Weekly Foreign Exchange Insights: November 28th

November 28, 2008

The defining moments for currency markets during 2008 have not come from released data, other than the cumulative realization that the U.S. recession is not an isolated event. Euroland, Japan, Britain, Sweden, probably Canada and New Zealand, and possibly Australia will experience recessions, too. So will a number of developing economies in all major regions. The present quarter and the first quarter of 2009 will see horrific GDP contractions in Europe, Japan, and the United States. The contagion was unexpected and has contributed to a stronger dollar this year than analysts predicted around this time a year ago, but currency market turning points and inflection points have not been associated with unexpectedly shocking or favorable data announcements.

Nor has the shifting interest rate cycle or the replacement of inflation worries by fear of deflation framed movement in currencies. The strongest major currency has been the yen, which makes intuitive sense because long- and short- term rates have fallen the least in that country, and the Bank of Japan has been the most resistant central bank to easing its stance.  However, officials at the ECB and Bank of England also dragged their feet relative to their U.S. counterparts, but the euro and sterling lost ground against the dollar.

The main impulses for currency market direction in 2008 were provided by the Book of Life decisions involving ailing financial institutions: who will be deemed too big to fail and therefore salvaged and which will be cast off to die? The actions of Washington officials, as with people’s lives, have appeared arbitrary and inscrutable, and they have been poorly explained. In the wake of the Lehman bankruptcy and demise of the investment banking industry, equity price destruction intensified, but the dollar thrived in a process that continued through the first three weeks of November, as market players feared a policy vacuum until January 20th. The rescue of Citibank one week ago fittingly book-ended a period of hyper-risk aversion. But neither that act nor the introduction of a vast array of grand projects to circumvent distrustful banks in providing desperately needed liquidity to final users restored the international monetary system to anything resembling normal functionality. Whereas stock market losses and dollar and yen appreciation were trimmed this past week, long-term interest rates kept falling. More seminal moments lie ahead like a final decision on GM, and markets await further details and eventual implementation of the latest monetary and fiscal steps to promote growth. Not in many decades has there been so much broad change on the policy front, and but it’s important to know that this policy backdrop has been in constant flux because remedies taken earlier did not produce intended results.

The unpredictability of these trial and error experiments will continue to guide currency markets. One lesson of the past 15 months is that many truths that were supposedly understood turned out to be elusive. Reminiscent of Japan in the 1980’s before everything there went south, strongly rising U.S. productivity, the Holy Grail of long-term growth with price stability, was highly touted as a Star Wars shield that would keep America’s economy rolling along in the 21st century no matter what surprises might arise. Markets also now realize that economic performance is proverbially a reflection of a radically reworked infrastructure. Economic models that simulate the future have become less reliable, not that such ever could claim real clairvoyance. In this stew of uncertainty, portfolio management will remain very defensive. A considerable amount of trades will be inspired by considerations other than a hope to maximize return or minimize risk, and such activity could continue to be pivotal during the great deleveraging of debt. Cash will remain king, and investor judgement will be more sensitive to confidence in policymaking and new schemes to help economies get through the recession than to the explicit evolution of the downturn. Progress toward a new economic equilibrium, moreover, should not be monitored by old yardsticks like inventories, because this is a very different kind recession than earlier post-war slumps. It’s more akin to recessions during the 19th century. One indicator that I will be watching closely this time will be the U.S. savings rate, which I expect to climb beyond 6%.

It is premature for possible adverse implications of runaway deficit spending and or out-of-control central bank balance sheets to undermine certain currencies. These may or may not be important future considerations, but the operative word is “future.” Markets don’t like to dwell on “what ifs” because the most influential future factors tend to be shocks that were completely unforeseen. The news this past week saw more terrorism than in quite some time, which markets shrugged off. I think geopolitics would have to deliver an event bigger than the September 2001 attacks for terrorism to dominate currency trading again the way it once did.

The big question for dollar holders is whether its setback this past week represents a return to the long-term downtrend of 2002-7. I suspect not. The dollar’s upward correction was bigger in magnitude and longer in duration than a typical counter-trend correction imbedded in a long-term move. Intervention by Japanese officials to cap yen strength remains a possibility, and that would funnel a greater percentage of the energy from falling European currencies or commodity currencies into the dollar. Some of President Obama’s appointments may leave his most left-wing supporters feeling betrayed, and certainly allays the campaign accusations that an Obama-led government would pursue a more Liberal line than Clinton, Carter, or Lyndon Johnson did. Investors, like American voters, seem in the mood for a pragmatic centrist approach. The President-elect has not given the markets an excuse for a knee-jerk sell-America response. If the corny yes-we-can mantra restores confidence and national unity in the way that former President Reagan washed away the stagflationary malaise of the late 1970’s, the dollar should perform respectably in the period ahead. It’s important to remember that these are early days, however.


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