Dollar Performs Best When Investors are Worried

October 5, 2012

Uncertainty promotes currency market stability.  The dollar’s major appeal over the last four years didn’t reflect comparatively resilient U.S. economic growth or other fundamental advantages associated perennially with U.S. asset markets.  Rather, the dollar performed best when elevated risk aversion caused the search for asset safety to become paramount.  The yen has also benefited from such a metric.  Swings in risk aversion have meanwhile been the rule rather than an exception, and this on-off pattern has limited sustained cumulative movements in either the dollar/yen or EUR/USD relationships. 

Looking ahead, I expect the noise element in currency movement to eclipse any trend component as has been the case so far in 2012.  The euro recorded average readings of $1.3120 in the first quarter, $1.2831 in the second quarter, $1.2509 in the third quarter but at $1.3016 is currently quoted closest to its early- rather than mid-2012 levels and quite far from its low of $1.2041 touched in the summer.  The dollar posted quarterly means of 79.38 yen in the first quarter, JPY 80.09 in the second quarter, JPY 78.61 in the third quarter, and is presently trading at 78.67. 

European risk has been lower since European central bank officials unveiled the OMT program of unlimited but conditional sovereign bond purchases.  Governments in the monetary union members coping with punitive borrowing costs haven’t yet accepted the ECB terms for this relief, but the open offer continues to dampen overall global financial market risk, and this helps the euro.  The ECB’s emphasis on the euro’s irreversibility supports confidence in the euro as well.  But make no mistake, country risk among the 17-nation monetary union participants is far from uniform, and the possibility is very real that a fresh euro-centric spike in risk aversion will occur quite soon.

Even if European financial markets fail to deteriorate anew this quarter, the potential for greater risk aversion could arise from separate developments in the United States.  Less than five weeks remain until Election Day, and the presidential contest is tightening after the first Romney-Obama debate.  In this column last week, I explored possible implications of an Obama reelection because a victory for him was then looking more and more likely.  My original presumption in the spring had been that Romney will win, and the direct implications of a political transition are seemingly negative for the dollar.  Rapid or even plain decent economic improvement is unlikely regardless of which party wins the White House.  Under Republican management, non-defense government spending will be squeezed even harder, but defense spending will enjoy a higher trajectory.  On balance, this shift in priorities will exert a drag.  For another thing, the Republicans have been hostile to the Bernanke Federal Reserve, and perceived threats to central bank independence tend to depress currencies wherever that happens.  Romney has also done a fair share of China bashing.  So did Obama when he campaigned four years ago, but the difference now is that Romney is beholden to Republican interests that will not let this agenda item drop.  Finally, new governments mean new policy spokespeople, and inevitably comments about the dollar and U.S. export competitiveness are going to be made that generate suspicious doubt about strong U.S. dollar commitment. 

Even when the dollar was performing better in the first half of 2012, U.S. direct investment and portfolio investment flows revealed greater fragility in the currency than realized at the time.  The table below breaks down the eight components of these long term capital movements into and out of the United states.  The third column indicates the changes between the first and second quarters where a positively signed change indicates an increased net inflow, a reduced net outflow, or a swing from a net outflow to a net inflow.

  1Q12 2Q12 Change
U.S. Direct Investment Abroad +116.1 +79.2 +36.9
Foreign DI in the U.S. +22.2 +33.4 +11.3
U.S. buying of Foreign Bonds -18.4 -26.5 +8.1
U.S. + Foreign Stocks +14.8 +21.0 -6.2
Foreign + Treasuries +43.8 +7.4 -36.4
Foreign + U.S. Corporates -14.8 -33.3 -18.5
Foreign + U.S. Agency bonds -0.4 -1.3 -0.9
Foreign + U.S. Equities +18.9 -8.6 -27.5


Against all the enumerated negatives in the above two paragraphs must be weighed the fact that generalized risk aversion usually supports the dollar even if the cause of the concern originates in America.

Two currencies, the Japanese yen and Swiss franc, face continuing policy manipulation.  The need for Swiss intervention has dropped substantially because of the euro’s better tone, which has been reflected in the franc’s value not only against the dollar but in its major crosses.  If generalized risk aversion intensifies in coming weeks and that puts new downward pressure on the euro, the franc will become better bid, climbing close to the policy threshold of 1.2000 per euro but not through such because the central bank will sell more of its own currency to defend its pegged limit of appreciation.  The Bank of Japan, which analysts believe will expand quantitative easing further at the end of this month, has not reported intervention lately, but voiced greater alarm in today’s statement:  “Furthermore, attention should be paid to the effects of financial and foreign exchange market developments on economic activity and prices.”  Although generally steady at near record-highs against the dollar, the yen soared 18% from as low as 111.44 per euro on March 21st to as high as 94.07/EUR on July 24, and exports for the first twenty days of September were 10% weaker than a year earlier.

The stronger-than-desired Australian currency has also influenced monetary policy.  In a move that analysts did not anticipate, the Reserve Bank implemented a fifth Official Cash Rate cut this week, and at 3.25% such is 150 basis points lower than its level in the year to November 2011 and just 25 basis points above the 3.0% Great Recession record trough.  Several Aussie economic indicators are conveying greater vulnerability, and the elevated Aussie dollar is the source of one of the headwinds.  Central bank officials noted this past week that “the exchange rate has remained higher than might have been expected, given the observed decline in export prices and the weaker global outlook.” 

Many indicators from a variety of economies will be released next week, but these will be mostly of a second tier nature, e.g., consumer prices, industrial production and trade figures.  Fewer central bank meetings are scheduled than in the week that just ended, and U.S. markets have a shortened week because of the Columbus Day closure on Monday.  The vice presidential candidates debate on Thursday, and a lot of attention will be directed at the steady stream of political polls to see if Romney has drawn even with Obama or perhaps even taken the lead.

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

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