Weekly Foreign Exchange Insights: May 8th

May 8, 2009

Uncertainty remains very high over three basic issues that affect currency markets:

  • Whether U.S. money center banks have truly avoided a slew of failures and nationalizations,
  • Whether the most intense part of the global recession is now past and, if so, the type of economic recovery that will develop, and
  • Whether subsiding risk aversion will continue to depress the yen and dollar.

Market chatter suggests that most investors would agree the stress tests on U.S. banks produced better-than-feared findings in part because of assumptions that did not embody worst-case possibilities.  Nevertheless, equity markets and financial shares in particular bought into the view that the Geithner plan might work.  It is noteworthy that banking sector doomsayers who accurately predicted the 2007-8 meltdown, such as NYU Professor Nouriel Roubini, do not believe the government scheme will be adequate, and it is equally noteworthy that investors have initially chosen to give officials the benefit of the doubt.

The upbeat market reaction is being fed by a stream of indications that activity is dropping less rapidly, and this slowdown in the rate of decline is more pronounced than anticipated.  Numerous key data from the PMI readings in Europe and North America to labor market reports from the United States, Canada and Australia were better than feared.  After the worst two consecutive quarters of global growth in over a half century, some moderation was to be expected.  Because of enormous monetary and fiscal stimulus as well as the numerous actions to liquify various financial markets — a much more proactive policy response than in the early 1930’s — a depression has been avoided so far.  But it does not follow that this severe recession will be followed by a typical post-war recovery.  The previous pattern has seen the deepest downturns associated with the strongest recoveries.  But only a minority of analysts expect a classic V-shaped business cycle.  A U-shaped cycle seems more probable.  So does an L-shaped path such as Japan experienced in the 1990’s.  And if the nationalization or failure of the big banks has only been postponed, another bear-leg of the stock market as a whole lies ahead, which would be conducive to a W-shaped, double-dip recession.  In the best of circumstances, economic growth in the United States is unlikely to merge with its post-war trend-line of 3-3.5%.  Potential GDP growth is lower now in most economies, and monetary and fiscal policymakers will be reversing gears more quickly than after previous recessions.

Recoveries will not feel genuine, so relative economic growth will not be a prime determinant of currency movement.  Forthcoming first-quarter GDP data for Euroland at the end of next week will reveal more negative growth than experienced in the United States.  GDP also fell more sharply in Britain, but the U.S. recession was plenty steep too and not construed in a positive way merely because of even worse conditions in Europe.  Since March 4, the euro has advanced 8.8% from $1.2459 to $1.3554, and sterling is over 10% stronger than its low in March of $1.3658.

The dominating metric in currency trading has been the rise and fall of risk aversion.  The second of these stages favors commodity currencies but depresses the yen and dollar.  From first-quarter lows, the Australian and New Zealand dollars have recovered roughly 22% against the U.S. dollar, and the Canadian dollar has recouped about 13%.  The yen has fallen about 16% against the euro and around 12% against the dollar.  The yen interestingly peaked on the first full day of the Obama presidency and thus has performed diametrically differently from the start of the last U.S. Democratic Party presidency of Bill Clinton when it rose 24% within the first seven months of his first term.

Currency movements promoted by receding risk aversion have not offset the changes that came during the buildup and most intense portions of the global recession.  On balance since August 8, 2007, the U.S. dollar has advanced some 34% against sterling, 29% against the New Zealand dollar,14% against the Australian dollar, and 10% against the Canadian dollar.  However, it is just 2.2% higher against the euro on net and has lost over 16% against the yen.  Likewise, the stock market recoveries this spring pale in comparison to the previous erosion of wealth.  Net stock market declines since the start of the crisis in August 2007 amount to 31% in the British Ftse, 35% in the German Dax, 38% in the Dow Jones Industrials, and 45% in the Japanese Nikkei.

Although there have been occasional days when the negative dollar correlation with the stock market seemed to be breaking down, the overall pattern remains. Over the past week, global stock markets did very well, and the dollar recorded broad-based and substantial losses of more than 3.5% against the kiwi and Aussie dollar, 2.6% against the Canadian dollar, 2.1% against the euro and Swiss franc, and 1.4% against sterling.  The greenback even slid 0.5% against the yen, and failed to penetrate the key Y 100 level.

The market’s acceptance of the stress tests looks too unquestioning to last.  Moving deeper into spring, investors will have second thoughts about the safety of the banking system and will show some impatience with the business cycle.  A reverse swing in the pendulum of risk aversion is likely.  Even if something that dramatic in sentiment fails to occur as soon as next week, the dollar will be overdue for a bounce after such widespread and significant losses this past and since early March.  A consolidation in recent equity price advances could be a catalyst.  Another plausible factor to support the dollar might come in the form of a protest from officials.  The Chinese and Europeans have been sensitive to excessive dollar weakness, and increasingly one-way declines in the dollar could aggravate the bear market in Treasuries.  On the other hand, currency markets have not been disorderly, and verbal intervention can produce unintended adverse consequences.  Only Swiss officials have placed high priority on an exchange rate target, and their interest is directed at the franc’s euro cross, not its parity against the dollar.

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


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