Weekly Foreign Exchange Insights: April 3rd

April 3, 2009

The past week saw risk aversion recede additionally in global financial markets.  Stock markets and bond yields advanced.  Gold retreated, and oil stayed above $50 on hopes that a world recovery would indeed emerge.  The biggest currency beneficiaries from the blanket of risk aversion that descended last September had been the yen on the unwinding of carry trades and the dollar on flight into Treasury securities.  In last week’s “Insights” column, I called the dollar’s resilience in the face of diminishing risk aversion impressive.  It was too good to last, and sure enough, most dollar pairs lost ground this past week.  As of 15:30 GMT today, depreciation amounted to 3.2% against sterling, 2.1% relative to the Australian dollar, 1.0% against the euro, 0.8% against the Swiss franc, and 0.4% against the Canadian dollar.

Although the G-20 summit failed to produce a dramatic policy shift on the dollar to rank the meeting along with Breton Woods in 1944, the Smithsonian agreement in 1971, the Plaza summit in 1985 or the Louvre Accord in 1987, Chinese officials have revealed important information.  Their economy is awfully over-exposed to a currency with a long-established trend of depreciation, and that fact is influencing their present thinking.  On one level, Beijing officials were trying to shame their U.S. counterparts into paying more than lip service to the responsibility of preserving the dollar’s external and internal long-term value.  It was a reminder that a shift in Chinese behavior could have a profoundly negative effect on America’s reserve asset hegemony and U.S. interest rates, even if the veiled threat could be dismissed as a bluff.  The Chinese would themselves be victimized by such action.  On a separate level, Beijing raised the dialogue of changing the international monetary system to a new level.  If one constructs a T-account of reasons why the dollar might fall against reasons it might rise, assets like a reduced current account deficit, extensive depreciation since 2002, and cyclical support from an earlier and faster U.S. economic recovery must be set against the liabilities of lessening safe-haven capital inflows, massive Fed printing of money, diversification into the euro by China and other fearful offshore holders of U.S. currency, and less powerful U.S. influence on global economic diplomacy.  If conventional wisdom that the U.S. economy will recover sooner and more solidly than Europe proves to be fallacious (see earlier post today on service sector PMI’s), the finely balanced near-term case for dollar depreciation becomes much more compelling.

One major currency against which the dollar rose this past year was the Japanese yen, the risk aversion poster child not long ago.  Japanese growth has been even more negative than growth in North America or Europe.  The will and ability of Japanese policymakers to address its worst recession since the 1930’s is severely hamstrung.  Japan’s breed of democracy has ruptured, and the country needs something more sweeping than a change of government, more along the lines of a new constitution, to tackle immense and building structural economic problems like a debt:GDP ratio that’s near 170%, renewed deflation, and a current account that is no longer a source of strength.  Meanwhile,a parliamentary election that must be held by September continues to paralyze fiscal policy, and Bank of Japan officials are not up to the economic challenges they face.  The Nikkei-225 index fell 35% last fiscal year and remains 77.5% below its end-1989 level despite this past week’s improvement.  It’s easy to get bearish about the yen especially since the present value against the dollar of 100.05 lies 17% above its 20-year moving average.  In the near term, however, there is a catch, and that is the yen’s historic buoyancy during April, the first month of each Japanese fiscal year.  During the eighteen Aprils to 2006, Japan’s currency had recorded a drop against the dollar of 1.0% or more in only three years.  Between end-March and end-April of 2006, for instance, the yen rose by 3.4%.  It may be that this pattern has broken down, since the yen fell 1.4% in April 2007 and by 4.0% in April 2008 against the dollar.  A big yen drop this month would extend the streak to three.

Like Japan, Switzerland is in recession, already has extremely low interest rates, and experienced an unwelcome appreciation of its currency that aggravated the economic downturn during the heyday of risk aversion.  Swiss officials took a more proactive stance against the franc’s upward drift than their Tokyo counterparts.  The Swiss National Bank said enough is enough to franc appreciation, intervened, and threatened to intervene again if the franc strengthens against the euro.  The Swiss-euro cross rate is on the franc-weak side of 1.50, and Swiss officials should be assisted in keeping it that way by the G-20’s war on bank secrecy and tax havens.

Copyright 2009 Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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