Dangerous to do Business

May 11, 2012

Risk aversion is back in vogue.  One saw this in equities more quickly than in foreign exchange.  Investors can think of many reasons to be averse. 

  • The May 6th elections in Europe improved the probability of Greece leaving the common currency bloc in 2012.
  • Four years and 10 months after the onset of the global financial crisis, banks deemed too big to fail are still making huge mistakes in the management of risk exposure.  The distressing news from J.P. Morgan may not be an isolated instance.
  • The politics in the world’s two most influential countries, China and the United States, are each approaching important watersheds with vast, yet unpredictable, economic policy repercussions.
  • Much of what one observes in the global economy still appears unsustainable such as huge current account imbalances, an increasing concentration of wealth and income in the hands of a few, financial markets that are still not functioning normally, and mountainous private and public-sector debt. 

Risk aversion is said to favor the dollar, yen, and Swiss franc, but currency markets haven’t offered many slam dunk opportunities. From when the World Trade Center was attacked to the end of 2001 some sixteen weeks later, the dollar and yen slid 0.7% and 6.7% against the euro.  After the global financial crisis was triggered in August 2007 in the U.S. sub-prime mortgage market, the dollar at first retreated, falling from 1.380 per euro to 1.460 at end-2007 and 1.604 in mid-July 2008.  A downturn of the euro thereafter coincided intensifying risk aversion surrounding the failure of Lehman Brothers, but after reaching $1.24 in October 2008, the euro recovered to $1.40 by the end of that year and edged above $1.50 in October 2009. Only when the object of greatest fear focused on European sovereign debt and the region’s banks did the dollar benefit again, but its path over the past 2-1/2 years hasn’t been direct, either.  $1.1878 per euro in June 2010 still represents the low for this era.  The common currency recovered some 30 cents to $1.48 in May 2011 and still hasn’t escaped the gravitational force of $1.30. 

Since the start of the banking crisis, the yen and Swiss franc had been more reliable beneficiaries of heightened uncertainty and risk aversion.  I say “had” instead of “have” because neither of those currencies is being allowed anymore to float unconditionally in accordance with market supply and demand.  Prior to government interference, the yen appreciated from 119.8 per dollar on August 7, 2007 to 111.5 at end-2007, 90.7 at end-2008, and 75.55 on October 31, 2011 for a net gain of close to 59%.  The Japanese currency’s advance against the euro between July 2008 and January 2012 was 75%.  Between October 11, 2007 and August 3, 2011, the Swiss franc climbed over 55% against the euro from 1.6825 francs per euro to CHF 1.0795. 

The yen and Swiss franc, unlike the dollar, have long-time hard-currency reputations backed by traditions of low inflation and a strong balance of payments.  The dollar’s ability to benefit consistently from bouts of risk aversion, in turn, has been undermined by a Fed policy that implicitly seeks to promote a soft dollar and by a lack of fiscal clarity in defining the problems and designing a credible plan. Officials in Japan and Switzerland are now trying to override natural support for the yen and franc with commitments to resisting upward pressure on their currencies.  The commitments are verbal and backed by action as needed.  An explicitly-stated line in the sand for the franc lies at 1.20 per euro, and the Swiss currency has been stronger than 1.21 since mid-March.  An implicit line in the sand for the yen has been the 80 per USD level, and it’s once again through that barrier by a slight margin.  If risk aversion ramps upward in the week ahead, the Japanese and Swiss exchange rate policies will likely be challenged with greater force than seen before, and one cannot be sure that the authorities will be able to control events.

Market chatter today is meanwhile gearing up for the dollar to stage a more decisive move toward the mid-1.20s against the euro.  Such a move is more likely to occur if the Swiss and Japanese policies can hold the line on the yen and franc.  Then a stronger dollar would be the path of least resistance.  Another possible object of selling could be the Australian and New Zealand dollars, not only against the greenback but also their Canadian counterpart.  Canadian labor market data showing the biggest two-month rise in Jobs since the beginning of 1981 are almost too good to be true but nonetheless create a tempting target to the extent that speculation grows about Canada breaking away from the cue of easy Fed policy.  No such chance exists with the policies of the central banks Down Under. 

And then there is the inscrutable pound sterling.  Over my nearly 40 years of watching currency markets, sterling has packed many humbling surprises.  Recently Britain’s currency has crept higher despite consecutive quarters of GDP contraction and mounting tension inside the ruling political coalition of Conservatives and Liberal Democrats.  The pound has been supported by the paradox of comparatively high U.K. inflation, because such has dampened prospects for further quantitative easing by the Bank of England.  Any tightening still seems ages away, however, and the British economy will be hurt by Euroland’s recession.  If the dollar climbs against the euro, so likely will sterling but to a lesser degree.  Whether the pound can retain its beachhead above $1.60 is a wholly different matter.  I tend to think it will be trading a bit more weakly than that three months from now.

Copyright 2012, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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