Dollar Outlook Hinges on Risk Preference

January 22, 2010

Twenty years after the self-destruction of communism, democracy faces a crisis of its own, unable to address a multitude of problems.  This paralysis of government makes financial markets prone to episodes of risk aversion that favor the dollar and yen and hurt European and commodity-sensitive currencies. 

The perceived likelihood of a double-dip recession had seemed no greater than 15-20% coming into 2010.  But suddenly investors are more fearful because economic data and the political backdrop have worsened.  Many disappointing statistics have been reported this month.  Among worse-than-forecast U.S. releases, the list includes non-farm payroll employment, retail sales, industrial production, the trade balance, jobless claims, consumer sentiment,  housing starts, and pending home sales.  In the euro area, unemployment rose unexpectedly, purchasing manager indices seem to have crested, retail sales are still weak, and investor sentiment has darkened.  An 11.3% plunge in core machinery orders was the biggest Japanese shocker but far from the only one.  Business and consumer sentiment have staggered in Japan, unemployment rose, and consumer spending continues to look shaky.

World leaders did a very good job of averting a depression in 2009.  However, they are currently being second-guessed by voters and investors on practically every issue.  President Obama and the Democrats had an awful week, leaving their agenda in considerable doubt.  Proposed measures to constrain bank risk-taking have dismayed investors, who view such as blatant populism and a threat to the fragile recovery.  In the current atmosphere, it’s very plausible to imagine Congress watering down the Fed’s authority, as the central bank already has lost the public respect that will be needed to fend off assaults on its independence.  The Japanese and German governments are also in disarray.  British Prime Minister Brown will limp along for several more months as a lame duck.  Investors view economic prospects uneasily and uncertainly, but they do not trust politicians and bureaucrats to make things right and fear that policy changes will do more harm than good.  Among developing economies, those with authoritarian but economically ambitious motives have seen the fastest improvement in standards of living.  Such systems are now out-performing most advanced capitalistic societies, too.

During the worst of the 2008-9 recession, feedback loops between financial markets and the real economy — mutually reinforcing cause-and-effect relationships —  were blamed for amplifying the downturn’s severity.  Feedback loops can be a two-edged sword, as favorable ones subsequently expedited the transition of the U.S. and other economies back to recovery.  The appreciation of equity prices was promoted by a policy-driven explosion of the money stock, and markets rallied far further than the medium-term prospect of sub-trend economic growth with high unemployment ought to have justified.  The exaggerated rebound in asset prices in turn stopped the bleeding of wealth and promoted the revival of business and consumer confidence.

To avoid a second bout of recession, it will be critically important to avoid a bear run in asset prices and associated negative feedback loops.  I’ve mentioned three reasons why that may not be possible:  1) the data will be less upbeat, 2) the climb in asset prices got ahead of itself, and 3) political leaders lack the mandate to act decisively because of withdrawn public support in the process of change.  Massive fiscal deficits and very low short-term interest rates are generating more anxiety than a year ago, and people want less, not more, stimulus.  A fourth threat to investor psychology comes from China, amid signs that officials there are reining in their policy support.  In a country as dynamic as China’s, it is very hard to modify policy without over-steering the economy.  Restraint applied in 2007 and 1H08 resulted in a sharper subsequent slowdown than the government had intended, and the stimulus that was provided in late 2008 and 2009 has led to quicker growth than sought.  On-year GDP growth accelerated from 6.1% in 1Q09 to 10.7% by 4Q09.  Industrial production and retail sales were 18.5% and 17.5% higher in December than a year earlier, and business investment soared 30.5% last year.  Imports and exports posted on-year surges of 55.9% and 17.7% last month, and money and credit trends suggest a rising danger of over-heating.  Chinese officials will not be dissuaded from restraint by the risk to western markets and economies.

China’s last application of restraint included a controlled appreciation of the yuan, and so will the coming tightening cycle.  Most likely, central bank officials will copy the form of that episode.  The intent will not be to satisfy foreign critics of their rigid currency policy but rather to use mild yuan appreciation as a tool to alleviate the growth in hot money inflows and to complement hikes in interest rates.  In 2005-8, the rate of yuan appreciation was at first slow and then accelerated progressively until it was stopped abruptly.  After an initial 2.1% one-shot revaluation against the dollar on July 21, 2005 that severed a decade-long pegged parity, China’s currency firmed against the dollar by 0.9% at an annualized rate over the rest of 2005, then rose by annualized rates of 1.9% in 1H06, 4.6% in 2H06, 5.5% in 1H07, 8.7% in 2H07, 13.5% in 1H08 and 12.5%  in the first half of July 2008.  The operative words here are gradual and progressive.  The policy will be in place for a while before appreciation against the dollar is significant enough to influence other currency pairs in a meaningful way.

Europe’s karma took a turn for the worse this month, but the euro has not fallen out of bed.  Market chatter remains abundant about how Greece’s very high relative deficit and debt levels will be addressed and whether Greece’s membership in the European Monetary Union might become imperiled.  There is concern that contagion difficulties for other members of the common currency bloc could intensify.  The dollar rose 1.6% against the euro this week, more than against sterling or even the Swiss franc, which although persistently stronger than 1.50 per euro since mid-December retains an aura of two-way risk despite breaking through that threshold.  Regarding EUR/USD which ended 2009 at $1.4318, trading remains confined to the 1.40s where this pair has traded almost exclusively since June 2008.  This isn’t the first time in seven-plus months when market psychology swung more sharply than currency prices.  Seven months is a long time for this major currency pair to hold steady.  Maybe this time will see it break to a new range.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.

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One Response to “Dollar Outlook Hinges on Risk Preference”

  1. Jimbo says:

    It seems to me in the long run, as China and India run out of water, the US will be exporting huge amounts of grain and maybe knock off some of that trillion dollars we owe China. Maybe the dollar’s stength will be based on the US’s stability in shakey times and a never-seen-before huge demand for our farm products.