Early Days in a Newly Perceived Threat to Currency Market Stability

June 19, 2014

A lack of meaningful currency market movement this year among the major advanced pairs like EUR/USD and dollar/yen has been one element of a broader dampening of volatility in all sorts of financial markets.  Many commentators have noted that often such stability came before disruptive crises, and the worry that we may be in a calm before the storm has arisen among central bankers, too.  Today’s quarterly review from the Swiss National Bank identifies potential strains from  “current geopolitical conflicts, pressure to consolidate public sector finances in the euro area, structural problems in different countries” and unsynchronized monetary policy cycles.  Federal Reserve Chair Yellen was asked yesterday about how Fed policy might be impacted by financial market stability or the lack of such.  Her answer implied keen awareness of the issue and its potential for disruption but no methodical or mechanical procedure for acting preemptively before the problem becomes symptomatic.

Trends in leverage lending in the underwriting standards there, diminished risk spreads in lower-grade corporate bonds, high-yield bonds have certainly caught our attention. There is some evidence of reach for yield behavior. That’s one of the reasons I mentioned that this environment of low volatility is very much on my radar screen and would be a concern to me if it prompted an increase in leverage or other kinds of risk-taking behavior that could unwind in a sharp way and provoke a sharp, for example, jump in interest rates. And we’ve seen what effect that can have on the global economy, and I think it’s something that it’s important to avoid. But broadly speaking, if the question is: To what extent is monetary policy at this time being driven by financial stability concerns? I would say that–well, I would never take off the table that monetary policy should–could in some circumstances respond. I don’t see them shaping monetary policy in an important way right now. I don’t see a broad-based increase in leverage, rapid increase in credit growth or maturity transformation, the kinds of broad trends that would suggest to me that the level of financial stability risks has risen above a moderate level. And we are using supervisory tools and regulations both to make the financial system more robust and to pay particular attention to areas where we’ve spotted concerns like leverage lending, which is very much a focus of our supervision.

Financial market history since the 1970s has bounced through a series of crises that seemingly escalated in their severity.  A lesson I take from the anatomy of these breakdowns in market functionality is that do not erupt without clear warning.  There tends to be a specific triggering device that makes a prior buildup of presumed safe investments no longer so.  Japan’s banking crisis in the 1990s was ignited by a tightening of Bank of Japan policy.  Under a new leadership, the overnight money rate rose from less than 3% to more than 8% even though inflation never exceeded 4.5% and much of its rise was related to the 1990 oil price spike.  The Asian financial crisis was sparked by a devaluation of the Thai baht in mid-1997 and an ensuing string of events laid out in this timeline.  Before the Great Recession of 2008-09, there was a U.S. subprime mortgage credit crisis that kicked into emerged early in 2007, kicked into higher gear that August, and then rippled outward with impacts on almost all global financial markets.  A chronology of those events that cascaded in domino fashion was in turn preceded by a reversal of U.S. housing prices, which had peaked early in 2006 and eventually resulting in a contagion of home loan defaults. 

Very low central bank rates around the world may indeed be sowing frothy equity and fixed income security prices that some day may drop with a thunk.  The above experiences, however, suggest that the reversal will be far from spontaneous.  Other things will need to shift course first, and the likeliest suspect is the inevitable normalization of monetary policies that’s going to come sometime.  Only the timing is in doubt.  By making that moment data-driven, monetary officials will try to pick the moment that offers the least scope for generating a crisis, but that’s a moment that can at best be managed and cannot be eliminated.  Among the main central banks, the flashpoint will be reached first at the Bank of England and then at the Fed.  One can be sure with great confidence that the federal funds rate is not rising before 2015.  A divergence between the Fed and ECB will then emerge, but until U.S. interest rates go up the current reality between those two central bank stances does not present a meaningful contrast.  Each is running an extraordinarily stimulative policy, and there’s no energy there to generate the kind of swift and extensive euro depreciation that the ECB needs. 

Japan’s 20+ year experience with very low interest rates is a sobering story.  Every government thinks its situation is different from Japan’s, including China and the group leading Japan now.  The third pillar of Abenomics, structural reform, proved to be a dud.  The second pillar, fiscal policy, has piled up even more public-sector debt on an already very unbalanced situation.  The main successes of the first pillar, quantitative and qualitative monetary policy, have been low interest rates across the spectrum and the initial depreciation of the yen, but those intermediate objectives failed to stimulate bank lending and  the export growth to anywhere near what the government was seeking.  Japan may see a 2% inflation rate for a short while but is unlikely to secure such in a sustainable way.

The major economy that has improved the most this year relative to expectations has been Britain’s.  Sterling’s rise to touch $1.70 has been a real grind.  To the extent that Britain continues to outperform the euro area by a wide margin and the U.S. by a lesser degree, the pound’s recovery should still show life.

I’m more worried about the ability of economies to handle central bank interest rate hikes anytime soon than about the possibility of an inflation problems caused by keeping current stances for too long.  In the case of the United states, investors playing the market, as opposed to conservatives on the radio and TV business talk shows, seem to agree.  Over the last month, the 2-, 10- and 30-year Treasury yields have risen only 9, 2, and 1 basis point.  Compared to June 19, 2013 levels, they are up 13, 22 and a single basis point.  The Dow has advanced 10.3% over the past year, including 2.2% over the past month.  The S&P respective gains were 18.5% and 3.7%.  The dollar is merely 0.6% higher against the euro than a month ago and still down 1.9% on year, while dollar/yen has risen 6.4% on year but just 0.3% on month.  Before currency markets spring back to life, other extraordinary developments will probably need to transpire.  But this is summer, a season known for the unexpected and for currency market trend reversals.

Copyright 2014, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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