Risk Aversion Isn’t Over until It’s Over

October 7, 2011

Don’t be fooled by the latest respite from risk aversion.  Such will return and generally linger around for considerably longer.  More about that in a moment after some quick comments on specific currencies.

The euro/dollar key relationship is currently trading very near the $1.3375 average level for the nearly eight years that Jean-Claude Trichet has been president of the European Central Bank. The ECB’s commitment to internal price stability implies a parallel preference for external currency strength.  The credit or blame for the euro being no weaker than its eight-year mean in spite of the euro debt crisis goes to the central bank.  ECB credibility is vulnerable now not from any doubt about its will to deliver price stability but from fear that its intransigence on other issues will prevent a solution to the debt crisis.

Aggressive quantitative easing by the Bank of England should increase sterling’s downside potential.

The Swiss National Bank’s policy of pegging a minimum franc/euro cross rate of 1.2000 continues to be successful.  The franc hasn’t moved above that level even momentarily since it was announced September 6, and the Swiss currency has in fact drifted further away from the ceiling boundary.  One would expect this to happen as investors become more convinced the policy will endure successfully.

Since resuming foreign exchange intervention for the first time in many years, Japanese authorities have operated on just three occasions, albeit heavily on those days.  They would like to see the yen at 80 per dollar or weaker.  Instead, it has been very steady with a handle of 76 or 77.  The yen’s stability seems too good to be true and makes one wonder if other covert means are being utilized to keep it from strengthening further

The Chinese yuan was frozen against the dollar for two years from the summer of 2008 to around mid-2010.  With recessionary breezes again blowing in the advanced economies, it looks like the yuan’s freeze has been imposed again.  The dollar fell 3.5% against China’s currency over the rest of 2010 and by 3.2% (4.8% annualized) over the first eight months of this year.  But no further net change has occurred since end-August.  Efforts are again under way in the U.S. congress to pass legislative penalties on imports of Chinese goods.

About risk aversion…  Market fear lessened in the first week of October because the news on several fronts was constructive.  First, chatter persisted that European leaders are finally getting serious about recapitalizing banks and creating an adequately sized war chest of pooled resources to convince investors that the wherewithal exists to handle Greece’s debt problem and any contagious debt service problems that larger members of the union may encounter.  Second, by actually taking new steps to counter the darkening economic outlook, central bankers demonstrated that the scope for supporting weak aggregate demand with looser monetary policy has not been exhausted.  Kudos went to the Bank of England for announcing more quantitative relief than markets were anticipating.  The ECB chimed in with a number of non-standard actions.  Investors didn’t get the euro area interest rate cut they wanted, but neither were they left empty-handed.  Third, U.S. data released in the week were generally better than predicted and, more importantly, not consistent with an ongoing or imminent plunge into recession.  A palpable sigh of relief could be heard that October 2011 wasn’t beginning in the fashion of October 2008.  Fourth, eulogies upon the death of Steve Jobs focused attention on what has gone right in the U.S. economy and western capitalism more generally.

The past week instead saw most commodity prices, share prices and Treasury yields recover partly.  True to form, the dollar, which thrives on risk aversion, did not do nearly as well as it had in September.  The euro recovered 2.9% from an intra-week low of $1.3144 to a high today of $1.3526.  Commodity-sensitive currencies were even more volatile, with trough to peak moves in the week of 5.3%, 4.5%, and 4.1% in the case of the Australian, New Zealand and Canadian dollars versus the greenback.  Friday-to-Friday dollar advances against the yen and Swiss franc also told a consistent story of diminished flight from risk.  Switzerland and Japan have even lower interest rates than the United States.

Looking ahead, only a cock-eyed optimist would faithfully believe that the final week of the third quarter represented the last moments in the four-year-long bout of riskphobia.  The new normal has stayed around long enough to constitute a “long run” period of time, yet plenty of unfinished adjustment remains.  Current account imbalances are unsustainably wide.  Workers are woefully underemployed, and not enough of them are equipped with the right education to be absorbed.  Solutions to economic problems will require a political will to change, yet a yawning gap between profits and wages is fanning social tension and hurting the effectiveness of government.

The European debt crisis pits sovereign nations against one another.  An enormous quantity of real economic pain needs to be distributed in a manner that voters supportively accept, but the original sin of the union, namely railroading the project through legislatures without demonstrated voter understanding and approval, remains a formidable obstacle to crafting a common fiscal policy.  Lacking widespread consent from the 332 million people scattered across 17 nations, political leadership has repeatedly resorted to denial and gimmicky plans that have all failed to pass muster in the marketplace.  This past week’s optimism has seized upon the meeting October 14-15 of G20 finance ministers as a firm date when a workable deal will finally be done.  A deal without a Greek default and a de facto transfer of resources between nations will lack credibility, and the long chronology of disappointments from European negotiations since late 2009 suggests that the G20 meeting will not deliver what markets hope to see. 

The United States still plays a vital role in the world economy, so while the U.S. underperforms its own historical norms, risk appetite cannot fire on all cylinders.  After a week’s worth of better-than-predicted U.S. statistics, current conditions are still very fragile.  U.S. real GDP grew at only a 0.8% annualized rate in the first half of 2011.  That’s far better than the 6.3% rate of contraction in the second half of 2008 yet understandably left three-quarters of a recent poll of Americans convinced that there’s another recession already.  Unemployment of 9.1% hasn’t climbed back to double digits because the labor force is expanding at a much slower pace than its old trend.  One in six workers who want to be employed are either out of a job, discouraged from looking, or settling for part-time employment instead of the full-time position with benefits that is desired.  While the U.S. economy limps along barely above stall speed, the hard evidence from the euro area points fairly convincingly to a contraction of activity in the present quarter, and Japanese GDP fell sharply in each of the last three reported quarters.  In conjunction with the dash for fiscal austerity by both advanced and developing countries, investors would be predisposed to reducing exposure to riskier assets even if the European debt crisis wasn’t happening.

The rapid life-changing development of technology has been a two-edged sword for the U.S. economy.  It’s not a coincidence that this age of consumer device invention coincided over the last dozen years at least with a period of sub-trend expansion in real GDP and jobs.  The technology revolution promoted and co-existed with an infinitely more interdependent global economy, closing the gaps between historic “have” and “have not” nations.  Old-way jobs requiring old-way skills were plowed under, and newly created jobs were taken disproportionately by developing countries.  With unfavorable consequences, technology revolutionized how market orders were placed and the business of banking in general.  Yet another disadvantage occurred as new technology shifted the education requirements of new industry jobs at the same time that U.S. education standards began to slide relative to those of other countries. 

A main question about chronic risk aversion is not whether it will persist for a couple of more years, but whether this might be a permanent downshift to a lower trend rate of growth as happened in Japan.  For now, bouts of risk aversion should more often than not favor the dollar.  But if the change and the shift to a 1-2% annual rate of U.S. trend growth becomes permanent, diversification away from the dollar will accelerate as it transitions to a reduced role in the international monetary system. 

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

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