business sentiment indices, which Reuters compiles, improved in June by 19 points for manufacturers and 13 points for non-manufacturers.  The magnitude of the rises far exceeded expectations and corroborates other hopeful trends in industrial production, exports and consumer sentiment.  Japan’s government and the central bank each upgraded their economic assessment in monthly reviews released this past week.
  • U.S. continuing jobless claims fell 148K, the biggest weekly decline since November 2001, and housing starts rebounded 17.2% in the latest monthly report.
  • Investor sentiment toward Germany and the whole euro area improved much more sharply than anticipated in June according to the widely followed ZEW surveys following impressive gains as well in May.
  • Britain reported the smallest monthly increase of unemployment in a year, a rise of 39.3K in May compared to 93.4K per month in the first quarter.
  • Key emerging markets like China and India are looking better.  The World Bank was one of several groups to revise up projected Chinese growth.

It is right for investors to remain on their guard about recovery prospects.  For every better-than-expected data report, there was a clunker such as British retail sales, Swiss industrial production, and Euroland export and import growth.  The world economy is benefiting from fiscal antibiotics and the spring rally in stock prices.  However, soaring budget deficits are producing a public backlash, and business and consumer confidence would relapse in a hurry if equity wealth were to slip away again.  Martin Wolf of the Financial Times wrote a column this past week documenting incredible similarities between financial and economic trends of this cycle so far and those from the initial stage of the Great Depression — certainly enough fodder to agree with Yogi that the global recession ain’t over until it’s over.  There has indeed been a fairly uniform message from all major central banks that while an exit strategy should be thought out in advance and applied with some dispatch in a timely manner, conditions remain far from a point where the unwinding of monetary stimulus can begin safely.  The FOMC statement on Wednesday should echo this sentiment.

Whereas the dollar performed decently this past week, it remains significantly down from levels two months ago. Compared to closings on Friday, April 17, it has lost 10-12% against the kiwi, Australian dollar, and sterling and slightly more than 6% against versus the euro, Swiss franc, and Canadian dollar.  It is even down about 2.5% against the yen, which is also susceptible to selling at times when risk aversion subsides.  In this period, oil prices have soared more than 40%, and gold, a winner when paper currency is disparaged, has climbed around 7.5%.  To put these declines in context, the dollar previously had performed better than anticipated in 2008 and very early this year but suffered substantial erosion from 2002 through 2007, interrupted by just one respite in 2005.  Throughout that slide, market conditions were generally orderly.  Dollar weakness did not spill over into fixed income securities, and intervention was limited only to unilateral Japanese operations prior to March 2004. 

Emerging market governments have nonetheless grown fidgety about the dollar,  calling for a a more diversified international market system.  That’s code for a shared and diminished role for the dollar in reserve asset portfolios, and analysts for the most part have ignored the rhetoric because of the reality that no really viable alternatives are battle-ready to challenge dollar dominance immediately.  I agree with that thought but disagree that no latent dollar vulnerability exists as a result of the restiveness of big dollar holders.  In the last quarter of the 20th century, complaints were heard about dollar hegemony during times when it depreciated in a disorderly way.  The nature of such grumbling was cyclical and therefore transitory.  Current recommendations for change, in contrast, are part of a broader distrust of the old regime that failed to prevent a series a increasingly disruptive financial market crises.  Greater consensus exists that many elements of the old ways are unsustainable.  The call for something different from dollar hegemony has become more organized, it is part of a movement to modify many other things too, and it is unlikely to be silenced by a better dollar performance.  What all this means is that the big dollar holders from Asia and the middle east will diversify the deployment of incremental wealth more aggressively.  They may become more responsive to any dollar setbacks, and they are likely to remain vocal in suggesting monetary system modifications.  All of such will not go unnoticed by other market participants.

The U.S. currency nonetheless has a number of factors in its favor.  Less concern now surrounds U.S. banks than European banks, which are exposed to Latvia and the rest of Eastern Europe and which were  never subjected to stress tests.  European “green shoots” have been more restricted to surveys as opposed to hard data than has been the case with the United States.  The European recovery is apt to lag America’s, but caution should be taken in not overstating that dollar advantage.  Growth will be sluggish everywhere, and interest rate differentials between G-7 economies are unlikely to change much anytime soon.  A related point is that considerable uncertainty surrounds the outlook in most economies.  Investors worry about future inflation one moment, and swing their fear to the possibility of a renewed economic collapse in the next.  This high level of doubt seems to have bred stability.  $1.40 per euro has become a pivot for the most influential dollar relationship.  The yen has been trading comfortably in the high 90’s since February.  And in those instances where currency appreciations have cumulated, such as the Canadian dollar and Swiss franc, government officials in this recessionary environment of near-zero inflation have been quick to protest verbally and, in some cases, impose stiffer deterrents against further rises of their own currencies

A final factor to keep in mind relates to political risks.  Iran has been pretty much a non-factor for currency markets but has potential to create enormous havoc.  It’s the proverbial geopolitical wild-card.  Iran is a major oil producer and represents a critical test for foreign policy in the young Obama Presidency.  The first Iranian Revolution influenced currency trading enormously, discredited the Carter administration, and helped clear the way for America’s subsequent shift to the Right.  I suspect events now unfolding in Iran will eventually impact financial markets and the dollar in ways that are not yet clear.  In the meantime, the economic policy agenda of Obama is at a cross-roads.  He’s much more popular than are his historic policy proposals.  He’s trying to get a great deal accomplished this year, and delay will likely hurt his domestic and worldwide image, which has th
us far lent the dollar background support.  To keep things that way, Obama will have to be a great communicator in coming months.  Political changes could also happen soon in Japan, Britain, and Germany, but these situations do not appear to carry the same scope for currency market influence as what happens in Iran and the United States.

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

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