Currency Implications of an Obama Win and Other Uncertain Matters

September 28, 2012

The assumption that Barrack Obama would be a single-term president appeared to be one of the safer bets that I made early this year.  Historically speaking, second terms have been difficult to secure when U.S. unemployment was above 7.0%.  Economic growth in the second term of a presidential year, not 3Q or 4Q, has in the past correlated best with election day support for incumbents, so U.S. growth of just 1.3% annualized in the spring is an ominous signal especially in the absence of broadly improving demand and output this past summer.  In a close election as this one appears to be, turnout and financial resources for advertising will be crucially important, and Romney has the edge on both of those criteria.  With just over five weeks left before November 6, opinion polls show momentum drifting in Obama’s favor, however, so it’s clearly warranted to ask how the dollar and other currencies might behave differently if Obama, not Romney, wins.

Romney would represent the greater departure from the past, but it’s greatly mistaken to infer that Obama implies more of the same.  Second terms have their own distinct tone and have generally delivered less success than first terms since the 22nd constitutional amendment prohibited more than two terms.  The different flavors of a president’s two terms filter down to foreign exchange.  Dollar/mark, for instance, appreciated 58.5% in Reagan’s first term but fell by 42% in his second term.  A president’s inner circle of advisors on economic policy may change after the second election including the post of Treasury Secretary in whom currency policy rests.  So might global and U.S. economic conditions and the administration’s policy priorities.  Based strictly on the tendency for financial recessions to be followed by very long periods of sub-normal growth, it’s reasonable to assume that the next four years will see better U.S. growth emerge eventually than the last four years produced.

There are implications for monetary policy.  Romney has promised not to reappoint Fed Chairman Bernanke, whose term ends in January 2014 and no doubt would carry out such a breach of Federal Reserve independence.  There’s no way to know if Obama will keep Bernanke or if the Chairman even wants a third term, but less enduring damage to Fed credibility would occur, and that kind of chairman succession process would better serve the dollar in the long run.  Romney is also committed to exploring the merits of returning to a gold standard or some related arrangement that links monetary policy more closely to commodity price trends.  Obama has expressed no such plans and doubtless would not go there, given the belief by historians that a factor that deepened and prolonged the U.S. Great Depression experience was staying on the gold standard longer than, say, Britain.

Of more immediate concern is how avoidance of the fiscal cliff might be impeded or fostered by an Obama victory.  The answer is extremely ambivalent because it depends on the margin of Obama’s victory, the political party composition of the two houses of the U.S. Congress, and where Republicans cast blame for losing an election that ought to have been a slam dunk win.   Considering all the variables and the post-election game theory dynamics, it appears that averting or at least watering down fiscal drag in 2013 could prove easier if Romney wins.  I wouldn’t assume, as many investors are doing, that a fiscal cliff will be averted one way or another because of the extreme consequences involved, namely a drag of 4-5% on GDP.

What about the size of Washington’s budget deficit and the rising burden of debt?  I’m in the camp that thinks the near-term consequences of such on long-term interest rates and U.S. inflation are considerably less than feared generally.  U.S. similarities to Japan and Britain are more obvious than to Greece, Spain or Italy — all of which are hamstrung by the lack of one’s own customized monetary policy and the ability to adjust the exchange rate against those of its major trading partners.  Excessive disinflation seems likelier than excessive inflation in America because of the size of its output gap.  Britain has tried in vain to slash its fiscal deficit, only to learn that the result has been weaker growth but continuing massive trade and fiscal red ink.  So from the dollar’s perspective, prospects look worse under Romney than Obama.

No matter who wins, a safe bet is continuing extreme turmoil and uncertainty in the Middle East.  Romney has criticized Obama for being too conciliatory with America’s enemies like Iran and insufficiently solicitous of its allies.  Bush43 made the same point, but in fact one hears less negative chatter abroad about U.S. foreign policy now than last decade.  Through decades of alternating Democratic and Republican leadership, Middle Eastern geopolitics have defied efforts to broker regional stability and peace, and one is left to suspect that this problem has no more likelihood of a solution than a single equation with two unknown variables.  To minimize damaging America’s vital interests, one hopes that the military budget associated with operations in the Middle East is contained and that oil price developments do not create a recession.  As currency markets consider these ever-present risks, greater comfort may be found in the status quo than in a whole new team of policymakers working with little institutional memory.

Currency market participants will be grappling with other issues.  The risk on/risk off trade continues to control trading patterns much as it has for the last four years.  In weeks such as this past one when equities sputter and long-term interest rates fall, the dollar and yen tend to be well bid.  When uncertainty swells, so does risk aversion because it’s harder to properly price risks that are less predictable.  The U.S. election and its implications are not the only source of uncertainty.

  • In the coming quarter, risk aversion will be supported by weak global growth.  Much of Europe is in recession.  Japanese GDP is likely to contract in the second half of 2012.  U.S. GDP, which expanded just 1.6% annualized in the first half, is on a low simmer.  Chinese growth slowed 4.2 percentage points from 11.8% in the year to 1Q10 to 7.6% in the year to 2Q12.  That’s no more trivial than going from +3% to minus 1%.  On-year Chinese growth is likely to be slightly lower in 3Q than 2Q but there are some signs that sequential quarterly expansion stabilized or even strengthened somewhat. 
  • The ECB bond buying proposal is conditional on the countries meeting externally mandated reforms.  Resistance to these conditions is giving up without a fight.  An ECB crisis endangers the euro and puts extra upward pressure on the Swiss franc.
  • Sino-Japanese tensions are especially worrisome because they involve the second and third largest global economies.  Fallen Japanese exports to China due to weaker Chinese demand could be exacerbated if relations between the two powers continues to deteriorate.  So far, trade and investment ties haven’t appeared to be affected unduly, and the yen continues to trade more strongly than Japanese officials want.
  • Domestic politics in Japan and China are each at an uncertain crossroads.  At stake is their future policy toward one another and individual decisions on monetary and fiscal policy. 
  • Whether Japanese officials continue to refrain from intervening in foreign exchange markets by selling yen is another uncertainty.  I share the conventional view that it would probably take a further spike of the Japanese currency to near 75 per dollar to trigger intervention.

Two more issues are of particular importance to the week just ahead.  First, it’s a block buster week from the standpoint of potential market moving data releases.  Among these are the Bank of Japan Tankan survey of business conditions and expectations, the purchasing manager surveys from many economies around the world, revised euro area GDP, and the U.S. Labor Department monthly jobs data.  The first Romney-Obama debate is set for Wednesday, and central banks are holding monetary policy meetings in Euroland, Britain, Australia, and Japan.

The last factor to note is that we’ve crossed over into a new calendar quarter and the second half of Japan’s fiscal year.  From 1999 to 2007, the dollar rose against the yen in the first October week seven out of nine times but just twice by more than 1.0%.  The average change was a dollar gain of 0.6%.  After the financial crisis, the dynamic seems to have changed.  In each of the last four years, the dollar in this equivalent week fell against the yen and by an average of 0.9%.

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

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