Weekly Foreign Exchange Insights: January 23rd
January 23, 2009
The dollar and yen are off to strong starts in 2009, while sterling broke sharply lower this past week. Currency movement continues to be driven by financial market deleveraging and the flight to safety, not fundamental economic comparisons or interest rate differentials. Global economic prospects remain too uncertain to rank with confidence the severity of the recessions now being experienced throughout the Group of Seven, but Japan could wind up with the deepest downturn because of the well-bid yen. Paradoxically, Britain also could claim that honor because its manufacturing sector was already depressed and overall British growth was the most reliant on financial services. Britain had built up the largest housing bubble.
The yen is a genuinely strong currency, with a trade-weighted advance of 35% over the past half-year, more than twice the dollar’s comparable climb. No other developed economy has Japan’s stockpile of reserves, second only to China’s, and Japanese financial institutions were re-capitalized in the late 1990’s and early this decade and no longer have an undue buildup of toxic assets. Japanese officials will become increasingly frantic about the potential harm that a strong yen will wreak, but their policy options are limited because yen appreciation reflects global forces. It remains to be seen how the exchange rate will react to unilateral intervention. The tactic might prove a bust but is worth finding out for sure. Japan’s stock market has dropped another 42% in the past six months, which is more than the U.S. and most European markets. The Nikkei closed today just 1.9% above its 2003 low and 80% below its all-time high. That peak occurred slightly more than 19 years ago, and a comparable prolonged downtrend of the DOW would put that U.S. benchmark at 2,330 on February 6, 2019.
One should not mistake the U.S. dollar for a hard currency. It’s present strength stems from a rupture in the global financial system. At 15:30 GMT today, the dollar had gained 7.7% for the week against sterling and was up more than 3.0% against the euro, Swiss franc, and Australian and New Zealand dollars. Although up about 15% trade-weighted over the past six months, the dollar is down roughly by a similar amount from its level of ten years ago. Incoming Treasury Secretary Geithner made sure to say the magic words — a strong dollar is the U.S. interest — but also signaled a more aggressive policy regarding China’s handling of the yuan including the possibility of declaring Beijing a “currency manipulator.” Everyone knows the yuan is managed on a very short leash. Calling a spade a spade in this instance reveals a preference for a weaker, not stronger, dollar in a general sense. But it is very appropriate to raise this issue with Beijing now because the least painful way of promoting a return to global expansion and functional banks involves rotating Chinese growth away from net exports and investment and toward consumption. That’s not going to happen unless the yuan goes much higher. Nonetheless, picking a fight with America’s biggest foreign creditor creates new uncertainty for foreign exchange and global growth.
Sterling appears poised for a full-fledged crisis. After posting successive period lows of $1.9650 last July, $1.8224 in August, $1.7448 in September, $1.5270 in October, and $1.4559 in November, the pound seemed to stabilize with lows of $$1.4385 in December, $1.4430 in the week to January 9th and $1.4472 in the week to January 16th. Today’s low was $1.3502, 8% below last week’s trough. Some spillover of strain has occurred in Gilts, where the 3.69% yield on ten-year issues is 39 basis points higher than a week ago and 67 basis points greater than at the end of 2008. The immediate catalyst has been speculation that British banks will be nationalized, and background worries include worries about massive fiscal and external deficits, the possibility that the Bank of England will engage in increasingly bold quantitative easing (running the printing press overtime in the layman’s vernacular), and fear of soaring foreign debt. Except for the last item on this list, similar issues surround the United States, yet the different behaviors of the pound and dollar has emerged as singular foreign exchange market paradox. The United States has a huge advantage shared by no other economy. As long as the dollar remains the paramount component of reserve asset portfolios, Washington can fund its deficits in its own currency and not be subject to a mounting debt service burden if its currency depreciates.
That uniqueness does not eliminate the possibility that the dollar may in time head lower for reasons similar to sterling’s present downtrend. In fact, some famous sterling crises have in fact preceded similar downdrafts of the dollar. Sterling was devalued in November 1967 to $2.80 from $2.40, and the dollar suffered devaluations in 1971 and 1973, followed by the discarding of fixed parities. After sliding under $2.00 in early March 1976, the pound plunged rapidly to below $1.60 within a half-year and forced Britain to seek a loan from the IMF. The dollar began its own major decline in the middle of 1977 that culminated in a rescue plan in late 1978. The pound again found itself in grave danger at the turn of the year in 1984/5, and the Bank of England had to lift interest rates by several hundred basis points to prevent a psychologically humiliating decline through dollar parity. A turn came on February 26, 1985 at $1.0375, when the dollar also peaked against other major currencies. By end-1987, the U.S. currency had lost about 55% against the mark and yen. Selling pressure forced Britain to abandon the European Exchange Rate Mechanism in September 1992, and it fell 29% from $2.0660 early that month to $1.42 by the following February. The dollar was in and out of trouble in the early 1990’s as well, hitting record lows against the mark and yen in March-April 1995. Reminiscent of early 1985, the focus of sterling is now on whether it will drop below par against the euro. In contrast to then, the Bank of England is reducing interest rates rapidly, and domestic inflation is receding rapidly. I suspect we will see the Euro climb above one pound this year.
The U.S. dollar’s protection via global deleveraging seems secure for now but is unlikely to persist until the end of that process. When sharply higher U.S. base money growth and deficit- and debt-to-GDP ratios become documented facts and not merely prospects, the dollar will become vulnerable. A new administration in Washington will be tempted to expedite a softer trend in the dollar. The two previous Democratic Party administrations, Carter’s in 1977 and Clinton’s in 1993, did exactly that in economic environments that were much more benign than the present one. Meanwhile, commodity-sensitive currencies do not appear to have hit bottom, since the global recession will continue to erode demand. The softness of these currencies will support the trade-weighted dollar, even if other relationships stabilize.
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