Storm Clouds Over All the Major Currencies

May 20, 2011

The industrialized economies share many common problems and challenges.  Recovery from the financial crisis and Great Recession has been uneven and frustratingly moderate on the whole.  The scent of possible stagflation fills the air.  Fiscal deficits need to be reined in, and exit strategies from unsustainably loose monetary policies either remain in early planning stages or have not even begun. 

The United States, Great Britain, euro area, and Japan must each navigate problems, which if played wrong could get extremely messy. 

  • A failure by Congress to raise the U.S. Federal debt ceiling could put America on a slippery slope to default and almost surely would throw the economy back into recession.  The Federal Reserve needs to persuade investors and a hostile Congress of its resolute commitment to price stability without actually raising interest rates for perhaps another year.  Long-term unemployment will create a mounting structural threat to U.S. prosperity, the longer it is neglected by policymakers.  Middle East unrest is distracting attention away from domestic economic priorities, and financial reform is in danger of unraveling.
  • Britain is the guinea pig that will tell other governments if draconian fiscal restraint can succeed in the current environment.   Every concern and response seems more extreme there.  The fiscal deficit is larger.  Budget reductions are deeper and already being implemented in an economy that failed to expand on net between 3Q10 and 1Q11.  Inflation is higher than elsewhere in the Group of Seven.  The fractious domestic political currents are on full display in the ruling coalition.  No other central bank airs its internal differences quite so transparently as does the Bank of England. 
  • Eighteen months have elapsed since Euroland’s debt crisis surfaced, and it’s been a year since an EU/IMF liquidity package was fashioned for Greece.  That rescue effort was woefully inadequate in size and its diagnosis of the problem.  The world investment community has become convinced that the debt of Greece and others will need to be restructured eventually, but the timing of such a reckoning remains highly uncertain because of powerful political resistance to such a move and the myriad of ways that the final resolution could take.  Rumors persist that the euro may break apart or that the hard currency ideals upon which it was founded may get abandoned. Symptomatic of the widespread cynicism, Greek 10-year bond yields exceed 16% and are some thirteen percentage points higher than those on German bunds.  Comparable Irish and Portuguese spreads exceed 700 and 600 basis points, while those involving Spanish and Italian debt are above 200 bps and over 150 bps.
  • Japan is again back in severe recession, with real GDP tumbling at a 3.4% annualized rate over the last two reported calendar quarters.  Almost 21-1/2 years after cresting, Japanese share prices are 75% lower than their end-1989 peak.  Real GDP growth over this generation of time averaged just 1.0% per annum, an enormously negative transformation for a place that routinely grew faster than 4% a year previously.   The U.S. Federal Funds rate has been no higher than 0.5% for almost 2.5 years, but Japan has been in the equivalent predicament without interruption since September 1995.  Officials in the Japanese government and at the country’s central bank expect a spontaneous economic recovery starting in about five months, but that baseline estimate doesn’t embody the risk of another earthquake beforehand.  Nor are there policy remedies in place to return Japan to its more dynamic past.

Trading a range of unattractive currencies is difficult.  Short-term dynamics hinge too often on political headlines that cannot be anticipated like the arrest of former IMF Managing Director Strauss-Kahn or the killing of Al Qaeda founder Bin Laden.  Strong convictions about the relative strengths of the dollar, euro, pound and yen are unlikely to develop when the economic and political negatives associated with each dwarf any grounds for genuine optimism.  Verbal market chatter has lately favored the dollar and panned the euro, mainly because that key currency relationship is felt to be too uncompetitive.  But although EUR/USD hasn’t printed lower than 1.4000 for the past two months, the common currency is presently just 1.5% stronger than its year-to-date average level of $1.3958.  Sterling is merely 0.4% stronger than its 2011 mean of $1.6147 and has had a handle of 1.6 since April 4.  The yen has been confined between 82.57 and 79.55 per dollar over the last month and is separated from its 2011 mean value of 82.25 by just 0.7% at present.  The Canadian dollar, 0.9730 at this moment versus a 2011 mean of 0.9765 per USD, is even closer to its equilibrium.  The proximity of all these currencies to their 2011 centers of gravity highlights the lack of cumulative movement even amid plenty of day-to-day and week-to-week volatility.

In an arena that often reward short-term thinking, the current backdrop and recent experience should reinforce those properties.  At such times, the usefulness of fundamental economic analysis is limited for formulating profitable strategies for currency trading.  A related question concerns whether this is a passing phase or part of a permanent transformation.  If we are indeed in a transition stage, it would seem to be a passing of the torch from long-established industrialized country monies to those of the emerging markets, which increasingly are providing the power for global growth.  Until emerging markets like China abandon capital and credit controls, however, the usual suspects that comprise reserve asset portfolios will continue to be the only true game to play.

Three currencies that have shown more decent deviation from their 2011 means are the Australian dollar, New Zealand dollar and Swiss franc.  All have links to commodities, the first two as producers and exporters and the last as the fully convertible currency most closely associated with gold as a reliable hedge against inflation and store of value.  The AUD, NZD, and CHF are presently quoted with advances against the U.S. dollar of 5.1%, 4.1% and 3.6% relative to their 2011 averages.  Even in these three instances, change is comparatively modest, and given the sharp downward break in silver and some other commodities from peak, this may be the wrong time to pile into commodity-sensitive currencies. 

Data releases next week include several meaningful indicators of activity and demand  but are unlikely to enable any currency to emerge as a clear-cut winner to acquire.  Revised GDP reports are due from the United States, Germany and Britain.  Euroland consumer confidence, business sentiment and preliminary purchasing managers surveys are also on the calendar as well as Japanese customs trade, retail sales and small business sentiment and U.S. new home sales, durable goods orders and pending home sales. 

Copyright Larry Greenberg 2011.  All rights reserved.  No secondary distribution without express permission.

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