Weekly Foreign Exchange Insights: August 14th

August 14, 2009

Midway through August and the third quarter, prospects for all markets seem to hinge on what happens to equities and other asset wealth.  Stock market players today experienced second thoughts about the strong price recovery since early March.  The S&P 500, Nasdaq and Dow had advanced 50%, 59%, and 43%.  Elsewhere, stocks had rebounded 63% in Germany, 49% in Japan, and 35% in Britain.  Hardly anybody is forecasting future growth commensurate with those kind of gains.  To justify them, a case needs to be made that the debacle last autumn and winter was 90% panic and 10% reality, which isn’t true.  Serious imbalances in the world economy had build up and been exposed.  If the economic and market blowouts reflected a negative psychology taken to irrational extremes, economic conditions ought to return to normal historical trends reasonably quickly, and the evidence does not suggest that will be the case.  It’s not the message of officials, nor is it the conclusion of most private-sector pundits.

Because the global recession was triggered by financial-sector problems, real economic weakness was unusually interconnected with stock market trends, and that will continue to be the case.  If the recession seems poised to end sooner than expected several months ago, it is because of the surprising restoration of financial asset wealth, which has buoyed business and consumer confidence.  If wealth takes a new tumble because investors conclude that the market rally was overdone and that a return to pre-2007 trends isn’t likely, market losses will amplify negative force bearing on risk preferences.  Stock markets have been one barometer of the ebb and flow of risk aversion, and currency markets have been another.  Willingness to assume greater risk bolstered the dollar and yen, or from the euro’s point of view EUR/USD and EUR/JPY.  Fresh concerns about the economic outlook should weigh on the dollar and yen.

New information on economic activity this past week was more negative than positive, and it favored Japan more than Europe or the United States.  Japan reported stronger-than-expected machinery orders and service-sector activity, positive monthly export growth, and the best reading on consumer confidence since the final quarter of 2007.  Emerging Asia is where recovery began and will be strongest.  Although Germany, France, Portugal and Greece reported positive second-quarter GDP growth, the sign remained negative in the cases of Spain, Italy, the Netherlands, and Belgium.  Overall euro area growth slid 0.1%, which was better than growth in the United States, but a 0.6% drop in June Euroland industrial production was significantly worse than assumed.  Disappointing U.S. retail sales suggested that the cash-for-clunkers program is creating much less net stimulus than hoped.  The FOMC statement underscored the fragile nature of the coming recovery and failed to withdraw monetary stimulus, while the Bank of England’s quarterly Inflation Report played up risks of below-target inflation in the medium term and implied that markets are pricing in too many eventual rate hikes.  Chinese data, which tend to get released within a single week each month, fell below expectations, and many figures released in Eastern Europe were downright troubling.

The dollar/yen relationship has lately been much more responsive to changes in risk aversion than the euro/dollar pair.  at 14:30 GMT, the dollar showed a 3.0% decline against the yen for the week.  The U.S. currency was up 0.9% against sterling but actually off 0.5% against the euro.  In a revival of risk aversion, one would expect the dollar to firm against the euro.  That such did not happen may reflect the surprising news that GDP fell less last quarter in the euro area than the United States, but such would constitute the first instance in quite some time when relative growth, not risk aversion, was the primary influence on the dollar’s main relationship.

The summer season continues but has just three weeks remaining.  August has so far been uneventful, and that has not always been the case.  For example, the suspension of dollar convertibility to gold happened thirty-eight years ago tomorrow.  The sense is of a currency market looking for a new driver to replace risk aversion, but none has caught on.  Maybe politics will emerge as a new key.  A factor ignored until now has been the declining popularity of President Obama and his administration’s mounting frustrations on several domestic and foreign policy fronts.  Presidencies that failed to pass legislation have been associated with a weak dollar as during the Carter administration, and unexpected political developments are the ones that impact markets the hardest.  The situation is even murkier in Japan, where elections on August 30th are likely to oust the LDP and bring an inexperienced opposition to power with a controversial and potentially reckless agenda.  Germany faces a national election late next month.  Chancellor Merkel’s hold on power would be solidified if opinion polls prove representative.  That didn’t happen in the last election when her support sagged late in the campaign, so it’s best not to presume how this year’s vote will go.

Viewed from a long historic perspective, the dollar is presently weak.  It took 360 yen to buy a dollar until August 1971, and dollar/yen averaged 120 during 1987-2007.  The yen has spent very little of its time in the 80’s or better, but it is marginally stronger than 95/$ at this moment.  The D-mark translation value of the euro is presently 1.3767, just 2.3% below the best level it ever attained before the euro was launched in 1999.  For most of the 1960’s, by comparison, four marks exchanged for a single dollar.  Large holders of dollars like China have been less vocal lately about urging U.S. officials to preserve the dollar’s value.  The LDP has not sold yen in intervention since March 2004, but the new bunch of leaders coming to power might be more predisposed to intervention.  An immediate answer to that is likely to be learned if the yen drifts toward 90 from its recent range in the mid-to-upper 90’s.

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


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