Few Feeling Confident or Lucky on This Friday the Thirteenth
August 13, 2010
A mid-August Friday afternoon and Friday the thirteenth no less would be a precarious place for currency traders to sit in the best of circumstances, and these are certainly not that. Trouble lurks wherever one peers, and the market reaction is risk aversion.
Start with the U.S. economy because that is where perceptions have been changing most quickly. The talk is that growth last quarter will get revised down to 1.5%, or perhaps less, and that a possible double-dip recession lies ahead. Business and consumer confidence are going south, but the most disturbing symptoms involve the labor market. Without job security, worker earnings and consumption stall. It is astonishing that roughly a year after economic recovery seemingly began, layoffs are running at more than 475K per week, which is highly recessionary by historical standards. There are slightly fewer workers nationwide now than at the end of 1999. Jobs should instead have climbed by 25-30 million workers, so it could take a generation or longer to close such a huge gap. Corporate profits built on cost-cutting rather than top-line growth will be bumping against diminishing returns. Unlike the autumn of 2008, the Fed is poorly equipped to attack renewed weakness with maximum force. Fiscal policy in this election year appears to be totally out of order since many voters are convinced that every piece of fiscal policy support was ill-chosen in its composition or size. Confusion is rampant about next year’s tax law and how broad regulatory reform of financial institutions will be implemented. The return of risk aversion has depressed long-term interest rates and lifted the dollar. The housing and auto sectors failed to respond to the drop in rates, but net exports are exerting a mounting drag on the economy. The private sector, government, and financial markets seem powerless to avert a near-term wreck.
From a medium-term standpoint, mounting evidence of less frenetic growth in China and other parts of the Pacific Rim is welcome. The pace of activity had been unsustainable, and policies to slow things down a little are appropriate and working. Unfortunately, greater balance between domestic and foreign demand was not secured. Another pressing risk is that policy-guided economic growth tends to be over steer. Beijing officials haven’t taken their foot of the brake because inflation is above target. Even if a shift toward growth is made in the autumn, a more appreciable slowdown than desired domestically could easily be felt early in 2011, and that would be regrettable from a global economic standpoint as well. Japan will release data Monday showing lessening economic growth. Japan’s economy seldom performs adequately when the international environment is uncooperative. The two determinants of net foreign demand — conditions in foreign markets and the competitiveness of the yen — look more adverse than three months ago.
Europe’s sovereign debt crisis is back in the news. German GDP expanded by 2.2% last quarter, while Greek GDP contracted 1.5%. ECB President Trichet is fond of dismissing complaints about a a one-size-fits-all monetary policy by noting it’s not different from the Fed setting the same interest rate all of the state economies. When annualized, the gap between Germany and Greece last quarter was about fifteen percentage points wide. How often does one observe positive growth of 7.5% in California at the same time as negative 7.5% growth in New York? In the year between 2Q09 and 2Q10, real GDP rose 3.7% in Germany but only 1.4% in Portugal. Greece and Spain had contractions of 0.2% and 3.5%. Eroded confidence in the common European currency was reflected in a German-Greek 10-year bond spread of more than eight percentage points today, the most since May. Likewise, the euro is presently 4.1% weaker against the dollar than its high last Friday. That matches the euro’s loss against the yen between August 1st and yesterday. The euro lost as much as 1.7% against the pound between August 6th and 13th, but the most impressive shift in the last couple of days was a 3.5% drop against the Swiss franc since Tuesday.
Like U.S. monetary authorities, Bank of England policymakers have become more guarded about growth. Their job has been complicated this year by 3.0%+ consumer price inflation, which has been a puzzle to them and conspicuously high in a disinflationary or deflationary price environment elsewhere. The August quarterly Inflation Report of Britain’s central bank nonetheless has a more dovish flavor than earlier reports. It wasn’t long ago that a tightening in 2010 had seemed possible. Now the directional risk of a sooner rather than later policy change lies clearly in the direction of easing. Officials assume that no changes will be made for considerably longer but took this opportunity to reassure investors implicitly that they are prepared to respond if weakness in the economy gathers steam. Given the strength of GDP growth in the second quarter, this shift in bias was surprising, but sterling advanced against the euro.
The Canadian dollar remains tantalizingly close to parity with its U.S. counterpart without advancing the remaining distance. The loonie’s high this past week was at 1.0256 per USD, which compares with highs of 1.0107 in the week of August 6, 1.0264 in the week of July 30, 1.0347 in the week of July 23, 1.0276 in the week of July 16, 1.0297 in the week of July 9, 1.0320 in the week of July 2, 1.0139 in the week of June 25 and 1.0207 in the week to June 18th. The Australian and New Zealand dollars likewise continue to hover near ninety U.S. cents and seventy U.S. cents. All of these commodity-sensitive currencies lost ground this past week against the greenback, but the Canadian dollar proved most resilient. The kiwi and Aussie lost over 2.0%.
Chinese officials on June 19th unveiled a more flexible foreign exchange policy, or so they said. In the week of June 25 and July 2, the yuan advanced 0.5% and 0.3% against the dollar. The exchange rate was unchanged in both of the next two weeks, slid 0.1% in the week of July 23, rose a tenth in each of the following two weeks, and fell back 0.3% this past week. From June 25th, yuan appreciation amounts to less than 0.5% annualized. U.S. officials have yet to demonstrate any leverage over China in currency policy discussions. This is very different from Washington’s earlier experience with Japan. There are two important reasons to explain this. Since the aftermath of the Second World War and throughout the Cold War, the United States took responsibility for the defense of Japan. The countries were foreign policy allies, but U.S. taxpayers did the heavy lifting. China and the United States were Cold War adversaries and still are on opposite sides of the foreign policy fence. Beijing owes America nothing. Yes, China has benefited from U.S. demand for low-cost Chinese goods. So did U.S. consumers, and in return the United States enjoyed lower long-term financing costs and stronger economic growth than it would have sustained if China had not bought so many Treasury assets. It was a consensual deal.
The second reason why Chinese officials are not heeding U.S. advice about their currency is the Japanese experience. Beijing authorities believe the yen’s advance from more than 260 per dollar in February 1985 to 120 per dollar at end-1987 and again from 125 per dollar early in 1993 to 80 per dollar in the spring of 1995 bear significant responsibility for producing a deflation from which Japan’s economy still has not escaped. Power will become much more evenly divided in the U.S. Congress after November’s election. By then, the Democrats who favor imposing trade penalties on Chinese goods may have lost the clout to pass legislation to back up their threat. China’s yuan ruse may have bought all the time that Beijing officials need.
Copyright Larry Greenberg 2010. All rights reserved. No secondary distribution without express permission.
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[…] markets have mostly been marking time in late August. Since my previous Insights essay written two weeks ago, the U.S. currency experienced scant net changes of +0.7% and +0.4% against […]