End-Summer Thoughts

September 8, 2015

Unusual properties to summer financial market activity subdivide foreign exchange trading into three uneven seasons.  The unofficial summer for traders is bordered by the U.S. Memorial Day and Labor Day holidays.  Without going into what makes the summer different, an important take-away is that it’s a time of year to be generally a little bit more quizzical  about perceived market sentiment and revealed preference.  Trust but verify is a good attitude at this back-to-school season.

We learned a number of things in the summer of 2015.

First, oil prices haven’t stabilized yet.  The conventional wisdom of financial pundits back in May was that a bottom had been reached and that WTI crude was likely to settle in a range of $50-60 over the coming 6-12 months.  This view was widely represented in government and central bank reviews as well, and it was a critical assumption in the expression of optimism that moderate economic recovery was the most likely scenario in the rest of 2015 and 2016.

Second, equities were more volatile than either the dollar’s main relationships or sovereign debt yields.  Between Memorial Day and Labor Day, the dollar slipped only 2.1% against the yen and 1.2% versus the euro.  Ten-year bond yields rose seven and six basis points on net in Germany but fell 11, 8 and 6 basis points in the U.K., the United States, and Japan. 

Third, the dollar wasn’t buoyed by global risk aversion.  Usually it is at times when fear dominates greed such as in late 2008-early2009.  The volatility and downward direction of global equities this past summer examplifies elevated risk-off trading.

Fourth, the behavior of commodities — oil and gold dropped 23% and 7%, respectively — and continuing subdued inflation reported by most countries cast doubt on worries U.S. inflation could overshoot the Fed’s 2% target.  Inflation prospects are dictated by global, rather than country-specific, economic trends to a greater extent than generally realized, and the globalization of the inflation process is much stronger now than during the 1970s era of high U.S. inflation.  Two very sharp OPEC-engineered oil price increases occurred that decade, and the U.S. problem of high inflation was accompanied by historically high inflation in many other economies as well.  It’s counter-intuitive to presume that juxtaposed against a downward spike in oil prices of 60%+ and a time of subdued wage pressure that the first excessive acceleration of U.S. inflation in a generation would erupt.

Fifth, the Fed is still moving toward a rendezvous with its first interest rate hike.  I believe it will be done this month.  The criteria laid down by officials for acting has been met, more or less.  Tightening has never been about countering inflationary pressure.  One motivation of the rising concern about possible long-term damage to money market functionality from zero interest rates involves the long duration that the policy has now existed.  Another objection is that a policy installed in response to emergency conditions is not appropriate now that those conditions do not still exist.  And a third excuse for acting is the need to create flexibility for the Fed to cut rates when the next need to do so arises.  To not hike rates in September would require decisive evidence of a significant setback in the U.S. economic upswing, and it would be accompanied by now with more ambivalent rhetoric signals than one is hearing.  Fed officials, likewise, would not be deterred by additional monetary easing soon by the ECB or Bank of Japan.

Sixth, U.S. political developments took a wacky turn during the last 3-1/2 months.  The Democratic front-runner has been damaged possibly beyond redemption, and the most demagogic candidate in the whole race is pulling away in front on the Republican side.  The common thread is a seeming collapse in confidence in the U.S. system of government, in the integrity, skill and judgement of people that find a calling to do public service, and a conviction that elected officials are owned by special interest groups.  None of this seems to be affecting the dollar directly, yet.

Seventh, it was hot and dry summer in the United States.  Even Seattle, synonymous with a low cloud cover and raining most of the time, is in a drought.  The influx of Middle Eastern refugees into Europe may be among the first mass migrations where global warming is a primary cause.  Water shortages figure to be a main theme of the rest of the 21st century.  The solution lies in greater policy coordination between governments, but instead isolationism is rising.  Similar to point six, it’s too early for climate change to dominate currency movements.

Eighth, with the global economic pie growing more slowly both in total and on a per capita basis, the temptation of currency warfare is rising.  China’s mild early-August devaluation of the yuan, however modest that it was, still gave an outsized lift to global risk aversion.  Chinese GDP growth has slowed five percentage points in just a couple of years.  Never mind that such still exceeds 6% according to official data, a downshift from almost 12% to almost 7% in the world’s second largest economy is like a slowdown from 2-4% in the United States to full stagnation.  It’s really big.  Whether through trade or the financial market tentacles of this development, it’s going to be hard for most economies to stay insulated.  In a low inflation world, competitive currency depreciation is too good a stimulus to pass up. 

Finally, what should be anticipated in the autumn?  By yearend, it will be known whether equities are in a correction or bear market.  If the latter, the dollar ought to resume the rise that generally coincides with extreme risk aversion.  If the peak-to-trough move in stocks surpasses 20% but the dollar fails to gain traction, it will be a sign that something more insidious is holding the U.S. currency down.  By late December, the U.S. presidential sweepstakes will have emerged from the silly season.  The Iowa Caucus and N.H. primary will be front and center.  If extreme, anti-government candidates are still in the lead, they will be taken much more seriously by political pundits and financial market investors.  Fed tightening will be underway.  Of interest there will be whether monetary officials try to avoid the kind of circus of uncertainty that has ruled prior to the first move.  The contrast between the Fed and other central banks will matter greatly, and equally so will be how emerging markets like Brazil are able to cope.

For much of the time since the dollar floated, the autumn tended to see the U.S. currency weaken.  Between Labor Day and yearend, the dollar since 1976 recorded an average decline of 2.0% against the mark and/or euro, and it has lost an average of 1.4% versus the yen in this season since 1980.  However, the dollar’s fortunes over the past six years — covering the period since the present U.S. cyclical economic upswing started — have improved considerably.  Last year, for instance, the dollar advanced 15% against the yen and 8.6% relative to the euro from Labor Day to end-December.  The average dollar rise over these six years has been 1.0% against the euro and 5.1% relative to the yen.  The yen advanced in just one of those six autumns, a 3% rise in 2010, and the dollar did not drop as much as 4.5% against the euro in any of those six periods.

Another consideration in contemplating the dollar outlook over the rest of 2015 is its high on-year elevation.  At last Friday’s close, the dollar was 17.9% stronger against the euro (mark) than its pre-Labor Day 2014 level.  Compared to other Labor Day-to-Labor Day changes since 1976, only a 35.9% jump in 1981 and a 22.1% advance in 1997 had been larger.  A 17.9% rise between Labor Day 1999 and Labor Day 2000 had also occurred.  Regarding dollar/yen, the 14.3% Labor Day-to-Labor Day rise this year was surpassed only by a 25.2% appreciation of the dollar in 2013.  While the dollar still looks pricey despite small losses this past summer, the U.S. trade and current account deficit look manageable on several grounds: from the standpoint of their relative size to GDP, from how that ratio has changed in the past couple of years, and in terms of the relatively muted drag that net exports has been exerting on U.S. GDP growth.  Cumulative dollar appreciation may have been a deterrent to additional appreciation this past summer but is unlikely to be the decisive restraint against renewed dollar gains going forward from here.

Copyright 2015, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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