Weekly Foreign Exchange Insights: November 21st

November 21, 2008

With one notable exception, this past week in foreign exchange was pretty much a carbon copy of the prior week. The yen continued its advance against just about all other currencies including the dollar. The U.S. currency posted sharp further gains against many emerging market currencies and commodity-sensitive currencies. Chinese officials kept the yuan steady as they have done since midyear. The main exception involved sterling, which at 16:00 GMT was showing net gains of 0.75-1.0% against the dollar and euro after plunging nearly 6% against the dollar in the week to November 14th. The economic and financial backdrop was also similar during each of the past two weeks. Equities crumbled everywhere, bonds rallied strongly, and oil (but not gold) continued to drop. Very few advanced economies have escaped a recession that promises to be among the worst, if not the most severe, since World War Two. The stimulus of low interest rates, cheaper energy, and more deficit spending will continue over coming quarters to be overwhelmed by difficult credit conditions, rising joblessness, deflating housing and financial asset prices, and major adjustments by consumers to a substantial loss of wealth and reduction in income. Housing markets must stabilize before economic rebirth can begin, but that development is no longer a sufficient condition for recovery. It is doubtful that Europe, Japan, or Canada will be able to secure upward traction until the United States is doing so, and a huge risk for other advanced economies is that the United States experiences an L-shaped business cycle. The new leadership taking power in the U.S. Federal government in 60 days faces daunting challenges. Success may hinge more critically upon how clearly change and hope is communicated to markets and voters than the specific actions that will be taken. 

Equities in the United States and Europe have tumbled about 20% in the very brief time since the election. The Nikkei lost somewhat less, but many Asian markets did worse. The bear market was already long in the tooth by the start of this month, and recent data, although grim, do not reflect this latest shock to wealth. Resolution of the GM bailout request has become a lightning rod for the markets if one believes the chatter. But most likely, markets and economic data will continue to accentuate the negative whatever is decided about GM. Interestingly, as the chart below indicates, the period since the U.S. election has been one of those rare times when the dollar, euro, and yen all moved in the same direction on a trade-weighted basis. Such has happened because of steep declines in many non-G-7 currencies.

Trade-Weighted Chg Since Nov 04 Since Sept 12 Since one year ago
U.S. Dollar +3.8% +10.0% +15.8%
Euro +1.4% -2.9% -4.2%
Yen +7.6% +20.9% +37.1%
Sterling -5.2% -9.2% -18.6%


Japanese intervention to reduce yen appreciation is a mounting risk. Economic prospects in Japan have darkened as a result of escalating global financial turbulence. The recession is getting worse. A softer yen would be appropriate, and the sharp appreciation depicted above will inflict substantial incremental damage. The tightening impact on domestic monetary conditions needs to be offset with much easier domestic monetary policy. However, short-term interest rates are below 0.5%, and BOJ officials still refuse to bring them to zero and resume quantitative easing. Given those constraints, officials might as well sell yen in the market, a policy tool that the G-7 has given Tokyo permission to try.

The stabilization of sterling in recent days probably will prove brief. Britain is likely to experience a deeper recession than most advanced economies. It’s chronic current account deficit and weak factory sector point to a need for a more competitive exchange rate. With domestic inflation subsiding faster than expected, the path is clear for the Bank of England to continue cutting interest rates aggressively. The pound has fallen over the past year about as much as the dollar rose. The rally in the dollar is welcome, because holders of big dollar portfolios were expressing impatience about a year ago with the U.S. currency’s persistent loss of value and threatening to diversify into the euro. Aside from that situational consideration, sterling has moved more appropriately than the dollar in a deleveraging world where both the United States and Britain will be required afterward to become more reliant on net exports for growth.

The euro continues to be an object of stability in contrast to the three other currencies featured in the above table. Flexible exchange rates have been embraced for the past 35 years because they give policymakers and economies an extra option when adjustments are unavoidable. However, currency movements will not promote appropriate adjustments in the case of the dollar and yen, and exchange rate stability would be a more desirable outcome in those instances. More broadly, G-7 leaders introduced new language earlier this year in their shared foreign exchange policy, which declared that “sharp fluctuations in major currencies” could have adverse “possible implications for economic and financial stability.” Their point is that currency volatility per se can undermine economic growth especially if conditions in the marketplace are borderline disorderly. A debate has indeed broken out in Europe’s financial press regarding whether the question of Britain joining the common currency system is an idea who’s time may have come. Not to get into the pros and cons of joining, I will simply say that the British and world recessions will be completely in the rearview mirror before this possibility will be even taken seriously.

A more interesting test posed by the recession is whether capitalist or planned economies handle it better in the sense of emerging sooner with restored trend growth. Advanced capitalist economies like the United States have already made huge concessions to the other side, pouring taxpayer money into the financial sector and considering the same into other areas deemed by some as too important to fail. China stands at the top of the planned economy food chain. China has adopted a many elements of capitalism, but the central government retains immense powers that can be used for managing a crisis like what the world faces now. The yuan’s appreciation was halted in July, for instance, and a fiscal stimulus equal to 15% of GDP over two years was announced recently. China was not spared from the global slowdown. Growth has slowed already by nearly 3 percentage points from 11.9% in full-2007 to 9.0% in the year to 3Q08. That’s a bigger percentage point slowdown than in many advanced capitalist regimes, and the social consequences of not getting over this hump quickly could be huge. China may slow appreciably further in 2009. The real test will be if it resumes double-digit expansion faster than Europe, the United States, or J
apan take to recapture trend rates of growth


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