Unlikely to Stop the Risk Aversion Express
September 23, 2011
Risk aversion, which benefits the dollar and yen, has taken hold of all financial markets, and confidence-boosting factors are nowhere in sight.
First, the economic backdrop among advanced industrialized nations recently began a fifth year of bleakness. Substantial balance sheet deleveraging remains to be done, and these economies still cannot sustain recoveries without macroeconomic support. In addition widespread efforts to cut debt and difficult financing conditions for borrowers, collateral damage to employment and incomes have spawned fresh economic headwinds. Emerging market governments are less receptive to stimulative demand management than they were three years ago.
Second, confidence has been shattered that democratically elected governments can improve conditions or in fact that such a wish is even the intent of most politicians. In their parochial demeanor and dim record of achievement, elected officials and appointed bureaucrats have seemingly failed time and again in Japan, the euro area and the United States. The presumption is that only people looking for personal fortune or power go into public service. No Rooseveltian figure looms to re-inspire consumers, investors, or business owners that present-day challenges can and will be overcome. Amid this gloom, Japan has assumed the role of “ghost of Christmas future,” foreshadowing ridiculously low trend growth for the foreseeable future in Europe and the United States. The U.S. congressional deal raising the debt ceiling in early August ensured that a relapse into recession is extremely likely, and the July 21 accord on Greece sparked the recent equity price sell-off. Both policy efforts were meant to create confidence but instead deepened despair.
A third driver of risk aversion is a perception of diminishing effectiveness of monetary policy. Many policy bullets have been fired already. When the financial crisis escalated in the fall of 2008, central bank rates were at 7.2% in China, 7.5% in New Zealand, 7.0% in Australia, 5.25% in South Korea, 5.0% at the Bank of England, 4.25% at the ECB, 3.5% in Taiwan, 3.0% in Canada, 2.75% in Switzerland, and 2.0% at the Fed. Criticism against quantitative easing has thrown up walls against its usage and convinced many people that such actions do more harm than good. The stimulus unveiled by the Federal Open Market Committee this past week looks fairly substantial on paper but hammered commodities and sent equities to new lows. The knee-jerk reaction to rhetoric and actions of central banks now mimics the negative response to government initiatives.
Comparisons of the present circumstances to 2008 are heard with increasing frequency. After the collapse of Lehman, market players could not imagine a reversal of market trends as soon as March 2009. The politics this time around looks much less cohesive both within key regions of the world and across the oceans. Wave after wave of risk aversion is being driven, as in 2008, by doubts that core challenges — sovereign debt strains, fragile financial institutions and systems, weak economic growth, damaged labor markets, and the roller-coaster price action of the markets — are going to be met. Each of these problems is likely to get worse in the next three months.
The dollar received an impressive lift from risk aversion in 2008. It rose by 30.1% against the euro that year between July 15 and October 28, 27.6% against the Swissie from March 17 to November 21, and 41.8% relative to the pound between March 14 and December 29. Commodity-sensitive currencies were hammered in 2008, sending the greenback up 63.9% against the Australia dollar between July 15 and October 27, the Canadian dollar up 34.0% from February 28 to October 28, and the kiwi up 58.1% between March 14 and November 20. In 2008, the yen did even better than the dollar, appreciating 28.6% from the start of the year through December 17.
Every point in time has some unique circumstances, however similar it may appear to an earlier period, and here are some features bear in mind about the present.
- Ground zero in 2008 was the United States, where a housing market downturn had led to the sub-prime banking crisis. Europe’s sovereign debt problem had not yet surfaced. Europe, Japan, and emerging economies were threatened and victimized by the contagion of the U.S.-made crisis. When U.S. officials allowed Lehman Brothers to collapse, the fallout intensified. Ground zero this time lies in Europe, and it’s America’s turn to be affected indirectly.
- The Swiss franc was removed as one of the usual safe-haven currency suspects by a dramatic shift that subordinated domestic monetary policy in Switzerland to the enforcement of a pegged minimum euro value of CHF 1.2000. The dollar and yen are the surviving safe havens among major paper currencies. The oldest safe haven for wealth, gold, has been very volatile. A fall recently from over $1900 to less than $1750 hasn’t caused the withdrawal of predictions of $2000 per ounce by yearend.
- Regarding yen appreciation, Japanese officials have now reached the limit of their tolerance. Verbal jawboning to protest yen strength has escalated, with the implied threat of intervention that can happen anytime but is unlikely to be used day after day. Other governments are not sympathetic about containing yen appreciation.
- Beijing officials in 2008 halted their program of gradual appreciation of the renminbi/dollar rate. Replicating the same reaction this time would be more problematic because of higher inflation that has prompted the People’s Bank of China to tighten their monetary policy several times.
- The possibility of a Greek default, which looks increasingly probable sometime soon, will constitute a big step into the unknown. The chain reaction of ensuing financial market chaos will no doubt produce some unexpected lines of contagion as well as others that investors already anticipate.
- The recent speed of decline in global equity prices is almost comparable to that seen in 2008-09. A 15.6% drop of the DOW over the two months between July 21 and September 22 compares to an average 45-session slump of 12.4% between the Lehman collapse in September 2008 and the market’s trough in the following March. The maximum 45-session slump of 31.5% was registered between September 18 and November 20, but drops of more than 17% were confined mostly to November and occurred again briefly in early March. This year, the German Dax and Japanese Nikkei fell between July 21 and yesterday by 30.7% and 14.5%.
- The governments in advanced and emerging markets responded with strong fiscal and monetary stimulus in 2008. As noted, fiscal support is a no-show in 2011, and monetary policy appears to be at a point of diminishing bang for the buck both from the standpoint of what’s being done and the amount of hope such is inspiring.
- EUR/USD is more appropriately valued now than in the summer of 2008. It recorded an outlying quote of $1.6038 in mid-July 2008, at which point the common currency had risen 95% from its October 2000 low and over 35% from its starting level. Even ECB officials were protesting the euro’s strength. By a variety of measures including purchasing power parity, the euro/dollar relationship is presently not far removed from equilibrium. The average value over the whole common currency experience is $1.2021. Since inflation tends to be lower in Euroland than the United States, equilibrium now lies at a stronger euro level than $1.20.
Several important indicators will be released next week such as the German IFO business climate index, euro area sentiment and unemployment, U.S. house prices, durable goods orders, consumer confidence and revised GDP, Japanese household spending, industrial production, and small business sentiment, Canadian GDP, and British industrial sector trends and consumer confidence. The IMF meetings will focus attention on how the Greek crisis may further infect other parts of Europe and the regional and global financial systems. On Friday, another calendar quarter will end and also the first half of Japan’s fiscal year, which may have been generating yen-supportive capital flows in September.
Beyond next week looms the British and ECB monthly policy meetings. The Bank of England is edging closer to renewed quantitative easing, but perhaps not quite this soon. The anticipation of QE1 in the U.K. weighed more heavily on the pound than the actual implementation of the program. Sterling fell against the dollar this past week more or less in tandem with the euro and is roughly 4% weaker than its 200-day moving average against the common European currency. Ten-year gilt yields remain at a smaller-than-70 basis point premium to bunds, confirming the wisdom of keeping sterling outside the Economic and Monetary Union (EMU). The ECB has beefed up its non-standard measures to enhance market functionality and may signal a readiness to reverse July’s rate increase. ECB President Trichet steps down at the end of October, raising a new element of uncertainty that may also promote some further euro depreciation against the dollar. Recent months have seen atypical public airing of internal policy disputes at the Fed and ECB, creating yet one more reason to stay risk averse.
Copyright 2011, Larry Greenberg. All rights reserved. No secondary distribution without express permission.