Weekly Foreign Exchange Insights: December 4th

December 4, 2009

An enormous amount of churning went on the currency markets today that may take time to sort out, and the old pattern of good U.S. news depressing the dollar failed to play out.  Given the magnitude of the jobs data surprise, the initial up-leg in U.S. stocks seemed understated, and those gains sure enough were relinquished later.  By day’s end, the yen and euro had moved in opposite ways against the dollar, which is a now-familiar pattern.

It’s premature to declare a new currency market paradigm.  Strange stuff happens on Fridays in the end-of-year holiday season.  Net movement of many dollar pairs switched direction this week from the price action that occurred over the Thanksgiving break.   Compared to November 25 closings just before the break, the dollar is firmer against commodity currencies, the yen, and euro.  So Investors sense newfound resilience in the greenback.  Major supports like 1.50 per euro, Swiss franc parity, and 90 yen were bent but not shattered

The hot theme, however, concerns the yen rather than the dollar or yuan.  Loud protests by Japanese officials, a rare emergency meeting by the BOJ Policy Board, its anti-deflationary but meager offer of three month loans at 0.1%, and the Democratic Party government’s consideration of still more fiscal stimulus are only partly responsible for the yen’s abrupt 6.12% setback from a high of 84.83 per dollar last week to a low of 90.38.  Although Japan posted stronger GDP growth in the third quarter than any other G-7 country, its economy is in deep trouble, having needed macro stimulus too often and too heavily already and yet being repeatedly unable to function normally without the government hand-holding.  The debate twenty years ago revolved around how soon Japan might supplant the United States in economic might, but now analysts are starting to write the economy off as having regressed beyond a point of no return.

Not only is Japanese growth unsustainable without continually new policy support, it also cannot adapt to yen appreciation.  A foretaste of this inability to cope with a strengthening  exchange rate came in 1995 when an upward run from 100/$ to 80/$ in 3-1/2 months sent the economy into a fresh recessionary tailspin.  It wasn’t always that way.  Japan’s currency averaged 286.9 per dollar in the 1970s, 25.5% above its mean level in the 1960s.  It advanced by a sharper 44.2% to 198.9/$ on average in the 1980s and even more steeply (67.4%) to 118.8/$ in the 1990’s.  That era with 1.2% per annum growth is called Japan’s lost decade, but the present nearly completed 10-year period is headed for a sub-1% pace.  Moreover, Japan’s public finances, financial markets, and deflationary tendencies are now more intractably dysfunctional than ever.  Currency markets can be notoriously brutal in dealing economies exactly what is not needed, but eventually exchange rates seem to accommodate fundamental economic realities.  In contrast to the sharp rates of appreciation in the final three decades of the 20th century, the yen on average this decade has been only 6.0% firmer than the woeful dollar with a period average of 112.13/$.

Nonetheless, the yen is now 24% stronger than its average level for this whole decade and 31.7% above its mean value in the 1990’s.  Japan used to absorb appreciation on such as scale quite readily, and the difference between now and then is not associated with competitiveness-eroding inflation.  Quite the contrary, because of Japanese chronic deflation, a certain amount of nominal yen appreciation is required to prevent price competitiveness from drifting higher.  Japan is unlikely to keep up with the other heavyweight economies, its historical rivals and rapidly emerging China.  That’s why Japan’s currency faces a precarious future.  This past week, the U.S. reported much better-than-improved labor statistics.  European purchasing manager surveys produced a similar upbeat story.  Japan’s sub-50 services PMI, in contrast, slumped to 43.3 from 45.0 in October and 48.1 in August, while its manufacturing PMI dropped two points to 53.3.  While most advanced economies are advancing unevenly toward broader expansion, Japan may be careening toward a double-dip recession.  Japanese scheduled data releases in the coming week such as machinery orders, consumer confidence, and the economy watchers index may fuel such fears.

The biggest currency market stories of this past decade were the extensive and broadly based retreat of the dollar and the increasingly overvalued yuan.  I suspect yen weakness will be among the key themes of the next ten years, if not the top one.  It’s very hard to see how Japan’s problems do not keep worsening.  There’s no scope for safe stimulus.  The demographics are even worse than in other G-7 economies, and the country’s politics are going through an uncertain transition.  At 90/$, let alone 112/$, the yen’s price embodies history more than future.  The dollar could encounter further difficulties against the euro and other European economies, and still the yen would be at risk to record a lower average value than in the past decade against the greenback.  If recession returns to Japan, the yen’s bleak future may begin quite soon, and the slide would produce a fall-out for currencies of other governments with especially large deficits like Britain and the United States.  So long as the yuan remains pegged at 6.83 per dollar, a softening yen would also impair the competitiveness of Asian countries whose currencies have climbed sharply against the dollar like the won.

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


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